The Risks and Benefits of Contractors Taking “Equity” In the Project In An Effort to Get Paid and The Use of Non-Traditional Litigation Strategies.
2008-2009 bore witness to the unimaginable. Contractors who worked hard on a Project to deliver a quality product to the Owner, faced the prospect of lender defaults. The prospect of either an outright lender default or revised loan standards by lenders results in a wide variety of scenarios. Owners raise non-existent construction problems to avoid full compensation to Contractors and Lenders create additional construction requirements before funding will be provided. Worse still, as banks continue to fail, the FDIC is taking them over and there is either a total project shut down or long term delays while the FDIC sorts out the project. Amidst the current financial backdrop it seems hard enough for contractors to find their next project and try to fill up their plate for 2010, but unfortunately, as everyone knows, simply ensuring payment on current projects and the work they have completed in 2009 is becoming a new challenge for contractors as well.
Traditionally, a general contractor could feel relatively comfortable with an Owner’s financial stability through reputation and due diligence in investigating whether adequate financing was in place. This article will serve as an overview of some of the new challenges contractors are facing, as well as potential risks and benefits for contractors who use creative financial arrangement in an attempt to receive the benefit of their work. In addition, it will briefly evaluate the situations which may come up for a general contractor facing a risk of either bank failure or an Owner who is running low on funds and near bankruptcy. Options in these situations include alternative structuring of ownership interests and creative and aggressive monitoring in conjunction with new litigation strategies to improve the chances of recovery.
Owner Near Bankruptcy, Danger of Preference and Potential Rescue Through Equity Ownership?
The threat of bankruptcy does not necessarily mean it will happen and in many cases could simply be an attempt to bide more time. A general contractor needs to evaluate the likelihood of a bankruptcy and the options within bankruptcy to advance payment to the general contractor. Even if a payment is made, an actual bankruptcy can present issues as the bankruptcy estate has a right to recover payments if those payments are deemed a preference. An alternative approach (especially in a situation where the main financial problems for the Owner/Developer relates solely to its financial arrangement with the bank on the Project at issue) may be an offer by the contractor to help facilitate an ownership interest in the Project to see it through to completion and try to recoup your investment. Such an approach would require the contractor to take off its construction hat, and evaluate the risk/rewards of development. Security of payment and the validity of the project having a viable return are paramount considerations.
The Contractor will need to undertake its own feasibility study and determine whether the Project is worth continuing. Regrettably, many projects may currently be perceived as depreciating and not worth the risk. The cost of the investment makes this option more viable for large general contractors, but even a smaller contractor on a smaller project should consider it as an alternative to traditional approaches. The structure of any new arrangement is key and would basically require the financing arm, the owner and the contractor to sit down together and devise a strategy for moving forward. Risk should be evaluated and properly allocated, inclusive of potential incentives through increased equity for the contractor should the project come in under budget. The Contractor must also take into account what new roles and responsibilities they will assume as the co owner of the Project. Premises liability, design defects and may of the traditional risk allocation lines are blurred by any change in the traditional roles of Owner and Contractor and require additional effort on the front end to ensure protection for the Contractor in the end.
FDIC takes Over and Quits Funding, Even on Approved Pay Apps:
General contractors are also facing lender defaults and/or new bank ownership (the FDIC), who refuses to fund the construction loan or substantially delays the project. General contractors want to control and minimize risk, but this threat is completely beyond the control of the Contractor. Certainly, any new contracts should require as a precondition of continuing work that there are ongoing and transparent reports of financing. However, even the most transparent financing can still leave a general contractor 30 to 60 days out in the event of a lender default.
In the event that the FDIC has become involved or is likely to become involved, the typical avenues of litigation against the Owner who can’t pay are always available. However, if the Owner is not receiving funding from its bank, the likelihood of recovery is small and traditional litigation may not work. This is because the FDIC generally has the right to repudiate all contracts and the damages that may be recovered as a result are limited to those actual damages at the date of take over.
The Contractor needs to ensure the Owner is pursuing (on its own behalf and to protect the contractor) all available administrative remedies against the FDIC. To the extent that existing contracts do not require this right, then the Contractor may need to leverage this right if there is evidence of financial instability and a basis for the Contractor to stop work. To ensure that these claims are preserved, the Owner is required to file a claim within 60 days of FDIC take over or risk waiving its claim and thus risk the Contractor’s best option of recovery vanishing. Note that the FDIC does not give notice of the need to file claims to borrowers (the Owner) in this situation, and the clock starts at the point of an FDIC takeover. Additional timing mechanisms apply and should be reviewed prior to the Owner instituting litigation.
Surviving in today’s economic climate requires that Contractors become more attuned to the legal environment and new project delivery methods which surround today’s distressed real estate market. As new challenges present themselves, Contractors who wish to survive 2010 cannot simply bury their head in the sand and rely upon traditional avenues of dispute resolution. Instead, they must be prepared to consult with trusted business and legal advisors to ensure payment in ongoing projects whether through restructuring and equity ownership, or alternatively, using new litigation strategies involving third parties and closer monitoring of the financial solvency of all players on the Project.
By Kevin Hudson and Matthew Spivey
Reprinted from The Georgia Contractor, September/October 2009