How to Protect Yourself Legally on Problem Construction Projects: Handling Failed Subcontractors

Welcome to another episode in our series for general contractors! Marty Frenkel and Corinne Rockoff discuss a crucial topic: dealing with failed subcontractors. They explore the signs of subcontractor failure, how to differentiate between typical delays and more troubling issues, and the proactive steps general contractors can take to protect themselves and their projects.

• What constitutes a failed subcontractor?
• Early warning signs and how to handle them.
• Best practices for providing effective contract notice
• Ways to minimize risk and manage subcontractor defaults
• The financial risks that fall on the general contractor and the importance of knowing and leveraging your subcontract to maintain project stability.

Being a general contractor isn’t easy—you’re balancing obligations to the owner on one side and subcontractors on the other. Let us help you navigate this challenging space with insights on managing operational risks effectively.

Transcript

Marty Frenkel: Hello, my name is Marty Frenkel at Madden Hauser. With me again is my partner Corinne Rockoff. And as part of our continuing series aimed at general contractors and how to assist them in handling operational issues. Today we’re going to deal with the subject of addressing. Failed subcontractors.

Corinne Rockoff: So let’s start out by talking through what exactly do we mean by failed subcontractor?

Corinne Rockoff: It seems like there are a lot of ways that a subcontractor can fail, so tell me what you mean.

Marty Frenkel: Sure. Well, a subcontractor can fail, as you’ve already noted in numerous ways. One, they can simply abandon the job, they can walk off the job, and we never see them again. They can. They can absolutely breach a contract by delivering the wrong materials, by consistently, uh, providing poor workmanship by not staffing the project with sufficient labor, they also can engage in and begin to fail based upon something in between where it’s not as clear cut that they’ve walked off the job.

Marty Frenkel: Or that they’ve absolutely breached the, the contract, but they’re slow rolling the project. They, they get behind, they catch up, they get behind, they catch up. We start to get claims and noises from sub subcontractors or suppliers that they’re getting slow paid by the subcontractor. And so there’s smoke, but not yet fire.

Corinne Rockoff: So in those situations. Is there a way that a general contractor can identify when the smoke starts and we’re moving towards something a little bit more troubling versus your average slightly a pain in the behind subcontractor that’ll turn out fine. How do we know the difference?

Marty Frenkel: Well, I guess it’s just a question of degree and frequency.

Marty Frenkel: If you are dealing with a subcontractor that you’ve, that you’ve had on your projects for many years, and you know the ownership of that subcontractor, well. And it’s merely they have fallen behind schedule based upon some identifiable event. There’s been a death in the family. They got pulled off on another project.

Marty Frenkel: They have materials that were delayed, something that is a specific one-time event. I typically don’t get very concerned about that. But if I have a subcontractor that I don’t know. That I haven’t worked with before and out of the gate there’s an issue, or even if it’s a subcontractor with whom I have great experience, but now this is the third instance that I’m seeing an issue with their performance.

Marty Frenkel: All of a sudden the antenna go up that, okay, something in these scenarios is is not gonna be right.

Corinne Rockoff: There’s a degree of extra caution that I think is natural for GCs who are working with new subs and who are getting acquainted with them. But there’s also often an instinct towards wanting to be kind and wanting to give latitude and wanting to be understanding and balancing.

Corinne Rockoff: I think that desire to be understanding and communicate. With keeping an eye on contract obligations can be tough. So that’s an area where keeping your contract obligations in mind when you’re working with someone is always gonna be to a GCs advantage. But is there something a little bit concrete that a GC might be able to do to protect themselves if they’re starting to see those warning signs?

Corinne Rockoff: Warning, but they’re not ready to really sound the alarm a hundred percent yet? What can they do in the the early parts of

Marty Frenkel: concern? Okay, so. I’ve always said that being a general contractor is one of the toughest jobs, uh, on the planet. It really is because here you are your sandwiched between owner on this side and subcontractor on this side.

