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Construction after the Real Estate Boom
Legal Protection in a Volatile Market
Part One of a Two-Part Series
By Kevin S. Blanton and Joseph J. Devine

Although the nation’s economy is showing signs of recovery, failed construction projects continue to plague our communities and make headlines. What do you do when a project goes broke?

Do Your Homework Before Taking the Job
The best way to prepare for the potential failure of a project is to carefully plan for it. Although one hopes that every job goes well and ends in success, planning for a potential failure is like having insurance—it’s the best investment that you hope you’ll never need.

Before accepting a new job or a purchase contract—especially if the job involves significant upfront costs—thoroughly check the business reputation and creditworthiness of the potential customer or contractor. An effective way to do this is to engage in a process similar to one that a bank or lending institution would go through when considering an application for credit; after all, in most situations, you are being asked to extend credit in the form of advancing goods and services prior to getting paid. Thus, it makes sense to adopt procedure similar to that of any other lending entity.

A preliminary search of Dun & Bradstreet (www.dnb.com/us/) can provide you with what is effectively a credit report for most businesses. The report may include a company’s credit and payment history, notice of any outstanding liens, as well as financial projections and credit limit recommendations based on the company’s profile as compared to other companies of similar size, industry and credit usage. If your end-user happens to be an individual, a similar report can be obtained through any of the popular credit reporting services (Equifax, TransUnion or Experian).

Properly Allocating Risk
Once you have determined the relative financial strength of your customer or contractor, you can then determine the best way to allocate the risk related to the possibility of non-payment during the course of the project in order to minimize your risk. The payment terms and conditions that you employ can be based on the financial strength of your customer and may be altered during the course of your relationship once the customer develops a satisfactory payment history.

Perhaps the most effective way to ensure timely payment, at least for new customers that are not well-established or for existing customers facing financial difficulties, is to require payment for goods and services at the time they are rendered or delivered. In appropriate circumstances, goods and services may be paid for in advance.

Another method of protecting oneself against unnecessary credit risk is to require that goods or services be guaranteed by a parent company or someone involved in the project with sufficient assets to pay for services rendered in the event that the customer or contractor defaults on payment. A payment guaranty is a particularly useful device when dealing with start-up companies or special purpose entities that have been set up to run a particular project and hold little or no assets. The guaranty can be unconditional, absolute and irrevocable, or subject to certain conditions. The attractive feature of the guaranty is that, under most circumstances, the guarantor may not avail itself of any defenses available to the party (i.e. the customer or contractor) for whom it has guaranteed the obligation. Accordingly, if after the delivery of goods or services the customer claims you have breached your shared agreement, the guarantor must, in most circumstances, nonetheless pay the obligation and the customer must reserve the fight against you for another day. This feature also serves as a deterrent against particularly litigious customers.

Similar to a guaranty, a letter of credit is a contractual agreement substituting the credit of an issuing bank for that of a customer for purposes of facilitating a trade. With a letter of credit, you—as the contractor or supplier—would have a right to seek payment directly from the issuing bank in the event that the contractor or guarantor defaulted in its payment obligation to you. The bank’s payment is not subject to offset or defense and a letter of credit is payable upon presentment to the issuing bank, generally with an accompanying statement that the underlying obligor has defaulted in its payment obligations to you.

The terms of letters of credit are negotiable and can be structured for a short-term guaranty of a single project or a long-term relationship with a customer. The issuing bank essentially agrees, in the event of a default in payment to you, to loan the defaulting party the amount needed to cure the default. As such, the customer supplying you with a letter of credit will likely incur certain costs with the issuing bank, which should be considered and taken into account to ensure that you do not bear the burden of those costs.

"Once you have determined the relative financial strength of your customer or contractor, you can then determine the best way to allocate the risk related to the possibility of non-payment during the course of the project in order to minimize your risk."

Level the Playing Field by Negotiating Your Contract
Once you have agreed on the mechanics of how to minimize your credit risk, you should look carefully at the terms of the purchase order or contract that you are being asked to sign in connection with the project. As a general rule, form construction contracts and purchase orders (such as those commonly used in the trade and provided by the American Institute of Architects) usually are biased toward the interest of the owner. A supplier or vendor should pay careful attention to the terms and provisions of the contract and negotiate a more level playing field that will govern the relationship of the parties. This is particularly true in a down economy or when dealing with specialized or unique goods and services because, in such circumstances, the strength of a supplier to negotiate better terms increases.

