Tuesday, November 26, 2013

Hedge Fund Action Points to Further Pain for Yen ETF

Hedge Fund Action Points to Further Pain for Yen ETF

November 26th 2013 at 2:30pm by Tom Lydon

Currency ETFs News:

Japanese yen exchange traded fund traders could see more weakness ahead, with hedge funders betting on rising inflation in Japan and tapering in the U.S.
Futures traders pushed net shorts – bets that the yen will fall against the U.S. dollar – to the highest since July 2007, reports John Detrixhe for Bloomberg.
“Everybody likes dollar-yen higher,” Brad Bechtel, the managing director at Faros Trading LLC, said in the article. “And everyone has it on.”
George Soros reportedly made $1 billion between November 2012 to February 2013 on bets against the yen. Soros’ former chief strategist, Stan Druckenmiller, the founder of Duquesne Capital Management LLC, is “short some yen,” while being “long some Japanese” stocks.
The Bank of Japan has enacted an aggressive $70 billion monthly bond purchasing program since April to depreciate the strong yen currency, stimulate economic growth and reverse deflationary pressures. Consequently, the yen has declined 15% this year, the fastest drop since 1979.
The Bank of Japan has set an inflation target of 2% in two years. Governor Haruhiko Kuroda expects the target will be achieved sometime late in 2014 or early 2015. To put this in perspective, consumer prices have been declining 0.1% per year over the past 15 years. [Next Year Could be a 2013 Sequel for Japan ETFs]
Speculation that the Fed could taper its $85 billion a month bond purchasing program has also weighed on the yen against the U.S. dollar – tapering would reduce the supply of U.S. dollars in the economy and strengthen the U.S. dollar against foreign currencies. Fed minutes indicate they could reduce stimulus “in coming months” as the economy improves. [Yen ETF Investors Say ‘Sayonara’ in Risk-On Environment]
The yen traded as low as 101.92 per U.S. dollar Monday, the lowest since May. The Japanese currency sits around 101.32 per USD Tuesday.
The CurrencyShares Japanese Yen Trust (NYSEArca: FXY), which follows the price movement of the Japanese yen against the U.S. dollar, has declined 14.8% year-to-date.
As the yen continues to weaken and the Japanese economy expands, investors can take a look at yen currency-hedged Japan equity ETFs, like the WisdomTree Japan Hedged Equity Fund (NYSEArca: DXJ) and db X-trackers MSCI Japan Hedged Equity Fund (NYSEArca: DBJP), which have gained 35.6% year-to-date and 42.9% year-to-date, respectively. In comparison, the iShares MSCI Japan ETF (NYSEArca: EWJ), a non-currency hedged ETF, rose 24.3% year-to-date. [Good News for Japan ETFs: Goldman’s Still Bullish]
CurrencyShares Japanese Yen Trust

For more information on the yen currency, visit our Japanese yen category.
Max Chen contributed to this article. Tom Lydon’s clients own shares of DXJ.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Mr. Lydon serves as an independent trustee of certain mutual funds and ETFs that are managed by Guggenheim Investments; however, any opinions or forecasts expressed herein are solely those of Mr. Lydon and not those of Guggenheim Funds, Guggenheim Investments, Guggenheim Specialized Products, LLC or any of their affiliates. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.
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Improving A Simple SPY Trading Model


