‘Pay-If-Paid’ Clauses—The Freedom to Contract vs. the Subcontractor’s Statutory Rights to Enforce Payment by Mechanic’s Liens or by Payment Bond

by James Palecek, Palecek & Palecek, PLLC

It has been noted that a majority of states in America allow a general contractor and a subcontractor to enter into a construction contract which “shifts the risk” of non-payment from the owner to the subcontractor. See “PAY IF PAID” CONTRACT PROVISIONS, Providing Some Enforcement Consistency and Predictability in an Unsettled Area of Law, 57 No. 2 DRI For Def. 23, February 2015, by Ronald P. Friedberg. On the other hand, a vocal minority of states do not allow this contractual risk-shifting, and part of the reasoning in some of these states, including California, addresses the subcontractor’s statutory rights to lien property or to make a bond claim when there has been non-payment from the general contractor, regardless of the reason for the non-payment. See FREEDOM FROM THE FREEDOM-TO-CONTRACT: CALIFORNIA SUPREME COURT INVOKES PUBLIC POLICY TO INVALIDATE “PAY IF PAID” CLAUSES IN CONSTRUCTION CONTRACTS, 21 T. Jefferson L. Rev. 253, October 1999, by Eric N. Larson. However, for the majority of states, a valid “pay if paid” clause will invalidate a subcontractor’s lien or payment bond remedy.

This article will first address the state of the “pay if paid” law in Arizona. Then, it will compare it to California’s public policy against such clauses. Finally, this article will discuss the majority rule whereby such clauses are enforceable and address the inherent conflict in not allowing subcontractors the rights to enforce lien and bond claims when payment is not made by the owner.

Arizona Enforces Valid ‘Pay If Paid’ Clauses

The current case precedent in Arizona on a “valid” pay-if-paid clause is L. Harvey Concrete, Inc. v. Agro Constr. Supply Co., 189 Ariz. 178, 939 P.2d 811 (App. 1997). In Harvey, the trial court concluded as a matter of law that the pay-if-paid provision in the subcontract created a condition precedent to contractors’ obligation to pay subcontractor. Id. Defendants argued and the court agreed that, “Arizona law permits an absolute shifting of the risk of nonpayment through a pay-when-paid provision that clearly and unambiguously establishes an intent to create a condition precedent.” Id. at 180. No “magic words” are required, just “contractual language demonstrating the parties’ unequivocal intent that the obligation be paid out of that fund and not otherwise.” Id. at 182. The relevant contract language in the Harvey case reads as follows:

Notwithstanding anything to the contrary in the preceding paragraphs of this agreement, subcontractor agrees as a condition precedent to payment, of either progress or final payment, that the owner shall have first paid the payment applied for to the contractor, and that payment for either progress payments or final payment is not due and owing to the subcontractor as provided for herein until the owner has made such payment to the contractor. The subcontractor recognizes that the source of funding for this subcontract agreement are [sic] the progress and final payments that are to be made by the owner to contractor. Id. at 180, 939 P.2d at 813 (emphasis added).

However, not all “contingent payment” language in contracts in Arizona constitute “pay IF paid” clauses. Some clauses, depending on the language, constitute merely “pay WHEN paid” clauses, which do NOT absolutely shift the risk of payment from the general contractor to the subcontractor.

In Watson Const. Co. v. Reppel, 123 Ariz. 138, 140, 598 P.2d 116, 118 (App. 1979), the Court of Appeals considered language in a construction subcontract that said the general contractor would pay the subcontractor “promptly upon receipt from the Owner, the amount received by the Contractor on account of the Sub-Contractor’s work to the extent of the Sub-Contractor’s interest therein.” The subcontract in Watson also had language that said “[a]t all times subcontractor shall be paid to the extent that the contractor has been paid on his account.” Id. Considering the language of the subcontract, the court in Watson held that the subcontract “created fixed obligations” to pay the subcontractor, and the payment provisions “merely provid[ed] a convenient or normal time for payment.” Id.

Similarly, in Darrell T. Stuart Contractor of Arizona, Inc. v. Bridges & Rust-Proofing, Inc., 2 Ariz. App. 63, 64, 406 P.2d 413, 414 (1965), the Court of Appeals addressed language in a subcontract that provided, “The contractor shall pay the subcontractor’s pay estimate (less ten percent (10%) retainage within ten days after receipt of payment by the contractor and as allowed by the Government.” In an opinion that reviewed the history of pay-if-paid and pay-when-paid provisions, the court in Darrell Stuart held:

[T]he plaintiffs’ entitlement was not conditioned upon the receipt of the money by the defendant. If and when the defendant received money from the contractor, the defendant was obligated to pay the plaintiffs within 10 days from said receipt. If the defendant did not receive all of its money from the contractor, the defendant nevertheless remained indebted to the plaintiffs and the plaintiffs were entitled to payment within a reasonable period of time following the completion of the performance of their contract obligation. Id., 2 Ariz. App. at 65, 406 P.2d at 415.

Third, the court in Pioneer Roofing Co. v. Mardian Constr. Co., 152 Ariz. 455, 733 P.2d 652 (App.1986) reviewed contract language that provided “the recovery by Subcontractor for [additional] work shall be conditioned upon a prior recovery therefore by Contractor from the Owner.” 152 Ariz. at 469, 733 P.2d at 666. Even with language saying that payment was “conditioned” on approval by the owner, the court rejected the general contractor’s defense, holding, “we find no proof of an intent that payment to [the subcontractor] was to be made exclusively or only from funds paid by or on behalf of [the owner].” Id. at 470, 733 P.2d at 667.

The emphasized language from the contract in L. Harvey is distinct from the three earlier cases, Watson, Darrell Stuart and Pioneer Roofing. The subcontract in L. Harvey specifically referred to a “condition precedent to payment:”

The language used here is much stronger than that used in Watson or Pioneer Roofing in showing an intent to limit recovery to the payments received from the owner. The contract between Agate and Harvey expressly states that receipt of payment from the owner is a “condition precedent” to recovery. It further states that “payment for either progress payments or final payment is not due and owing … until the owner has made such payment to the contractor.” Finally, the contract identifies as the source of funding for the subcontract the “progress and final payments that are to be made by the owner to the contractor.” We find the language here sufficiently reflects the concept of exclusivity necessary to demonstrate that the parties clearly and unequivocally intended to create a condition precedent shifting the risk of nonpayment from Agate to Harvey. Thus, the condition precedent is valid and enforceable. L. Harvey Concrete, Inc. v. Agro Const. & Supply Co., 189 Ariz. at 182, 939 P.2d at 815 (emphasis original).

