Banking Volatility – Lessons Learned from a Surety Perspective
Banking is critical to the construction industry. Borrowing ability is key to building new projects, and for contractor cash flow. As the banking industry goes through another crisis, contractors will again be impacted. From a surety bond perspective, banks are one of our biggest partners, but I’ve also seen the pitfalls that can be created for contractors during times of volatility. Contractors should take proactive steps to protect themselves from pitfalls ahead.
Verify Financing or Cash
The risk of non-payment is one of the largest risks a contractor faces. In construction, work is often performed, and costs incurred 30 – 90 days before payments are received. Many contractors simply cannot absorb not getting paid for this work. Therefore, it is vital for contractors to verify that a project is fully financed, or cash is in place, before ever starting a project. Additionally, this financing should be set aside or put into escrow for the project.
During the Great Recession many banks were failing, getting taken over and re-evaluating their loan portfolios. This caused some lenders to start pulling project financing. Owners and Developers were left scrambling to find new financing in a difficult lending environment and many of these projects were canceled or put on hold. This left many contractors unpaid for the work they had done, and led to bankruptcy for some.
Contractors often make the mistake of thinking they can rely on mechanic’s liens for payment. Although mechanic’s liens are a valuable tool, they do not provide adequate protections by themselves. When a project is stalled due to financing, it can take significant time for another lender to step. If the project goes bankrupt, contractors are often asked to settle their Mechanic’s Liens for much less than they are owed. In the Great Recession, both of these things occurred. I had contractors that waited more than ten years and participated in many mediation meetings. The result was that the building was liquidated, and they received 10% of the money that was owed to them. Verification of financing should be a vital part of every contractor’s risk management.
Contract Bonds and Subcontractor Default Insurance
Contract Bonds such as Payment and Performance Bonds are one way to protect contractors from non-payment during times of bank volatility. By having a payment bond in place, certain contractors and suppliers can be protected against non-payment on the project. These products are not perfect though and may still take time for a contractor to collect upon. Additionally, these payment protections may be nullified by certain contract terms such as contingent payment clauses discussed below.
While payment bonds protect subcontractors and material suppliers, subcontractor default insurance (SDI) does not. Contractors should understand this distinction to protect their payment rights. SDI protects the general contractor and the owner but does not provide payment protection to other parties. It is not a way to reduce the risk of non-payment for most parties.
Watch Contingent Payment Clauses
Contingent payment clauses are common in construction. They condition payment to a contractor upon payment by the owner or upstream contractor. Pay-If-Paid clauses become particularly problematic in a volatile lending environment. If a project’s financing is unavailable and the owner cannot pay the general contractor, it creates a valid reason not to pay subcontractors for their work, even when the General Contractor has a Performance Bond or Payment Bond on the project. This fact was upheld by the case of Zurich/Brown Construction No. 10-2375-KHV. Pay-if-Paid and Contingent Payment clauses are not legal in every state. However, contractors operating in states where they are legal should exercise extra caution during periods of banking volatility.
Bank Lines of Credit
Project financing is a major risk, but contractors should take steps to protect themselves against direct bank actions as well. Many contractors have bank lines they use for managing cash flow. These bank lines are vital to finance periods between costs incurred and collections.
During the Great Recession, we saw many banks re-underwrite their loan portfolios. This led to the “calling” of some contractor bank lines under the demand clause. Calling a contractor’s bank line of credit can create serious cash flow issues for contractors. A contractor may or may not be able to find another lender to refinance the debt for them under these circumstances. Contractors with large amounts of borrowings on a bank line of credit may want to consider converting some of this debt into term loans. Although this may sacrifice some flexibility, term loans do not have demand provisions and can be a hedge against a lender calling the loan.
Offset
Contractors may be surprised to learn that many loans contain offset language with the contractor’s deposit account. In other words, a bank may be able to use money from a contractor’s account to pay down other debt with the lender such as a bank line of credit. The bank typically has the right to do this if certain creditor ratios are not met such as debt to tangible net worth. This may sound harsh but was utilized by certain lenders during the Great Recession. Contractors may want to protect themselves by holding certain liquid assets in separate financial institutions.
Banks are and continue to be vital to the construction industry. However, contractors need to take extra steps during times of bank volatility to protect themselves and their operations. Being aware of these risks will help contractors make better decisions and ensure success.
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