In Tough Times, the Tough Protect Themselves

May 1, 2008
This is not the first economic downturn that most contractors will have experienced. This one, however, seems to have hit construction first rather than other segments of the economy.

This is not the first economic downturn that most contractors will have experienced. This one, however, seems to have hit construction first rather than other segments of the economy. Due to the sub-prime mortgage situation, the residential construction market was one of the first to be seriously impacted, but many others have followed. I recently have seen large commercial projects slowed or even halted due to the nervousness (read “panic”) of lenders.

So, when times get tough, what separates the survivors from the failures is how they respond to these impending risks. No one makes money by having to go to court or enforce lien rights in order to get paid. Not only is cash flow hurt (forcing the firm to borrow on a line of credit), but the cost of hiring a lawyer also will quickly wipe out any profit that could have been generated by the work. Taking proactive steps up front to manage risk where possible and making decisions to limit risks where managing it is not possible will allow firms to reduce their overall risk exposure.

The following are some ideas for risk management. First, obtain and use the right to get financial information. Most “standard form” construction contracts (such as AIA) give the contractor the right to receive reasonable evidence that the owner has financing lined up to cover the expected costs. There is no reason that a subcontract can't also contain similar language, requiring that this information be shared.

Lenders (and their lawyers) are very savvy as to the liability they may face if they misstate their commitments in such letters, so it takes some education to know how to read and interpret these commitment letters. Further, the contractor has to ask and demand answers as to how much of those funds are available for the actual construction, as opposed to the cost of land acquisition or “soft costs.”

Contractors also should know who owns the property and make sure that person is someone with money and integrity. More often than you would expect, your contract is with “AAA Land Development LLC” but the owner of the property is “AAA Land Holdings LLC” or some other very similar name of a wholly separate entity.

Developers gather different groups of investors for their various projects, which is not unusual. But in many states, your legal rights change if you did not contract with the owner of the property. Since the whole purpose of setting up these entities is to protect owners' assets, it is important to ask questions to satisfy yourself that this is someone you want to do business with.

Additionally, it is advisable to monitor the availability of funding throughout the project. One of the ways that projects get into financial trouble is if the owner doesn't borrow enough money up front so that overruns or change orders have no funding. In the “old days” of a year ago, most lenders would probably just choose to advance additional loan dollars to avoid seeing projects stopped and their collateral deteriorate.

Currently, there is a much higher risk that the lender will not step up. The new 2007 AIA A201 general conditions no longer give a contractor the right to demand additional financial information unless “cause” exists, so if that form of document is used, the contractors should make sure they have the right to monitor release of loan funds to ensure that there will be enough to cover their costs. They should further provide that they can stop work or refuse to perform changes unless adequate evidence of ongoing financing is produced.

It also is important to watch for signs of financial distress. If you have been in business long, you know what I am talking about — people being laid off, slow pay, short payments with suspicious excuses and less equipment or materials on site. Listen for news of other projects being built by the same owners or contractors. You do not want to be the last passenger on a ship that is going down.

Contractors also should get funds put in escrow. Particularly for residential construction, it is typical for contractors to insist that loan proceeds be placed with a title company or other escrow service under a clear agreement that requires the escrow agent to use them only for this project. The agreement should be reviewed by your lawyer to make sure that it protects your interests.

It also is a good idea to develop written agreements for service work and take credit cards. It is much easier to enforce your rights for service work if you can show that the customer was provided all your rates and charges and signed off on an estimate before the work was done. Your lawyer can help you develop forms that will hold up in court.

You also should know your lien rights and develop a cost-effective system for using them. Again, this should be a last resort, but it is an effective tool to protect the rights of contractors.

Susan McGreevy is a partner at Stinson, Morrision, Hecker LLP, Kansas City, Mo., 816/842-4800, e-mail to [email protected].

About the Author

Susan Linden McGreevy

Susan McGreevy is a former partner at Stinson, Morrison, Hecker LLP, Kansas City, Mo., 816/842-4800.

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