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August 17, 2022 Feature

Retainage and the Potential Defense to the Surety for Early Release of Retainage

By Drew J. Gentsch
A basic understanding of the role of retainage may protect the parties to a construction project from costly consequences.

A basic understanding of the role of retainage may protect the parties to a construction project from costly consequences.

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Retainage on a construction project can be governed by arcane rules and the common law and is dependent upon the jurisdiction of the project. A failure to properly understand payment of retainage can be detrimental to a claim under the surety bond should the owner of the project be seen as having released the surety’s collateral early, whereas a basic understanding of the role of retainage may protect the parties to a construction project from harsh and costly consequences arising from the early payment of retainage.

Surety bonds on construction projects generally, as pertinent to this article, stand for the payment of subcontractors and suppliers. If a general contractor fails to timely make payment to a subcontractor or supplier, and a claim is properly filed, the surety is called upon to investigate and, if appropriate, make the missing payment to the subcontractor or supplier.

Retainage is an accumulating pot of money that is withheld from payments to the general contractor, based upon its pay applications on the project. The money is withheld from each payment to protect lower-tier subcontractors and material suppliers from a failure of payment by the general contractor, among other reasons not pertinent to this article. Generally, retainage is withheld from payments to the general contractor based upon a statutory guideline or by contract. A typical rate for retainage can be in the range of five percent of each pay application but may be otherwise stated based upon the jurisdiction of the project, as well as if it is a public or private project. A surety relies on the proper treatment of retainage to protect the surety from having to make payments under its bond. The retainage acts as the surety’s collateral for the proper stream of payments on a project.

The process for the final completion of a construction project is the issuance of the punch list items to be completed following substantial completion of the project. Once the general contractor completes the punch list items, a final payment application is issued to the owner of the project by the general contractor. As part of the final payment application, the general contractor provides lien waivers from each of its subcontractors and suppliers to demonstrate its entitlement to the retainage. Once the owner declares final completion and acceptance of the project, jurisdictions vary on the length of time that must pass after the owner issues final completion, before the final payment of retainage may be released to the general contractor. It is during this period between final completion and the release of the retainage that claims are generally allowed to be filed with the court to determine liability on the retainage as well as the surety bond.

The key to understanding the proper timing and sequence of claims and payment of retainage lies in the contracts and the law of the jurisdiction. The first step is to understand if the project is governed by public or private law.

Generally, if the project is to be paid for with money from the public purse (government), then it is considered a public improvement. There are generally more statutes and rules that govern retainage on public improvements. Public improvements paid with United States funds are federal projects, in which case they are governed by the Miller Act. If the project is paid for with state funds, then it is governed by the particular state’s public improvement statutes, known as Little Miller Acts. Each jurisdiction has its own statutes, rules, and case law to deal with issues surrounding retainage, so understanding the jurisdiction of the contract will direct the legal basis for the analysis.

On the other hand, a project can be paid for with private funds, in which case there may be separate statutes in the given jurisdiction or common law to address how retainage, if any, is to be handled.

Difficulties may arise in ascertaining the jurisdiction and law of a project where it appears to be a private construction project, but the project receives substantial funding from state or federal programs or tax incentives. However, this hybrid scenario is beyond the scope of this article.

Should a subcontractor or supplier not be timely paid by the general contractor on a project, a claim is to be timely filed with the owner of the project, and often copies of the claim are provided to the surety. Later, based upon the jurisdiction, the claimant is required to timely file a case based upon its claim to protect its right to payment.

Generally, so long as a claim remains outstanding at the time of final acceptance and completion, the owner of the project is to keep at least the amount of the claim, and sometimes more, to protect the claimant from the costs and fees of proceeding with a lawsuit. This fund held from the retainage is maintained until the claimant either timely files and proves its case against the general contractor or the claimant fails to timely file its claim in court.

Problems may arise with retainage when the owner of the project receives a claim from a subcontractor on a project that is not being paid by the general contractor but nevertheless releases the retainage, a prepayment. Because jurisdictions vary in how to treat such prepayments, knowing the jurisdiction’s statutes and rules on point is key to properly protecting the parties to the contract and payment bond.

For instance, in some jurisdictions, the courts have interpreted a prepayment of retainage as not releasing the surety from its bonded obligation. In these jurisdictions, the surety may still be bound to make payment to the unpaid subcontractor and then be forced to seek its contribution or indemnity from the owner of the project, the general contractor, or other indemnitors.

However, in some jurisdictions, the prepayment of retainage is seen as the release of the surety’s collateral. In such cases, the surety may receive a pro tanto discharge for each dollar prepaid out of retainage. As a result, if the retainage was sufficient to pay the claim, the surety may be totally released from its bonded obligation. However, the owner that issued the prepayment to the general contractor, may be on the hook to pay the unpaid subcontractor for its proven claim. In other words, the owner of the project may end up paying the same costs twice, once to the general contractor and a second time to the successful subcontractor. The owner may have to then seek contribution or indemnity as appropriate.

The best protection for all parties to a bonded contract is to not allow the early release of retainage on a bonded project. If such a release does occur, then the parties will need to understand the jurisdiction to best protect themselves from the potentially harsh and costly consequences.

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By Drew J. Gentsch

Drew J. Gentsch is a member with the firm Whitfield & Eddy, PLC in Des Moines, Iowa. He is also a Co-Chair of the ABA TIPS Fidelity Surety Law Committee’s (FSLC) Law Division. He is a long-time contributor to the FSLC’s publications and presenter at its seminars.