Research professor Thomas Schleifer has published a string of op-ed articles at ENR.com warning those in the construction industry about the financial perils and risks associated with a rebounding economy. In turn, we’ve highlighted these articles and had discussions and Webinars of our own setting forth how to navigate the financial risks of a rebounding economy.
Earlier this week, Schleifer published another ENR article titled “The New Rules of Risk Include an Increased Threat of Contractor Default.” While this article highlights an important concern for the industry, unlike Schleifer’s other articles, I believe this one falls short in explaining the problem and helping contractors and suppliers understand what they can do to address it. This article picks up where we think Schleifer left off.
Why Increased Contractor Default Is Happening In The Market Now
Let’s first convince you that contractor default is a real financial risk with heightened importance in the current economic climate.
Under normal economic circumstances, the risk of contractor default is already great. The construction industry leads all other industries in its business failure rates. This is not an unexpected consequence of the industry’s challenges, which include strong cash flow needs, complicated projects and project schedules, and a sometimes unfortunate low barrier to entry into the marketplace.
Nevertheless, the contractor failure and default problems are heightened in our current economy, which shows promises of being a “rebound economy.” Schleifer does a great job of explaining why rebounding economies are risky to construction outfits in his previous article, Beware The Recovery: What History Teaches Contractors and Sureties.
“Contractor default and failure is a real challenge for the industry at all times; but in the current economy, it is especially challenging.” The contractor default problem presented by a recovering economy boils down to cash. Recovering economies offer huge opportunities for growth, but this growth consumes cash and the market is relatively cash poor coming off the recession. This antidotal thought is backed up by Schleifer’s research at the Del E. Webb School of Construction, Arizona State University.
Contractor default and failure is a real challenge for the industry at all times; but in the current economy, it is especially challenging.
Schleifer’s ENR article re-states and confirms this contractor default problem, but fails to offer any help to the reader to overcome the accurate warning that “some of the common ways of dealing with the risks may be self-defeating.” Picking up where Schleifer left off, the next two sections of this article will address: (i) What subcontractors can do to avoid being a statistic; and (ii) What suppliers and subcontractors can do to avoid risks associated with failure by others on the project.
Part I: What Subcontractors Can Do To Avoid Being A Statistic
The statistics promise that unprepared contractors will fail and default on some projects as the economy recovers. If you’re participating as a subcontractor on a construction project in the current market, therefore, you want to be aware of this and prepared to avoid the risk. The question, of course, is how?
Understand And Avoid The Problems That Cause Contractor Failure
The most effective way a subcontractor can avoid becoming a default statistic is to learn, understand, and appreciate the market risks that may lead to default. There will be enormous temptation to quickly scale up a business as growth opportunities present themselves (and indications are that these opportunities are on the horizon), but resisting the temptation of always saying yes and stretching the company too thin will be a rewarding discipline.
This speaks to the biggest problem that can cause contractor failure: running out of cash.
The construction industry is already cash-hungry, but running out of cash will be a lot easier as the market starts to grow quickly. Your business can take a few precautionary measures to prepare for this risk:
- Get your financial documents in order and make cash projections each month; use these projections to guide the company as to which projects to accept, and which to discard;
- Secure cash financing and availability now, before your company gets desperate
- Don’t get greedy and take on too much work
- Be careful with your bids and estimates, and don’t promise to do projects for too low a fee, relying on good luck or change orders to make up for unexpected costs
Insulate Yourself Against Risk By Preparing For Mistakes And Failures By Others
“Keeping your own house in order is critical, but equally critical is preparing for everyone else to be a mess” Understanding the default risks and taking steps to keep your company healthy during the economic recovery is fantastic and will go a long way to get your company out the other side successfully. However, it is not enough. Companies with extraordinary discipline and good cash practices are going to be pretty safe, but not completely secure, and that’s because the poor practices of other companies on the construction project may easily create problems for them.
Anyone in the construction industry knows how one company’s default, delay, or poor workmanship on a project can cause problems for everyone. Scheduling problems, cash flow problems, and even scope of work problems.
Keeping your own house in order is critical, but equally critical is preparing for everyone else to be a mess. How to do this is the subject of this article’s next section.
Part II: How Subcontractors And Suppliers Can Prepare For Defaults and Failures By Others On The Construction Project
“While you may not be able to prevent your customer or another contractor from defaulting or shutting down, you can insulate your company from the risks associated with that event.”You can pick your friends, you can pick your nose, but you can’t pick your friend’s nose, right? You may be sold on doing things internally to prepare for financial risks, but what can you to do prevent other contractors from defaulting and failing? While you may not be able to prevent your customer or another contractor from defaulting or shutting down, you can insulate your company from the risks associated with that event.
1. Always Protect Your Mechanics Lien & Bond Claim Rights
The first and very most important thing a material supplier or subcontractor can do to insulate themselves against the risk of contractor default or failure is to protect and manage its mechanics lien and bond claim rights. The reasons for this are numerous, as we’ve explored in the post 17 Ways A Mechanics Lien Works To Get You Paid.
Respecting contractor failure issues in particular, a mechanics lien or bond claim filing will enable your company to skip right past the defaulting contractor to seek payment directly from the prime contractor or property owner. If your customer is having cash problems or is slow to pay, this will be an incredible tool, and the single difference between a write-off and cash. It is very, very important. If you want help managing your preliminary notice filings and mechanics lien deadlines, consider the Levelset platform.
Also read: 5 Alternatives to filing a mechanics lien.
2. Rely on Strong Credit and Collection Policies
Hand-in-hand with the protection and use of your lien and bond claim rights is the utilization of strong and consistent credit and collection policies. We’ve talked about these policies in great length here on the Lien & Credit Journal.
A credit policy is a set of procedures your company follows to determine who will receive credit terms and who will not, and specifically what terms will be offered. A collection policy, on the other hand, is a set of procedures your company will follow when a customer goes into non-payment status.
These procedures are critical to insulating your company from a contractor default situation. First, the credit policy may help avoid risky contractors. Second, the collection policy will help offset the risk, by prioritizing your debt, increasing recovery rates, and cutting off the customer before the bill gets too high.
3. Use Joint Checks, But Don’t Get Burned By Common Mistakes
“The joint check agreement is a floatation device and not a security device.” We recently conducted a webinar about joint check agreements: Joint Check Agreement Mistakes That Can Cost You Thousands. These contracts are wildly popular in the industry, but surprisingly very dangerous and risky for those who rely upon them. Common mistakes can put your company in a very bad legal position with respect to the money owed.
Since joint check agreements are so common in the industry and mistakes are so easy to make, we dedicated two weeks of blog posts to the instrument last year: Read The Joint Check Agreement.
One point in the webinar and the blog series is very important to remember when thinking about the economic challenges discussed herein, and is particularly relevant to this topic: The joint check agreement is a floatation device and not a security device.
Unlike liens and bond claims, or even personal guarantees, the joint check agreement is never offered to “secure” a debt. It is almost exclusively used to salvage a bad or desperate situation. Someone is out of money, someone is defaulting, someone is having project problems, etc. etc. For whatever reason, the customer cannot pay you and they extend a joint check agreement offer to keep going forward. The joint check device, in other words, is thrown to sea to help a drowning business.
Treat it like that! The situation is not safe until you get the money in hand (i.e. the drowner in the boat). Joint checks can be a fantastic tool in desperate situations, but use caution.