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Risk Transfer and Payment Protections for Contractors Be Aware of Risk-shifting Techniques

Every business must deal with certain risks – but the risks in the construction industry seem to come from every side, from personal safety risks to financial risks and risks of business failure.

Financial risk, specifically the risks associated with non-payment (throughout the project), is fairly universal in construction, but a party’s tier significantly impacts their leverage to shift that 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. Contractors should be aware of common risk-shifting techniques and how to avoid them.

Financial Risk

The terms risk, risk-shifting and risk management are routinely used in construction and construction payment specifically, but what exactly do those terms mean?

Construction payment is credit-heavy and, accordingly, there are always questions and concerns regarding the risk of non-payment or default somewhere along the payment chain. Since the payment chain in construction is interconnected, any little inconvenience, delay or dispute about any component of the work can affect payment for everyone on the project.

For example, parties may purchase materials on credit and then show up and perform labor. However, these parties then typically bill their customer and get paid after completion or partial completion. That party, then, assumes the financial risk of non-payment, and if they are not paid on time (or at all) they will be forced to make difficult choices about which of their own bills, for expenses they’ve already fronted, don’t get paid. Further, contractors and subcontractors generally have multiple ongoing projects at the same time. If there is a payment issue on any there can be repercussions on a project that otherwise would be clear sailing. The risk of default from problems on other projects is just another wrinkle in the construction financial risk tableau.

Risk-Shifting

Contractors are aware of risk-shifting and know that there are significant financial risks on nearly every construction project, but how can they mitigate those risks?

The first place, and probably still the most effective place, companies use as a platform for risk-shifting is the contract itself. This has also been the case historically. In the 1940s, contracts began to include “no lien clauses” in an attempt to pass the financial risk to subs and suppliers. However, when cases involving these no-lien clauses made it to court, the clauses were routinely thrown out as against public policy for impermissibly denying a statutory right.

After no-lien clauses became passé due to their unenforceability, GCs and property owners adapted and began to include different risk-shifting clauses in their contracts, like pay when paid clauses. Again, however, courts generally responded by taking the teeth out of these clauses by treating them as a timing mechanism, rather than a means to avoid payment.

With uncertain availability, or the outright ban of some of the mentioned above, 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. This is accomplished by providing a short and set time in which complaints, disputes or the like must be brought, 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, without, potentially, drawing the ire of the courts.

This is not to say, however, that the pay when paid, or even pay if paid clauses are dead and gone. In fact, they are still relatively common in construction contracts – despite the potential to be of limited practical use. If proper and specific wording is used there are jurisdictions that allow for pay if paid clauses to transfer the risk of nonpayment, so any contract should be carefully examined relative to the specific laws of the state.

Visibility Helps

Proper visibility on a project means that the parties in charge of the money know everybody on the project, and therefore, nobody gets overlooked. There are multiple reasons a lack of visibility can cause payment issues. Since construction projects routinely have companies providing labor or materials 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 actually make sure everybody is paid.

If the top-of-chain parties do know who the project participants are, however, 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 is 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 throwing a wrench in the works.

This visibility can be provided by sending appropriate notices. Notices have the two-pronged benefit of both providing upper-tiered parties with the ability to know and track the project’s participants and those participants’ security status, as well as maintaining the lower-tiered party’s security rights.

The knowledge of each participant’s identity allows upper-tiered parties the ability to track parties and manage exposure by providing a made-to-order checklist of who needs to provide lien waivers to guard against double payment. The ability of the lower-tiered parties to remain secured means that they don’t need to worry about not getting paid.

Mitigate Risk-Transfer by Staying Secured

Mechanics lien and bond claim laws have the explicit purpose of protecting parties in the construction industry against non-payment and risk-shifting and are built directly into the law in every state. The ability for construction participants to secure the value of their work or materials with the value of the improved property provides a huge amount of protection when used correctly. These participants are allowed to force a sale of the improved property itself to recover what they are owed 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 is the best protection against the transfer of risk on construction projects.

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