Volume 30, Number 5
Projects on the Brink:
Part I — When the Money
Stops Flowing
by W. Henry Parkman*
A. Troubled Market Conditions Jeopardize
the Continuity of Construction Projects
News reports of stalled construction projects are becoming more and more common in
these uncertain economic times. A Dubai developer recently announced that it was shelving plans for what had been described as the
world’s tallest skyscraper. Work has stopped
on the prominent Chicago Spire project, and
the Chicago Sun-Times reported that the main
lender to the Spire developer was near collapse. Architects and engineers have filed millions of dollars in lien claims, and the Chicago
Spire project site consists of a deep hole in the
ground. Work has reportedly been halted on
11 percent of skyscraper projects worldwide,
including 29 of 301 skyscraper projects in the
United States.
* W. Henry Parkman is a partner with Sutherland, resident in its Atlanta office. He has practiced
construction law for 24 years, focusing on mediation,
litigation, and arbitration of disputes arising from
industrial, commercial, heavy-highway, and other
complex construction projects. He acknowledges
the research assistance of Sutherland associates Eric
L. Hurst, Adam D. Nugent, and Laura J. Stipanowich.
REPRINT ARTICLE
May 2009
Construction of Echelon, a Las Vegas casino resort, was suspended after it had reached
twelve stories. Boyd Gaming, Echelon’s developer, indicated that the suspension was
expected to last for three or four quarters,
while banks are reluctant to lend, and the U.S.
economy slows.
Many less-prominent projects have been
shelved or are at risk of loss of funding. The
contraction of the economy presents a “double whammy” to developers and contractors.
Both are affected by shrinking of available
financing and reduction in property values.
Declining real estate values harm developers’
pro formas, and diminish contractors’ traditional security of mechanics’ lien rights.
What can participants in the construction industry do to reduce their risk on projects that
are in economic jeopardy? This article focuses
on the suspension or threatened suspension of
projects after a construction contract has been
signed and performance has begun and outlines options available to participants on such
projects that may mitigate financial losses.
B. The Owner/Developer Has Three
Basic Choices — Suspend, Terminate, or
Complete
1. The Owner May Suspend the Project
If the owner/developer loses financing or
market conditions undermine the economic
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construction litigation reporter
viability of a project, three basic options present themselves. The owner/developer may suspend the work until financing becomes available/and or market conditions substantially
improve. The suspension option requires the
owner/developer to evaluate realistically how
long it will take for market conditions to improve and/or to locate new sources of funding.
Although the owner/developer may be able
to negotiate more favorable terms with the
prime contractor for the good of the project,
negotiation will not alter statutory requirements for filing and perfecting mechanics’
lien claims. Any suspension plan will need to
minimize and deal with the mechanics’ lien
claims that will inevitably be filed. Some states
require a subcontractor or supplier to file a
lawsuit to perfect a lien claim within a year of
the claim becoming due. If a suspension will
last too long, an owner will likely be forced to
choose between termination and completion.
2. The Owner May Terminate the Project
The owner/developer has the option to terminate an economically-troubled project. The
owner/developer should be prepared to deal
with the legal fallout from a termination, and
weigh that risk against the risk of attempting
to continue with a project.
The owner/developer should consider its
rights against the lender under applicable financing documents. Is the lender justified in
suspending or terminating financing under
the terms of the loan documents? If not, the
developer as borrower should consider traditional legal remedies that may be available,
such as breach of contract, misrepresentation,
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© 2009 Thomson Reuters
MAY 2009
and/or promissory estoppel, assuming that the
facts and law of the applicable jurisdiction support a claim against the lender. Such disputes
involve highly factual issues, including the
terms and binding nature of loan documents.
The law applicable to these disputes varies by
jurisdiction. As in any commercial dispute the
claimant should consider the solvency of the
defendant and weigh the prospect that the defendant may file for bankruptcy.
