Search Results for: financial risk shifting

ENR.com and the Construction Financial Management Association (CFMA) recently published some articles suggesting that “cash-strapped public and private owners are shifting greater risk onto contractors through onerous deal terms” [Owners Shift More Financial Risk as Recovery Remains Sluggish]. This is true, but it’s not necessarily new.  As this article will explain, this risk shifting tug of war has been going on for over 200 years.  Nevertheless, it doesn’t minimize the importance to subcontractors and suppliers to understand the game and prepare for it.

History of Owners Shifting Risk Down The Contracting Chain

In 1791, Thomas Jefferson invented the mechanics lien, and in doing so he set forth the unique American policy that subcontractors and suppliers should be paid on every project, and that the financial risks on construction projects should be shouldered by developers. Mechanics lien laws were quickly passed in every state across the nation, and in some instances, even inserted into state constitutions.

It’s the US public policy that financial risk should be shouldered by property owners and developers. Did you pick up on what I just said there?  It’s the US public policy that financial risk be shouldered by property owners and developers.

Do you believe me?  Consider this:

• Every state has mechanics lien and bond claim laws which are designed to protect subcontractors, suppliers, laborers and those down the contracting chain from non-payment.
• Every state has some form of “prompt payment” laws that apply only to the construction industry.
• In many states, misappropriating construction funds is a crime.
• States have laws that restrict how much retainage can be withheld from a sub-tiers contract

I could go on and on.  State statutes are riddled with legal provisions to prevent those with the money (i.e. owners and generals) from taking advantage of those without (subs and suppliers). If that is the case, why in the world is it so difficult to get paid in the construction industry?

The answer is that owners and their lawyers have been working for 200 years to contractually shift the financial risk on projects. That is precisely what ENR and CFMA are currently warning about here: Owners Shift More Financial Risk as Recovery Remains Sluggish.

To combat the legal provisions and policy protecting subcontractors and suppliers, owners are constantly conjuring up new contractual provisions to offset the laws.  Here are some example provisions designed to shift the risk down the contracting chain:

• Pay when paid clause
• Pay if paid clause
• No lien clauses
• Claim notice provisions
• Retainage Requirements
• Payment bond requirements

Owners have been using these provisions to shift the financial risk on construction projects for generations, and there is a battle between what controls: the law’s public policy or the contract terms.  In many cases, you’ll find that the courts invalidate contract provisions that conflict with the state’s public policy protecting subcontractors and suppliers. However, how courts will rule on the issue varies with each generation, court, and circumstance (Boooo!).

What You Can Do To Balance The Risk Shifting Efforts of Owners

Something mentioned in the ENR article about financial risk shifting is dead-on accurate:  “The financial consequences of risk-shifting are hitting subcontractors first since ‘they are furthest from the cash flow.'”

The financial consequences of risk-shifting are hitting subcontractors first since ‘they are furthest from the cash flow.’ This is a sobering statement.

Being a subcontractor (or a supplier) is a perilous endeavor. The construction industry boasts the highest business failure rates in the nation. Financial risk mitigation efforts are being employed by parties subcontractors and suppliers cannot control (i.e. between the GC and the Owner), but the effects of those efforts are hitting the subcontractors and suppliers.

This all seems horribly unfair…but wait…

The financial risk shifting game has been a cornerstone of the American construction market since the late 1700s, and so the nation’s laws have created legal tools for the subcontractors and suppliers to use to offset that uncontrollable risk.  There are many tools, but as we’ve suggested in the past, the mechanics lien laws are by far the most effective for protecting your right to payment and simply getting paid.

It’s a fundamental tenet of American public policy that trade contractors and suppliers should be paid for their work, and should not be the parties required to bear the financial risk of construction projects. This belief that people should be paid what they are owed, and that the parties closest to the money should bear the ultimate financial risk, is deeply ingrained in the laws governing the American construction industry.

In fact, this is why the mechanics lien instrument was created. The concept that subs and suppliers, (people further down on the payment ladder), deserved to be protected from non-payment above them traces back all the way to the founding our this country.

The financial risk of non-payment shouldn’t fall on the lower-tiered parties. The offshoot of the belief that the financial risk of non-payment shouldn’t fall on the lower-tiered parties — and the corresponding result that GCs and property owners (those at the top end of the payment ladder) should be the ones to bear the burden of a project’s financial risk — is that property owners and GCs have looked for ways to change that equation.

