Protect yourself

Facing construction credit risk

By Larry Michael
The Brehmer Agency

These days, having worked as a subcontractor/supplier for a well-known general contractor or owner for many years may not be adequate prequalification .

We have recently witnessed the closings of the 105-year-old Geo. M. Hougard & Sons Inc., the 50-year-old Guenther-Wagner-Johnson and Klug & Smith Co. These firms were among the finest in their day.

This raises some questions. What construction company might be next to succumb to the current construction downturn? When will they succumb? Who will not be around in 2005? Will I be in the middle of a job with them?

Without surety bonding on many projects, subcontractors/suppliers are left with only lien rights to secure their credit risk. While bond and lien rights might provide for collection some time in the future, the disruption in cash flow could have serious and immediate consequences. What subcontractor has too much cash on hand these days?

The years 2000 and 2001 produced record-breaking sales for many contractors. Last year flattened our sales growth, and 2003 is showing substantially lower sales volume.

Economic indications show a continued decline in construction for 2004. Whenever construction sales peak then fall off, cash flow crunches are unavoidable even for the most profitable contractor.

Changes needed

Perhaps new paradigms can be established whereby subs and suppliers will routinely prequalify generals and owners on a project-by-project basis — as with any commercial business credit transaction — by obtaining financial information, credit reports, letters of reference and bank-lending accommodations.

And why should this sound far-fetched? On private owner nonbonded construction projects, the subcontractor/supplier is asked to take significant credit risk.

Adequacy of construction financing can mitigate this risk. Subcontractor/supplier bids can be conditioned on:

  • The bidder (and the bidders surety) shall not be bound hereunder unless the owner/general provides satisfactory evidence of adequate financing to the bidder (and the bidders surety) prior to the execution of the contract. Acceptable evidence of adequate construction financing is a condition precedent to signing a subcontract.

Also, the sub could request the following from the general/owner on a private contract:

  • Provide evidence of funds in the amount of the total construction costs, including contingency for over-runs.

  • How were construction costs determined?

  • What are the lenders' names and how can they be contacted?

  • What is the total amount of construction loans?

  • If the loans are less than the contract price, how will the difference be financed?

  • Who is the payout agent?

  • Who is the escrow agent?

  • How will funds flow from the source to the subcontractor?

  • When and how often will the subcontractor be paid?

  • Can the subcontractor be paid bi-weekly?

The subcontractor and its surety can also request copies of these documents:

  • the general's or owner's certified financial reports;

  • construction loan agreements;

  • the lender's set-aside letter;

  • the owner/architect agreement;

  • the builder's risk policy;

  • the architect's professional liability policy.

While this may sound like subcontracting in heaven, why would we want to do commercial business credit-risk taking any differently?

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