Safeguarding construction finances: the future of cash retentions

Written by David Christie and Charles Mak, Robert Gordon University

David Christie and Charles Mak explore how you can safeguard construction finances following the recent collapse of ISG.

Introduction

The recent collapse of ISG, one of the UK's largest construction firms, into insolvency in September 2024 has once again highlighted the issue of construction industry cash flow. In response to the immediate loss of over 2000 jobs at ISG, the Construction Leadership Council has already begun collating guidance for those impacted by ISG's administration, emphasising the urgent need for industry-wide solutions to protect cash flows and prevent further financial distress.

Most of the UK legal regime which supports this is considered robust, and the model used has been adopted internationally, most recently in Canada as well as Australia, Ireland, New Zealand and Malaysia to name a few.

There is one area where Australia and New Zealand have introduced reforms and in which the UK has yet to catch up, however, and that is in the area of cash retentions.

Cash retentions are a common feature in construction contracts, where a portion of the payment is withheld by the client (also called the employer) to ensure the contractor fulfils their obligations. Previously, insolvency of major firms, like Carillion in the UK, has highlighted the vulnerability of contractors when these retained funds are not securely protected, leading to calls for reform. The funds retained are often substantial, impacting the contractor's cash flow and potentially hindering operational activities or further investments.

Those efforts have stalled with at least two private members Bills in the UK Parliament running out of parliamentary time, and the report of a Short Life Working Group for the Scottish Government (of which one of the authors of this piece was a member) awaiting further action. The Scottish Government would like to reduce and in time remove the use of retentions altogether – recently introducing new guidance to that effect.

Although, it is likely that cash retentions will remain a feature of the vehicle for some time to come. The key is to consider how reform can be achieved.

The issue with cash retentions 

The main attraction of cash retentions is that they are somewhat “cheap and (in their own context) cheerful” as remedies go. They do not require significant administration nor contain the need to involve third parties. Put simply, the designated money is held by the employer and its retention of itself creates a form of performance incentive for the contractor and a degree of security for the employer. If the works are successfully completed then the contractor gets the money, or if there are defects, the employer has a ready pot of cash to tap into.

The alternatives to retentions which have been explored tend to require some form of bureaucracy and attendant cost.

However, this practice of retentions ties up capital that could be otherwise utilised by contractors, which is especially critical in an industry where liquidity is paramount. Moreover, if the employer becomes insolvent, contractors face the risk of losing these retained funds entirely, as seen in the Carillion case. This issue is exacerbated by the lack of clear legal frameworks and the infrequent judicial consideration of retention disputes, leading to uncertainty in how these situations should be handled.

The Role of Trusts

Trusts seem to be the “consensus” alternative safeguard for retentions. They provide a level of security, as the retained funds are kept separate from the employer's general assets. This approach, while offering protection, does not solve the problem of funds being inaccessible for immediate use.

Various jurisdictions have explored alternative mechanisms to address the issues posed by cash retentions. In Australia and New Zealand, trust structures for holding retention funds have been adopted as a measure to safeguard these monies in the event of payer insolvency. These trust structures typically require retention funds to be held in separate bank accounts, explicitly designated as trust accounts for the benefit of contractors or subcontractors. This arrangement not only protects the funds from being used as working capital by the employer but also ensures that in the event of insolvency, the retained money is not considered part of the employer's assets, thereby safeguarding the contractors' rightful payments.

The Hip Hing Case: A Case Study in Hong Kong

The recent case of Hip Hing Construction Co Ltd v Hong Kong Airlines Ltd exposes one of the main issues with the use of trusts. In this case, Hong Kong Airlines had not actually done what they were supposed to do and had actually separated the retention funds into a specific account. The Hong Kong Court of First Instance's decision hinged on the principle of certainty in identifying trust assets, a fundamental requirement for a valid trust. As a result, the court's conclusion was that the trust was not effectively established.

This highlights a persistent problem with the use of trusts and indeed other safeguard mechanisms which is that they need the parties “to do the admin” by setting up the bank account, or in the case of other safeguard mechanisms get the necessary agreements in place. Compelling parties to do this can be difficult as it will impact on the parties’ relationship and burn “relationship capital” over what can seem like technicalities at the time of the request .

This issue is exacerbated in the Scottish context as the Trusts and Succession (Scotland) Act 2024, emphasises the need for transparency and clear delineation of trust assets. This approach contrasts with the English focus on the identification of the trust property. The practical challenges, such as the frequent need to reconstitute the retention "trust" due to the provisional nature of construction payments, further complicate the use of trusts in this context.

Potential Solutions and Future Directions

One potential solution might be to amend the Housing Grants, Construction and Regeneration Act 1996 to explicitly include provisions for cash retentions and trust arrangements. Parties could also consider using adjudication to compel the performance of the more collateral obligations.

This would be far from perfect but might provide a clearer legal framework and compel compliance with retention and trust requirements.

Looking to the future, leveraging modern technology, such as smart contracts and blockchain, to automate the retention process could potentially revolutionise how retentions are managed in the construction industry. These technologies could facilitate the automatic segregation and communication of retention funds, reducing the risk of administrative oversight and ensuring that funds are appropriately protected. This was something considered by the Scottish Government Short Life Working Group and it would be well worth developing this solution further. Smart contracts, in particular, have the potential to revolutionise the management of cash retentions in the construction industry. Unlike traditional contracts, smart contracts are self-executing agreements with the terms directly written into code. When applied to cash retentions, a smart contract could automatically hold and release funds based on predefined conditions, such as project milestones or quality assessments. This automation could significantly reduce the administrative burden and potential for disputes associated with traditional retention practices. Moreover, the use of blockchain technology could provide an immutable and transparent record of all transactions, enhancing trust and accountability in the retention process. While the distinction between 'smart contracts' and 'smart legal contracts' is still being debated in legal circles, the potential for these technologies to reform cash retention practices in construction is clear and warrants further exploration and development.

Written by David Christie and Charles Mak, Robert Gordon University. We would like to express our gratitude to Carole Lyons for her insightful comments, which have greatly contributed to the development of this piece.