Nobody likes to be forced to shoulder a financial risk, so GCs and property owners have attempted to shift the burden back to the parties below them on the chain via contractual risk-shifting clauses. This battle of contract vs. policy is ongoing.

After the creation of statutory protection for subs and suppliers vis-a-vis the allocation of the ultimate financial risk of a construction project on their property to the owners and GCs, an ongoing string of risk-shifting contractual clauses emerged.

Risk-shifting contract provisions

In the 1940s, contracts began to include “no lien clauses” in an attempt to pass the financial risk to sub and suppliers. When cases involving these no-lien clauses made it to court, however, these clauses were routinely thrown out as impermissibly denying a statutory right, and as against public policy. Since “no lien clauses” were determined to be impermissible, GCs and property owners adapted and began to include a different risk-shifting clause in their contracts, the pay when paid clause. Again, however, courts came down on the side of the subs and suppliers by treating pay when paid provisions as a timing mechanism, rather than a means to avoid payment. This means they allowed the GCs to wait for a “reasonable period of time” to receive payment before they were obligated to pay the subs — but they were not absolved of that responsibility altogether.

When the effect of pay-when-paid clauses was lessened, GCs and owners responded by modifying pay when paid clauses into pay-if-paid clauses, and again inserted them into contracts in an attempt to shift the risk down the payment chain.

Learn more – Pay-When-Paid vs Pay-If-Paid: Contingent Payment Clauses Explained

These, again, have been the subject of much litigation, and the results have varied. Many courts have also held these provisions to be akin to no-lien clauses, and have declared them void as against public policy, but there are situations in which these provisions may still be effective.

While the required language varies from state to state, it is generally required that the clause specifically state that it is meant to shift the risk of nonpayment to the sub or supplier, and that payment to the GC is a condition precedent to payment of said sub or supplier.

Many states, either via court decision or through statutory law, have decided that shifting financial risk through pay-if-paid clauses to be void as against public policy.

This is not universal, however, or even necessarily the norm. Pay-if-paid clauses are still allowed and enforceable in many states, provided certain specific language is included in the clause itself.

On one side of the scale, there are statutory laws protecting subs and suppliers that attempt to keep the financial risk of construction projects on the property owners and GCs: mechanics liens, bond requirements, criminal statutes, payment timing provisions, etc., and on the other side there are the contract provisions described above with which the GCs and property owners attempt to shift the project’s financial risk back down the ladder. Generally, judges tip the scales back in favor of the subs and suppliers when these issues come up in litigation, but by no means is that always the case.

A prudent construction credit manager is wise to keep these provisions in mind.

Today, at the Construction Financial Management Association (CFMA) Annual Conference, experienced construction industry financial professional, Steven Lords, is presenting an all-day “mini-conference” on Cash Management.

Cash management is a highly valuable topic for construction participants. There are obvious reasons why cash is important to any business, but there are additional layers of value in the construction industry where participants must balance cash challenging situations and must maintain positive cash flow to ensure access to capital, bonding capacity, and to meet contractor qualification criteria.

This article focuses on a few interesting comments from Mr. Lords’ presentation and slide deck that should assist the reader in developing successful cash management strategies.

“CFOs or Controllers Can Generate More Profit From Effective Cash Management Than Project Managers Can On Their Projects”

This statement is made in the introduction to Mr. Lords’ written materials for the session and it makes a terrific point. The speaker is in a position to authoritatively make such a remark as well, having acted in a financial capacity in the construction industry for over twenty-five years. His experience includes acting like a CFO for commercial general contractors and specialty subcontractors.

Companies rarely look at finance as a revenue or profit generating function. Instead, most companies credit the sales process, or even the performance process, when both the top and bottom line perform well. Unfortunately, this often even leads to tension between sales professionals and credit, collection, and finance professionals within a single organization.

Nevertheless, companies should think carefully about this particular comment. CFOs and controllers can generate more profit through intelligent cash management on a project than project managers.

Further, if you want to compare the finance function to the sales function, generating additional profit is equal to generating ten times or more of that amount in revenue.  Mr. Lords’ comment could be extended, therefore, suggesting that CFOs and Controllers can compete with salespeople in generating company revenue by simply managing cash better.

