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Subcontractor default is a problem that is neither understated nor under-reported. Everyone in the industry is familiar with it and the consequences of the likely, yet always surprising, situation when a subcontractor goes into default on a project.

Starting in 2008, the construction economy started to tank, and the industry experienced a wide number of subcontractor defaults. Now that the economy is recovering, it’s natural to think that defaults will be less common. The unfortunate fact is that subcontractor default is three times more likely in this recovering period than it ever was in the economic downturn.

Therefore, it is more important now than ever to review why subcontractors fail, and what everyone else should be doing about such failures.

Why Do Subcontractors Fail?

Subcontractor failure is a clear problem, but there are options for companies to mitigate the risks of such failures. Understanding why subcontractors fail can help fix the problem at the source, as opposed to focusing on too many failure symptoms.

• Cash flow. The most basic explanation for subcontractor failure is that the business organization runs out of cash. There are many reasons for this; most notably, subcontractors are expected by many to float the project costs. They pay for all materials on terms, pay all laborers weekly, give up 10 percent of their revenue to retainage withholdings, and then wait for 30, 45, 60 days, or longer, after fronting the cash to get paid from the general contractor or owner. These are unrealistic expectations for any company that is not flush with capital.

• Lack of access to capital. Because subcontracting is such a risky and cash-hungry business, it’s really difficult for these businesses to get capital access from traditional banking sources. This is especially true in the recovering economy, where lenders are more reluctant to fund construction investments than ever. The result is that subcontractors lack any access to affordable capital. When they are pushed to get funding, they pay higher rates, putting them into a vicious cycle of interest payments and cash needs.

• Tough work. The transaction is simple if you sell washing machines. A buyer gives the seller money, and the seller gives the buyer a washing machine. The machine may have a flaw, but identifying the flaw and fixing it is pretty simple. Such is not the case with subcontracting. In that business, work is layered upon the work of tens or hundreds of other parties; the work itself must meet a subjective-type approval; and there are many things that can wrong on the jobsite that puts the subcontractor in a practical or legal cross-hairs. This all feeds into the aforementioned problems, as this is yet another cause for heightened cash needs.

Who Is Affected By Subcontractor Failure?

Everyone associated with a construction project is affected by a subcontractor failure. Those at the top of the chain (general contractors, developers and lenders) must absorb the loss, find another contractor to do the work, and deal with the inevitable payment and damages dispute. This likely causes project delay and additional expense.

Other subcontractors on the job, although likely horizontal to the defaulting contractor, are affected because of the delay and expense caused to the job as a whole, becoming yet another thing that contributes toward the odds of their own failure. And finally, the suppliers and equipment providers are left hanging dry on their terms to the defaulting subcontractor.

Top Three Ways to Handle Subcontractor Failure

The failure of a subcontractor can be sudden and can cause vast problems. Therefore, the question is whether anything can be done about it. Here are the top three ways to protect against subcontractor failure.

1. Lien rights. Though this one doesn’t apply for those at the top of the chain (general contractors, owners and lenders), it is still the number one protection measure because of how enormously effective it is for all of the other affected parties. In fact, it is even effective for the defaulting subcontractor, as it can put it in the best position possible to claw its way out of a bankruptcy proceeding. Lien rights protect a company’s right to get paid for work, and more importantly, prevent companies from being placed into the back of a payment line. A subcontractor in the front of the payment line avoids cash problems, and is insulated from others defaulting on the project.
2. Surety bonds. Subcontractors can obtain performance bonds and payment bonds, and it’s common for general contractors, owners and lenders to require some subcontractors to acquire these bonds. When a subcontractor has these bonds, a default is less burdensome because the surety bond will compensate the affected parties for the losses.
3. Prequalification. Prequalification often is used by top-of-the-chain parties to assess the likelihood of failure by a lower-tiered party (i.e., a subcontractor). It also can be used by lower-tiered parties to assess the problems that might arise by higher-tiered parties. Everyone is affected by default and should do preliminary analysis to avoid the same. Examining the ability for a subcontractor to deal with the expected cash flow challenges is a necessary evil in today’s construction economy. Also, it serves everyone well to make sure the subcontractor is also taking measures to protect lien rights. If not, the subcontractor is going to be in the back of the payment line, and the result is a heightened default risk.