When a main contractor goes bust, can the courts assume that the employer has set up a retention fund for subcontractors – even when it has not?
What happens to retention money deducted by a solvent employer when a main contractor goes into liquidation? Is it to be distributed to the contractor’s general creditors? Or do employers or subcontractors have rights to part or all of the retention?
The answers depend on the terms of the particular contracts and circumstances. However, it may be interesting to revisit some of the cases that deal with this situation. For example, under the scheme of the 1963 JCT main contract and the FASS subcontract there were provisions that the employer under the main contract and the contractor under the subcontract should hold retention money on trust for respectively the contractor and the nominated subcontractor, subject to the employer’s right to recover the cost of defective and incomplete works.
In the 1981 case of Re Arthur Sanders, the court decided that where the employer is solvent, the court would proceed on the basis that the employer set up a separate fund of retention money (even where it had not set up a separate fund) and that the money remained subject to the trust. The court concluded the solvent employer held the subcontractors’ portion of the retentions on trust for the contractor as trustee for the nominated subcontractors. That meant the main contractor and its liquidators had no beneficial interest in the nominated subcontractors’ due portion of the retentions but must pay it over to the subcontractors. Subject to rights to claim for defective and incomplete work, the retention money would find its way to the nominated subcontractors. That decision was later approved in the Court of Appeal.
Recent JCT contract forms have weakened the subcontractor’s position because, for example, although the JCT 2016 main contract requires the employer to hold retentions as trustee (SB/Q clause 4.17) and gives a right of deduction therefrom, (clause 4.12.3) there is no equivalent express trust provision in the JCT subcontract requiring the main contractor to hold the subcontract retentions as trustee (clause 4.12).
NEC 3 is weaker still, since even in the main contract there is no mention of the employer holding retentions as trustee (clause X16 of the NEC 3).
It is some time since the Court of Appeal has considered these specific issues, although it did consider the JCT 1987 Management Contract scheme in the important case of PC Harrington vs Co Partnership in 1998 (holding that the employer held works contract retentions on trust for the works contractor).
However, the Court of Appeal of Malaysia has considered the effect of retention provisions in Qimonda Malaysia Snd Bhd vs Sediabena Sdn Bhd, reported at  Building Law Reports 65. In that case the employer went into voluntary liquidation. It still held retention money relating to a construction contract. The main contractor sought a declaration that the employer held the retention money on trust for the main contractor and the nominated subcontractor.
The employer opposed this on the grounds that there was no contractual stipulation that the retention money was trust money and that it had not been set aside in a separate account prior to the employer’s liquidation.
An implied trust
The court held that a trust of the retention money could be implied even where the contract did not contain an explicit provision that an employer held the retention money on trust. It relied on English authority for the proposition that the use of the word “trust” or cognate words was not essential for the creation of a trust where in substance a sufficient intention to create a trust has been manifested.
In the Malaysian court’s view, the retention money was by its nature and purpose held for a specific purpose, namely held by the employer for the purpose of paying the cost to the employer of uncompleted or defective work and if not so used held for the benefit of the contractor. In law and fact, it held, the retention money by its very nature and purpose was trust money held by the employer.
The court held that the fact that the retention money was not separated from the employer’s general funds prior to its liquidation did not change the status of the retention money as trust money (disagreeing in this respect with an English first instance decision). Trust money, even if mixed with the employer’s other money, could be traceable in principle. As trust money it was not the property of the employer such that it fell into the general distribution of its assets upon liquidation, and so treatment of the money in accordance with the trust was not a preferential payment under Malaysian insolvency law.
The editors of the Building Law Reports database describe the case as a fine decision to be welcomed as a clear and practical exposition. However, the case did not consider the employer’s rights as against an insolvent contractor’s liquidators and nor did it consider a subcontractor’s rights against the employer’s retention funds where the main contractor was insolvent. It cannot therefore be simply read across to such situations.
Each main and subcontract and, importantly, the circumstances surrounding the relationship between the parties require particular consideration in this difficult area of law. Reading the rules for retention may be a practical step for employers and subcontractors facing a main contractor’s liquidation.
Nicholas Baatz QC is a barrister at Atkin Chambers