Construction payment structure and risk simplified
Wednesday, January 07, 2015
Construction projects have an interesting and unique payment structure. The credit-heavy nature and the routine, but unfortunate, lack of visibility throughout a project make payment issues of paramount importance for parties at both the top and the bottom of the payment chain.
Construction payment structure-associated difficulties
Historically, participants in the construction industry have had a remarkably challenging time getting paid (for those at the bottom of the payment chain), or properly controlling payments (for those at the top). And, because the construction industry is a credit-heavy market, it is easy to see why.
Instead of requiring payment prior to delivering materials or performing work, almost all materials and labor are furnished on credit. This is true from the general contractor all the way down the payment chain, even when the value of the labor or materials furnished is quite substantial.
This credit-based payment scheme extends throughout the payment chain on virtually every project, and most companies both extend credit and need a line of credit of their own. For many parties (in many situations), payment of their own bills must wait until payment is received from those higher in the contracting chain.
Since parties must sometimes wait for payment from the top of the chain (after already performing work or furnishing materials on credit), the general structure of financial risk on a construction project increases in proportion to the distance from the top-of-the-chain.
There are many places for money to slip through the cracks and reasons why payment gets delayed. Because of the interconnectedness of the payment chain, any little inconvenience, delay or dispute about any component of the work can impact payment for everyone on the project. These payment hiccups can cause problems for parties whether or not they were directly involved in the situation or mishap at issue.
Further, this payment environment can force companies to make choices regarding which invoices to pay on time. Companies that are forced to wait for payment from parties higher on the payment chain may not have enough ready cash to float the invoices received from parties below.
Risk of nonpayment or other financial risk
The higher up on the contracting chain that parties can be found, the more leverage the party can exert over the payment process. This is because the parties higher on the chain are closer to the money, and when money passes through fewer hands it has fewer chances to become stuck.
The top-of-chain parties are not without their own financial risks and difficulties, however. Chief among these difficulties is the problem of visibility on the project, and the associated risk of liens from unknown parties who are far removed from the parties with the money. After all, a GC can't make sure a supplier is paid if the GC has no idea who that particular supplier is, or that he or she was even on the project.
This type of worry led to the development of many contractual risk-shifting mechanisms that were designed to allocate the majority of the financial risk burden onto the lower-tiered parties. Among the most well known of these risk-shifting clauses are the pay-if-paid and pay-when-paid clauses that seem nearly ubiquitous in payment contracts.
Pay-if-paid and pay-when-paid clauses are so well known and expected by construction industry companies, it can be hard to see how odd that practice is. In fact, however, courts view the risk-shifting purpose of this type of clause with disfavor, and they have routinely disallowed or mitigated the effects of clauses of this type.
General public policy of the United States has long been — and continues to be — that the heaviest weight of the financial risk on construction projects should be borne by the parties closest to the money. To bolster that position, every state has provided statutory instruments that provide protection to lower-tiered parties — mechanics liens.
Mechanics liens are statutory security interests in the actual improved property, and they are given to nearly every party on a construction project. However, to protect the property owner and other parties near the top of the contracting chain, these security interests are only given when certain specific requirements are met.
These specific requirements include required notices and time deadlines by which these notices (and the lien itself) must be sent or filed. When these requirements have been complied with, however, the general allocation of risk is a mirror-image of that presented above — with the parties at the top of the chain shouldering the heaviest financial risk.
Since nobody is comfortable bearing the financial risk burden, the top-of-chain parties have begun to use other means to manage and chip away at the risk of mechanics liens on their projects. Lien waivers are routinely requested in consideration for payment, no matter what rung the paying party inhabits.
These lien waivers generally purport to work all the way down the payment chain in order to insulate the paying party from the threat of liens from parties below. These waivers, when not included in a contract preemptively and requested in exchange for actual payment, serve an important purpose in managing the flow of funds on construction projects.
The construction payment process, while complex, convoluted and messy, can be made fair and manageable by the use of technology designed for that purpose. Construction technology platforms can provide visibility for the top of the chain and protection for the bottom of the chain. They can also enable the exchange of legally sufficient lien waivers in exchange for actual payment — and ensure a fair process that leaves each party satisfied.
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