Think of an unsecured credit card that has no annual fee, no interest and a ... owner project financing; and a copy of C
White Paper on Project Financing
Published by American Subcontractors Association, Inc. Foundation of the American Subcontractors Association, Inc. 1004 Duke Street Alexandria VA 22314-3588 (703) 684-3450
[email protected] www.ASAonline.com
Copyright © 2016 by the American Subcontractors Association, Inc. and the Foundation of the American Subcontractors Association, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the American Subcontractors Association, Inc. Disclaimer: This publication does not contain legal advice. The discussion is intended to provide information and guidance to individual subcontractors. Specific circumstances vary widely, so subcontractors may need to consult their attorneys before acting on the premises described herein. Each subcontractor should decide for itself the contract terms and conditions which it believes will best protect its interests. Subcontractors should not agree among themselves as to the form of contract terms and conditions they will use. Such agreements may violate federal or state antitrust laws and could result in the imposition of civil and/or criminal penalties.
Project Financing Introduction Think of an unsecured credit card that has no annual fee, no interest and a sky-high spending limit. Most people would assume that only the most creditworthy clients could qualify to receive such a card. Surely, they would think, the bank would conduct a rigorous investigation of any applicant for this card and exclude 99 percent of applicants. Most people wouldn’t even try to apply for the card, thinking it wasn’t worth their time just to be rejected in the end. But now imagine that the bank made an incredible offer: Anyone who just submitted an application could get the card. No pre-qualification required. It wouldn’t be long before the Postal Service could not even deliver all the applications — the volume of applications would be too great. This credit card offer would be crazy from the perspective of any bank that wanted to stay in business long, right? Right. When you think about the credit terms that some construction subcontractors offer their clients, it’s not much different than the too-good-to-be-true credit card offer. Subcontractors foot the bill for labor, equipment and materials for a project on a promise that the funding will come through. The subcontractors that do so without checking the “creditworthiness” of the project owner essentially are offering the same credit terms as the issuer of the imaginary credit card. If the subcontractor doesn’t have any assurances that the funding even exists to pay it, it is gambling when it finances its portion of the project. And ensuring that funding is in place is just the first step. Even if the funding is there, the subcontractor still needs the assurance that it will be able to collect its due when its work is complete. Banks ensure creditworthiness and effective collections in several ways: They investigate prospective customers, draft credit terms that establish the banks’ (and customers’) rights, and lobby to make sure that the laws allow them to collect monies due if the customers that refuse to pay are able to pay. Naturally, the banks’ favored manner of managing the risk of financial loss on credit is to exclude high-risk debtors in the first place. It’s much easier and less expensive for them to obviate problems with an initial credit examination than to collect funds after extending credit. Likewise, subcontractors have different options to ensure the creditworthiness of their potential customers. Some are easier to implement than others. It’s much easier for a subcontractor to request project financing information up-front from the prime contractor and to incorporate contract terms that will help it collect this information than it is for the subcontractor to get laws passed that will assure it of 1
adequate project financing and timely final and progress payments. The main reason that it’s easier for subcontractors to tackle credit risks early is that they haven’t yet fully extended their company “credit” in case they detect problems with project financing before their companies start work. Surety payment bonds and mechanics lien laws provide assurances too, but by the time these options are exercised, subcontractors already have substantial interest invested in a project. Plus, the claims process can be very complex and frustrating. The subcontractor that wants to investigate project financing has some excellent tools at its disposal. ASA’s “Addendum to Subcontract,” which is one of documents in ASA’s Subcontract Documents Suite, includes a model provision for contract modifications or addenda: “The subcontract is subject to credit approval by Subcontractor, and Subcontractor shall be provided with the legal description of the property; the name, address and representative of the project owner; evidence of adequate owner project financing; and a copy of Customer’s payment bond for the project, if any. Customer shall promptly notify Subcontractor of material changes in the project owner’s identity or financial arrangements. Subcontractor shall not be obligated to commence or continue Subcontract Work absent adequate assurances of payment.” Such language is especially important when the proposed contract includes a contingent payment clause, especially pay-if-paid (but also pay-when-paid). The subcontractor takes an enormous risk of nonpayment (or delayed or partial payment) when such clauses are included in the contract. Just as a bank would investigate a seemingly high-risk customer under a microscope, subcontractors may seek full and continuing disclosure of the financial situation of the construction owner. If the prime contractor questions the subcontractor’s requirement of project financing disclosure, the subcontractor may point out that many industry documents, including documents from ASA, ConsensusDocs and the American Institute of Architects contain project financing disclosure terms. These documents allow the contractor not to commence work unless the project financing information is provided. They even allow contractors to stop work if the financing information is not provided in a timely manner. Since a subcontractor will effectively be extending credit, and at the same time does not have a contract with the owner, the only assurance of obtaining the information is through the subcontract agreement. On publicly-funded projects, it is a good idea to check the records of public agencies to ensure that full appropriations have been secured. If the funding has not been appropriated, consider modifying the contract to deal with the possibility that the funds do not come through. As a general rule, the more quality project financing information the subcontractor can obtain, the better. For example, the actual loan agreements for construction and 2
