The construction industry has experienced strong and consistent growth in the last few years in almost every market. Public and private projects are being bid on in greater numbers, and contractors in every trade are hiring new employees. But bank credit lines are more difficult to obtain and contractors do not have the resources to advance material and labor costs. For these contractors, factoring may be the solution.

There are many advantages to factor in this niche market, such as the additional security to factors provided by lien and bond rights and the possible reimbursement of attorneys’ fees and costs from account debtors. However, factors must master technical knowledge of the construction industry, such as payment procedures, and perform additional and continuous due diligence on the client. This is a great time to factor construction receivables for those willing to take these extra steps.

A factor considering entering this market should consider the following.

Additional Security for Factors

In addition to all of the typical rights under the UCC, factors of construction receivables have greater secured rights against the account debtor. If the applicable state or federal rules are followed and deadlines are met, the factor (on behalf of its client) will have a construction lien against the real property where the construction work is located or a claim against a solvent bonding company. Under most state laws, a claim under the lien or the bond also grants the factor the right to reimbursement of attorneys’ fees if it prevails in a legal dispute.

Protecting Lien or Bond Rights

Most states require the client (or the factor as assignee) to provide notice to the owner, the general contractor (GC) and/or the bond company explaining the client is providing services and materials on the project and must be paid. For example, Florida requires delivery of a “Notice to Owner/Notice of Intent to Rely Upon Bond” to all relevant parties no later than 45 days after the first day of the client’s work. Other states do not require a notice to owner, but require “Notice of Intent to Lien” or “Preliminary Notices” instead. If the notice is late, even by one day, you lose the lien/bond rights.

To perfect the lien, the client or the factor assignee must record a “Construction Lien” or “Mechanic’s Lien” within a certain time period. In Florida, the construction lien or claim against the bond must be recorded no later than 90 days after the last day of the client’s work. Again, if you miss the deadline by one day, the lien/bond rights are lost.

These deadlines are strict. Despite the fact that the client may have been in the industry for a while, many contractors are not knowledgeable about protecting their rights to payment. Many contractors have no internal system in place to ensure that deadlines are complied with and proper documentation is prepared. However, if the rules are followed, these rights give the client and the factor leverage. From a practical perspective, if the client records a lien, that lien can lead to the suspension of all funding on the project until you are paid. This leverage can be crucial.

More Due Diligence Required

The greatest burden facing the factor is committing to a greater level of due diligence before accepting the client and before each funding. The factor should also generally monitor construction projects. Because the account debtor (the GC) has many different contractual rights to withhold and offset payment, the factor must conduct a detailed evaluation of the client’s business and expertise. For example, the factor must know the client’s sub-subcontractors and suppliers and make sure these parties are paid and provide construction releases. If not, these sub-subcontractors and suppliers have the right to seek payment directly against the account debtor, offsetting the money owed to the factor. In essence, the factor must be confident the client has the skills to perform the construction work.

How to Conduct this Due Diligence?

The factor should determine if the client been a defendant in prior litigations. Has the client been sued for not paying its sub-subcontractors and suppliers even though the client has been paid? Has the client been sued for defective work or delayed work? This information is a good indicator of the client’s ability to perform the construction contract.
Has the client been terminated for cause or had liquidated damages imposed due to its own delay on prior projects? Again, this information is a good indicator of whether the GC will withhold or offset payments that are due to the client/factor.

Does the client have all required licenses? In many states, a contractor is not entitled to any payment if the license was not active, even if all the work was performed.

Taking Action Before Funding

The factor can perform the following actions before and after the client’s first funding:

• Review all documents between the client and the GC, including the client’s scope of work on the project. Confirm that the client has the track record, ability and manpower to complete the job it was hired for. Truly know the customer.
• Obtain a list from of all of the client’s subcontractors and suppliers on the project. To reduce the factor’s risk, it can pay sub-subcontractors and suppliers from the funding to the client. Make sure that you obtain releases in exchange for the payments.
• With every application for payment, confirm with each of the client’s sub-subcontractors and suppliers how much they are owed.
• If you are not the one paying the client’s subcontractors, contact them and confirm that they are being paid.

The Most Common Problem

Most, if not all, construction contracts between a GC and the factor’s client permit the GC to offset claims against a subcontractor, even if the claims arise after approval and payment of the invoice that was factored. Offsets may include costs incurred by the GC to correct the client’s defective work, failure of the client to pay its employees or failure of the client to pay its suppliers.

Counsel commonly become involved on behalf of a factor in the following situation:

• The factor entered into a standard factoring agreement with a subcontractor.
• The client has already entered into a standard construction contract with the GC on the project. The construction contract contained an offset provision such as: “Subcontractor’s rights hereunder are subject to the right of contractor to offset any and all claims contractor has against subcontractor, whether or not arising under this subcontract.”
• The factor sends the GC a Notice of Assignment instructing the GC to pay all receivables due and owing to the client directly to the factor.
• The client submits various pay applications and/or invoices approved by the GC.
• The factor is unable to obtain an “estoppel” or “no offset” letter from the GC.
• After approval by the GC and funding by the factor, but before payment is made by the GC, the GC asserts that the subcontractor (the client) has failed to perform in some manner.

Even if the factor sent the GC a Notice of Assignment, the factor is subject to the offset provision in the construction contract. Even if the GC approved payment of a factored invoice, the factor may never receive payment because of the proper offset by the GC. So, what can you do?

The factor may try to obtain a typical “estoppel” or “no offset” letter which is signed by the GC. By having the GC sign this separate letter with each invoice, the factor creates a direct contract with the GC, bypassing the offset language of the underlying construction contract. Each letter should enclose a copy of each invoice and should ask the GC to confirm, by signing the letter, that the enclosed invoice is, in fact, due and owing to the client and will be paid to the factor “without defense, offset or other claims”.

If a factor is willing to take a few extra measures, he or she can confidently enter this market while helping to facilitate the comeback of the construction industry