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Counter-party risk: Is there enough margin in the tank?

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December 17, 2014 by DAVID BOWCOTT

We are at a crossroads within the economy. On the one hand the U.S. is beginning to fire up. On the other hand China is starting to slowdown. Which path will the Canadian economy follow? Nobody can say for certain, but I’ve got one risk that will not go away no matter which direction the economy goes. And if you manage it effectively, your company will stick around to enjoy the next economic growth phase.

What I’m getting at is the risk of counter-party failure to perform. This risk will likely get worse regardless of how the economy fluctuates. If the economy is heading upwards, many of these counterparties may not have enough margin in their backlog due to a slowing economy and tighter bidding over the past few years. These counter-parties will need that margin to fuel the growth required by a growing economy. If the economy is heading downward, then the thin margins picked up over the last few years will continue to get thinner as there are less and less options to replace them with jobs that can continue to feed the counter-parties overhead. Financial difficulties won’t be far off.

The point is that the future will likely hold an increased risk of counter-party failure to perform. Empirical evidence within the insurance sector suggests as there has been increased claims activity with lines of cover that provide security for subcontractor performance. Some of these lines of cover are experiencing their highest frequency of claims activity ever.

Given the likelihood of this risk impacting your company over the next couple years, here are some helpful practices that will help you effectively manage this risk:

1. Change counter-party bid philosophy:

a: Don’t take the lowest bidder; take the lowest qualified bidder instead. There is a difference.

b: Determine what your company considers a “dangerously” low bid. Is it 40 per cent low, 30 per cent low, 20 per cent low, 10 per cent low, or event five per cent low? The subcontractor performance security industry usually considers 10 per cent low “dangerous” and worthy of investigation.

2. Prequalification:

a: Consider developing a counter-party prequalification practice. Most leading companies no longer pre-qualify based on subjective criteria like “Joe is a good guy.” Developing a formal prequalification protocol could be well worth your while.

b: Ensure your prequalification assessments are available to all those employees at your company that make decisions on who to award contracts to.

3. Contract forms:

a: Are your contract forms and purchase orders best in class? They have to be fair or you will have difficulty attracting any bidders to your jobs. But know full well there are forms in the market that are fair both ways and clearly outline responsibilities of both parties.

4. Contract award:

a: What protocols do you have in place to manage low bids? Who assesses the risk of low bid and decides whether to take the bid, change the term, or pass on it?

b: Do you have in-house capabilities to verify the accuracy of bids? Use those resources by doing take-offs on key contracts.

5. Contract management:

a: Do you allow counter-parties onto the job site prior to having a signed contract or clearly constructed letter of intent? What about initial payment protocols?

b: If a counter-party begins to fail in performing its agreed upon obligations, do you have a set of best practices to manage this risk?

6. Quality assurance/Quality control

a: Do you have a formal protocol to ensure the counter-parties work is being done in line with what is required in your contract and what is required in the design?

b: Do you have a dedicated QA/QC team? Do they have authority? The above are some select practices you should consider to manage the growing risk of counter-party failure to perform. There are several more and I’d encourage you to investigate all available in order to ensure your company is ideally positioned to weather any stormy conditions that might come from the ups and downs of the economy.

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