Subcontractor default and the buyout risk an owner carries
A subcontractor stops showing up. Or it shows up but cannot pay its suppliers. Or it files for bankruptcy with half its scope installed. Under a CM at risk contract the contractor holds the subcontract, so the default is the contractor's to manage. The cost of managing it, though, has to come from inside the GMP, and that is where the owner's interest begins.
What a default costs
Replacing a subcontractor mid stream is expensive in ways that go beyond the unpaid balance of the original subcontract. The replacement subcontractor prices the remaining work at a premium because it is taking on someone else's partial installation. There are costs to assess and correct defective work. There may be supplier liens to clear. There is schedule delay, with its general conditions cost. And there is the contractor's own staff time, which under some agreements is a general conditions cost and under others is in the fee.
The sum can exceed the original subcontract value. It almost always exceeds what the contractor carried in the GMP for that package, because the package was bought at a competitive price and the replacement is bought under duress.
Where the cost lands
Under most AIA A133 based agreements, subcontractor default is a contractor risk. The contractor chose the subcontractor, holds the subcontract, and is responsible for performance. The replacement cost is paid from contractor contingency first. If there is subcontractor default insurance or a performance bond on the subcontract, recovery from that reduces the contingency draw. If contingency is exhausted, the contractor absorbs the rest from fee.
The owner's exposure is indirect but real. A large contingency draw for a default leaves less contingency for everything else. If the contingency runs out, the remaining risk on the project is carried by the contractor's fee, and a contractor working without fee is a contractor with a reason to pursue every change order. The default itself costs the owner nothing. Its consequences for the rest of the project can cost a great deal.
A fictional default
On a fictional $64 million hospital addition, the drywall subcontractor defaults in month eleven with 40 percent of its $3.2 million scope complete. The replacement prices the remaining 60 percent at $2.6 million, against $1.9 million unpaid on the original subcontract. Corrective work adds $200,000. The contractor draws $900,000 from a contingency that had $1.3 million remaining, and recovers $400,000 under its subcontractor default insurance. The net contingency draw is $500,000, leaving $800,000 for the final year of a project with significant finish work ahead.
Early signs in the buyout record
Defaults are rarely sudden. A package bought well below the carried value and well below the other bids is a package where the subcontractor may have underpriced. A subcontractor whose pay application amounts fall behind its schedule progress is one that may be short of cash. Supplier inquiries to the contractor about unpaid invoices are a clear signal. The owner does not see most of these directly, but the owner can ask.
The buyout record is the owner's early view. A package awarded 25 percent under its carried value deserves a question at award, not congratulations. Ask whether the contractor leveled the bid, whether the scope was complete, and whether the subcontractor is bonded or covered under default insurance. Record the answers against the package.
What the owner's ledger should hold
For each package: whether a bond or default insurance applies. For any default: the date, the unpaid balance, the replacement cost, the corrective cost, any recovery, and the net contingency draw with the contingency log entry it corresponds to. For the project: the contingency balance after the draw and a revised projection of exhaustion. A default changes the runway, and the runway is what the board needs to see.
Costwitness records the default against the package in the buyout tracker, posts the net draw to the contingency ledger, and revises the runway projection in the monthly report. The software moves the numbers. Judging whether the replacement cost is reasonable is something the owner and the contractor work out together.
What to do this month
- Ask the contractor whether subcontractor default insurance or bonds are in place on each major package, and record the answer in the buyout log.
- Review any package bought far below its carried value and ask what the contractor did to confirm the bid was sound.
- Check your contract for how default costs are treated and whether insurance recoveries must be credited to the GMP.
- Add a default scenario to your contingency projection so the board has seen the downside before it happens.
Questions on this
Does the owner pay for a subcontractor default?
Not directly, under most CM at risk contracts. The cost comes from contractor contingency and then from fee. The owner pays indirectly if the contingency is exhausted and later risks that would have been covered by it become change order claims. Check your contract, since a few agreements share default cost in specific circumstances.
What is subcontractor default insurance?
It is a policy the contractor carries that pays for the cost of replacing a defaulting subcontractor, subject to a deductible and limits. It is an alternative to requiring a performance bond from each subcontractor. The premium is usually a cost of the work and the recoveries reduce the cost of the work, so both sides appear in the owner's numbers.
Can the owner refuse a replacement subcontractor?
Under most agreements the owner has limited say over subcontractor selection, though some contracts give the owner the right to object to a proposed subcontractor for cause. The more useful owner role is to ask for the replacement pricing and the schedule recovery plan, and to record both.
In the product
Buyout tracker, Contingency ledger, Monthly owner report. Free tool: Contingency Runway, Schedule Risk versus Float.
Keep reading
Earlier: A buyout log for owners: the five fields that matter. Later: How allowance overruns eat the savings pool. All articles on buyout and shared savings.
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