1. Presented by Co-sponsored by Handling Subcontractor Default Claims Presented by Christopher Barbarisi, Partner, K&L Gates LLP James Bly, Managing Director, Marsh USA, Inc. Colin Daigle, Managing Director, Marsh Risk Consulting Anthony La Rocco, Administrative Partner, K&L Gates LLP

2. 1 SUBGUARD CLAIM PREPARATION

3. 2 Subguard Claim Preparation  Contract type and contract administration.  Project governance.  Scope.  General conditions.  Schedule.  Documentation.  Claims team. Pre-Claim Considerations

4. 3 Subguard Claim Preparation  Identify pitfalls affecting overall completion, issues with the owner, entitlement and proof around default, etc.  Stay ahead of the default impacts.  Develop a claim strategy to maximize recovery and expedite processing.  Align project controls with claim prep.  Be proactive — engage all relevant parties.  Timing of payments typically becomes a frictional area with complex claims. A Default Occurs – Initial Focus (Continued)

5. 4 Subguard Claim Preparation  Simple calculation: difficultly tends to be more on establishing a reasonable level of documentation.  Draws a line in the sand at default.  Reconciles the amount of the subcontract dollars available.  Applies those dollars to completion costs.  Overrun is the claim. The Proof of Loss - Overview

6. 5 Subguard Claim Preparation The Proof of Loss – Example Calculation PRE-DEFAULT CATEGORYAMOUNT Original Subcontract Amount $15,000,000 Changes to Scope/Change Orders $ 1,000,000 Revised Subcontract Value $16,000,000 Amount Paid to Sub $13,000,000 Subcontract Balance $3,000,000 ADDITIONAL COMPLETION COSTS POST-DEFAULT CATEGORYAMOUNT Labor Costs$1,000,000 Material Costs$ 1,500,000 Equipment and/or Tool Costs$ 500,000 Subcontractor's Costs$ 4,500,000 Legal/Consulting$ 500,000 Unpaid Vendors$300,000 Indirects$1,500,000 Total Costs Incurred$9,800,000

7. 6 Subguard Claim Preparation  Contract/subcontract.  Job cost reports.  Change order log.  Original budget/estimates.  Drawings/submittals.  Vendor invoices.  Time cards.  Payroll reports.  Daily reports.  Baseline and all update schedules.  Project photographs.  Correspondence/emails. “Contemporaneous” Claim Documentation

8. 7 Subguard Claim Preparation  Multiple submissions — put some thought into cut-off dates and Proof of Loss amounts.  Consider time to review and process for responding.  Requests for Information (RFIs).  What to expect and how to manage them.  Qualitative tracking of the process.  Contractor should keep a record of information provided and the number of times a question is asked.  Engage the insurer’s consultants to expedite.  Dedicate resources. Managing the Claim Process

9. 8 PRODUCTS TO MITIGATE SUBCONTRACTOR DEFAULT RISK

10. 9 Products to Mitigate Subcontractor Default Risk  Surety bond vs. Subcontractor Default Insurance (SDI):  Tri-party relationship between surety, bond principal, and bond obligee.  Surety’s right of indemnification from bond principal.  Surety stands in the shoes of subcontractor.  Potential for multiple lawsuits.  Negotiate subcontractor bond language — dispute resolution, surety’s time to respond recoverable damages, attorney’s fees.  Performance bond claims — may require subcontract termination to trigger surety’s performance unless surety chooses to finance defaulted subcontractor.  Termination — drastic measure that increases risk for all parties. Subcontractor Default Insurance

11. 10 GC/CM Subcontractor (Obligee) (Principal) Surety GC/CM Subcontractor Products to Mitigate Subcontractor Default Risk What is Subguard®?  Definition  Subguard® is a first-party insurance policy that indemnifies the insured for costs incurred as a result of a default of performance by one of its subcontractors. Subguard® = The First SDI Policy Written by Zurich in 1996

