Retention in Contracts for Work

The fundamental problem with retainage in the Czech legal environment is that, unlike international accounting standards (e.g., IAS 11), Czech legislation contains no explicit legal regulation or definition of the term "retainage" or "retention money".

This lack of a specific legal definition creates significant legal uncertainty and makes court case law absolutely crucial for the interpretation and application of these arrangements. The decisions of the Supreme Court of the Czech Republic and the Constitutional Court thus have far-reaching impacts on how retainage is interpreted, what rights and obligations arise from it, and what risks are associated with it. Therefore, it is essential for every entrepreneur operating in the field of contracts for work to have an up-to-date overview of legal developments.

At the ARROWS law firm, we deal with the issue of retainage daily and understand the complexity this instrument brings. Our goal is to protect our clients' interests, whether they are contractors seeking their rightfully withheld money or clients who want to ensure a defect-free work and minimize their risks.

Retainage Under the Magnifying Glass: Legal Nature and Purpose

Retainage is a contractually agreed portion of the price for work, the payment of which is deferred until specific conditions are met. In practice, these conditions most often relate to the work being free of defects, such as the removal of all defects and snags, or the expiration of the warranty period. This mechanism is particularly widespread in the construction industry, where we also often see the gradual release of the withheld amount, for example, 40% of the retainage after two years and the remaining 60% after five years from the completion of the work. 

The key legal perspective on retainage, which has far-reaching consequences for both contracting parties, is found in the case law of the Supreme Court of the Czech Republic. It has repeatedly emphasized that an agreement on retainage is not merely an agreement to postpone the due date of the price for work. Instead, it is an agreement on the conditions for the entitlement to the payment of the remainder of the price for work to arise.

This difference is fundamental. If retainage is understood as a deferred payment, the claim exists but is not yet enforceable. However, if retainage is a condition for the entitlement to arise, it means that the right to payment of this part of the price for work does not arise at all until the agreed condition is met.

This case-law distinction between a condition for entitlement to arise and a deferred due date fundamentally changes the allocation of risk and the enforceability of retainage. Its nuances are often overlooked by parties who draft contracts without specialized legal assistance. If the condition is not clearly defined and met, the right to payment simply does not arise.

This has profound implications, especially in the event of insolvency. If the contractor goes bankrupt before the condition for releasing the retainage is met, this amount does not become part of the insolvency estate, which protects the client from having to pay the insolvency administrator without receiving the consideration, such as the removal of defects. For the contractor, on the other hand, it means that failure to meet the condition can lead to a complete loss of the claim to the retainage, even if the work is largely completed.

This is where the critical importance of precisely defining the conditions for releasing the retainage in the contract becomes apparent. Vague or poorly formulated conditions can lead to disputes about whether the right to payment has arisen at all, making the overall purpose of the retainage uncertain.

Risks for Contractors: When Can Retainage Become a Nightmare?

For contractors, retainage represents not only financial security for the client but also a potential nightmare if there are obstructions to its release. Imagine a situation where, as a contractor, you complete extensive work in accordance with the contract, but the client, for various reasons, prevents the conditions for releasing the retainage from being met. This could involve refusing to accept the work, denying access to remove minor defects, or deliberately prolonging the entire process. Your money is blocked, and you find yourself in a situation where you have done the work but cannot access your rightful funds, which can have a devastating impact on your business.

Fortunately, Act No. 89/2012 Coll., the Civil Code (hereinafter the "Civil Code"), offers a lifeline in such cases in the form of Section 549. This provision states that if the client deliberately and unjustifiably frustrates the fulfillment of a condition on which the release of retainage is dependent, the condition is deemed to have been fulfilled. This means that even if the condition was not formally met due to the client's obstructions, the contractor becomes entitled to the release of the retainage.

However, to successfully apply this provision, it is crucial to prove four elements: (i) the inadmissibility of the client's conduct, (ii) its intentional nature, (iii) its unlawfulness, and (iv) the benefit the client gains from frustrating the condition. Intentionality means the client's intent is aimed at frustrating the condition, and an actual consequence must occur, not just an attempt.

As a result of this legal fiction being fulfilled, the contractor may become entitled to demand the release of the retainage. The key is that Section 549 of the Civil Code shifts the burden of proof regarding the "frustration of the condition" to the contractor, which requires careful documentation. When the client intentionally frustrates the fulfillment of conditions, they directly cause financial harm to the contractor by withholding legitimate payments

Another critical risk for the contractor is the client's insolvency. As mentioned in the previous section, if the right to the retainage did not arise before the client's bankruptcy (i.e., the condition for its release was not met), the claim does not become due and cannot be registered in the insolvency proceedings. However, if the entitlement to the retainage has already arisen (i.e., the condition was met before the bankruptcy), it is absolutely crucial to register the claim in the insolvency register in a timely and correct manner. If the client's insolvency administrator refuses to perform the contract for work, the contractor is entitled to compensation for damages, which is claimed by filing a claim in the insolvency proceedings.