Improving A Simple SPY Trading Model

Nov 26 2013, 09:34  |  about: SPY, includes: DIA, DOG, IWM, PSQ, QQQ, RWM, SH, SSO
BOOKMARK / READ LATER
Disclosure: I am short SPY. (More...)
In a recent article we explored some optimizations of a simple way to trade the S&P 500. In this article we'll take one additional step in developing a higher performance strategy to trade SPY that's still easy to implement.
We'll begin with an observation; this is not your father's or grandfather's market. We've gone from fractional values for shares to decimal and now we even have high frequency traders competing for fractions of fractions and a market that trades in microseconds. What's really been striking over the last 7-10 years in the markets is the explosive growth and proliferation of ETFs. Of particular interest are the original index centric ETFs that purport to accurately mimic the behavior of popular indexes like the S&P 500 (SPY) in 1993, the Dow Jones Industrial Average (DIA) in 1998, the NASDAQ 100 (QQQ) in 1999, and the Russell 2000 (IWM) in 2000 to name a few. What is even more interesting from a modeling and trading perspective was the introduction of inverse ETFs for each of these indexes that purport to accurately mimic shorting an index; these include (SH), (DOG), and (PSQ) in 2006, and (RWM) in 2007. For now we'll assume that, at least for short periods of time, these inverse ETFs do what they claim and reflect a true short position in their respective indexes to a reasonable degree of accuracy (they don't but the differences can be small for short time periods).
Let's start with a short review of the original strategy presented in a previous article, and the optimization proposed in the most recent article. The original strategy was a simple "skimming" algorithm; simply stated the strategy is you are long the S&P 500 when the price of the S&P 500 is above its 300-day Simple Moving Average [SMA], and you retreat to cash when the price is below the 300-day SMA. This is easily modeled using a spreadsheet and the results were a bit disappointing when viewed over the 20-year price history for the SPY ETF.
(click to enlarge)
Performance Ratio = 0.91:1
The most recent article improved on this strategy by first optimizing the value of the SMA chosen to produce an optimal result for the 20-year period, and then by employing a leveraged ETF (SSO) to further increase overall gain. For this article we'll leave the leveraged ETFs out; my basic tenet is if you can get a model to work well with unleveraged ETFs then using leveraged ETFs will probably add both volatility and gain although you'll likely not see anywhere near the 2X gain they advertise. For this article all runs will be done close to close; i.e., the switch from long to cash or long to short will be done at the market close on the day the transition occurs.
(click to enlarge)
Performance Ratio = 1.35:1
So let's look a bit at algorithms, trading strategies and models. From our experience the basic idea is to look for an edge that persists over time and also works on multiple indexes and asset classes. Generally, the longer the time frame that's used in generating the model the better, but probably just as important is that the time frame chosen include at least 2 bull markets and 2 corrections to have some degree of confidence, going forward, that the model will continue to accurately follow the index and outperform whatever baseline you choose. Typically the baseline or benchmark is a simple buy and hold strategy in the underlying index.
A trading algorithm can take many forms and have a wide range of rules from simple to complex, but in the case of trying to beat an index the key metric is simply the performance ratio achieved. We define that as the total gain over a given time frame that the algorithm delivers divided by the total gain that a simple buy and hold strategy would deliver. The original and optimized algorithms in the earlier articles are what I call "skimming" algorithms, they're either 100% Long or 100% Cash, never Short. If you think about that you'll quickly realize the following:
  1. When the algorithm is long the best you can do is simply track the underlying index. If the index goes up 1% you gain 1% and if the index goes down 1% you lose 1% (assuming there's negligible slippage in the ETF), but you cannot gain a performance advantage over the underlying index.
  2. When the algorithm is in cash, this is the only opportunity in a skimming algorithm to gain a performance advantage over the index. If the index goes down 1% and the algorithm has you in cash, you effectively gain a 1% advantage over the index. Conversely, if the index goes up 1% and you're in cash you effectively lose 1% relative to the index.
  3. Last, we'll introduce the ability, via inverse ETFs beginning in 2006/2007 to go short the index using a timing algorithm. In this case we're essentially "supercharging" a cash position; if the index goes down 1% and we're short presumably we'll gain 1% resulting in a 2% performance advantage. However, like all things in the market there's no free lunch. If the algorithm is wrong, and the index goes up 1% we'll lose 1% and effectively lose 2% relative to the index.
Basically, we need to be very careful in constructing an algorithm that can go short; get it right (and typically a 52-53% win rate is all that is required) and we can gain a nice advantage over a given buy and hold strategy or a long-cash strategy for an index, get it wrong and you'll have a model that loses money quickly.
To begin, we'll simply take our optimized 379-day SMA strategy and go short instead of cash when the price of the S&P 500 is below its 379-day SMA.
(click to enlarge)
Performance Ratio = 1.53:1
We now have a somewhat higher performance ratio versus moving to cash, but what is also quickly apparent is that the algorithm produces a pretty volatile chart with a significant drawn down in the 2009-2011 region. So is there a way to improve on this, substantially reduce the volatility, and retain or improve performance?
Let's look at the 379-day SMA chart vs the S&P 500 and a couple of data points.
(click to enlarge)
It's clear from a simple visual inspection that we have three peaks and two valley in the chart; what's also clear is that the 379-day SMA algorithm does a pretty decent job of getting into cash or short near a peak, but a pretty poor job of getting back to long near a bottom. Here's a couple of data points to illustrate:
2000 Peak 9/01/2000 1520.77
2000 379-SMA Crossover 10/10/2000 1387.02
Lag = 133.75 (8.8%)
2003 Valley 3/11/2003 800.73
2003 379-SMA Crossover 6/4/2003 986.24
Lag = 185.51 (23.2%)
2007 Peak 10/09/2007 1565.15
2008 379-SMA Crossover 1/4/2008 1411.63
Lag = 153.52 (9.8%)
2009 Valley 3/09/2009 676.53
2009 379-SMA Crossover 9/14/2009 1049.34
Lag = 372.81 (55.1%)
What we observe here is that while the lag from the peak to a crossing of the 379-day SMA from above is under 10%, the lag from a bottom to a crossing of the 379-day SMA from below is much larger. How do we fix this? One way is to look for a shorter duration SMA for the short side.
(click to enlarge)
This chart shows both a 379-day SMA and a popular SMA for trading algorithms, the 50-day SMA.
So here's the algorithm we'll initially look at:
When the price of the S&P 500 (SPX) is above its 379-day SMA the algorithm is Long.
When the price of SPX is below its 379-day SMA then:
  • if the price of the SPX is below its 50-day SMA then the algorithm is Short
  • if the price of the SPX is above its 50-day SMA then the algorithm is Long
Let's see how that performs.
(click to enlarge)
Performance Ratio = 1.26:1
So comparing this chart to the previous 379-day SMA Long Short Chart we've clearly reduced volatility but also sacrificed a lot of overall gain as we now have a lower Performance Ratio. So let's do some optimization on the short duration SMA (50-day) to see if we can find a set of better, optimal values. We'll write a little code and look at a range of both long duration and short duration SMAs in combination. We'll sweep from a long duration SMA of 375 to 425 and a short duration SMA from 50 to 100.
(click to enlarge)
It turns out that there's two combinations that produce the same peak value:
Long Duration = 393 or 394 SMA
Short Duration = 77 SMA
What I believe is also important is that the Percent Gain chart is fairly consistent; there's a wide range of values that produce a decent gain (say > 200%) although the algorithm is sensitive to the low duration SMA. Next, let's look at the performance graph of 393 SMA by 77 SMA.
(click to enlarge)
Performance Ratio = 1.66:1
So we now have more performance but at a cost of rather high volatility, especially in the 2011 region. There's one more "tweak" we can look at: instead of executing the transition when the price is below the long duration SMA (393) based on price moving up above a short duration SMA (77) let's look at using the slope (positive versus negative) of a short duration SMA to toggle the transition between short and long.
First, we'll need to sweep across SMA pairs using this new rule to find an optimal pair. For this study we'll sweep from a long duration SMA from 375 to 425 and a short duration SMA from 2 to 20.
(click to enlarge)
For this new algorithm, using the slope of a short duration SMA to transition from short back to long, the optimal values are 385 for the long duration SMA and 13 for the short duration SMA. The performance graph for this combination looks like this:
(click to enlarge)
Performance Ratio 1.96:1
So now we've got a really nice performance ratio (nearly 2:1) with some volatility, especially in the 2008-9 downturn but overall a decent chart.
Last, I know I'll get questions about dividends. So here's a final chart of the SPX SPY 385 by 13 Slope SMA Model where the baseline is now the "Adjusted Closing Price" for SPY and we've accounted for the dividends when the model is Long.
(click to enlarge)
Performance Ratio 1.86:1
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Monday, November 25, 2013

