The continuing financial crisis is having a profound effect on every sector of the economy, and construction is no exception. With the likelihood of contractor and subcontractor default and abandonment increasing every day, now is a good time for owners, developers and lenders to review the rules for crisis management on troubled construction projects. Owners who follow these rules can maximize the chances that their projects will be completed successfully, and minimize the chances that troubled projects will turn into fullfledged disasters.
1. Know The Early Warning Signs
Some of the warning signs of a project going bad are more visible than others, but almost all share a common characteristic—they signal either an impending breakdown of the flow of money through a project, or a growing inability of one or more project participants to fulfill their obligations.
Some of the more readily-observable red flags include the following:
- Falling manpower. A daily manpower count can tell volumes about the health of a project. Inadequate levels of supervision or deficient staffing of the trades is a sure sign that a project is headed for trouble. A decrease in manpower is often one of the first symptoms of deep-rooted and less visible problems.
- Late deliveries. Like falling manpower, chronic late delivery of material or equipment is frequently a sign of worse problems to come.
- Slow-down in submitttals. Delays in providing submittals can be a signal of problems among the lower-tier subcontractors. Slow-downs in the submittal approval process can also signal difficulties within the design team that can have a ripple effect through the project.
- Poor workmanship. An increase in failed test results or project inspections can signal deeper problems related to quality of the workforce and supervision, as well as the financial health of the contractor and subcontractors.
- Schedule slippage. Frequent schedule updates and rigorous comparison to the as-planned schedule will identify schedule slippage before it becomes a major problem. A slipping schedule is often a result of the factors listed above.
- Dropping productivity. Like its close relatives, falling manpower and schedule slippage, a decrease in productivity can be a symptom of deeper problems with the contractor or its subcontractors.
- Failure to meet draw or payment schedule. Failure of the contractor to submit complete and timely draw requests, or failure of the owner to pay in a timely manner, are both red flags that should be heeded by all parties.
- Unclean or unsafe jobsite. Lack of attention to detail, such as clean-up and safety requirements, is sometimes a signal of contractors or subcontractors that are distracted, over-stressed or under-staffed.
2. Recognize The Root Causes of Default
The visible warning signs listed above are often symptoms of the root causes that lead to project default and abandonment. The underlying problem on terminated or abandoned projects can usually be traced to one or more of the following:
- Interruption of the payment stream. Money is the lifeblood of all construction projects. A steady flow of cash from the lender to the owner, from the owner to the contractor and from the contractor to subcontractors and suppliers is essential if a project is to be completed on time and within budget. When this payment stream is interrupted, serious problems usually ensue.
- Many different circumstances can lead to an interruption of the payment stream. Some of the more common causes include a loss of confidence by one of the parties in an upstream of downstream counter-party, an inability by one of the project participants to obtain funds, an inability by a contractor or subcontractor to perform, or even diversion of money to other projects. If any of these occur, immediate steps must be taken to prevent the project from sliding into catastrophe.
- Difficulty on other projects. A project can quickly be dragged down by difficulties besieging the contractor or subcontractors on another project far away. Resource drain from other projects, or financial problems on another job, is among the most common causes of financial failure, non-performance, default and abandonment.
- Industry-wide problems. Escalating costs, shortages of material and labor, or freeze-ups in the financial sector can manifest themselves as problems on numerous projects simultaneously. The result can be late payments, falling manpower, late deliveries, delayed performance and cost overruns. These problems can quickly derail an otherwise healthy project.
3. Develop An Action Plan—and Follow It
Particularly in uncertain economic times, an owner ignores these warning signs at its peril. To proactively address project failure requires developing an action plan, and detailing how the warning signs will be addressed before they appear. The action plan of an owner or developer should include at least the following elements:
- Update lien waivers. The lien waiver requirements of the contract should be reviewed, and the lien waivers of all contractors and subcontractors should be checked to make sure they are current. If a pattern of not requiring lien waivers has been established in the past, the owner must take immediate steps to reinstate the requirement. New processes must then be put in place to make sure that the contractual requirements for lien waivers are stringently enforced going forward.
- Update change orders. The change order provisions of the contract should also be checked, and the owner’s project personnel should be questioned to make sure that there are no pending or open change order requests. If a pattern of waiving contractual notice and documentation requirements has been established, then the owner must take immediate steps to revoke this waiver. If the project descends into turmoil, disputes will coalesce around any unexecuted or improperly documented change orders. Every effort must be made to strictly adhere to the change order process, and to limit the number of open issues as a troubled project winds down.
- Review “open book” and other disclosure rights. Contracts should be reviewed for “open book” provisions, change order substantiation clauses, or other disclosure requirements relating to cost and schedule. Such provisions can be used to obtain valuable information about the financial health of the contractor and the project.
- Check payment and retainage rights. Once warning signs appear the rights of an owner or developer to withhold retainage and disputed payments becomes paramount. Care should always be exercised in exercising rights to withhold payment, since a flow of funds is required to sustain continued construction activity. At the same time, an owner or developer should exercise its contractual rights in a prudent manner, to ensure that its financial interests are protected in the event of abandonment or termination.
- Verify the dispute resolution process. Many contracts contain detailed dispute or claims clauses with time limits for notices, mandatory stair-step negotiations, and other dispute resolution mechanisms. All parties should be aware of the consequences of failing to comply with these requirements. An owner or developer should also make wise use of these informal dispute resolution mechanisms, in an effort to obtain information and resolve small problems before they become big ones.
- Call on experts and professionals as needed. If it becomes clear that a project is headed towards a rocky landing, the parties might benefit from the advice of experts and professionals to work through the issues at hand. For example, a scheduling expert can help to find ways to mitigate the damaging effects of delay. Other subject-matter experts can often suggest fixes that are more effectively implemented mid-stream than after the fact.
- Check bonds and insurance. The status of all relevant bonds and insurance policies, and in some cases the financial health of their issuers, should be checked. Particularly when the financial health of the contractor and subcontractors may not be good, it is usually best for an owner or developer to shift as much risk as possible to an insurer or surety.
- Review contract terms and conditions. This is a good time for someone to sit down and read the construction contract, exhibits and change orders from beginning to end. Frequently, there are requirements and remedies built into the contract—relating to substantial completion, defective work, indemnities, staffing, recovery schedules and the like—that, if exercised in a timely manner, can mitigate the adverse effects of the warning-sign events described above.
Even in the best of times, and even for the most experienced owners and lenders, construction projects often present unexpected challenges. When the times are as uncertain as they are today, it is even more important for prudent owners to have a well thought-out action plan, and to follow it when warning signals appear.