USING NON-BONDED SUBCONTRACTORS

without betting the company



John received the last receipt on his last job last month. What he now has is the most he will have, and it isn’t much.

A few years ago John was the owner of a thriving construction firm with realistic dreams of a comfortable retirement. The beginning of the end was the letting of a non-bonded subcontract with a company we shall call Shakey Sub, Inc.

Shakey failed to perform. John terminated its contract. Shakey sued. John counter sued. The job got behind schedule and the owner withheld payments. John redoubled his efforts to perform and was permitted to remain on the job. He was, however, denied payment for change orders and extras and time delays. The owner contended, with some justification, that the time delays had been caused by the failure of Shakey Sub, Inc., and were therefore John’s responsibility. After several years of expensive trial preparation, John’s claim for extras was settled, literally "on the court house steps."

Aside from bonding all subcontractors, were there things John could have done to protect himself?

Certainly. The purpose of the remainder of this article is to discuss various practical ways to minimize the pain and peril of using non-bonded subcontractors.

PRE QUALIFICATION OF SUBCONTRACTORS

The use of non-bonded subcontractors puts the contractor in the position of assuming the role of a surety. The most expeditious way to approach this role is to start with the same procedures used by surety companies - pre qualification.

Develop a roster of specialty subcontractors. Check each one out with other contractors, with his banker, and with his bonding agent. Items of concern should be: Pre-qualifying subcontractors permits a contractor to quickly ascertain a potential subcontractor’s reputation, technical competence, and financial strength. Reserve the right to reject any or all bids, regardless of whether such bids may be low. The lowest price at the beginning of a job isn’t always the lowest price at the end. There still exists the desperate undercutting on bids, where subcontractors work cheap in a sometimes futile effort to pay off the last job’s costs with the next jobs receipts.

At bid time send the low bidder a "letter of intent". Include a statement reserving the right to cancel this letter of intent subject to a review of bonding requirements and financial statements. Next, review your roster of pre-qualified subcontractors. If the potential subcontractor is not on the list it will be necessary spend time gathering and reviewing the information previously described before proceeding further.

 AWARDING OF SUBCONTRACT

Once it is determined that the lowest qualified bidder has been selected, it is time to award the subcontract and get on with the project. The subcontract agreement should:

Be explicit regarding partial and final payments. A provision should be included that permits the contractor to require timely written statements setting forth what amounts, if any, are payable by the subcontractor to third parties arising out of the performance of the subcontract. It should provide that the contractor may withhold, or may pay directly or by joint check such sums as the contractor may determine are necessary to protect the contractor and the owner from claims or liens that may be brought by third parties.

Contain a provision that the subcontractor execute and deliver to the contractor a full and valid release and complete discharge of and from any and all claims and demands whatsoever as a condition precedent to final payment.

Contain a strong provision regarding the completion of the subcontractor’s scope of work by the contractor. This provision will prove essential if the subcontractor fails to commence, prosecute, or perform according to the provisions of the subcontract agreement. In other words, this provision should give the contractor the full power and authority, without process of law and without violating the subcontract agreement, to take the prosecution of all or part of the work of the subcontractor and complete it at no cost to the contractor. This provision should specify that neither by the taking over of the work nor by its completion shall the contractor forfeit its right to recover damages from the subcontractor for failure to complete or for delay in such completion.

Contain a "pay when paid" clause. While it is common practice in the construction industry to pay when paid, this clause avoids any misunderstanding of the issue.

Without such a clause, the subcontractor could attempt a forced collection where payments have been withheld by the owner, and the contractor could be forced to pay before being paid.

Contain provisions whereby the performance of the subcontracting firm is personally guaranteed by the owners of the subcontracting firm. Virtually all sureties obtain such guarantees, and for good reason. Without such guarantees it is possible for the owners of the subcontracting firm to walk away from a problem, leaving the contractor to suffer alone.

 MONITORING OF SUBCONTRACT

While the monitoring of subcontracts in progress is essential to the contracting process, it is particularly critical when the subcontractor is non-bonded. Performance of the following steps should greatly enhance the probability of a favorable outcome.

