Erica Dickson: The proposed ban on construction retentions

Erica Dickson

As detailed in our previous articles, the direction of travel on the Commercial Payments Bill is becoming clearer. The Bill has completed committee stage in the House of Lords, with further parliamentary scrutiny still to come. Subject to that process, the proposed ban on construction retentions would represent one of the most significant changes to payment practices in the sector for decades.

There is widespread support for tackling poor payment practices and improving cash flow. However, removing retentions also raises an important practical question for employers and main contractors: how will they protect themselves against defective work when retention is no longer available?

That question is likely to become increasingly important as the industry prepares for a potentially retention-free environment.

Why change is being proposed

Cash retentions are a familiar feature of UK construction contracts and have been standard practice for decades. Typically, an employer or main contractor will hold back, or “retain”, a percentage of the contract sum, often 3% to 5%, until practical completion and then until the end of the defects liability period. This provides a sum that can be used to fund remedial work if defects emerge.

Retention has historically been viewed as a practical way of managing performance risk. It is relatively simple to administer, involves only the parties to the contract and is generally less expensive than alternatives such as bonds or insurance.

Supporters argue that retentions provide useful financial leverage and encourage contractors to complete work to the required standard first time. Critics question how effective they are in practice and point to longstanding problems around the release of retained sums.

Addressing those payment practices is a central purpose of the Bill. Late or non-payment of retention sums can create significant cash flow pressures, particularly for smaller businesses. Evidence considered by Parliament suggests that 44% of SME invoices are paid late, while late payments are estimated to cost the UK economy £11 billion each year.

The construction sector has been identified as one of the areas where the problem is particularly acute.

What could replace retentions?

The debate surrounding retentions demonstrates a tension between two legitimate objectives. On the one hand is the desire to improve cashflow and eliminate poor payment practices. On the other is the need to provide employers and main contractors with assurance that defective work will be remedied. The challenge facing policymakers is how to balance these two competing interests.

The UK Government’s position is that retentions are not an effective means of preventing defects or addressing significant problems once they arise. The proposed ban is therefore intended to stop money being routinely withheld from contractors, sometimes for longer than necessary and, in some cases, never recovered.

For businesses operating on tight margins, withholding 3% to 5% of a contract sum can have a material impact on cash flow and financial resilience. Removing retentions, however, does not remove the underlying performance risk.

Employers and main contractors are still likely to want protection if work is defective or a contractor fails to meet its obligations. If retention is no longer available, greater use could be made of alternatives such as performance bonds, parent company guarantees and insurance.

Those alternatives can be more expensive or harder to obtain than retention. Contractors could therefore benefit from improved cash flow while simultaneously facing higher tendering, insurance or compliance costs which creates a particular concern for SMEs. If alternative forms of security become a routine requirement for larger projects, smaller contractors may find it harder or more expensive to compete.

The Bill currently provides for a two-year transition period before the prohibition on retention clauses fully takes effect. That gives the industry time to adapt, but businesses should start considering now what alternative approaches to performance security may be required.

Where could disputes arise?

A ban on retentions would also change how construction contracts are drafted and administered.

One area likely to attract particular attention is the Bill’s anti-avoidance provisions. As contracting practices evolve, questions may arise over whether particular payment mechanisms are legitimate contractual protections or replicate the commercial effect of retention in a way that falls within the prohibition. This distinction could become an important source of disputes as the legislation is tested in practice.

Greater use of alternative forms of security could generate other issues. Disputes may arise over the operation of performance bonds, calls under parent company guarantees and the scope of cover provided by defects insurance policies.

These disputes are already familiar to the construction sector. However, if use of these mechanisms increases after retentions are banned, disputes concerning their interpretation and operation may become more common too.

What should businesses do now?

The proposed ban signals a substantial change in the way construction businesses manage payment and performance risk. Employers, contractors and other businesses in the supply chain should consider reviewing their standard terms and conditions, bond requirements, parent company arrangements and insurance options ahead of the new regime.

For contractors and SMEs, the potential cash flow benefit is significant. The reforms are designed to prevent payment for completed work being unnecessarily withheld and to reduce exposure where money is lost through late payment or insolvency further up the supply chain.

For employers and main contractors, the challenge will be finding alternative forms of protection that are effective without creating disproportionate cost or complexity.

The success of the reforms may therefore depend as much on what replaces retention as on its abolition. If alternative protections are affordable, accessible and proportionate, the Bill could deliver meaningful improvements in payment practices. If they create substantial additional costs or barriers to tendering, the industry risks replacing one pressure with another.

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