Knowing all your retention options

How changes to the Construction Contracts Act could affect your retentions

New rules for protecting retention money came into effect on 31 March. These require developers and head contractors to hold ‘on trust’ any retention money they’ve withheld from their subcontractors.

This obligation, which only applies to commercial contracts, means the head contractor must hold that retention money in the form of cash or other readily convertible liquid assets, making it easier, in theory, for subbies to reclaim this money if the head contractor goes bust.

The problem with this model is that withholding retention money from subbies, but then having to account for it under trust obligations, is an inefficient use of capital in an industry that struggles with both equity and cashflow issues.

A new alternative – payment bonds

On March 30, Parliament passed a further amendment to the Construction Contracts Amendment Act (CCAA) allowing developers and head contractors to obtain an insurance-backed bond to cover the retention money they hold.

So, if the head contractor failed to pay back retentions, the subcontractor could claim them directly from the insurer. This ‘payment bond’ would most likely be capped at a certain level, different for each head contractor, who will be responsible for ensuring the amount of retentions they hold does not exceed this cap (or requesting an increase in their bond limit if it does).

A payment bond benefits subcontractors because they have a guarantee from a third party (the insurer or a bank) that they will get their money.

It also benefits the head contractors, because it means they don’t need to hold the retention money on trust.

They can use it and account for it within their business however they wish, as long as their insurance bond is enough to cover all the outstanding retentions they hold at any given time.

Another option – retention bonds

There is also another option, where the head contractor agrees to accept a bond in lieu of retentions (a retention bond) from the subcontractor instead of withholding retention money from each invoice.

This benefits the subcontractor because no retentions are withheld in the first place, so there is no danger of losing them and they get paid in full. However, a premium would be payable on each bond.

It also benefits the head contractor because they have no ‘on trust’ obligations.

The drawback for them is that they can’t use retentions as a form of revenue to fund their business (although this is not necessarily good business practice in the first place and part of the reason retentions are now being held ‘on trust’ or in a financial instrument). Retentions bonds are readily accepted under most major construction contracts.

The insurer’s view

Bonds are already common in large construction projects, where they protect the principal by guaranteeing that contractors will complete the project.

The basic principle of insurance is to transfer risk from one party to the other, in return for payment of a premium.

This frees up money, such as retentions, that the main contractor would otherwise have had to set aside to cover unforeseen costs.

This money can instead be invested in the contractor’s or subcontractor’s business, meaning that a bond-based model for retentions could lead to improvements in the overall financial health of the industry.

How do I apply?

The process for applying for an insurance-backed bond is simple. The contractor completes an initial assessment, which covers details such as their financial solvency and management structure.

This is effectively the insurer’s underwriting criteria, which they use to make sure they’re taking on ‘good risk’.

Once this is approved, the contractor simply applies for a bond each time they need one, in much the same way as they would for other insurance cover.

Premiums vary depending on the size and scale of the job, defects liability period and the amount of the bond required.

In a nutshell

If you’re a subcontractor who has retentions withheld, for any new contracts from 31 March, your head contractor must hold these retentions on trust, which means they have to account for them in cash or other
readily convertible form.

If proposed amendments come into law, head contractors could insure the retentions they hold instead of holding them on trust.

A subcontractor can provide a retention bond instead of having cash retentions withheld in the first place, so they get paid in full and there’s no risk of losing their retentions.

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Builtin New Zealand is a specialist in insurance and guarantees for builders and tradespeople. For more information visit www.builtin.co.nz, email Ben Rickard at ben@builtin.co.nz or call him on 0800 BUILTIN.