Written by Ali Salamirad, Partner at SMTD Law LLP
It is still too early to know how many banks will suffer the same, or similar, fate as SVB. It seems certain, however, that commercial real estate and construction lending from smaller regional lenders will tighten. As a result, an owner’s access to capital to timely pay for progress will become an even greater factor for contractors and sureties to consider when analyzing project risk.
My previous post discussed some of the “ripple effects” that the construction industry may encounter. One of those was the potentially catastrophic situation that general contractors may face if their owners cannot pay for work in place and they nonetheless have an obligation to pay their downstream subcontractors and suppliers.
In California, like many other jurisdictions, this is exacerbated by the prohibition on “pay-if-paid” clauses that contractors rely on to limit their financial exposure in the event of owner insolvency. As it stands, California contractors (and their sureties) cannot rely on the owner’s lack of payment as a defense to their obligation to pay others. You can see how this can be catastrophic.
Fortunately for those in California, there is a powerful “hedge” to play, which not many owners, contractors or their sureties are familiar with.
After the California Supreme Court held that “pay-if-paid” provisions were unenforceable in Wm. R. Clarke Corp. v. Safeco Ins. Co. (1997), the contractor lobby got to work and convinced the Legislature to enact a new set of laws titled, “SECURITY FOR LARGE PROJECTS.” (Civ. Code §§ 8700–8730 [formerly Civ. Code § 3110.5].) The law requires an owner of property who contracts for a private work of improvement in an amount exceeding $5 million (if the owner’s interest is a fee simple absolute or the lessee has an initial lease term of “at least 35 years”) or an amount exceeding $1 million (if the owner’s interest is less than a fee simple absolute) to provide one of three specified forms of security for the project to be used only when the owner defaults on its obligation to pay its general contractor. (Civ. Code §§ 8700, 8710).
The owner may satisfy its obligation by providing either a payment bond from an admitted surety, an irrevocable letter of credit (ILOC) or an escrow account for the benefit of the contractor (“Security”). The Security must be no less than 25 percent of the contract amount for projects with construction schedules under six months, and 15 percent for all other projects. For contracts without a fixed price, the “contract amount” is the Guaranteed Maximum Price (“GMP”) or the best estimate of that amount (against which the 25% and 15% factors are applied to determine the amount of required Security). The law is intended to provide the general contractor with access to funds to pay subcontractors upon the owner’s default. This is the exact “ripple effect” we want you to protect yourself against in the coming months.
You may ask, “why is the amount of the bond only a small percentage of the contract value?” The answer lies in the intended purpose of the statute. The percentages are intended to protect a general contractor from liability for work in place that has not been paid for by the owner – not the project financing altogether. Indeed, upon an owner’s failure to pay/default, a prudent contractor that has properly billed its client for work as it progresses up to that time should not have a receivable that exceeds the bond amount.
The law provides contractors with a powerful remedy to enforce the Security requirement – the right to suspend work if the Security is not in place within 10 days of the demand:
“If an owner fails to provide or maintain security required by this chapter, the direct contractor may give the owner notice demanding security. If the owner does not provide or maintain the security within 10 days after notice demanding security is given, the direct contractor may suspend work until the owner provides or maintains the security.” (Civ. Code § 8712.)
The statute, however, does not include any other penalty for the owner’s non-compliance. Thus, to trigger the statute, a contractor must make a demand for Security. This is likely why very few people are aware or and/or utilize this powerful hedge.
Finally, the Security requirement does not apply to single-family residences, public works projects, housing developments eligible for a density bonus. The scope of these exceptions and those relating to the whether an owner is “exempt,” has not been tested by any courts that I am aware of. If the market begins to utilize this law more frequently, we can expect courts to weigh in on the scope of this law.
For now, just know that the SECURITY FOR LARGE PROJECTS law is an important one to familiarize yourself with, and potentially use, to hedge your exposure to bank failure and owner defaults.
If you have any specific questions about this law, or any other issue relating to the construction industry and the expected “ripple effects” of regional bank failures, send me an email or give me a call.
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