Providing a Working Capital Line of Credit to contractors (General or Subcontractor) can be a tricky endeavor what with Progress Payments, Billings in Excess of Costs, Costs in Excess of Billings, weather delays, etc. Should I go on?
However, one of the more significant (and overlooked) risks in this lending arrangement can be receipt/processing of Joint Checks by your contractor borrowers.
What are Joint Checks?
Joint Checks are issued to your borrower (a contractor) and one of its vendors (either a subcontractor or material supplier) to pay the vendor for its services/supplies that were provided to the contractor. The request for a Joint Check usually comes from the vendor directly to the property owner or General Contractor (“GC”).
Why would a property owner or General Contractor agree to pay with a Joint Check? Simple, they do not want liens filed on their projects for non-payment of invoices related to the project. The Joint Check issuance can help alleviate that risk for the property owner or General Contractor.
So, let’s talk about the impact of the issuance of a Joint Check on the bank’s collateral (A/R). A typical A/R line would provide for an 80% Advance Rate on eligible A/R (invoices < 90 days past invoice date, etc.). Let’s use the example of a $100,000 invoice (a Progress Billing draw) –on which the bank has effectively advanced $80,000. For this invoice, the work done included $40,000 of materials from a vendor (steel, concrete, etc.). The vendor (having past experience with the subcontractor) is concerned that they may not get paid in a timely manner (or the invoice is already past due) and therefore notifies the GC to issue a Joint Check in the amount of $40,000 to the subcontractor and vendor.
The GC obliges (remember, they don’t want a lien on the project) and when the original $100,000 invoice is scheduled for payment, generates two checks – one for $60,000 made out directly to the borrower (contractor) and the other for $40,000 made out to the contractor and the vendor. The GC has now met its payment obligation.
Upon receipt of the checks
the subcontractor credits the $100,000 off of the A/R; however, only receives $60,000 in cash. The other $40,000 is generally posted to a Joint Checks Clearing Account. This account should have a -0- balance and the “deposit” is offset by a debit to the contractor’s AP account with the subcontractor. Remember, this check goes to the vendor and never is deposited into the subcontractor’s bank account.
The vendor credits the $40,000 against its A/R (clearing the amount owed by the contractor, and providing a Lien Release to the contractor/GC) and goes about its business.
So, what just happened here? The answer is the bank advanced $80,000 against the $100,000 A/R and the subcontractor only got $60,000 back in cash that would available to pay down the advance, so they are $20,000 short of being able to clear the advance. This transaction is dilutive (i.e. a non-cash reduction of A/R) and can have a major impact on the bank’s collateral position, especially in a workout situation. It basically turns the unsecured vendor into a secured lender by directly receiving payment from the GC.
So how do you address this possibility?
Bankers need to ask the borrower during loan negotiations if, and if so, how much in joint checks does it receive on a monthly/quarterly/annual basis. The bank can then determine if a lower advance rate needs to be considered or if a reserve should be established (another form of ineligible A/R) to account for the dilutive effects of Joint Checks. Bankers may also want to address Joint Checks in loan documentation (i.e. Loan Agreement) with a covenant that may require notification of receipt of Joint Checks, limitations on amounts received, etc.