Risks for Clients: How to Ensure Quality and Avoid Disputes?

For a client, retainage is a key tool for ensuring the quality of the work and protecting their investment. Imagine you have invested significant funds in a construction project or custom manufacturing, and defects appear after the work is completed. It is understandable that you want the work to function flawlessly and your money to be spent effectively. In such a case, retainage is your insurance and a means to ensure the removal of defects or to obtain compensation.

The foundation for the effective use of retainage and risk minimization is a precisely formulated contract for work. The contract should clearly define the subject of the work, its quality, performance deadlines, and, above all, detailed conditions for the release of the retainage. The more specific and unambiguous these conditions are, the less room there is for future disputes and ambiguities. The contract should always be "tailor-made" for the specific project and the relationship between the parties, not just a generic template.

The absence of clear written records, such as detailed handover protocols documenting defects, makes it significantly more difficult for the client to prove that the conditions for withholding the retainage were justifiably not met. Similarly, late or verbal notification of defects can lead to a loss of rights due to statutory deadlines. All this shows that "good practice" in contract management is not merely an administrative matter but a direct legal necessity for enforcing rights related to retainage. A client's failure to adhere to these practices creates significant legal and financial risk, as they may be forced to release retainage even for defective work or lose the ability to claim damages.

Insolvency Clauses: Final Confirmation of the Validity of an Agreement on a Price Discount in Case of the Contractor's Bankruptcy

The contractor's bankruptcy is a huge threat to the client. Modern contracts for work should therefore include so-called insolvency clauses. These clauses typically stipulate a reduction in the price for work (often by the amount of the retainage) in the event of the contractor's bankruptcy. The Supreme Court of the Czech Republic has clearly confirmed the validity of such arrangements in recent decisions.

It concluded that if the right to the retainage did not arise before the contractor's bankruptcy (i.e., the condition for its release was not met), there is no reason for the insolvency administrator to demand its payment into the insolvency estate. This clause is now a common and required instrument in commercial relations, providing clients with a clear tool to minimize the risks arising from the potential bankruptcy of a contractor and to prevent the insolvency administrator from demanding payment of retainage into the insolvency estate if the right to it had not arisen before the bankruptcy.

Administering retainage can be demanding – proper contractual setup and careful documentation will help prevent ambiguities and disputes. Retainage should be a motivation for both parties to complete the work smoothly and remove defects, not a source of uncertainty. If it is well-structured, the contractor knows what they must do to get the money, and the client knows they have an effective tool to secure their rights. Otherwise, it leads to administrative wrangling, mutual accusations, and, in the worst case, court disputes over relatively small amounts – which benefits no one.

Default Interest and Damages: When Are You Entitled to Interest on Unlawfully Withheld Retainage?

If retainage is withheld unlawfully, the contractor is entitled to default interest. The Constitutional Court repeatedly emphasizes that default interest serves a reparatory function and is crucial for effective judicial protection and full compensation for damages. Denying the right to default interest would allow the debtor to successfully evade their obligations without any penalty. The non-award of default interest is permissible only exceptionally in justified cases.

However, it is important to correctly distinguish between default interest and damages. A creditor is entitled to compensation for damages arising from the non-fulfillment of a monetary debt only if this damage is not covered by default interest. In commercial law relationships, default interest is counted towards compensation for damages caused by the delay in fulfilling a monetary obligation. The correct application of these claims is key to obtaining full compensation for unlawfully withheld funds.

Current Case Law You Must Know: Perspectives of the Supreme Court of the Czech Republic

Recent court decisions confirm the existing approach to retainage but also provide specific lessons for various situations. Below are a few examples from recent case law and their key conclusions:

• Judgment of 25 March 2019, file no. 29 Cdo 561/2017: The Supreme Court confirmed that an agreement on a price discount equal to the retainage in the event that the contractor goes bankrupt and cannot provide warranty repairs is valid. Such a clause expresses the value of the unused warranty – in other words, if the contractor becomes bankrupt, the client may keep the retainage as a discount on the price of the work. This decision (published in the Collection of Court Decisions) gives clients certainty that similar arrangements to secure warranty obligations are accepted by the courts.

