Constructor Magazine - A publication of the AGC

Focus on Insurance

May/June 2009

Doing Your Diligence

Contractors should have an action plan to mitigate risk from project defaults

By Angelle Bergeron

Contractors cannot control investor confidence or owners’ finances, but they can educate themselves to recognize warning signs of project interruption and owner default and take precautions to minimize their risk.

Although contractors cannot require owners to post payment and performance bonds, they can require evidence of owner financial viability, review their own contractual obligations and develop a survival plan in case of project interruption and/or owner default.

The suggestion that owners be insured against default is impractical because “nobody is willing to cover the owners,” says W. Milton Smith, vice president of McGriff Seibels & Williams Inc., an insurance brokerage firm in Birmingham, Ala., and a member of multiple AGC chapters. “There is nothing guaranteeing the contractor that the owner will remain solvent and that the contractor will get paid in terms of default.”

At the same time, the convergence of the global economic crisis and difficulties with financing have created the perfect environment for project interruptions in every phase of construction, says Steven Charney, co-managing partner of the legal firm Peckar & Abramson, New York City, a member of multiple AGC chapters. “I’ve worked with the construction industry over 30 years now, and I can’t recall any time in my career where we’ve had this combination of the economy and lending institutions struggling simultaneously.”

Back to Basics

If the likelihood of project interruption and owner default is increasing, and if insurance against such failures isn’t an option, how do contractors protect themselves? First of all, both Charney and Smith agree contractors must keep their eyes open for early warning signs, or red flags. Contractors should watch for things that may signal a problem behind the scenes. Is an owner missing a meeting because he is meeting with the lender? Is the lender suddenly showing up on a project?

Besides assessing the owner’s financial health, contractors can obtain public-domain documents that may reveal information about the status of the lending institution and its well-being. “It’s important to learn about and understand the financing source, its viability and its position on the project,” Charney says. “I can’t imagine that two years ago there would have been any contractor who would have looked for that.

“With a robust economy and projects going forward without these problems for so long, it forced the contractors to let their guard down,” he says. “I think what we’re really talking about is going back to some real basics and contractors doing what they should have been doing before: keeping their eyes open for problems.”

The challenge is opening up the door and telling the owner you want access to the lending facility, loan documents and a meeting with bank representatives. The primary key to survival for a contractor is communication with the lending facility, Smith says.

“Banks are willing to do it because on large projects the bank or lender has a tremendous stake in the project,” he says. “I can’t think of one reason why a lender would be uneasy with that process. If the owner is uneasy, that’s a red flag.”

Know Your Obligations

It’s routine for Brasfield & Gorrie General Contractors of Birmingham, Ala., a member of multiple AGC chapters, to request owners provide verifiable financing, and owners are happy to oblige, says Jason Hard, operations manager. “People don’t just have $200 million lying around, so it’s not a contentious deal to ask an owner to show you how it’s financed and bring our financial people in to talk about it.”

One of the nation’s leading health-care contractors, Brasfield & Gorrie has had no qualms about demanding full financial disclosure since the company was burned by an owner default in 2000.

“That was back in the heyday of corporate fraud, before the Sarbanes-Oxley Act, so it was a different type of default than you see today,” Hard says. “These days, when you ask for an audited financial statement, it’s likely legitimate.”

In addition to exploring owner and investor financial strength, contractors should protect themselves by knowing their contractual rights and obligations. “If a notice comes in your door and that’s the first time someone is picking up the contract to confer with legal advisers, time is being lost,” Charney says.

Contractors must know their obligations to subcontractors, including when they are allowed to stop work. “It is not uncommon for a lender to ask the contractor to sign a consent agreement, the gist of which is often that the contractor agrees to give notice to the lender before taking some action such as a stop-work or contract termination,” Charney says. “There could be obligations and responsibilities the contractor has assumed for the lender outside of the contract with the owner.”

Exploring Options

Brasfield & Gorrie managed to avert a lot of liens, litigation and bankruptcies by offering subcontractors the option to accept cost-plus-reasonable-fee payments. “We have a diversified business model, so we would have survived if we hadn’t been paid,” Hard says. “But a lot of our subs would have gone under.” In business since 1964, Brasfield & Gorrie recognized the significance of maintaining those relationships for future viability.

“Smart contractors will have thought through and have an action plan considered before notices enter their door.”

— Steven Charney, Co-managing Partner, Peckar & Abramson

The contractor was “fighting for his life” but took the option with the lowest-cost impact to each party involved, Smith says (see story, below). “When people go into survival mode and look out for No. 1, it typically costs the contractor a lot more money in the long run. At the end of the day, Brasfield & Gorrie did not want to turn its back on its subs. They asked them to hang in there and promised to make them whole. That is phenomenal.”

