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Financial Risk Shifting Techniques

Switch button positioned on the word transfert, black background and green light. Conceptual image for illustration of risk management.

The construction industry is full of risks: safety risks, company financial risks, risks of other business’s failure, and more.

Each tier of a project has certain risks specific and unique to that tier. Financial risk is universal throughout the construction industry and there are methods by which parties attempt to transfer (or guard against the transfer of) that risk. The particular project tier occupied by a participant has real impact on the leverage available to shift financial risk, and sometimes in the available options to protect against risk shifting. In general, the higher up on the contracting chain a party is (the closer to the money), the more leverage that party has.

Financial Risk

Financial risk, risk shifting and risk management are routinely discussed, but not necessarily as routinely understood, especially because every party on a construction project must deal with and juggle many different risks.

Because the construction industry is fundamentally based on a credit-heavy payment system, there are always questions and worries about potential non-payment or a default somewhere in the payment chain. And, because the multiple parties on construction projects are interconnected, any little inconvenience, delay or dispute about one particular component of the work can affect payment for everyone on the project.

In a typical situation, parties purchase materials (usually on credit) and then show up and perform labor. These parties then usually bill their customer and get paid after completion or partial completion of the work. That party then assumes the financial risk of non-payment, and if not paid on time (or at all) will be forced to make difficult choices about which of their own bills, for expenses they’ve already fronted, don’t get paid (or get paid late). Additionally, because contractors and subcontractors generally have multiple ongoing projects at the same time, a payment issue on one (or many) projects can have repercussions on other projects that otherwise would be without issues. The risk of default from problems on other projects is just another wrinkle that construction industry participants must deal with.

what is Risk Shifting?

The construction industry is aware of risk shifting, and participants know there are many different ways parties with more leverage can attempt to shift the project’s financial risk.

The first place to use as a platform for risk shifting is the contract itself. This originated with “no lien clauses,” but when cases involving these no-lien clauses made it to court, the clauses were routinely thrown out as impermissibly denying a statutory right and as against public policy. After no-lien clauses became passé due to their unenforceability, general contractors and property owners adapted and began to include a different risk shifting clause in their contracts, the pay-when-paid clause. Once again courts generally disallowed these provisions or took the teeth out of them by treating them as a timing mechanism, rather than a means to avoid payment.

With uncertain availability, or the outright ban on those clauses, contract clauses that work to shift financial risk have moved from being blatantly obvious to being more covert. In many current contracts, the risk shifting is done by including strict noticing provisions. That is, that the contract provides a short and set time in which complaints, disputes or the like must be noticed, and disallowing the claim after the noticing timeline has passed. This can put a heavier burden on the party that is to be providing notice, potentially without drawing the ire of the courts.

Visibility Is Always Good

Proper visibility on a project can help assure that nobody gets overlooked for payment. Because construction projects routinely have numerous parties unknown to the parties with control of the money, the top-of-chain parties are worried about the risk of double-payment or stoppages in work caused by lower-tiered parties’ usage of lien or bond claim rights, and have little ability to make sure everybody is paid.

However, if the top-of-chain parties know who the project participants are, this problem can be avoided. Payments can be made, lien waivers obtained and participants tracked. In a perfect world, every party on a construction project would be known to the party in control of the money, along with the parties’ payment and security status. Lower-tiered parties will get paid, which, in turn, means that the top-of-the-chain parties won’t have to worry about lien claims.

This visibility can be provided by sending preliminary notices up the contracting chain, or by sending requests for information down the contracting chain. These notices provide upper-tiered parties with the ability to know and track the project’s participants and those participants’ security status. This tracking ability allows the upper-tiered parties to manage double-payment and lien exposure by creating a ready-made checklist of parties from whom lien waivers should be obtained, and providing control over the payment process. And, as an added benefit to the lower-tiered parties, sending the notices can help them avoid the risk shifting that they worry about.

Staying Secured Mitigates Risk Shifting

Mechanics lien and bond claim laws have been explicitly designed for the purpose of protecting against non-payment, (and protecting against risk shifting), and are built directly into the law in every state. These security instruments provide a significant amount of protection to construction industry participants when used correctly. In fact, public policy regarding the right of parties on a construction project to be paid for the work they have done is so strong that every state has a provision in its law allowing these parties to sell the improved property itself to pay the debt if they are not paid. While there are strict requirements in order to be able to use this remedy, remaining in a secured position is a virtual guarantee against assuming the financial risk of a project, and thus, a virtual iron-clad protection against risk shifting.

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