Strategies to help general contractors avoid litigation

Issue August 2010 By Bradley L. Croft

Once upon a time, we lived in a commercial construction environment where contractors could bid jobs which included a profit margin of greater than 2 percent, where subcontractors could make successful careers based on a single relationship with the right general contractor, where owners could obtain financing based on a good set of plans and a solid track record, and where payment squabbles got resolved by agreeing to make it up on a future project.

Times certainly have changed. Over the past few years, the commercial construction industry has become clogged with contractors bidding jobs with flat margins just to maintain cash flow, subcontractors watching their longstanding work-supply sources dry up, and banks tightening the reins on lending to a point where the private construction market is suffocating.

Relationships are fractured. Nerves are frayed. People are anxious about the future, and rightly so.

The present construction landscape is a minefield of risks, particularly for general contractors. Perhaps no risk is greater than winding up on the wrong side of an expensive and drawn-out lawsuit. As a general contractor's profit margin decreases, so does its margin for error. One step in the wrong direction can spell significant legal exposure or worse. While there is no guaranteed formula to eliminate these risks, there are some practical ways for general contractors to minimize their legal exposure and protect themselves from potential problems.

1. Obtain lien waivers from all downstream subs and suppliers. At this stage of the game, it is simply too risky for a general contractor not to require every subcontractor and supplier - regardless of tier or contract amount - to provide a lien waiver as a condition of payment. Sure, such a requirement poses an added layer of administrative hassle for a project manager, but it protects a general contractor from having to chase a subcontractor who decided to make a car payment with the disbursement that should have gone to his material supplier.

A GC should be sure that its subcontracts require lien waivers from all subcontractors and suppliers, and provide for an absolute right of setoff against a subcontractor's balance for all payments made directly to lower-tier subs or suppliers and/or attorneys' fees incurred in addressing any related matters.

Receipt of a Notice of Identification should trigger an automatic procedure whereby a joint-check is issued for all future payments made to that supplier. Finally, failure to provide proof of payment for all labor, equipment and materials should be expressly set forth as grounds for immediate termination.

2. Prequalify owners. These days, general contractors can be so relieved to be awarded a job that they fail to do their due diligence to ensure that the owner has the means and intentions to meet its financial obligations of the project. Such a blind faith approach is an invitation for problems.

With increasing regularity, owners are defaulting on their payment obligations, usually after much of the construction is in place, leaving the general contractor in the impossible position of either taking a sizable financial hit on the project, or putting dollars into an expensive lawsuit against a potentially bankrupted owner. No matter how responsible, efficient and effective a general contractor is, it is only as solvent as the owner on which it relies to fund the project.

It is critical to know as much as possible about the financial wherewithal of the owner prior to commencement of construction and at all necessary times throughout the project. The 2007 iteration of the American Institute of Architects A201 General Conditions contract document greatly restricted a contractor's right to obtain financing information from the owner after commencement of construction. A general contractor therefore should consider making the owner's provision of financial information a condition precedent to beginning (or continuing) work.

In addition, the general contractor must be careful that the entity that is acting as the owner is an entity with assets. A single-purpose LLC that was established specifically for a project likely has no real assets to which a general contractor can look to secure payment. A prudent general contractor asks for a corporate guaranty or some other security so that if the worst case becomes a reality, its chances of reaching assets to satisfy a judgment improve.

3. Go public. While the private construction market has yet to make a serious rebound from this recession, the public construction market has remained steady. Many contractors are weathering the current economic storm by adapting their operation to compete for public work. Although the potential profit is generally lower than private jobs and the
administrative requirements more burdensome, public projects usually spawn less payment dispute litigation since the risks of a non-paying owner are nearly non-existent (in light of the bond requirements and other statutory safeguards related to public jobs).

Of course, general contractors who pursue this work must become familiar with the public bidding procedures, prequalification requirements, and laws related to payments (such as the False Claims Act).

4. Train decision makers. Nearly every construction lawsuit can be traced back to a bad decision. Whether it was to bid a project in the first place, or to sign the contract without negotiation, or to proceed with extra work without a signed change order, often these decisions are made against a contractor's better instincts. Many of these decisions are made by people who are unqualified or unequipped to make them.

A general contractor should take special care to ensure that there is a clear chain of decision-making command on a project. Project managers and superintendents need to be trained so that they can (1) identify potential legal risks and (2) act quickly and appropriately to minimize the potential negative impact on the project and on the bottom line. They should understand mechanics' liens and bond claims. They should know what to do if a project is picketed. They should read the contract and be aware of key provisions, such as change order procedures, inspection requirements and liquidated damages. The more information and training a project manager has, the more likely he/she will be to make the right decisions.

Although most construction lawyers are keen to try cases, the good ones recognize litigation as a last resort, especially when legal fees can often subsume the amounts in dispute. Advising general contractors to take preventative actions such as those outlined above can help them minimize their legal exposure, which may well be the key to surviving these turbulent economic times.

Bradley L. Croft is a shareholder at Ruberto, Israel & Weiner in Boston. He focuses his practice on construction law and is the co-chair of the Construction Law Committee of the Boston Bar Association.