An article in Lexology caught my eye Today.  It’s a blog entry from the legal firm of Arthur Cox.  Arthur Cox is a law firm in Ireland that appears to have at least some of it’s practice in construction law.  The blog from Arthur Cox addresses the spectacular failure of Carillion.  You may recall my article on the failure of Carillion and a few other large Construction firms around the world.

Cox’s article talks about how Owners and Contractors can each play a role in preventing insolvency in construction.

I love the fact that Cox mentions due diligence and procurement among their top 4 suggestions.  I’ve written extensively about the value of due diligence and presented alternative delivery methods that relieve parties of risk.

Of course Cox goes on to mention insurances and bonds as a way of protection for an owner, but then they write:

Equally, the option of seeking an advance payment for large orders or significant design work, should be considered by a subcontractor.

While Cox is ONLY suggesting that advance payments be considered for “large orders” or “significant design work”.  My concern with this sentence is that contractors will grab on to this and begin demanding advance payments for all their work.

So Today I want to address the notion of advanced payments in construction.

What is an advanced payment?

Advanced payments occur any time the contractor receives money before goods or services are in place at the Owner’s premises.

In some cases, an owner might make a payment for the cost of materials that are onsite but have not been installed in place.  This is not considered an advanced payment as long as the amount the owner pays is limited ONLY to the cost of materials.  The materials must be at the Owner’s property and must have been purchased strictly for the Owner’s project.

When should I make an advanced payment?

Advanced payments should only be made when there is a specific reason for the payment and the payment can be confirmed.

Above all, be sure the specified reason will realize some benefit or schedule improvement for the project, only then would I recommend it.

Custom Equipment Purchases

If your project requires any kind of custom fabricated equipment, upfront payments or deposits are frequently required.

Equipment fabricators typically require some amount of deposit in order to buy the materials needed to fabricate equipment.  Once fabricated, if an Owner changes their minds or decides not to proceed, the fabricator can be stuck with a custom piece that can be difficult to sell to someone else.  Fabricators protect themselves from this risk by requiring advanced payments.

For this reason, I advise Owners to make all equipment purchases themselves.  This adds additional coordination work for the Owner, but it avoids making advanced payments to the contractor or putting the contractor in a position of financing large purchases.

Long lead items

Long lead items are items that take several weeks to receive.  An item may be long lead if it requires fabrication time (such as custom equipment), or if it is being imported from afar.  In such circumstances the purchase of the item may happen more than 4 weeks before it is delivered.

Such circumstances place a high financial burden on the contractor because vendors typically require payment before the item will be shipped.  This means the contractor must pay for these items in advance and it may be 60 days or more before he has an opportunity to invoice you.  Then add another 30 days for you to issue payment.  This means the contractor may have to shell out thousands of dollars and not be compensated for upwards of 90 days.

Be sure to clearly define which items are long lead items.  Also clearly discuss which long lead items require advanced payments and which ones do not.  Then be sure the contractor submits proof of the order and then you may issue a payment.  This validates that the purchase was made.  It should also show the terms of the purchase which ought to call for up-front payment.

When are advanced payments a bad idea?

I will begin this section by qualifying that some contractors simply don’t have access to financing and will always require advanced payments.  Generally these are smaller contractors working in the residential sector.  Most commercial contractors will have access to financing and are able to operate without the need for advanced payments.

Regardless, no matter how large or small, all contractors need capital to secure materials and labor.  You should bear that in mind and recognize that your payment is always a form of reimbursement.  This means the burden of paying for labor and materials is carried by the contractor well before you see their invoice.

In some cases (where permitted by law), contractors include “pay when paid” clauses in their sub-contracts.  This means sub-contractors have to wait until the prime contractor receives payment from the Owner before being paid.  These clauses have the net effect of transferring the financial burden down to the sub-contractor.  Even if this clause is used on your project, there is always someone in the construction supply chain waiting to be reimbursed for labor and materials.

Bearing that in mind, advanced payments should always be avoided.

The reason Owners should avoid making advanced payments is because it is the only leverage an Owner has.  Most contractors are honest well-meaning individuals who are happy to do good work, but some are not.  If an Owner is unhappy with any part of the work, getting a contractor to come back and make corrections after they have been paid can be difficult.

I have also had the unfortunate experience of dealing first-hand with charlatan contractors.  These thieves take advanced payments from unsuspecting owners without doing the work.  They string the owner along constantly looking to get more up-front money, but they never complete as much work as they were paid for.  They do just enough to make the owner feel that the project is progressing.  Eventually, when the owner gets wise to the scam, the contractor disappears and the owner is stuck with an incomplete project and no way to recover their money.

Paying in arrears only after the work is in place and accepted is the best option.  So, while we should be mindful and understanding that contractors are burdened with paying for labor and materials well before the owner sees an invoice, the risk to the owner is simply too high to make payments in advance.

How are advanced payments different than financing the project?

One of the biggest complaints from contractors is that long payment terms turn them into financiers of a project.  In the case of Carillion their failure can be partially attributed to working under inordinately long payment terms.  Long payment terms  strained the organization so much that they became insolvent.  The reality is that these were business terms Carillion accepted.  Carillion took on far too many projects with such terms.  Eventually the banks refused to lend them any more money.

All businesses require some form of cash flow.  Employee salaries, overhead costs, supplies, and materials all require capital regardless of whether the business has made any money.  That is the risk a business takes.

When a contractor uses capital to pay for materials, equipment, or labor, they are taking the same risks that any other business takes.  A construction contractor’s expenses are no different than a manufacturer that pays for raw materials, machinery, and labor to make a product they hope to sell weeks or months after production.  These are the costs of running a business.

So while I remain sensitive to the contractor’s need to recover their costs, I am far more sensitive to the owner.

Closing

I expect that contractors and those who sympathize with them will be shouting about Carillion for many weeks and months to come.  Carillion is an example of what happens when a contractor overextends itself and takes on far more than it’s able to handle.  However, those are business decisions that are made every day.  I don’t agree that elevating the risk of property owners by requiring advanced payments is a proper response.

What about you?  Have you ever allowed advanced payments on one of your projects?  If so, did you know what the payment was for?  Did you have any trouble ensuring performance?  Tell me your stories.

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