Mind the Gap: Start Early to Guarantee Payment to Subcontractors - Articles

The following content is sponsored by Old Republic Surety.

In construction contracting risk management, the certainty of payment for work put in place by the contractor is a fundamental component for predictable outcomes on any project. At the prime contract level between the GC and project owner (owner), this risk is manageable based on the strength of the contract terms and the verification of financing for the project.

Public entities are restricted by statute from letting work commence until the finances and/or budget is allocated to the project. Accordingly, in public construction, uncertainty of payment is less of a risk. But in privately-owned construction, the GC must seek to verify owner financing of the project and may rely on mechanic’s lien rights on the improvements to the real property as a payment guaranty.

So, what is the guaranty of payment for subcontractors, suppliers, vendors, and labor that may be one or two steps removed from the prime contract? This is an especially important question when the subcontract includes pay-when-paid and/or pay-if-paid clauses. This article covers the certainty of payment and dives into a scenario that explores problems and clauses related to payment.

Payment to Subcontractors

While a subcontractor would also have lien rights on a private construction project, the process and ability to perfect and enforce those rights may result in payment to the subcontractor only after a drawn-out process.

Having perfected lien rights does not immediately force payment, but it does cloud title to the real property. Making that cloud “rain dollars” down to subcontractors is a few legal steps into the future.

In addition, neither GCs nor subcontractors may place a mechanic’s lien on a public construction project. If the GC is required to provide a performance and payment bond to the project owner, whether public or private, then the payment bond provides a guaranty of payment to the subcontractor. This assumes the subcontractor has met the payment requirements under applicable statutes, subcontract terms, and payment bond conditions.

Subcontractors would be well served to review these governing documents with their legal counsel before entering the subcontract. This is especially true of the enforceability of pay-when-paid and pay-if-paid clauses if they are included in the subcontract.

This scenario is relatively simple to map: the owner pays the GC, and the GC pays the subcontractor. However, if the project is large and/or complex, then it is likely that there will be more than one tier of subcontractors engaged in the project. Subcontractors will, in turn, have other subcontractors and vendors that are also concerned with the certainty of payment.

Under normal circumstances, the certainty of payment to the subcontractor can be gauged by understanding the prime contract, the subcontract and subcontract purchase orders, and the performance and payment bonds at the prime contract and subcontract levels. But what happens when a review of these documents reveals a gap in the payment guaranty?

The following scenario is an example of what can happen when payment guaranties are not well thought out and where a professional surety agent and surety can help identify the problem, if not cure it.

What if Payment Guaranties Are Not Well Thought Out?

In this scenario, the GC had a project for a large private owner. The prime contract required a portion of the project to be completed by disadvantaged and/or minority subcontractors. To satisfy this requirement, the GC subcontracted a portion of the project to a construction manager (First-Tier Subcontractor) that held minority status.

The First-Tier Subcontractor, per the GC, was to provide administrative and management services. In turn, the First-Tier Subcontractor subcontracted various scopes of work to trade contractors, one of which was a surety account (Second-Tier Subcontractor). The First-Tier Subcontractor adopted the language of the subcontract it had with the GC word for word, only substituting its own name in place of the GC’s name.

In addition, at the request of the GC, the First-Tier Subcontractor also utilized the subcontract bond forms commonly used by the GC on private construction projects. As a result, these agreements had back-to-back terms. At this point, nothing done by the GC or First-Tier Subcontractor created a payment guaranty problem. It is what the GC did not do that created the gap in payment guaranties.

No Bonds Required

The GC did not require the First-Tier Subcontractor to provide a performance and payment bond. Accordingly, the Second-Tier Subcontractor had no payment guaranty in the form of a payment bond. However, the GC did require the First-Tier Subcontractor to obtain performance and payment bonds from all of its subcontractors. In addition, the GC required that it be named as an additional obligee on all of the bonds between the First-Tier Subcontractor and its subcontractors, including the Second-Tier Subcontractor.

Due to this requirement, as is customary in surety underwriting, the Surety required a multiple obligee rider to accompany the bond, which incorporated the following language:

It is agreed that the Surety shall not be liable under this Bond to the Obligees, or either/any of them, unless the said Obligees, either/any of them, shall make payments to the Principal or Surety strictly in accordance with the terms of said contract as to payments, and shall perform all of the other obligations to be performed under said contract at the time and in the manner therein set forth.

Discussion

This language is commonly known in the surety industry as the savings clause. While the savings clause language may vary slightly among sureties, the outcome of its operation is the same. For the additional obligee on the bond to enjoy the protections provided by the bond, it must agree to adhere to the terms and conditions of the bonded contract. This includes the requirement of payment for the work put in place.

Though the focus in this situation is payment terms, in a subcontract scenario, other clauses such as dispute resolution and unforeseen conditions are of equal importance. On private projects, it is not uncommon for the entity providing financing on the project to be named as an additional obligee on the performance and payment bonds. Financial institutions customarily approve the multiple obligee rider without comment.

It is less common for a GC to require a first-tier subcontractor to name the GC as additional obligee on bonds it requires of the second-tier subcontractor. Normally, the GC relies upon the hold harmless clause in its own subcontract with its first-tier subcontractor and requires a performance and payment bond from the first-tier subcontractor.

No Savings Clause Language

In this instance, the GC strenuously objected to the savings clause language. From the GC’s perspective, the requirement in the savings clause that the GC, as obligee, strictly adhere to the terms of bonded subcontract would require the GC to participate in any dispute between the First-Tier and Second-Tier Subcontractor. Accordingly, the GC rejected the multiple obligee rider to the subcontract bond.