The ARIMAX model muddle

The ARIMAX model muddle

Published on 4 October 2010
There is often con­fu­sion about how to include covari­ates in ARIMA mod­els, and the pre­sen­ta­tion of the sub­ject in var­i­ous text­books and in R help files has not helped the con­fu­sion. So I thought I’d give my take on the issue. To keep it sim­ple, I will only describe non-​​seasonal ARIMA mod­els although the ideas are eas­ily extended to include sea­sonal terms. I will include only one covari­ate in the mod­els although it is easy to extend the results to mul­ti­ple covari­ates. And, to start with, I will  assume the data are sta­tion­ary, so we only con­sider ARMA models.
Let the time series be denoted by y_1,\dots,y_n. First, we will define an ARMA(p,q) model with no covariates:
    \[ y_t = \phi_1 y_{t-1} + \cdots + \phi_p y_{t-p} - \theta_1 z_{t-1} - \dots - \theta_q z_{t-q} + z_t, \]
where z_t is a white noise process (i.e., zero mean and iid).

ARMAX mod­els

An ARMAX model sim­ply adds in the covari­ate on the right hand side:
    \[ y_t = \beta x_t + \phi_1 y_{t-1} + \cdots + \phi_p y_{t-p} - \theta_1 z_{t-1} - \dots - \theta_q z_{t-q} + z_t \]
where x_t is a covari­ate at time t and \beta is its coef­fi­cient. While this looks straight-​​forward, one dis­ad­van­tage is that the covari­ate coef­fi­cient is hard to inter­pret. The value of \beta is not the effect on y_t when the x_t is increased by one (as it is in regres­sion). The pres­ence of lagged val­ues of the response vari­able on the right hand side of the equa­tion mean that \beta can only be inter­preted con­di­tional on the value of pre­vi­ous val­ues of the response vari­able, which is hardly intuitive.
If we write the model using back­shift oper­a­tors, the ARMAX model is given by
    \[ \phi(B)y_t = \beta x_t + \theta(B)z_t \qquad\text{or}\qquad y_t = \frac{\beta}{\phi(B)}x_t + \frac{\theta(B)}{\phi(B)}z_t, \]
where \phi(B)=1-\phi_1B -\cdots - \phi_pB^p and \theta(B)=1-\theta_1B-\cdots-\theta_qB^q. Notice how the AR coef­fi­cients get mixed up with both the covari­ates and the error term.

Regres­sion with ARMA errors

For this rea­son, I pre­fer to use regres­sion mod­els with ARMA errors, defined as follows.
    \begin{align*} y_t &= \beta x_t + n_t\\ n_t &= \phi_1 n_{t-1} + \cdots + \phi_p n_{t-p} - \theta_1 z_{t-1} - \dots - \theta_q z_{t-q} + z_t \end{align*}
In this case, the regres­sion coef­fi­cient has its usual inter­pre­ta­tion. There is not much to choose between the mod­els in terms of fore­cast­ing abil­ity, but the addi­tional ease of inter­pre­ta­tion in the sec­ond one makes it attractive.
Using back­shift oper­a­tors, this model can be writ­ten as
    \[ y_t = \beta x_t + \frac{\theta(B)}{\phi(B)}z_t. \]

Trans­fer func­tion models

Both of these mod­els can be con­sid­ered as spe­cial cases of trans­fer func­tion mod­els, pop­u­lar­ized by Box and Jenkins:
    \[ y_t = \frac{\beta(B)}{v(B)} x_t + \frac{\theta(B)}{\phi(B)}z_t. \]
This allows for lagged effects of covari­ates (via the \beta(B) oper­a­tor) and for decay­ing effects of covari­ates (via the v(B) operator).
Some­times these are called “dynamic regres­sion mod­els”, although dif­fer­ent books use that term for dif­fer­ent models.
The method for select­ing the orders of a trans­fer func­tion model that is described in Box and Jenk­ins is cum­ber­some and dif­fi­cult, but con­tin­ues to be described in text­books. A much bet­ter pro­ce­dure is given in Pankratz (1991), and repeated in my 1998 fore­cast­ing text­book.

Non-​​stationary data

For ARIMA errors, we sim­ply replace \phi(B) with \nabla^d\phi(B) where \nabla=(1-B) denotes the dif­fer­enc­ing oper­a­tor. Notice that this is equiv­a­lent to dif­fer­enc­ing both y_t and x_t before fit­ting the model with ARMA errors. In fact, it is nec­es­sary to dif­fer­ence all vari­ables first as esti­ma­tion of a model with non-​​stationary errors is not con­sis­tent and can lead to “spu­ri­ous regression”.