California’s Supreme Court Invalidated “Pay If Paid” Clauses in 1997

In 1997, the same year that L. Harvey was decided in Arizona, the California Supreme Court affirmed (4-3) the Second District’s decision upholding the right of subcontractors to collect from a general contractor’s surety when there is a valid “pay if paid” provision and when, upon the owner’s default, the general contractor refuses payment to the subcontractor. Wm. R. Clarke Corporation v. SAFECO Insurance Company of America, 15 Cal. 4th 882, 886, 938 P.2d 372, 374, 64 Cal. Rptr. 2d 578, 580 (1997).

The California Supreme Court went much further though by invalidating all “pay if paid” clauses because, in short, they amount to a waiver of subcontractors’ constitutionally protected rights to mechanic’s liens, which rights are found throughout the California laws, including, among other provisions, the right to lien property where one has provided labor or materials (Cal Const. of 1879, art. XIV, Sec. 3 (1976), the preclusion of the waiver of such liens in contractual provisions where the terms “waive, affect, or impair the claims and liens…shall be null and void” (Cal Civil Code Sec. 3262). Moreover, the Cal Civil Code Section 3096 defined the parameters for which bonds could be issued, allowing a contractor to “foreclose the liens provided for in this title, and, finally, Section 3226 mandated that sureties would be “released from liability…by reason of any breach of contract between the owner and the original contractor.” See “Freedom from the freedom to contract…, Larson, at 276-277.

In this law review article, the author, Eric Larson, does an in-depth analysis of the case and the many issues that were addressed. Importantly, he provides a critique on the Supreme Court’s decision and finds that the court got it right. He addresses the various arguments made by general contractors in favor of pay if paid clauses, including freedom to contract. Id at 272-281.

He also alludes to courts in other states that have found “ambiguity” in these contractual payment provisions (Florida, as an example) so as to not invalidate the subcontractors’ rights to mechanic’s liens, while a Virginia court took great pains in its analysis before it was fully satisfied that the subcontractor “truly intended” to share the risk of owner default.

Larson concludes that California’s Supreme Court got it right because invalidating “pay if paid” clauses will bring predictability to the ambiguous area of contract interpretation: “Building contractors will be able to focus on their business of constructing projects, as opposed to the wrangling over contractual vernacular and the legal nuances that emanate there from. Subcontractors may now take solace with the assurance that their mechanic’s liens will protect them as designed, and that sophisticated contract drafters will not be able to undermine the important constitutional protection.”

The Alternative (and Majority) View: Ohio’s Transtar Electric Case

In contrast, the majority of states allow the enforcement of pay if paid provisions. Ronald Friedberg analyzed the “state” of this contingent payment clause in a variety of states and found that there is still a lack of “settlement” in the states. “PAY IF PAID” CONTRACT PROVISIONS, Providing Some Enforcement Consistency and Predictability in an Unsettled Area of Law, 57 No. 2 DRI For Def. 23, February 2015, by Ronald P. Friedberg.

In Transtar Electric, Inc. v. A.E.M. Electric Services Corp., 140 Ohio St. 3d 193, 16 N.E. 3D 645 (2014), the Ohio Supreme Court reversed the Sixth Appellate District Court of Appeals saying, essentially, that the words “condition precedent” in the pay if paid clause ARE clear and unambiguous (by themselves) to clarify to a subcontractor that it is giving up its rights to enforce payment if the Owner does not pay the general contractor (including the giving up of its mechanic’s lien rights).

Friedberg finds this decision to be right and to create some certainty in Ohio law. He further believes that the “transfer of non-payment risk through a “pay if paid” condition precedent does not bestow undue hardship upon a subcontractor, een one who has less sophistication, economic wherewithal and/or bargaining power vis a vis the general contractor” because “the risk-assuming subcontractor can, and should, take into account this transfer of risk in setting the subcontract price…” He further says that the “prevention” doctrine will prevent an unsavory general contractor from enforcing the clause.

However, while noting that in the robust minority of states (California, New York, North Carolina, and Massachusetts, as examples), the courts have addressed the constitutionally or statutorily-protected rights of subcontractors to enforce mechanic’s liens, nowhere in his conclusions does it appear that Friedberg addresses this same public policy protection in his state of Ohio.

There are those states that clearly see that a contractual pay if paid provision cannot undermine a subcontractor’s lien and bond rights protected by the laws of a state; however, contractual waiver of lien and bond rights is found in a majority of states, which is dubious. Clearly, no subcontractor ever intends to “waive” its mechanic’s lien or bond rights. However, until such time that the issue reaches the highest court of these states, general contractors will continue including and asserting these provisions to keep subcontractors from enforcing their payment rights.

James Palecek is a co-managing member of Palecek & Palecek, PLLC. He started out his legal career in Ohio as an associate in a law firm founded by his father, and, for the last 20 years in Arizona, he has advised construction and other corporate clients in business transactions and in litigation. His clientele has included suppliers/vendors, subcontractors, general contractors, developers and consultants in both the commercial and residential construction arenas and in both the public and private sector. In addition to a focus in construction law, he has also led the firm’s corporate transactional and real estate practice areas for over 14 years. He can be reached at (602) 522-2454 or  jpalecek@paleceklaw.com.

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Additional Insured Provisions, Traps and Pitfalls

by Jonathan A. Cass and Michael Metz-Topodas, Cohen Seglias Pallas Greenhall & Furman, P.C.

Many, if not all, construction subcontracts contain a provision requiring the subcontractor to name the general contractor, owner, and others as “additional insureds” on the subcontractor’s liability insurance policies. Contractors include such “additional insured” clauses, or AICs, to obtain coverage under the subcontractor’s insurance policies for claims against the contractor, and the other additional insureds, related to the subcontractor’s work.

