Construction Retentions Explained: Government Proposals And What They Mean For Your Business

We recently reported on the UK Government's landmark late payment reform consultation, which outlined eight proposed new legislative measures set out in the consultation paper aimed at tackling poor payment practices in the UK economy.

In this follow-up article, we take a closer look at the proposals relating to retention payments. We explain what retentions are, why they remain contentious in the construction sector, and we explore the Government's current proposals to reform how retentions are managed.

What are retention payments and why are they under scrutiny in UK construction contracts?

Retentions – where the employer withholds a percentage of the contract value (typically 2–5%) as security to ensure the contractor rectifies any defects, complies with its contractual obligations and as protection against insolvency – have historically been common practice in construction contracts. The withheld amount, known as the retention, is typically released in two stages: a portion being released upon completion of the works and the remainder after the defects liability period has passed.

Retentions are governed by the terms of the applicable contract. Standard form construction contracts such asJCTandNECinclude specific provisions governing retention payments. MostJCTforms allow for a 3% retention, with half released at practical completion and the balance after the certificate or notice of making good defects is issued.NECcontracts, on the other hand, make retention payments optional, e.g. via Option X16 of the Engineering and Construction Contract (ECC).

However, retention payments often lead to disputes due to:

• Delayed, partial, or non-payment of retention sums;
• Loss of funds due to upstream insolvency;
• Lack of transparency and ring-fencing, allowing funds to be used as working capital; and
• Their disproportionate impact on small and medium-sized enterprises (SMEs) and subcontractors lower down the supply chain.

It has been estimated that around £4.5 billion is tied up in retentions annually, with 44% of contractors having lost retention payments due to insolvency. The current proposals – which we outline below – follow calls from certain industry bodies, such as Build UK and the Construction Leadership Council, to remove retentions from the supply chain by 2025.

What are the UK Government's two proposed legal solutions?

The consultation sets out the following two proposals for retentions, both of which involve amending Part 2 of the Housing Grants, Construction and Regeneration Act 1996 (Construction Act) to either:

1. prohibit the use of retentions outright – which the Government has signalled is its preferred option, citing the entrenched nature of poor payment practices and the need for structural change; or
2. introduce requirements to protect retention funds deducted and withheld from insolvency and late or non-payment.

If enacted, this would arguably be one of the most transformative changes for the construction industry in respect of payment.

The consultation observes that while the Construction Act "created a specific payment and dispute resolution framework for the construction sector, intended to ensure fair and prompt payment through the supply chain, and the right to dispute resolution via adjudication", it does not address any of the "problems associated with retentions, including the protection of these during insolvency, or from delayed, partial or non-payment".

We take a closer look below at the proposed options and what each would mean for construction parties.

Option 1. Prohibiting retention clauses in construction contracts

This option would amend the Construction Act to make it unlawful for payers to deduct and withhold retention sums. Payers could still seek alternative forms of surety, such as performance bonds or insurance, but these would not be mandated.

The change would apply only to construction contracts (as defined in the Construction Act) after a prescribed date, which would be subject to a transitional period for parties to adjust to the new requirements. What this transitional period would look like is currently unknown and the consultation paper does not give anything away.

Option 2. Mandatory protection of retention payments

Alternatively, the Government proposes allowing the use of retention clauses but requiring that withheld sums be protected through:

• segregating retained sums in a separate bank account; and/or
• protecting the sums through an instrument of guarantee (insurance / surety bond).

This approach aligns with theJCT's stance on retention payments: the payer's interest in retention being fiduciary as trustee for the payee (without the obligation to invest) and where the payee requests, the payer will place the cash retention in a separate bank account (the payer being entitled to any interest accrued).

The consultation envisages that this measure would:

• be applicable only to the use of retention in construction contracts (as defined in the Construction Act);
• where the construction contract makes no such provision for the required protection measure, the Scheme for Construction Contracts would imply relevant terms;
• require a single retention sum to be deducted and withheld from the final payment until the expiry of the defect liability period;
• automatically segregate monies which would be held for the payee's benefit;
• the market will deliver provision of any bank account or instrument of guarantee;
• the retention will be automatically released unless the required notification is made – this may give rise to the release of retention before the end of the defects liability period;
• interest earned would be owned by the payee – currently, theJCT(for example) provides that the payer is entitled to the interest;
• the payer will be required to keep accounting and records for all retention sums held, make the same available for inspection and report to the payee on all sums held and method(s) of protection;
• any disputes are intended to be dealt with by existing dispute resolution processes – we expect that construction contracts will need to be amended to provide for this.

If enacted, this would dilute the payer's ability to:

• omit the fiduciary obligation to place the cash retention in a separate bank account;
• allow the payer to withhold the cash retention until completion provided that the payee has satisfied certain conditions e.g. rectification of defects and provision of outstanding certifications;
• withhold a sliding scale of cash retention where the payee fails to provide forms of security e.g. a performance bond where provision of the same is hampered, e.g. by difficulties in the bond market.

Protection of cash retention through an instrument of security in the context of a difficult bond market also gives rise to questions over:

1. whether the bond market would be as stringent as it currently is in respect of performance security – will expiry options be limited? Will there be debate over the payer's entitlement to the whole or any portion of the retention in the event of the payee's insolvency? Will this be appropriate for smaller value contracts where the costs of obtaining a bond may be disproportionate? More importantly; would there even be scope for negotiation of the instrument of security if the market is to provide the standard?
2. how insurance companies propose to manage payer's expectations – who will take out and bear the costs of such insurance? Will the insurance be accompanied by a plethora of exclusions?

What's next for the construction industry?

There is no dispute that retentions present challenges, particularly in the context of contractor insolvency. But is there appetite for change within the construction industry?

The proposals are likely to encounter resistance from developers and project financiers, given they bear the ultimate risk of loss associated with payee insolvency. In such cases, they would need to foot the bill themselves if issues arose in the defects liability period- a stage where cash retentions would usually be relied upon.

The consultation paper notes that either reform option could lead to a temporary rise in disputes, as parties adjust to new ways of working- potentially increasing the cost and complexity of dispute resolution.

Whilst smaller value projects may be less affected by a complete ban on retentions, projects of significant size and value still rely heavily on them, particularly in the defects liability period and in the context of a difficult bond market with high rates of contractor insolvencies.

Either legislative option would mark a significant shift in the way construction contracts are drafted, financed and operated, and necessitate an overhaul of existing payment practices.

The consultation closes on 23 October 2025 and a final decision is expected in early 2026, with any legislative changes likely to include a transitional period to allow the industry to adapt.

We will continue to provide further updates on the consultation's outcome in respect of retention once the response is published, and if and when draft legislation emerges.

Read the original article on GowlingWLG.com

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.