18 of 19: Innovative Strategies for the Contractor in Default

Part 18 of Our Series on Construction Project Management Skills

XVIII. Innovative Strategies for the Contractor in Default

A. Arranging Joint Payment Agreements

Toward the conclusion of the project, it is not uncommon for the Contractor to begin to incur financial issues. A substantial amount of retention is usually being held by the owner that will not be released until the project is completed. The cumulative effect of delays, extra costs, and unexpected events is a strong temptation to avoid distributing funds to subcontractors and use the money for other purposes.

Project managers should make a practice of regularly contacting subcontractors to ask whether the subcontractor had received payment from the last progress payment request. Upon receipt of any complaint concerning payment or receipt of a stop notice, the project manager should arrange for an immediate meeting with the contractor to go over the documentation demonstrating that all subcontractors and other potential claimants have been paid. The first step that most project managers take when a contractor has failed to pay all subcontractors money that is due is to enter into a joint check agreement. A joint check agreement allows the owner to write checks with the payees being the contractor and the contractor's subcontractor.

The use of a joint check agreement is an imperfect solution at best. Many contractors are so desperate for money that they will go ahead and endorse the check for themselves and the subcontractor, thereby defeating the purpose of the joint check agreement. The preferred method to handle a joint check agreement is to maintain custody of the check. Contact the contractor and arrange for the contractor to come and endorse the joint check. Then invite the subcontractor to come by and provide the second signature to the check, make a photocopy of the check, and then hand it over to the subcontractor, with an acknowledgement of receipt and a conditional lien release. This is the only way that an owner can ensure that subcontractors are getting paid.

B. Arranging for Secured Contractor Loans

When a contractor is approaching a default on a project, every possible method of obtaining money will likely be employed. Multiple change orders of dubious validity will be presented. Progress payment requests will overstate the percentage of completion. There will be requests for at least the partial release of retention.

Many owners respond to these indirect pleas for cash flow in a harsh manner. Change orders are rejected out of hand. Progress payments are rejected. Reduction in retention requests are tabled. This does not give the contractor many options, and may succeed in the owner's worst nightmare of dealing with a contractor default.

An innovative means to accomplish the owner's true goal of project completion is to consider providing a loan to the contractor that is secured by the contractor's principals. Many contractors stuck in a desperate question for cash flow will welcome the opportunity to receive additional cash, and will be all too willing to make concessions in order to receive some relief from their cash flow issues.

The owner's risk in such lending is generally quite low, particularly when the cost impact of a contractor default is taken into account, as well as the ensuing efforts by the contractor to recoup money through the assertion of various claims for additional compensation. In addition, the owner will obtain the personal pledge of the contractor, which will provide additional incentive to the participants not to attempt to walk away from their contractual obligations.

C. Risks and Benefits of Taking Over Some of the Contractor's Operations

If a contractor is having trouble, there is usually a strong temptation on the part of the owner to take over some of the operations of the contractor. The owner may elect, for example, to hire some subcontractors directly to get the project finished, may negotiate some of the payment issues directly with the subcontractors, and otherwise take over the position of contractor on the project in an effort to mitigate the impact of a contractor default.

This is a very risky step for any owner to take. Contracting directly with subcontractors or making direct payments to subcontractors changes the relationship between the owner and the subcontractor. No longer is the owner insulated from subcontractor claims, and may be subject to direct lawsuit from the subcontractor for unpaid work. Contracting with subcontractors may also jeopardize the right to enforce a payment or performance bond against a surety. The effectiveness of project insurance may be greatly hindered through direct contracts with the subcontractor. The period for filing lien and stop notice claims may also be extended by having a direct contract with a subcontractor.

If there is a need to take over the operations of the contractor in order to complete a project, the preferred method is to do so through notification to the surety of a default, and provide the surety with the option of providing a replacement contractor, or, if there is no bonding, hiring a new contractor to take over the operations of the contract and receive the assignment of the subcontractors' contracts.

D. Involving the Surety

The realization that performance and payment bonds are not all what they are purported to be usually first arises when the contractor is declared to be in default, and the surety is called upon to complete the project. Sureties are notoriously slow in responding to claims of default, and usually attempt to get the owner to agree to have the original contractor return to the project.

The owner is greatly benefited in a contractor default situation to have a well documented basis for contractor default that discourages the surety from pursuing the return of the contractor.

When and if the surety does become involved, the surety will propose a replacement contractor if the original contractor is not acceptable. Replacement contractors are notorious for providing the absolute minimum required under the contract documents. As part of the negotiations with the surety, consideration should be given to the selection of an alternative completion contractor who is not closely tied to the surety. It may be worth agreeing to pay additional money in order to hire a replacement contractor preferred by the owner.

Completion work needs to be watched carefully and inspected thoroughly. The owner should anticipate that any work not squarely identified in the contract documents will be the subject of a claim from the surety or replacement contractor.