Risk management: plan for the worst

Custom Home, Jan-Feb, 2005 by Steve Maltzman

Even in the best of times, it's important to remember that a custom building business always faces risks. Most of the custom builders I've met and worked with in the past year have strong volume, increasing profits, and a healthy market. But there were a few who experienced hard times because of events they were not prepared for. In this column I want to share some of these events with you and discuss steps you can take to minimize risk should something similar happen to your business.

Litigation. I recently received a call from a custom builder who said he was being sued by a homeowner for damages caused by problems with a roof on a home he had completed nine years ago. Alter examining the problem, both the builder and his attorney felt that the lawsuit was frivolous and that the builder had to defend himself. The first thing he did was call his liability insurance carrier, who immediately claimed this risk was not covered under the builder's policy. To make a long story short, the builder so far has shelled out over $200,000 both to his attorneys and to fixing the problem. He is also spending a large portion of each business day working with the attorneys to pull together information for the case. Sales, production, customer service, and profitability have suffered because the owner and several of the company's key people are involved in preparing for the lawsuit.

Frivolous or not, lawsuits by homeowners are becoming more common. Here are some things you can do to minimize your company's risk of facing a lawsuit:

Implement strong quality control procedures. QC checklists and training for your superintendents and field personnel can limit risks resulting from construction defects.

Make sure that all of your project documents (sales contracts, warranties, etc.) include protective provisions such as alternative dispute resolution (i.e., mediation and binding arbitration); right of access for the builder to inspect, test, and repair claimed defects; a provision that allows the builder to correct claimed defects prior to a suit or arbitration; and clauses imposing consumer obligations regarding inspection and maintenance.

Review your new home warranties to make sure that they are risk management tools. They should include a clear roadmap of warranty claim procedures, and you should apply them consistently.

Put in place effective contract administration procedures that help you track compliance with contractual insurance requirements. For example, make sure you have valid, up-to-date insurance certificates that list the builder as additional insured for all of your subcontractors.

Understand the coverage set within your insurance policies as well as the carrier's track record in supporting other builders in frivolous claims. In today's insurance environment, getting solid coverage from a strong company is sometimes difficult. Explore all options available to you when renewing your insurance and stay abreast of developments on the insurance front throughout the year. Challenge your broker to be proactive and work for you. Many agents and insurance companies have tools available to assist you in minimizing risk of loss.

Minimize your financial exposure by undertaking an asset protection program. If a claim is asserted against a builder for which insurance is not adequate, the company's assets are at risk of being taken. This risk can be lessened by minimizing the assets that are maintained within the building company. Here are some steps to consider:

* To minimize your personal liability, make sure that your building company is set up as a corporation or limited liability company (LLC) instead of a sole proprietorship or general partnership.

* Make sure that the corporation is truly being treated as a separate entity by keeping minutes and other corporate documents up to date and maintaining corporate formalities such as documenting all intercompany transactions and transactions between the corporation and its owner.

* If you are involved in land development or are holding land or spec inventory, you may want to consider establishing a separate company to develop the land or hold your specs and other key assets.

* Pull excess equity out of the building company and move it to either a personal asset or into a separate entity that is not involved in the construction process. If you want to loan the money back to the building company, make sure that it is properly documented and done via a formalized note with interest and other terms that would be afforded to a bank or other outside creditor.

Clients withhold payment. When a custom builder I know got to the end of a job, the clients refused to submit the final payment of more than $100,000, claiming that the project took too long and went over budget. When doing the final walkthrough with the customer, the homeowner took out his magnifying glass and developed a mile long punch list. The builder did everything possible to satisfy his clients but the homeowners still refused to pay. Not being able to collect the final payment on this job forced the custom builder to start using cash flow from other jobs in progress to cover overhead as well as cover the cost over-runs and pay off all trade partners and suppliers on the clients' home. After several months and attorney's bills, the builder discovered that the clients didn't have the cash to make the final payment.