Bankruptcy for Building Contractors
Contractors are individually vulnerable in an insolvency scenario. They are vulnerable because typically the insolvent contractor is the center of a combination of dangerous factors.
First, the insolvent contractor normally has numerous creditors, some of whom are well funded and already burned. So, the insolvent contractor may have well funded enemies with grudges. This is more or less the definition of exposure. How he treats them personally is extremely important.
Second, like most contractors, the insolvent contractor has probably operated his business from a single operating account with nothing more than a checkbook to show whose money was spent on which job. This is especially troubling because the contractor often uses money that he received for one job to pay the expenses of a different job. When he does this, he violates the contractors' trust fund statute. The contractors' trust fund statute provides that the contractor holds the money that he receives for a job in trust for the benefit of subs, laborers and suppliers who worked or supplied materials on that job. The contractor cannot use any of that money to pay expenses that are not directly related to that particular job.
The allegations generally allege that the contractor underbid a job in order to get it, and then funded it through the use of money received for other jobs.
The real problem with this scenario is that in Texas a violation of the contractors' trust fund statute can be a felony. It is a difficult statute to prosecute and there are statutory defenses, but just being charged with a crime can be life-changing. There are only two criminal convictions on record in the Texas Courts of Appeal, but that number does not reflect the number of convictions that were not appealed. Contractors should do whatever is necessary in order to avoid exposure to prosecution.
So, the reorganization or the winding down of a contractor with a history of violations requires significant care and experience with a goal of first avoiding a criminal prosecution and, second, either reorganizing or winding down the business fairly and effectively.
Third, in the event that the contractor files a personal bankruptcy, improperly addressed trust fund violations by his corporation can follow him into his personal bankruptcy. They can result in a challenge to his discharge. If he does not file a bankruptcy, the trust fund statute results in a private cause of action against the officer responsible.
We advise contractors to set up their books to mirror the contractors' trust fund statute through the use of an actual trust. This accomplishes several things.
It insures that at any given time the contractor is safe - even if insolvency strikes without warning.
His customers, who may have already been burned by other insolvent contractors, are far more prone to hire him because they know that their money will be held in an actual trust. To them this means two things: no liens and no losses.
The money in the trust is protected from the contractor's creditors, from IRS, from judgments against the contractor, from seizures and from bankruptcy.
The main reason that contractors file bankruptcy is plain and simple: they are not making enough money. As a result, the receipts from one job are used to pay the subcontractors of another job, the employment taxes may go delinquent and suppliers, just like subcontractors, get paid as soon as the deposit on the next job comes in. When this occurs, the contractor has unwittingly stepped into a criminal liability because all of the funds that he receives on one job he he holds in trust for the benefit of the subs and the suppliers on that job. If he uses the money to pay the expenses of another job, he has breached that trust and in Texas that is a crime.
The primary pattern of disaster in contractors’ bankruptcies can be summed up in one word: bids. Just one seriously underbid job can hit the contractor so hard that he cannot recover. In the bankruptcy of one of the most successful commercial plumbing contractors in North Texas, and in the bankruptcy of a large Texas steel manufacturing business, and in the bankruptcy of a commercial excavation business each one of these businesses failed just because of bad bidding.
And in each of these cases, the principal of the business had delegated the responsibility of bidding to someone else.
In one case the principal had delegated the bidding because of serious illness; in another case, he delegated because of absence and in he delegated pursuant to a business decision. All these reasons were good reasons, to be sure, but they were disastrous all the same. Bidding is the absolute core of a contractor’s business – it is his foundation - and if the bidder is not reliable, profit is illusory at best.
Contractors, consider what happens when you delegate your bidding to an employee. You place your entire financial survival in the hands of one man, a man who may have no real interest in whether you live or die financially.
The delegation of this amount of responsibility to one man does not occur in any other aspect of the contracting business. Everywhere else, the risk is spread over numerous people.
Everywhere else the business can be structured to be practically fail-safe or at least structured to where the failure of one area will not bring the others down. As the risk is spread over various people, so is the potential loss. So failure in one area can be limited to the amount of risk that was assigned to that area and the loss can be absorbed. But this is not so with bidding, because with bidding, in just one number, the bidder encompasses all of the other areas at once.
Now let us consider the structure of the bidder’s job. Quite often, the bidder is autonomous. He has his own office and his own files, he is not closely supervised and what he does may not be reviewed until after he has completed the bid and then the review is often cursory. None but the principal himself has this amount of autonomy. The foremen, the workers, the drivers, the assemblers, the managers, the dispatchers, and everyone else, except perhaps for the bookkeeper, is doing his job in full view of everyone. Everyone sees what the manager and the foremen are doing (and comment on it daily) and the managers and the foremen see what everyone else is doing because that is the nature of their job. But not so for the bidder. In most contracting firms, no one watches the bidder; he is autonomous.
What happens to the bidder when the bidder bids on a job and gets it? He brings in much needed money and work and he is viewed favorably. What happens if the bidder if his bid is unsuccessful? He does not bring in much needed money and he is not viewed favorably. So, where is the bidder’s reward? His most immediate reward is in bidding low enough to get the job. Is the bidder being paid by the jobs that he brings in? Is he being paid by the hour? Either way, he is rewarded for underbids. What fail-safe procedures does the contractor have in place to ensure that the bidding is both skillful and honest?
And what if the bidder feels that he deserves a little more than what he is paid by his employer? How easy is it for him to arrange that? Well, perhaps this question should be rephrased as “How easy it is for him to arrange that!”
Our purpose here is not to demean bidders. Our purpose is to warn contractors and to demonstrate that many contractors have an exposure that they may not have fully appreciated and not yet addressed..
Do you have an honest and skillful bidder? If so, the chances are that you will never have to call us for legal advice. Are you changing bidders? If so, be extremely careful and we advise that you implement checks and double checks.
Another reason why contractors file bankruptcies is because they do not forcefully collect what is due to them and because they do not structure their business so as to protect themselves from their customers filing bankruptcy.
I sincerely hope that you find this to be helpful or instructive.