permanent financing are “preferable over a simple commitment letter, because the loan documents will include all of the lender conditions and requirements. In addition to contractual recourse, commercial services like Dun & Bradstreet, public services such as the business center at a local library, and not-for-profit services such as the Business Practices Interchanges conducted by many ASA chapters, may be helpful to subcontractors in the quest for quality project financing information. In general, customizing contracts to make project financing information available, and obtaining project financing information, are “ideas you can bank on.”
ASA Member Concerns Construction project insolvency is a major concern of construction subcontractors because they provide large amounts of labor and material to the prime contractor on credit. Complete disclosure by a project owner showing adequate project financing is, therefore, crucial to obtain the most competitive bids from responsible contractors. A 2015 ASA survey revealed that slow final payment, slow progress payments, and pay-if-paid subcontract clauses are among the top concerns of ASA members. All three of these concerns can be traced back to the adequacy of project financing (at least absent predatory behavior by those controlling the cash flow). “Pay-if-paid” clauses, for example, are used by contractors to shift the risk of project insolvency to subcontractors, which have no contract with, and thus no recourse against, the owner, by making owner payment of the contractor a condition precedent to contractor payment of subcontractors. Prime contractors frequently are aggressive in insisting on the inclusion of “pay-if-paid” provisions in their subcontract forms. Contractors’ use of pay-ifpaid terms in their subcontracts underscores their concern that owner financing arrangements may be inadequate to compensate subcontractors fully for the labor and materials that they provide on credit, and that they bill in arrears. Economically-rational construction bidders will place a high value on information that the owner has a fully adequate source of financing to pay project-related invoices as they become due. Moreover, those same rational bidders will interpret any lack of transparency in the owner’s financial arrangements as a warning of potential troubles. Contractors that are not satisfied that disclosed financial commitments will be sufficient to complete a project may either refuse to bid, or will add sufficient contingency amounts to their bids to account for the likelihood that they will pay substantial interest charges to float the owner’s project while awaiting late payments, or while awaiting longdelayed approvals of change order requests.
Industry Policies Payment delays (including delayed owner approval of change orders) are a wellrecognized source of conflict on a construction project. The “Guideline on Owner’s Ability to Pay,” part of the Guidelines for a Successful Construction Project jointly published by ASA, Associated General Contractors of America, and the Associated Specialty Contractors, states: 3
“Delays or defaults by owners in meeting contractual payment obligations to contractors is a growing cause of litigation, liens, long delays in completion of construction, abandonment of contracts, and bankruptcy of contractors and subcontractors. Qualified contractors often are unwilling to bid on projects for owners whose financial capacity and credit rating are not widely known. This results in reduced competition and the possibility of higher bids to the detriment of the owners…. “A trouble-free arrangement from the beginning to the completion of the construction requires that the owner have a sufficient commitment from a lending institution or other source of construction capital. This includes funding to make all progress payments, release of retainage, and final payment promptly as provided for in the contract documents, as well as a sufficient reserve to pay for changes and any claims for which the contractors are entitled to reimbursement …. “It is improper for a payment delay of even one day to occur because of administrative lapses or because release of funds is deliberately delayed while waiting for certificates of deposit or investments to mature. Such actions pass on to contractors the responsibility of financing the project, which should not be a contractor obligation …. “In order to obtain the most competitive bids, owners should furnish current written information needed by contractors and subcontractors to enforce lien and bond rights …. “Invitations for bids must contain clear statements that the owner has made sufficient financial arrangements for completion of the project and administrative arrangements for timely disbursement of every payment, including change orders and claims. Bidders should be invited to make inquiry about these arrangements so that they may satisfy themselves about financial details. Inquiries from contractors who have been invited to bid the project should be answered quickly and candidly by the owner or its construction lender. “In the case of governmental bodies, confirmation is needed that necessary funds have been appropriated for the financing of the project by legislative bodies having funding authority or that necessary bonds have been sold, and adequate funds are on deposit. Many contractors who once felt confident in bidding to governmental bodies have lost that confidence because of the number of governments that have defaulted or approached default on obligations. Because of the reputation of many governmental bodies for delaying payments due to procedural red tape and funding technicalities, it is especially important that bidders on public works have clear assurances that such delays will not occur.”
