Wednesday, July 15, 2009
Set-Off : a Cost of Risk?
This risk management paper is focused principally on the constructor. It uses a popular definition of Cost of Risk and proposes that set - off or financial hold back due to an incident of some sort is a predictable event. As a predictable event it further proposes that the constructor should include an allowance for set-off within its annual cost of risk calculations and ultimately into its overhead. This allows the constructor to spread its risk of set-off among its annual work.
I hope you enjoy the paper. Should you have any questions, please contact me.
Have a great day.
Simon Fenn
Owner/ General Contractor Payment Set-Offs: A Predictable Cost of Risk?
One of the most frustrating things for me as a construction insurance broker is being unable to address the fact that in so many cases when something goes wrong on a construction project, the Owner or General Contractor holds back payment to the contractor/subcontractor (hereafter subcontractor) for its progress payment or completed work, irrespective of insurance being involved to cover the incident. I suggest it may be time for the subcontractor to anticipate such situations within an annual cost of risk calculation to become part of your overhead.
Many times my clients look to me as if I can sort out the holdback situation if it is connected to an insurable incident. Helplessly, I shrug my shoulders, part my hands with palms up and say:
“The insurance claim is in the realm of the insurance industry; whereas, the holdback is a contractual dispute”.
This of course does not help my client who, because of an incident that might not even be its fault, can wait for months or years before receiving payment from its client. Such situations add stress, not only on cash flow but, depending on the size and financial strength of the firm: its very existence. I have looked at potential insurance solutions but have come to the conclusion it is a risk management issue, not an insurance issue.
In one recent case, my client’s claim occurred in November 2008 and repairs did not conclude until June 2009. For this entire period of time the payment for the work has been withheld by the Owner who has refused to pay the contractor until such time as the authorities had given the repairs a clean bill of health. Sadly, I have seen much longer examples.
Is this right? Should General Contractors and Owners be allowed to hold back payment when there is an incident on a jobsite? I decided to explore this.
As you might expect when serving a large number of contractors and consequently insuring a large volume of their work, I get to see how the sector is affected by such payment hold back activity. Almost every single third party liability property damage claim against one of my clients includes a payment hold back situation. From what I can tell the frequency of such situations seems very high.
The term hold back is really an incorrect term to use in these cases as it in itself is usually more strictly defined within and relates to the Construction Lien Act (Ontario). To avoid confusion henceforth we change the term of reference to the Common Law right of Set- Off. The version of Set-Off we are dealing with here is considered “Equitable Set Off”.
According to a December 11, 2006 article written by Christopher Hurst & Norman Streu of Alexander Holburn Beaudin & Lang LLP (full copy of article http://joconl.com/article/20061211500):
“The right to an equitable set-off arises when a defendant’s cross-claim is so clearly connected with a plaintiff’s demand that it would be unjust to allow the plaintiff to enforce his demand without taking into account the defendant’s cross-claim. In the construction industry, this often arises when a contractor (or subcontractor) seeks to enforce a demand for payment, and the owner (or contractor) sets - off against that demand its own claim, generally for delay or for construction deficiencies.”
Here is a good example of Equitable set - off from the same article:
Swagger Construction Ltd v. University of British Columbia:
“UBC hired Swagger Construction to build the Forest Sciences Centre. At substantial completion, Swagger brought an action for payment with respect to the 33rd Progress Certificate. The Court allowed UBC to set off against this payment its own claim in damages against Swagger, for delay and for the cost of correcting deficiencies and completing the work.
In reaching its decision, the Court ruled that one party to a construction contract has the right to defend, by way of equitable set-off, against the claims of the other party. The Court further noted that this would generally constitute a claim for contract monies on the one hand, and a claim for damages for poor workmanship or delay, on the other.”
The article further states that:
“The right of equitable set-off exists as part of a construction contract unless it is specifically excluded by the parties.”
Furthermore, the CCDC 2 (1994 & 2008) standard contract makes references to set – off, it sometimes includes the right and in one case excludes the right. Equitable set-off is often not addressed and so may be interpreted as not excluded.
The same article refers to an Ontario case that does at least seem to put some limitation on right to set-off involving third parties:
“The court found that it would not be fair or reasonable to allow a third party ……..to determine arbitrarily what amounts could be held back from a subcontractor.”
and that…
“….the claim for damages was made by a third party, and was not a claim for construction deficiencies or damages for delay involving the two parties to the contract, Axor (contractor) and Armenia (Owner).”
In discussing this recently one lawyer said to me that this is just a case of Common Law rights. The lawyer said it’s a case of “I owe you, you owe me, but the party withholding had better be sure it has a right to set-off or it could end up paying the other’s interest and costs.”
The clear message in this statement – if money is being set – off, have your lawyer (preferably a construction lawyer) review the situation to ensure that whoever is setting – off is within its legal right to do so.
From an insurance professional’s perspective we can only offer some risk management suggestions. Firstly it is unlikely that you will succeed in avoiding such situations through amendment of contractual language. You could try but someone else will likely not be so concerned and will win the contract. Secondly you could risk manage by verifying the payment reputation of the Owner/ General Contractor before you submit your bid, especially if you have never worked for them before. If you don’t get a good sense of their payment reputation or what they are like to work for, you may wish to cushion your bid to include a contingency if you bid at all. Again this could work against your bid success as someone else may not be as concerned and will bid below you. Thirdly, you could make an allowance within your annual cost of risk against such situations.
IRMI (International Risk Management Institute) defines Cost of Risk as:
“The cost of managing risks and incurring losses. Total cost of risk is the sum of all aspects of an organization’s operations that relate to risk, including retained (uninsured) losses and related loss adjustment expenses, risk control costs, transfer costs, and administrative costs.”
It is conclusive from my experience that the frequency of an individual subcontractor’s work related incidents is fairly low but with each such incident, the likelihood of a set-off situation being triggered by an Owner or a General Contractor is high.
You may not yet as an organization be calculating your annual cost of risk within your operating costs. Right now you probably just look at the insurance premium and deductible and include this in your overhead. You’re almost there. As described above, you should include in your annual cost of risk estimate uninsured losses, administration time on your part, the premium you pay and an allowance for the deductibles you “may” pay, let alone the many issues you face yearly that are not within the realm of insurance, but still represent risk that your organization will sustain (including write offs/ bad debts etc.). This is not dis-similar to insurance itself, you are spreading the risk.
As contractors whether subcontractors or general contractors, you have all had incidents where it has cost you something to negotiate away a potential claim against you. This negotiated settlement is a perfect example of what constitutes cost of risk.
Controlling your cost of risk is possibly more important than the cost of your insurance. The insurance premium could pale by comparison to the overall cost of risk calculation. Please try and anticipate that you may have a payment set-off situation arise and consider putting an allowance for this into you cost of risk estimate and then putting your cost of risk estimate into your overhead costs.
Fenn & Fenn Insurance Practice Inc. is a commercial and construction insurance practice in Newmarket, Ontario, Canada. Simon Fenn, CIP is President of Fenn & Fenn Insurance Practice Inc. This document is prepared as general information only and is not to be interpreted to apply as advice to any specific situation. Fenn & Fenn Insurance Practice Inc. will not be accept liability for the losses arising from the use of this information for any specific application. If you require advice or assistance in calculating cost of risk, please contact your insurance professional.