Are Your Claims Subject To A Flow-Through Clause?

Are Your Claims Subject to a Flow-Through Clause?
A Review of the Effect of Subcontract Clauses Which Incorporate the Prime Contract.

By
William C Last, Jr.

Almost all subcontracts include a provision that references the prime contract between the project owner and the prime contractor. By inserting the clause, the prime contractor seeks to shift the risks the prime contractor undertakes to the subcontractors. While such a clause appears on a superficial basis to be innocuous, it has far ranging implications to both the prime contractor and the subcontractor. This article will examine the impact of such a clause in greater depth and conclude with suggestions to prime contractors and subcontractors.

The typical clause states: “....the provisions of the prime contract, plans, specifications, addendums, change orders, and other documents that comprise the prime contract are incorporated into this subcontract with the same force and effect as though set forth in full.” This type of incorporation clause includes both prime contract general conditions as well as the technical specifications. While most subcontractors closely review the technical specifications and plans that are incorporated into their subcontract they fail to review the prime contract general conditions.

It is not uncommon to have conflicts between the prime contract provisions and the subcontract provisions. Typically, the subcontract will identify which provision will apply to the subcontractor in the event of a conflict. A common conflict provision will state that in the event of a conflict between the two agreements, the subcontractor will be obligated to satisfy the provision that places a greater duty on the subcontractor.

The types of general conditions contract clauses that typically flow through to the subcontractor and should be reviewed include:

1. Scope of Work Responsibilities Provisions: For example, the subcontractor may be obligated to perform work to Code even if the plans and specifica­tions do not meet Code requirements.

2. Change Order Provisions: Prime contracts can include: (a) methods for determining the cost of extra or additional work (e.g. time and material plus a limited mark-up, equitable adjustments); (b) the owner personnel having the sole authority to authorize changes in the work; (c) a requirement for the contractor to perform additional work even if the price for that work cannot be agreed upon in advance of the work being performed; (d) the terms for payment for changes in the scope of the work; (e) the time limits on making a change order claim; (f) a requirement that the change order be in writing; (g) a requirement that the subcontractor perform additional work in the event there is an ambiguity in the plans and specifications.

In addition, many prime contractors are concerned about authorizing subcontractors to perform additional work without first obtaining the owner’s approval, particularly where the prime contract includes such a requirement. As a result, many subcontracts require that the subcontractor seek the owner’s approval for the additional work before it is commenced. These clauses are typically called “pass-through” clauses. Many subcontracts, as a prerequisite for payment of the additional work by the prime contractor, state that disputed change orders will only be paid by the prime contractor if they are approved for payment by the owner. However, the prime contractor can waive the requirement for owner approval, by his actions or writing, in which event the subcontractor is entitled to recover the value of the change order from the prime contractor.

In the event there is a disputed change order, the subcontractor may be forced to await the outcome of litigation over the issue. On the other hand, if such a clause exists the prime contractor is obligated to present the disputed change order to the owner in a prompt manner.

Many contracts require that the contractor and subcontractor perform all additional work that is requested by the owner. Such clauses may bind the subcontractor to perform the additional work unless the extra work is essential to completion of the project. If, for example, the contractor is building the core and shell of an office building and the owner then requests the contractor to complete the tenant improvements, the contractor could reasonably refuse to perform the tenant improvements. In essence, the tenant improvements are severable from the agreed scope of the original services.

3. Insurance: The insurance requirements for projects are constantly increasing. While most prime contractors are slow in updating their subcontract forms, project owners typically tailor their prime contracts for each project. Thus, the insurance requirements in a subcontract may be significantly less than in the prime contract. It should be noted that many flow-through clauses establish which contract will take precedence in the event of conflicting clauses. However, many of the priority clauses establish priority as the one that places the greater duty and/or risk on the subcontractor.

Insurance clauses that may create problems for a subcontractor include: (a) the requirement for an occurrence type policy if the subcontractor maintains a claims made policy; (b) the types of endorsements that are required (e.g., endorsements for excavation collapse and underground, contractual liability, products and completed operations, and premises coverage); (c) the dollar amount of insurance; and (d) the requirements for additional insured endorsements.