Perhaps the most significant part of the contract or purchase order is the provision or provisions regarding payment. First, review them carefully to ensure that any previously negotiated arrangements, such as payment before delivery, guaranty or letter of credit are adequately covered in the document.

Second, review clauses relative to when payment will be made to you. In particular, avoid “pay if paid” clauses that are popular in many form construction contracts. A “pay if paid” clause essentially provides that a contractor will have no obligation to pay any amount to a subcontractor (or vendor or supplier) for which a corresponding payment from the owner is not received. Further, under a “pay if paid” clause, if a contractor is not paid by the owner, the owner does not have an obligation to pay the subcontractor, vendor or supplier. This results in an inequitable shift of the contract risk to the subcontractor and supplier. An example of a “pay if paid” clause is as follows:

The contractor shall pay the subcontractor for all properly completed portions of the work for which the contractor receives payment from the owner within seven (7) working days of receipt thereof. The contractor shall have no obligation, however, to pay any amounts to the subcontractor for which a corresponding payment from the owner is not received, it being the intent of the parties that the risk of loss for the owner’s non-payment shall be with the subcontractor and the payment by the owner is an absolute condition precedent to the contractor’s obligation is to pay the subcontractor.

The more preferable contract provision, often termed a “pay when paid” clause, will require that the contractor pay each subcontractor’s (or vendor’s or supplier’s) progress payment or invoice no later than a specified time from the date that the contractor receives payment from the owner. Although the language in each provision is similar, courts have interpreted “pay when paid” clauses to relate only to the timing of payment and not to require payment from the owner as a condition precedent to receipt of payment. An example of a “pay when paid” clause is as follows:

The contractor shall pay the subcontractor each progress payment no later than seven (7) working days after the contractor receives payment from owner.

The language in the second example is clearly preferable, and a vendor or supplier should seek to have such language included in any contract.

Another contract clause that is receiving heightened focus in light of today’s challenging economy is a clause requiring the owner to provide adequate assurance of payment. These clauses are designed so that the owner, throughout the course of the project, is required to provide evidence that it is able to continue to meet its financial obligations to pay the amounts due under the contract as they become due. An example of such clause is as follows:

Prior to commencement of the work, the contractor may request in writing that the owner provide reasonable evidence that the owner has made financial arrangements to fulfill the owner’s obligations under the contract. Thereafter, the contractor may only request such evidence if (1) the owner fails to make payment to the contractor as the contract documents require; (2) a change of work materially changes the contract sum; or (3) the contractor identifies in writing reasonable concern regarding the owner’s ability to make payment when due. The owner shall furnish such evidence as a condition precedent to commencement or continuation of the work or the portion of the work affected by the material change. After the owner furnishes such evidence, the owner shall not materially alter such financial arrangements without prior notice to the contractor.

Another simple, yet effective tool is to require interest payments at a prescribed rate if payment is late. In addition to the interest payments, provisions can be added that include recovery of the cost of collection including, where applicable, the cost and expenses incurred in hiring attorneys to pursue such payments.

A final contract term that has become more negotiated in recent times is the provision relating to damages for delays in the performance of work. Often, due to financial concerns, the inability to secure end-users for construction projects or other considerations, an owner will suspend work under a contract or delay delivery of certain goods and services. It is important, when reviewing contract provisions, to ensure that the contract adequately provides for additional compensation to you in the event that your cost of labor or materials increases during the course of this delay. This is especially important where goods are subject to specific price volatility such as those made with petroleum and petroleum by-products or metals that may fluctuate in price on a daily basis.

Although planning for failure of a product may seem counterintuitive initially or not worth the extra time and effort, by carefully investigating customers prior to entering into a contract or purchase agreement, and with careful attention to the terms and provisions thereof, you can effectively limit your credit risk and exposure and equitably shift the risk of non-payment to others when appropriate. However, even if one takes such measures, unavoidable situations may arise. The steps outlined in this article will not keep the unavoidable from occurring; however, they will ensure that you are in the best position to deal with them in the event they do.

Kevin S. Blanton and Joseph J. Devine are partners with Schnader Harrison Segal & Lewis LLP. Their opinions are solely their own and not necessarily those of this magazine.

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