To Risk or Not To Risk?

One of the prime responsibilities of any business owner or manager is to manage risk. Your business's financial success—and even its survival—depend on your prudent management of risk in its myriad of forms. You manage risk in a variety of ways, including avoiding certain activities, gaining specific skills or knowledge, maintaining a system of operating and financial controls, requiring hold harmless agreements, purchasing insurance, requiring financial/performance guarantees, etc. You can never avoid all possibility of loss and, by choice or by default, will always retain some degree of risk.

Performance Options

Your principal reason for considering a performance guarantee from another party is to assure their compliance/performance. This is most easily illustrated in the context of a construction contract where an owner hires a general contractor to build a structure per plans and specifications for a stipulated sum of money. The owner wants to assure himself vis-à-vis a financial/performance guarantee that all work will be properly performed in a timely manner and all project labor and material costs will be paid. If the contractor fails in his/her performance obligations, the owner will look to the guarantee.

One of the risk management options, as in all activities, is for an owner to fully retain the risk of non-performance. Given the magnitude of the risks associated with most construction work, I'm often puzzled (and sometimes dumbfounded) why so many parties choose to retain these performance risks. Reasons cited include the following:

• The perceived cost of the guarantee.
• "We know the contractor, and they've always performed."
• "We pre-qualified the contractor."
• "We won't allow the contractor to get ahead of us (meaning the owner won't pay out more money than the value of the work performed and bills paid)."
• "The lender didn't require any guarantees."
• "Our contract is ironclad and includes broad hold-harmless provisions."

Pre-qualification

With regard to pre-qualification, the fact is most owners possess neither the skills, time, and/or resources to financially evaluate contractors prior to taking bids or awarding a contract. Because of confidentiality and competitive reasons, it is unlikely that most contractors would divulge full financial information, including required footnotes and detailed open and closed job schedules. Many times the financial reports given to an owner are not CPA-audited or reviewed but rather are prepared in-house.

For much the same reasons, it's most unlikely an owner will be given details about the terms and conditions of any bank credit facilities or information on any of the contractor's affiliated entities, joint ventures, and/or the owner's other investments (e.g., real estate development), all of which could impact the contractor's performance. Even when financial information is provided, it may be for only one accounting period with no way to compare it to prior periods.

The first question or concern should be: Is the financial data credible? Unless the statements are fully audited by a qualified CPA, there may be no assurance that they have been prepared in accordance with generally accepted accounting principals. Other questions include the following:

• How valid/legitimate are the balance sheet items, e.g., how good are those trade and affiliate/shareholder receivables?
• Are the under-billings recoverable?
• Are all the liabilities reflected?
• Are there any open/closed jobs that are causing financial distress because of losses and/or collection issues?
• Is the contractor embroiled in any actual or pending litigation with an owner and/or subcontractor/supplier?
• Are there any pending issues with any taxing authority?

These are just some of the items you would need to know to effectively evaluate the financial condition of a contractor.

While most contractors are honest and diligent, that alone may not qualify them to perform your work. Besides skill and experience, a contractor needs adequate working capital to finance their particular type/size work and they must have a commensurate net worth to absorb losses or other "bumps in the road" that may (will) from time to time occur.

Recently, I saw a requirement by an owner that any prospective bidder must have a minimum working capital of $3 million. This amount, while seemingly sizable, is of little value unless you relate it to the contractor's uncompleted backlog and consider the type of work the contractor performs. To illustrate, $3 million in working capital would be considered excellent for a general contractor with a $25 million backlog; probably good for a road or bridge contractor with the same backlog; and poor for any contractor with a $500 million backlog.

Past performance is certainly a key factor in assessing the qualifications of any business. The construction business is dynamic and generally a high-risk enterprise. Success is often tied to the skills of the business owner and key members of the staff. When there is turnover among key people, it may have a direct affect on future performance. To presume that because the firm performed well in the past, it will do so in the future, may be a leap of faith especially if you've not done business with the contractor for some time.

The profile of the contractor you think you know so well can change rapidly because of losses on one or more jobs, untimely or over aggressive expansion, or the death/divorce/buyout of an owner. Past performance deserves full recognition, but don't ignore the other forces or events that can rapidly change a contractor's fortunes.

Relying Solely on the Contract

Many owners are convinced their contract with the builder will assure performance and provide the owner with the tools to deal with any nonperformance issues. Yes, a good-fair contract document is essential and should provide a clear roadmap on how issues are to be addressed, e.g., how payments will be issued, how change orders will be processed, etc.