The traditional legal concept of “force majeure” has recently been asserted as a justification for avoiding contractual performance. The
well-known developer of the Trump International Hotel and Tower in Chicago claimed in
a lawsuit that the lender should delay its effort
to collect $40 million that he personally guaranteed because the current economic downturn
constitutes a “force majeure,” or an event not
within the reasonable control of the borrower.
The contract between the owner/developer
and the contractor is likely to contain a “Termination for Convenience” clause, under which
the owner may terminate the contract for any
reason. Such a Termination for Convenience
clause, however, requires the owner to pay the
contractor’s specified costs of termination. The
owner should understand the magnitude of the
cash outflow required to settle the contractor’s
termination for convenience costs.
Such an obligation to fund the contractor’s
termination costs may prompt owners to search
for a justification to terminate a project for default, instead of for the owner’s convenience. A
termination for default will likely meet a challenge from the contractor, leading to a lawsuit
or an arbitration. Fighting over whether the
termination for default was justified is likely
to be expensive, but would allow an owner to
avoid an immediate obligation to pay the contractor, as would be the case under a termination for convenience.
If the owner terminates a project, it may hope
to sell the project or to assign the development
rights to the lender or to another developer. If
there is no reasonable prospect of having another developer step in, however, the owner will
© 2009 Thomson Reuters
need to prepare for the cost of “mothballing”
the project, to preserve value in the asset while
waiting for market conditions to improve.
Aside from the cost of “mothballing” a project, owners must keep in mind their obligations
to municipalities. A municipality may revoke
the building permit if a suspended project is
considered to be abandoned. A project that is
not properly mothballed may become a nuisance, allowing the municipality to invoke demolition rights.
An owner/developer also has the option of
a partial termination of a contract, including
the right to delete scope by deductive change
order. For example, suspension of the Echelon
project had a ripple effect on CityCenter, another Las Vegas mega-development. Changing
market conditions created an opportunity for
the developer to minimize costs of the ongoing CityCenter project. With the contractor’s
consent, the developer deleted a major portion
of interior work and awarded that work to the
contractor whose work had stalled on Echelon.
This move was designed to take advantage of
better subcontractor pricing, expected in a
more competitive market.
3. The Owner May Complete the Project
Finally, the owner has the option of completing the project with a different lender or a group
of lenders. Engineering News-Record recently reported that the Chicago Spire developer is in
preliminary discussions with representatives
from AFL-CIO Housing Investment Trusts. An
incentive for using unions’ pension funds to invest in the Spire project would be the creation
or preservation of thousands of jobs over what is
anticipated to be five years of construction.
Depending on the financial strength of the
contractor, the owner should also consider approaching the contractor to act as a lender or
to take a partial equity stake in a project. The
decline in real estate values makes a contractor’s
lien rights less desirable as a security mechanism. The contractor, if in a position to contribute financing, labor, and materials to a project,
may be motivated to partner with an owner to
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construction litigation reporter
complete the project, rather than face termination and litigation, with an uncertain ability to
recover earned contract funds.
Of course, if a contractor is in a position to
contribute to the completion of a project, the
owner should be willing to modify the contract
terms to provide the contractor with an improved security position, a greater “up-side”
upon successful completion of the project, and/
or a guaranty of some level of payment, with appropriate collateral.
C. How Does The Contractor Respond?
1. The Contractor May Request Evidence that
the Owner Has Arranged Sufficient Financing
to Pay for the Work
If an owner is slow in funding pay applications or if the contractor becomes concerned
about the owner’s ability to pay, the contractor
should see whether its contract allows the contractor to request evidence of the owner’s ability to fund the remainder of the project. For
example, section 2.2.1 of AIA Document A-201
– 1997, “General Conditions of the Contract for
Construction,” allows a contractor to seek assurances regarding the owner’s financial arrangements:
The Owner shall, at the written request of the
Contractor, prior to commencement of the
Work and thereafter, furnish to the Contractor reasonable evidence that financial arrangements have been made to fulfill the Owner’s
obligations under the Contract. Furnishing of
such evidence shall be a condition precedent to
commencement or continuation of the Work.
