Think Risk

By William J. Ferguson | Sep 15, 2007




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Even under optimal circumstances, it is difficult to control risk in the construction industry. Owners have certain advantages because they control the purse strings and often can obtain performance security in the form of surety bonds, letters of credit, guarantees or other protections. General contractors have fewer advantages since they must properly perform their work to get paid, yet they often rely on the performance of subcontractors to complete substantial portions of their work. Subcontractors, including electrical contractors, are in a more precarious position than owners or general contractors.

Subcontractors can do everything in their power to perform their work efficiently and per their contracts, however, one misstep by another subcontractor, the general contractor or the owner can spell disaster for a project. Being at the bottom of the payment totem pole, subcontractors usually end up waiting for an owner to pay the general contractor who, hopefully, will pay the subcontractors.

A dispute between an owner and general contractor can cause problems even if a subcontractor’s work is not an issue. Schedule delays and other kinds of project impacts can increase a subcontractor’s cost and time of contract performance, making it difficult to recoup all damages short of litigation. A bankruptcy by an owner, general contractor or another subcontractor can complicate things even further, as creditors line up and battle over assets while the debtor avails itself of the special protections afforded under the bankruptcy code.

Controlling one’s own destiny under these circumstances is almost impossible. Nevertheless, there are certain things an electrical contractor can do to reduce project risk and maximize its chances of getting paid in full. At the outset, a contractor must decide in what form to conduct its business. There are several basic choices, including a sole proprietorship, general partnership, business corporation, Subchapter S corporation and limited liability company. The greatest risk with respect to personal liability is with sole proprietorships and general partnerships. Personal liability in such cases is limited only by protections that may be negotiated in individual contracts. For this reason, most contractors form corporations or conduct their businesses as limited liability companies.

There are, of course, various tax considerations with respect to the form of business chosen. Proprietorships, general partnerships, S corporations and limited liability companies are not taxed at the entity level, whereas traditional business corporations are taxed at the entity level and then receive separate tax treatment at the personal level for related salaries and distributed gains or losses.

Take cover

Electrical contractors should have adequate insurance to manage their risks. When setting up an insurance program, make sure you have comprehensive general liability insurance, automobile insurance and, ideally, an umbrella policy to cover your potential business exposures. For your employees, you will need workers’ compensation insurance. You may also wish to have a policy to insure against loss, damage or theft to tools and equipment; an installation floater policy to cover stored equipment on or off a site; and, depending on your role on the project, a builder’s risk insurance policy. If you plan to do design/build work for which you are required to maintain a professional license, you may also need professional liability insurance.

There are many other forms of insurance available, including director and officer insurance and fidelity insurance (e.g., employee dishonesty, etc.). If you ever are required to indemnify and hold another party harmless for personal injury or property damage arising out of the work performed under your contract, you will want to obtain a contractual liability endorsement to your general liability policy. Finally, owner-controlled and contractor-controlled insurance programs help manage project risk.

Often referred to as “wrap-up” insurance, such programs may offer insurance cost savings, broader coverage, higher limits, better claims management, and more effective safety and loss control on a project. These also generally reduce subrogation actions, including cross-claims and litigation between project participants. Be wary, however, of the deductibles under such wrap-up programs, as they can be higher than your traditional insurance, meaning the first layer of exposure will be borne by the responsible party or parties.

Another risk-management tool is the critical path method (CPM) schedule. In today’s world, CPM scheduling is an essential tool of project management. Among other things, it is a necessary tool for proving many construction claims. A resource-loaded CPM schedule shows the complicated relationship between tasks, time, manpower, equipment, material delivery, weather and other inputs. Electrical contractors should try to plan and schedule their work carefully using, where possible, CPM methodology. Try to work with the prime contractor or construction manager to develop a realistic and efficient plan for the project. It is important for general contractors and construction managers to allow subcontractors to provide input into the overall project schedule. Active subcontractor participation in CPM scheduling is almost always useful because it reduces error and surprise, obtains buy-in from the project participants, and fosters a team approach with specific accountability.

