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Participants in the construction industry are in an enviable position in that the ability to secure every extension of labor and/or materials on credit is built directly into the law, as long as certain procedural steps are taken. Despite this, payment difficulties persist, and the bad-debt ratios and failure rates of construction industry participants are high. Why is this? Even though construction industry companies are given this ability to use security rights on every project, the industry has consistently failed to take advantage of this capacity. Given the benefits of properly using security rights, should construction companies be required to use them?
Directors and Officers have a “duty of care” to the corporation. Does ignoring and/or not fully utilizing available security rights breach this duty?
As more and more information becomes available regarding the positive effect security rights can have on A/R, Cash on Hand, and even Company Value for construction industry participants, the lax attitude toward the use of security rights is likely to change.Failure to comply with industry “best practices” generally does not result in a breach of director and officer duty. This is in direct contrast to behavior that can be considered grossly negligent, or recklessly indifferent to the company’s well-being. The difference between failing to follow industry-standard practices and acting in a grossly negligent or recklessly indifferent manner may be smaller than one might think, however. Practically speaking, it seems impossible to deny at least some link between industry standards and how reasonable a specific action may be. The failure to secure an extension of credit may be acceptable in construction, but it may not be in an industry like banking. Since the action and result are equivalent in both situations, the only measurable difference is the particular industry’s attitude toward the action itself. As more and more information becomes available regarding the positive effect security rights can have on A/R, Cash on Hand, and even Company Value for construction industry participants, the lax attitude toward the use of security rights is likely to change.
One of the facets of the duty of care is to be informed of all relevant and reasonably available material in making business decisions. Security rights directly and significantly impact both timing and likelihood of payment and, as such, directly and significantly impact A/R and cash flow. Because the expected write-off for secured extensions of credit is meaningfully reduced as compared to unsecured extensions of credit, the calculation of “bad-debt” related to each differs in a corresponding amount. This can have a significant impact, and much relevant information is easily available.
Generally accepted accounting principals allow companies to calculate outstanding bad debt by different methods. However, “there is very little regulation around what methods may be used, except to require ‘conservatism’.” Since studies have frequently shown that secured accounts receivables consistently outperform unsecured receivables, “segregating these two classes of receivables and applying a different allowance would be an acceptable multi-method calculation of bad debt, and likely would result in increasing and making more accurate the earnings reported by companies.”
Security in the Construction Industry Is Getting Easier to Use
Not only can the proper use of security rights provide a large financial impact, the historic challenges to their use (for companies in the construction industry) are rapidly becoming obsolete. The largest obstacle in using security rights routinely has generally been the number and complexity of the laws and requirements. Compliance with these regulations has historically been nearly impossible from a practical standpoint. Because of this, the benefit gained by securing every extension of credit was possibly offset by the associated costs.
Managing and tracking mechanics lien requirements no longer requires bulky and cumbersome in-house departments or inefficient third-party outsourcing. Construction companies have new tools to deal with the thousands of different requirements that may apply, when the numerous variables are considered. Emerging software has the ability to decode and streamline the unique security circumstances and associated requirements for parties at both the top and bottom of the payment chain. As this new technology penetrates more deeply into the marketplace, the industry view regarding the acceptability of a failure to use security will likely change.
Top of the tier parties (GCs, Owners, and Lenders) are already using technology to determine which subs and suppliers have secured their extensions of credit. A financial manager who either 1) does not know that the security status of his/her company is being tracked on every project, and fails to take reasonable steps to secure mechanics lien rights, or 2) does know that security status is being tracked and chooses to disregard that information with regard to securing mechanics lien rights, is doing his/her company a disservice.
Given the drastic impact of security rights on construction companies, these companies should start to implement the robust use of security into their credit policies.
While it is likely not yet a breach of duty to fail to secure extensions of credit in the construction industry that doesn’t mean it shouldn’t be done.
Officers and directors of construction industry participants have overlooked or delegated security rights for years, but their counterparts at banking or financing institutions would never do the same. Because these divergent practices are not tied to the legal availability of these rights, they must be related to their historical practical availability. As the practical hurdles to the availability of security rights for companies in the construction industry disappear, the view that failure to use security on all projects will likely dissolve, as well.
Because of this, construction companies would be prudent to implement “best practice” policies of securing extensions of credit now – rather than play catch-up when every other successful construction company has already implemented that policy.