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Tips, Tricks & Tidbits to Help Identify & Manage Struggling Subcontractors

By Rick Ciullo, Ryan A. Hiss & David L. Sauerman

What should a GC or first-tier subcontractor do when a  subcontractor or material supplier appears to be unable to complete work according  to the contract terms?

Rick Ciullo, Chief Operating Officer for Chubb Surety; Ryan Hiss, Partner at Lyman & Nielsen; and Dave Sauerman, Managing Director at the PrivateBank, recently discussed some best practices for managing this risk.

Dave: I’ve noticed that my clients are much more focused on prequalifying their subcontractors. I see more seminars and articles on this topic than in previous recoveries. I can’t help but feel that part of the reason for this increased interest is a higher level of fear and uncertainty on the part of GCs and first-tier subcontractors regarding their subcontractors’ ability to complete the project without financial drama.

Rick and Ryan, what trends are you seeing in your respective worlds?

Rick: We see that same issue and view it as three distinct challenges: prequalification, in-process management, and “nursing to the finish line.”

While prequalifying subcontractors has always been an important strategy for GCs and first-tier subcontractors, it has seemed like more of a science since the introduction of subcontractor default insurance (SDI) more than a decade ago. SDI gave contractors a financial incentive to prequalify and offered access to best practices and tools to help them do so more effectively.

As we entered the recession in 2008, many GCs, whether or not they used SDI, had extensive data and well-honed processes for prequalifying subcontractors and managing this risk. As the recession lingered, prequalifying subcontractors remained a critical strategy. For GCs that are just getting started, it may be too late – the risk may already be embedded in their backlogs.

Prequalification is necessary, but it’s not sufficient. To more thoroughly manage the risk, even a subcontractor that is qualified at the outset of a project has to be managed throughout it. But sometimes even the best prequalification and in-process management can still leave a GC with a troubled subcontractor.

A third component of managing risk is having the skills to help a subcontractor, or its replacement, finish its portion of the job without impacting the critical path or the cash flow.

Ryan: The risk of nonperforming subcontractors certainly isn’t a new one; however, it is getting more attention in today’s subcontracts. Over the past six months, I have noticed more expansive risk shifting to the downstream contractors than in times past. Particular provisions that are becoming more burdensome for downstream contractors are the indemnification, supplementation of work, and termination provisions.

Dave: What skills should a GC or first-tier subcontractor look for or what tools should they use in order to spot a troubled subcontractor before it’s too late? Too often, we see subcontractors operating well right up until the moment that they implode. My gut tells me that we don’t see the signs simply because we aren’t looking very hard.

Rick: GCs and first-tier subcontractors use their in-depth knowledge about their marketplace and the subcontractors that work in it to spot trouble early. For example, they take note of changes in behavior, the workforce, responsiveness, and the overall way a subcontractor executes and manages its work. These can be signs of a larger change.

GCs and first-tier subcontractors can learn about a subcontractor’s reputation by periodically checking on its other jobs, looking at how it meets its staffing (and union, if applicable) commitments, and knowing how it is keeping up with subcontractor and supplier payments. Some of this should happen organically through casual conversation, while other information can be gleaned through routine inquiries with those who do business with the subcontractor in question.

A subcontractor experiencing trouble can kill a project; knowing about it early is better, but it doesn’t eliminate the risk. Once a GC or first-tier subcontractor realizes that it is faced with a struggling subcontractor, the next steps may include:

  • Engaging the subcontractor directly to learn the depth  of the problem and explore a potential solution,
  • Notifying the surety for the subcontractor  (if applicable), and
  • Determining if it (the GC or the first-tier subcontractor) has any field superintendents or others with practical experience in the struggling subcontractor’s type of work.

The tricky part is managing the speed or amount of payments to the subcontractor. Paying a subcontractor too quickly or too much up front could create a challenge since the GC may need the unpaid amount if the subcontractor fails. Paying a subcontractor too slowly or too little could create or worsen financial problems for the subcontractor.

