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Preventing Financial Ruin from Construction Contracts

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Juanita Ferguson
BKK Construction & Land Use Newsletter
June 2009

The construction industry has realized the enormous impact of the financial crisis over the last several months. Even with the prospect of new business from the economic stimulus package, contractors have had to readjust to these uncertain times to ensure survival. With a little planning, you too can weather the financial storm.

Investigate your customer – Many resources exist for owners of projects to determine whether a contractor is licensed or has violated state laws. Unfortunately, contractors are not privy to the same amount of information for prospective customers. The reason – contractors do not usually report customers to credit reporting agencies. However, prior to entering into an agreement, contractors can and should secure their financial position.

Be proactive in obtaining credit information about your prospective customer. If the project owner is a sole proprietorship or a partnership, find out information about the principals such as home addresses and social security numbers. Find out if the owner of the project has ever done business under another name. If a prospective customer has operated under three different business names in a span of five years, it may be an indicator that the business has experienced reorganizations on a routine basis to avoid satisfying financial obligations. 

Confirm that the names of any other parties to your construction contracts are existing entities. Find out the names of the banks where your prospective customer does business as well as the account numbers for primary bank accounts. The information will be useful in the event that you have to garnish the owner’s bank accounts in an effort to collect for unsatisfied judgments. Obtain the names of other trades with which a prospective customer has done business. Then contact the trades to discuss what type of customer with which you may be entering in to an agreement. Check to see if your prospective customer has been a party to any lawsuits. There is no cost to access court records in a majority of jurisdictions and the information is often available on the Internet. It is better to know the benefits and the burdens associated with a prospective customer prior to signing a contract to do business and it makes it a lot easier to address any issues which could tarnish the relationship.

Review your contract language – Ensure that your standard contracts include provisions that allow for you to suspend work in the event that a customer fails to provide financial information or until disputes are resolved if a customer fails to make payment for any reason. If a customer fails to provide assurances of its ability to make payment, you can make a case for breach of contract and position yourself to suspend work or even terminate the contract.

Other contract provisions that can benefit a contractor include authorization for a contractor to run credit reports or to verify proof of a customer’s ability to pay if the cost of the construction project exceeds the original budget. Protecting your rights in the event that you have to take legal action against your customer should be addressed in part with a forum selection clause that allows for you to sue or to be sued in a court that is near your place of business. The goal is to minimize your litigation costs while to make it less convenient and more expensive for your customer to take action against you. A provision addressing attorneys fees is important and often a disincentive for either party to take action by way of a frivolous lawsuit. Limited resources should not prevent you from consulting with an attorney to review your contracts. While the contract price, fee schedule, and scope of work are key provisions in any contract, those provisions embedded within or at the end of a contract can become crucial in determining substantive rights in the event that problems arise in the contractor-customer relationship.

Have a contingency plan – A seemingly lucrative contract may be difficult to turn down even if your investigation produces less than stellar results. If you are a subcontractor growing your business and are prepared to accept the risks that maybe associated with a bad debt, factoring may be an option that you may want to consider. Factoring is the purchase of accounts receivable at a discount for cash. Factoring allows the contractor to minimize inconsistent cash flow and to convert assets into cash in order for business operations to continue while the project is completed. The following is an example of how factoring works for a contractor or a subcontractor:

Common sense and attention to details prior to entering in to a construction contract will minimize the unforeseen situations that can disrupt your business and threaten your ability to get paid for supplies provided and services performed. Proactive measures are a main ingredient to successful prevention of catastrophic losses and ensuring the long-term financial health of your business.