One of the myths in today's construction industry is that retainage is exclusively the tool of the owner. Retainage is a contractually created security system designed to protect the owner by allowing it to withhold an agreed portion of earned progress payments until satisfactory completion of the job.
However, retainage is much more. It is also a special fund—trust, escrow or otherwise—for the benefit of the contractors and subcontractors and their sureties who perform the work.
Historically, courts have recognized that sureties have a preferred status when it comes to fighting at the end of the job for entitlement to those last dollars. Through the process of subrogation, a surety who completes a job under a performance bond after a general contractor defaults stands in the shoes of the owner and the general contractor in asserting a claim to retainage. Likewise, a surety who satisfies its obligations under a payment bond by paying the unpaid subcontractors of the general contractor is similarly subrogated to the rights of the subcontractor and the general contractor to the remaining retainage funds.
In some cases, the surety's rights go beyond claiming entitlement to remaining retainage. Sureties may be able to recover from owners who prematurely release retainage to the general contractor. For example, in one case the owner, the federal government, was liable to a surety when the owner failed to withhold retainage. In this case, the government entered into a contract calling for 10 percent retainage. The contract also required the contractor to provide a "project arrow diagram." The contract gave the government discretion to release retainage after the government approved the schedule and was satisfied with the contractor's progress.
However, the government's contracting officer waived the requirement of an arrow diagram and accepted a "progress curve." Having approved the contractor's schedule, the government released all retainage to the contractor. When the contractor defaulted, its surety was required to complete its work.
The surety successfully maintained that the government was obligated to withhold retainage for its benefit. The court found that the early release of retainage was a material change to the construction contract to the detriment and prejudice of the surety. In the court's view, the contractual retainage requirement contributed to the surety's assessment of the risk and the surety was entitled to rely upon the government's obligation to retain it. [National Surety Corp. vs. United States, 118 Fed. 3d 1542 (Fed. Circuit 1997)]
In a New York case, the owner was liable to a contractor for failing to withhold retainage. In this case, the court ruled that a contractor was a beneficiary of a contract between a city and a turnkey developer allowing the municipality to retain 5 percent of each progress payment. The court found that the city had not only a right, but also a duty, to withhold retainage.
When the contractor who built the garage was not paid by the developer, it brought suit against the city alleging that the city breached its contract with the developer by failing to withhold retainage, and that the contractor, as a third-party beneficiary was entitled to recover the amount of missing retainage. Even though the contractor was not a party to the contract between the city and the developer, the court ruled that the city was liable to the contractor because the retainage account was intended for the benefit of the contractor. [Murname Associates vs. Harrison Garage Parking Corp. 659 N.Y.S. 2d 665 (N.Y. App. Div. 1997)]
No one should assume that retainage is a security account withheld exclusively for the owner's benefit. Courts have recognized for more than 100 years that contractors and sureties have a peculiarly equitable claim to the fund to satisfy claims they have for the physical completion of building contracts. Contractors, and particularly subcontractors, would of course prefer to operate like other industries where there is no retainage.
However, as long as it continues, contractors, subcontractors and sureties need to view retainage as an asset that is temporarily being held in trust for them by the owner.
As a means of attracting a greater number of quality subcontractors, Merck & Co. Inc., one of the world's largest pharmaceutical companies, changed its company policy on retainage at two of its research and manufacturing sites in New Jersey and Pennsylvania.
The new policy drops the starting level of retainage to 7 percent and, based on performance, offers subcontractors the opportunity for incremental reductions down to 2 percent. All new contracts allow 7 percent retainage until 50 percent complete, and if performance and quality of work are satisfactory, Merck will reduce retainage to 3 percent until completion. At substantial completion, retainage will again be reduced to 2 percent until completion and acceptance of work.