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May 2009 >>
Managing the Risks of Long-Term Contracts
Why do owners turn to long-term contracts when they are less competitive and more costly?
The answer is simple: Long-term contracts are a way to transfer risk from the owner to the contractor. As a result, they have become a growing source of contention between sureties and contractors. Contractors are drawn to the higher margins and lower competition levels, butsureties fear the heightened risk that liability entails in the long term.
Historically, in the surety world, any contract exceeding three years was considered unbondable. Despite this precedent, sureties provide bonding to four- and five-year contracts, which allows contractors to meet bid requirements and qualify as a responsible low bidder.
To qualify for such a bid and expect support from its surety, a contractor must first demonstrate a track record of evaluating and mitigating the risks associated with long-term contracts, as well as present a balance sheet strong enough to endure the monumental costs of a mistake.
Recent price escalations have wreaked havoc on both short- and long-term contracts. The price and supply of steel caused problems in recent years, and for most of the last decade, the same was true of concrete, asphalt, oil and gas. International shortages and dramatic price increases caused contractual trouble around the world.
In what has become the worst economic downturn in the post-World War II era, contractors must look more closely at protecting their organizations when assuming the risks of long-term contracts.
Subcontractor or Supplier Default
Sureties want their clients to mitigate the risks associated with all subcontractors and suppliers, especially those affecting the critical path of the project. A general contractor should closely manage its subcontractors and suppliers by reviewing past performance and experience to determine their capacity to perform.
The schedule of values, especially on a long-term contract, is a critical component of managing subcontractor and supplier risks. If allowed, a subcontractor or supplier can front-load its schedule of values and end up ahead of a general contractor. This can impact quality and the ability to meet schedule demands.
Payment terms are vital to keeping subcontractors and suppliers financially viable. Additionally, surety carriers suggest bond backs as a way to mitigate risk and protect against defaults.
Joint check payments for major material or equipment purchases also can mitigate risk. One of the most common issues surety companies and contractors face is a subcontractor’s or supplier’s failure to pay a vendor. All too often, a general contractor pays a subcontractor or supplier, which in turn fails to pay the vendors. These vendors then have a legitimate claim against the surety bond.
Confirmation of financing and clear payment terms with the owner are critical for the general contractor. It is in the best interest of all parties to keep the money flowing into the project on a consistent basis to maintain stability and productivity.
Price Escalation
Price escalation is exponentially more important for contractors to evaluate with long-term contracts.
Supply hedging is an option that can be executed in several ways. This concept recently made headlines when it helped Northwest Airlines maintain strong profitability through the dramatic priceescalations of 2007 and 2008, but in the second half of 2008 it ended up working against the company as the price of crude oil fell from $149/barrel to $35/barrel. Supply hedging can come in many forms, including buying products and materials upfront with prices locked in via contract. Contractors also may receive supplies and materials directly, eliminating the supplier from the equation when figuring prices in the long term.
Subcontracting also can hedge the risk of price escalation, but it is critical to back that hedge with a quality surety product so the guarantee extends beyond the subcontractor or supplier to the surety.
Payment terms are critical when supply hedging. A contractor that accepts delivery of materials should receive payment for those items as quickly as possible to avoid financing them through the life of the hedge.
Unforeseen Events
Global and natural events beyond one’s control become more of a threat the longer the term of the contract and can endanger its execution.
The area of operation is a critical consideration. A contractor knows the environmental, political and legal landscape close to home. When contemplating long-term contracts, a contractor should not venture out of its normal area of operation. If necessary, access information through local professionals or colleagues.
Additionally, include a specific “force majeure” clause in the contract. These clauses excuse a party from liability if an unforeseen event beyond the control of the party prevents it from performing its obligations under the contract.
Every contract poses its own unique set of circumstances and needs to be approached with vigilance, particularly when considering the costs and risk associated with long-term projects. As owners attempt to transfer risk to the contractor, it is critical to realize this risk can turn into a reward for the professionals that assume and manage it skillfully.
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Friday, September 3, 2010