R func­tions

The arima() func­tion in R (and Arima() and auto.arima() from the fore­cast pack­age) fits a regres­sion with ARIMA errors. Note that R reverses the signs of the mov­ing aver­age coef­fi­cients com­pared to the stan­dard para­me­ter­i­za­tion given above.
The arimax() func­tion from the TSA pack­age fits the trans­fer func­tion model (but not the ARIMAX model). This is a new pack­age and I have not yet used it, but it is nice to finally be able to fit trans­fer func­tion mod­els in R. Some­time I plan to write a func­tion to allow auto­mated order selec­tion for trans­fer func­tions as I have done with auto.arima() for regres­sion with ARMA errors (part of the fore­cast pack­age)
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Friday, November 22, 2013

Understanding Tesla's Life Threatening Battery Decisions

Understanding Tesla's Life Threatening Battery Decisions

Nov 22 2013, 00:52  | 99 comments  |  about: TSLA
BOOKMARK / READ LATER
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
In the last couple of months, electric cars from Tesla Motors (TSLA) have had three collision-related battery fires that were widely covered by the media. Last week, the NHTSA decided to conduct a formal investigation of these incidents. While Tesla's CEO Elon Musk immediately went on the offensive arguing that Tesla's BEVs have a lower fire risk than gasoline powered cars, the question an increasing number of investors are asking is "Why has Tesla had three battery fires in a fleet of 17,000 BEVs while Nissan hasn't had any fires in its fleet of over 90,000 BEVs?" The answer is simple. Tesla's battery decisions significantly increased battery risks for both the customer and the company.
My primary resource for the discussion in this article is a 2012 study published by the National Renewable Energy Laboratory titled "Vehicle Battery Safety Roadmap Guidance." Since the roadmap provides far more scientific detail than most investors need or want, I'll focus on the general themes that impact investment risk and leave the electrochemical and engineering minutiae for professionals.
The generic term "lithium-ion battery" includes at least a half-dozen varieties that range from relatively safe iron phosphate formulations to relatively unstable cobalt oxide formulations. I use the word relatively because no lithium-ion battery is 100% safe. All lithium-ion batteries will burn if the cell is punctured. In general, fires resulting from a punctured cell are the least violent. Lithium-ion batteries can also ignite spontaneously if debris left over from the manufacturing process pierces a 15- to 25-micron separator and creates an internal short circuit. In those cases, which are referred to as "field failure events," the internal short circuit ignites materials inside the cell and causes internal temperatures to spike to a few hundred degrees centigrade in seconds. At that point, the cell ruptures feeding additional oxygen to the fire. In rare unexplained cases, internal temperatures to spike to a couple thousand degrees centigrade in seconds, which suggests that thermite reactions might be taking place.
The failure mechanisms in lithium-ion batteries are not well understood because it's darned near impossible to extinguish a lithium-ion battery fire. In the event of a fire, the best first responders can do is try to cool the surrounding pack to keep the fire from spreading. What we do know is that punctured cells react less violently than cells that have a field-failure event and that field failure events are less violent than other failures that some experts attribute to thermite reactions.
Since the thermal energy released by a burning lithium-ion battery is up to three times greater than the electrical energy the battery could release in a normal discharge cycle, cell punctures and field failure events can be a very big deal as increased temperatures in one cell propagate to adjacent cells causing them to go into thermal runaway. The phenomenon is like lighting one side of a matchbook on fire. Once the first one goes, the others are sure to follow. One recent Tesla fire in Yucatan Mexico was captured in a YouTube video that shows how the process of lithium-ion battery fratricide unfolds in a large battery pack. The video begins with what appears to be a modest fire in a couple of punctured battery modules. As the temperature builds, other modules reach the thermal runaway point and explode. During the grand finale, several modules join the party and explode at the same time. If the incident didn't involve a $100,000 car and a real life accident, it would be a great special effect for Hollywood.
Tesla's first risky battery choice was picking cells with high energy density and a less desirable safety profile than the low energy density cells chosen by all of the other automakers.
Its second risky battery choice was ignoring the laws of large numbers.
Field-failure events are very rare and while I haven't been able to find detailed statistics for the 18650 cells Tesla buys from Panasonic, the NREL report noted:
"Field failures arising from manufacturing defects that cause internal short circuits have very low probabilities of occurrence (estimates for 18650-size cells that fail catastrophically are 1 in 10 million cells to 1 in 40 million cells). While this may be reassuring for manufacturers of portable electronics, EV and HEV battery packs may have thousands of cells and up to 1,000 times more stored energy, making even this small failure rate unacceptable."
The battery pack in a Tesla Model S uses about 7,000 high-energy 18650 cells that are more prone to field-failure events than safer lithium-ion chemistries. Since each cell in the battery pack represents an independent field failure risk, the risk of a catastrophic field failure event at the battery pack level is:
  • One in 1,429 if you assume a 1 in 10 million risk at the cell level;
  • One in 2,857 if you assume a 1 in 20 million risk at the cell level; and
  • One in 5,714 if you assume a 1 in 40 million risk at the cell level.
Nissan, in contrast, uses 192 large format lithium-ion battery cells in the Leaf. That factor alone reduces its catastrophic battery pack failure risk by about 98%.
Some of the more troubling aspects of the NREL report included observations that:
"When discussing battery safety, it is important to understand that batteries contain both an oxidizer (cathode) and fuel (anode as well as electrolyte) in a sealed container. Combining fuel and oxidizer is rarely done due to the potential of explosion (other examples include high explosives and rocket propellant), which is why the state of charge (SOC) is a very important variable. Lower SOCs reduce the potential of the cathode oxidizing and the anode reducing. Under normal operation, the fuel and oxidizer convert the stored energy electrochemically (i.e., chemical to electrical energy conversion with minimal heat and negligible gas production). However, if electrode materials are allowed to react chemically in an electrochemical cell, the fuel and oxidizer convert the chemical energy directly into heat and gas. Once started, this chemical reaction will likely proceed to completion because of the intimate contact of fuel and oxidizer, becoming a thermal runaway. Once thermal runaway has begun, the ability to quench or stop it is nil."
"Although much study has gone into understanding and modeling the lifetime of cells with aging, little work has been done on the effects of aging on thermal stability and abuse tolerance."
"USABC goals, in line with the DOE research program for HEVs, are a calendar life of 15 years for HEVs and 10 years for EVs. A cycle lifetime of up to 1,000 cycles at 80% depth of discharge is also required. Little or no safety testing has been performed on cells approaching these lifetime limits. There are valid concerns about the stability of the active materials, separators, and possible reactions involving new degradation or contamination products."
"(H)igher energy cells have a stronger response to abuse events and usually have poorer safety performance."
Batteries in an electric car are maintained at a high state of charge to maximize driving range. Unfortunately, that practice also maximizes the potential for a field failure event. Since Tesla wanted its cars to have the longest possible driving range with the lowest possible battery weight, it chose a relatively unstable high-energy battery chemistry while its competitors who make electric cars with shorter ranges chose safer and more stable chemistries. Since Tesla wanted to keep its battery costs low and take advantage of a global capacity glut for 18650 cells, it decided to use 7,000 small format cells in its battery pack while more experienced automakers paid premium prices for large format automotive grade cells that reduce the impact of the law of large numbers.
All of Tesla's public talking points on the three fires focus on the collision-related nature of the battery pack failures. The statistics in the NREL report indicate that a catastrophic pack failure rate of 1 in 6,000 would be just about right if Tesla was using a safer low-energy chemistry like lithium iron phosphate.
If the NHTSA concludes that the fires were attributable to Tesla's risky choices of high energy density batteries in 7,000 cell packs instead of road debris, the impact on Tesla will be life threatening. The current market price of Tesla's common stock does not, in my opinion, reflect this real and substantial short-term survival risk.
Additional disclosure: I am a former director of Axion Power International and hold a substantial long position in its common stock. I currently serve as executive vice president of ePower Engine Systems, a privately held company that's developing an engine-dominant series hybrid drivetrain for heavy trucking.
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Friday, November 1, 2013