Marty Frenkel: So you owe all of these obligations this way to the, the owner, project owner, and you have all of this obligations and duties to supervise the subcontractor this way. And so one thing to keep in mind is that anything that this subcontractor does that’s wrong in terms of the contract that causes a problem and performance of the general contract, you general contractor, you own that problem, that’s your problem as a matter of law, even though you didn’t have any control necessarily over the subcontractor and couldn’t avoid it.

Marty Frenkel: So what are some things that I can do? I’m gonna know my contract well, I’m gonna know my subcontract and hopefully my subcontract is pretty robust, so I’m gonna put my subcontractor on regular notice if there are issues of the, in terms of their defective performance. ’cause I at least wanna set myself up if I have to enforce a remedy, you know, take action under my subcontract.

Marty Frenkel: I’m putting the pieces in place. Even if I’m providing that notice in a very nice fashion, not everything has to be nasty, but I’m putting them on notice. That’s one.

Corinne Rockoff: So beyond those performance related warning signs, someone not showing up, things like that, are there other warning signs that a GC should be alert to that may indicate something’s going wrong with a subcontract?

Marty Frenkel: A absolutely. Um, one that we’ve seen frequently is we’ve received as a general contractor. Garnishments issued by other creditors of the subcontractor seeking to grab onto construction proceeds that are due the subcontractor, ’cause the subcontractor owes this other creditor money. It could be a supplier, it could be a bank, it could be anyone.

Marty Frenkel: That’s definitely a, a significant warning sign. IRS Tax liens Receiving notice of gar of IRS Tax lien garnishments. If you’re not paying the government, that’s usually not a good sign.

Corinne Rockoff: Definitely a red flag.

Marty Frenkel: Um, receiving claims by fringe benefits funds that they’re not receiving their contributions. Also a warning sign.

Marty Frenkel: And then finally being contacted by Department of Labor investigators indicating, uh, is a good indicator that the subcontractor is not complying with various obligations.

Corinne Rockoff: So if you’re hearing about a subcontractor on your project. From other third parties not relating to the project, particularly if those third parties are creditors or the government, that’s gonna be a red flag that you should be a closer eye on that particular sub.

Marty Frenkel: Absolutely.

Corinne Rockoff: Let’s pull over for a second and talk about what it means to actually give notice, because I think a lot of folks, when you talk about notice under a contract, you are imagining a big scroll that is delivered in a formal fashion and is on letterhead at the very least. But is that the only way that notice can be effective when you’re working with a sub, or are there other ways that you’ve seen folks use it effectively?

Marty Frenkel: Presuming that your subcontract allows you flexibility in terms of how to provide notice? Absolutely. Doesn’t have to be some formal WR written letter. It can, it has to be in writing, but it could easily be an email. It doesn’t have to be this whole long treatise. It could be a paragraph. Merely saying under paragraph such and such of the subcontract, we’re putting you on notice that the couple of things, 1, 2, 3 have happened that is not in compliance with the contract and you have so long to go ahead and correct that performance.

Marty Frenkel: That’s it.

Corinne Rockoff: I think that’s often a big concern for folks as though if I give notice, is it going to seem aggressive or formal or damage the relationship? But I think knowing that assuming your contract language provides for it. An email is in writing, and personally, I love an email because it’s timed and dated.

Corinne Rockoff: You know when it went, it says right on its face, and it can still be communicative and conversational. As long as it contains those required elements that you’re just describing, it can still serve as notice while maintaining the relationship and not necessarily getting into it with your subcontractor.

Marty Frenkel: And, and further, we’ll often say to our, our general contractor clients that it’s not always what you say, it’s how you say it. So if I do have a long time relationship with a subcontractor, or even if I don’t as a general contractor, I might just call, I might call that subcontractor up and say, listen Bob, I wanted to let you know what’s coming, because I general contractor, I have to protect my backside with the owner because again, I’m gonna be responsible for the subcontractor’s, breaches, or failure performance.

Marty Frenkel: So I gotta protect myself first. As much as I might like my subcontractor. I have to take care of myself first.

