Prequalifying Owners: “Funding Is Covered” Is Not Enough
General contractors devote substantial business development efforts pursuing opportunities to build for a wide variety of parties ranging from experienced institutional owners in education and health care to first-time developers dipping their toes in the construction market. When securing a new project, a general contractor’s primary focus is often assembling and prequalifying its subcontractor team. However, the COVID-19 pandemic’s impact on construction cash flow and the instability of projects in retail and hospitality have heightened the importance of working with quality owners that can survive uncertain times. After all, a general contractor’s ability to pay its subcontractors is only as good as the owner’s ability to pay the general contractor.
While the past decade has generally been a period of prosperous growth for the industry, the fertile backlog on contractors’ books suffered great uncertainty in early 2020 with the COVID-19 global pandemic. Some projects experienced only a minor setback and some additional costs, but others have been mothballed or scrapped altogether due to a lack of funding leaving general contractors hung out to dry. Every general contractor knew it was important before COVID-19 to prequalify its subcontractors. The COVID-19 pandemic is a reminder of the importance of prequalifying owners as well.
It should be no surprise that owners do not like sharing their financials, but that does not mean a general contractor should accept it at face value when an owner says “funding is covered.” Unless the contractor has a pre-existing relationship with the owner or the owner is a well-recognized institution, a reliable prequalification protocol should be followed before commitments are made. While general contractors have forms and processes for prequalifying their subcontractors, prequalifying an owner is an area that is not as well-developed. Obtaining useful due diligence on a prospective owner requires more care and creativity than with a potential subcontractor.
Some form contracts provide a framework for obtaining financial assurances from owners and are recommended. For example, the AIA A201–2017 contains good protections for obtaining useful information before and after commencement of work. Section 2.2.1 requires an owner to furnish “reasonable evidence that the Owner has made financial arrangements to fulfill the Owner’s obligations under the Contract” before the contractor is obligated to commence work. Following commencement, Section 2.2.2 requires the owner to furnish the same “reasonable evidence” if the owner misses a payment or the contractor discovers a reasonable concern the owner cannot make a payment when due. Failure to comply will permit the contractor to stop work until the financial assurance is provided.
In addition, since most projects will have some layer of financing involved, the owner’s lender will require the general contractor to execute a consent to assignment of the prime contract that will allow the lender to step in and take control of a project should the owner default. Some consents to assignment will disclose the amount of the owner’s loan, which will typically contain a contingency above the projected cost of the project. If the owner isn’t self-performing any of the work, the contractor can use this information to confirm financing is available so long as everything goes according to plan. If a bank’s form consent to assignment does not contain the amount of the loan, the contractor should ask if it can be included.
When forming a new relationship, the general contractor may want to ask the owner for the financials in a verifiable format. This can be a copy of the loan commitment or a recent balance sheet. The owner can also obtain a “comfort letter” from its bank that discloses sufficient financial information to satisfy the general contractor’s concerns. The comfort letter can contain the principal amount of the loan, availability on a line of credit, total deposits in the owner’s accounts and confirmation the owner has no prior missed payments or defaults on its loans with the bank. However, the bank will only provide this information with the owner’s consent, so it is best to work with the owner in obtaining the comfort letter.
If the owner refuses or the general contractor is uncomfortable asking for this information, at a very minimum the general contractor should conduct its own investigation into the creditworthiness of the owner. Plenty of information can be obtained online and in public records. How long has the owner been in business? Has the owner had any public disputes with other contractors or troubled projects? Has the owner or its principals, parent, or affiliates been involved in litigation or filed bankruptcy? Have any of subcontractors or industry contacts worked with the owner on other projects?
If done properly, due diligence on the owner should not create any problems for securing a project or obtaining future work. The requests will be mutual, so be prepared to respond with the same type and depth of information. Remember, everyone is working toward the same goal, and both sides of the financial equation should be able to legitimately evaluate the financial risks.