Lien and Mean - How To Protect Your Property During a Construction Project

Lien and Mean - How To Protect Your Property During a Construction Project

January 26, 2005
It should come as no surprise that if you hire a contractor to make improvements to your property, and you fail to pay him or her, the contractor has a right of action against you and may seek to place a lien upon your property. What is surprising, however, is that if this contractor fails to pay any of his or her subcontractors, one of them may be able to place a lien upon your property as well. In short, although you have paid your contractor all sums that are due, your property may still be at risk. The contractor’s failure becomes your liability.

As in most states, Massachusetts has a Mechanic’s Lien statute. This statute is codified in Massachusetts General Laws Chapter 254. In essence, the Mechanic’s Lien statute allows a contractor to place a lien upon property to secure his or her payment. This seems reasonable. What most people would view as unreasonable though, is to allow a subcontractor to place a lien upon your property, after you have paid the contractor in full. As with most areas of construction litigation, perils such as these can be avoided with a small amount of forethought and preventative action.

The statutory scheme for Mechanic’s Liens provides protective alternatives to avoid or dissolve any lien placed upon one’s property to those who are potentially subject to a Mechanic’s Lien. The first order of protection is to secure a no lien or blanket bond. Once filed, these bonds stand in the place of the real property. This means that liens of subcontractors attach to the bond as opposed to the real property. This remedy is codified in M.G.L. c.254, §12.

Another type of bond, codified in M.G.L. c.254, §14, is the target bond. This is used when the property is already the subject of a lien, and the property owner wishes to substitute a bond in place of the lien. This type of bond is most commonly used when a property owner wishes to refinance his or her property and is unable to do so because of a pre-existing lien. When a particular lien is “bonded off” by a target bond, the property owner must serve notice of the recording of the bond to the lien holder.

While the filing and posting of bonds can help alleviate some of the complications that arise from the filing of a lien, the best remedy for a property owner is to never have the lien arise in the first place. Rest assured that if the company issuing the bond eventually pays the subcontractor, it will seek reimbursement from you.

In Massachusetts it is illegal to require a contractor or subcontractor to execute a blanket lien waiver prior to performing his or her services. Although you cannot require a contractor or subcontractor to agree that they will not file a lien upon your property, you can require such a waiver at the time of payment. In most construction contracts, especially ones for new construction, payments are made to the general contractor at different intervals throughout the project. Prior to tendering any funds to the general contractor, the property owner should require that the general contractor, and all subcontractors who will perform services on the project, will agree execute a lien waiver. This protects you from essentially having to pay twice.

In order to ensure that all the applicable subcontractors have executed a lien waiver, you must first know what subcontractors are being retained. As such, all construction contracts should contain a provision that the general contractor will provide you with a list of the subcontractors that he or she plans to use on your job. Although this provides you with a limited degree of awareness, it is no substitute for first hand observation. In other words, visit the construction site often. Write down the names of any companies that appear on vehicles at the site, and do not be afraid to ask people who they are working for.

