Managing Subcontractors in the Midst of Economic Meltdown
By Gregory T. Spalj, Esq.
The current economic decline has hit the stage when those who were just hanging on by their fingernails are starting to fail and fall. While contractors always need to be attentive to ensure that subcontractors are passing along payments to lower tier subcontractors, the impact of the current economy now requires that contractors be ever more vigilant in protecting themselves and their sureties from bond claims and mechanic’s liens by reason of payments diverted by an upper tier subcontractor that should have been passed on to a lower tier subcontractor.1 We have seen a disturbing trend of claims from sub-subcontractors and suppliers against the general contractor’s bonding company and mechanic’s lien claims against the owner, based upon the fact that although the initial subcontractor was paid for the work performed, that subcontractor never paid its sub-subcontractors or suppliers. Few object to paying once, but everyone objects to paying twice for the same service.
The Problem – Paying Twice for Subcontract Work
On public works construction projects, under the Federal Miller Act and the Little Miller Acts adopted by virtually every state in the United States, including Minnesota, contractors are required to furnish payment and performance bonds. Subcontractors and suppliers, including lower tier subcontractors that have no contract with the general contractor, who are not paid for their contribution of labor, equipment, supplies, and the like, have a claim against the contractor’s payment bond. Even on large private projects, payment and performance bonds are routinely required to cover the same obligation - that is, to ensure that subcontractors, sub-subcontractors and suppliers are paid for their contribution to the project. Additionally, on private projects, even if no bond is required, nearly every jurisdiction, including Minnesota, has a mechanic’s lien statutory scheme under which unpaid sub-subcontractors and suppliers have claims against the owner of the project (who in turn will have indemnity claims against the general contractor) for unpaid labor, materials, and equipment on the project. What this all means is that in most instances, and with a few procedural hurdles, the general contractor (and the indemnitors on the bonding line) are ultimately liable for a “busted” sub’s failure to pay its subcontractors and suppliers. Read that last sentence again as it is the source of a substantial amount of angst and frustration to a general contractor who has never considered the possibility of this type of liability.
True, there are many hoops through which mechanics’ lien claimants and bond claimants have to jump in order to preserve and perfect their rights but once they’ve been burned once, they tend to become skilled at complying with the bond claim and mechanics’ lien statutes. Therefore, general contractors need to be equally skilled at avoiding paying twice for the same service through proper management of subcontractors.
With increasing frequency, lower tier subcontractors are not paying their bills. While there is a time during which the “robbing Peter to pay Paul” system works for the subcontractor who is slowly rolling down the economic hill, when there is no future project to pay past debts, the scheme comes tumbling down. Similarly, as jobs become scarcer, subcontractors lower their prices to garner work priced below cost. Many unpaid lower tier subcontractors who face more demands on their construction funds than the funds will allow, will frequently operate for many, many months before claims for unpaid work are turned into judgments, bond claims are filed, or mechanic’s lien claims are asserted. The general contractor may be completely unaware that its subcontractor is failing because the work is getting done and because the subcontractor is assuring the general that there is nothing to worry about. Nevertheless, the results of the subcontractor not paying its workers, and its sub-subcontractors and suppliers will be apparent eventually – at a time when it may well be too late to do anything about it.
Compounding the Problem - Perception Versus Reality
Many contractors who have never been involved in a bond claim or mechanic’s lien action may be surprised to learn that a lower tier subcontractor or supplier (or even an employee of a subcontractor) may have a claim against the project owner, the contractor, or the general contractor’s bonding company for the unpaid value of the lower tier subcontractor’s labor, materials and supplies, even though the contractor has paid its immediate subcontractor for the labor, equipment and supplies. Yes, you read that right: notwithstanding the fact that you may have paid your subcontractor, if your subcontractor did not pass those payments down to its lower tier subcontractors and suppliers, and to its employees, those claimants can, in effect, make you pay twice.
The perception among many contractors is that if they get lien waivers from their subcontractors, they are protected in full. In fact, they are not. The lien waivers that a contractor needs for protection against double payment are lien waivers not only from its subcontractor, but also from all subcontractors and suppliers of every tier. In many states, Minnesota included, even the subcontractor’s employees and their unions are protected, so that if the unpaid subcontractor does not make contributions to the union health and welfare benefit funds, those funds have a claim against the contractor’s payment bond or they can file a mechanics’ lien against the project. So, even though the employees are being paid and are themselves unaware that their union benefits are not being funded, the contractor who paid union scale to its subcontractor may be required to pay twice for those benefits if the union perfects its claim. In fact, the first sign that things are going awry is frequently a garnishment summons from the union health and benefit fund garnishing the subcontractor’s rights to payment to satisfy the obligation owed to the union for unpaid benefits. The unions are vigilant in prosecuting their rights, and that vigilance has the unintended benefit of often alerting the general contractor to a problem the general contractor did not know existed. Too often, however, at that stage, it is too late to do anything to protect oneself.
The 75% Solution
There is no complete remedy to immunize a contractor from having to pay twice for its subcontractors’ debts. The solution to the problem is only partial and involves a series of steps, the totality of which will cover most of the problem.
The first step involves subcontractor selection. Pay attention to the quotes you receive and the experience of those who are quoting. If one subcontractor quote is markedly lower than the rest, be suspicious and inquire. If the subcontractor is one not normally quoting that particular kind of work, be wary. Lean economic times often cause subcontractors (and general contractors) to venture off into areas of construction work for which they are ill equipped, and, therefore, they are ignorant of some of the most important price considerations. Additionally, even experienced subcontractors bid work cheaply in order to keep their crews busy so as not to lose them to competitors. Unfortunately, in the heat of bid preparation, there is not time for thoughtful reflection so your analysis must be immediate and quick. Common sense must be your guide here – if something looks too good to be true, it probably is not true.
