These are trying economic times. The recession is drying up jobs, and the credit crunch is significantly reducing available funds for everyone. Indeed, banks are steadily drawing in lines of credit from their customers on nearly every front from credit cards, to home equity loans, to commercial operating lines of credit.
Cash is truly king these days, like no time in recent history. To see this first hand you need only look to the major department stores that are reinvigorating their layaway programs for the upcoming Christmas season.
The construction industry is certainly not immune from these problems. The biggest hurdle for public owners used to be getting voter approval to issue bonds for public projects. These days, the voter hurdle is still significant, but equally significant is market access for local governments that do not enjoy the highest credit ratings. As a result, funding the project may be difficult and may take place on a different timeline than planned.
Contractors are also feeling the crunch in the form of reduced cash flow. When operating lines of credit are no longer available to carry the float period in between pay applications, it typically means that subcontractors and material suppliers are not getting paid timely, if at all. And if that goes on for too long, the subcontractors stop performing work and the suppliers refuse to supply materials, which will put a contractor out of business in a hurry and cripple a construction project.
Unfortunately for contractors, construction is a business that requires a large, up-front investment prior to actual cash inflow. On the typical project, approximately 30 percent of the total value of the contract has to be available before any billings are sent out, and the project won’t start creating positive cash flow until the last 5 to 10 percent of the billings are submitted. In a tight credit market, the effects of this cash flow dynamic are significantly exacerbated.
One of the indicators used by accountants in analyzing a contractor’s cash flow is determining if a project is underbilled or overbilled. If a project is underbilled, cash is left at the site. If a project is overbilled, the owner has paid for work that has not been performed.
There are a number of reasons that a project might be underbilled or overbilled, but one sure way for a contractor to increase cash flow, at least at the beginning of a project, is to overbill. Obviously, however, overbilling at the beginning of a project creates a big problem at the end of a project, because the cash flow is not available to finish the work.
From the owner’s perspective, the best case scenario is to have a project that is accurately billed—neither overbilled nor underbilled—so that the contractor has an appropriate level of cash flow to pay subcontractors and material suppliers and so that the balance of the contract accurately reflects the value of the remaining work.
The entity charged with the responsibility of ensuring that the pay application accurately reflects the progress of the work is, of course, the project architect, and most construction contracts will give the architect the discretion to withhold certification of the pay application, in whole or in part, in order to carry out that responsibility.
For example, in the AIA Document A201-2007, General Conditions of the Contract for Construction, Section 9.4.2 states, in pertinent part:
The issuance of a Certificate for Payment will constitute a representation by the Architect to the Owner, based on the Architect’s evaluation of the Work and the data comprising the Application for Payment, that, to the best of the Architect’s knowledge, information and belief, the Work has progressed to the point indicated and that the quality of the Work is in accordance with the Contract Documents.
Section 9.5.1 then goes on to provide, in pertinent part:
The Architect may withhold a Certificate for Payment in whole or in part, to the extent reasonably necessary to protect the Owner, if in the Architect’s opinion the representations to the Owner required by Section 9.4.2 cannot be made. . . . If the Contractor and Architect cannot agree on a revised amount, the Architect will promptly issue a Certificate for Payment for the amount for which the Architect is able to make such representations to the Owner. The Architect may also withhold a Certificate for Payment or, because of subsequently discovered evidence, may nullify the whole or a part of a Certificate for Payment previously issued, to such extent as may be necessary in the Architect’s opinion to protect the Owner from loss . . . , because of . . .
.3 failure of the Contractor to make payments properly to Subcontractors or for labor, materials or equipment;
.4 reasonable evidence that the Work cannot be completed for the unpaid balance of the Contract Sum; [. . .].
Under this provision, an architect has the right to withhold payment from a general contractor if the architect determines that the pay application is overbilled, or, if at any point, the architect determines that the project is overbilled. Moreover, this provision gives the architect the right to withhold payment if a contractor is not paying its subcontractors or suppliers.
Thus, Section 9.5.1 is a very important and useful tool for an architect to use to curtail aggressive billing by contractors and to prevent contractors from attempting to manage their own cash flow at the expense of their subcontractors and suppliers.
In times of economic crisis, it is more important than ever to make sure construction projects are billed appropriately. Thus, owners should instruct their architects to strictly monitor the progress of the work to make sure that both the billings are in accordance with the progress of the work and the subcontractors and suppliers are paid timely. Additionally, architects should not be hesitant about using the tools provided in the contract, such as Section 9.5.1, to protect the owner against aggressive billing by contractors.