If you develop or build on real property in Oregon, your progress payments to contractors on future projects will be affected by a new law, effective on March 7, 2024. If you are a construction lender, your borrower may request that your periodic loan advances to fund progress payments to its general contractor be increased to match the progress payments required of the owner by the law. The good news: interest-bearing escrow accounts are no longer required for retainage for new construction contracts. In their place, contractors may post “retainage surety bonds” with an owner and lender to forego cash retainage.
Retainage
Retainage is the practice—unique to the construction industry—to withhold up to 5 percent of earned monthly progress payments to contractors until final payment at the completion of the project. Retainage is intended to provide funds, like a security deposit, to ensure successful completion of the contractor’s work. On projects financed with a loan, the retainage starts with the lender holding back from the borrower an agreed-upon percentage of the loan proceeds from its monthly loan advances. Whether or not a lender is involved, withholding retainage typically cascades down the contracting tiers, where the property owner (public agency or private owner) holds back the retainage from monthly progress payments that the general contractor earned the prior month. The general contractor, in turn, withholds retainage from its first-tier subcontractors’ monthly payments, who also withhold retainage from their second-tier subcontractors, and so on. Note that the percentage withheld under the construction loan and the retainage from payments to the general contractor and subcontractors need not be identical, but in practice they each are typically 5 percent, which is the maximum amount by law that an owner or contractor can retain from contractors. While lenders are not subject to the 5 percent maximum, as an accommodation to their borrowers, they typically do not retain more than 5 percent.
Escrows Eliminated
Public and private construction contracts of more than $500,000 have been subject to a 2019 Oregon law requiring that retainage withheld from progress payments be placed in interest-bearing escrow accounts for the benefit of the contractors who earned the payment. This turned out to be unworkable and created a plethora of unanswerable questions. There was no market for these escrow accounts, which made it almost impossible to comply with the law. Also, on commercial projects that are financed, lenders typically advance the loan proceeds net of the retainage and do not actually disburse retained funds, so no cash is available to be placed in escrow.
A consortium of construction industry participants and attorneys worked for more than two years to develop a solution, which unanimously passed the 2024 special session as HB 4006. The new law eliminates the 2019 escrow requirements effective with new construction contracts created on or after March 7, 2024.
Retainage Surety Bonds
The new law permits contractors and subcontractors on “large commercial” (essentially, nonresidential projects of more than 10,000 square feet or $250,000) and public improvement construction contracts to purchase and post a surety bond with the owner and lender to eliminate retainage from their progress payments. ORS 279C.560 (2024) (public improvement contracts); ORS 701.435 (2024) (large commercial contracts). This surety bond is separate from traditional performance or payment bonds and is issued only for the retainage that otherwise would be withheld from progress payments to the contractor.
The specific form of the retainage surety bond is provided in the new statute.
A contractor may post a retainage surety bond at any time prior to final payment under the construction contract. Once the bond is posted, retainage will no longer be withheld under the construction contract and any retainage that had been withheld to that point must be paid to the general contractor within 30 days, at least to the extent of the penal sum of the bond. (For example, a contractor could post a bond for only a portion of the retainage under the contract.)
Subcontractors May Post Bonds
Subcontractors may also purchase and post a retainage surety bond with the general contractor, who in turn will post its bond with the owner and lender on behalf of the subcontractor. (The general contractor may post a separate retainage surety bond with the owner and lender for the subcontractor or simply incorporate the subcontractor’s retainage amount in the general contactor’s own retainage surety bond.)
Lenders’ Perspective
While a lender’s disbursement of construction loan proceeds is not directly regulated by the provisions of the new law, because an owner/borrower whose general contractor has posted a retainage bond is no longer permitted to withhold retainage under the construction contract and must pay 100% of the progress payment earned, we expect that such an owner/borrower may request that its lender likewise disburse loan proceeds in full amount of the progress payment earned, so that the owner/borrower will not need to use its own funds to pay its contractor the difference.
Before agreeing to such a request, lenders should consider that the scope of losses covered by a retainage surety bond is substantially narrower than the scope of losses that withheld loan proceeds may be used to address; although there is some overlap, the two are not equivalent. The retainage surety bond secures performance by the contractor of its obligations under the construction contract, in the same way that cash retainage withheld by an owner does. Unlike loan proceeds reserved from an advance, the retainage bond does not secure performance by the borrower of its obligations under the construction loan agreement. For example, if a borrower does not pay its general contractor in full and a lien is recorded in violation of the loan agreement, the retainage surety bond is not available to cover the lien. Also, if a project has a cost overrun that is not attributable to a contractor’s default, such as increased costs of materials that the construction contract allows to be passed on to the owner or force majeure delay that results in increased labor costs, a lender that has withheld loan proceeds will not be required to fully disburse until the project is completed, lien-free; meaning that the owner must contribute equity to pay the increased costs and if it does not, the withheld loan proceeds are available to pay them. Retainage bond proceeds will not be available to pay such increased costs because they are not attributable to the contractor’s breach and are therefore beyond the scope of retainage and the retainage surety bond.
A final word of clarification and caution to lenders: although the new law requires that any retainage bond be delivered to both the owner and its lender, a lender has no right to receive payment under the retainage bond unless documentation is in place that allows the lender to present the owner’s claim against the contractor that is secured by the bond, such as an assignment of the owner’s rights under the construction contract and the bond and/or being named a dual obligee on the bond.
New vs. Existing Contracts
Owners, lenders, and contractors should consider how HB 4006 will change their progress payment and loan advance procedures. For example, owners must disburse the full amount of a progress payment for those contractors or subcontractors who have posted a bond, and lenders might elect to do the same for loan advances to fund such payments. Most construction contract forms and construction loan agreement forms will need modifications, especially if adaptations were made after 2020 to work with (or around) the escrow requirement. But dual processes will be in place until the contracts entered into from January 1, 2020, to March 7, 2024, are closed out.
Please contact us with further questions about the new retainage law.
This article is provided for informational purposes only—it does not constitute legal advice and does not create an attorney-client relationship between the firm and the reader. Readers should consult legal counsel before taking action relating to the subject matter of this article.
