Have you considered if a retention is needed under NEC?

NEC and CLC have produced updated guidance

NEC and CLC have provided guidance on the use and applicability of retentions in response to the growing consensus in the industry that retentions are counterproductive and that they are routinely used without due consideration as to their benefit. This article explains how a retention is intended to work, with particular reference to NEC contracts, so that Clients can consider if this is something they require.

Having a retention is optional

The retention provisions in an NEC contract operate as a Secondary Option clause known as X16. As it is not one of the Core Clauses, Option X16 needs to be actively selected in the Contract Data for it to apply. In an NEC contract, it is therefore possible for the parties to agree that there should be no retention mechanism at all and/or to use alternative mechanisms instead of having a retention.

Due to the economic climate, retentions have become increasingly unpopular with contractors due to the cashflow pressure that results from the large sums of money that are routinely retained, exacerbated by the late and non-payment of retentions. It is also argued that the practice of withholding retentions is inconsistent with procurement “best practice”, which emphasises the importance of collaboration and early supply chain engagement with a view to managing quality and achieving a best value solution for the project.

How does having a retention work under NEC?

If Option X16 applies, the Client is able to retain a proportion of the Price for Work Done to Date. As indicated above, Option X16 needs be selected in the Contract Data if it is to apply. The relevant Contract Data entries should then state the “retention percentage” (i.e. the percentage withheld from each interim payment) and, if appropriate the “retention free amount” (i.e. if the retention is only to apply for sums above a certain threshold amount).

Half of the retention is released to the Contractor at the earlier of Completion or when the Client takes over the whole of the works. The remainder is included in the final amount due to the Contractor in accordance with payment provisions in the NEC contract.

Particular features of NEC

It should be noted that this guidance note applies to NEC contracts and not to construction contracts in general. There are some particular features in NEC that are relevant when considering whether or not a retention should apply, which do not apply to other standard form contracts, including:

1. NEC’s definition of Completion

One of the advantages for the Client in having a retention is that it acts as a financial leverage, incentivising the Contractor to correct defective or incomplete work following Completion.

However, the definition of Completion in NEC already sets a high threshold. To achieve Completion, the Contractor is required to have completed all of the work that the Scope requires to be done by the Completion Date and to have corrected all Defects that would prevent the Client from using the works (or others from doing their work). Provided that the requirements for Completion are clearly specified in the Scope, there should therefore in theory be no Defects at Completion.

The NEC approach contrasts with the concept of “practical completion” under JCT contracts, which is not defined and is typically taken to mean when a project is complete, except for minor defects that can be put right without undue interference or disturbance to an occupier.

By defining Completion in this way, coupled to its proactive approach to contract management, NEC seeks to minimise the extent to which Defects will apply, which arguably addresses one of the reasons for having a retention in the first place.

2. Payment mechanism under NEC

It is also worth noting how the payment structures of NEC are set up to deal with Defects, such that payment is only due for completed work. Under a priced contract (i.e. Options A or B), the Contractor is not due payment for work that contains a Defect and under a target cost or cost reimbursable contract (i.e. Options C, D or E), payment is only made for Defined Cost, which excludes the cost of correcting Defects after Completion and also the cost of correcting any Defects resulting from a failure to comply with one of the constraints specified in the Scope. In a target cost contract, the Contractor also shares the cost of correcting Defects prior to Completion through the operation of the pain/gain share mechanism.

The payment mechanisms in the NEC therefore incorporate a number of inbuilt ways of withholding or recovering money from the Contractor in respect of Defects, which again seeks to mitigate the need for having a retention

3. Ethos of NEC

As indicated above, NEC promotes proactive contract management, so that matters are dealt with as they are arise and not stored up for later in the project. The parties are to work under the spirit of good faith and co-operation and any matters that they think could give to a dispute are to be managed and mitigated by way of an early warning notice.

The NEC and CLC guidance states, “The existence of non-compliant work at the end of an NEC project would imply the contract has not been managed properly, and any refusal to fix it would not accord with the collaborative ethos of the contracts…”

It is argued that having a retention is contrary to the general ethos promoted by NEC as it reflects a level of distrust and uncertainty that the Contractor will carry out its obligations. It also postpones resolving issues until the final payment of the retention to the Contractor. Countering this, it is argued that the real benefit in having a retention is if the Contractor becomes insolvent and/or is subsequently unable or refuses to correct defective work. The initial selection of the Contractor and the relationship between the parties is therefore very much at the heart of the decision as to whether or not retention should apply.

Some alternatives to having a retention

When considering whether or not to use a retention, Clients should also consider the possibility of alternative ways of securing their position:

1. A retention bond

The parties can opt to use a retention bond if Option X16.3 is selected. A bond is procured either as an alternative to using a retention at the outset of a project, or during a project to get the retention released. Although there is an upfront cost involved, there is improved cashflow for the Contractor, as monies are not withheld throughout the job.

In some circumstances it might not be appropriate to have a retention bond. They are often expensive and so the cost incurred in procuring the bond may be disproportionate to the size of the project. It may also be possible that the financial covenant strength of the  proposed bank or insurer providing the bond may not be considered acceptable by the Project Manager.

2. Parent company guarantee

A parent company guarantee (PCG) can be requested from the ultimate holding company of the Contractor through the selection of Option X4. A PCG can provide the Client with security as the parent company guarantees to perform the Contractor’s obligations or pay damages. Unlike a retention bond, there is no cost involved in procuring a PCG.

However, this option depends on the Contractor having a parent company with sufficient assets to support the PCG. It also very much depends on the terms of the PCG itself.

3. Project Bank Account

Project Bank Accounts (PBAs) have been in use via Option Y(UK)1 since 2007 and have been popular with the public sector. This mechanism means that monies that would otherwise form the retention are instead held on trust, according to the rules of a Trust Deed.

Using a PBA requires set up and administration costs, investing in finance systems and training staff, which means that they have not been popular in the private sector as an alternative to having a retention.

4. Performance bond

Option X13 requires the Contractor to provide a performance bond, which protects the Client if the Contractor causes a breach resulting in loss. These can be made “on demand” (subject to the constraints of the current bond market) or upon default (i.e. “conditional”) and can provide protection to the Client against the Contractor’s insolvency, subject to the specific terms of the bond.

The cost of procuring a performance bond on the required terms can be prohibitive. The market has contracted significantly over the past few years and it can be difficult to get a performance bond that continues after Completion. Very often, performance bonds are therefore required in addition to a retention, with a performance bond providing protection against the Contractor’s insolvency during the works and the retention providing security for the remedying of Defects. 

Some closing thoughts

There are certain features particular to NEC contracts that should be considered when evaluating the need for a retention. In accordance with NEC and CLC guidance, parties should not necessarily default to using a retention without first considering its relevance and effectiveness. If a Client automatically insists on having a retention, without considering the wider context or the alternatives available, then this could have an unduly onerous effect on the Contractor’s cashflow (and that of the entire supply chain), which could in turn have a detrimental impact on the project as a whole.

Conversely, the interests of the Client need to be protected at all times. Other forms of security may not be as appropriate or convenient as having a retention and so there are often legitimate reasons for the ongoing popularity of having a retention. The NEC and CLC guidance nevertheless provides a timely reminder of the need to reflect on and consider the availability of alternative options and not to default automatically to the use of retention without thinking about it first.

Written by Gemma Irving and Peter Scurlock.