A general contractor default is one of the most disruptive events that can occur on a construction project, and one of the most consequential for construction lenders. When the GC defaults, the owner has a partially complete building and no contractor to finish it. The lender has a loan secured by an incomplete building and a borrower whose construction program has just experienced a major failure. The path from that point to a completed project and a repaid loan is complex, expensive, and time-consuming in ways that a functioning construction program is not.
Understanding what happens when a GC defaults, what options lenders and owners have, and how to manage the transition to a new contractor gives lenders the context to respond effectively when the situation arises, and to structure loans from the outset in ways that give them maximum flexibility if it does.
What Constitutes a GC Default
A GC default under a construction contract typically occurs when the GC fails to perform the work in accordance with the contract requirements, which can take several forms. The most common: the GC abandons the project by stopping work without legal justification, the GC fails to pay subcontractors from draw proceeds (resulting in mechanic’s lien exposure), the GC becomes insolvent and cannot continue operations, or the GC’s performance is so deficient that the owner has legal grounds to terminate the contract for cause.
The distinction between termination for cause (the GC is in default) and termination for convenience (the owner is terminating without cause) has significant legal and financial consequences. A termination for cause allows the owner to call on the performance bond, pursue the GC for damages, and withhold payment for incomplete or deficient work. A termination for convenience entitles the GC to payment for work completed through the termination date and, in many contracts, to recover lost profits on the uncompleted portion, a substantially more expensive outcome for the owner.
The owner’s decision to terminate for cause should always involve legal counsel and a thorough documentation of the GC’s defaults before the termination notice is issued. A termination for cause that is subsequently found to be wrongful becomes a termination for convenience, with all the financial consequences that entails.
The Performance Bond and Its Limitations
Most commercial construction lenders require a performance bond as a condition of the construction loan, a surety instrument that provides a source of funds to complete the project if the GC defaults. Performance bonds are underwritten by surety companies who evaluate the GC’s financial strength and track record before issuing the bond.
In practice, performance bonds are more valuable as a GC qualification filter than as a direct financial remedy. The process of making a claim on a performance bond, notifying the surety, allowing the surety to investigate the default, and waiting for the surety to exercise one of its remedies, takes months and involves significant legal and administrative cost. The surety’s remedies include completing the project themselves, financing the original GC’s completion, or paying the project owner the cost of completion up to the bond amount.
The bond amount, typically equal to the original contract amount, sounds like it should be sufficient to cover a completion cost overrun. In practice, the cost of completing a partially built project after a GC default typically runs 15% to 30% above the original contract’s remaining uncompleted value, because the replacement contractor’s price to complete must include the cost of assessing the existing work, repairing any deficiencies, re-mobilizing subcontractors who have demobilized, and carrying the overhead of completing a project whose documentation may be incomplete.
The Lender’s Position in a GC Default
The construction lender’s primary concern in a GC default is protecting the collateral, ensuring that the partially complete project is completed and that the loan is repaid. The lender’s options depend on the loan’s structure and the specific circumstances of the default.
If the construction contract has been properly collateral-assigned to the lender, the lender has the right to step into the owner’s position in the contract and to take over the project completion directly. This is a significant step that most lenders prefer to avoid, taking on the operational responsibility of completing a construction project is not a lender’s core competency, but it preserves the option to control the completion process if the borrower is unable or unwilling to do so.
More commonly, the lender works with the borrower to identify a replacement contractor and to fund the completion through an amended or extended loan. The lender’s leverage in this process is the construction loan: the borrower cannot complete the project and repay the lender without the lender’s continued cooperation, which gives the lender meaningful influence over how the replacement contractor is selected and how the completion process is managed.
Managing the GC Transition
The GC transition process, from the defaulting contractor to a replacement, involves several steps that must be managed carefully to minimize additional project cost and schedule impact.
Assessment of the work in place: An independent construction manager or owner’s representative should assess the project at the time of the GC transition, documenting what work has been completed, identifying any deficiencies that require remediation, and establishing the baseline from which the replacement contractor will price the completion work.
Subcontractor retention: The defaulting GC’s subcontractors may or may not continue on the project with a new GC. Subcontractors who have not been paid by the defaulting GC have both lien claims against the project and leverage in negotiations with the replacement contractor. Maintaining communication with major subcontractors during the transition and providing payment clarity is essential to keeping the subcontractor team in place.
Replacement contractor selection: The replacement contractor should be selected through a competitive process focused on the specific requirements of the completion scope. Experience completing projects mid-construction is distinct from experience building from the ground up, the replacement contractor needs to understand how to assess existing conditions, work around completed work, and manage the interface between what was built and what they will build.
Innergy Integral’s Founding Principals have direct experience managing mid-construction transitions, including the Meridian at Stone Creek and Lyon’s Gate projects where our team assumed management at 40% to 65% completion and delivered on schedule.
For a complete treatment of this topic, see our guide to construction loan monitoring: the complete guide for lenders. Innergy Integral provides these services in Seattle, WA and across our six-state footprint.
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