From the Second-Tier Subcontractor’s perspective, the overall arrangement was unattractive and unreasonable. By declining to bond the First-Tier Subcontractor, the GC had created a gap in the guaranty of payment. If the First-Tier Subcontractor became insolvent and was unable to perform in its subcontract as construction manager, then the Second-Tier Subcontractor had very limited ability to pursue a claim for payment against the GC. The rejection of the multiple obligee rider brought the arrangement to the attention of the Surety.

During a call with the GC, the First-Tier Subcontractor, the Second-Tier Subcontractor, and the Surety to attempt to resolve the issue, the GC stated that it would not accept the multi-obligee rider. It put forth no alternative other than the elimination of the savings clause from the rider.

From the Surety’s perspective, this is a very undesirable, unattractive, and unreasonable proposition. The GC was not signatory to the subcontract between the First-Tier and Second-Tier

Subcontractor, yet the GC required all of the rights and remedies of an obligee under the Second-Tier Subcontractor’s bond without being bound to follow the terms of the bonded subcontract. This represented a change in the risk taken by the Surety when underwriting the bonded obligation.

Discussion

If an obligee is not obligated to adhere to the subcontract terms but requires performance on the part of the surety, should the obligee choose to default the bond principal, the outcome is far from certain. In this instance, it was difficult to understand the basis of the GC’s objection.

Dispute Involvement Concerns

The GC had no answer when questioned how it would be drawn into every dispute between the First-Tier and Second-Tier Subcontractors if the First-Tier Subcontractor was solvent and performing under its subcontract with the GC. Given the facts, the GC is not in privity of contract with the Second-Tier Subcontractor; therefore, the Second-Tier Subcontractor could not make a direct claim against the GC for a dispute between the First-Tier and Second-Tier Subcontractor.

Only one scenario drew the GC into a contractual conflict directly with the Second-Tier Subcontractor: the GC would inherit an existing dispute between the First-Tier and Second-Tier Subcontractors only if the First-Tier Subcontractor was insolvent and defaulted from its subcontract with GC. If the First-Tier Subcontractor defaulted under its subcontract with the GC, then the GC had the option to take assignment of the subcontract between the First-Tier and Second-Tier Subcontractors.

If this were the case, the Surety was only requiring that the GC would adhere to the terms of the bonded subcontract. Since the GC was the author of the subcontract language, the GC could not criticize the terms of the subcontract it would inherit.

An hour of circular discussion and some uncomfortable silences ensued wherein the GC failed to come up with a scenario that would draw them into a dispute with the Second-Tier Subcontractor while the First-Tier Subcontractor was solvent and performing under its own subcontract with the GC.

Unfortunately, no resolution was reached. The GC could not explain why the Second-Tier Subcontractor should take the risk of nonpayment, nor why the gap created by the GC in not bonding the First-Tier Subcontractor while requiring the GC be named as an obligee on the Second-Tier Subcontractor’s bond with no savings clause would be an acceptable risk to a surety. The GC stated rather disingenuously that, because other sureties had deleted the savings clause from the multiple-obligee rider, neither the Second-Tier Subcontractor nor the Surety should object to it.

Discussion

Had the Second-Tier Subcontractor and the Surety moved forward under this scenario, the Second-Tier Subcontractor would have been more exposed to the risk of nonpayment than initially apparent from the subcontract documents and bond forms. The Second-Tier Subcontractor would have the right to lien the project since it was privately owned. As mentioned, this does not provide for a prompt recovery.

Possible Increase in Size of Loss

Additional risk is yet another layer below the surface. In the event that the First-Tier Subcontractor was terminated, and the GC made a claim on the Second-Tier Subcontractor’s bond with no savings clause, then the Second-Tier Subcontractor would be exposed to any additional issues and increased bond claim costs caused by the GC’s failure to adhere to the bonded subcontract terms. The general agreement of indemnity would come to bear between the Second-Tier Subcontractor and the Surety.

Failing to include the savings clause may increase the size of the surety loss, as the funds not forthcoming from the GC would come from the Surety to complete the work remaining after a default. This, in turn, would increase the indemnity obligation of the indemnitors to the Surety.

Discussion

It is particularly important to understand this where the personal indemnity of the owners of the bonded subcontractor is concerned. It’s one thing to consider additional risk to an owner’s business entity, but it’s quite another to put the roof over one’s head at additional risk where the GC is not reasonable.

As presented, the Second-Tier Subcontractor had little negotiating leverage with the GC. The First-Tier Subcontractor had no incentive to support the Second-Tier Subcontractor’s objections. And the GC attempted to shrug off the objections of the Surety as business as usual.

But the scenario was not business as usual. Each level of the guaranty of payment must be understood and easily mapped for a predictable outcome. If a level of payment guaranty can’t be mapped from project owner to each level of subcontractor, then the overall project and all the underlying agreements, as well as the reasonableness of each of the parties, deserve additional scrutiny and evaluation before reaching a final risk management decision to proceed.

Conclusion

The scenario presented here is not often encountered, but it has the potential to be devastating to a bonded trade contractor if ignored or not fully understood. Each subcontract should be reviewed thoroughly for any impediments to payment that are beyond the immediate control of the subcontractor.

Whether or not a subcontract bond is required, the subcontractor should fully investigate the guarantee of payment from the project owner through each tier of contractors between them. A professional surety agent and surety underwriter can be very helpful in reviewing the project payment scenario for gaps. Once the review is performed, the subcontractor can make an informed decision to pursue a remedy to a gap or pursue other projects that provide for more certainty of payment.