After such evidence has been furnished, the
Owner shall not materially vary such financial
arrangements without prior notice to the Contractor.
Pursuant to this clause, if the owner does not
furnish evidence that adequate financing is in
place, the contractor has the right to suspend its
work. Moreover, if the owner fails to provide evidence of its ability to pay, upon seven days’ written notice, the contractor has the right to terminate the contract and to recover payment for
4
work performed and for proven loss, “including
reasonable overhead, profit and damages.” Section 14.1.3, AIA Document A201 - 1997.
The 2007 edition of section 2.2.1, AIA Document A201, limits the contractor’s right to request the owner to provide evidence that construction financing is in place. The 1997 version
allowed the contractor to make such a request,
without any showing, after the work commenced.
Under the 2007 edition, after work commences,
“the Contractor may only request such evidence
if (1) the Owner fails to make payments to the
Contractor as the Contract Documents require;
(2) a change in the Work materially changes the
Contract Sum; or (3) the Contractor identifies
in writing a reasonable concern regarding the
Owner’s ability to make payment when due.”
A contractor on a condominium project in
Florida demanded assurances from the owner,
pursuant to the 1997 version of section 2.2.1,
that adequate financing was in place. The owner
allegedly did not provide such assurances. After
suspending its work for a month, the contractor
gave notice that it was terminating its work on
the project as a result of, among other things,
the owner’s failure to provide evidence of adequate financial arrangements. Later, the contractor assigned its contract and lien rights to its
surety, and the owner sued the surety, asserting
multiple claims. Goodbys Creek, LLC v. Arch Ins.
Co., No. 3:07-cv-947, 2008 WL 2950112 (M.D.
Fla. July 31, 2008). The case remains pending.
Even without an express contract clause allowing a contractor to require the owner to furnish
evidence of adequate financing, the doctrine of
anticipatory repudiation may allow a contractor
to seek assurances of payment before continuing performance. The Supreme Court of New
Hampshire has recently held that a contractor
was justified in suspending construction work
until the owners supplied adequate assurance
of financing the work. McNeal v. Lebel, 157 N.H.
458, 953 A.2d 396 (2008).
The McNeal court concluded that the right
to demand adequate assurance (as recognized
in section 2-609 of the Uniform Commercial
Code) is closely related to the implied duty of
© 2009 Thomson Reuters
MAY 2009
good faith and fair dealing and could be invoked where the contractor was informed that
the lender would not be funding additional construction draws. Because the contractor had sufficient grounds “to seek adequate assurance of
future performance, which the [owners] did not
supply, neither [the contractor’s] request for the
escrow of funds, nor his cessation of work pending such assurance was a material breach relieving the [owners] of further obligation under the
contract.” Id. at 463, 953 A.2d at 401.
2. The Contractor Can Pursue Legal Remedies
The typical response of a contractor to the
owner’s failure to pay is to assert the traditional
legal remedies of breach of contract and to file
lien or bond claims. Contractors have also utilized other theories, such as promissory estoppel, to assert claims against lenders, even in the
absence of a direct contract.
For example, another contractor’s request
for assurances of adequate financing prompted
a bank to provide the contractor with a letter
confirming that the bank was committed to financing the project. Suitt Construction Co. v. Hill,
150 P.3d 335 (Kan. App. 2007) (unpublished
opinion). After the owner had drawn down
all available loan amounts, the owner filed for
bankruptcy. Based on the commitment letter,
the contractor asserted a promissory estoppel
claim against the bank. The court rejected that
claim, however, because the bank’s letter merely
committed to financing the project, but did not
require the bank to pay the contractor directly.
A contractor who is terminated because the
owner cannot or will not pay has available legal
remedies for breach of contract. That remedy
for material breach or wrongful termination by
the owner, however, may have little value if the
owner/developer has become insolvent or is on
the brink of bankruptcy.
