Is Illinois Ready for Retainage Reform?

Is Illinois Ready for Retainage Reform?

March 26, 2018

Illinois is considering joining the growing ranks of states that restrict retainage withheld on private or public construction projects.  Illinois Senate Bill 3052, invalidating contract clauses calling for retainage in excess of 5% for most privately funded construction projects, was passed by the Senate Judiciary Committee on March 13, 2018.  The bill will become law only if passed by the full Senate and House and signed by the Governor.  The retainage proposal presents an opportunity to examine the practice of retainage in the construction industry.

Retainage is a contractual arrangement by which a percentage of payments made during the course of a job, frequently 5% to 10%, earned by contractors and subcontractors for work completed is withheld for a period of time, usually until after completion of the project.  When the prime contract between a project owner and general contractor provides for retainage, subcontracts on that project will typically include the same percent retainage.  While retainage for a contractor performing work toward the conclusion of a job might be held for only a few months, a contractor working at the beginning of a large project, such as a demolition contractor, might have to wait two years to be paid retainage for work completed at the beginning of a project.   

The opponents of the Illinois measure and similar laws in other states argue that retainage is needed by project owners to ensure contractors and subcontractors finish the project and to preserve funds for potential problems at the end of the job.  Further, they insist that freedom of contract should rule such decisions, letting contracting parties decide for themselves whether and how much retainage is needed on a particular project to best serve the interests of all the participants in the project.  

Proponents of retention reform claim it is needed to protect subcontractors with little economic leverage to insist on fair retainage provisions in their contracts.  The argument goes that it is particularly difficult for small and minority subcontractors who have less access to credit markets and are burdened by the diminished cash flow caused by withholding payment after all parties agree the work is properly performed.  The practice of retainage became common in the mid 1800’s when average contractor profits were 10% or more, but average profits are closer to 2% to 5% in modern times.  Contractors and subcontractors contend that withholding 10% retainage amounts to forcing them to finance the construction project.  In addition, subcontractors and contractors complain that retainage is the first fund used to pay the debts of a bankrupt or financially troubled developer, resulting in contractors, especially lower tier subcontractors, never receiving full payment for their work.

Beginning in the 1980’s, a movement both in the United States and abroad has resulted in many jurisdictions enacting laws and regulations to curb the use of retainage.  A number of states limit the percentage of retainage that may be held on both private and public projects.  Others require owners to pay interest on retained funds or to pay retainage within a specified period of time, and still others have mandated retainage be maintained in a trust account for the benefit of the contractors that earned it.  According to a study published by the Foundation of the American Subcontractor’s Association, Inc., forty seven states restrict the amount or manner of withholding retainage on construction contracts, with the exceptions being West Virginia, South Dakota and Illinois.  All fifty states are strictly limited by Federal law from withholding retainage on projects with funds administered by the Federal Department of Transportation.  A number of foreign countries also regulate retainage practices in their construction industries.  Thus, many jurisdictions have decided, mostly since the 1980’s, that public policy would be better served by restricting unbridled use of retainage.

Economic arguments have been made by some in favor of restricting retainage to lower levels.  One oft-cited retainage study, written in 2004 by Dennis Bausman, a professor in construction science at Clemson University, considered the economic effects of retainage practices and found that most contractors and subcontractors tended to increase their bids for projects holding higher percentages of retainage.  The study reported that competition was diminished by higher retainage because smaller contractors with tighter cash flow were unable to participate in some construction projects with higher retainage.  Interestingly, Bausman noted there was no evidence to link retainage to enhanced performance and the majority of contractors were not more likely to finish their work when retainage was used.  The Federal Department of Transportation regulations restricting retainage state “…Retainage should not be used as a substitute for good contract management, …”  Prudent project management calls for withholding payment only when there are questions or concerns about performance or a contractor’s ability to complete the work.  Bausman echoes this sentiment in pointing to the inefficiency of withholding retainage from all contractors and subcontractors, regardless of their performance history or where they fall on the project timeline.  

Hopefully, as the Illinois retainage reform bill winds its way through the legislative process, the above factors, as well as others, will be considered in fashioning an appropriate law to encourage parties to use retainage in a responsible, non-abusive and efficient way for the good of the construction industry.

Contact Jim Rohlfing for assistance on this issue in Illinois, or any other member in the Firm’s Construction Practice Group for assistance with retainage laws in your state.