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Viewpoint: When the Owner Fails

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Since 2010, more than 30 municipalities nationwide have filed for bankruptcy. Many states have experienced budget crises that have slowed payments or shelved projects, and the U.S. faced an operational shutdown that threatened the federal government's ability to pay its contractual commitments.

Meanwhile, bankruptcies of major public companies remain near an all-time high. In the traditional paradigm for construction, the project owner worries about failure or default of its general contractor.In today's construction market, the reality is that the general contractor must pay close attention to the owner's ability to pay, regardless of how stable the owner appears to be.

Tools From the Business Sector

While the construction industry has well-developed tools, such as retainage and surety bonds, to protect the owners' interests, general contractors should look to concepts that are common in the business sector to ensure the owner's performance. One increasingly common security device is a standby letter of credit. Generally speaking, a letter of credit is drawn on a U.S. bank and can be written to secure the owner's payment obligations. In contrast, a surety bond generally allows the surety to investigate the claim, and the surety may deny payment depending upon its evaluation. On the other hand, a letter of credit can be written to allow immediate payment on demand, regardless of an owner's objection. It is important to note that letters of credit are controlled by the exact language used, and accordingly, proper financial and legal advice is essential to avoid a false sense of security.

It may be simpler for the general contractor to ask for an advanced payment. If the client is not amenable, the general contractor can bill more frequently than on a typical monthly basis—say, every two weeks, with payment due within 10 days of receipt of invoice.

A similar step, but one with more structure, is to escrow the client's construction funds with a third party, such as an escrow agent or bank. The general contractor may insist the owner make multiple deposits to the escrow account during the project, ensuring that funds available to the general contractor keep pace with, or ahead of, the work being put in place. If this tool proves useful, a general contractor may want to establish a repeatable escrow process with a trusted banking partner, so the tool is available when the general contractor needs it on short notice.

Contractors should also take care to know exactly with whom they are contracting. Many large private owners often use single-purpose entities to own and manage construction projects. In these instances, contractors should consider seeking a parent-company guaranty to ensure the project has sufficient financial backing.

In many instances, such as public or competitively bid projects, the above options may not be available. However, a careful general contractor will conduct financial due diligence on its client before getting too deep into any bid or project. Financial information is generally available for public owners, and publicly traded owners' financial information is available through the company's SEC filings.

Unenforced Protection

Contractors should closely review this information before agreeing to make significant investments. Although the typical AIA construction contract permits the general contractor to ask the owner for documentation evidencing its ability to pay for the work, seldom will the general contractor actually receive such assurance. Owners may not like being pressured to divulge financial information or having to give assurances of performance, but reputable owners should understand the general contractor's legitimate concern. Many states have prompt payment laws, but those statutes cannot ensure that funds are in place and available at the time payment is to be made. Prevention is cheaper than cleanup, and performing work for an insolvent owner can lead to disastrous results. By managing financial risks at the outset, contractors can focus on bringing in quality projects on time and under budget. 

Doug Lareau (dlareau@shawmut.com) is chief legal officer with Shawmut Design & Construction, a construction management and general contracting firm.

Ken Rubinstein (krubinstein@preti.com) is co-chairman of the construction practice at Preti Flaherty Beliveau & Pachios LLP.

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