Ryan: GCs and first-tier subcontractors must provide themselves some contractual flexibility at the first sight of subcontractor trouble. At this early stage, termination may be too severe and unnecessary. However, a contract should allow the GC the right to step in for the subcontractor and keep the project moving while the subcontractor tries to right its ship.

Sometimes this involves self-performing a portion of the work on behalf of your subcontractor. Other times, it may require bringing in outside forces to perform limited, supplemental work. In order to do this, a contract must provide the right to supplement a subcontractor’s workforce and define the particular circumstances under which this right is triggered. For example, if the subcontractor fails to diligently pursue its work, the GC or first-tier subcontractor has the right – not the obligation – to hire additional workforce to supplement the subcontractor’s labor until the subcontractor cures this default. The contract must provide the GC and first-tier subcontractor with the right to reimbursement of all reasonable costs incurred (including extra general conditions) during this supplementation.

Of course, if the project is bonded, then the GC or first-tier subcontractor must notify the surety of the default and give the surety the opportunity to cure before supplementing the bonded subcontractor’s workforce. Sometimes, GCs or first-tier subcontractors have been hesitant to notify sureties of defaults in their subcontractors’ work until the project is complete; that is too late. If and when performance deficiencies arise, the surety should be notified in order to preserve a claim against the bond, but more importantly, to give the surety the opportunity to do what it is supposed to do: make sure the work is completed.

Rick, you mentioned making outbound inquiries concerning payment to downstream subcontractors. Although lien waivers are helpful in this process, they are not the end of the story. I have seen too many subcontractors of all tiers fail to include all of their suppliers and sub-subcontractors on their lien waivers. In many instances, the GC is aware of materials or labor being supplied by these non-listed suppliers and sub-subcontractors (e.g., trucks bringing materials to the project, materials with the names of these companies on them), but fail to inquire as to why these companies are not listed on the relevant waivers.

These questions need to be asked as they raise red flags and make the lien waivers less trustworthy confirmations of payment. Don’t assume the lien waiver is accurate; confirm with the subcontractors that each of their suppliers and sub-subcontractors are listed through pointed questions. (e.g., Who is supplying your branch circuits or switch gear? Are you using another contractor to install fireproofing?) Also, as further investigation, don’t overlook checking the local recorder of deeds and clerk of court records for evidence of liens and lawsuits involving the subcontractors on your job for signs of payment struggles. As part of the prequalification process and during performance, your local counsel can look these up quickly to help you identify potential troubled contractors.

Dave: Rick, you noted that a savvy contractor can see the signs of potential subcontractor problems by observing changes in the workforce, performance, pace, etc. From my perspective, these are suggestions of a potential issue rather than clear evidence. Furthermore, these changes could be indicative of a subcontractor that is either going through a temporary rough patch or on a fast track to failure. Is there anything else in the tool chest that can bring us to a more definitive conclusion regarding a subcontractor’s financial stability?

Rick: Since missing signs of trouble can carry a high penalty, GCs or first-tier subcontractors should react to any potential issue rather than wait for clear evidence. It’s better to be only nearly right than 100% wrong. Time is not on our side, and we can’t wait for a problem to be verified since it may already be in process. GCs and first-tier subcontractors must have a robust prequalification process that would include an analysis of the subcontractor’s financial statement, regular check-ins with the marketplace, and other reference points. The trouble is that no prequalification process is airtight. So, what I’m suggesting is a proactive way of observing the subcontractor’s performance, behavior, and attitude.

Behavior and attitude may sound like soft terms, but I think these are the first to show signs of change and stress of any sort. The careful observer is likely to notice trouble before others do and act more quickly to secure their project and protect themselves.

Dave: Let me ask the question in a different way. You see some signs that give you concern. On one hand, waiting until there is firm evidence may be dangerous, but so is overreacting and identifying a pending crisis that really isn’t there. So…let’s say that you see the “soft signs.” Do enough soft signs equal a “hard sign”? Are there any specific soft signs that should really get you moving?

Rick: I don’t view this as a threshold issue, where either one specific soft sign or a collection of soft signs suddenly dictates a call for action. It’s an accumulation of knowledge – some based on facts and some on experience – that might cause a GC to take action.