The contract, no matter how well drafted, is not a performance guarantee. Contracts include hold harmless language, but without adequate insurance, the indemnification language may be just words on a piece of paper. When I see to what lengths owners will go to detail insurance requirements for the ostensible purpose of backing up the indemnification provisions, I'm often puzzled (and again sometimes dumbfounded) that they are not also requiring performance guarantees.

Cost Considerations

The perceived cost/expense is probably the most cited reason for an owner not requiring a performance guarantee. I've seen instances where the contractor will persuade the owner to waive the guarantee requirement by demonstrating to the owner the dollar "savings." While admittedly some owners could easily afford the financial loss associated with nonperformance of the contract, there are other factors to consider. If, for example, a contractor fails to pay for material or labor, the owner will have to handle the claims. Therefore, there may be administrative and legal time spent resolving claims/liens made against the owner for the failure of their contractor to fully perform its obligations.

Imagine for a moment you are the executive in charge of the building program and you have to inform your board of directors that the new $5 million building your company was scheduled to move into won't be available because the contractor you hired is broke and on the verge of filing bankruptcy. To make matters worse, you have received well over $600,000 in lien filings from various subcontractors and material suppliers. Consider the following dialogue.

One of the board members asks: "Did we have a bond?"

Answer: "No."

Question: "Why not?"

Answer: "Well, they were a good contractor, and we didn't want the expense of a bond."

Question: "What would have been the cost?"

Answer: "Around $30 to $40 thousand."

Another director asks: "Have you talked with legal about this?"

Answer: "Yes … this morning."

Question: "What did they say?"

Answer: "We need to retain an outside bankruptcy firm for guidance."

Question: "What will that cost us?"

Answer: "Maybe $25,000, but it all depends how long and how complex the case."

You suddenly jerk your head back and realize you'd dozed off reading this article. Thank goodness it was only a bad dream.

Tempting Fate

In my view, most owners, lenders, or contractors who don't require or waive performance guarantees on private work in the belief that they have the capacity to fully and adequately pre-qualify the contractors with whom they will contract are tempting fate. Fortunately, most construction projects are completed without any declaration of default, but the record also shows that many projects involve disputes, claims, and payment issues.

Owners will not hesitate to purchase fire insurance on their properties even though most structures never catch fire. Yet, when it comes to a high-risk and dynamic enterprise like construction, the majority of private owners and construction lenders will not require financial guarantees.

Contractor Reluctance

If owners/lenders implement a mandatory bond guarantee process, they can expect some flack from the contractors:

• The bonds won't really benefit the owners/lenders.
• The expense is a waste of money.
• Bonding companies never pay claims.
• The contractor's own reputation is so good that they've never been asked to give a bond (i.e., they will act insulted that you asked).
• Sureties are idiots, and contractors won't deal with them.
• Only some of the subcontractors need to be bonded.

Everyone is of course entitled to their own opinion, but as an owner/lender who bears the ultimate risk of nonperformance, you should also be suspect that the contractor who is giving you these arguments perhaps is unable to secure a bond for your project or has no bonding relationship.

Keep in mind that sureties and bonding agents make their living writing bonds. They are motivated to find a way to write a bond for a qualified applicant. It's a competitive marketplace, and if a contractor can't bond your project, it should sound some warning signals.

How Much Risk Can You Accept?

While private owners, unlike public/governmental entities, may have more latitude to negotiate contracts not based solely on who tendered the lowest responsible bid, the fact remains private owners are directly or subjectively influenced by the proposal that appears economically most advantageous. This means going with the proposal that offers the shortest construction schedule, the lowest guaranteed maximum price, the lowest unit prices, and/or the lowest contractor fees and reimbursables.

Implicit in all this is risk. A financial guarantee from a third party, such as a surety, effectively provides another opinion. If the guarantor errs in the underwriting of their contractor, the owner's ability to fulfill its responsibilities (e.g., make payment), the quality of the subcontractors, and/or the inherent difficulty of the project, then the guarantor bears the financial risk of satisfactory completion of the contract and not the owner or the lender.

Conclusion

Hopefully, this article will assist you in evaluating/addressing the financial guarantee conundrum: "To Risk or Not To Risk." The next topic in this column will be "All Guarantees Are Not Created Equal."