Construction Due Diligence: Sooner Is Always Better than Later
The recent economic downturn in real estate development and construction has
significantly and negatively impacted contractors, subcontractors, and material
suppliers. Non-payment of receivables is an ongoing problem even in good times,
but even more so during the current recession and recovery (albeit slow) period.
Having knowledge of one's alternative available legal remedies gives contractors,
subcontractors, and material suppliers a distinct advantage, especially as the
market for local contractors, subcontractors, and material suppliers is growing to
encompass the entire country.
When a contractor, subcontractor, or material supplier "sells" a job, it is selling
three things - "labor, materials, and credit." The sales department job is to sell the
"labor and/or materials," while the credit department's job is to evaluate whether to
extend credit on such sales. These conflicting goals could result in friction between
the sales department and credit department. In fact, it has been said that the
ultimate conflict in life is not between good and evil but rather between sales and
credit. However, if the parties work together towards an acceptable solution
balancing the sale with the extension of credit, ultimately the company will benefit.
This is where the construction due diligence process and understanding the laws
that benefit contractors, subcontractors, and material suppliers is valuable.
The first step in the due diligence process is the determination of the
creditworthiness of the customer. This is performed by the credit department of a
contractor, subcontractor, or material supplier. The review of the creditworthiness
(or so-called "credit due diligence") of a potential customer is not only good practice
but essential in becoming a part of a successful and profitable construction project.
While credit due diligence is an important factor, there is no guarantee that a
particular construction project will be successful or that otherwise having a "good
customer" will result in payment in full. Let's face it, contractors, subcontractors,
and material suppliers sell to and/or work with many qualified contractors and
owners but still find themselves in the middle of a troubled project, whether as a
result of lack of additional financing to complete, a bankruptcy within the tier of
contractors, or some other circumstance.
What can a contractor, subcontractor or material supplier do to help protect
themselves in such situations? An important option to consider is to perform "legal"
due diligence up front at the same time that the credit decision is being made. In
other words, in the event of non-payment by your customer, what rights and legal
remedies may you have in the event of such non-payment above and beyond a
breach of contract action against your customer? Such rights as to third-parties
(other than your customer) are known as "third-party" rights. Such third-party
rights may include mechanics' lien rights against the subject property, lien rights
against undisbursed constructions funds, and/or rights against a surety under a
The availability of such rights varies by state and are based upon the type of project
(i.e., public project or private project) and the nature of the owner (i.e., federal,
state or local agency, or private entity). Also, the determination of where a
contractor is within the tier of overall contractors (i.e., general contractor,
subcontractor, sub-subcontractor, material supplier, etc.) is crucial in making such
determination. As part of the analysis, it is essential to obtain as many facts
related to the project as possible at its beginning (i.e., owner's name, legal
It is important to consider the availability of third-party rights "sooner rather than
later" because depending on the circumstances, in order to preserve one's rights,
affirmative action in the form of a notice and/or filing may be required at the
beginning, during, and/or within a limited period after the completion of the work or
shipment of materials. If any deadlines are missed, the rights are waived.
Knowledge of the availability of third-party rights is extremely beneficial in making
a credit determination about a customer and assessment of a project. To the
extent third-party rights are available, a contractor and/or material supplier may
still decide to perform work and/or sell to an otherwise questionable creditworthy
customer. Other forms of protections to consider are personal and corporate
guaranties, joint check agreements, and a requirement that questionable customers
provide a surety bond for the company's benefit.
Third-party rights are a valuable tool for contractors, subcontractors, and material
suppliers in securing payment on their construction projects; however, without
having performed the appropriate due diligence prior to acceptance of the project
and commencement of the work, these third-party rights may be waived or
relinquished as a result of a contractor, subcontractor or material supplier failing to
take appropriate action to protect such third-party rights. In today's financially
turbulent world, it is more critical than ever to consider the availability of thirdparty rights on a project, if any, sooner rather than later.