The Risks of Selling to Unlicensed Contractors

What happens if you find yourself working with an unlicensed contractor? Or your customer's customer—perhaps, the general contractor—is unlicensed? Understanding the risks beforehand and the steps for mitigating them will help you avoid unnecessary headaches.

Even if your company has contracted with a licensed party in the supply chain, are you sure about upper-tier contractors? If your company's customer does not receive payment from the unlicensed general contractor, for example, how could this impact your company's ability to get paid for supplies it has provided?

Performing work as an unlicensed general contractor is often illegal when the cost of a job exceeds a certain amount specified in individual state statutes. An unlicensed contractor likely won't volunteer whether it lacks the proper documentation required by the governing state law. It is up to you and your company to determine whether a contractor is properly licensed.

Why It Matters

Licensing protects not just the public, but also the contractor and the parties with which it works. Licensing involves passing exams and meeting certain criteria to demonstrate reasonable competency in a trade. There is no oversight for contractors without licenses, which means there are fewer legal remedies if something goes wrong.

"We call it the death penalty for contractors when they are unlicensed [because] the contract is of an illegal nature," meaning it is unauthorized or unlawful, said Christopher Ng, managing partner at Gibbs Giden Locher Turner Senet & Wittbrodt (Los Angeles). In most cases, the unlicensed contractor has no protections under the law—even if the owner knew the contractor was unlicensed. However, "It is a violation of the law for a contractor to hire an unlicensed subcontractor," he added. "That may lead to disciplinary action by the Contractor's State License Board, resulting in civil and even potentially criminal penalties."

An unlicensed contractor that falls anywhere within the tier of suppliers and contractors could disrupt an entire project—putting lien rights in jeopardy. Typically, unlicensed contractors do not have lien rights, and contractors that do not have lien rights lose their ability to put pressure on the project owner for payment, which means material suppliers and subcontractors could go unpaid, said Chris Ring, of NACM's Secured Transaction Services (STS). In some states such as Washington, the loss of lien rights carries down to the material supplier.

However, a loss of lien rights could extend to your company, depending on how courts view it. A savvy attorney, owner, lender or general contractor might convince a court that you are a supplier to another supplier because an unlicensed contractor could be viewed as a distributor, Ng said. In some states such as California, a supplier to a supplier does not have lien rights.

"You should always confirm that the contractor is licensed," Ring said. "Washington is the only state where if you sell to an unlicensed contractor, you also lose your lien rights." In other states, suppliers can still exercise lien rights within statutory guidelines regardless of the contractor being unlicensed. Ring stressed being mindful of the supplier-to-supplier scenario mentioned by Ng because that could apply in any state.

And without proper licensing and workers' compensation coverage, a contractor is more likely to be insolvent or go bankrupt if an accident occurs or an unexpected issue arises. For example, "If you sell supplies to an unlicensed contractor for an installation that involves security measures such as a fire alarm or security system, the liability from that system's failure could carry down to you," Ng said. "Conversely, if you sell supplies to a licensed contractor and the same issue occurs, you may be protected due to the contractor's liability insurance coverage."

Cover Your Bases

It is not always easy to determine whether a contracting entity is licensed or not. A company may list a sole proprietor or individual officer who is a licensed contractor, but the company itself might not be. Verify that the name on the credit application for the contractor you provide goods matches the licensed entity, Ng advised. "And vet the license number and name on the Contractor's State License Board website."

In some cases, suppliers may want to ask for a copy of the agreement between its customer and the general contractor or owner to ensure the subcontractor has agreed to perform work on the construction project, Ng said. If there is push back, ask them for a redacted copy.

"You don't need to see the contract price or some of the more sensitive information, but you do want to make sure you are covered under state mechanic's lien laws," Ng said. If you already supplied the material and found out the contractor was unlicensed afterwards, ask your customer for written assurances that seek to rectify the issue, he continued. For example, "Because you don't want to be accused of pulling the rug out from underneath your customer, I would send a notice under 2609 of the California Commercial Code, which may allow you to suspend performance of your obligations until you get adequate assurances of performance (i.e., payment) from those upstream." Check state commercial codes for the areas in which you do business.

"In most states, licensed contractors that do not maintain proper workers' compensation coverage or utilize a proper qualifier may be considered unlicensed," according to Ng. Moreover, a contractor's failure to post a surety bond may render it unlicensed. In California, contractors must post a surety bond of $15,000, soon to be $25,000, to do business, Ng said. The state licensing board overseas all administrative regulation of contractors and ensures contractors are performing work they are qualified for depending on the class of their license.

To learn more about licensing laws in the state of California, be sure to register for Ng's presentation during NACM's upcoming webinar, How California's Contractor Licensing Laws Impact Distributors and Suppliers, at 3 pm ET on April 18.

-Bryan Mason, editorial associate