What’s more, how do you define “overreaction” when the health of your company might be at stake? If, for example, a subcontractor has changed the way it mans a job, wouldn’t it make sense to quickly address that with the subcontractor? Don’t accuse the subcontractor of anything, but ask questions and pay attention to the answers, the way they’re delivered, and the plan to correct the issue. Then watch for action and follow through.

The same is true of other so-called soft signs – rumblings from union halls, late or short delivered materials, cash-on-delivery purchase orders, asking the GC or first-tier subcontractor for help or consideration on payment terms, etc. All of these would beg questions and careful observation.

Dave: Clearly some subcontractors and suppliers are more critical to the success of a project than others. Ryan, would you advise a different approach for a key subcontractor/supplier than you would for a less critical one?

Ryan: There are two separate issues at play. As far as the contract terms are concerned, I advise to treat the subcontractors the same, regardless of the monetary value of their contract. Keep the subcontracts consistent and provide the same right to supplement forces and terminate the contract in each of the subcontracts. The GC or first-tier subcontractor needs those rights set forth explicitly in their contracts to give themselves the flexibility to take the most appropriate action under the circumstances.

The second issue is more practical. Should the GC or first-tier subcontractor exercise these rights against all subcontractors, regardless of their contract value? Part of this issue is determined by the project schedule. If the subcontractor is not on the critical path or there is substantial time before that subcontractor impacts the critical path, then you obviously have a longer leash and may delay exercising the right to supplement their forces.

However, be cautious. I have seen subcontractors and suppliers start to show signs of financial problems through failed or delayed deliveries or decrease in labor supply, and be given ample time to right the ship. Their problems got worse, and they filed for bankruptcy. This type of situation takes time to unwind.

Once a contractor files for bankruptcy, it is not able to act on its own. The GC or first-tier subcontractor must then work with the Bankruptcy Trustee in order to get proper documentation from that subcontractor (i.e., lien waivers, pay apps, warranties, etc.), and the payment of downstream contractors and suppliers requires court approval. This slows down the flow of documents tremendously.

All of a sudden, the small supplier that did not seem to be much of an issue has made it very difficult to obtain the closeout documents needed to receive final payment. So while the schedule may allow a struggling subcontractor some time to get back on its proverbial feet, be cautious and watch the situation closely, as it can quickly escalate. Also, make sure to include in your contract protection for if and when a bankruptcy or assignment for the benefit of creditors occurs.

Dave: Okay – we looked at all of the soft signs and suspect that we may have a subcontractor issue. We asked the probing questions and come away even more convinced that we may have a looming issue and need to take some action. Obviously, if it is indisputably bad, we can begin pursuing termination of the contract. Short of this, what tools do we or should we have in our toolbox? In other words, what does “take some action” mean in the real world?

Ryan: From a legal perspective, a contract hopefully provides three different options:

1)        Supplement the subcontractor’s workforce;
2)        Suspend the subcontractor’s performance; or
3)        Terminate the subcontractor.

The route you choose will depend on the circumstances. There are some general rules of thumb to help you make the decision. If the issue appears to be a temporary problem for the subcontractor, and you have available labor forces (either your own or another reliable subcontractor), it is best to supplement the subcontractor’s performance at its own cost. If the problem is with a subcontractor that is ordering and storing materials now for work that will occur several weeks or months from now, consider suspending performance since the GC or first-tier subcontractor will be invoiced for materials supplied to that subcontractor or by that supplier, that may never make it to the project if the subcontractor closes its doors, goes into bankruptcy, or is simply unable to perform.

By suspending performance, you potentially avoid incurring these costs in the meantime because the subcontractor is not authorized to make any purchases during the suspension. However, this becomes less of an issue if the materials are being stored onsite or within the GC or first-tier subcontractor’s possession. If the problem appears more than temporary, or a temporary problem persists, then the best course of action is to diligently pursue a termination – quash the ripple effects of a nonperforming subcontractor.

Again, if this is a bonded project, you need to give the surety notice before supplementing forces, suspension, or termination in order to preserve your claim against the bond and obtain the assistance of the surety in completing the work.

