Protect Yourself From Subcontractor Default




You are excited about your new project. You had to bid aggressively to get it, the margin is not what you would like, but you need the business. Ten months later, one of your major subcontractors suddenly announces they cannot finish the job and five of their vendors have not been paid. Your project is falling behind schedule by the day, you are getting notices from the owner about liquidated damages and you are having a tough time finding a new subcontractor.

In today’s economic conditions, you cannot always avoid this scenario. You can, however, reduce the chance of being the victim of today’s crisis in subcontracting and you can reduce your exposure if you do lose one of your major subcontractors.

Contractors are facing a tough environment. Labor and material costs have risen and the cost of running a business keeps increasing. More general contractors and subcontractors are competing for public projects. Contractors are underbidding jobs to keep their doors open and undercapitalized contractors face a tough credit environment.

While there is always a risk that one of your subcontractors will go out of business, today’s contracting environment demands that you take more care in selecting your subcontractors.

It is always tempting to use a new subcontractor who will do the work for less. While that low bid helps you compete, someone in your organization should be considering whether that subcontractor is actually going to be able to perform. Otherwise, you can end up with a weak link that will put your entire project into the red.

In tough economic times, relationships you have built over the years with stable subcontractors are more important than ever. You may have to pay a little more to work with someone you know but that may be the right call.

Even an established company can face problems when there are changes in ownership or management. Solid companies can stumble when the old man is gone and the next generation of management is not ready.

Checking Credit and References

If you are considering working with someone new, do not take their word that they have successfully performed similar work.

Subcontractors who have worked on residential and commercial projects cannot always make the transition to public projects. They may be used to performing work to different standards and do not always appreciate that public owners are not as flexible when it comes to alternates and quality. Checking references takes time, but if you are not talking to people who have recently used that same subcontractor on a similar public project, you are not doing your job.

Due diligence in today’s environment also means checking up on the financial performance of the company. Do not enter into a $500,000 contract with a subcontractor without spending a few bucks on a credit report. A credit check should not only be part of your initial investigation, consider updating your credit checks during the project. Knowing that a subcontractor is having trouble paying bills on another job can provide you with a critical early warning and a more complete picture of the resources of the individuals you are dealing with.

When you take on a public job, you are also paying for a performance and payment bond that protects the public if you fail to complete the job or fail to pay your subcontractors. 

Because your subcontractors do not need to be bonded, you do not have the same protection. Most jobs do not justify obtaining subcontractor bonds but that does not mean that you cannot ask whether the subcontractor is bondable. Find out how large a job they can be bonded on — it will tell you something about the financial strength of the subcontractor.

Your surety may insist on a personal indemnity from you just as your bank may insist that you personally guarantee your line of credit. While no subcontractor wants to have any personal responsibility if a job goes south, you are not asking them to do anything more than you are being asked to do. If you are contemplating using a new subcontractor, one option is a personal guarantee limited to a portion (10 percent to 15 percent) of the contract amount.

Warning Signs

Even after you have complete due diligence and put together a good team, your job is not finished. You have to keep an eye out for a subcontractor in trouble — the sooner you discover you have a problem, the sooner you can solve it.

One clear warning sign is when the subcontractor cannot supply enough skilled personnel to meet your schedule.

Skilled workers command competitive pay and steer clear of uncertainty. They know when a company is in trouble. Another warning sign is turnover in superintendents and foremen.

If there are unexplained delays in delivery of key components, you may be dealing with a subcontractor that does not have enough working capital to pay for materials in advance.

Subcontractors in trouble often have to choose which resources to devote to which jobs. If you let a problem slide week after week, your project will be the one left in default. You need to take action to ensure your project is their priority.

A troubled subcontractor will often promise anything to avoid grave consequences. If you demand that a subcontractor take actions that are beyond their capability, you will not accomplish anything. Instead, reach a realistic agreement based on what the subcontractor can accomplish, document that plan and have the subcontractor sign off on it.

If the subcontractor promises you will have a crew of 12 workers, put that promise in writing and get it signed. If they do not perform, do not wait a week to follow-up.

end them the message that you are willing to work with them but only if they put your job on the front burner.

A subcontractor with financial problems looks for jobs that can put immediate cash in their hands. If you are not paying careful attention to conditional and unconditional releases, your project could be that job.

Be on the lookout for anomalies in releases, such as dates and amounts that are inconsistent. Confirm that materials are actually being delivered to your job. Do not be afraid to call suppliers directly. Avoid being the victim of a forged release or a forged endorsement on a joint check.

Deciding Whether to Terminate

Even if you have solid grounds to terminate a subcontractor, that is not always your best option. The disruption and extra costs associated with changing subcontractors in the middle of a job can be significant. Your best alternative may be to nurse the subcontractor along until the job is completed.

Just because a subcontractor does not have the financial resources does not mean that their personnel cannot finish the job. Agreeing to front some of the subcontractor’s financial obligations — while still preserving your rights — can be cheaper than termination and replacement.

Before you decide, take the time to determine which alternative is most likely to result in timely completion of your job at the lowest cost. If you terminate immediately, you take one option off the table. If you delay making a decision, you end up muddling along until the situation becomes critical. The best approach is to weigh the alternatives and make an informed decision early on.

You cannot make a decision on whether to replace a subcontractor until you know what it is going to cost to bring in someone new. You will have to make concessions to make the job attractive to the replacement subcontractor, which can include indemnifying the new subcontractor for anything that has occurred on the project.

Before you decide on a new subcontractor, make sure you are both on the same page with the schedule, scope of work and pricing. If you can, pin down those details before deciding whether to terminate your existing subcontractor.

In deciding which alternative is best for you, assume that you cannot count on collecting one dime in damages from any subcontractor you terminate. While you may see some money down the road, your decision should be based on what is the best immediate alternative regardless of any future recovery.

The value of most construction companies is their ability to secure work and make money on their projects. Few have substantial assets. When they go under, they tend to leave a trail of unpaid employees, past-due union trust fund contributions and IRS liens.

Protect Yourself

Termination has significant consequences for a subcontractor. If you need to terminate for cause, follow your contractual requirements to the letter. There should be a clear record of written communications from you that document the problems. All notices required for a termination for cause must be communicated on a timely basis.

If you put a subcontractor out of business without adequate justification or proper notice, you can find yourself on the wrong end of a lawsuit.

A subcontract is only as good as the subcontractor behind it. Take the time to ensure every subcontractor on your team is up to the task. If you end up with a problem, move quickly to determine whether working with that subcontractor is better than replacing them. The success of your project depends on your ability to spot and solve subcontractor problems.

Michael Lateef, J.D., Wallace Smith, J.D., are partners at California-based law firm Carroll Burdick & McDonough, specializing in intellectual property rights protection, business development and restructuring, and construction litigation:;