Not all AICs, however, are created alike. Sometimes even small changes in the language used can significantly affect the coverage the subcontractor needs to have to satisfy the subcontract’s requirements. Subcontractors need to understand what coverage such AICs require, so they can verify with their insurance lawyer and agents or brokers whether they have the required coverage and, if not, negotiate revised subcontract terms. Failing to do so could open up a subcontractor to unexpected additional insured claims. Worse, it could leave a subcontractor in breach of the agreement and thus liable for all “uncovered” claims—which can reach amounts that would jeopardize a business’s very survival.

Determining the coverage an AIC requires depends on its particular terms. The following offers examples and explanations of key AIC provisions that often affect the scope of the coverage required.

  • Whom the Subcontractor Must Name as “Additional Insured”: Typically, an AIC requires the subcontractor to name the contractor and owner as “additional insured.” But, some clauses expand the scope of coverage to unnamed individuals, as this example illustrates: “The Subcontractor shall cause the commercial liability coverage required by the Contract Documents to include the Contractor, the Owner, and any of their agents as additional insureds.” Unfortunately, this language does not specifically identify these “agents.” This group could include individuals or entities that the subcontractor would not have agreed to name as an additional insured if specifically identified. As a result the subcontractor has agreed to provide additional insurance coverage to unknown parties. Agreeing to such a requirement could lead to unexpected additional insured claims and higher future premiums on the subcontractor’s liability policies.
  • The Primary/Non-Contributory Requirement: More often than not the AIC will require that the subcontractor provide the additional insureds coverage that is “primary and non-contributory to any of the additional insured’s general liability insurance policies.” This provision means that the subcontractor’s policy must provide that in the event of a claim for which the policy provides coverage to the additional insured, the subcontractor’s policy responds to that claim first, with the owner’s and general contractor’s policies providing coverage once the subcontractor’s policy is exhausted.
  • Ongoing and Completed Work Requirement: Typically, the AIC demands that the subcontractor’s coverage for additional insureds applies to both “ongoing and completed ” This means that the subcontractor’s insurance would cover not only claims that arise while the subcontractor is actually performing work, but also those related to claims arising from the subcontractor’s work once completed. Accordingly, the subcontractor needs to make sure that its policies cover both scenarios.
  • Coverage for Claims Where Additional Insured Is Solely Liable: Often, an AIC will require the subcontractor’s policies to cover the additional insureds “even for any of their sole negligence.” At first glance it may seem odd that a subcontractor would have to provide coverage where others, such as the contractor or owner, have sole responsibility. This requirement, however, is meant to address a particular situation. Where a subcontractor employee suffers injury, illness, or death, workers’ compensation laws limit the employee’s recovery against the subcontractor. Those laws, however, do not apply to general contractors or owners, as they are not the injured person’s employers. Consequently, employees often bring an action against just those entities, making them “solely liable” based on the allegations. AICs’ “sole negligence” language addresses this situation. Such language, however, puts the subcontractor in a problematic situation. Few insurers will easily provide subcontractors additional insured coverage for that additional insured’s “sole negligence,” making it very difficult to comply with a subcontract’s “sole negligence” requirement.
  • Policy Endorsements: In some cases, an AIC will require the subcontractor’s insurance contain particular additional insured endorsements, almost always referenced by a number, e.g. CG 2010 1185 (the “1185 Endorsement”). These endorsements refer to prescribed policy provisions used throughout the insurance industry. For example, the 1185 Endorsement “include[s] as an insured” any entity listed on a prepared schedule “with respect to liability arising out of [the subcontractor’s] operations.”

Although the 1185 Endorsement was once widely available, times have changed. To limit losses, the insurance industry has moved aggressively to rein in the scope of coverage available to an additional insured. This creates a problem where a subcontractor agrees to provide the coverage required by the identified endorsement, but then fails to obtain that exact coverage because the endorsement no longer exists or is available. In that case, the subcontractor has breached the terms of the subcontract’s insurance requirements. So, for any claim for which the subcontract required the subcontractor to obtain coverage, but the subcontractor failed to do so, the subcontractor would bear full responsibility. The subcontractor would effectively become the insurance carrier for the additional insureds—an extremely undesirable position.

As the above illustrates, AICs present many traps for the unwary. To avoid falling into these, subcontractors must have their counsel and insurance agents or brokers (the “Advisory Team”) review additional insured requirements (plus all other subcontract insurance requirements). The Advisory Team needs to make sure the insurance policies comply with any AICs and other insurance requirements. Subcontractors can help this process by using the above discussion as a guide to make sure to ask their Advisory Team the right questions. Failure to conduct a proper insurance review could subject a subcontractor to unintended and undesired liability. The subcontractor could become a project insurer—exposing the business to liability that could ruin the company.

Jonathan A. Cass is a partner in the Commercial Litigation Group and the chair of the Insurance Coverage and Risk Management Group at Cohen Seglias Pallas Greenhall & Furman, P.C. He concentrates his practice in commercial litigation, representing individuals and businesses in a wide variety of disputes, including breach of contract matters, employment disputes involving restrictive covenants, and claims arising from tortious interference and misappropriation of trade secrets. He can be reached at (215) 564-1700 or jcass@cohenseglias.com. Michael Metz-Topodas is an attorney in the Construction Group at Cohen Seglias Pallas Greenhall & Furman, P.C. He represents commercial and construction clients in all stages of litigation from assessing claims and developing case strategy to final resolution or adjudication. He also counsels clients on business disputes and compliance issues in ongoing public and private construction projects. His practice also includes preparing and reviewing construction and commercial contracts. He can be reached at (215) 564-1700 or mmetz-topodas@cohenseglias.com.

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Recommended Do’s and Don’ts in Project Scheduling, Schedule Analysis and Delay Claims

by Jason Ebe, Snell & Wilmer, LLP

Our construction attorneys frequently represent subcontractors and other construction professionals in disputes regarding delays, disruption, acceleration, inefficiency, cumulative impact and alike. Based on that experience, this article provides a summary refresher on some of the more important do’s and don’ts with respect to subcontractor project scheduling and claims analysis.

Do prepare a schedule at the time of the bid. Your superintendent and other time-based costs are tied to that schedule. Don’t assume that the time allowed by the owner or the general contractor will be sufficient and that you can come up with a schedule to fit the work after the subcontract is awarded. Under applicable case law, the subcontractor’s bid could be argued as a warranty to the general contractor or owner that the subcontract time is sufficient (not the other way around). Do document your bid assumptions as to the schedule including, where applicable, a critical path, logic ties between activities, and resource allocation.

