It has been a tumultuous year for the banking industry. Since the beginning of this year the industry has seen the collapse of Silicon Valley Bank and Signature Bank, the shotgun marriage between failing Credit Suisse and USB, and, most recently, the collapse of First Republic Bank this past week and its purchase by JP Morgan Chase. Indeed, according to the New York Times, these three bank failures cum bailouts alone were bigger than the 25 banks that collapsed during the financial crises of 2008 and some are concerned that it is just the beginning.
This, of course, has impacted the stock market, with Forbes reporting that the banking industry lost more than $300 billion in market value as of the end of March. However, it also raises concerns regarding liquidity on construction projects.
While the failing banks have either been bought out by other banks or shored up by the federal government, which, in the case of Silicon Valley Bank and Signature Bank, involved the Federal Deposit Insurance Corporation (FDIC), the Treasury Department and the Federal Reserve stepping into to protect depositors by guaranteeing deposits in excess of the current FDIC limit of $250,000, there continues to be concerns over access to cash. This can impact construction projects in several ways.
First, and most obviously, it could impact cash flow to downstream contractors, material suppliers and equipment lessors due to delays in accessing cash or, if there is a bank failure and the FDIC, Treasury Department and Federal Reserve don’t step in as they did a la Silicon Valley Bank and Signature Bank, there might not be access to sufficient cash at all.
Less obviously, it could result in more foreclosures if owners find themselves without sufficient cash. Although only interest is typically due on construction loans through completion of a project, at which time many owners will refinance the loan into a traditional loan, for larger construction loans even interest payments could become difficult. And, finally, stricter lending by banks who want to preserve their cash reserves, together with rising interest rates, could impact construction projects that have yet to break ground.
So, what can contractors, material suppliers and equipment lessors do to protect themselves? Here are some suggestions, some obvious, some less so:
- Increase Your Cash Reserves: Paying your downstream contractors, material suppliers and equipment lessors may be less important than paying your employees and keeping the lights on, but you need adequate cash reserves to do so, particularly if you don’t have money coming in.
- Know Who You Are Dealing With: Dealing with clients you know, and knowing whether your clients are getting the money to you from elsewhere, whether it is a bank or a higher-tiered party, can help you to navigate no to slow payment.
- Protect Your Statutory Payment Remedies: If you’re a subcontractor, material supplier, or equipment lessor, or if you are a prime contractor on a lender-financed project, make sure you serve a preliminary notice. A preliminary notice is required for these parties as a condition of recording a mechanics lien, serving a stop payment notice, or, in some cases, making a payment bond claim. Also, if you are a design professional (e.g., licensed architect, registered engineer, or licensed land surveyor), while a preliminary notice is not required, make sure to record a design professional lien if you satisfy the requirements.
- Review the Payment Provisions in Your Contract: California does not permit “pay if paid” provisions in construction contracts although it does permit “pay when paid” provisions. The difference between the two is that a “pay if paid” provision conditions payment to a lower tiered party on payment being made by a higher tiered party. In other words, a “pay if paid” provision in a subcontract between a general contractor and subcontractor might read that the general contractor will pay the subcontractor for its work but only “if” the general contractor is paid by the project owner. “Pay if paid” provisions are illegal in California. On the other hand, a “pay when paid” provision provides that a lower tiered party will be paid “when” the party with the payment obligation is paid by a higher tiered party, although it must be within a reasonable time. “Pay when paid” provisions are legal in California. However, some general contractors have tried to push this to the limit by defining “reasonable time” as the time it takes the general contractor to adjudicate a claim to final conclusion, which could take years if you include appeals. In 2020, a California court said that such provisions are not “reasonable,” although neither that court nor any other court has to date set a bright light standard as to what time period below that would be considered reasonable. Finally, it’s important to know not only what the payment provisions are in your contract, so that you can enforce them, but to know what your remedies are in the event that those payment provisions are not complied with.
- Security on Large Construction Projects: A lesser known remedy available to prime contractors is the security on large construction projects statute found at Civil Code sections 8700 et seq. Under this statute, a project owner can be required to provide either a payment bond, an irrevocable letter of credit, or place funds into an escrow account to ensure that money is available to pay for work performed on a construction project. There are, however, several important limitations. The remedy is only available on construction projects with a value greater than $1 million or in some cases $5 million, does not apply to single-family construction projects or housing developments subject to a density bonus, and does not apply to project owners who are publicly traded companies or private companies with a net worth in excess of $50 million. The statute also provides that if the project owner fails to provide security when required that the contractor can suspend work until such security is provided. This would, in my opinion, apply even if there is a “work despite dispute” provision in your construction contract.