Secrets of Bonding 130: Borrow From Peter to Pay Paul

downloadIt’s only human nature. You have a problem, a need. A financial issue has come up and the timing is inconvenient. So if you just move things around, you can handle the problem and back-fill later.

For construction companies managing multiple projects, not every job goes smoothly. Construction work is complicated with many variables and uncontrollable elements. Sometimes the only solution is to throw money at the problem. When cash flow on the project is “temporarily” insufficient, there is a natural temptation to borrow money out of another healthier contract, with the intention of paying it back at a later date. Is this bad?

Trust Funds

From a legal standpoint, money a general contractor (GC) holds, that is destined to pay the subcontractors (plumber, electrician, HVAC, etc.) he hired on the project, is held “in trust” for the benefit of those subs. The law says it is their money, and the GC must safeguard it. Therefore, any money in this trust fund category cannot be “loaned” to another of the company’s projects.

Bonded Contracts

When a Performance and Payment Bond covers a contract, the payment section of the bond guarantees that suppliers of labor and material will be paid. This includes the subcontractors that were hired by the GC. The bonding company is guaranteeing that the trust funds will make it into the hands of the subs.

If money has been diverted into another project by the GC, and subs remain unpaid, they are entitled to make a claim against the payment bond. Sureties are risk averse and strive to avoid all bond claims. Underwriters are well-aware of the “Peter Paying Paul” scenario where the funds are never restored and a payment claim results.

Protective Measures

Bonding companies may take steps to prevent such misapplication of funds. One is Joint Checking. Under this procedure, the project owner (paying for the work) issues joint payee checks in the name of the GC and the sub or vendor. Now there is absolute certainty that the funds will get to the sub as intended.

This procedure does not cost money to implement (other than the administrative expense), but is dependent on the willingness and continuing participation of the project owner.

Another protective device is the use Funds Control, also called a Funds Administration. Think of this as a professional paymaster who pays everyone on the project, including the GC. Money goes from the owner to the funds administrator, who then issues all the checks. By avoiding the GC’s handling of the money, there is no risk of funds flowing to another contract.

The funds administrator charges a fee, which is paid by the GC. For this procedure to be successfully implemented, the owner must officially agree to pay the funds administrator instead of the GC.

Conclusion

When it comes to money handling on construction projects, many people have a stake in the process. The GC’s obligation is more than to simply complete the work. They have a fiduciary responsibility to handle funds properly and assure that deserving parties are paid. That’s what the bonding company expects, and it’s simply the right thing to do.

Steve Golia is an experienced provider of bid and performance bonds for contractors. For more than 30 years he has specialized in solving bond problems for contractors, and helping them when others failed.