Originally posted Thursday, 12 January 2012

Written by Andrew Ness and Elizabeth Walsh

Times are still very tough for many contractors, and some who have been hanging on since 2008 may yet run out of cash. A contractor in serious financial trouble is hardly likely to volunteer the extent of its financial difficulties to its clients until it’s likely too late. So staying alert for the early signs of trouble is a must. Here we have listed, in order of increasing cause for concern, five warning signs we’ve seen again and again that should trigger further inquiries into the contractor’s ongoing viability.

Warning Sign #1: Schedule Updates Don’t Make Sense.

When the work is not going as planned, adding resources is usually the cure. But for a financially squeezed contractor that may be impossible, so the game may become hiding the slippage from the Owner until replacing the contractor is no longer a viable option. Catching this requires close scrutiny of the schedule updates. If many activities that were scheduled for completion last month didn’t get completed, but the completion date is not moving backwards, in theory the contractor could just be using up float. But it often means that critical activity durations later in the project are being compressed arbitrarily and unrealistically to hold the completion date. Substituting longer “summary” activities for shorter, more detailed activities is a frequent way to disguise this compression and avoid detection. Another technique is to change from one update to the next the scope of the current activities that are lagging behind schedule. This can make it difficult to tell if the progress that was forecast last month actually was accomplished.

In any given month, there can certainly be a rational explanation for such schedule changes, but when they happen repeatedly, it’s time to blow the whistle and start asking pointed questions. Most contracts require submission of schedule updates, give the Owner schedule review or approval rights, and often allow insisting on acceleration at no cost to the Owner if the contractor is falling behind schedule. These provisions generally provide a sufficient contractual basis to force answers.

Warning Sign #2: Key Personnel Aren’t Sticking Around.

Key personnel in a position to see problems looming frequently bail out and leave the company ahead of a crisis. So, when well-regarded senior project staff and company executives are leaving in a steady stream, particularly long-time employees, it’s time to begin making inquiries as to why. And don’t expect to get many straight answers on their reasons for leaving; you will need to do a lot of reading between the lines. Also, the contractor may try to fill growing holes in its staff by shifting members of the capable team that started your project elsewhere and replacing them with less qualified (and less expensive) employees.

Notices that previously selected subcontractors or suppliers are being replaced may similarly indicate that the contractor is trying to save dollars by using a less reputable firm that cuts corners in order to offer a rock-bottom price. Many contracts include requirements that you consent to proposed changes in key personnel and approve subcontractor selections. Use those rights to ask questions, prevent loss of qualified personnel to other projects, and veto proposed subcontractors when there is a reasonable basis to do so.

Warning Sign #3: Payment Applications Don’t Add Up.

Contractors desperate for cash are naturally tempted to abuse the progress payment process. In the normal course, a little front-end loading of the schedule of values or overbilling for the percentage of work completed evens out in the end, because the contractor gets paid less on the back end of the project. But if the contractor instead goes bankrupt and disappears before the “evening out” happens, the Owner ends up effectively paying twice for the same work. Close scrutiny of the schedule of values and pay applications (both percentages complete and amounts billed for “stored materials,” particularly for commodities) is needed to keep control over this and to minimize exposure in the event of contractor failure.

Absent an agreement to make advance payments, you never need to pay for work not done, so you have the contractual authority to reject attempted overbilling. But keep in mind that overreacting—hoarding cash to make sure there is enough left to have another contractor finish the job if needed—may well accomplish exactly the result you are trying to avoid. Unreasonable reductions on pay applications have hastened the demise of many a cash-strapped contractor. Be aware that you are walking a tightrope, and play it down the middle.

Warning Sign #4: Nothing is in the Scope of Work.

It’s almost a tradition that a struggling contractor will look to generate extras as a supplemental source of much-needed revenue. Is a steady stream of Requests For Information raising items that, in the design team’s view, are clearly part of the base scope? Are the change notices flying at a rate seemingly unsupported by the reality? Does the contractor submit extra work pricing that is consistently more than reasonable or that ignores agreed pricing terms like pre-agreed labor rates or markups? Take these as warning signs of a possibly deeper problem than just being an aggressive, change-happy contractor.

Prompt review, approval, and payment for legitimate change order work is an appropriate way for an Owner to assist a contractor on the edge. But letting the change order process become a hidden subsidy attempting to keep the contractor in business is not advisable, since it’s basically uncontrolled and can end up costing far more than anticipated before you know it.

Warning Sign #5: Suppliers and Subcontractors Aren’t Getting Paid.

The most ominous and obvious indication of a contractor in serious financial trouble is when you start hearing regularly from unpaid suppliers and subcontractors. Not only is this a violation of contract obligations, in many states, it is a violation of prompt pay or trust fund laws, some with criminal penalties. It also often means that the contractor has reached a stage of desperation where it not only is willing to violate the contract and state laws, but is burning bridges with subs and suppliers who are important to the contractor’s continuing ability to compete for and perform new contracts.

Hopefully, your contract requires submission of partial lien releases from at least key subcontractors in order to qualify for progress payments. First, confirm that all of your existing contract rights in this respect are being enforced; and then consider whether it’s appropriate to tighten them further, even if imposed unilaterally. Again, you don’t want to constrict the timely flow of proper payments, but you do want to make sure your funds are reaching the intended parties. Sometimes contracts expressly permit joint check arrangements so you can issue checks payable jointly to sub and contractor, which keeps the contractor from depositing them without the sub’s approval. But, by this point, you may well have the leverage to insist on joint checks even without such a contract term. The hard part is staying ahead of events. By the time mechanics’ lien notices or payment bond claims start piling up, it’s likely too late.

In conclusion, if you can gain an understanding of a troubled contractor’s financial position early on, you can then make intelligent choices as to how to best protect your interests in completing the project. If you are not proactive in uncovering the financial problems, instead you will simply be reacting to events and left with doing what little damage control remains possible. It pays to stay alert to the early signs of trouble.

Andrew Ness is a Partner, and8_Walsh8_Ness_CROPPED

Elizabeth Walsh is a Senior Associate,

at the Washington,  D.C.

office of Jones Day.