Do seek to use subcontract form or terms that provide a fair allocation of rights and obligations with respect to project scheduling. For example, use the ASA Subcontractor Bid Proposal—part of the ASA Subcontract Documents Suite available free to ASA members under “Contracts and Project Management” in the Member Resources section of the ASA Web site by logging in at “LogIn/Access Member Resources”—to condition your bid on the use of a ConsensusDocs 750 Standard Agreement between Constructor and Subcontractor. The ASA-endorsed ConsensusDocs subcontract form provides the following language:

Subcontractor shall provide Constructor with any scheduling information proposed by Subcontractor for the Subcontract Work. In consultation with Subcontractor, Constructor shall prepare the schedule for performance of the Work (“Progress Schedule”) and shall revise and update such schedule, as necessary, as the Work progresses. The Progress Schedule binds each Party and all subsequent changes and additional details shall be submitted to Subcontractor promptly and reasonably in advance of the required performance. Constructor shall have the right to determine and, if necessary, make reasonable changes to the time, order, and priority in which the various portions of the Work shall be performed and all other matters relative to the Subcontract Work. To the extent such changes increase Subcontractor’s time and costs, Subcontractor may seek equitable adjustment in the Subcontract Amount or Subcontract Time in accordance with the Subcontract Documents.

Need tips to negotiate this language with your general contractor? Do use the ASA Subcontractor’s Negotiating Tip Sheet on Project Schedule—also located under “Contracts and Project Management” in the Member Resources section of the ASA Web site. This tip sheet includes helpful points to negotiate your terms:

When the GC Says: “You’re going to have to be flexible and adjust your schedule as necessary.”

The Sub Should Say: “I understand that you may have to make subcontract schedule changes, but I can’t agree in advance to adapt and adjust my work to suit your needs without the right to more money and an extension of time for me to finish my work.”

When the GC Says: “Don’t worry. We’re going to have everything ready for you.”

The Sub Should Say: “I can’t make the schedule unless your jobsite utilities are ready on time, and my submittals are approved and returned promptly.”

When the GC Says: “We don’t pay for acceleration. You just have to be flexible.”

The Sub Should Say: “If my work doesn’t start on time because of project delays, I’ll need to be paid for my acceleration costs or be allowed more time to finish.”

When the GC Says: “Time is of the essence on this project. There’s never an excuse for not getting the job done on time. You’ll be held fully responsible.”

The Sub Should Say: “We agree to make a good-faith effort to help you meet your completion date, but we can’t give up any delay claim rights if we incur more cost for reasons outside of our control.”

Do keep your schedule updated—not just short-term, look-ahead schedules but the project schedule as a whole. Do it regularly, perhaps with every pay application, so all parties are apprised of the impact of conditions as they occur. Send out notices of impacts, in accordance with the claims provision in the subcontract, if at all possible. Moreover, even if you fail to provide the contractually required notice, submission of periodic updates should help in disputes where one party argues it had no idea that the schedule was being affected.

Do provide prompt written notice of all delays and impacts to the schedule, and comply as best as possible to all contract notice provisions to avoid having your claim disapproved for a failure to provide notice. Don’t assume a prior course of dealing with respect to claims or actual notice is an appropriate substitute for compliance with the contract requirements. It will only cost you additional attorney fees to argue over the notice issue.

Do include as much information as you can at an early stage even if time and cost impacts are estimates only at the time of the notice. Do include downstream subcontractors and suppliers.

Do review your subcontract to see what is recoverable in addition to a time extension. Many contracts may have limitations on recovery of overhead (direct and/or home office), profit and the like on delays even if compensable. Do negotiate these provisions if possible. Use the ASA Subcontract Addendum—also part of the ASA Subcontract Documents Suite—which provides:

Subcontractor shall be entitled to equitable adjustments of the contract price, including but not limited to any increased costs of labor, supervision, equipment or materials, and reasonable overhead and profit, for any modification of the project schedule differing from the bid schedule, and for any other delays, acceleration, out-of-sequence work and schedule changes beyond Subcontractor’s reasonable control, including but not limited to those caused by labor unrest, fires, floods, acts of nature or government, wars, embargos, vendor priorities and allocations, transportation delays, suspension of work for non-payment or as ordered by Customer, or other delays caused by Customer or others. Should work be delayed by any of the aforementioned causes for a period exceeding ninety (90) days, Subcontractor shall be entitled to terminate the subcontract. Subcontractor change proposals must be processed in not more than thirty (30) days or as otherwise indicated on the change proposal.

Do know whether there is any case law or statutes that affect the enforceability of these provisions and consult with a knowledgeable construction attorney if needed. Do expressly reserve any claims that you can’t completely or quantify right away (for example, cumulative impact). Failure to do so may result in waiver of that portion of the claim.

Do keep track of all your costs from the impact and put in place accounting mechanisms to track such charges. Do reserve your rights to pursue these claims, in your contracts, change orders, lien waivers, and pay applications. Don’t assume you can compute a persuasive damages figure by comparing total costs to bid costs. The total cost method is disfavored and is widely rejected, particularly now with scheduling and claim digger software.

In the event of a delay claim or dispute during the project, and subject to the contract requirements, do keep working. Suspending work without justification under the law or the contract will usually make a bad situation much worse. Don’t terminate or threaten that action without a comprehensive review of the contract, key project documents and the pertinent facts, and legal consultation with your construction attorney. Aside from personal injury or death, contract termination is the most disruptive event that can occur on a construction project and will almost certainly result in contentious and expensive litigation. If you are on the receiving end of the termination threat or notice, do immediately seek experienced legal counsel. Time will be of the essence. Any wrong move can have long lasting consequences.

When resolving claims, do be mindful of waivers. Pay applications and acceptance of payments (whether progress or final) may constitute waivers of claims that arose prior to the application for payment and not preserved depending on your contact and pay application form. In addition, be careful when signing lien waivers. Lien waivers by their language may waive not just liens but claims of any nature. Under general case law, acceptance of final payment by a general or subcontractor could be a waiver of any claims for payment not reserved. From the owner’s perspective, making final payment in most cases is a waiver of any claim for delay, for example, liquidated damages.