Cash Management is NEGOTIATED

Savvy companies leverage their negotiating ability to get the best terms from their vendors and customers, and then to push the limits on those terms. So, how does a company go about managing cash? What is Mr. Lords’ first item of instruction?  He starts his cash management session by telling participants that cash management is “negotiated.”

It’s easy to think about cash flow as a static concept.  Cash flows in and out of a company pursuant to factors subject to only limited control: market conditions, payment terms with vendors, invoice terms with customers, and the like.  At the CFMA Cash Management mini-conference, it’s suggested that cash is affected by the following:

• Economy
• Technology
• Market Perceptions
• Entity Perceptions
• Negotiating Ability
• Choice of Business Parties

Ah, ha!  While some of these items are largely uncontrollable (i.e., economy), the majority are subject to control.

Companies and financial managers choose the technology used to manage and optimize cash. Companies choose their business partners.  And finally, savvy companies leverage their negotiating ability to get the best terms from their vendors and customers, and then to push the limits on those terms.

Gain Control Over Cash Flow Factors And Negotiate Your Best Position By Minimizing Assets and Maximizing Liabilities

Managing cash flow really boils down to what tangible things companies can do to get cash faster and keep their own cash longer; and that, in turn, simply refers to the following:

• Billing:  What technology does the company use to bill most efficiently?  What are the terms of payment required from customers?  What are the procedures for collecting on receivables?
• Paying Vendors:  What terms does the company require from vendors? How are vendor payments handled?
• Capital Access: Where does the company have access to capital? What is the cost of that capital access? What are the procedures for when this capital is used, and how does that fit into the waiting period on receivables and the payment period on vendor invoices?
• Deliverability of Money:  Who is delivering the money from one source to another (i.e. USPS? EFT?), and that impact does that have on cash flow?
• Who Are The Customers?  Are the customers solvent enough to pay according to the required terms? What does the company do to limit its customer base to folks who will pay according to terms?
• Construction Cash Realities: Construction participants sometimes have to wait for cash from the owner or lender, or are restricted from collecting – despite their terms – by the terms of the underlying construction contracts.  What are the company’s policies concerning evaluating these risks, and setting forth the parameters of risk the company will accept?

All of the above bullet-point items are adjustable and negotiable factors that affect cash management.

Accounts receivables are generally the largest single Cash Flow component in the construction industry. One interesting note about Mr. Lords’ presentation is that he called accounts receivables “generally the largest single Cash Flow component.”

This is a pretty large statement and should motivate construction financial managers everywhere to think long and hard about their receivables management processes.

Receivables management is a topic of its own, and an intricate issue in the construction industry context.  Anyone in charge of receivables performance, however, should understand Mr. Lords’ directions in managing cash.  He states that there are two simple rules to increase Cash Flow:

1)   Accelerate receipts and decelerate payments; and

2)   Minimize assets and maximize liabilities

These two rules are not secret – this is Cash Management 101.  And that is precisely the problem addressed by this article’s next section.

Mastering The Cash Flow Catch 22 In Construction

The real challenge is in how widespread the two cash flow rules are within company cash management procedures. If everyone is adhering to these two rules, in other words, that makes it exponentially more difficult to achieve success.  One company’s effort to “accelerate receipts” is met with another company’s efforts to “decelerate payments” and vice versa.

What can a company do to actually “accelerate receipts?”  How can a company “accelerate receipts” when their customers are simultaneously “decelerating payments?”

The answer is a basic tenant of receivables collecting: prioritize your accounts.  And interestingly, goes back to one of Mr. Lords’ points in this Cash Management mini-conference: negotiation.

When an organization is “decelerating payments,” they are not refusing to pay all of their bills. Instead, they are making choices about which bills to pay and when. Those companies who have a hard time accelerating their receipts and getting open receivables paid simply do a poor job of negotiating their position to get paid. These companies are bad at prioritizing their accounts in the eyes of the customer.

There are many ways to prioritize accounts and accelerate receipts, and each financial manager is going to favor a particular theory or practice. Nevertheless, one thing can be said for certain: security rights matter, and they matter in getting a company’s receivables prioritized.

