Retentions – bond or trust?

Retentions are often a source of headaches for those working in the construction industry – but did you know that there’s an alternative to help alleviate the associated stress?

Most subcontractors who’ve had to agree to have retentions withheld from their invoices will have experienced the trepidation that comes with worrying if they’ll ever see that money again.

Many find recovering it once their defects liability period has ended a long and painful process, even from a main contractor that’s still trading, let alone one that’s gone bust.

Fortunately, from 1 April 2017 retention money withheld by a principal or contractor must be held ‘on trust’ until being released to the subcontractor. See the MBIE article on page 8 for more details.

The retention trust regime will only apply to commercial construction contracts (not to residential contracts with the home owner) where the retention money is above a specified amount, yet to be determined by regulation.

Held on trust means the money has to be properly accounted for and can’t simply form part of a ‘slush fund’, or be used as working capital to cashflow the main contractor’s operation. Subcontractors will be able to demand evidence that their retentions are being held on trust.

However, these changes – passed into law in 2015 as part of the Construction Contracts Amendments Act – will not require retention money to be held in separate, secured bank accounts.

This means there is still a risk that a principal or main contractor could wrongly use the money and that if they get into trouble, their subcontractors could still lose out.

However, it does mean that rather than being at the back, subcontractors will be at the head of the queue to get their retention money back through the liquidation process.

Making retentions easier for main contractors

Because of these new requirements, principals and main contractors will need to develop contract agreements, payment terms, accounting policies and reporting systems that comply with their own trust obligations.

Should retention funds be kept in separate trust accounts for each job, or in one consolidated retentions account, or neither, and simply be accounted for separately in the books?

MBIE warns that breaching these obligations, which may implicate directors personally, could result in substantial penalties, including criminal prosecution.

In this new environment, one alternative that provides the same security as cash retentions, but is much easier to administrate (and comes without the consequent trust obligations), is a bond in lieu of retentions or retention bond.

A bond in lieu of retentions

Rather than withholding the subcontractors’ retentions from each invoice and having to hold it before repaying it at the end of the defects liability period, a principal or main contractor can simply demand a retention bond.

The subcontractor arranges the bond with an insurance company and presents it to their main contractor. The bond covers the amount of their retentions and expires at the end of the defects liability period.

A retention bond provides the same assurance to the main contractor that, should any problem arise after the work is finished, the subcontractor will come back to fix it.

If they refuse or can’t do so, the main contractor simply calls on the bond and the insurer pays out first, then seeks recovery of their money from the subcontractor.

They are called ‘on demand’ bonds, because there is an obligation on the insurer to pay first and assess the claim later, to ensure the process is swift and the bondee (the main contractor) can get on with fixing the defects.

The subcontractor doesn’t get off the hook, because they’ve paid a premium for the bond and, if they’re still around, the insurer who backed it will want to recoup their money.

Benefits for principals and main contractors

Firstly, bonds provide the same security as withholding retentions. In the event that the subcontractor fails to rectify defects, the bond can be used to pay another contractor to fix them.

Secondly, because they’re not holding any funds on trust, there are no trust obligations or trustee liabilities on the company directors or compliance requirements under the Construction Contracts Act.

Finally, a bond in lieu of retentions is easy to specify in contracts and they expire when the defects liability period ends (or on whatever date is agreed in the contract), so there is no administrative burden or paperwork involved in returning them.

Benefits for subcontractors

Firstly, providing a bond in lieu of retentions means that the subcontractor’s cash flow position is immediately improved, as every invoice is paid in full with no retention money withheld.

Secondly, they don’t have to wait for three, six or 12 months after the project ends to get their final payment (return of their retentions) and book the profit on the job.

Finally, they don’t have the risk that their main contractor goes into liquidation before returning their retention money.

Even under the new CCA rules, there is still a risk that retention money could be lost if it hasn’t been accounted for properly or there isn’t enough to go around.

How to arrange a bond

Once the two parties have agreed that a bond in lieu of retentions is the preferred method of guaranteeing defect resolution, the subcontractor applies for the bond.

After a one-time assessment of the company’s management structure and financial position, each subsequent bond application resembles a normal insurance application.

It requests details of the project, the two parties and the amount being bonded. There is a premium to pay and then the bond is issued to both parties.

If you’re interested in replacing your cash retentions obligations with an insurance-backed bond, contact your broker or Builtin for more information.

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Builtin Insurance is a specialist in insurance and guarantees for builders and trade professionals.
For more information visit www.builtin.co.nz or contact Ben Rickard at ben@builtin.co.nz or 0800 BUILTIN.