Evaluate problems with the existing construction payment structure & key methods for change
by Nathan Budde
January 25, 2016

The construction industry has a payment problem. The razor-thin margins, complicated payment structure, high failure rates throughout the payment chain, hidden parties, risk of liens or double payment and confusing and contractual clauses all combine to make streamlined, efficient construction payment difficult.

Construction Payment Structure

Historically, the construction industry has struggled with its payment structure. Parties at the bottom of the payment chain have had a remarkably challenging time getting paid, and parties at the top of the chain have had significant difficulties in properly controlling payments and mitigating their risk of double payment. One reason for this is that the construction industry is heavily dependent on credit.

This is true from the general contractor all the way down the payment chain, even when the value of the labor or materials furnished is quite substantial. This credit-based payment scheme extends throughout the payment chain on virtually every project, and most companies extend credit to other parties on the project and provide labor and materials on credit themselves. It is not unusual for bill payment to wait until payment is received from the contracting party. This need to float construction costs, especially when the contractor is doing the same thing on multiple projects, can negatively affect cash flow and even solvency.

All construction industry participants can agree that problems with the construction payment process exist, and the problem remains how to change that.

What’s the Problem?

Companies  found near the top of the construction payment chain have financial risks and difficulties that are both similar to and distinct from those of the parties below them. General contractors worry about getting paid by the owner, but must also manage payment down the chain and protect against the risk of liens and double payment. Chief among the difficulties faced in this management is the problem of visibility. It is impossible and unfair for contractors to properly manage all payments down the chain.

Because large construction projects can routinely have numerous parties unknown to the general contractor, it is reasonable for the top-of-chain parties to worry about the risk of double payment or stoppages in work caused by lower-tiered parties’ usage of lien or bond-claim rights, whether or not the usage of these rights is warranted. Along with the necessity of managing lien exposure (and protecting against unwarranted lien exposure), the top-of-chain parties are also required to manage parties that may be less financially sophisticated. While lower-tiered parties have a significant and appropriate objective to get paid—the top-of-chain parties have an equal interest in making sure they are not required to pay more than once for the same work.

As reactions to bearing the financial risk of construction projects, parties at the top of the payment chain attempt to insulate themselves through the use of risk-shifting contract provisions. Many of these provisions, however, have been struck down or weakened when examined by courts pursuant to litigation surrounding payment disputes. The weakening of the contractual leverage general contractors use to shift some financial risk down the payment chain makes creating a fair and reasonable payment structure of paramount importance.

Mitigating the Problem

As unbelievable as it sounds, construction payment can be fair, streamlined and efficient. While the fundamental underlying structure of the credit-based process is not likely to go anywhere and will continue to cause occasional problems, and the risk of failure will likely remain high for the industry overall, many fundamental problems in construction payment can be addressed and resolved. To do so, two main problems must be addressed:

  1. Visibility
  2. Double payment or lien risk

In order to fix these problems, the solutions must be fair to parties throughout the contracting chain. This means that any proposed solution must provide some kind of benefit to everyone on a construction project. Bottom-of-the-chain parties want to get paid quickly, and top of chain parties want to avoid the risk of double payment and not be forced to pay more than what is due.

If a fix to the construction payment problem must be based on fairness and transparency, visibility is fundamental. In order for the general contractor to properly manage payment and insulate itself from the risk of double payment, every party on the project should be known, along with the parties’ payment and security status. Fortunately, this can be accomplished in a way that provides benefits to everybody. While many general contractors understand that receiving preliminary notices from lower-tiered parties is a general aspect of doing business, they should be ecstatic to receive these notices. What general contractors may not immediately realize is that these notices are a built-in tracking and management system. If the contractor uses construction software, the notice information can be input and the identity, payment status, security status and lien-waiver status of all parties can be tracked. The ability to track all project participants allows the upper-tiered parties to manage exposure by providing a made-to-order checklist of parties from whom lien waivers may be required.

The second step of mitigating construction payment problems revolves around lien waivers. Lien waivers are routinely requested in consideration for payment, no matter what rung the paying party inhabits. These lien waivers are generally supposed to work all the way down the payment chain in order to insulate the paying party from the threat of liens from parties below. These waivers, when requested in exchange for actual payment, serve an important purpose of managing the flow of funds on construction projects. In fact, providing conditional lien waivers with every pay app or every invoice makes good business sense for lower tiered parties. Putting the general contractor at ease by providing a waiver of the worrisome lien rights even before it is requested benefits all parties. General contractors don’t need to worry about double payment, and subs get paid faster. 

It is undeniable that the construction payment process is complex, convoluted and messy. However, it can be made fair and manageable by understanding the problems and attacking them in a fair and focused way. By focusing on solutions that provide benefits to both the bottom and the top of the payment chain, construction payment can be made fair and can become a process that leaves all parties satisfied.