Dave: How standard are these contractual options? Assuming that the contract does give the right to supplement the subcontractor’s workforce, what words of caution might you offer a GC or first-tier subcontractor in exercising these rights?

Ryan: These are standard contractual options, recognized in the industry form contracts. (See ConsensusDocs 750, Standard Form of Agreement Between Contractor and Subcontractor, Article 10.1.1; AIA A201-2007, General Conditions of the Contract for Construction, Article 14; and AIA A401-2007, Standard Form of Agreement Between Contractor and Subcontractor, Article 7.2.)

Before supplementing the subcontractor’s workforce, the GC and first-tier subcontractor must make sure they follow the notice requirements in the contract. A contract should require the GC or first-tier subcontractor to give written notice of default to the subcontractor; that written notice should clearly state the GC or first-tier subcontractor will supplement the subcontractor’s workforce should the subcontractor fail to cure the default within 48 hours of receipt of the notice.

The letter should also provide that any costs incurred by the GC and first-tier subcontractor will reduce the contract balance of the subcontractor, and if the contract balance is insufficient to cover all costs, then the subcontractor shall be responsible for reimbursing GC and first-tier subcontractor for the additional costs. Any funds due and owing to the subcontractor shall first be used to pay GC or first-tier subcontractor for the cost to supplement the subcontractor’s workforce.

A copy of the notice must be sent to the surety on a bonded job. If a GC or first-tier subcontractor fails to give a defaulting contractor proper notice before supplementing its workforce, then there will be a dispute as to whether the supplementation was reasonable and necessary, and the GC or first-tier subcontractor may face a legal challenge to its recovery of the expended costs.

Dave: How easy is it to default a subcontractor in a situation where the work to date has been performed as required, but the prime contractor sees those signs that indicate a growing risk of the subcontractor eventually being unable to perform?

Ryan: It is not easy at all when the subcontractor is performing as required, except if your contract provides that the GC or first-tier subcontractor can take certain action when certain circumstances arise (e.g., payment applications are received late, lower-tier subcontractors are informing GC or first-tier subcontractor of delayed payments, inability to timely confirm orders for materials have been placed).

That “certain action” may require documented evidence or proof the subcontractor is in a position to timely and fully perform the remainder of its subcontract obligations. The written proof should be provided within a short time period (48-72 hours) and must be satisfactory to the GC or first-tier subcontractor. If it is not satisfactory, then certain rights should automatically trigger for the GC or first-tier subcontractor, such as supplement forces or suspend performance.

If the contract does not specifically address these issues, then the GC or first-tier subcontractor must rely on the legal doctrine known as anticipatory repudiation before it can take action against a performing subcontractor showing signs of trouble ahead. To prove anticipatory repudiation, the GC or first-tier subcontractor will need to show the “signs” that clearly demonstrate the subcontractor will not be performing its remaining obligations.

Over the past decade, we have become accustomed to a contract provision that allows a GC to require the owner to provide proof of funding before starting or continuing with the project. This should work downstream as well, with a requirement that when certain specified circumstances arise, the subcontractor must provide proof of ability to perform, or the GC/first-tier subcontractor can take action.

As you can imagine, this is difficult to prove. Therefore, it is a better practice to spell out specific circumstances that trigger the right to supplement forces in the contract documents.

Rick: Ryan reminds us that there can be danger in proactivity. The struggling subcontractor may not be willing to admit it needs help and is not going to give up its rights. I think we need to tackle this issue from two directions:

  • What contract provisions should a GC/first-tier subcontractor insist on, and how can those provisions be used  to protect their project?
  • Irrespective of contractual rights, what can a GC/first-tier subcontractor do when it notices performance shortfalls? What action can a GC/first-tier subcontractor take if the struggling subcontractor is willing to accept help?

One way to partially address the latter point is for the GC to invest in field supervision that has mechanical, electrical, and plumbing (MEP) capabilities. This may help the GC be more alert to changes among critical path subcontractors and better able to support them with real experience, if necessary.

Dave, is this the direction you want to take us in?

