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April 5, 2017

Best Practices: Navigating Conflicts Between State Statutes and the SOP

by Katherine D. Tohanczyn

In construction law, retainage is the percentage of the completed work that is deliberately held back until a project is completed (or sometimes substantially completed) and not paid to the contractor or subcontractor until that project is satisfactorily finished. Therefore, retainage provides a property owner – and by extension the owner’s lender – “insurance” for the timely completion and quality of a contractor’s or subcontractor’s work.

The amount of retainage is negotiated as part of the construction contract between the contractor and borrower and varies by project. It is generally calculated as a percentage of the total contract price, but it can also be characterized as a progress payment.

Whether retainage is mandatory or permissive varies from state to state. For example, under the Texas Property Code, an owner is required to retain 10% of the contract price or the value of the work for at least 30 days after the work is completed. If an owner fails to retain these funds,  the owner is liable to a mechanic’s lien claimant. However, if the owner properly withholds retainage, then any mechanic’s lien claims may only be filed against the retainage and not the real property. Conversely, states like Alaska and South Dakota do not allow owners or lenders to withhold any amount of a project as retainage.

As a practical matter, it is important for all construction lenders to understand these statutory requirements to ensure that retainage is withheld in accordance with state law. It is equally important for lenders financing construction loans under the Small Business Administration (“SBA”) 7a guaranteed loan program, to recognize instances where state law may be inconsistent with the SBA’s Standard Operating Procedures (“SOP”).

With SBA lenders, a key conflict can arise when state law requires retainage to be held in an escrow account. Specifically, Connecticut, Louisiana and Tennessee require an owner to establish an interest-bearing escrow account in which all retainage must be held until paid (along with the accrued interest) to the contractor or subcontractor. However, the SOP directly prohibits a lender from complying with this statutory requirement. Specifically, the SOP states that “[l]enders may use an escrow account for not more than 5 business days to facilitate a loan closing.” Since projects in which retainage would be utilized will likely require more than 5 days to complete, SBA lenders will likely be unable to comply with both the state statute and the SOP.

A solution in this situation could be to forgo withholding any retainage. However, in situations where a borrower is adamant about including a protective incentive the construction contract, SBA lenders must find alternative solutions, such as making conventional interim advances for the construction in accordance with both state law and the SOP.

For more information on retainage and SBA construction loan compliance, contact Katherine at 267-470-1187 or at ktohanczyn@starfieldsmith.com.