Ways to Guard Against Insolvency Risks

Originally published as an Op-Ed by the Oregon Daily Journal of Commerce on July 14, 2022.

Headlines such as “US set for recession next year, economists predict,” from the June 12 edition of the Financial Times, are a reminder insolvency risks are real and should be top of mind when moving forward with new construction projects. But there are ways to mitigate the risks.

Performance bonds, as their name implies, hold a surety jointly and severally liable to the owner for the contractor’s performance of the work. Depending on the bond’s form, if the contractor becomes insolvent and is put into default, the surety can either perform the work itself or indemnify the owner for costs incurred hiring a replacement contractor. Convincing a surety to take over a contract following a contractor’s default is not easy. When sureties do agree, the contractor is often insolvent. Generally, if the surety takes over under a bond, it steps into the defaulting contractor’s shoes.

A payment bond is different. Under this type of bond, the surety is jointly and severally liable to, and/or will indemnify, the owner against claims and liens by subcontractors retained under the prime contractor. The surety’s obligation to act under the bond may be contingent upon the owner paying the prime contractor in accordance with the contract. When a subcontractor lien is filed, the owner will notify the surety, and in theory, the surety will cause removal of the lien through a lien release bond or otherwise.

In deciding whether to issue either form of bond, a surety will typically scrutinize a contractor’s financials and require the contractor to indemnify and hold harmless the surety against any losses it incurs under the bond. This is one of the major differences between bonds and insurance policies: insurers cannot seek reimbursement from their insureds for amounts paid out under the policy, whereas sureties can require reimbursement from the obligor (contractor) for any losses incurred by the surety under the bond. Also, insurance policies can be modified only through boilerplate endorsements, and the language is often take-it-or-leave-it. In contrast, owners have input into how bonds are drafted and should negotiate for favorable language.

The surety may also require personal guarantees from the contractor’s ownership team. Whether a contractor is bondable or not is a “stress test” that can provide a sense of the contractor’s financial health. If the contractor is not bondable, or has relatively low bonding capacity (i.e., the surety will issue bonds covering only a small dollar value), that could signal a failing grade.

As further protection, owners can consider structuring payments, not based on the contractor’s costs incurred, but based on the contractor hitting milestones throughout the project, so that payments are conditioned on progress. Depending on state law, the owner may elect instead, or in addition, to withhold retainage from each contractor draw. One problem with retainage is that it includes amounts earmarked for subcontractors, and withholding amounts due subcontractors because of prime contractor defaults will likely result in subcontractor liens. For retainage to protect against prime contractor default, it should be withheld from the contractor’s general conditions and/or fee.

Contractors also have tools to guard against solvency risks. In the standard AIA agreements, the contractor can request proof of financial arrangements for the project from the owner, both before the project begins and at certain times during the project, including when the contractor identifies in writing a reasonable concern regarding the owner’s ability to make payment when due. Sections 2.2.1 & 2.2.2, General Conditions of the Contract for Construction, A201 – 2017 (General Conditions). The owner’s financial arrangements should not materially vary without notice to the contractor. And should the owner fail to provide the information, the contractor can terminate for default. Section 14.1.1.4, General Conditions.

To guard against subcontractor insolvency, more and more prime contractors are acquiring subcontractor default insurance (SDI), which, when triggered, reimburses the contactor against certain costs incurred as a result of an enrolled subcontractor defaulting. Because subcontractors often work with the prime contractor on multiple projects, if a subcontractor fails, this can have a domino effect, ending in financial distress for the prime contractor. SDI can pass some or most of that risk onto the insurer, for a premium. Some contractors will in turn pass through the cost of the SDI premium and deductible to the owner as a cost of the work. Owners, however, typically have no rights under the insurance, unless both the contractor and subcontractor are insolvent, and therefore many do not agree to pay for this cost and/or markup on the cost. Owners often view the benefits of SDI as duplicative of payment and performance bonds and refuse to pay for SDI on this basis when the project is already bonded.

Contractors typically have mechanic’s lien rights arising from state law, which can provide some security for unpaid invoices, depending on the amount of equity in the project and whether the contractor has priority over the security interests of the project’s lender. However, an often-overlooked tool is what is referred to as a “stop notice” or “notice to lender.” Under some states’ laws, a contractor can issue a notice to the lender of non-payment and, if the lender fails to take certain actions, namely withhold payment to the owner, future payments issued by the lender to the owner become subordinated to any lien recorded by the claimant who issued the notice. Gaining priority ahead of the lender can be the difference between getting paid or not. This tool is not without risk. For wrongfully issuing a notice to the lender, claimants may face exposure for attorney’s fees and costs incurred by the owner and lender, as is the case in Washington.

A year ago, this author wrote about the early impacts of price escalation, which we have seen bleed into 2022. Hopefully, we’ll avoid the recession that some economists are predicting, and my next article will be on a more upbeat topic.