Dave: Yes, these are exactly the questions that I want to deal with.

In my world, if a customer defaults on its Loan Agreement – perhaps a default on a financial covenant – the bank has the right to do many things, including calling the loans immediately due. That doesn’t mean that it will do so. In fact, calling the loans is generally the last resort after all else has failed. Ryan, what are your thoughts?

Ryan: Terminating a subcontract is an expensive proposition. Substitute performance, no matter how efficient, takes time and likely delays completion. Also, substitute performance is expensive, costing more than finishing the job with the original subcontractors. We advise termination only where it is absolutely necessary, such as:

  • Bankruptcy
  • Assignment for the benefit of creditors
  • Abandonment of the job
  • Failure to pay subcontractors
  • Clear inability to meet the project schedule subjecting the contractor to delay damages
  • Clear indications of insolvency

In fact, the construction contracts should provide that if and when a subcontractor files for bankruptcy or enters an assignment for the benefit of creditors, the contract automatically terminates, and any sub-subcontracts or supplier purchase orders are assigned to the contractor. Once the bankruptcy trustee or an assignee for the benefit of creditors is involved, the contractor will need to seek court approval or the approval of the assignee for any action it takes concerning or with the subcontractor, which is time-consuming and cumbersome.

By automatically terminating the contract immediately upon filing bankruptcy or assignment, the contractor can avoid this process. Because termination is laden with risk, the contractor needs to have the option of supplementing or suspending performance; the contract must provide these remedies.

The ability to supplement performance is very effective. At the first sign of trouble significant enough to expose the contractor to potential delays or cost overruns, the contractor should put the subcontractor on notice of its right to supplement the work within three days of receipt of the notice. If the subcontractor does not cure its performance in that time, then the contractor should step in and supplement as needed (e.g., order materials from the supplier, pay downstream subcontractors to reduce balance due to subcontractor, utilize other labor forces).

As this remedy does not terminate the subcontract but rather keeps it in place, the subcontractor is given ample opportunity to prove to the contractor that it can and will diligently complete performance and fulfill its contract obligations. If the subcontractor fails to cure its defaults, then the contractor can continue to supplement the work for the remainder of the contract or decide to terminate.

If the subcontract is near completion, then supplementing the work to the end is likely preferable. But if the subcontract work has just begun, then a termination may be the better remedy since the contractor has not budgeted the time and cost to perform the entirety of a certain trade contractor’s scope of work.

To stay on top of these issues, there clearly needs to be effective field supervision and financial management of the project that picks up the key signals of trouble when they first arise.

Dave: Let’s say that a contract gives you the right to supplement the subcontractor’s performance under certain circumstances. Exactly what are those circumstances? If it were in default, then I would assume that those circumstances are by definition met.

How about when it isn’t in default, but things are looking a bit shaky – a situation that eventually become an actual default? In this case, is the “burden of proof” on the GC to “prove” that the subcontractor is at risk of default or is the burden of proof on the subcontractor to prove that they are okay? I see a lot of room for disputes here.

Rick: The first step is to determine the subcontractor’s critical impact on the job. This would include subcontractors on a critical path as well as a subcontractor that is unique or otherwise difficult (or impossible) to replace. While it may be difficult to replace or reinforce a subcontractor, it may be necessary to be proactive when the subcontractor is critical to the overall job.

Most GCs will have subcontractor bonding policies. If a GC has bonded a struggling subcontractor, it’s very important that it engages the subcontractor’s surety early and throughout the process. I have seen cases where a GC holding a subcontractor bond goes through a long “nursing” process with a struggling subcontractor, only to ask months later: “How should I use this bond?” But because the GC did not notify the surety in a timely manner, it found that all of its work with the subcontractor could have abridged its rights as obligee under the bond.

Ryan: The burden of proof is on the GC or first-tier subcontractor to prove the circumstances warrant it supplementing the work or terminating the subcontract. If your agreement is silent as to when you can take these steps, then there is too much uncertainty surrounding your exercise of these rights, making it risky to do so unless the subcontractor has clearly breached its duties and obligations under the agreement. As Dave says, when the contract does not specify the circumstances under which these rights can be exercised, there is room for disputes.

