Escrow Accounts & Retention Bonds

19 February, 2009
by: Cripps

This article explores two methods that can be used by contractors to enhance their financial security and improve cashflow during these increasingly difficult times.  The first part of this article looks at the use of escrow accounts to ring-fence an employer’s funds and provide security over interim payments.  The second part explores the use of retention bonds in enhancing cashflow during a project.

 

Escrow Accounts

Escrow accounts can enhance financial security where there are doubts over an employer’s ability to meet payments due to a contractor.  An escrow account ring-fences an element of an employer’s money in a place where the contractor can see and use the money as security for interim payments. 

Typically, the way the account works is that the employer will be obliged to deposit an agreed sum (usually the equivalent of 2 or 3 months’ projected interim payments) in an independent deposit account held by a third party (normally a solicitor’s client account), who holds the money in an interest-bearing account as stakeholder for both parties.

That third party will be instructed (by way of a tripartite escrow agreement) to hold the money in the escrow account until whichever is the earlier of (i) payment to the contractor of all sums due to it under the final account for the work (or, if there is a dispute as to the final account, payment to the contractor of all sums properly due and payable to it following the determination of that dispute) or (ii) in the event of an earlier termination of the building contract, payment to the contractor of the sums due to it under the building contract up to that point.

In the event of non-payment of an interim certificate by the employer, the contractor may then require the third party to release the unpaid amount from the escrow account in payment of the money owed to the contractor.  If such a release from the escrow account is made, then the employer will be under an obligation to pay that amount back into the escrow account within a set number of days (say, 5 working days).  A failure to do so will entitle the contractor to suspend or terminate its employment under the building contract.

When all the money that is owed to the contractor has been paid, the third party is under a duty to pay the escrow money back to the employer, together with any accrued interest.

For ultimate security, the payment mechanism under the building contract can be linked to an escrow account, so the interim payments from the employer are automatically made from the escrow account by each final date for payment, with the employer under a duty to top up the escrow account within a certain number of days.

Using an escrow account can be of great benefit to contractors worried about an employer’s financial standing.  The mechanism ensures that the contractor’s interim applications are paid promptly, serves to provide an early-warning system to the contractor that the employer may be struggling financially and maintains the contractor’s remedy either to suspend or terminate its services under the building contract.

 

Retention Bonds

 

Retention bonds are a method used by contractors to increase cashflow.

In most standard forms of building contract, including the JCT, there is provision for a deduction of retention (usually 3%) during the course of a project.  This retention fund is intended to provide the employer with some protection against failure by the contractor to remedy defects in the works carried out.  It is usual for one half of the retention to be released on practical completion of the works, with the second half following the making good of any defects (normally 1 year after practical completion).

However, this retention fund can represent a significant part of the contractor’s profit on a particular project, and the failure to release the retention fund at the appropriate time (for example, through insolvency) can have a significant effect on the profitability and solvency of contractors. 

Contractors should consider requiring a retention bond as an alternative to this retention system.  The option of a retention bond is also contained in JCT contracts, as is a form of retention bond.  Before work starts the contractor provides the bond incorporating the maximum aggregate sum and the expiry date.  Instead of a retention fund, the employer pays all sums due to the contractor, but the contractor will in return give a retention bond to the employer as security against defects.  The employer will need to approve the surety who is providing the bond.  The value of the bond reduces by 50% at practical completion.  The bond expires on the issue of the Certificate of Making Good Defects at the end of the defects liability period.  If the contractor fails to rectify defects, then the employer can claim its losses back from the surety who has provided the bond.

This has the obvious advantage of all cash being paid to the contractor at an earlier date, but the contractor should be careful to consider the increased administrative burden and additional cost of providing a bond.  However, in an environment where “cash is king”, the value of using a retention bond is well worth considering.

 

Conclusions

 

There are a number of ways in which contractors can stimulate cashflow and enhance their financial security in these difficult times.  Two of these methods are the use of escrow accounts and retention bonds.  Escrow accounts are useful in providing a ring fenced fund to provide security for payments due to the contractor throughout a project.  Retention bonds are an inventive way of increasing cashflow, whilst also providing the security an employer will expect in relation to defects following practical completion.

Reviewed in 2015