Do comply with all applicable notice of claim statutes or ordinances. This is even more critical in claims involving public owners for which state statutes, local ordinances, and/or other requirements may apply for timely and proper notice of claims. Don’t expect the court to excuse your failure to comply. Don’t create another issue for your attorney to fight about. If you lose the issue, the claim may be dismissed.

Do engage the appropriate professionals at an early stage. This includes not just legal counsel experienced in delay claims but also the right expert (either as a consultant, testifying expert, or both). Do find an expert who has performed critical path analysis both in and out of claim situations (in other words, with real world experience). Do make sure the expert has a plan for analysis and presentation of the claim in a manner that has already been accepted by the court. Don’t assume that an expert’s creative approach will translate into recovery if the methodology has not previously been accepted as legitimate by the counter. Do take time to walk the expert through not just the documents but also provide the expert with the opportunity to interview the key project personnel in the trenches so the expert has an adequate picture of what happened. Do be sure that your claim shows entitlement, causation and damages. Don’t assume that if you can show enough impact the court will award your damages without a showing of causal connection.

Jason Ebe is a partner in Snell & Wilmer, LLP’s Phoenix office and leads the firm’s national construction practice. He is a former chair of the ASA Attorneys’ Council. He can be reached at (602) 382-6240 or jebe@swlaw.com.

 

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Design Responsibility

by J.T. Gallagher, Esq., Hendrick, Philips, Salzman and Siegel, P.C.

Should a subcontractor with absolutely no control over a scope of work be responsible for the proper performance of that work? It seems like a no brainer that the answer should be no. As examples, an electrical contractor would not guarantee the proper performance of a roof; nor would a masonry contractor guarantee the functionality of an HVAC system; and for good reason—that work is outside their expertise and they would typically have no control over its performance. Such uncontrollable risk is something that a prudent subcontractor should not take on, unless it is paid accordingly. Yet, there are multiple clauses commonly seen in construction contracts that shift what should be a designer’s risk to contractors and subcontractors.

It is standard industry practice for subcontractors to rely upon the designer to properly design the project so that the work can be constructed in accordance with the plans and specifications. When the work is constructed in accordance with those contract documents, it should be the designer’s responsibility to ensure that the project will comply with the applicable code requirements and perform as the designer intended. Indeed, that is the task a design professional is paid to perform. Typically, a subcontractor does not have control over the design of the project nor does it have the right to unilaterally make changes to the design. So why should a subcontractor agree to take on the risk of a defective design? Unless the subcontractor expressly intends to take on design responsibility and is being paid to do so, it should not.

Accordingly, it is important that subcontractors closely examine contracts for clauses that shift design responsibilities from the designer to the contractor and subcontractors. These clauses come in multiple forms and some seem rather innocuous, but each clause shifts significant uncontrolled risk to the subcontractor. The intent of this article is to help subcontractors identify the trigger language commonly seen in the common “design responsibility” clauses and understand the risks of those clauses so that subcontractors can take appropriate measures to mitigate those risks.

Design ‘Intent’ Clauses

The first commonly seen class of contract clauses seeking to shift the designer’s responsibility are clauses that place the burden on the contractor or subcontractor to satisfy the “design intent” or “to produce the intended result.” The basic problem with theses clauses is that the subcontractor is typically not the designer and cannot know the designer’s intent. The subcontractor can only rely on the plans and specification, which should be the designer’s expression of its intent. As such, a subcontractor’s responsibility should be limited to performing in accordance with the contract documents and its work should include only what can reasonably be inferred from those documents. In fact, even the architect’s standard form, AIA A201-2007, requires only that the contractor perform the work “in accordance with the Contract Documents.” See AIA A201-2007 ¶ 3.1.2.

An example of one of the many iterations of a design “intent” clause is as follows:

The intent of the Contract Documents is to include all items or services necessary for the proper execution and completion of the Work by Contractor.

Conflicting Design and Performance Specifications

Another commonly seen class of design responsibility clauses are those that require a subcontractor to strictly comply with the contract documents and, at the same time, to ensure that the building component or system constructed will function properly. “Performance” requirements in a contract should always pique a subcontractor’s attention. The danger in theses clause is that the design may be defective and prevent the finished product from performing properly even when the work was constructed as specified. When a subcontractor is required to install the work in accordance with the contract documents, that should be the subcontractor’s sole responsibility. If the subcontractor does not have control over the design, it should not be responsible for guaranteeing that the design will result in a properly functioning system.

An example of a conflicting design and performance requirements is as follows:

Contractor shall furnish all Work in accordance with the plans, specifications and other Contract Documents, such that the completed Work shall ensure a functional and complete facility meeting the owner’s intended purpose.

Design Coordination Responsibility

Design responsibility can also be shifted by clauses that make the subcontractor responsible for identifying design conflicts, errors, and omissions. This requirement is often imposed through a clause requiring the subcontractor to investigate and affirmatively discover design issues in the plans and specifications and immediately report them to the owner or designer. Subcontractors should avoid clauses that impose affirmative duties to ensure the design is appropriate, because, the contractor is typically not a design professional and not being paid to ensure the propriety of the design. Therefore, a subcontractor’s review of plans and specification should be limited to the subcontractor’s expertise; the constructability of the scope of work.

Latent Ambiguities

Contract clauses can also seek to shift design responsibility through provisions that provide that, in the event of conflicts, ambiguities, or discrepancies among or between various contract documents, the most stringent, most exacting, most expensive, or otherwise most onerous requirement will prevail. In the case of latent ambiguities and conflicts, the subcontractor’s reasonable interpretation of the contract documents would typically prevail under general legal principles. Thus, a subcontractor faced with a provision imposing the most expensive, onerous, exacting, or stringent standard or means and methods in the case of a latent ambiguity or conflict should seek to modify the terms to allow for instead what is reasonable under the circumstances. An appropriate resolution may be that the designer provides a reasonable interpretation in response to an RFI and the subcontractor submits a corresponding change order if necessary. Indeed, the designer is the party who likely created the conflict and should be responsible for providing a reasonable and cost effective resolution.

An example of this type of clause is as follows:

If the Contract Documents do not specifically allow the Contractor a choice as to quality of items to be furnished, but could be interpreted to permit such choice, they shall be construed to require the Contractor to furnish the best quality. . . . Owner will not accept Work which fails to comply with such standards, unless the departure from such standards is specifically identified to, and thereafter authorized in writing by, Owner’s Representative.