• Resolution of 20 November 2024, file no. 33 Cdo 3199/2023: In this dispute, the contractor duly completed the work, the client accepted it without reservations, and the work was handed over without defects. Nevertheless, the client refused to pay the retainage, citing a contractual penalty for failure to remove defects. However, the lower courts (and the Supreme Court dismissed the appeal) sided with the contractor: if the work was completed without defects, the client is not entitled to a contractual penalty for failure to remove defects and must pay the withheld portion of the price. In other words, an unjustifiably claimed penalty cannot justify the non-payment of retainage. This verdict emphasizes that the client can only withhold retainage for actual defects or unfulfilled obligations of the contractor, not arbitrarily. 

• Judgment of 2 July 2024, file no. 23 Cdo 2220/2023: The Supreme Court repeatedly confirms that retainage is not a simple postponement of the due date for part of the price, but an agreement on the creation of the right to its payment only after a condition is met. Until the agreed conditions are met, the contractor is not entitled to the retained amount, and such a claim does not exist at all. A lawsuit for payment of retainage filed before the suspensive condition is met would therefore be dismissed. This concept corresponds to the purpose of retainage as a tool to protect the client – the client gains certainty that the contractor will fulfill their warranty obligations. If it were merely a postponement of the due date, the contractor would, after a certain time, become a creditor for that part of the price even if they had not fulfilled their obligations, which would negate the purpose of retention money. The courts therefore insist that a properly formulated retainage functions as a conditional claim – it arises for the contractor only upon proper fulfillment of what they have committed to (e.g., removal of defects).

The aforementioned decisions confirm that retainage is a legal and effective tool if it is clearly agreed upon and used in accordance with the contract. At the same time, however, they warn that its misuse or formal shortcomings can lead to disputes or unenforceability. 

Practical Tips for Your Contract for Work

A proactive approach to creating and managing contracts for work is essential for minimizing risks and protecting your financial interests. The following practical tips, supported by current case law and practical experience, will help you ensure that your contracts provide a solid foundation for your projects.

How to Correctly Formulate the Conditions for Releasing Retainage

Given that retainage is, in a legal sense, a condition for the entitlement to payment to arise, it is critically important to clearly and unambiguously define the conditions for its release in the contract. Avoid vague and general formulations that can lead to different interpretations and disputes. Precisely specify what the contractor must fulfill (e.g., handover of the work without defects and snags, expiration of a specific warranty period, submission of a final building approval) and within what timeframe. Consider the possibility of a phased release of the retainage depending on project milestones or the expiration of part of the warranty period, which can improve the contractor's cash flow while maintaining your security.

The recurring theme of "common mistakes" and the judicial emphasis on strict adherence to procedural requirements (e.g., timely notification of defects, proper handover protocols) reveals a significant gap between common business practice and legal necessity. This gap often stems from a lack of awareness or an underestimation of legal risks, which leads to preventable financial losses.

An informal approach to contractual documentation and communication, such as relying on oral agreements, leads directly to a "lack of evidence" in court proceedings. The absence of clear written evidence, such as detailed handover protocols documenting defects, makes it significantly more difficult for a party to prove that the conditions for withholding the retainage were justifiably not met.

Similarly, late or verbal notification of defects can lead to a loss of rights due to statutory deadlines. All this shows that "good practice" in contract management is not merely an administrative matter but a direct legal necessity for enforcing rights related to retainage. Failure to adhere to these practices creates significant legal and financial risk, as a party may be forced to release retainage even for defective work or lose the ability to claim damages.

Don't Be Caught Off Guard – With ARROWS, You Are Safe

Retainage in contracts for work is a powerful yet treacherous tool that requires careful attention and deep legal understanding. Its legal nature as a condition for the entitlement to payment to arise, rather than a mere deferred due date, has far-reaching consequences for the financial stability and legal standing of both the contractor and the client.

Thus, retainage can be a great servant but a bad master. When set up correctly, it protects both parties – the client is assured of getting what they paid for, and the contractor knows they will receive their full reward after fulfilling their obligations. However, when agreed upon carelessly or misused, it becomes a source of disputes and mistrust. 

Do not be caught off guard by the complexity of legal regulations and constantly evolving case law. Whether you are a contractor trying to recover your retainage or a client wanting to ensure defect-free work and protect your investments, the lawyers at ARROWS are here to help you. 

Expert lawyers can save you considerable sums with timely advice – for example, in the e-book "Lawyers Advise How to Save Millions," we share a number of tips on how to prevent unnecessary losses by correctly setting up contracts. Therefore, do not let retainage or other important arrangements in your contracts for work be set up unprofessionally.

The lawyers at the ARROWS law firm have extensive experience with this issue and will help you set up contractual terms to be unambiguous, enforceable, and in compliance with the law and case law. They will also guide you through the resolution of any disputes – from negotiation and out-of-court settlements to representation in court if necessary. An investment in professional legal assistance pays off in this regard: you will avoid the risk of invalid agreements, long disputes, and the loss of money that is rightfully yours or that you rely on to ensure the quality of the work.