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The introduction to AGC’s “Guidelines for Obtaining Owner Financial Information” (1998) aptly notes: “In any contractual venture, each party has a legitimate interest and responsibility in ascertaining whether the other party is fully capable of performing all of its contractual obligations. In an owner/contractor relationship, before entering into a contract with a contractor, an owner often requires financial statements and bank references from the contractor, and may require a surety bond which guarantees both project performance and payment obligations.” The proven ability to pay is just as important as the proven ability to perform. A contractor, therefore, has an equally valid interest in receiving assurances that a project owner has sufficient funds available to make payments in accordance with the terms of the construction contract. Of course, AGC’s “Guidelines” are directed at contractors that have a direct contractual relationship with the owner. Subcontractors, however, also have a genuine interest in assuring the owner’s capacity to keep current with the general contractor’s payment requisitions, especially considering the nearly universal industry practice of shifting the risk of payment delays to subcontractors using either “pay-when-paid” or “pay-if-paid” subcontract terms.
Industry Practice Provisions assuring that a prime contractor will have the right to disclosure of project financing arrangements are common in industry standard documents. Subcontractor rights have been less well-defined, although the use of either “pay-when-paid” or “pay-ifpaid” terms in construction subcontracts has become essentially universal. Prompt pay laws governing payment of subcontractors, which regulate public procurement, private construction, or both, generally require payment of subcontractors within a certain number of days after the contractor is paid, and so any payment delays from the top translate into payment delays to all of the contractor’s subcontractors. Thus, the state and federal prompt pay laws governing payment of subcontractors essentially institutionalize pay-when-paid payment terms. Model subcontract forms published by ConsensusDocs and AIA also incorporate pay-when-paid payment terms. Public Procurement Federal law has long provided that no federal agency can enter a contract “for the erection, repair, or furnishing of any public building, or for any public improvement which shall bind the Government to pay a larger sum of money than the amount in the Treasury appropriated for the specific purpose.” Thus, the federal government requires construction projects to be fully funded from commencement. In fact, it is an implied term of every federal government contract that the contract amount is subject to the amount appropriated. The federal policy is mirrored in states and localities throughout the country. Indeed, it is the prevailing view that state and local governments risk rendering their contracts void 5
and unenforceable if they fail to comply with laws requiring them to have funding before incurring an indebtedness. In the public procurement context, then, contractors and subcontractors may be lulled into thinking they have adequate assurances of project financing in the form of public appropriations laws, statutes and ordinances. However, there are sufficient instances in which sufficient funding was not in place because of poor planning or overspending. Thus, contractors and subcontractors on public work are advised to assure that sufficient funding is in place, particularly on a project with extensive change orders. Model Contract Forms Popular construction contract forms published by all segments of the construction industry, including ConsensusDocs and AIA, not only recognize the importance of adequate information to assess the financial viability of a construction project, but actually allow the contractor to stop work if the owner fails to provide that information on request. ConsensusDocs and AIA forms also explicitly obligate the owner to give notice of any changes in project financing. The ConsensusDocs 200, Standard Agreement and General Conditions Between Owner and Constructor (Lump Sum Price) (2012, at ¶ 4.2, also affords “condition precedent” protection for the contractor’s right to seek project financing disclosures: “Prior to commencement of the Work and thereafter at the written request of the Constructor, the Owner shall provide the Constructor with evidence of Project financing. Evidence of such financing shall be a condition precedent to the Constructor’s commencing or continuing the Work. The Constructor shall be notified prior to any material change in Project financing.” AIA’s A201-2007, General Conditions of the Contract for Construction, at ¶ 2.2.1, provides: “Prior to commencement of the Work, the Contractor may request in writing that the Owner provide reasonable evidence that the Owner has made financial arrangements to fulfill the Owner’s obligations under the Contract. Thereafter, the Contractor may only request such evidence if (1) the Owner fails to make payments to the Contractor as the Contract Documents require; (2) a change in the Work materially changes the Contract Sum; or (3) the Contractor identifies in writing a reasonable concern regarding the Owner’s ability to make payment when due. The Owner shall furnish such evidence as a condition precedent to commencement or continuation of the Work or the portion of the Work affected by a material change. After the Owner furnishes the evidence, the Owner shall not materially vary such financial arrangements without prior notice to the Contractor.” By making financial disclosure a condition precedent to either commencing or continuing work, the ConsensusDocs and AIA documents make project financing 6