Incorporation by Reference

Contract clauses that incorporate terms and conditions not specifically set forth in the language of the contract can be especially dangerous for subcontractors because, when the subcontractor signs off on the contract, it is presumed to know what is in the referenced documents even if they are not attached to the contract. These clauses are often used to incorporate upstream contracts, but can also include standards, laws, regulations, or other secondary sources that can impose design or performance requirements. At a minimum, a subcontractor should investigate and understand what is contained in any referenced document and how the document will affect the subcontractor’s performance. However, it is typically better practice, if possible, to strike or significantly modify contract language that expands a subcontractor’s obligations to referenced materials that were not included in the bid or contract documents.

Building Code Compliance

Finally, subcontractors should be wary of contract clauses that require them to investigate and discover non-compliance with the applicable building codes. A subcontractor should not be required to assure that the design is in compliance with applicable building codes. Instead, the subcontractor should have the right to rely on the fact that the design professional has designed the work to meet the applicable code requirements. No more than a good faith duty to perform a reasonable review should be imposed on a subcontractor and that review should not be for the purpose of discovering code violations, but, instead, for facilitating construction.

An example of this type of clause, which also serves as an example of an incorporation by reference clause, is as follows:

Compliance With Applicable Laws. Contractor shall reasonably ensure that the Services and Work are performed, and the Project is constructed in a manner which meets the requirements of all applicable laws relating to the design, construction, occupation, and operation of the Project, including, but not limited to, building codes, fire and safety regulations, and environmental regulations. Such Applicable Laws shall be deemed minimum standards for the Project. Contractor shall immediately notify the Owner’s Representative in writing of any known violation by Architect or any Subcontractor of any Applicable Law, or any such violation of which the Contractor reasonably should have known.

Subcontractors are typically not design professionals and should not be forced to take on liability for the errors and omissions of the designers unless they have explicitly agreed to do so and are being compensated accordingly. A subcontractor should be able to rely on the designer to properly design the work just as the subcontractor will be relied upon to properly construct the work. Therefore, subcontractors should diligently identify risk shifting contract clauses and seek to appropriately modify the clauses when they can—during contract negotiations.

J.T. Gallagher, Esq., is an associate with Hendrick Phillips Salzman & Siegel, P.C., Atlanta, Ga. He brings a breadth of experience in the field of construction law with a targeted focus on construction litigation. He can be reached at (404) 522-1410 or jtg@hpsslaw.com.

 

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Indemnity Provisions in Subcontracts May Burden Subcontractors with Excessive Risk

by Joseph M. Sweeney, Esq., and Scott A. Mangum, Esq.

Indemnity provisions are often highly contested subcontract provisions since they shift risk from general contractors to subcontractors. While subcontractors may understand the general purpose of indemnity provisions, i.e. that one party (the “indemnitor”) agrees to indemnify and defend another party (the “indemnitee”) from claims, they sometimes do not understand how indemnity provisions are applied to significantly increase their risk on construction projects.

This article discusses indemnity provisions in three parts: 1) how and when indemnity clauses impose a duty on subcontractors to reimburse general contractors or owners for sustained loss and damage which they may not expect; 2) how to negotiate a balanced indemnity provision that limits a subcontractor’s indemnity obligations to claims for their own fault or that may be covered by insurance; and 3) a comparison of California and Texas indemnity laws to illustrate the importance of reviewing the indemnity laws of your state.

What Is Indemnity?

“Indemnity” is “(1) A duty to make good any loss, damage, or liability incurred by another; (2) The right of an injured party to claim reimbursement for its loss, damage, or liability from a person who has such a duty; (3) Reimbursement or compensation for loss, damage, or liability in tort; especially, the right to recover from the party who is primarily liable for reimbursement of expenditures paid to a third party for injuries resulting from a violation of a common law duty.” Black’s Law Dictionary 784 (8th ed. 2004).

Put succinctly, one party agrees to defend another party for any loss relating to a third party’s claim. Indemnity clauses shift risk by requiring the indemnitor to pay damages that have been or might be caused by the indemnitee.

Consider a third party who slips on stairs. The third party may sue the building owner for its injury alleging that the stairway’s design or construction was deficient because the stairs were too tall, too steep, lacked slip protection, or violated building codes. If the owner has an indemnity provision in its contract with the contractor who built the stairs, the owner may look to the contractor, as the indemnitor, to compensate the building owner for damages awarded to the injured third party. Likewise, if the contractor hired a subcontractor to participate in the design or construction of the stairs and included an indemnity provision in the subcontract, the contractor may look to the subcontractor for indemnity relating to the claim, i.e. the subcontractor must compensate the general contractor for money the general contractor pays to the building’s owner.

Onerous Indemnity Provisions

Indemnity provisions are typically more favorable to the indemnitee, for instance, the owner or the general contractor, than to the indemnitor (the subcontractor). Consider this indemnity provision used in many California subcontracts:

AGCC Short Form Standard Subcontract: To the fullest extent permitted by law, Subcontractor shall indemnify and hold harmless Owner and Contract and their agents and employees from claims, demands, causes of action and liabilities of every kind and nature whatsoever arising out of or in connection with Subcontractor’s operations performed under this Agreement. The indemnification shall extend to claims occurring after this Agreement is terminated as well as while it is in force. The indemnity shall apply regardless of any active and/or passive negligent act or omission of Owner or Contractor, or their agents or employees, but Subcontractor shall not be obligated to indemnify any party for claims arising from the sole negligence or willful misconduct of Owner or Contractor or their agents or employees, or arising solely by the designs provided by such parties. The indemnity set forth in this Section shall not be limited by insurance requirements or by any other provision of this Agreement.

This AGCC indemnity provision underscores how indemnity provisions can be onerous to subcontractors. First, it obliges the subcontractor to “indemnify and hold harmless” the indemnitee from “claims, demands, causes of action and liabilities of every kind and nature whatsoever arising out of or in connection with Subcontractor’s operations …” Second, the provision applies regardless of the indemnitee’s passive negligence. Lastly, the indemnity obligation is not limited by insurance, thereby presenting increased risk to the subcontractor in the event of a third-party claim exceeding the amount of the subcontractor’s insurance.

