A retail construction project illustrates the risks to an owner when the general contractor encounters financial problems. As is typically the case, the general’s financial troubles started when he got behind in payments on earlier projects. As a result, the initial payments on the retail project went to pay subs and suppliers from the earlier projects, which in turn, of course, left subs and suppliers on the retail project unpaid.

This game of catch-up worked for a brief period, as do most Ponzi schemes, but during that time, the problems only compounded themselves. Not only were subs and suppliers going unpaid, but the general was also spending less and less time supervising the project and more and more time dealing with his increasing financial troubles. Among other things, the distractions caused him to fail to get signed subcontracts. Work-quality issues became common, and, in the absence of written subcontracts, change order disputes became difficult to resolve.

The owner paid the monthly draws timely, but was lax in monitoring the collection of lien releases. The general began using the owner’s payments to cover obligations from other projects and even to pay personal financial obligations. Eventually, the subs and suppliers started filing liens, and it was at this point that the owner first realized there was a problem.

The owner retained an attorney to deal with the liens and investigate claims against the contractor. In fairly short order, the contractor was terminated, which resulted in the project slowing to a halt and ultimately led to a completion delay of several months. These conditions placed the owner in default of its bank loan.

The owner’s expenses and losses included multiple items: (i) paying several of the subs and suppliers amounts that had previously been paid to the general; (ii) paying attorney fees and 18 percent interest to discharge multiple liens from the property; (iii) hiring a replacement contractor at a fee significantly greater than the amount remaining in the prior general’s contract; (iv) paying the bank’s attorney fees, along with default interest; (v) paying its own attorney fees; and (vi) responding to legal claims from preleased retail tenants who were delayed in moving into the project.

In the end, the owner’s cost overruns very well may force it into insolvency and it may, as a result, end up losing the project. While the owner certainly has claims against the general, they likely have no value in light of the general’s insolvency.

The owner could have done a number of things to prevent these problems. First, it could have investigated the contractor’s financial condition before even contracting with it. An investigation might have involved looking at the contractor’s financial statements, speaking with the owners of the contractor’s most recent projects, and ordering a Dunn & Bradstreet report. Second, the owner could have insisted on receiving lien releases from subs and suppliers as a condition to paying the general. While these steps are not foolproof, and while fraudulent tactics can be used to undermine them, a cautious owner can do a lot to avoid the problems that can result from a contractor’s insolvency.