disclosures perhaps the most easily enforced of any rights provided to the contractor in the general conditions. ASA’s “Addendum to Subcontract,” also seeks to promote the trend favoring financial disclosures down the contractual chain. Like the protection afforded to prime contractors in the ConsensusDocs and AIA, the addendum sets up the contractor’s obligation to provide disclosures to the subcontractor as a condition precedent to the subcontractor’s performance.
Protecting Your Business ASA’s Subcontractor Negotiating Tip on Evidence of Owner Financing provides subcontractors with arguments to use at the negotiating table when pursuing owner financing information: When the GC Says: “The owner is my customer. If I’m comfortable with his wherewithal, you should be, too.” The Sub Should Say: “Your subcontract refers directly to payment by the owner as the trigger for when I get paid. You’re asking me to rely on the credit of your customer. How can I rely on the credit of the owner without investigating it?” When the GC Says: “I’ve already agreed to eliminate the pay-if-paid clause in my subcontract, so I’m ultimately on-the-line for payment to you.” The Sub Should Say: “And I appreciate your working with me. But even with the pay-when-paid clause to which we’ve agreed, the timing of my payment is dependent on the credit of the owner. If the owner pays late, everyone gets paid late, which puts pressure on my cash flow. If you want me to base my payment on the owner’s cash flow, then the owner’s financial status is very much my business.” When the GC Says: “How do you expect me to convince the owner to provide me with this information?” The Sub Should Say: “It’s standard practice in the construction industry for the owner to provide financial information to its GC. After all, you’re extending credit to him. Both the ConsensusDocs and AIA general conditions require the owner to provide you with reasonable evidence that it can meet its financial obligations. I’m confident that you’re enough on your toes to negotiate for this important right with your customer.” ASA’s Subcontractor Negotiating Tip on Pay-if-Paid Clauses closely ties credit judgments with the use of pay-if-paid language. The tip sheet provides subcontractors with arguments to use at the negotiating table when dealing with pay-if-paid subcontract terms: When the GC Says: “The subcontractor should share in the risk of owner insolvency.” The Sub Should Say: “My credit risk is with you. There’s no justification for me to also extend credit to the owner. I don’t have a contractual relationship with the 7
owner. You did the credit check on the owner and your decision to go forward is strictly your responsibility.” When the GC Says: “A subcontractor’s lien rights and the job’s payment bond will offer payment protection.” The Sub Should Say: “Bonding companies routinely deny claims on pay-if-paid terms, reasoning that no money is owed when an owner fails to pay. Liens also are often challenged using the same logic.” When the GC Says: “You should always be willing to wait for your money until I’m paid.” The Sub Should Say: “I can’t wait until you pay me to issue checks to my jobsite workers, office staff, utility companies and suppliers. If I’m supposed to finance you, I’ve become a banker, not a builder. When the GC Says: “Pay-if-paid is a valid concept.” The Sub Should Say: “Contingent payment terms are void in some states as being against the public interest and fair contracting practice. Even widely-endorsed model documents, such as ConsensusDocs and AIA, do not include a pay-if-paid clause. I would have to be a pretty lousy business person to agree to such a questionable concept as pay-if-paid.” A subcontractor must understand the link between pay-if-paid language and the credit judgments it must make before becoming obligated to perform work on a project. Even absent pay-if-paid terms, a subcontractor should investigate the financial commitments on which the project depends, because pay-when-paid payment terms will likely transfer all the risk of late payments to subcontractors. Finally, a subcontractor should consider providing two prices for its work at bid time when bidding to contractors who employ pay-if-paid subcontract language: one price for bearing the risk of owner insolvency, and a cheaper price for more favorable, “paywhen-paid” subcontract language.