12. 11 Products to Mitigate Subcontractor Default Risk  Subguard®:  Insurance product that protects contractor from subcontractor’s default:  Insurance company pays for “paid project losses.”  Losses must be first paid by the GC — Subguard® will not front the loss.  Proof of loss — covered costs, procedure, and timing.  Direct and indirect losses/costs:  Delay, impact, attorney/consultant fees.  Separate limits of coverage.  Exclusions.  Deductible.  Subrogation recovery against subcontractor.  Subguard® and contractor vs. defaulted subcontractor.  Subguard®/Insurer — right of recovery against contractor for Subguard® payments in event of wrongful default. Default Protection and Risk Transfer

13. 12 Products to Mitigate Subcontractor Default Risk  Contractor Default Insurance (CDI).  Similar coverage to Subguard® with a few differences:  CDI has no minimum premium requirements.  $20 million per loss and $30 million aggregate vs. $50 million/$150 million with Subguard®.  Indirect expense is 5 – 25% of direct loss incurred vs. $5 million per claim limit with Subguard®.  Co-pay is eliminated if loss is reported within five days.  Lower deductible levels offered. A Second Market — Arch

14. 13 Products to Mitigate Subcontractor Default Risk  $50 million per claim/$150 million aggregate.  Indirect cost sublimit — $5 million or percentage of claim.  Copay may be waived if reported in five days.  CapAssure product:  Coverage A: Prime to owner coverage — up to $25 million/claim and $50 million aggregate.  Coverage B: SDI. A Third Market — XL

15. 14 Products to Mitigate Subcontractor Default Risk Control  Gives the named insured (GC or CM depending upon contract delivery method) control over default resolution process, keeping the project on time and within budget.  Insured manages claims in most efficient manner without surety approval.  Insured decides what subcontractors are enrolled in the program through a prequalification process.  Successful prequalification may include comprehensive financial analysis that includes balance sheet, cash flow, job profit, and historical and future earnings projections.  Marsh’s SubSecure prequalification tool is a best-in-class process as recognized by all three SDI markets.  Owner can be added to the policy through a Financial Interest Endorsement, and dedicated limits can also be provided to the owner. Why Subguard® or SDI?

16. 15 Products to Mitigate Subcontractor Default Risk  Joint checks.  Funds administration services.  QA/QC.  Increased retention.  Personal guarantees/parental guarantees.  Letters of credit.  Labor-only subcontracts. Other Products/Solutions

17. 16 Products to Mitigate Subcontractor Default Risk  Default under a subcontract bond:  Generally moves control of account out of underwriting into claim, unless job- specific, no financing, adequate capital.  Surety’s options in default:  Pay third party to assume liability (surety negotiates constraints).  Take over job.  Finance/workout existing contractor — the surety decides the course of action.  Owner rebid.  Surety rebid.  Deny.  Surety defenses:  Material change to contract.  Forgery of bond.  Obligee failure to pay, perform. Filing Claims Under a Subcontract Bond

18. 17 Products to Mitigate Subcontractor Default Risk  Surety’s options are limited by bond form language, including:  Forfeiture language.  Limited response time — AIA312 Payment Bond.  Limitation of options — owner takeover mandate, etc.  Public vs. private owner.  Factors considered when making financing decision:  Receivable/payable/contract balance/CTC.  Historic margins vs. CTC.  Bank support — collateral — covenants — violations — forbearance.  Ability to cross job funds.  Bid spreads.  Nature of work — ability to find replacement contractor.  Performance problems not normally financed. Filing Claims Under A Subcontract Bond (Continued)

19. 18 Products to Mitigate Subcontractor Default Risk  Default under a Subguard®/SDI policy:  First-party coverage, insured (GC) files claim with its carrier, reducing possibility of need for legal action.  Gives control of claims process to insured (GC), keeping project on time and within budget.  GC makes decision to finance defaulting sub or hire a new sub to complete work.  Notify insurer immediately with description of situation and anticipated cost of claim.  Provide proof of loss, including:  Written description of circumstances.  Notice of default to subcontractor.  Complete cost reconciliation of claim.  Copy of subcontract.  Labor costs for self-performed work.  Material costs.  Equipment costs.  Sub costs to complete work.  Legal costs.  Proof of payments to unpaid vendors.  Documentation of indirect costs incurred. Filing Claims Under A Subguard® Policy