A contractor on a terminated project also has
available statutory lien rights, the traditional
security for a contractor when the owner “goes
bust.” The contractor’s lien remedy may turn
out to be hollow, however, if the pre-construction assumed values for the project greatly ex-
© 2009 Thomson Reuters
ceed the current true value of the real estate. A
project that is terminated mid-stream will be less
attractive to buyers, with less opportunity for
satisfaction of a contractor’s lien claim.
3. The Contractor, Stuck in the Middle, Will
Have to Deal with Subcontractor Lien Claims
If a contractor is terminated because funding has become unavailable, the contractor will
not only have to assert its rights against the
owner, it will have to defend subcontractor lien
and payment bond claims and lawsuits to perfect. Lien claims of subcontractors and suppliers usually represent the first wave of legal filings, indicating that a project may be on shaky
economic ground.
The terms of the subcontract and the applicable law are vital to developing the best defense,
especially if the owner’s funding is slowing or
stopping. Analysis is needed to see what subcontract terms the contractor may use to defeat or to
delay the subcontractor claims.
Many states will enforce a “pay-when-paid”
or “pay-if-paid” provision in the subcontract, if
receipt of payment from the owner is stated as a
condition precedent to the contractor’s obligation to pay the subcontractor/supplier.
The following questions should be addressed.
Does the contractor have an obligation to keep
the project property free and clear of lien claims?
If the lien claims are a direct result of the owner’s failure to pay funds earned by the contractor and its subcontractors/suppliers, is the contractor relieved of the obligation to satisfy or to
bond off subcontractor/supplier lien claims?
Does the contractor have flow-down provisions in its subcontracts?
If the contractor is terminated for convenience, the contractor should likewise be able to
terminate the subcontracts/purchase orders for
convenience and pass on these termination costs
to the owner. If the owner does not or cannot
satisfy its obligations to pay applicable termination for convenience costs, the contractor will
likely have to defend lawsuits brought by unpaid
subcontractors and suppliers.
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construction litigation reporter
4. Instead of Adopting an Adversarial
Posture, the Contractor May Be Better
Off by Teaming with the Owner to Maintain
the Viability of the Project
Because of the possible inadequacy of their
legal remedies, contractors on troubled projects
should be open to the option of teaming with
the owner, in the interest of keeping the project
viable. Perhaps the owner could avoid termination or suspension of the project if the contractor agreed to act as a lender or to provide labor
and materials in exchange for receiving an equity stake in the project.
Of course, any contractor that increases its
risk for the good of the project should receive
a higher priority and/or improve its security
for the increased indebtedness. Under a teaming approach where the contractor contributes
money, labor, and/or materials, it will be necessary to modify the contract terms to reflect the
different arrangement and to assure a fair (and
secure) return upon successful completion of
the project.
One challenge to be faced by a contractor under this scenario is how to keep major subcontractors and suppliers on board. Unless major
subcontractors and suppliers receive funding
and/or better security positions, they are likely
to stop work and file lien claims.
6
D. Modify Contract Terms to
Minimize Risk on Future Projects
Most of the contracts utilized on the projects
jeopardized because of current economic conditions were prepared, reviewed, and signed without consideration of what has been described as
a “financial tsunami.” Now that what was unforeseen has occurred, participants in the construction industry should modify their contracts to better allocate risks and rewards on future projects.
Contract terms to be reviewed include the
right to request assurance of adequate financing;
payment guaranties; and rights and remedies for
convenience terminations. In contract negotiation, contractors and owners should address the
risk of lender default and contemplate ways the
contractor may improve its security if the owner
needs the contractor to contribute financing, labor, and/or materials to complete the project.
The breadth of the topic of this article has required somewhat cursory treatment of the relevant issues. The author hopes, however, that the
options explored may allow industry participants
to mitigate losses resulting from the reduced flow
of financing for construction projects.
© 2009 Thomson Reuters