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Subcontractor defaults require decisive risk management

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HOUSTON — Dealing with financially struggling subcontractors is a risk of doing business for construction firms, but by monitoring trades partners and acting swiftly when they show signs of financial distress, risk managers can help their firms avoid some significant problems, experts say.

Contractors should build relationships with subcontractors before projects start, conduct prequalification reviews and intervene quickly when problems arise, they said, speaking at the International Risk Management Institute Inc.’s Construction Risk Conference in Houston on Wednesday.

The role of the risk manager in managing subcontractor default risks is critical, said Jim Richert, risk engineering manager, subcontractor default insurance at Axa XL, a division of Axa SA, in New York.

Risk managers can lead the process of preparing for and reacting to a default by bringing all the necessary parties together to minimize the effect of a subcontractor failure, he said.

To try and avert subcontractor default problems, risk managers should concentrate on “getting to know” the firms they contract with, Brandon Beane, vice president, risk management at Coastal Construction Group of South Florida Inc. in Miami.

Coastal conducts extensive prequalification questionnaires with subcontractors but in addition makes personal contacts with the firms’ managements where possible, he said.

When a subcontractor is employed on a project, Coastal ensures the firm is familiar with Coastal’s processes and procedures. and “then we keep in constant contact with them so we have their feedback and we can identify problems early,” Mr. Beane said.

While there are several causes of subcontractor failure — including poor management, economic downturns, overexpansion and material shortages — they usually fail for a combination of reasons, he said.

“Usually the subs that become distressed have a number of smaller issues that in and of themselves are not red flags. Only by aggregating the data and looking at them from a wholistic perspective can you start to see those issues,” Mr. Beane said.

When a subcontractor does default, it typically costs about 65% more to complete the work they were contracted to perform, Mr. Richert said. About 32% of those extra costs relate to physically completing the work, 21% relates to the costs of correcting poor-quality work, 12% goes to unpaid lower tier subcontractors, 9% goes to legal costs, 5% relates to staffing costs, and 21% are indirect costs, such as adjusting the schedule of the job, he said.

“Really, though, the project cost element is the tip of the iceberg,” Mr. Richert said.

Other consequences of defaults relate to project delays, balance sheet erosion, dissatisfied clients, reputational damage, frustrated project teams and management distraction, Mr. Beane said.

“It’s hard to put a number on them, but they are real,” he said.

To better manage a subcontractor default risk, contractors should “manage by fact” and review what they knew about the subcontractor before the work started — sometimes subcontractors are used because they have unique skills even if they have financial issues — address immediate issues when they default, and look at bigger picture issues that the default may affect, Mr. Beane said.

Coastal has a “distressed subcommittee” to react to subcontractor defaults, Mr. Beane said. The committee is chaired by Mr. Beane and includes the vice president of cost accounting, the original estimating team for the project, the ownership of Coastal and the project team involved, he said.

When a subcontractor does become distressed, contractors must to decide whether to supplement the subcontractor with additional resources or to terminate the contract. Claims experience shows that supplementation is usually slightly more expensive than termination, Mr. Richert said.