Who gets screwed when money gets tight on a construction project? That is the question, and for over 200 years the United States’ legislatures, courts and construction industry participants have been in a tug-of-war over who bears the ultimate financial risk. This article discusses the debate and reports on the current state of affairs.
Getting Paid In The Construction Industry Is Tough
I’ve written about this quite often, and in fact, it’s the very reason why we built the Levelset platform. The construction industry has a remarkably challenging time getting paid, and it’s easy to see why.
All materials and labor are furnished on credit, and the furnishing amounts are usually quite substantial. Most companies need the line of credit from furnishing parties because they can’t pay the bill until they receive payment from those higher in the contracting chain. Everyone on a construction project, therefore, is waiting for money to trickle down the contracting chain and get to them.
The construction industry is extremely volatile. You’re so likely to fail in the construction industry that it’s easier to start any other type of business and succeed. There are lots of places for money to slip through the cracks or get delayed. Any little inconvenience, delay or dispute about any component of the work will likely impact payment for everyone on the project, regardless of their involvement in the dispute. Plus, this environment forces many companies to misappropriate funds, robbing Peter to pay Paul.
It’s no wonder that the construction industry is extremely volatile. You’re so likely to fail in the construction industry that it’s easier to start any other type of business and succeed.
If you do succeed, you’re likely to profit very little and constantly fight cash flow concerns as the average net profit margins in the industry are excruciatingly low. In fact, Bloomberg Businessweek and Sageworks did a study on the least profitable businesses in the United States, and of the 10 least profitable business types, 9 of them were in the construction industry operating on profit margins between 0.6% and 2%.
Mechanics Lien Laws: Financial Risk Must Be Borne By The Developers
The difficulty of getting paid in the construction industry is not a new problem. In fact, it’s a very, very old problem. It’s actually a problem that Thomas Jefferson addressed while a Maryland state legislator.
As explained in the Short History of the Mechanics Lien, the United States was rich in land at its founding, but it was impossible to get suppliers and tradespeople to develop the land because of the high risk associated with getting paid (see the above discussion). This is when Thomas Jefferson invented a device that rapidly spread across the country and remains in our legal parlance today: the mechanics lien.
The mechanics lien concept is simple. Every single tradesperson or supplier who furnishes anything to a construction project can claim that project job site as collateral. Just like a bank secures every loan with collateral, similar security can attach to every construction furnishing.
This is an astonishing legal tool. Think about the purpose of these mechanics lien laws. Each state has passed a law that essentially says we want to ensure that suppliers and tradespeople always gets paid. Instead of letting the sellers and laborers take the risk of payment problems because of the above-cited reasons, these mechanics lien laws push the risk on the people at the top: the developers and prime contractors.
While mechanics lien laws have a lot of associated technicalities and headaches, these are not put in place to reduce the effectiveness of the remedy. The stated purpose in every state is to protect laborers, tradespeople and suppliers. In fact, this is why most states prohibit any contracts containing a “no lien clause.” You can’t waive your mechanics lien rights if you try.
On the question of who gets screwed when money gets tight on a construction project, the state legislatures have weighed in and say it’s the developers, lenders and prime contractors.
Pay-When-Paid and Pay-If-Paid Clauses Attempt To Shift Risk Down The Contracting Chain
It’s didn’t take long for folks in the construction industry to understand the risk impact of mechanics lien laws, and so industry participants soon began writing language into the construction contract to shift the financial risks to other parties.
“No Lien Clauses” is one example of such language, whereby a party prohibits a mechanics lien filing right at the beginning of the project. As above mentioned, however, these clauses are prohibited in nearly every state.
“Pay-When-Paid” clauses, however, is a very popular risk shifting clause that has some traction and effectiveness in the construction industry. The purpose of the clause is to make payment for services or materials contingent upon the receipt of payment up the contracting chain. So, if a prime contractor hires a subcontractor and inserts this clause in the contract, the subcontractor will do the work and must wait for payment until the prime contractor is paid for the subcontractor’s work. Only upon this payment is the subcontractor due any money.
Can you imagine any other industry where this restriction would be accepted? What if you told your dentist you’d only pay his bill if and when you get your next payroll or contract payment? Nevertheless, these agreements are signed all the time because those up the contracting chain generally have more bargaining power than those below.
