Keeping the project on track: Guarding against distressed contractors in uncertain times.

In today's unsteady economy, real estate owners and developers may find themselves in the difficult position of working with contractors who are--or may become--financially distressed. The contractor's problem can quickly become the worst nightmare of an owner or developer. Progress can be delayed or halted completely, costing precious time and money. What can owners and developers do to protect themselves?

Due Diligence 

It starts by thinking ahead. In challenging times, owners and developers should apply increased scrutiny to the due diligence process. They must pay close attention to the financial condition of the contractor from start to finish, seeking to identify red flags along the way.

Before hiring a contractor, an owner may want to request audited financial statements to gauge a company's financial heath.

Does it have a strong balance sheet? Has it collected from past clients and is it current with subcontractors on past projects? Private firms, of course, are not required to release this information, but given the competitive nature of the construction business, many will comply.

Those who refuse to provide evidence of financial stability should probably be eliminated from consideration.

In addition, owners and developers also should conduct a basic Web search for information and news reports about the company. Depending on the jurisdiction, court docket information may be available to the owner's counsel on-line.

Has the contractor been involved in any litigation? Has it received negative publicity associated with any of its projects or other relevant issues?

Reference checking also is key. Contractors bidding on a project should provide a list of references, including other owners and developers with whom they've worked previously.

Check to see how each contractor has performed in the past. Did it complete the job on time? Was it within budget? Did labor issues arise? Was the owner satisfied with the contractor's choice of subcontractors?

As part of the due diligence process, it's also prudent to inquire about recent ownership or organizational changes within the contracting company.

Many are family owned businesses whose management shifts from generation to generation. Sometimes the reputation or expertise of a son or daughter taking over a business differs from that of the preceding generation.

In the case of non-family owned businesses, changes in ownership or management could signal changes in construction quality or financial health.

Put it in Writing

After a contractor has been effectively vetted, and ultimately selected for the job, developers and owners must devise a contract that provides as much protection and flexibility as possible in the event of problems. Most contracts are based on established AIA guidelines, which provide a strong framework from which to work.

For example, contracts can be drafted with provisions allowing owners and developers to evaluate the financial viability of the contractor at any time during the project, such as requiring them to provide assurances that subcontractors are consistently paid. If they are not being paid, that could be a red flag for financial distress and worse, result in subcontractors placing liens on the property.

Contracts should also contain termination provisions. Generally there are two types of terminations: "for cause" and "for convenience."

A "for cause" termination occurs when the contractor has failed to meet obligations such as staffing the job appropriately and paying subcontractors, meeting specific milestones or adhering to a pre-determined schedule or budget.

The expectations of the contractor should be clearly outlined in the contract to minimize the potential for disputes and/ or litigation in the event of a termination.

Terminations "for convenience" allow owners and developers to end the relationship for essentially any reason. Unlike "for cause" terminations, however, "for convenience" terminations typically require owners to pay the contractor the profit they would have earned if the job had been completed. Termination provisions can often be a catalyst for litigation.

Owners should ensure--should they elect to terminate--that they strictly comply with the terms of the contract.

Bonding Against Risk

Developers and

owners can also contractually require contractors to obtain performance and payment bonds to ensure a project's viability.

If the contractor encounters financial distress, for example, payment bonds will ensure that subcontractors are paid, and prevent them from placing liens on the property that could halt funding of the project.

Without such a bond, an owner could be forced to pay twice to keep the project on track--once to a contractor who fails to pay a subcontractor and then again to the subcontractor to satisfy a lien.

A performance bond can guarantee the performance of the contractors' obligations to construct to project.

Of course, such bonds add to the overall cost of the project. Professional developers may have a greater tolerance for risk and making the project as profitable as possible may be the top priority. On the other hand, the managers of a nonprofit educational institution, for example, not in the real estate business, and under significant time pressure to complete a project by a certain date, may sleep better with the extra security.

Preparation is the Best Protection

In the end, even the best-laid plans can go awry--particularly when it comes to real estate development. In the event of a problem caused by a financially distressed contractor, developers must weigh their options and deal with the situation in a way that results in a minimum amount of disruption and cost.

While developers and owners can't predict the future, they can at least prepare for unforeseen events.

Mr. Hill is a member of Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, PC, practicing in the firm's litigation section. He represents clients in trials, arbitrations and mediations on a variety of matters including construction law, commercial and corporate litigation, and real estate law.