There is no such thing as being too proactive when it is your project. The old adage stands true here; an ounce of prevention is worth a pound of cure.

Adam J. Basch, Esquire, is an associate with Bacon & Wilson, P.C. He is a member of the Litigation Department with expertise in the areas of construction litigation, personal injury, general litigation and creditor representation. He can be reached at 413-781-0560 or abasch@bacon-wilson.com.
by: Adam J. Basch, Esq.

BusinessWest
January 2005
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Tuesday, October 29, 2013

Frequently Asked Questions FAQ - Construction

Frequently Asked Questions FAQ

Contractor Forms for Each State
Visit USLegal Contractors Forms. Packages and forms available for any type contractor. Lien forms also available.

What is a contractor?
A contractor is an individual or company who contracts for and supervises construction (e.g., a building).
What does construction law basically involve, and can it vary from state to state?                                        
Construction law involves the formation of agreements and disputes between the builder and the property or building owner. Construction law most definitely can vary from state to state. 
What does it mean for a contractor to bid on a project?
The Construction bid is an offer to provide construction services at a certain price.  
What is a construction bond?                                                                                                      
A bond is an obligation, expressed in writing, to pay a fixed and sum on the happening or non-occurrence of a specified condition or event. A construction bond may be either a performance bond or a payment bond. A performance bond is a commitment issued by a surety to the owner of the property on which the construction is to take place guaranteeing that the contractor will complete the construction contract within its set terms and conditions. A payment bond guarantees that all subcontractors, labor and material suppliers will be paid leaving the project lien free. Construction bonds serve as a type of insurance policy to the property owner that the project will be completed and the subcontractors and suppliers of materials will be paid.
What is a change order?                                                                                                                
A change order is a written order signed by the owner or his agent directing the contractor to make a change in the construction contract. It involves a change in the original construction plans. Change order procedures and requirements are governed by the contract terms and contract law, as well as various laws, which may vary by jurisdiction.
What is construction fraud?                                                                                                 
Construction fraud involves deceit in the performance of construction work, often involving home repairs. Basically, promises are made that are intended to be relied on, and that reliance leads to harm or loss when the promise fails to be fulfilled. In home repair scams, it may involve using substandard supplies or methods of construction. Sometimes, the contractor committing fraud may claim unnecessary work is needed or even create the damage they say needs to be repaired. According to one state’s definition, construction fraud is committed when a person knowingly:
  • Misapplies money;
  • Obtains money, property or labor by false pretense;
  • Receives payments and fails to state his own true name, or states a false name, contractor’s license number, address or telephone number of the person offering a service;
  • Diverts money or commits any act of theft, forgery, fraud or embezzlement, in connection with a construction project;
  • Acts as a contractor without a contractor’s license;
  • Submits false information concerning a payroll to a public officer or agency in any report relating to a contract for a public work; and/or
  • Fails to disclose a material fact.
How can I enforce my mechanic’s lien?
You will need to file a law suit seeking a court order to sell the property subject to the lien with the net proceeds to be distributed according to the lien laws of your state.
What is a Construction Proposal?  
A construction proposal is a written offer from a bidder to the owner, preferably on a prescribed proposal form, to perform the work and to furnish all labor, materials, equipment and/or services for the prices and terms quoted by the bidder. A proposal form may be used, which is a standard written form furnished to all bidders for the purpose of obtaining the requested information and required signatures from the authorized bidding representatives. The bid submitted must conform to the applicable requirements of content, form, and timeliness in order to be considered.
When is a building permit required?
This varies by jurisdiction but typical homeowner construction projects requiring permits include: room additions; decks; roofs over decks; swimming pools of a certain depth, finishing basements; lawn irrigation systems; accessory buildings; and all installations or modifications to electrical, plumbing, or heating or air conditioning systems.
Can I as homeowner do my own work?
This varies by jurisdiction, but in most cases laws pertaining to contractors allow homeowners to obtain permits and perform construction work on their personal home.
What is the responsibility of the contractor after the building permit has been issued?
Once a permit has been obtained, authorization to commence construction within the scope of the permit is deemed to be granted. It is the responsibility of the contractor to conform to the building and technical codes for all installations or repairs of a building or service system and to schedule all the required inspections.
Where can I get a building permit?
Your community’s building inspection department, office of planning and zoning, or department of permits will have a listing of the necessary construction law permits, construction contract law regulations, and inspections related to building and zoning codes for new construction or remodeling.
What is the difference between a building inspection and a home inspection?                       
A building inspector may evaluate the building project several times at various stages of construction to be sure that local building codes are being followed. In some communities, a certificate of occupancy is given only after the home passes a final building inspection. Home inspectors generally evaluate an existing home as a part of the sale or purchase of the home. Home inspectors look at readily accessible systems and components, but do not certify that a home is in compliance with the building codes. 
Do you have to get different permits for constructing homes and commercial construction?
This depends on your jurisdiction. However, typically the permit requirements and the inspections are generally more stringent for commercial applications.
How do I know if a contractor is licensed and bonded?
Before signing any contract, check with your local contractor licensing board. It should tell you whether the contractor’s license is valid, whether a bond is in place, and perhaps whether there have been any claims filed against the contractor.
How does a contractor get a license? 
States license contractors and each state has its own licensing board with its own requirements. State laws differ on both the requirements for getting a license and the type of license that is needed for a particular job.
I already have the contractor’s license in my name. However, I want to form a corporation. What do I do?                                                                                                     