Remember, however, the above discussion of the mechanics lien and the purpose of these statutes? The state legislatures have gone out of their way to force the higher parties to bear the financial risk of loss. When parties insert “no lien clauses” courts have nullified them as against public policy. Will courts allow parties to use these “Pay When Paid” clauses to similarly risk shift?
The answer to this is very confusing.
Courts looks upon these clauses quite strictly, and have a pretty convoluted method of determining just how contingent payment is based on the clause.
We’ve discussed, for example, the differences between “pay when paid” and “pay if paid” clauses in a previous post, and how courts will interpret these differently. Some courts just declare complete contingencies (i.e. pay if paid clauses) void and against public policies. Other courts, like the Ohio courts in a very recent case, will make it virtually impossible to create a strict contingency to shift financial risk down the contracting chain.
On the question of who gets screwed when money gets tight on a construction project, construction industry participants are in a tug-of-war, negotiating contract clauses and language that shifts the risk down the chain to the sellers, trades and laborers. However, because the state legislatures and courts are interested in making sure the bottom chain participants get paid, many of these clauses are invalid or significantly restricted in application.
Construction Project Complexities Heighten Tempers And Cause Expensive Personality Conflicts
While not official at all or represented by state statutes or jurisprudence, personalities and temper problems in the construction industry is a very real and important component to the payment problem. The construction industry is riddled with hotheads and egos.
The environment is a perfect breeding ground for this sort of problem. This industry lacks legal and business sophistication but the projects themselves are very complex and involve a heap of legal and practical challenges. When things go wrong, they go wrong quickly and sometimes street smarts is more important or practical than legal positioning.
Those at the top of the contracting chain (generals, lenders, developers, and some high-tiered subs) will sometimes bully their way through these payment issues.
Withholding money on purpose is a common tactic, for example. These projects are high dollar endeavors and withholding a single payment for a week or two can cause serious cash flow problems for the lower tiered contractors or suppliers. They can’t afford the cost and time of a legal dispute, and they sometimes give away money they deserve just to get the money available.
Bullying a lower tiered contractor or supplier to agree to additional work scope items or change order prices is also common, as those with money have enormous leverage over the lower tiered. It’s precisely why the lien protections exist, although some bigger players can avoid this danger by just getting a temper and “crushing” a small participant if they do proceed to file a lien.
Accordingly, despite the legal protections put into place with mechanics lien laws and the invalidation of certain contractual provisions, the bullying and temper tactics used by top-of-the-contracting-chain parties works to push the risk of financial loss upon sellers and trades.
Current Framework: Trades and Suppliers Have Strong Protections, But Only If They Have The Courage And Resources To Use Them
This post intends to be a conversation about the challenges, legalities and strategies of getting paid in the construction industry. It is not a simple issue, and because the laws are different from state to state, it’s not an issue with a single answer.
If there are any trends nationwide it is simply this: the law goes out of its way to protect tradespeople, subcontractors, laborers and material suppliers.
There are strong protections available to these parties. The primary protection available is the mechanics lien law. Suppliers and the trades just need the courage and resources to use them.
This would manifest itself in two ways:
It’slevelset’s mission to empower your company to utilize the mechanics lien laws. (1) Courage: Having the courage to utilize the mechanics lien laws in the face of prime contractors, developers or lenders who try to bully you away from using these remedies. Ask yourself, why exactly are they doing this? Because you don’t “trust them?” Really? Protecting your lien rights is not a matter of “trust,” it’s a matter of common business sense. If these parties candidly cared for your company they would encourage you to take your protections.
(2) Resources: Complying with mechanics lien laws, utilizing a construction attorney to negotiate for you or represent you in a dispute, being willing to not receive a payment for long enough to fight your fight…all of these things require resources. It’s levelset’s mission to take care of the first thing: empowering your company to utilize the mechanics lien laws.
Opinion: Who Should Bear Financial Risk And Why?
So, what do you think?
From my experience, the construction law and construction world seems to be separated into two camps: the top of the chain folks and the bottom of the chain folks. The opinion about who should bear financial risk is usually guided by where a person falls in the contracting chain (or where their clients typically fall).
Every construction project has financial risk. Somebody has to be the ultimate bearer of that risk. Who should it be and why?