Receiving payment is an important piece of any for-profit business. And construction contractors are no exception. But sometimes payments do not arrive on time (or, worse yet, not at all), even when a contractor has done everything right.
Ensuring that owners have the ability to pay invoices when they become due is an important upfront risk mitigation strategy that can help reduce future risks of non-payment. Although it is not possible to entirely remove this risk, there are options to help reduce it. This article will highlight some of the options to help increase payment security, both before and during the Project, to reduce the risk of non-payment for work that is otherwise properly performed. This article does not cover the entire waterfront of available options, including liens (which could be a separate topic for an entire thesis). But this article nonetheless provides some practical options for consideration to reduce payment risks.
Contract Language
As with so many other risks on a construction Project, the contract is a key tool to preemptively address potential issues with non-payment. As outlined below, there are various options to reduce non-payment risks, both before and during Projects. But those mechanisms should be captured in the contract whenever reasonably possible and appropriate. This can be done first by identifying available options, and then by drafting and negotiating contract clauses that capture these options and set contractual rights and obligations in place.
But as with any project, doing so requires understanding the applicable law, including any statutory or other legal mechanisms that may provide relief for non-payment. So, when reviewing the below options, remember to consider whether and in what manner these options can be captured in the contract at the outset of the project.
Proof of Financing
Trust, but verify. This advice holds true for Project financing as well. Contractors often do not want to start a project on the wrong foot by implying, or perhaps overtly stating, that the owner cannot pay its bills. But this is generally not an unreasonable request. And it is often a good place to start when trying to reduce future risks of non-payment.
Obtaining proof of financing at the outset of the Project can calm fears and reduce risk of non-payment. So, contractors should not hesitate to request this proof, even from large or otherwise well-capitalized owners.
Furthermore, ConsensusDocs offers Form 290, which outlines strategies and options to obtain owner assurances of financing. This is a good resource to consult when assessing financial risks on a project.
Possible proof of financing can come in many forms. For example:
- If there is a construction loan, a lender’s commitment letter can serve as proof of financing. This commitment letter could generally confirm the lender’s intention to provide financing, along with the conditions for that financing. Again, this offers some assurance that funds are (or will be) in place.
- Documentation of loan terms, disbursement dates, and a commitment for a loan closing date can also serve as relevant proof of financing.
- If there is no loan and the owner is self-financing a Project, an owner’s financial statements, bank statements, or bank credit ratings could suffice. Although realistically, few owners may be comfortable disclosing that information, it may not hurt to ask. And those types of documents can provide peace of mind and reduce risk, particularly if the owner is self-financing the project.
- The owner could also establish an escrow account with certain minimum deposit limits that must be maintained throughout the project. This would ensure that at least some amount of money is held by a neutral third-party to cover payments for work properly performed. But understand that this is a more substantive option than many of the other suggestions above, and it is highly likely that an owner will pushback on this requirement. Establishing an escrow account also usually requires separate, specific escrow agreement terms, as well as a third-party to manage the account (who will charge a fee). Nonetheless, it is still an option, particularly if there are more serious concerns about current and long-term payment issues.
These are just some examples. And there are many other options that may be suitable under the specific circumstances of the project and the relationship between the parties. But some form of proof of financing can help reduce future risks of non-payment.
Finally, as noted above, the parties can draft and negotiate contract terms to put these requirements in place at the outset of the project, and to place ongoing requirements during the project to continue to provide proof of financing (if appropriate based on the circumstances). Again, this article does not cover every angle of this issue, but know that the contract can serve as a key tool.
Contractual Rights in the Event of Non-Payment
Proof of financing at the outset of the project can be helpful, but it does not entirely protect against future risk of non-payment. However, contractors can negotiate and include terms in their contracts that provide avenues of relief if an owner fails to pay for properly performed work during project execution.
Many standard form contracts give the contractor the right to suspend work for non-payment. For example, ConcesusDocs Form 200 permits the contractor to first suspend work, and then terminate work, if certain conditions are met in the event of owner non-payment for work properly performed. Provisions like this give contractors leverage in the event of non-payment. And can provide an avenue to force payment.
Contractors can also seek to include provisions allowing them to terminate the contract if non-payment stretches over a pre-determined period of time (example, 30 days). The right to terminate gives the contractor a potentially significant tool to use against an owner if an owner fails to make undisputed payments. However, a termination for default is a serious and generally last-resort option. And it does not guaranty payment. Nonetheless, it can still provide the contractor with leverage to help force payment for properly performed work.
It is also worth noting that some states have statutory laws in place that permit contractors to stop work for non-payment. For example, California statutory law permits a contractor to stop work in the event of non-payment for properly performed work (Cal. Civ. Code §8830 et seq.). To do so, a contractor must fall within the definitions of the statute, provide proper notices, and otherwise comply with the statute’s overall requirements (again, it is important to understand the applicable law). But statutes like this give contractors additional options in the event of non-payment.
As noted above, incorporating terms into the contract can help reduce the risk of non-payment and provide better protections for the contractor. And although this risk cannot be entirely removed, it can be mitigated.
Maintain Open Communication During Project Execution
Maintaining open communication and solid project documentation can also help mitigate payment risks. If a contractor has concerns that there may be actual or future payment risks on the project, then it is important to document those concerns in a written communication to the owner. Likewise, if an owner fails to make timely and proper payments when due, this should be documented in accordance with the terms and requirements of the contract.
This may seem like elementary advice, but far too often contractors fail to properly document and communicate issues on a project. And payment issues are no different. So, if there are actual or looming issues regarding payment, be sure to properly document them in accordance with the contract.
Conclusion
Although it is generally not possible to entirely remove the risk of non-payment on construction projects, there are still actions that contractors can take to reduce this risk. Taking certain steps proactively at the outset of the Project before any work begins is an important place to start. And then addressing risk of non-payment by negotiating and including contractual terms providing the contractor with rights in the event of non-payment is a good way to try to ensure that the risk remains minimal. Finally, maintaining good project documentation and communications is an important step as well. And although it is generally not possible to entirely remove this risk, these actions can help provide greater peace of mind.
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The views expressed in this article are not necessarily those of ConsensusDocs. Readers should not take or refrain from taking any action based on any information without first seeking legal advice.