Mind the Gap: Start Early to Guarantee Payment to Subcontractors

In construction contracting risk management, the certainty of payment for work put in place by the contractor is a fundamental component for predictable outcomes on any project. At the prime contract level between the GC and project owner (owner), this risk is manageable based on the strength of the contract terms and the verification of financing for the project.

Public entities are restricted by statute from letting work commence until the finances and/or budget is allocated to the project. Accordingly, in public construction, uncertainty of payment is less of a risk. But in privately-owned construction, the GC must seek to verify owner financing of the project and may rely on mechanic’s lien rights on the improvements to the real property as a payment guaranty.

So, what is the guaranty of payment for subcontractors, suppliers, vendors, and labor that may be one or two steps removed from the prime contract? This is an especially important question when the subcontract includes pay-when-paid and/or pay-if-paid clauses. This article covers the certainty of payment and dives into a scenario that explores problems and clauses related to payment.

Payment to Subcontractors

While a subcontractor would also have lien rights on a private construction project, the process and ability to perfect and enforce those rights may result in payment to the subcontractor only after a drawn-out process.

Having perfected lien rights does not immediately force payment, but it does cloud title to the real property. Making that cloud “rain dollars” down to subcontractors is a few legal steps into the future.

In addition, neither GCs nor subcontractors may place a mechanic’s lien on a public construction project. If the GC is required to provide a performance and payment bond to the project owner, whether public or private, then the payment bond provides a guaranty of payment to the subcontractor. This assumes the subcontractor has met the payment requirements under applicable statutes, subcontract terms, and payment bond conditions.

Subcontractors would be well served to review these governing documents with their legal counsel before entering the subcontract. This is especially true of the enforceability of pay-when-paid and pay-if-paid clauses if they are included in the subcontract.

This scenario is relatively simple to map: the owner pays the GC, and the GC pays the subcontractor. However, if the project is large and/or complex, then it is likely that there will be more than one tier of subcontractors engaged in the project. Subcontractors will, in turn, have other subcontractors and vendors that are also concerned with the certainty of payment.

Under normal circumstances, the certainty of payment to the subcontractor can be gauged by understanding the prime contract, the subcontract and subcontract purchase orders, and the performance and payment bonds at the prime contract and subcontract levels. But what happens when a review of these documents reveals a gap in the payment guaranty?

The following scenario is an example of what can happen when payment guaranties are not well thought out and where a professional surety agent and surety can help identify the problem, if not cure it.

What if Payment Guaranties Are Not Well Thought Out?

In this scenario, the GC had a project for a large private owner. The prime contract required a portion of the project to be completed by disadvantaged and/or minority subcontractors. To satisfy this requirement, the GC subcontracted a portion of the project to a construction manager (First-Tier Subcontractor) that held minority status.

The First-Tier Subcontractor, per the GC, was to provide administrative and management services. In turn, the First-Tier Subcontractor subcontracted various scopes of work to trade contractors, one of which was a surety account (Second-Tier Subcontractor). The First-Tier Subcontractor adopted the language of the subcontract it had with the GC word for word, only substituting its own name in place of the GC’s name.

In addition, at the request of the GC, the First-Tier Subcontractor also utilized the subcontract bond forms commonly used by the GC on private construction projects. As a result, these agreements had back-to-back terms. At this point, nothing done by the GC or First-Tier Subcontractor created a payment guaranty problem. It is what the GC did not do that created the gap in payment guaranties.

No Bonds Required

The GC did not require the First-Tier Subcontractor to provide a performance and payment bond. Accordingly, the Second-Tier Subcontractor had no payment guaranty in the form of a payment bond. However, the GC did require the First-Tier Subcontractor to obtain performance and payment bonds from all of its subcontractors. In addition, the GC required that it be named as an additional obligee on all of the bonds between the First-Tier Subcontractor and its subcontractors, including the Second-Tier Subcontractor.

Due to this requirement, as is customary in surety underwriting, the Surety required a multiple obligee rider to accompany the bond, which incorporated the following language:

It is agreed that the Surety shall not be liable under this Bond to the Obligees, or either/any of them, unless the said Obligees, either/any of them, shall make payments to the Principal or Surety strictly in accordance with the terms of said contract as to payments, and shall perform all of the other obligations to be performed under said contract at the time and in the manner therein set forth.

Discussion

This language is commonly known in the surety industry as the savings clause. While the savings clause language may vary slightly among sureties, the outcome of its operation is the same. For the additional obligee on the bond to enjoy the protections provided by the bond, it must agree to adhere to the terms and conditions of the bonded contract. This includes the requirement of payment for the work put in place.

Though the focus in this situation is payment terms, in a subcontract scenario, other clauses such as dispute resolution and unforeseen conditions are of equal importance. On private projects, it is not uncommon for the entity providing financing on the project to be named as an additional obligee on the performance and payment bonds. Financial institutions customarily approve the multiple obligee rider without comment.

It is less common for a GC to require a first-tier subcontractor to name the GC as additional obligee on bonds it requires of the second-tier subcontractor. Normally, the GC relies upon the hold harmless clause in its own subcontract with its first-tier subcontractor and requires a performance and payment bond from the first-tier subcontractor.

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