Corinne Rockoff: You like you better than you like your sub.

Marty Frenkel: Yeah. And so I’m gonna call them though, and I’ll say, listen, this is coming. Don’t be surprised. I still wanna work with you, but you need to get this cleaned up.

Marty Frenkel: And I’ll send, then we’ll send, uh, the email notice

Corinne Rockoff: and remember that those don’t replace one another. It’s not a phone call or an email. That written notice does have to happen, but you can always soften it with extra communication and preserve the relationship. And when you’re trying to decide how to handle things, sometimes, I know folks if found it helpful to think about it.

Corinne Rockoff: Think about yourself in the future. If someday you find yourself trying to look back through all of your documents, through all of your paperwork to figure out where and when did I check that box to give that notice that the contract requires, what can I do that’s gonna make it easy and clear? Hey, I checked this box, this is done.

Corinne Rockoff: Having an email written notice is a lot easier than trying to remember and talk through what did you say on the, and that often doesn’t even meet contract requirements in first place.

Marty Frenkel: That, that, that is, that is, that is correct. And there are also some other things that one can do. Um, presuming again, your, that your subcontract is robust enough.

Marty Frenkel: In particular, if there are payment issues where you see that your SOB. Is not paying sub subs and suppliers in a timely fashion. ’cause they’re starting to chirp in your ear. These people are coming to you as GC saying, I’m not getting paid. I will, um, as a general contractor, exercise the right to issue joint checks.

Marty Frenkel: Obviously, that that has to be provided in your subcontract. But by virtue of doing that, I can ensure that downstream payments are being made. And again, depending upon the quality of your subcontract, you may have the ability, just as I referenced in the A I A contracts that you typically see with owners, you may have the ability to demand that the subcontractor make financial disclosures to you in the event that you are concerned again about their financial wherewithal.

Corinne Rockoff: So in that situation. The joint checks not only help protect the sub suppliers, but is there value to the GCs own benefit in protecting those sub substance suppliers? What’s in it for the GC to put that focus on the folks down the,

Marty Frenkel: well, there are a couple of things. One is by virtue of doing that, I, as general contractor, I’m trying to make sure that I’m maintaining a lien free project because if there are liens recorded against the project.

Marty Frenkel: Generally speaking, my general contract with the owner is gonna require me to take action to do something about those liens. And then secondly, um, if I am keeping those sub subs and suppliers happy, in the event that I have to terminate my subcontractor, I may be able to resuscitate those relationships to help me finish the project.

Corinne Rockoff: You may have heard something about the Builder’s Trust Fund Act and some of the specific complications that can bring to a project. Can you talk us through that a little bit?

Marty Frenkel: Sure. And by the way, the Builder’s Trust Fund Act, although that’s a law in Michigan, there are other states that have similar laws or have the common law that imposes what’s called a constructive trust over construction proceeds.

Marty Frenkel: So what does the Builders Trust Fund Act do? What it does is. In Michigan, using the Michigan structure payments are made, uh, pursuant to a sworn state. So if I general contractor am asking for a million dollars on draw number six of my project, that million dollars might have a hundred thousand dollars for retention.

Marty Frenkel: $80,000 is coming to me. Then I’ve got all of these various amounts that are going to electrician, plumber, excavator, whomever else might, might be due money on that draw when the project owner pays that million dollars. It is earmarked, it is sacred, it is earmarked for payment specifically, and the amounts and to the parties listed in my sworn statement.

Marty Frenkel: So it has this, it’s this mythical like myth mythical protection that goes around the actual dollars that are being paid. And that protection follows those dollars downstream. So for example, if I had $45,000 earmarked for my excavator. I decide I’m not taking that $45,000 that I received from the owner under my sworn statement to pay the excavator, but I wanna pay myself.

Marty Frenkel: That’s illegal. I, the owner of the general contractor can be both criminally and civilly liable for taking that $45,000. Similarly, if I say I’m gonna take that $45,000, I’m not gonna take it for myself. I’m gonna pay it to the painter even though the painter didn’t have any money earmarked for him on that sworn statement.

