Construction Litigation: A Necessary Evil?

Deal volumes in commercial real estate fell 46% worldwide in the first quarter according to industry research firm Real Capital Analytics.[1]  The latest news is that fallout from the sub-prime crisis is beginning to affect the commercial market with banks tightening terms and buyers demanding discounts.

Even in the best economic circumstances it’s easy for contractors and builders to find reasons to sue each other.   In fact many think of litigation as one of the costs of doing business. But as times get tougher projects stall costs rise and markets tighten. Banks contractors and builders are all focusing more closely on the cash looking to salvage as much as possible often as quickly as possible from every project.

In my practice I spend hours sorting through the documents in construction cases. Depending on the matter my goal might be to determine who is getting paid for what whether draw requests are appropriate if delays are documented in change orders if the issues were contemplated in the agreements or whether there have been any inappropriate transactions. This time-consuming work is required to determine the merits of a case and calculate the effects on the various parties.

Decades of tracking through records that range from untidy to chaotic and worse have taught me the steps many clients should have taken much earlier to avoid this moment or at least prepare for it.   These steps are often omitted in the haste to get a project started the pressure to move the process forward or the rush to get the job done. In a tougher market these steps become even more important.

While I may be acting against my best interests in making these suggestions here are the top seven things you should have done last time you began a project. We can’t change the past but you should definitely do these things next time to minimize the need for a forensic investigation into your project.

1.      Choose the right bank. This seems easy doesn’t it? The “right bank” is the one that wants to fund your project on reasonable terms at the best rates isn’t it? But not so fast. If the bank you’ve chosen for great rates isn’t well-capitalized — a growing issue — you could end up struggling if you need unanticipated cash to complete the project.

How can you find out how well your chosen bank is doing? Check on their stats at www.fdic.gov. Under Consumer Resources choose Bank Find. Once you’ve found the bank you’re considering look at Last Financial Information.  There are many reports available from the drop-down in the middle of the page – I like Performance and Condition Ratios. Take a look at things like the Equity Capital to Assets ratio.   As of March 2008 the Equity to Assets ratio of all FDIC insured institutions was 10.18%.[2] If the bank you’re considering is much lower you may wish to shop around.  Use the Industry Statistics tab at the top of the page to see the latest stats for comparison.

2.      Be conservative in your projections to the bank.   Debt is drying up but that’s no excuse to be aggressive in your projections. It may feel good to promise completion in 18 months but the pain when you have to ask for more time (and money) won’t be worth it. When you calculate your return look forward and be conservative. You won’t get the same return 24 months from now that you could get 12 months ago.  The banks know this so terms will be tougher. At the end of the day you’ll look better exceeding expectations rather than failing to deliver.

3.      Choose a general contractor who pre-qualifies his subs. When selecting your G.C. ask to see a list of his pre-qualified subcontractors. An excellent way to delay a job and increase costs is to lose a sub in the middle because he wasn’t qualified to handle the size or type of project. I’ve worked on matters where replacing a sub-contractor more than tripled the plumbing cost. Prequalification can minimize the risk to the G.C. to the bank and to you.

A good prequalification process asks for more than license numbers and maximum project size desired. Evidence of the size and type of projects completed in the recent past plus references should be part of the process.    Many contractors’ forms are posted on the internet; a quick google search will find some samples.   You can use a similar process to pre-qualify your G.C.

4.      Choose a general contractor with low staff turnover. How long has your project manager been with the G.C.? What is their staff turnover rate over the past five years?   You should ask these questions in the prequalification process.

If your project manager has only been there a few months and turnover among other staff is high as well chances are the people you start the project with won’t be there at the end.

Why should you care? Yes it’s annoying to have to bring someone new up to speed in the middle of a project. But even worse if there were issues you resolved with the first project manager you’d hate to have to tackle them again in court when the successor doesn’t agree with the arrangements.

5.      Choose a general contractor with a good job costing system. If you’re like most builders you don’t have time to waste combing through draw requests that lack detail or make no sense. Yet time and time again busy people choose to work with contractors whose expense tracking seems designed to confuse (at best) and mislead (at worst). Often the disarray presented month after month is so difficult to review that payments are made which should have been questioned.

A good job-costing system will break costs down by cost code change order and cost type. It will provide vendor and sub-contractor detail on draw requests. Draw requests will be in a format that matches your agreement. Without good record-keeping you’re likely to wind up needing a forensic investigation into payments you probably should have questioned in the first place.

6.      Have your engineer or your accountant review every draw request in detail every time. With good records this shouldn’t be difficult and it is essential. It costs a lot more to dispute expenses once you’ve paid them than it does to review and question before paying.

7.      Be careful about your agreements.    Work with a good attorney to make sure you’re protected. Try to stick to fixed price or guaranteed maximum price agreements not cost plus. In the current economic environment the cost of everything is rising by the minute.  If at all possible cap your costs up-front so you’re not caught short in the end.   And make sure your agreement with the G.C. matches your agreement with the bank.

What could go wrong?
Imagine you’ve purchased an excellent site for a mixed use project. It has great access plenty of room for parking and substantial pedestrian traffic for the shops and restaurant you plan on the ground floor. You’ve arranged for a zoning change invested $10 million in cash and secured financing for $60 million. Your projections for the bank are based on completion in 24 months and you selected a general contractor you’ve worked with half a dozen times though not in a few years.

If you haven’t taken the seven steps above here’s what could happen.

Your G.C. doesn’t pre-qualify his subs and he chooses a plumbing contractor who hasn’t worked on jobs this big. He’s really not qualified and his deficiencies cause construction delays that ripple through all the other processes. But the G.C. doesn’t have a good job costing system so your engineer has a hard time reconciling the draw requests. Under pressure to finish the job and meet the aggressive projections you made to the bank you pay the draw requests without understanding the real issue the unqualified plumbing sub.   Somewhere around month 16 he goes out of business. A replacement company comes in that ends up costing you twice the original contract. Because of the increased costs and construction delays you need more funding from the bank. But the bank you need more funding from the bank. But the bank reeling from losses in the sub-prime market is too thinly capitalized to meet your needs. And everyone in the picture winds up suing.