Accompany each progress payment to your subcontractor with a partial waiver and release of lien form. Before any subsequent payment is made, the partial waiver and release of lien form must be fully executed and returned. In addition, a final or partial waiver and release of lien should be required from any material supplier or subsequent tier contractor who has filed a preliminary notice of intent to lien. Failure to provide these lien waivers should result in lack of payment to the subcontractor.

Make sure that the supplier or subtier requests it in writing if it becomes necessary that joint checks be written to assure payment of obligations to suppliers or subtiers of your subcontractor. This agreement must be signed by all parties (contractor, subcontractor and supplier) before a joint check is issued. Also, be aware of the risk inherent in forced management of your subcontractor’s business, document your transactions very carefully, and keep your attorney informed. This is no time to save on attorney fees.

  USE OF FINANCIAL STATEMENTS - SOURCE OF INFORMATION

Obtaining and using subcontractor financial statements is a powerful and largely unused tool. Financial institutions use this information routinely and extensively, however contractors generally do not. There are good reasons why a subcontractor would be reluctant to give this information to a contractor, and better reasons why a contractor contemplating the award of a non-bonded job should require them.

By far the most important reason is the information contained in financial statements, and the ease with which it can be extracted. Financial statements may seem boring and sometimes complicated, but gleaning useful information about most of the important items does not require great effort.

USE OF FINANCIAL STATEMENTS - POTENTIAL SOURCE OF RECOVERY.

If a contractor relies on professionally prepared financial statements in selecting a subcontractor, and the financial statements are faulty, and the contractor suffers as a result, he may be able to recover from the accountant. Accountants can sometimes be held liable for failing to disclose what they knew or what they should have known.

It is advisable to obtain financial statements from the accountant who prepared them, with the clients permission of course. This prevents the accountant from later asserting a "privity defense" if the statements prove to be faulty and their use results in damage to the contractor. Further, it would be both wise and elegant to send the accountant a "thank you letter" after receiving them, and making some comment to the effect that they will be relied on in the decision making process. Not only is this polite, it also establishes the basis for a claim, should one become necessary.
 
 

USE OF FINANCIAL STATEMENTS - ESSENTIAL STEPS

Read the accountant’s report. There are three levels of assurance - Compilation, Review, and Audit. By and large, Review is the standard of the industry. Compilation is essentially no assurance at all, and Audit is generally considered not cost effective. The primary difference between Review and Audit relates to the independent verification of facts. As an example, an audit would generally require independent confirmation of accounts receivable whereas a review would not.

Examine working capital and its ratio to work in progress. These are vital short term considerations. Working capital is generally defined as current assets less current liabilities. While substantial variance exists, a working capital to work in progress ratio of 10% is normally considered a healthy ratio. Be alert for current assets of dubious collectibility. Such things as "prepaid expenses" do not produce cash, and "cost of unapproved changes" may or may not ever be collectible.

Observe overall profitability and retained earnings. Construction is a volatile business. Profitability varies greatly from year to year with even the best contractors. Consistent losses, however, are a sign of trouble, as are numbers that "just don’t make sense." You should know the conditions that prevail in your market. Are the subcontractor’s numbers consistent with what you know is happening in your market.

Probe the schedules of work in progress and completed jobs. These schedules are the heart of a contractor’s financials. They should be carefully explored for indications of excessive over billing, excessive under billing, and severely erratic profits. Modest over billing is a sign of health. Excessive over billing is not, particularly if coupled with slow receivables. Excessive under billing is almost always a sign of problems.

Beware the subcontractor who has no financials. While a well managed subcontractor may very well refuse to release its financials, and offer a bond instead (paid for by the contractor of course), beware of a subcontractor who does not have current financials. In all probability this subcontractor doesn’t know what its financial condition is and any representations it makes are meaningless. Unless you are willing and able to manage this subcontractor very closely you would be wise to place your work elsewhere.

 Labor is still considered by some to be the greatest risk factor in the construction industry, followed by materials, equipment and consumable supplies. It is the opinion of the authors, however, based on our own experience, that non-bonded subcontractors operating without adequate administrative procedures create substantial and often unrecognized risks. According to Dun & Bradstreet, specialty construction failures accounted for nearly 60% of all U.S. construction failures in 1990. We can only wonder how many of the remaining 40% (prime contractors) failed as a result of defaults by their specialty subcontractors.
 
 
 
 

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