Minimizing Subcontractor Default Risk

The construction environment over the last several years has presented challenges that have placed subcontractors and general contractors in a state of vulnerability that must be properly managed to avoid negative impacts on their organizations. Scarcity of work and ferocious competition have driven profit margins down, resulting in balance sheet erosion and layoffs. We are left with an industry that is thinly capitalized and thinly staffed. Ups and downs are not new to the construction industry, and, in general, contractors are a resilient bunch. However, the current state of the market presents challenges that the industry has seldom faced simultaneously.

For the most part, subcontractor defaults occur during an upswing in the market, not in a downturn. Those companies that survive downturns often come out as smaller versions of their former selves. When the pendulum of available work finally swings the other way, their ability to perform that work is diminished, and default rates begin to spike. We have been in a recession for so long that much of the labor force that was laid off has left the construction industry and is unlikely to return. When you couple this with an aging workforce, the industry is in a particularly precarious position. The issue is compounded through the banking industry’s retraction of availability of credit.

While the status of the construction industry remains unpredictable, certain segments are showing signs of recovery. As the availability of work begins to rise and backlogs build, however, the pressure on the ability to perform is going to build. Now more than before the recession, it is critical that you choose your partners wisely and work diligently to develop a consistent and thorough process for the prequalification of subcontractors. Although there are certainly steps to manage a default scenario once it has occurred, for the purposes of this article, I am focusing on the prequalification process and the process of managing the prevention of default.  

There are generally three key elements to managing subcontractor default risks:

• The prequalification process
• Contractual language
• Interaction with the subcontractor during construction

The goal of the prequalification process is to create a fair and consistent system that generates a preferred list of firms that should be considered in bidding projects to mitigate default risks while increasing the probability of on-time, on-budget delivery. Although this process will differ from one firm to the next, you should focus on a few key items:

• Financial review – The Construction Financial Management Association is an excellent resource for information related to acceptability of liquidity and debt ratios and has a guide that can be found at www.benchmarkmetrics.com/cfmaratios.cfm. Aside from the ratios, it is important to note the quality of statement preparation (audit, review or compilation), as well as overbillings, underbillings and the health of cash flow.   
• Insurance program review – Verify that the subcontractor’s insurance program is in compliance with the contractual requirements and is carrying sufficient limits relative to the work performed.
• Bonding capacity – Confirm that they have an adequate bonding capacity for the job and that they are using a reputable surety.
• Reference checks – Reach out to vendors to get a sense of payment cycles and the health of existing relationships.
• Know their key personnel – It is important to have an understanding of who is behind the company, how they run their business and who to call if an issue should arise.
• Efficiency – Focus on traditional workload as compared to current backlog to determine their capacity relative to their workforce. 
• Ongoing health – Request updated financials at regular intervals. 

Examining Contractual Language
In conjunction with the prequalification process, you should use contractual language to manage default risks. Avoid onerous language that would have more of a probability of placing a sub into default than keeping them profitable. Some examples of contractual default mitigation practices are as follows:

• Require identification of all subcontractors and suppliers, along with the right to reject or approve them.  
• Require a flow down of all key contractual requirements to ensure that your contractual obligations are included in your subcontracts.
• Require lien waivers up front and certification of downstream payments at all levels.
• Consider bonding subs, specify the bond form and verify the strength of their bonding companies. 
• Maintain the right to withhold payment under certain circumstances.
• Be clear about retainage, including how much will be retained, how long it will be retained and the terms of its release.
• Include a termination for convenience clause to allow for an easy out in the event that a party needs to withdraw from the contractual obligations with minimal impact on the project.
• Authorize joint payments when necessary. 

Interacting with the Subcontractor
The third key element of managing subcontractor default risks entails interacting with the subcontractor during contract performance. This is as important as any other step in the process and requires you to remain diligent throughout the life of the project to maintain the health of the relationship. Take the following steps to maintain a healthy relationship with the subcontractor:

• Pace your progress payments so as not to fall behind relative to the work being performed.
• Honor and enforce your contracts.
• If utilizing bonds, obtain surety’s consent and make sure the penal sums of the bonds are being properly adjusted in accordance with change orders.
• Practice open and clear communication throughout the project. Ideally, you want continual communication among prequalification services, preconstruction services and operations in order to detect any signs of stress or potential default early. 
• If parting ways becomes necessary, it is generally better to objectively negotiate a resolution through termination for convenience, deductive change order, etc., as opposed to a contentious departure, which inevitably leads to delays and increased costs. 
• Know your rights and remedies.

This is by no means an exhaustive list of best practices, but these are key components of developing a plan to mitigate default risk. As with any plan, the most important thing to remember is to be consistent and use the plan you have developed.