By: Kendall Jones on June 21st, 2016

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Tips for Avoiding & Dealing With Subcontractor Default

Blog Posts | Operating Insights

Dealing with a defaulting subcontractor can be a real nightmare for general contractors. A nonperforming subcontractor or one that isn’t meeting its contractual obligations can wreak havoc on a project. This can lead to delays in the schedule that impact other subcontractors and can result in costly rework. Having to replace a terminated subcontractor or supplement their work can kill a project. If a subcontractor is experiencing difficulties it is imperative that you work with them to resolve any issues before they escalate and get out of hand.

The first thing to keep in mind is that no subcontractor enters into an agreement with the intention of not performing the work. Subcontractors have to front a substantial portion of the costs on a project before they start getting paid. This can quickly lead to cash flow problems despite having the capital to handle a project once it began. This often occurs when they overextend themselves by taking on too much work or when a contractor on another project is delaying payment to them.

Prequalify your subs

Before you take pricing or solicit bids from subcontractors you need to make sure they are capable of completing the work, both physically and financially. Review your prequalified subcontractors to weed out those that aren’t experienced with the size and scope of the project. You might have a dozen prequalified electrical contractors that you regularly work with but for this particular project only six might be capable of doing the work. Invite those six to bid on the project.

If a subcontractor ever asks why they weren’t invited to bid, be as open as possible and explain the situation. You want to maintain a good relationship with all your subs. Just because they aren’t right for one particular project doesn’t mean you won’t need them for future projects.

Be sure to check out our earlier post, “Not Prequalifying Subs is Still Risky Business,” for some pointers on what information you should be asking for to adequately prequalify your subcontractors.

Know the signs

Subcontractors might not always be forthcoming when they begin experiencing difficulties. Even if they are performing their work and staying on schedule, trouble could be brewing just beneath the surface. It’s important to keep a watchful eye on all of your subcontractors to monitor for any signs that they are experiencing difficulties or at risk of defaulting.

Common signs a subcontractor is running into problems include a sudden decrease in their workforce for a project, change in demeanor, delayed materials deliveries and failing to pay their subcontractors or suppliers on time. Be proactive in monitoring your subcontractors if you suspect things might be getting off track.

Don’t be fooled. If you start noticing some of these red flags, you should address them immediately with your subcontractor regardless of whether they are performing their work as required. Waiting too long to react to a subcontractor who might be struggling can kick off a chain reaction that can derail the whole project.

Craft a plan

Whether you discover it on your own or if the subcontractor comes to you about it on their own, you need to sit down and work with them to correct the issue. Once you’ve determined what the issue is, you need to determine the root cause. Find out if they are having difficulties with one of their subcontractors underperforming or a supplier not delivering materials on time. If they are having cash flow problems make sure the issue isn’t with you not paying them enough or on time for the work completed.

Sit down with your subcontractor and discuss what options are available and what assistance you can provide to help them get back on track. This is typically the easiest and most cost-effective solution. It could be as simple as supplementing some of their workforce with your own or self-performing some of the work. You may need to alter the subcontract to a labor-only contract to alleviate some of their financial burdens so they can focus on paying their workers and completing the project on schedule.

Put it in a contract

Make sure your contract includes provisions outlining your rights to supplement work, suspend the subcontractor’s performance or terminate the contract. Failing to perform work as required should obviously be covered, but you may want to include other circumstances such as delaying payments to their subs and suppliers. The contract should also include the right to reimbursement for any reasonable costs you incur should you have to step in and take action.

If your subcontractor defaults make sure you follow any notice requirements before you exercise your right to supplement their work or take other action. Typical contract documents require you provide the subcontractor with written notice of default and a deadline for curing the default. If the sub hasn’t cured the default within the specified timeframe the general contractor can then go in and supplement the work. Failing to provide written notice as prescribed in the contract can result in legal challenges down the road if the subcontractor feels that supplementing their work wasn’t needed.

To further protect yourself, the contract should also include a provision that automatically terminates the contract if the subcontractor files for bankruptcy.

Protect yourself

The two most common methods for protecting against subcontractor default are subcontractor bonds and subcontractor default insurance. Both are used to manage the risk of subcontractor default but there are differences in how they work, who bears the risk and what parties are protected.

A subcontractor performance bond is a three-party agreement between the surety, general contractor and subcontractor. The surety is responsible for prequalifying the sub and assumes the risk should a default occur. They are responsible for managing the default which is why they should be contacted immediately if a subcontractor defaults or is at risk of defaulting. They will arrange and pay to have the project completed. A subcontractor payment bond ensures that the subcontractor’s subs and suppliers are paid in the event of a default.

Subcontractor default insurance is a two-party insurance policy between the insurer and the general contractor. (Sometimes owners will take out a default insurance policy to protect themselves from subcontractor default.) The general contractor is solely responsible for prequalifying the subcontractor.

If a default occurs, the general contractor will file a claim and is responsible for managing the default and completing the work.  They are also responsible for paying deductibles if they file a claim. Suppliers and sub-subcontractors get the short end of the stick since there is no protection for payment in the event of a default.

Other methods protection include having the sub secure a line of credit, getting a personal guarantee from the business owner or increasing the retainage.

Termination

Terminating a subcontract requires careful consideration and should be used as a last resort. Termination is typically the most costly and time-consuming option for dealing with subcontractor default. Terminating a subcontract probably means you will have to rebid the remaining work which will cause delays to your schedule and costs more than the other options available.

Again, the contract should clearly define the circumstances under which you can terminate the subcontract. If it’s early on in a project and you are seeing multiple red flags or if the subcontractor is having major issues, it is probably best to cut ties and terminate the contract before it starts impacting other areas of the project. If the subcontractor is having temporary or minor issues, you’re probably better off working with them to come up with a solution. If the work is almost completed and the subcontractor defaults, the smartest course of action is to supplement the work rather than terminating the contract.

Each situation is different. Have an open and honest discussion with your subcontractor if you feel they are at risk of defaulting on their contract. They may just be going through a small rough patch that can easily be resolved with a little help. Other times it could be a major issue that will end up harming the health of your business.

Your response to a defaulting subcontractor should be commensurate with how much it will impact you successfully completing the project. Most issues can usually be resolved by working with the subcontractor rather than outright termination of the contract.