The Birth of Retentions 1840

The Rise of Industrialisation and Transportation


The 19th century saw the age of trains rise to dominate commercial transportation. The most common form of land transport prior was foot, horse power, or its mechanical alternative, the bicycle developed in response to a lack of horses in 1815/16 due to volcanic eruption induced climate change, crop failure and starving animals. [NZBE Link]


Carting coal by horse and cart was limited, given coals weight, and canals can only go so far. Unsurprisingly, coal was rarely used more than 10-15 miles from a coal-field or navigable waterway. Moving coal by water was radically cheaper than moving it overland, because water massively reduces friction. A reduction of friction was a major factor in the development of the railways, to move coal.


The Railways (Construction) Manias


The railway age began with the opening of the Stockport and Darlington Railway in 1825 and the Liverpool and Manchester Railway in 1830. Following the Liverpool and Manchester Railway, there was a forty-year period of railway construction on a massive scale - as can be seen in Figure 10, which shows the year-by-year net additions to railway mileage in Britain. At the end of 1830, there were just over 125 miles of railway lines in Britain yet, by the end of 1871, this figure had jumped to more than 13,000 miles. Railway expansion did not proceed at an even pace over this time. In contrast, there were three separate periods of intensive and speculative railway promotion, investment and construction; known as the ‘railway manias’ these periods occurred in the late-1830s, the mid-1840s and the early-1860s.


One reason for the railway manias was the lack of government regulation or intervention. Anyone with sufficient financial means, or the capacity to borrow sufficient funds, could form a railway company, raise capital, and put forward an application for a railway Bill to Parliament that would propose railway routes and enable land to be acquired. Virtually no real checks existed on the financial viability of a proposed railway line. The economic policy of laissez faire left the design and construction of railways almost entirely to private enterprise.


Also the success of the railway industry in the 1830s made it an obvious investment choice. The impressive profits of the railway companies in the 1830s enabled them to pay out high dividends, which explains much of the overly optimistic speculation that occurred in the 1840s. Furthermore, capital formation in the railway industry during this mania relied on derivative-like assets, which amplified potential risks and eventually contributed to the bursting of the speculative bubble. “It would have been unthinkable to pause, consider, and calculate. Immediate action was called for, without any nice scruples or refinement of thoughts. Very much indeed was at stake, to be settled in the shortest possible time, against the clock.”

[NZBE Link]

Our history source for the birth of Retentions is American, where Retentions are referred to as Retainage.


Retainage


The practice of retainage has its origin in the UK industry at the onset of construction of the railway system in the 1840’s. This massive construction undertaking created an environment encouraging new entrants into the construction industry to meet surging demand. Many of these ‘new’ contracting entities were unable to successfully perform, resulting in a high number of insolvencies. This situation led to the practice whereby railroad companies would withhold 20% or more of the contractors’ payments to ensure performance and offset completion costs should the firm default.



United States


From its origin in the UK the practice of retainage has grown to widespread use in the United States. In addition to protection against contractor insolvency, proponents have encouraged its use to provide a ‘buffer’ for the valuation of work installed, remedy defects found during turnover of the facility, and encourage contractor performance. However, opponents often argue that the primary purpose of retainage is to provide a source (or offset the need) for cash for the organization holding the retained funds. [NZBE Link]


Germany


The retention system is not used in Germany where the works remain the property of the contractor until completion and are, therefore, liable to be withheld from the client in cases of dispute. [NZBE Link]


Commentary on the birth of retentions


The unique factors leading to the introduction of retentions were;

[1] an uncontrolled massive investment in new railways requiring;

[2] the addition of a large number of unproven (probably unqualified) resources;

[3] at a time when there is an extreme shortage of qualified resources;

[4] resulting in a larger frequency of insolvencies, compared to otherwise normal market conditions for supply and demand of construction resources.


How can paying someone less money, act as insurance against their insolvency? Surely the opposite is true?


Railway investors knew there is a of lack resource and could expect inefficiencies with new entrants. They could have paid for those inefficiencies, as a cost of doing business, and still made phenomenal returns on investment, without insolvencies, delays or retentions.


Cashflow is the lifeblood of any industrial endeavour, including the railway developer! Once retention practice is established, decades of railway developers can enjoy a cashflow benefit that keeps their mania venture alive for longer, while they scramble for more frenzied investors, until the bubble bursts. Free cash anyone?


Retentions were born in a mania frenzy, to underpay the unproven, and mitigate losses from failed start-ups. For the reasons retentions arose, they are ineffective in performing their intended function, when they are applied to a contractor with a proven track record that is well capitalised.



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“Celebrating 50 years of New Zealand Building Economist 1972 to 2021”


By Matthew Ensoll

FNZIQS. Reg.QS.

Editor New Zealand Building Economist.


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