The bargaining also benefits owners and investors who have nothing if the project is not sale-ready. Usually, contractors can get owners to realize the benefit of closing in a building and roughing out the HVAC to keep air circulating, making the project more marketable.

Both Charney and Smith agree a common key to minimizing risk is being prepared. Know your contractual obligations. Confirm the financial vitality of lenders and owners; communicate. “Brasfield & Gorrie was able to get to a place where they could minimize the impact, control the bleeding,” Smith says. “The only way they were able to do that was because they had a survival plan in place.”

Charney agrees. “Smart contractors will have thought through and have an action plan considered before notices enter their doors,” he says.

He suggests a plan should include when and how the contractor can stop work and what options are available to address that. Also, a contractor should know how and what it takes to preserve and exercise lien rights, how permits should be addressed, what insurances will be in place during a project interruption, what notices are required by the contractor and what rights and restrictions are available to address subcontractors.

HOW TO HANDLE THE EARLY WARNING SIGNS ON EXISTING PROJECTS
Demand Proof of the Owner’s Financing
Many contracts allow the contractor the right to this information.
Review your contract to determine when and how often you can request it.
Review Lender Consent or Other Agreements Between the Contractor and Lender
These agreements may permit or even require that the contractor communicate with and notify the lender of potential problems.
Remember that opening a channel with the lender, where permitted, can give warning signs.
Provide Notice as Required by Your Agreements with the Lender
Review the contract about right to payment and change orders.
Contractors often do not enforce their rights to change orders before proceeding with added work.
Contractors often miss the right to insist on payment as early as the contract permits, both for base contract work and change orders.
Understanding and enforcing these rights will contain damages and expose possible red flags.
Conduct a Basic Project Review
Determine if and how payments may be slowing.
Take note of whether there have been changes in who is attending meetings or is on-site. Is a representative of the lender around more often?
Talk to Your Client and Ask Direct Questions
Source: Peckar & Abramson

Honorable Discharge

In early 2000, Brasfield & Gorrie General Contractors, Birmingham, Ala., one of the largest health-care contractors in the country, found itself holding the bag for $20 million in back pay and the potential for millions of dollars in litigation when an owner defaulted. “We were halfway through the project, a $200-million hospital,” says Jason Hard, senior project manager at the time and current operations manager for Brasfield & Gorrie. The owner was caught by the Securities and Exchange Commission cooking the books and wanted to shut the project down.

“We had a subcontract that said ‘pay when paid,’ but it didn’t say ‘they don’t get paid if we never get paid,’” says Hard. The contractor called in all the subs and made an offer to pay cost plus reasonable fee (3%) on the spot, or the subs could opt to get in line and wait for the owner to declare bankruptcy and maybe pay something several years down the road.

“We did that immediately, within two weeks of the owner defaulting, which eliminated 75% of our potential liens and lawsuits upfront,” Hard says. “We did have to put out tons of cash, but it preserved our reputation with our subs and didn’t hurt our ability to do business with them in the future. We basically eliminated the entire subcontractor problem so we could focus all our corporate efforts on dealing with the owners.”

In the meantime, the contractor used every legal avenue to protect itself, including placing liens on the construction property and the owner’s corporate headquarters. Concurrently, a diplomatic team of high-level Brasfield & Gorrie executives worked on convincing the owners that it was in their best interest to pay the contractor at least some of what was owed.

“Even though we weren’t getting paid, we came up with creative, low-cost ways to make it a viable asset so it could be sold,” Hard says. “We knew that was the best way we were going to get paid. Plus, we knew we would run into them again, and there was the potential we might work with some of the owners, subs or another owner who had them as a tenant.”

The contractor had been pouring the roof when the project was shut down. “We had to finish the skin and get the air moving so it would be a viable property,” Hard says.

Brasfield & Gorrie convinced the owner that completing additional work would mean less financial damage from litigation in the future. “We scaled back our operation and went to limited work flow that matched the cash flow they were able to put into the job until it got to the point where it could be sold,” Hard says. Over the next two and a half years, the contractor performed an additional $60 million of work on the project for the owner. The property was recently sold.

Hard’s advice to others who find themselves with an owner who wants to shut down: “Never quit. Continue to work with your client because you really don’t have a choice,” he says.

Had they not come to an equitable resolution, the owner would have been forced to declare bankruptcy, and Brasfield & Gorrie would still be involved in litigation eight years later, he says.

“We would have nothing,” says Hard. “Our subs would hate us. Instead, we settled with the owner for what we gave to the subs, so we were able to cover our costs and move on.”