Check out your state laws. In some states, you can get an application to transfer your license from your name into the company name. 
Is there an exemption from the license requirement for “handyman” work?                     
This depends on your jurisdiction. A license may not be required if the aggregate contract price for the project, including labor, materials, taxes, and all other items, is not more than a certain amount. This exemption generally does not apply to electrical or plumbing work requiring a permit. Furthermore, even if an electrical or plumbing permit is not required by the county on a particular project, the work may still have to be performed by a licensed electrician or plumber.
What is a construction defect?                                                                                             
Construction defects may occur when a building is not erected in a reasonably workmanlike manner or the contractor failed perform in a manner reasonably expected by the buyer. Usually defects are caused by a failure in development, construction, alteration, repair, maintenance, moving, demolition or excavation of a building. Improper construction can lead to water leaks from the roof, windows, or basement; building settlement; concrete corrosion; cracked foundation; mold; electrical problems; plumbing defects; insect infestation and heating and air conditioning defects. A defect may be anything that lowers the value of your home.
Who is responsible for such defects?
Usually the responsibility will lay with the general contractors, developers, and the builders of structures even if the work was performed by subcontractors or if the defective materials used in construction were manufactured by others.
Does the statute of limitations apply to these types of claims?
Yes. The time varies from state to state, but the shortest statute is most likely three years from the date the defect was discovered (or reasonably should have been discovered). However some statutes start from the date of the completion of the home.
Am I responsible for proving that a defect exists and if so, how do I do that?
Yes, you would be responsible for proving that a defect exists, or hiring someone who can do so. Your attorney will likely call upon experts to do this. For example, if you were claiming a defect in the plumbing, your attorney would call a plumber as an expert witness to testify after looking at the building and its plumbing.
If I recover damages what is that likely to include?
Recovery will include the reasonable cost for repairing your defects, expenses for temporary housing during the repairs, the value of any other property that was damaged as a direct result of the defect, and sometimes you will be awarded attorney and other legal fees.
Am I required to make repairs while the lawsuit is pending?
In most cases you will be required to take the necessary steps needed to protect your property from sustaining additional damage. Such costs are recoverable in the lawsuit.
Can I sell my home during a pending lawsuit?
The answer is most likely yes, but you will be required to disclose to any potential buyer that the home is involved in litigation.
What do I look for in the construction contract to protect me from delays?
If you are a homeowner, you will want to provide a penalty, such as the right to withhold progress payments, if the builder does not complete the job by a certain date. If you own land zoned for commercial building use, then you would want the right to withhold the final payment until the building department issues a certificate of occupancy.
How can I protect myself in the event the builder fails to do the job right?
You can put language in the construction contract providing for the right to withhold payments or take an offset, or deduction, against the contract sum if the builder quits or fails to build to code.
What if the subcontractor threatens to sue me or file a lien on my house?
You might have a claim against the general contractor. The reason the subcontractor is threatening you with legal action is likely to be that the subcontractor has not been paid by the general contractor.
I am a home building and I am worried that there might be something which could unexpectedly increase my costs and ruin my profit. What do I do?
The best way to pass this cost onto the homeowner is to put language in the contract specifying that any expenses from unforeseen events during the construction shall be passed along to the homeowner.
What is the best forum to resolve disputes between a contractor and homeowner?\
Arbitration or mediation is generally cheaper and faster than a court trial. Mediation is a process by which parties in a dispute negotiate a settlement of their claims against each other through the assistance of a trained, neutral mediator. It is a non-adversarial process. Mediation is entirely voluntary and non-binding. The mediator has no power to render a decision nor force the parties to accept a settlement. The mediator generally does not give an opinion or render an award. Arbitration is a process in which the disputing parties choose a neutral third person, or arbitrator, who hears both sides of the dispute and then renders a decision. The biggest difference between mediation and arbitration is that a mediator helps the parties to fashion their own settlement, while an arbitrator decides the issue. An arbitrator is more like a judge than a mediator. The parties go into arbitration knowing that they will be bound by the decision. The parties go into mediation knowing that nothing will be decided unless and until they agree to it. Arbitration, however, is unlike litigation in that the parties choose the arbitrator, the proceedings are conducted in a private manner, and the rules of evidence and procedure are informal. Also, in arbitration, the arbitrators tend to be experts in the issues they are called on to decide.  
Is there a government agency that might help me with my claim?                                        
Some states have a contractor’s board that regulates the contractors and may have procedures where a claim could be filed against the builder, or his bond.
What if I decide I want the house built differently after the builder has already begun the work? 
 The two of you will probably need to draft and sign a change order. It should spell out what the change is in detail, the increase (or decrease) in cost to the contract. Both of you will need to sign it.
Does the contractor have to give a warranty?            
That will depend on your state’s laws. Some contractors will give you a limited warranty simply because they “stand behind their work” and/or wish to preserve and enhance their reputation. The homeowner should always request that the contractor put a warranty into the written contract, since cracks, chips, and other defects often are discovered within a one-year period after completion.
What are the most common construction disputes?         
Poor workmanship or defective materials. An owner may object to the quality of workmanship, either by the general contractor or by a subcontractor hired by the general contractor, or to the quality of materials used. It will be much easier to resolve this kind of dispute if the agreement with the contractor is very clear in specifying what materials to use and how the project is to be done. If the construction contract is vague, and says something like, “good quality materials,” the owner may find that his or her idea of good quality is not the same as the contractor’s and it will be very difficult to prove whether or not the materials were of good quality.
  • Failure to complete on time. Damages are generally recoverable by the owner:                      
       a.            If the contractor agreement specified an approximate time for the completion of the project;
