Mitigating Risk Associated With Using Subcontractors

With subcontract failures on the rise, and construction jobs being won by contractors bidding work with little profit, general contractors are forced to make their bid process more detailed. A general contractor’s ability to prequalify its subcontractors and manage the consequences of their default could mean the difference between success or failure of an entire project. The financial strength and overall dependability of a project’s subcontractors directly impacts the ability of the general contractor to provide a quality project, on time and within budget.

When a general contractor enters into a construction contract with a project owner, it assumes the responsibility of completing the performance of all of the work in a timely manner as well as the risk associated with that responsibility. Typically, a bond is provided to the owner to assure performance and project completion. In many cases, those bonds are required by statute. But, how does a general contractor gain the same assurance from the subcontractor? Through Screen, Monitor and Protect.

Most general contractors have developed practices to screen out unqualified subcontractors, monitor subcontractor performance, and protect against subcontractor failure within their company. Some of the common practices used by general contractors are:

  • Checking with references and select bid lists
  • Monitoring payments to the subcontractors’ vendors through periodic lien releases, joint checks, bills, and paid affidavits
  • Managing the subcontract draw process through careful evaluation of progress percentage of completion, and remaining cost to complete
  • Recognizing and understanding the signs of subcontractor failure such as:
    • Ineffective financial management systems
    • Bank lines of credit constantly borrowed to their limits
    • Poor estimating
    • Poor job cost reporting
    • Poor project management
    • No comprehensive business plan
    • Communication problems

In order to overcome these problems you need to make clear what you think the problems are, state how you want them corrected, and determine what the subcontractor intends to do about them.

Bonding Subcontractors

Another common practice that is increasing in popularity within the Commercial Construction Industry is the use of bonds with subcontractors. Many general contractors simply consider bonding all subcontractors over a certain dollar amount a sensible business policy to mitigate risk. In fact, sureties are also starting to require general contractors to bond major subcontractors as a tool to reduce risk and project default.

Bonds are project and subcontract specific and there are limits specifically dedicated to each bonded subcontractor’s work. Coverage is “first dollar” and does not involve deductibles or co-pays. The subcontract performance bond is typically:

  • Written in an amount equal to 100% of the subcontract amount
  • Provides coverage if the subcontractor should default in its performance.
  • Provides a direct right of action to an unpaid supplier or sub-subcontractor

Sureties issuing the bonds employ professional claims staff who will often take an active role in helping prevent a subcontractor failure, or providing a responsible solution when one occurs. One of the greatest benefits of bonding is that a professional and regulated third party performs a comprehensive underwriting and prequalification process before issuing the bonds.

While the project owner benefits from these features, subcontract bonds are not a substitute for bonds at the general contractor level.

The premium for performance bonds will depend on the nature of the work, length of the project, and the financial strength of the subcontractor. Rates of 1%-2 % are common, with 1 1/2% as a “rule of thumb” rate used by estimators in projecting the costs of subcontract bonds for a project.

In competitive economic environments, the success or failure of a project will depend on the increased due diligence a general contractor performs when selecting subcontractors. Proper due diligence is an important tool to help manage risk, but it is important to note that similar to prime contractors, subcontractors can still pull out of bids that require bid bonds.

Article by Grassi & Co.