Creating a ‘Conduit Relationship’ to Avoid Construction Payment Mishaps

The business-to-business (B2B) credit process is fairly similar across various industries: A grantor provides credit to a debtor for business or commercial purposes. While this definition, found in NACM's Principles of Business Credit, extends to the construction industry, project owners often encounter additional hurdles that, otherwise, aren't as prevalent to borrowers in another sector. A prime example lies within the payment process between a lender and owner, as the borrowed cash flows from the owner to and from other parties such as general contractors (GCs), subcontractors (subs) and material suppliers. At the end of the day, the owner must pay back the lender, so it's important to adopt an effective payment process further down the chain.

Let's say an owner is seeking a significant amount of credit for an apartment complex. Although the owner is the initial debtor, the borrowed funds are used to pay the project's GCs who need to pay their subs who then must pay the material suppliers. What if a sub has to delay payment to a material supplier because of a pay-if-paid clause in the general contract? According to professionals in the industry, there are a couple of methods material suppliers can adopt to ensure efficient and steady lending practices.

In the March PYMNTS article, "Why Construction Payments' Friction Has Nothing to Do with Payments," CEO Will Mitchell, of construction loan automation software company Rabbet, said owners must document a laundry list of information to keep the credit grantor informed on a project's status and must do so in order to receive funds for the project. Invoices are a top priority because they track the involvement of specific parties as well as any payment, and legal and compliance documentation.

"Unfortunately, developers who need to send that information too often rely on email chains, PDFs and Excel spreadsheets to generate a document package each month to obtain funds," PYMNTS states. "The process forces a developer to manually access information across multiple back-office systems, which Mitchell said creates massive inefficiencies and room for error."

Attorney Jim Fullerton, of Fullerton & Knowles, P.C., in Clifton, Virginia, said the paperwork is the link in what he describes as "a conduit relationship" between all involved parties. Paperwork can easily "jam up payment" because most of owner-GC relationships and general contracts incorporate a pay-when-paid or pay-if-paid clause, meaning the GC is under no obligation to pay the sub unless or until they've been paid by the owner.

"That alone busts the 30-day payment cycle. The sub doesn't have the money to pay the material supplier unless or until they've been paid by the GC," Fullerton said. Conduit relationships are becoming unavoidable in the construction industry, with no "easy solution" in sight aside from refusing the general contract altogether.

However, Fullerton explained, many material suppliers accept they are going to be bound to the sub to the same extent the sub is bound to the GC and the GC to the owner in connection with the general contract. If this is the case, it's important that material suppliers carefully document the paperwork, which includes having a copy of and reviewing the general contract. Some GCs have been known to "hide the ball," providing material suppliers with the purchase order but no general contract.

"Nowadays, if you're a vendor on a construction project, you can usually go on the general contractor's website and they have it all there," Fullerton added. "The material supplier has to develop the skill to look at the contract and find the parts that concern what they're supplying."

—Andrew Michaels, editorial associate

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Monday, 30 March 2020

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