4. Progress and Final Payment Clauses: While “paid if paid” clauses are technically dead in California, many owners and prime contractors have drafted payment clauses that are intended to work around the prohibition. In the event that the subcontractor actions or inactions are the cause for the owner not paying the prime contractor, then the prime contractor may be entitled to withhold payment pending payment by the owner. Thus, the subcontractor should be careful to satisfy the following types of prime contract requirements: (a) timely and proper preparation of mechanics lien release forms, (b) timely and adequate preparation of applications for payments, (c) requirements for submission of proper supporting documentation, and (d) the right of an owner to audit the prime and subcontractor cost records for change orders and other required documentation (e.g. on a public works project, payroll records).

5. Remedies and Claim Clauses: Prime contracts typically contain detailed provisions for termination of a contract in the event of a default. Once the prime contract is incorporated by reference, those clauses will likely apply to the subcontractor. Provisions in those types of clauses necessitating review include: (a) under what conditions can the owner cancel the prime contract; (b) can the owner cancel the contract for its own convenience; (c) what constitutes a ‘material breach of contract’ which would allow the owner to cancel the prime con­tract; (d) what are the remedies in the event the owner declares a default; (e) in the event of a default, is the owner allowed to keep the contractor’s equip­­ment and materials until the work is completed; (e) is the subcontractor required to continue to perform if there is a dispute between it and the general contractor; (f) incorporation by reference of a schedule; (g) a bar on recovering monetary damages in the event of delays caused by a party other than yourself; (f) notification provisions for delays, change orders and other claims; (g) provisions concerning the timing for the preparation of a claim and the claim format; (h) provisions concerning delay damages (e.g. liquidated damages and “no damage for delay” clauses).

6. Claims Resolution Procedure Clauses: Virtually every prime and subcontract contains provisions for how a dispute is to be decided. There may be differences between the provisions in the prime and subcontract dispute resolution provisions. The subcontract should set forth what will happen in the event of conflicts between the two agreements.

Provisions to review include: (a) the forum for dispute resolution (e.g. arbitration) and who is to be joined in the proceedings; (b) limitations on the time in which the contractor must request arbitration; (c) whether or not the subcontractor must wait for the prime contractor and the owner to arbitrate an issue of dispute prior to proceeding with their own arbitration; (d) whether or not the subcontractor is bound by the results of any arbitration between the prime contractor and owner and, if so, is the subcontractor’s recovery is limited to an allocation by the prime contractor of the recovery and costs; and (e) does the claims resolution procedure limit the ability to join other responsible parties into the hearings.

Suggestions:

The preceding discussion of specific flow-through clauses is limited by the brevity of this article. Any time the subcontract incorporates the prime contract provisions, the risks that the prime contractor undertakes to the owner are being passed to the subcontractor. The prime contractor and the subcontractor should review the prime contract clauses in the context of their respective desire to shift risk or avoid risk.

Additional suggestions include:

1. If you are subcontractor, insist on reviewing the prime contract before executing the subcontract.

2 If you are a prime contractor, review the prime contract and subcontract to ensure that conflicting provisions are determined in your favor.

3. If you are prime contractor, promptly review and forward all subcontractor change orders, delay notifications and claims to the owner. If the subcontractor’s request appears to be fraudulent and susceptible to an owner asserting that it is a false claim, you should seek competent legal advice before forwarding the claim. The decision may then be made for the prime contractor to reject the claim and explain to the subcontractor why it is being rejected. The prime contractor’s letter rejecting the claim and the subcontractor’s claim can then be submitted to the owner for a decision.

3. If you are a prime or subcontractor, you should carefully review the relevant clauses to determine who has the authority to approve a change order, claim or delay notification and in what form it should be submitted.

4. If you are a subcontractor, determine the requirements for submitting detailed information and supporting documentation relative to a change order, delay claim or claim.

5. If you are subcontractor, determine who will have the responsibility for prosecuting a claim against the owner and how the recovery and attorney’s fees will be allocated.

This article, ©2000, was written by William C. Last, Jr. Mr. Last is an attorney who has been specializing in Construction Law for over 20 years.. In addition to belonging to a number of construction trade associations, Mr. Last holds a California “A” and “B” license. He can be contacted at 415-764-1990 or 650-425-7679. A number of his past articles can be found on his website (lhfconstructlaw.com). This bulletin is published periodically to provide general information about current legal issues. The articles are not intended to be a substitute for the advice of an attorney as to a specific problem. If you have a specific legal question or need legal advice, you should contact an attorney.