20. 19 Products to Mitigate Subcontractor Default Risk  Insurer actions in event of default:  Upon receipt and review of acceptable proof of loss, insurer will make payments for qualifying loss within 30 days.  Interim payments are available for losses occurring over period greater than 30 days.  Advanced payments made for qualifying losses that cannot be fully quantified at time of claim submission.  Insurer may elect to subrogate against defaulting subcontractor.  Wrongful termination of subcontractor:  Defense cost included in default claim.  Coverage eliminated and payments refunded if sub wins wrongful termination lawsuit. Filing Claims Under A Subguard® Policy (Continued)

21. 20 SUBCONTRACTOR DEFAULT INSURANCE What to Expect When Pursuing a SDI Claim

22. 21 What is SDI Insurance intended to “Cover”?  Costs to complete subcontractor’s contractual obligations;  Costs to remedy defective (nonconforming work);  Indirect costs associated with the default:  acceleration costs;  extended overhead;  liquidated damages;  Usually subject to a separate sublimit;

23. 22 What Costs Are Typically not “Covered”?  Misrepresentations;  Fraud;  Defaults pre-policy period;  Contracts acquired by other entities;  Nuclear reaction/radiation;  Professional services provided by the insured;  Costs covered by ‘other insurance’;

24. 23 Gauging Insurer’s Claim Response: Preliminary Questions  How large is your claim?  If significant, dig in for the long haul;  If relatively small, expect reasonable response;  Are you viewed as repeat business?  If not, dig in for the long haul;  If so, expect more reasonable response;

25. 24 Timing of Claim Process

26. 25 Timing of Claim Process: Marketing  SDI specifically marketed as:  an efficient alternative to bonds;  insurance that “empowers the contractor to evaluate and manage subcontractor default situations, bypassing potentially contentious and lengthy claims process that can result when using third-party guarantees.”  “Default need not mean delay – The... claims process requires the general contractor inform the insurer about the default and the steps they are taking to remedy the problem. This gives the general contractor the control to make decisions that keep work moving forward while supporting the cash flow needs of your project.”

27. 26 Timing of Claim Process: In Practice  Expect a reservation of rights (or declination letter);  ROR accompanied by extensive/voluminous Requests for Information (“RFI’) to rectify ‘defects’ in submitted Proof of Loss;  Anticipate lengthy RFI process;  Each claim is factually unique;  Anticipate preparing detailed response narratives accompanied with all documents associated with the circumstances of the default & costs to complete/claim value;  Case Example – 24 months, 4 rounds of extensive RFI’s, produced over 67,000 pages of material (carrier still processing proofs); *Be prepared to keep project financed during this process

28. 27 Timing of Claim Process: In Practice (cont.)  RFI Responses - practical considerations  Build strong narratives in RFI responses (will follow you throughout the process);  Create positive positions, i.e., highlight consistent positions taken by insurer in other cases;  Be flexible to expedite claim.  Don’t hesitate to give up weak/undocumented items to expedite process;

29. 28 Common Claim Defenses

30. 29 “Proof of Loss” = Payment: Marketing  “Default need not mean delay – The... claims process requires the general contractor inform the insurer about the default and the steps they are taking to remedy the problem.”  Common CDI policies promise to indemnify policyholder for a loss “within thirty (30) days after [it] receives the Proof of Loss”;  Policies define “Proof of Loss” to be: “a written description and any other supporting evidence [including the subcontract & default notice]... that document the claim...and quantify the amount....”

