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Manage Subcontractor Default Risk

Entrepreneur général gérant des sous-traitants sur un chantier de construction.

The success of any construction project depends on hiring qualified subcontractors and making sure they can finish the job on time and within budget. Too many construction projects have gone bad due to subcontractor problems, whether it’s scheduling issues, lack of skilled labor, financial difficulties or a contract dispute.

You can take steps to avoid subcontractor defaults through a combination of due diligence, commonsense precautions and risk-transfer tools, such as bonding and insurance. There are some key points to consider.

Pre-qualify your subcontractors. 

All subcontractors, from the largest to the smallest, should be properly vetted. Establish a consistent, uniform process for qualifying your subs. Check their references. Do they have the capacity to do the job? And make sure they will be on the job the whole time.

Specifically, ask:

  • Have they done this type of work before?
  • Are they local, or is this project out of territory for them?
  • Is this their largest project?
  • Do they have the right equipment and tools?
  • Do they have the labor they need?
  • Do they have systems in place to monitor expenses?
  • Do they have other jobs they must finish before yours (work in progress)?

Identify your critical-path subs. 

How much of the work will be done by critical-path subcontractors? These are the subcontractors who can make or break the project. Without their work being completed on time, you may fall behind and lose money on the job. In some cases, the failure of a key subcontractor can jeopardize the whole project. It’s doubly important that these subs be fully vetted.

Bond your key subcontractors.

Insist that key and specialty subcontractors be bonded. Surety companies, which issue performance and payment bonds, can be an invaluable resource because they require contractors to undergo a rigorous pre-qualification process. They have access to confidential information reviewed during underwriting that typically isn’t available to general contractors, thus providing a level of scrutiny well beyond what you could do on your own.

For example, sureties review a contractor’s financial statements, tax returns, balance sheets, work-in-progress schedules, etc., as well as references and letters of recommendation. When a surety issues a bond, there’s a degree of certainty that the contractor is competent and qualified to do the work. The surety stands behind its assessment that there’s a low risk of default. If a default does occur, the surety will step in and assume responsibility for completing the work.

Consider subcontractor default insurance. 

More recently, a new insurance product has been available to general contractors to protect against subcontractor defaults. Known as subcontractor default insurance (SDI), or “subguard,” these agreements are designed to protect against delays and additional costs associated with a defaulted subcontractor or supplier. Many general contractors now use these products in lieu of a standard performance bond.

SDI is a two-party agreement between the general contractor (GC) and the insurer. It typically requires the contractor to carry a high deductible, meaning the GC’s loss could be higher than under a surety bond, but under an SDI, the GC contractor has more leeway to work around a sub’s default to prevent the usual project delays that occur when a surety is involved.

Practice good risk management.

Construction is a complex business. Are you availing yourself of all the latest management tools to properly reduce the risk of subcontractor default? Make sure you have internal controls in place to monitor subcontractor progress and manage disbursements once the project begins. You should have a detailed schedule for your subcontractors to ensure the project stays on track.

Consider a construction completion commitment.

A construction completion commitment is another tool general contractors can use to help minimize the risk of default. A completion commitment includes a range of due diligence, oversight and monitoring activities, including work-in-progress monitoring, budget reviews and reconciliation of lien waivers, among other fiduciary protections.

Commitments are less expensive than a surety bond, but unlike bonds and SDI, they don’t provide funds for the project. Rather, if a default occurs, the provider of the commitment will assist with replacement of a subcontractor to get the project back on track.

Monitor the job site and pay attention to your subcontractors. 

Experienced general contractors learn to identify the warning signs that a subcontractor may be experiencing difficulty. Often subcontractors won’t share they are having problems, so it’s up to you to watch for red flags, such as:

  • A decrease in their workforce or a change in supervisory personnel
  • Delayed delivery of materials
  • Overbilling or billing for unapproved change orders
  • Failing to pay their workers on time

If you suspect there’s an issue, you should address it right away. There are options you might present, including supplementing their workforce or making the subcontract a labor-only contract to alleviate any financial burdens. You may also need to hold payment until the situation is resolved.

Put everything in writing.

Make sure there are signed contracts for each of your subcontractors that spell out your right to supplement work, suspend a subcontractor’s performance, withhold payment or terminate the contract. Be mindful of notice requirements for default so that you can exercise your right to step in and finish the job. Understand that terminating a contract is a last resort that may result in costly delays. Depending on the circumstances, you may be better off working with the subcontractor to come up with a solution.

Subcontractors are the backbone of any construction job. Take the steps to make sure you have experienced, qualified subcontractors on your team. Then institute procedures to ensure the job will go smoothly and be delivered within budget. Protect yourself by requiring your subs adhere to their contracts, then get bonded and talk to your insurance professional at Consolidated Insurance + Risk Management about subcontractor default risks.

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