      b.         The general contractor negligently failed to complete the project on time; and
      c.         The owner suffered damages because of the delay
  • Damage to the property. A contractor may cause damage to the property while doing the project that is not covered by the contractor’s insurance. This is why it is important to make sure the general contractor has up-to-date liability insurance.
How are damages figured?
 When an owner brings a lawsuit or other claim for breach of a construction contract there are two different ways of determining construction contract damages. The first, and most common, is that the owner can recover the amount of money it will take to repair defects or make the structure conform to the original plans and specifications for work and materials. In other words, the owner recovers damages in an amount needed to fix the home and make it the way it was supposed to be under the contractor agreement. There is an exception to this rule, however. If the contractor can prove that to tear out work and repair defects would be unreasonable economic waste, the owner’s damages are calculated another way. In that situation the owner is entitled to recover the difference in the value of the property as it exists and the value it would have had if the work had been done properly.
What should be included in agreements with contractors?
The following provisions are typically found in a contractor agreement:                                            
  • Names and street addresses of all parties. Because contractors have been known to disappear without finishing a job or after doing a defective job, make sure you have more than a Post Office Box and check to make sure addresses and telephone numbers are correct before you sign the agreement.
  • Specifications and scope of work. This section should be very specific, and should outline what is to be done, what products are to be used by brand name or model number, colors, grades of material, and any other relevant information. You need to include a provision about cleanup after the project, such as removal of debris and dumpsters. This section should also include a list of the steps to be taken and how the work is to be done if there are alternative ways of doing the project.
  • Price or how price is to be determined. The price should be clearly broken down and easy to understand. Be wary of costs that are not determined until the end of the project. It would be better to get a final price up front, but if you can’t, at least be sure you know exactly how costs will be calculated.
  • Approximate timelines. You can never be exactly sure how long a project will take, so an approximation should do, such as from May 15, 2008 to no later than September 15, 2008. Use dates instead of periods of time, like “4 months.”
  • Payment schedule. You should never pay a large percentage of construction costs in advance. Some states have limits on advance payment. Check with your state’s licensing agency to find out the rules in your states. Additional payments should be made as the work progresses, but payment schedules should be tied to work performance and not to dates. Do not make the final payment until after you’ve completely inspected the work and after any required inspections by building officials have been completed. Also do not pay before the contractor has proved that he or she has paid all the subcontractors and suppliers who could put a mechanic’s lien on your property.
  • Contractor will arrange for permits. The contractor should obtain any permits that are required and should check to see if there are zoning problems with your project. You can be fined or required to remove improvements if these requirements are not met.
  • Guaranties and warranties by the contractor. The contractor should give you a written warranty that the contracting company will be responsible for the failure of a subcontractor to perform adequately and a warranty on the workmanship and materials used by the contractor for a specified period of time.
  • Insurance. The agreement should require the contractor to provide worker’s compensation insurance and liability insurance. These are to protect the workers on the job and to protect your property from damage. If the contractor does not have worker’s compensation insurance, you might be sued if a worker is injured. This section should also include any bonds you and the contractor have agreed on.
  • Provision for additional work.  Sometimes additional work is needed that no one anticipated, such as work to repair termite damage. An agreement for additional work is often called a change order. Specify that additional work can only be done upon written agreement of the parties so that you can make sure the specifications for additional work are as carefully drafted as in your original agreement.
  • Termination. This clause usually sets out the amount of notice either party must give to cancel a contract.
  • Conflict resolution. This section can require the parties to resolve differences outside of litigation, such as by requiring arbitration of the dispute. You can also provide for liquidated damages, or an agreed upon amount that one party will pay if he or she fails to fulfill some part of the contract.
I am buying a house from the builder. We are about to close but the house is not finished. The builder assures me that he will complete items after closing but I am worried. 
Any such assurances should be in a written document that will survive closing. You may want to consult with a lawyer before closing to make sure that your interests are protected.
I am a commercial contractor and the general contractor and the owner have told me to go ahead with work that is not part of the contract and assured me that I would be paid. Is this ok?
This could be a problem. Such work generally requires what is called a change order. Many contracts require that a change order be in writing. Without the written assurance from the owner and the general contractor that you will be paid for this additional work, there is no guarantee that you will ever get your money. It is best to get a written assurance before you begin such work.
I am a small subcontractor and am beginning a large commercial job. The contract given to me by the general contractor is long and complex and seems to be skewed in favor of the general contractor and owner. The general contractor has told me not to worry about this, that he will take care of me. This job could be really big for my company but I am concerned.
It is best to fully understand the contract you are signing. If a dispute arises, you can be assured that the general contractor will have to look out for its own best interests rather than yours. It is best to consult with a lawyer to explain any components of the contract that you do not understand and make sure that you will be able to undertake this job.
Does a mechanic’s lien have priority over a pre-existing mortgage?
Generally speaking a mechanic’s lien does not take priority over an existing mortgage; however a contractor can commence a proceeding to foreclose the mechanic’s lien in the amount of his lien
How long does a builder normally have to complete items given to him on a punch list? In our contract it states that the builder will complete such repairs in a “reasonable amount of time”. 
A punch list is a record of incomplete or unsatisfactory construction items covered by a construction contract. This list is sometimes prepared by an architect or engineer, before certifying project completion. A “reasonable time” would most likely be determined to be whatever is common in the construction industry in your area.
- See more at: http://contractors.uslegal.com/frequently-asked-questions-faq/#sthash.PjQAuQ7M.dpuf
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