31. 30 “Proof of Loss”: In Practice  Is the Proof of Loss “Satisfactory”?  Insurer may focus on undefined policy language requiring “satisfactory” proof of loss to delay 30 day payment clock.  Wholly undefined/subjective term;  Insurer’s judgment may lead to delayed payment ; (Ex: ACH transfers with corresponding lien waivers not proof of payment)  Insurer must apply the term in a “commercially reasonable” manner;  If needed - can be basis for ‘bad faith’ claim —especially in light of the marketing materials;

32. 31 The “Default”: Marketing  “[t]he biggest advantage is that the ability to determine default rests with the general contractor, thereby allowing the general contractor to make a quick decision and remedy the situation without outside intervention. This avoids waiting for a third party to make a determination of responsibility and to select the remedy as may be the case with a subcontractor surety bond.”  prompt payment upon the contractor’s determination of default.  Policy defines “default of performance” as - “failure of Subcontractor to fullfill the terms of the [c]overed [s]ubcontract... As determined by you or a legally binding authority.”  provides for payment subject to disgorgement if subsequently determined that default was not valid – burden is on carrier to disprove the default.

33. 32 The “Default”: In Practice  Insurer may challenge default – Sound like a surety bond?  ROR letter may actually say: “Lack of default of performance by ___[subcontractor]__” (from actual ROR letter).  Insurer may posture that it has no obligation until it “makes a determination of responsibility” (from actual ROR letter)  Insurer may use as additional basis to withhold/delay payment. (Carrier will link it to “proof of loss” documenting “Loss” (caused by a default – circular position).  Insurer will contact defaulted subcontractor to gather evidence to disprove default (bad faith?);  *Before defaulting subcontractor – be sure to gather proofs and be prepared to defend/support the default

34. 33 A Note on Subrogation:  Most SDI policies provide subrogation rights to insurer against defaulted subcontractor;  Insurer who pays a SDI claim will sue subcontractor in name of insured;  If suit is unsuccessful, could lead to disgorgement of paid policy proceeds (improper default);  Practical – Insured should seek modifications of SDI policy to avoid this, e.g., perhaps carve out exceptions to disgorgement or allow insured to control/participate in subrogation suit;

35. 34 Interim Payment of Claim Items: Policy Language  “[i]f an amount would constitute a Loss except that the amount of the Loss has not been finally determined, [Steadfast] will indemnify [the policyholder] for the Interim Percentage... of the Loss payment which would have been payable as calculated above....”  Interim percentage subject to negotiation – can be as high as 95% of an item;

36. 35 Interim Payment of Claim Items: In Practice  Insurer may be reluctant to make interim payment until insured has completely documented the loss item;  Not “satisfactory” under the policy until 100% proven;  Position is inconsistent with: i.the Marketing Materials; and ii.the Policy. iii.N.Y. Law requiring partial payments for substantiated portions of claims. -*Clearly delineate claim items (avoid overlap) to maximize partial payment on items

37. 36 Beware of “Other Insurance” clause  SDI policies may state that it is “excess... Over other valid and collectible insurance available to you.”  Subcontractor default could trigger multiple overlapping policies.  Insurer should not have to pursue other insurance first.  * Practical Note – Insurers should seek removal/modification of “other insurance” clause.

38. 37 Last Resort: Arbitration or Litigation?  Insurer – strong preference for Arbitration;  not public – preserves marketing;  Insured – press for court litigation;  public forum;  pressure point;  capitalize on ambiguous arbitration provision;  assert non-arbitrable claims  seeking punitive damages, e.g., good faith; N.Y Gen Bus. Law Sect. 349 (deceptive business practices) & Sect. 350 (false advertising)

39. 38 Conclusion Practical Points to Streamline the Claim Process

40. 39 Conclusion Practical Points to Streamline Claim  Up front (depending on your buying power)  Attempt to negotiate SDI policy language for:  definition of “satisfactory”;  Negotiate policy language re: interim payment on unsatisfied items;  Negotiate modifications to subrogation and “other insurance” clauses;  Negotiate away arbitration provision (not likely);

41. 40  Claim preparation/submission  Manage expectations, i.e., be financially prepared for extended claim process;  Invest time to prepare a well documented claim;  Clearly delineate claim items (avoid overlap) to maximize partial payments;  Avoid RFI delays by giving on small/undocumented items;  If needed, assert lawsuit to include non-arbitrable claims – public pressure point; Conclusion Practical Points to Streamline Claim (cont’d.)

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