General contractors, owners, lenders, and sureties are very, very interested in mitigating their own financial risk. As we’ve explored at length on this publication, they employ various financial risk shifting tactics to insulate themselves from this risk. When a supplier, subcontractor, or other company is floating out on a project with security rights intact, that presents a “financial risk” to the top of the contracting chain.

The top of the chain is in charge of disbursing project funds. It would be naive to believe that these parties do not take a party’s security status into account when deciding which payments can be “decelerated.” This is absolutely done, and in fact, software products from Sage, Textura, and elsewhere are all helping these parties do it.

Conclusion: Negotiate Your Cash With Security And Watch Profits Grow

Mr. Lords’ presentation and materials on cash management were spot-on, as has been all of his published materials about managing cash flow in the construction industry. The lessons boil down to a few key takeaways.

First, CFOs and Controllers are in more control over company profits and the bottom line than appears at first blush.  Second, intelligent cash management is required to positively impact organizations.  Third, intelligent cash management is about understanding cash flow and negotiating companies into the best position. And finally, fourth, receivables are the single largest cash flow component, and getting receivables paid typically boils down to getting accounts prioritized.

We love security rights here on the Lien & Credit Journal, and it’s absolutely true that strong security positions translate into priority treatment from companies, enabling companies to actually “accelerate” cash flow, without being impacted by a customer’s desire to “decelerate payments.”

On September 20th at the McGraw Hill headquarters in Manhattan, general contractors, subcontractors, and suppliers faced off at the ENR risk summit.  According to ENR’s summary of the conversation the obvious happened: Views Differ From Places on the Payment Flow Chart.

General contractors complained about construction risk referring heavily to subcontractor defaults.  Subcontractors and suppliers, however, called for reform to payment procedures because the industry is riddled with subcontractor payment abuses.

What kind of subcontractor payment abuses, you ask?  ENR states that these practices include “sitting on invoices, withholding final payments for years or inserting favorable dispute-forum-selection clauses.”  These three examples, however, are just the tip of the iceberg.  Check out our discussion from an article published here just yesterday: CFMA Says Owners Are Shifting Financial Risks Down The Contracting Chain – Here Are Your Options.

Subcontractors call these risk-shifting devices “payment abuses.”  General contractors call them “risk management.”  This is a big, big topic in the construction industry, but one thing should be clear to you:  you cannot ignore this topic.

When you work on a construction project as a subcontractor or you furnish materials as a supplier you are extending credit to your customer. In the construction industry, this “credit risk” or risk of non-payment is a fact of life. When you work on a construction project as a subcontractor or you furnish materials as a supplier you are extending credit to your customer. Your company, in other words, is furnishing labor or material based upon a promise to get paid in the near or distant future. It happens every day.  In the construction industry, this “credit risk” or risk of non-payment is a fact of life.

Companies respond to this risk in one of three ways.

1. They aggressively protect themselves against the risk by preserving and using their mechanics lien and bond claim rights, and as a result, are almost always paid on projects in full and on time.
2. They use their mechanics lien and bond claim rights intermittently, and in turn, get paid intermittently.
3. They don’t use or poorly use their mechanics lien and bond claim rights, and as a result, they get abused and have cash flow problems, write-offs, high A/Rs, etc.

Let’s talk about this third category of folk.  Those who do not or poorly use their mechanics lien and bond claim rights.  The question to ask is why?

It’s all too often that a company will resist adopting an aggressive mechanics lien or bond claim policy claiming that their relationship with the customer is “too important” to jeopardize with such a lack of trust or what-have-you.  This sentiment is astonishing to me.

In every case, these important customer relationships are riddled with financial risk shifting contractual provisions putting the subcontractor or supplier behind the eight ball with regards to payment. The sentiment about the importance of the relationship, in other words, is only going one way.

Most of us know how one-way relationships turn out.

Payment flow “abuses,” as they are often called, are an absolute staple of every construction project. This is not a fake problem, and it is something that affects your bottom line. There is a way to combat it. It’s too expensive for your company not to.

The ENR article about this topic includes this really telling quote:

When trouble with a subcontractor arises, said Doug Lareau, chief legal officer of Shawmut Design and Construction, “The first question I ask is, how much money are you holding on that sub?” Lareau said his concern was the anticipated cost of remedial measures.

This is not a sentiment unique to Mr. Lareau.  Money is being held from subs and suppliers as a matter of course, and if you don’t protect yourself…you can finish this sentence.