Hong Kong SAR ruling highlights need to protect retention money in construction contracts

Traditionally, cash retention is widely practiced in the construction industry to offer some protection against contractors’ and subcontractors’ insolvency, among other things. If the party holding the retention money becomes insolvent, however, there is a risk that the party entitled to repayment of the retention simply becomes an unsecured creditor.

The commonly used Hong Kong Institute of Architects (HKIA) standard form of building contract expressly states that retention monies “shall be held upon trust” by the employer for the contractor. In the case between Hip Hing Construction Company Ltd and Hong Kong Airlines Limited, the Hong Kong High Court’s ruling highlighted the risk that this contractual label of “trust” may not be sufficient to secure retention money if the employer enters into insolvency before the retention money is paid.

Holding retention money on trust

Contractor Hip Hing sought a declaration from the High Court that employer Hong Kong Airlines held the sum of HK$56 million (US$7 million) as retention money on trust for Hip Hing, in accordance with clause 32.5 (GCC 32.5) of the general conditions of the HKIA standard form of building contract.

The issue in dispute was whether a trust had been validly created over the retention money held by Hong Kong Airlines and whether segregation of the funds was necessary for the creation of a trust, and to what extent.

Upon considering the parties’ arguments and the relevant authorities, the court held that no valid trust existed as the employer had not at any time paid any retention money into any segregated account or any specific account which could be identified, rendering the trust in question too vague and uncertain for the court to enforce or regulate.

In reaching this conclusion, the court considered two lines of conflicting authorities presented by the parties regarding whether segregation or appropriation was a necessary requirement for the existence of a valid trust. In particular, the case of Re Hsin Chong Construction Co, where the Hong Kong Court of Appeal held that retention money payable to nominated subcontractors did not form part of the estate of the liquidated main contractor for distribution to its creditors, was considered in detail.

In the Re Hsin Chong case, the provisional liquidators of the main contractor sought directions from the court in respect of the distribution of funds received from the employer containing, among other things, retention money payable to the nominated subcontractors. One of the legal questions considered by the court was whether the retention money had been sufficiently segregated in such a way that a trust had been created. While the retention money in this case had not been segregated into a separate bank account, the employer gave evidence testifying that it had adopted a stringent project accounting system which clearly identified the retention money, and had ensured there was no mixing of the money of the contractor or the employer.

In the Hip Hing versus Hong Kong Airlines case, the court considered this evidence given the Re Hsin Chong case to be the determining factor which led to the Court of Appeal’s decision. In contrast with the Re Hsin Chong case, there was no evidence in the present case to show that the retention money could be identified in any of the employer’s accounts. Instead, the contractor argued that the employer held retention money on trust for the contractor, and that it should make no difference from which source or account the employer allocated the retention money to the contractor. The High Court found this rendered the subject matter of the trust in question too vague and uncertain, and held that the trust failed as a result of this lack of certainty.

Key takeaways from the ruling

The concluding remark made by the judge, Madam Justice Mimmie Chan, with regard to GCC 32.5 serves as an alarm bell for the construction industry: “Bearing in mind that the intended purpose of GCC 32.5 is to protect contractors against the insolvency of the employer, it is unfortunate that the contractor in this case has been deprived of the intended protection as a result of the employer’s breach and failure to put the intended trust property into a segregated account.”

“Contractors can only be advised to be vigilant in safeguarding their rights and to apply to the court at an early stage of the project, to ensure that the trust property is preserved and protected, rather than to wait at its own risk in the event that the employer becomes insolvent or the trust property is otherwise dissipated.”

While the court concluded that the absence of segregation of retention money by itself is not necessarily fatal to the creation of an enforceable trust, each case must be considered based on its facts and on the evidence available.   

Ensuring there is evidence to suggest that retention money has been put into a segregated account, or is treated separately to ensure it can be identified in the accounts of the employer and is not mixed with other funds, is key to establishing certainty of subject matter of the trust.

Contractors should be vigilant in safeguarding their rights and request that employers provide evidence at the outset to show that retention money has been put into a segregated account and not mixed with other funds of the employer, or funds of other subcontractors. If necessary, contractors should consider applying to the courts to ensure that the trust property is preserved and protected.