Before you sign

Perhaps the best opportunity to reduce risk, maximize reward and protect your business is at the contracting stage. Develop solid strategies for contract negotiation, drafting and administration. There are some basic rules to follow when negotiating and drafting a contract. First, know the party you are dealing with (i.e., conduct due diligence). Avoid ambiguity in the contract as ambiguities lead to misunderstandings and, all too often, disputes. Make sure your payment terms are precise. Use the contract to protect your rights and to limit your risk. Carefully scrutinize proposed language regarding the contract schedule. For example, if time is of the essence, realize that such language has special legal meaning in many jurisdictions and can increase your liability if you are responsible for project delays. Plan for changes since few construction projects are built today without changes being implemented. The method of dispute resolution also should be addressed in your contract. Decide whether you prefer to arbitrate or litigate a dispute. There are advantages and disadvantages to both. Avoid waiving mechanic’s lien rights unless you are offered adequate substitute security (e.g., payment bond, letter of credit or third-party guarantee). Many state statutes render void and unenforceable contract provisions that require a contractor to waive its mechanic’s lien rights in the absence of receiving payment for the work performed. Nevertheless, the law varies considerably from jurisdiction to jurisdiction, and you must be cautious in this area.

Contract clauses to focus on when negotiating a construction contract include contract guarantees (performance, schedule, output, quality, etc.), warrantees, waivers of consequential damage, limits of liability, liquidated damages, suspension and termination of work, notice provisions, payment and performance security, changes, claims, choice of law, dispute resolution, indemnification, and insurance. This list is not all-encompassing, however, such provisions significantly affect a contractor’s risk profile.

In addition to negotiating the terms and conditions of your contract before undertaking a project, investigate the project’s structure, and know the participants. The location of a project can affect your economic model and, in some situations, can give rise to political risks and other factors that must be considered. For international contracts, analyze the tax consequences, including how to structure the performance of your work “on shore” and “off shore” in order to maximize your tax benefits. Know how the project is financed, including who the lenders are and whether there are mortgages and security interests that encumber the project assets, which may take priority over later filed mechanic’s liens. If so, before executing a contract, consider whether you need other forms of payment protection.

It is important to know who the legal entities are on a project. Are they subsidiaries rather than parent companies? Are they project-specific entities with limited available assets? To the extent possible, know the subcontractors and vendors that will be involved in the project, and determine their performance capabilities, since their actions can have a direct impact on your performance. Finally, know the local laws and customs, including licensing, registration and labor laws applicable to the location where the work will be performed. If you are performing work outside your traditional area, it is important to understand these laws, as they can be legal minefields for the unwary.

During contract performance, administer your contract in a proactive way to reduce risk and protect your rights. Give timely written notice of events that impact your cost and/or time of contract performance. Make sure you follow the contract procedures carefully, as a failure to follow the procedures in some cases will limit or preclude your right to obtain relief. Document changes to the work as required by the contract, and before agreeing to proceed with changed work, make sure there is a clear written understanding consistent with the contract as to how and when you will be paid for such work. As disputes arise, follow the claims provisions in your contract carefully. Address disputes promptly, as disputes do not get better with time. You should know the law applicable to your contract and exhaust the contractual administrative remedies set forth before proceeding with legal action. Many contracts require that the parties enter into good faith negotiations as a condition to undertaking legal action. Other contracts contemplate mediation (an informal process of resolving disputes using third-party neutrals as facilitators) before commencing litigation or arbitration.

An electrical contractor who follows these basic rules and remains diligent from the start of a project to its finish will be in a better position to complete its work on a timely basis and be paid in full for its services. If that happens, with any luck, the electrical contractor also will earn the respect of the other project participants and put itself in an enviable position to obtain future work.  EC

FERGUSON is a partner in the Boston law office of McCarter & English, LLP. He is a former electrical contractor with a national practice in construction law. Contact him at [email protected] or 617.449.6561.





About The Author

William J. Ferguson is a partner in the Boston law office of McCarter & English, LLP. He is a former electrical contractor with a national practice in construction law. Contact him at [email protected] or 617.449.6561.





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