Balanced Indemnity Provisions

While comparative negligence generally applies under the common law, contractual indemnity favors an indemnitee by circumventing the common law and imposing broad and sometimes unfair obligations on the indemnitor. A subcontractor who familiarizes itself with the typical language found in indemnity provisions will be better equipped to negotiate language shifting risk of loss. Specifically, options for protection include limited indemnity for fault or limiting indemnity obligations to insurable claims.

Subcontractors should seek to limit indemnity obligations to areas where they can obtain insurance. Broad indemnity provisions such as the AGCC language above require the indemnitee to indemnify the indemnitor from “claims, demands, causes of action and liabilities of every kind and nature whatsoever arising out of or in connection with Subcontractor’s operations performed under this Agreement.” For subcontractors, the broad scope is troublesome because it is unlimited and the subcontractor likely cannot obtain insurance on such a broad scale.

Subcontractors should propose indemnity provisions such that indemnity obligations are narrowed to insurable risks. For example, a subcontractor may limit claims for personal injury or property damage claims which are insured.

A subcontractor should also seek to limit its indemnity obligations only to third party claims relating solely to its fault. By excluding obligations to indemnify other parties to the contract for their fault (e.g. the building owner), the subcontractor is better able to limit and control risk. The following is a more narrowly tailored indemnity provision that obligates the subcontractor to a more limited scope of indemnity:

The Subcontractor shall indemnify and hold harmless the Owner … from and against claims, damages, losses and expenses … arising out of or resulting from the performance of the Work, provided that such claim, damage, loss or expense is attributable to bodily injury, sickness, disease or death, or to injury to or destruction of tangible property (other than the Work itself), but only to the extent caused by the negligent acts or omissions of the Subcontractor, Subcontractor’s subcontractor, or anyone directly or indirectly employed by or anyone for whose acts they may be liable. Subcontractor’s obligations hereunder shall be limited to the extent of Subcontractor’s insurance.

California and Texas Indemnity Principles

California

Type I indemnity provisions require a party to indemnify another from any claim arising out of or related to the indemnitor’s scope of work, including the negligence of the indemnified party. Only the indemnitee’s sole negligence or willful misconduct cannot be indemnified.

Although California law once permitted Type I indemnity provisions in construction contracts, California Civil Code 2782.05 now generally prohibits them in construction contracts entered into after Jan. 1, 2013, under 2782.05(a)., California construction contracts may not require a subcontractor to indemnify, defend or insure a general contractor, construction manager or other subcontractor for (1) claims of personal injury property damage, or other loss to the extent that the claims relate to the indemnified parties’ active negligence or willful misconduct; (2) claims that arise from any design defects provided by the indemnified parties or (3) claims that do not arise out of the subcontractor’s scope of work set forth in the subcontract. Any contractual provision attempting to waive these limitations is contrary to public policy and unenforceable. Cal. Civ. Code §2782.05(d).

Civil Code 2782.05 does allow several limited exceptions allowing Type I indemnity provisions, including (1) “contracts for residential construction” to the public; (2) “direct contracts with a public agency”; (3) “direct contracts with the owner of privately owned property”; (4) “any wrap up insurance policy or program”; (5) independently existing causes of action for breach of contract or warranty; (6) a subcontractor’s contractual insurance requirements; (7) “indemnity provisions in loan and financing documents”; (8) indemnity provisions in surety bonds; (9) benefits and protections under workers’ compensation and governmental immunity laws; (10) contractual provisions requiring certain construction risk insurance policies; and (11) contracts with “design professionals.” Cal. Civ. Code § 2782.05(b).

Texas

In 2011, the Texas Legislature enacted the Texas Anti-Indemnity Act (codified in Texas Ins. Code sections 151.001 to 151.151) to limit and void certain indemnity provisions in contracts entered into after Jan. 1, 2012.

The Texas Act prohibits in certain classes of construction contracts broad form indemnity (holding indemnitor responsible for any and all liability arising from the specified subject matter) and intermediate form indemnity (requiring indemnitor to indemnify indemnitee for all liability arising from a specific subject matter, even if damage is caused by the indemnitee’s negligence, but expressly excludes the indemnitor’s sole negligence) if the Act applies to the contract at issue.

According to Texas Insurance Code section 151.001, the Anti-Indemnity Statute applies to construction contracts for projects where an indemnitor procures insurance subject to the Act’s Chapter 151 (Consolidated Insurance Program where principal provides multiple kinds of insurance for a single construction project) or Title 10 (states regulations for Texas property and casualty insurance; includes standard commercial general liability and workers’ compensation coverage).

Section 151.105 contains eleven exclusions to the Anti-Indemnity Act: (1) consolidated insurance programs; (2) actions for breach of contract or warranty that exist independently of an indemnity obligation; (3) loan and financing documents other than construction contracts to which lenders are a party; (4) general indemnity agreements required by sureties; (5) workers’ compensation protections and benefits; (6) agreements subject to Texas Civil Practice & Remedies Code Chapter 127; (7) licenses or access agreements with railroad companies; (8) indemnity provisions applying to copyright infringement claims; (9) construction contracts or agreements collateral to or affecting construction contracts pertaining to single-family homes, townhouses, and duplexes; (10) municipality public works projects; (11) joint defense agreements entered into after a claim is made.

Section 151.104 states that any provision or coverage endorsement in a non-exempted construction contract requiring the purchase of additional insured coverage under an insurance policy with a scope of coverage to cover the other party’s own negligence is void and unenforceable to the extent that it requires coverage for such negligence.

A comparison of the Texas and California indemnity laws underscores the disparate nature of such laws as among different states, and the importance of carefully reviewing indemnity provisions on a state-by-state basis and with experienced local counsel. Understanding indemnity principles is an important skill for all subcontractors seeking to protect themselves in the event of third-party claims relating to their work or the work of an indemnitee party.

Joseph Sweeney, Esq., and Scott Mangum, Esq., are shareholders with Sweeney, Mason, Wilson & Bosomworth, Los Gatos, Calif. Since 1978, Sweeney has focused on construction and real estate law, both transactional and litigation. He has successfully represented owners, developers, general contractors, subcontractors, material suppliers and design professionals in multiple aspects of construction law issues through negotiations, disputes, mediations, arbitrations and trials. He can be reached at (408) 356-3000 or jsweeney@smwb.com. Mangum assists his clients in a variety of litigation matters, focusing primarily on construction and real estate disputes. He can be reached at (408) 356-3000 or smangum@smwb.com. SMWB would like to thank Brian Carroll for his input regarding this article, specifically relating to Texas law.