Marty Frenkel: That, again, is a misappropriation of the funds. That’s gonna expose me to personal liability as the decision maker of the general contractor.

Corinne Rockoff: I think that’s, uh, a higher degree of complication that a lot of folks see a sworn statement sort of as a box to check, as a matter of course, you gotta fill it out.

Corinne Rockoff: It’s not a big deal. It’s a situation where failure to keep in line with those amounts that are stated on the sworn statement can have real, genuine consequences and can also have personal consequences for whoever is signing those sworn statements, whoever’s doing the swearing. So beyond keeping an eye on that, if you start to see subcontractor failures, issues with consistency of subcontractor payment, all of those things that can go wrong with subs.

Corinne Rockoff: Where does the risk from those issues really fall?

Marty Frenkel: Well, the risk really falls on the general contractor. So if, let’s take two different scenarios. Let’s take the scenario that’s that’s clearer where a sub is either abandoned the project or is clearly and grotesquely in default and we’re, we are now having to terminate their, their contract.

Marty Frenkel: As the general contractor, as I said earlier, I own all of the issues flowing from that, that bad subcontractor. So if there is a, I need to find a replacement. So for example, I have, um, a carpenter, rough carpenter, and I have to terminate the rough carpenter and find a new rough carpenter. And my old rough carpenter, the contract was half a million dollars and they performed $150,000 of the work, and I terminate them.

Marty Frenkel: I only have $350,000 left in my budget for rough carpentry. I search around, I look for a replacement rough carpenter to come in and finish the work. The best replacement car rough carpenter I can find says, well, I can’t do the remainder of the work for $350,000. It’s going to take me $600,000 to perform that.

Marty Frenkel: So that delta of $250,000 in additional funds that are necessary to complete the rough carpentry is on me, the general contractor. I have to pay that. Sometimes I may if I have negotiated well with my own or have the ability to draw on my contingency, but if I don’t, or my contingency is exhausted, that $250,000 is coming outta my fee on the job.

Corinne Rockoff: So let’s use this an example. A scenario where we do have a clearly failed subcontractor, and let’s talk about where the risk of that really lands. So for example, if we have somebody who’s coming in to do carpentry, they get halfway through the job and they disappear never to be seen again. So say if they half a million dollars of carpentry work that was budgeted for, they’ve already been paid $250,000 and we’re coming back around, they’re absolutely gone.

Corinne Rockoff: We’re trying to replace our carpenter and now. The only folks that are available to take their spot are going to cost an additional a hundred thousand dollars over what’s left in the budget, the remainder of carpentry work. So there’s a hundred thousand dollars that somebody’s gonna have to pay to get the work done.

Corinne Rockoff: Where does that risk fall? Who’s responsible for that extra cost? Under most contracts,

Marty Frenkel: the, the general contractor is responsible for, for that a hundred thousand dollars. Now, if you’ve negotiated well, you may be able to tap your contingency for that a hundred thousand dollars. But oftentimes contingencies aren’t permitted for subcontractor breaches or maybe your contingency’s exhausted, so that a hundred thousand dollars in your hypothetical is coming out of my as general contractor fee.

Corinne Rockoff: And so when you find yourself in that situation and there’s this gap that somebody’s gotta cover that cost. Is there anything that a GC can do from the outside of a project to put themselves in the best possible situation when confronted with a failed subcontract?

Marty Frenkel: Sure. And, and although, and this is a teaser for one of our other presentations, is know your subcontract.

Marty Frenkel: Love your subcontract. Live your subcontract, so know the rights and remedies that you have under your subcontract. Understand how they fit together and what they allow you to do and relate to your subcontractor, and don’t be afraid to enforce those rights and remedies.

Corinne Rockoff: Know your subcontract live, your subcontract laugh, your subcontract.

Corinne Rockoff: I think we’re getting meant for you as an Marty. I.