Bond and Lien Waivers
Next, as a condition of periodic payments to your subcontractors, demand lien and bond claim waivers from subcontractors at any tier, and that means sub-sub-sub-subcontractors and suppliers. The problem is that many general contractors do not even know who their immediate subcontractors have used as sub-subcontractors, let alone who that subcontractor used as a subcontractor. Even if you obtain lien waivers from every entity of which you are aware, unless everyone in the chain has made full disclosure, there will be those of whom you are not aware, and, therefore, against whom you cannot protect yourself. Nevertheless, you could protect yourself from substantially most of the potential claimants by requiring two things: (1) require your subcontractors to disclose in writing the existence of any subcontractors and supply contracts they have entered into; and (2) require lien waivers from your subcontractors and those sub-subcontractors and suppliers; and, if the sub-subcontracts are large enough, from even the sub-sub-subcontractors themselves. The effectiveness of this portion of the cure depends on the truthfulness of your subcontractors. The waivers should contain an indemnity clause such that if a payment does not get passed downstream and the general contractor has to pay twice, the subcontractor agrees to assume the financial liability therefor. (This may prove to be a moral victory only inasmuch as, if the subcontractor was financially flush enough to cover the indemnity obligation to you, then it likely would have paid its sub-subcontractor in the first place.)
In addition, as a condition of payment to your subcontractors, your subcontracts should require your subcontractors to provide you with certified payrolls, which include a statement under oath that all taxes and fringe benefits have been paid. If the subcontractor is willing to lie under oath, you will get no protection from this, but it is at least a filter through which most subcontractors will not pass. In other words, most people will not out and out lie, but many would fail to volunteer the information if they are not asked. Remember though, once you obtain this information from the certified payrolls, you need to use it. Verify that the certified payrolls are current and do not just stick them in a file drawer.
Direct Payment and Joint Checks
Next, if you have reason to believe that one of your subcontractors is not passing on payments to his lower tier subcontractors, pay the sub-subcontractors directly or use joint payee checks for payment. The problem with direct payment to the lower tier subcontractors is that it requires an agreement on what is owed among the lower tier subcontractors and your subcontractor. If your subcontractor has claims against its lower tier subcontractors, or disagrees with the lower tier subcontractors’ payment requests, you run the risk of overpayment. Therefore, unless you have an agreement with your subcontractor to make direct payments to its subcontractors and suppliers, this can be a risky strategy.
Joint payee checks avoid the problem of resolving any dispute between your subcontractor and its lower tier subcontractors. If these parties are unable to resolve the dispute over what is owed, neither gets paid because it will take the signature of both to negotiate the check. This method of payment does require you to know to whom the payments should be made in order to make each entity a joint payee.
If you decide to issue joint checks, notify both the subcontractor and the lower tier subcontractor or supplier of your intention to issue a joint payee check. In order to avoid a false signature, if possible, personally deliver the joint payee check to representatives of both the subcontractor and the supplier or make a representative of each pick up the check from your office. On the check stub or voucher, type a directive that the proceeds of the check are to be applied solely and exclusively to debts arising from your project. (In some states, Minnesota included, in the absence of an express direction, creditors are free to apply payments to any debt owed. It is, therefore, a good practice to put the project to which the debt should be applied in the memo line of any payment check to your subcontractors.) Then, type on the back of the check an appropriately worded release of claims which becomes effective upon endorsement. This has the added benefit of wiping the slate clean as between the general contractor and the two joint payees upon the negotiation of the check.
Another option you might consider for a subcontractor who may be on the verge of bankruptcy is to enter into a formal Joint Payee Check Agreement to memorialize the parties’ intentions. This agreement should expressly state (1) the purpose of the payment, (2) its allocation toward the project specific debt, (3) the assent of the general contractor, subcontractor, and supplier, and (4) a partial waiver of the lien rights for the value conveyed in the agreement. That way, if the payment were subsequently scrutinized by a bankruptcy trustee, the Joint Payee Check Agreement will be evidence that the subcontractor was a joint payee for the purpose of holding the funds in trust for the lower tier subcontractor. (Trust funds are usually not a part of the bankruptcy estate.)2 This will provide some protection against the bankruptcy of your subcontractor and right of the bankruptcy trustee to recover payments made within 90 days of the bankruptcy petition being filed.
There is no complete answer to the problem discussed here, just as there is no complete answer to the question of what is the right subcontract, what is the right insurance policy for a contractor, what is the right price to bid, how to eliminate OSHA citations, how to reduce your workers compensation modification factor, or a myriad of other questions contractors face on a daily basis. If there were a complete and definite answer, it would be known by now, given the fact that construction contracting is one of the oldest professions in the world. The truth is that you can implement processes to decrease many of these risks. The balance of the problems can be dealt with on a case by case basis as they arise. Contracting is all about risk brokering, shifting, avoidance and balancing; it is not about risk elimination. Implementing the procedures noted above however, will go a long way to place you “behind the fan” when the stuff hits.
[This Briefing Paper is a reprint of an article the author published in the Quarterly Journal of the Power and Communications Contractors’ Association in December of 2010.]
1For simplicity, this Briefing Paper examines the problems caused by downstream subcontractors not paying their subcontractors from the perspective of the general contractor. The principles discussed, however, would be the same and the solutions posed would have applicability to a higher-tier subcontractor managing its lower-tier sub-subcontractors.
2This is a gross oversimplification of the trust fund theory in bankruptcy, the explanation of which would take many pages of text.
This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T