Mastering Construction Contracts

Construction contracts are the foundation of building projects, defining terms, responsibilities and expectations for all involved. They protect both contractors and clients by detailing project scope, timelines, costs and quality standards of a project. However, misunderstandings in contracts can lead to project delays, financial losses and legal disputes.

Why it matters: When credit professionals know how to manage construction contracts, they can reduce risk and successfully complete construction projects smoothly.

When working on a construction project, large or small, there are multiple types of construction contracts to consider:

• The general contract: a legally binding contract between the owner and the general contractor (GC). It outlines the details of a project, such as specific tasks that need to be completed.
• A subcontractor agreement: a contract between a GC and a subcontractor(s) to perform work for the GC's client. It serves as both a hiring contract and a request for proposal (RFP).
• The purchase order (PO): a contract where a supplier agrees to provide specified items to a subcontractor, who in turn agrees to pay the stated amount.
• And last, a credit application: a contract between the material supplier customer and a subcontractor or GC. Depending on the information in the credit application, the payment terms may be modified by the customer.

As a credit management professional, managing construction contracts may not be in your purview. However, gaining knowledge and skills in risk mitigation concerning construction contracts is essential.

Securing Lien and Bond Rights

Credit professionals can use mechanic's liens and bonds to reduce nonpayment risk. A mechanic's lien legally safeguards contractors and material suppliers from nonpayment on private projects. A construction bond is a surety bond that investors use to shield themselves from events that could hinder project completion, such as the builder's failure to meet contract specifications or insolvency.

"Make sure the contracts you're signing aren't negating any of your mechanic's lien rights or any of your legal rights that you could pursue later if something were to happen with the project to where you can't get paid," said Isaac Kotila, credit support manager at Insulation Distributors Inc. (Chanhassen, MN). "Also, make sure that you understand the terminology within that contract and that it's not referencing a separate contract that includes details that maybe aren't present to you in the contract that you're signing."

Before you begin work in a new state, it's recommended that you review the mechanic's lien laws so you know what to expect. If you don't follow the law, you could lose your right to file a lien.

Prepare for the "Battle of the Forms"

Credit professionals must understand what language is in these contracts and what their risk exposure is to minimize credit risk. The battle of the forms arises when multiple parties exchange documents with conflicting terms, start to act on these documents and then dispute which terms to follow. Despite the conflicting language, the contract that was signed last typically has precedent. For instance, if a credit application has 30-day terms but a customer's purchase order requires 60- or 90-day terms, you must adhere to the latter. "Once you execute that purchase order, that's the last contract that's in, and that means that that purchase order may trump your credit application," said Chris Ring of NACM's Secured Transaction Services (STS).

Seeking legal counsel can help prevent and offset conflicting contractual language. "We send the contracts to our CFO, and they will work with our legal counsel if they have any questions as they're the only ones authorized to sign off on them," said Adam Aune, credit manager at Butler Machinery (Fargo, ND). "The CFO would then provide feedback before we circle back with the customer. We try to be proactive and ask for changes or adjustments to be made before signing the contracts so that it doesn't come up after the fact that we sign this, and they sign this and now these don't align."

The bottom line: Credit professionals must attain a deep understanding and manage construction contracts effectively to reduce risk, guarantee project completion, protect lien and bond rights and handle potential conflicts in contractual terms.

-Jamilex Gotay, editorial associate