Earlier this month, a subcontractor default insurance company filed suit against an electrical subcontractor in New York state court.  The claim: a $12.8 million loss caused by the subcontractor’s admitted failure to complete electrical work under a subcontract at the Whitney Museum of American Art in Manhattan.       

The construction industry continues its strong growth since hitting rock bottom following the financial crisis.  While contractors used to worry about finding work, the most common concern today seems to be finding qualified resources to perform new and ongoing projects.

As the struggle to find support intensifies, many contractors overlook the risk of subcontractor default, forgetting that a single subcontractor default can cause a crippling loss.  Surprisingly, subcontractor defaults have actually increased as the industry’s financial picture has improved, as some subcontractors stretch to take on more work, pushing through project backlogs, overextending their capital and manpower, and causing cash flow problems. As a result, there is an ever-growing group of contractors who have been bitten by subcontractor default and have regretted not doing more to mitigate the risk beforehand.

Rubinstein

Although many contractors look to subcontractor default insurance (or SDI) or surety bonds to mitigate this risk, these tools are not appropriate for all contractors or all projects.  Further, these options are often expensive and are not always justified from a risk-benefit perspective. Instead, subcontractor pre-qualification remains one the most effective tools to guard against subcontractor default.  As the industry has gained sophistication (and as SDI insurers have developed specific financial metrics in evaluating risks), certain best practices have emerged in identifying and avoiding the risks of subcontractor default.

The first step in the pre-qualification process is to obtain a clear picture of a prospective subcontractor’s financial stability.  While there is no one-size-fits-all method when it comes to requesting financial information, contractors should generally require a current set of financial statements and the past three years of gross earnings. It can be used to evaluate the subcontractor’s stability and track record. Contractors should also make sure that their subcontracts allow them to obtain additional information if they need more data as the work progresses. When you receive a set of financial statements, review the balance sheet to develop a picture of what assets the subcontractor has. Then consider whether you are comfortable with their debt levels as compared to those assets.

Understandably, asking a subcontractor for detailed financial information can be a sticky subject. If a prospective subcontractor balks at providing financial statements or other detailed information, ask for a document listing their revenues in each of the past couple of years and dollar amounts for their currently-committed projects for the current year as a back-of-the-envelope way to evaluate if they may be overextended.  Another good strategy is to ask how many workers they employ and how many they have hired in the past six months, which may give you a sense of whether a subcontractor is growing sustainably or too rapidly. 

Complete Picture Needed

Equally important, contractors should solicit a complete picture of the prospective sub’s under-contract projects, including contract value, location, square footage, estimated date of completion and staffing levels. This allows the contractor to evaluate whether the subcontractor will have sufficient staff and resources to meet the contractor’s needs and to evaluate whether the subcontractor has fully considered and planned for its obligations. For each project, the subcontractor should provide a reference that the contractor can call to find out whether there have been any timing, safety, or other issues with the sub’s performance on the project.

Penley

Information on safety and accidents also is useful.  At a minimum, contractors should require information regarding a prospective sub's current experience modification rate to get a feel for the subcontractor’s past safety performance and level of going-forward risk. For risks above a certain threshold, contractors should request detailed information about past jobsite injuries and the subcontractor’s safety program. Contractors should also ask for a list of OSHA citations and injuries that caused employees to miss work over the past five years.

Contractors considering less-familiar subcontractors should start by calling references for the sub’s most recent completed projects.  Ask about whether the project was completed on-time and on-budget, and whether any major issues came up during the project that would make the contractor think twice about using the subcontractor in the future. Following through on these calls often uncovers revealing patterns about a subcontractor’s reliability, adaptability, and success in completing work on time. It is likewise a good practice to solicit and call references for a sub’s critical suppliers to identify potential downstream issues that could arise if the subcontractor has a history of slow paying its subs and suppliers.  

Prequalification data is only valuable to the extent it is reasonably current. For this reason, contractors should require all of their subs to periodically update some or all of their pre-qualification materials before bidding on new work. In particular, we recommend requiring that subs provide updated financial information and information about current projects annually, or biannually for trusted subs who have successfully completed multiple projects for the contractor. Subcontractor pre-qualification should not be seen as a one-time exercise; financial circumstances and project commitments can (and do) change between when information is first submitted and when a subcontractor is bidding on its second, third, or fourth project with a contractor.

Contractors with strong pre-qualification programs typically enjoy greater stability from their subcontractors and have stronger relationships with their subcontractors, who have earned greater trust that they will perform as needed. Ultimately, the risk of subcontractor default, even if not obvious, never goes away. A bit of extra diligence might just be enough to avoid a painful loss.

Kenneth Rubinstein, an attorney, is co-chair of Preti Flaherty’s Construction Law Practice Group and can be reached at KRubinstein@Preti.com.  Eric Penley is also an attorney with Preti Flaherty’s Construction Law Practice Group and can be reached at EPenley@Preti.com.