If a default that triggers your right to supplement work per the terms of the contract has not yet occurred, and your contract does not give you the right to supplement the work for any pre-default circumstances, then it is highly unlikely you will be compensated or reimbursed for the costs you incur from supplementing the work.

If you want the right to supplement the work of a subcontractor that has not yet defaulted, but appears headed for default, you may do so only if your contract gives you the right to supplement for such pre-default circumstances (e.g., “contractor may supplement the subcontractor’s work when the subcontractor represents or otherwise demonstrates to the contractor that it will not be able to provide sufficient workforce to maintain the construction schedule”).

As Rick also observed, field staff (PMs, superintendents) may be so focused on getting the job completed that they ignore any performance bonds that have been issued to address performance concerns. If the GC or first-tier subcontractor is having difficulty motivating a subcontractor to perform or getting answers to critical questions that could impact performance, then putting the surety on notice of default may be helpful in getting the subcontractor’s attention and obtaining the requested information.

As a practical matter, such notice could help get the subcontractor moving. As a legal matter, such notice preserves your claim for costs related to supplementing or substituting performance, if the subcontractor is unable to complete the job. Do not wait until the end of the project to notify the surety of a performance default. By that time, it is too late from both a practical and legal perspective.

Dave: We have covered a lot of ground in this discussion. At the risk of oversimplifying, our advice can be summarized in four simple rules:

1)                 Keep your eyes open at all times and monitor all sources of information for how your subcontractors are performing not only on your job, but also in their overall work program.
2)                 If you see a potential problem, start asking questions – don’t delay. Ignoring a problem or hoping that it goes away can lead to bigger problems.
3)                 If bonded, notify the surety once you detect a problem with the subcontractor.
4)                 Make sure that your subcontract provides the ability to take action to either terminate or supplement a struggling subcontractor.

RICK CIULLO is Chief Operating Officer of Chubb Surety in Warren, NJ, where he oversees Chubb’s worldwide surety business.

Rick joined the Chubb Group of Insurance Companies in 1981 as a surety trainee and spent three years as a surety underwriter. In 1984, Rick became responsible for managing Chubb’s surety operations in Denver, San Francisco, and New York City. He also managed Chubb’s insurance operations in Louisville and Kansas City from 1996-2005. Rick was appointed to his current role in 2008.

A previous author for CFMA Building Profits, Rick earned a BA in economics and history from Wesleyan University in Middletown, CT. He also continues education through Vistage, a worldwide organization dedicated to executive-level education and development.

Phone: 908-903-5555

RYAN A. HISS is a Partner in the law firm of Lyman & Nielsen, LLC in Oak Brook, IL. He drafts and negotiates contracts; prepares claims for additional compensation and time extensions; consults on dispute avoidance/resolution during projects; and represents clients in mediation, arbitration, and litigation in construction.

Ryan is a frequent speaker and writer on various construction law topics, including the negotiation of contracts, JVs, mechanics lien and bond claims, insurance coverage, and construction defects. He has presented at CFMA’s Annual Conference & Exhibition and is a previous author for CFMA Building Profits.

Ryan is a member of CFMA’s Chicago Chapter. He is also a member of the AICPA and the Tennessee Society of CPAs. He earned his BA from North Carolina State University and his JD from the University of North Carolina at Chapel Hill.

Phone: 630-575-0020

DAVID L. SAUERMAN is Managing Director for the Construction & Engineering Division of The PrivateBank in Chicago, IL. With 34 years in banking, Dave has worked exclusively in construction and engineering for 30 years.

A member of CFMA’s Chicago Chapter, Dave is a previous author for CFMA Building Profits, current Chair of CFMA’s Publications Advisory Group, and has presented at CFMA events. He has also been active in ASA, the Illinois Road and Transportation Builders Association, and the Illinois CPA Society’s Construction Contracting Committee.

Phone: 312-564-1237

Copyright © 2014 by the Construction Financial Management Association. All rights reserved. This article first appeared in CFMA Building Profits. Reprinted with permission.
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