Getting Financial Information A subcontractor should collect information from each prime contractor about its creditworthiness and the solvency of the contemplated project. With regard to the owner, a subcontractor should seek sufficient information to enforce mechanics’ liens and bonds, as well as information concerning the identity of the owner’s lender and the type. This information should include:
Name of project Address (legal description of real property) Project owner’s name and address Owner’s agent name and address Has the prime contractor provided the owner with a performance bond? Has the prime contractor provided the owner with a payment bond? 8
The percentage of the bond Name and address of surety company Name and address of surety company agent Construction loan information, including source, contact and address Permanent loan, including source, contact and address Name, agent and address of any municipal or government agency involved in the funding of the project
AGC’s resources suggest that contractors should look beyond loan commitments. AGC’s “Guidelines for Obtaining Owner Financial Information” states that the actual loan agreements for construction and permanent financing are “preferable over a simple commitment letter, because the loan documents will include all of the lender conditions and requirements. Of significance are the requirements for notification to the lender, whether the lender must approve changes, and assignment of the contract to the lender.” The AGC “Guidelines” also provide tips for evaluating loan commitments and other documents, such as: “10. Beware of a loan commitment that covers items other than construction. “11. Request a lender’s “set-aside” letter that acknowledges the portion of construction loan proceeds available exclusively for payment of construction draws. …. “18. Ask for a copy of the owner’s agreement with the architect. This will assist in assessing whether sufficient funds are available to cover the owner’s financial obligations, particularly if loan proceeds can be used to pay design costs. It will also identify the architect’s contract administration responsibilities and whether the architect’s responsibilities are consistent with the provisions of the general conditions for the project.” AGC’s “Guidelines” also suggest obtaining the owner’s credit report, and are distributed with an “Owner Financial Questionnaire” that provides a checklist including such items as the owner’s Dun & Bradstreet rating, bank references and certified financial statements. A subcontractor should consider the terms of its subcontracts (e.g., pay-if-paid vs. paywhen-paid), as well as the information contained in disclosures that they do obtain, when deciding whether to be satisfied with a loan commitment letter or loan agreement, or to seek additional evidence of adequate project financing and owner creditworthiness.
Conclusion The terms for the extensions of credit typically made by contractors and subcontractors are stated in the payment terms of a construction contract. Those terms generally require construction contractors and subcontractors to have fully completed any work 9
which is the subject of an invoice, with written certification from either the project architect or another owner representative that the work has, in fact, been properly completed. Those terms also generally require “lien waivers” or a sworn certification from the party seeking payment, showing that all lower-tier laborers and suppliers have already been paid in full. Thus, the extension of credit by contractors and subcontractors is a requirement of most, if not all, construction contracts and subcontracts. Laborers must be paid on a regular basis or civil and criminal penalties can result. Equipment and machinery must be maintained in productive, moneygenerating activity to pay for rental and upkeep. Crucial material suppliers must be kept current. Any sizable construction project entails a huge credit risk from the standpoint of any construction contractor or subcontractor. Payment terms like pay-when-paid that shift the burden of late payments to subcontractors, and pay-if-paid clauses that shift the burden of project insolvency to subcontractors, must be considered when deciding whether to bid work, what the price should be, and what financial disclosures should be required. On every project, subcontractors should assert their right to adequate disclosures of the owner’s financial arrangements. Such disclosures ultimately will benefit owners in the form of lower prices and better quality services.
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