It’s hard to understate how prevalently misunderstood the concepts of mechanics liens, bond claims and financial risk are in the construction industry. Yet, these issues permeate every industry relationship. Those who try to evade dealing with these issues tend to get scorned, while companies that confront these issues head-on tend to succeed.
FINANCIAL RISK IS UNAVOIDABLE
In the construction industry, financial risk is a zero sum game, which is to say that it is always present and always borne by some project participant. Neither the best intentions and procedures, nor the strongest relationships, can avoid this fact. There is always a risk of financial loss, and some parties are at more risk than others.
It is also true that the perception of who should bear the financial risk changes drastically depending on a party’s place in the contracting chain. Those at the top of the payment chain—lenders, sureties, owners and general contractors—perceive financial risk to be the consequence of subcontractor defaults. Those at the bottom of the chain—subcontractors and suppliers—perceive financial risk to be the consequence of non-payment, late payment, misappropriation of funds and payment default.
Who should ultimately bear the financial risk of loss may be debatable, but one thing is not: someone bears the risk.
THE STATE OF FINANCIAL RISK IN THE CONSTRUCTION INDUSTRY
The industry is cluttered with attempts by various parties to shift risk around. These financial risk-shifting measures come in a variety of forms, and they have been the subject of so much lobbying and strong-arming that the industry is left with a mess of rules and expectations. The consequence is a lot of unpredictability.
The first risk-shifting measure in the United States’ construction history came from Thomas Jefferson, who introduced the first mechanics lien legislation in 1791. Through that law, which eventually was adopted in some form by all 50 states, the United States set forth a policy that financial risk in the construction industry should be borne by those at the top of the chain.
The mechanics lien laws are not in isolation with this concept. Nearly every state also has payment bond requirements, prompt payment laws, misappropriation of funds statutes and labor regulations. All of these laws are designed to protect lower tier participants against top higher tier participants, and to push financial risk up the chain.
In fact, when parties attempt to contract around these laws, the courts repeatedly say no. This is why it is illegal to waive lien rights within contracts in 47 states, and why pay-when-paid and pay-if-paid clauses are subject to so many confusing legal interpretations.
Nevertheless, while the nation’s public policy interest is clearly to insulate bottom of the chain participants from financial risk, the nation also has a public policy interest in preserving the “freedom of contract” right.
When restrictive financial risk-shifting contractual clauses are matched against state public policy interests, the judiciary must perform a delicate dance between these two competing interests. In the past 30 years, that has left the industry with a wide variety of rules and, unfortunately, a lot of confusion.
Though financial risk-shifting clauses are part of every construction contract, it’s all too common for those provisions to have little to no settled-upon meaning. Yes, that includes the pay if paid clause. Yes, that includes the clause requiring all notices of disputes to be delivered within 10 days of the dispute. Yes, that includes the provision requiring subcontractors to sign an onerous lien waiver form. And yes, that means nearly any construction dispute can be thrown into a black hole of high-level legal and public policy theory. And yes, that is really expensive.
WHAT THE INDUSTRY GETS WRONG ABOUT FINANCIAL RISK
Though top-of-chain parties are supposed to assume a project’s financial risk according to the nation’s public policy, it’s naive to think they will accept this risk with open arms. These parties are constantly devising new ways to circumvent the policy through their freedom to contract, and to bury risk-shifting clauses within the mountain of paperwork that is the construction contract.
That leaves bottom-of-the-chain parties with a bunch of provisions with unclear meanings, and more importantly, it leaves them confused about their rights to ultimately get paid and avoid financial loss. For example, when a payment is late and they are staring at a pay-if-paid clause, subcontractors incorrectly think they are without lien rights. Or, when a general contractor claims there is no remedy to a subcontractor for a change order dispute because a notice was not delivered within 10 days of the dispute, as required by the contract, the subcontractor again mistakenly believes it cannot lien for the value of those changes.
Financial risk is the one thing everyone’s afraid of, yet no one is talking about. Because the result is uncertainty, anyone’s position that they are right is likely a clear indication that they are wrong.