Construction Defaults: The Need for Expert Advice

Francis J. Brennan, P.E.

A construction project in default is an emotionally charged situation, with many parties exposed and a lot of money at risk. The owner’s use of the facility will be delayed. The contractor’s work on the project and perhaps years in business may come to an end. The designer’s envisioned project is on hold. The surety faces an uncertain exposure.

Of these parties, the surety has the most pressing need to be brought up to speed on the project as it is usually not as intimately involved as the owner, contractor and designer. These other parties may be so wrapped up in the project financially and emotionally, that the surety cannot rely upon their perceptions and advice in assessing the surety’s proper course of action. Thus, sureties often retain consultants to investigate the project, finances, performance, status of the work, and recovery. Likewise, the owner may retain a consultant to watch out for the owner’s interests.

Protecting Surety Rights

The consultant retained by the surety must be ever vigilant not to jeopardize the surety’s rights to the contract balance and its right to be indemnified by the contractor/principal. In addition, the consultant must ascertain whether the contractor is truly in default; if not, the surety has no liability under the bond to the owner/obligee. The surety’s consultant may conduct an exhaustive investigation geared to recognize problem areas, to analyze critical technical and cost matters, and to present a comprehensive report providing sound conclusions and recommendations. The investigation must be done quickly to enable the surety to make crucial decisions to avoid enormous dollar losses which could result from delays.

Required Investigation

Four areas of inquiry are often undertaken by surety consultants: (1) the financial condition of the contractor/principal; (2) the ability of the contractor to complete the work; (3) the financial status of the project; and (4) the physical status of the work. Each of these aspects must be judiciously investigated to ascertain how the surety can most prudently meet its performance obligations, and whether any substantial defenses exist.

Contractor Finances

A fundamental concern is the financial condition of the contractor, whether its finances are adequate to allow it to meet its primary obligation to perform. Often strange things lurk beneath the surface of balance sheets and financial reports provided by contractors. It is prudent to dig into stated liabilities, such as loans, taxes, fringe benefits, invoices, unpaid subcontractors and suppliers, and administrative operation costs relating directly to the bonded project. In addition, there are relevant liabilities not covered directly by the bond, such as other outstanding creditor claims, litigation, and costs relating to other bonded or unbonded projects. Stated assets often have less value than purported and may not be liquidated easily. It is not uncommon that contract funds from the bonded project often disappear into a black hole.

Ability to Complete

The resources necessary to complete the bonded project often go beyond numbers on a financial report. Management talent at all levels and responsibilities may disappear in troubled times. Even qualified managers may be hampered by lack of experience in the geographic area or type of work involved in the bonded project. Other pitfalls include soured relationships with the owner or project architect, unavailable trade labor force, inadequate tools and equipment, incompetent subcontractors, troubled suppliers, bungled purchase orders and rumors of financial problems that may cut off vital relationships.

Project Finances

Often the financial status of the bonded project makes the contractor’s performance infeasible. Overpayment can be as devastating as underpayment, and may provide the surety with a defense to the surety’s performance obligation. Many contractors struggle waiting for payments for change orders performed months earlier. It is imperative to determine the status of all change orders – approved, pending, rejected, in progress or completed without formal approval.

Inappropriate back charges, improperly assessed liquidated damages and meritorious but unpaid claims may also provide additional contract funds. However, such funds may be readily depleted by unpaid suppliers, subcontractors, creditors, liens or judgments. Further, defective work is a dangerous unknown that may jeopardize the project’s financial outcome, especially as latent defects may not appear for months.

Perhaps the most crucial aspect of the investigation is the determination of the cost to complete. The approved payment requisitions may not properly reflect the percentage of work completed. The bonded contractor will likely provide an optimistic cost to complete that must be tempered with an independent estimate by the consultant or even a potential completion contractor. Determining the cost to complete is a challenging endeavor, often qualitatively different than cost estimating undertaken prior to construction or in support of change orders. For example, the cost to complete could increase significantly if different trade contractors are required to mobilize or if substantial remedial work is required. Such contingencies may be difficult to price.

Job Status

The fourth aspect of the investigation is the physical status of the work, as the consultant must inspect the project to determine the extent and quality of work in place. Ascertaining installed quantities may be difficult because some work items are not easily counted. The quality of the work is even more controversial, as the level of acceptability is often in the eye of the beholder. Judgement is required to determine whether work is in accordance with plans, specifications, and generally accepted practices. Estimates of remedial costs will also vary. In addition, the amount, condition and value of stored material must be assessed.

Also, important in assessing the physical status is an understanding of the contract time, actual performance to date and an objective evaluation of the time required to complete the work. Scheduling expertise will come to bear in determining a realistic completion schedule, entitlement, to time extensions, assessment of liquidated damages and delay claims.

The Performance Decision

The ultimate purpose of the consultant’s investigation is to provide insight, accurate information, and practical recommendations to the surety in a timely manner so that it may make prudent decisions concerning its performance obligations. As discussed in the Primer article on page 3, there are several options that the surety may consider in responding to the default of the contractor/principal. However, assessing the relative wisdom of each possible response requires reliable and expedited analysis from seasoned construction experts.