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Signs of Financial Distress in Sectors of Construction Market
Monday, April 8, 2024

Financial distress affects a range of parties, from project owners to general contractors to trade contractors. Currently, we are seeing increased signs of financial distress in certain sectors of the construction market, especially in the Chicagoland area. This distress seems to reflect a combination of factors, but appears to be particularly focused on two issues: 1) the relatively high interest rates and 2) a slow down in work in certain market sectors.

I. Financial Distress Signals

Often, before an entity fails entirely, there are signs that the entity is in distress. Below we touch upon signs indicating that different construction-related entities may be in distress – red or yellow flags that should cause concern or at least create heightened awareness. These signs become increasingly concerning, of course, when there are more than one sign appearing on a project.

A. Signs That a Project Owner Could Be in Distress

Owners and developers of projects, or even government entities, can lose funding or have unanticipated problems arise on a project that the owner neither contemplated nor included in a contingency in its budget. These problems can sometimes have compounding affects on the project. Signs of such distress can include:

  • Headlines in the media: Obviously, if the media is reporting a loss of funding or other signs of distress, this is not positive for the project. Similarly, if you hear rumors or reports in the industry, you may want to follow up to obtain additional information.  
  • Failures to make payments due: It is one thing if there is a dispute that arises during a project and, as a result, a payment is not made. However, it is a much bigger sign of distress if an owner fails to make a payment that is otherwise uncontested. 
  • Sudden slowdowns in payments: If the owner has been regularly meeting its payment obligations but suddenly materially changes its payment pattern, this could be a sign of problems. 
  • Suddenly unresponsive personnel: If the owner’s team becomes slow to respond or suddenly becomes unresponsive, this is not a positive sign. 
  • Significant turnover in personnel: If the owner’s personnel suddenly start leaving and, in particular, if senior officers, such as the CFO, leave, such turnover is not a good sign. High-level personnel often know of issues before others.

B. Contractors and Trade Contractors

When general contractors, trade contractors or suppliers are in financial distress, the signs are often similar to owners. Additional signs of trouble include:

  • Labor disruptions: If, suddenly, a contractor’s labor force is not showing up to the jobsite, and it is not the result of some other dispute on the project, this is a bad sign. A major red flag is if onsite labor is not paid by a contractor. It is also a bad sign if a trade contractor’s crew size decreases in unanticipated ways. 
  • Unplanned removal of equipment: If a trade contractor starts removing its equipment for unexplained or unplanned reasons, this should be a cause for concern. 
  • Sudden decrease in the quality of work: If a trade contractor’s work suddenly declines in quality for unexplained reasons, this could be a sign of distress. Similarly, a stoppage in deliveries can signify the contractor is not paying its suppliers or that the contractor is only paying essential suppliers.
  • Liens: A major concern is if lower-tier subcontractors or suppliers start to record liens due to non-payment. One lien or a related lien involving a dispute between two parties may not be a concern, but when there are unrelated or multiple liens recorded, this is a bad sign. 
  • Union notification or warnings: In union markets, labor is compensated in two ways: (a) the wages paid directly to employees and (b) the benefit contribution (pension, health insurance, etc.) paid by the employer to multi-employer union funds. Distressed contractors often treat the union funds as “lenders of last resort.” If the union funds are not paid by an employer, the fund has a legal obligation to pursue payment, including by liening the project. Warnings of unpaid benefit contributions are never a good sign. It is worth noting that most unions will notify a general contractor regarding whether or not a trade contractor, for example, has made its required payments. 
  • Account debtor default letters: In many instances, lenders providing lines of credit to a contractor are secured by the contractor’s receivables. When a borrower defaults on its loans, such lenders can issue letters demanding that all receivables be paid directly to the lender. Such letters, also sometimes referred to as “UCC Account Debtor Letters,” are usually a sign that a business is in significant financial trouble.

II. Things to Think About When You are Dealing with an Entity in Distress

If you see signs that a party with whom you are working is possibly in financial distress, besides contacting able legal counsel, there are steps you can take to put yourself in the best position to minimize the financial harm that could impact your business. Below we summarize certain key consideration a business can take to protect itself. 

A. Considerations When the Owner or Developer Is in Distress

  • Understand contractual right to stop working: If an owner is not paying its general contractor (or a trade contractor is not being paid because its general contractor was not paid by the owner), it is critical that the contractor understand when it has the right to stop working. Likewise, a contractor must understand the business implications of continuing to work when it is not getting paid. We note that these considerations can vary depending upon whether disputes exist or not on a project as well as the language in the underlying contracts. 
  • Understand the consent and assignment agreement: On most private projects, a general contractor negotiates and signs a consent and assignment agreement at the beginning of a project that gives the owner’s lender the right to take an assignment of the construction contract if the owner defaults under the loan documents. When the owner is in financial distress such agreements become critical. Keep in mind that these documents often require that the general contractor notify the lender in writing of an owner default. This notification is critical in order to protect the contractor’s interests 
  • Understand downstream payment obligation: Any contractor that has not been paid needs to carefully understand its own payment obligations. Pay if paid clauses become critical in such scenarios, but even if such provisions are in the subcontract, they may not trump certain legal protections. 
  • Understand lien rights and consequences of recording lien: There are both legal deadlines to record mechanics liens on a project and business consequences to recording a lien. It is important that a contractor, at any level, understand both the legal and business issues involved. 
  • Be ready for bankruptcy: On development projects it is somewhat rare for a single purpose entity that likely holds title to a piece of property to file bankruptcy, but it is not impossible. 

B. Considerations When a General Contractor or Trade Contractor is in Distress

  • Understand right to terminate and when to terminate: If a general contractor is not performing, try to understand why, but ultimately if the general contractor is not performing, termination may be the only options. The construction contract  governs whether the general contractor (or trade contractor) can be terminated and, if so, what requirements must be met before termination. Additionally, tactically there may be value in terminating before the general contractor (or trade contractor) files for bankruptcy, because once a party files for bankruptcy, whether you can terminate the construction contract will require authorization from the court. 
  • Understand right to supplement: If the general contractor or trade contractor suddenly is not keeping up with your schedule or is not able to obtain certain equipment or materials it owes, the owner or general contractor may need to supplement the problematic trade contractor. Again, the rights surrounding such supplementation are governed by the contract in place. 
  • Understand right to direct pay: Joint payment or direct payments to those below a distressed general contractor (or trade contractor) are important. The right to make such payments can help keep the job going. Again, this right is governed by the contract between the parties.
  • Consider notice and claims to bonds or SDI carrier: Most experienced general contractors have risk management protections in place to protect against a trade contractor failing. The most common form of protection are trade contractor bonds or subcontractor default insurance. If a trade contractor is in distress, such bonds or insurance offer significant protection. It is important to timely provide notice to the surety or insurer and to take the steps necessary to preserve the claim.
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