 

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Death, Taxes, and Change Orders

by Lee Brumitt, Esq., Dysart Taylor Cotter McMonigle & Montemore, P.C.

There are seldom projects that don’t have some measure of change or different site conditions requiring adjusted compensation to a subcontractor or a change in scheduled date of completion. The change order process doesn’t begin when a potential change is encountered. The process starts before a bid is submitted and long before a contract is delivered for signature.

Almost all subcontracts contain the following provision:

The Subcontractor represents and agrees that it has carefully examined and understands this Agreement and the other Contract Documents, has investigated the nature, locality and site of the Work and the conditions and difficulties under which it is to be performed and that it enters into this Agreement on the basis of its own examination, investigation and evaluation of all such matters…

Thus, the change order process must always start with a detailed review and complete understanding of the work site or description, drawings, specifications, contract documents, and time limitations. The conscientious subcontractor should look for and bring any design errors to the attention of the GC and architect so that supplemental instructions can be provided—preferably before a bid is submitted.

In developing a bid, make prices contingent upon written assumptions about the time and conditions allowed for performance of the work and build in protections for seeking adjustments in contract price, time of completion, or right of termination in the event of delays or other conditions out of your control. Identify the labor billing rates and mark-up on materials which you will use to price extra work encountered on a project.

One of the biggest mistakes made by subcontractors is assuming that the scope of work and written assumptions defined in a bid have been carried over and are the same as the work defined in the subcontract. When a subcontract is presented, it should precisely define the scope of work being undertaken along with the scope of work not undertaken in such a way that parties can determine whether work encountered after commencement is within or outside of that scope and, therefore, compensable as extra work. Provide a detailed description of the scope of work included in the bid and provide a complete list of work, materials, equipment, and services excluded in your bid and carry over in writing the written assumptions contained in your bid about time and conditions as well as labor billing rates and mark-up on materials.

Even if a subcontractor identifies the precise scope of work in the subcontract, the right to an increase in contract price can easily be lost through ignorance of or failure to follow the time frames lurking in the shadows of a subcontract to notify the GC of a condition requiring a change. The following subcontract provision is encountered frequently:

Subcontractor shall provide Contractor with written notice of any circumstance or direction given by Contractor which Subcontractor may regard as a change, addition and/or omission … within 5 days of the receipt of the direction or the occurrence of the event giving rise to such a request. Such written notice shall provide a full explanation of the circumstances or direction and the extent of the increase and extension sought, including a detailed breakdown and analysis supporting such request. Failure of the Subcontractor to provide such written notice shall constitute a waiver of Subcontractor’s right to any such increase or extension.

Even a diligent subcontractor can miss a five-day window. The requirement to include a detailed breakdown and analysis makes this unreasonable provision seem almost impossible to meet. Regardless of the time frame, it is critical for a subcontractor to train field personnel to immediately contact the project manager when (1) a site condition is encountered which is inconsistent with the plans and specifications; (2) the GC directs performance of work which is outside the scope of work; (3) more time is needed to complete work for any reason; (4) costs have been incurred due to the delays or performance of other subs, the GC, the design professional, or the owner. Moreover, it is critical to train project managers to immediately and aggressively document and notify the GC of any condition requiring an increase in contract price or more time to complete. Better to err on the side of caution than to waive the right to assert a change order.

Assuming time frames have been met and the GC acknowledges the need for a change, the next step in the change order process is arriving at an equitable price and/or a fair extension to complete work. Beware of the following provision commonly found in subcontracts:

Should the parties be unable to agree as to the value of the work to be changed, added or omitted, the Subcontractor shall proceed with the work promptly under the written order of Contractor from which order the stated value of the work shall be omitted, and the determination of the value of the work, if not resolved in the normal course, shall be addressed pursuant to the dispute resolution procedures

Beware of having to comply with yet another time frame set forth in the dispute resolution provisions. Many such provisions contain a short period by which notice has to be given to the GC of any disputes. Thus, a subcontractor could comply with the time frame for notifying the GC of a condition requiring a change but miss the notification period contained in the dispute resolution provisions.

This leads to the cardinal rule of change orders. Change orders should be signed by the GC before a subcontractor should commence any extra work. Never perform work on a verbal assurance that payment will be made. The subcontractor which performs change order work without receiving an executed change order runs afoul of an even more common provision:

If extra work is ordered by [GC] and Subcontractor proceeds with same but did not receive a written order, Subcontractor shall be deemed to have waived any claim for extra compensation.

The subcontract with these seemingly irreconcilable “damned if you do, damned if you don’t” provisions requires caution. The best rule is to proceed with extra work only if a signed change order is in place and, barring that, only if you are provided with a Construction Change Directive or similar order to perform extra work, which is in writing, acknowledges that the work is extra work requiring additional compensation and/or additional time and is provided by an individual authorized by the party to authorize extra work. Proceed with extra work if the party with whom you have contracted refuses to sign a change order or a Construction Change Directive or similar order to perform extra work under extreme caution and only if you prepare and send a written Change Order Memorandum to the GC describing the extra work you have been asked to perform, confirming the party’s refusal to sign a change order or Change Order Directive, and stating that the extra work is being performed under protest and with full reservation of rights to seek an increase in the contract price and additional time to complete the subcontract upon completion of the extra work when all information regarding the consequences of the extra work is known.

Once the extra work commences, take photographs, prepare a report of the extra work in daily logs and other reports, and maintain detailed daily records of all labor, burden, material, equipment, and other costs incurred in performing extra work and, if possible, obtain the signature of the party with whom you have contracted and/or the owner’s representative on a daily basis. Many GCs will reject any change order work not acknowledged and verified in the field on a daily basis.

Lastly, after painstakingly making your way through the change order maze, be careful not to waive change order claims through the lien waiver process. Many lien waivers contain a forfeiture of lien rights for work performed prior to a date stated in the waiver. The unresolved change order that is included on any pay application or hasn’t been presented by the date in the lien waiver can be waived. Reserve your rights to get paid for change order work by stamping or writing the following on any time-based or unconditional lien waiver:

This release shall apply only to work for which payment has been received in full; shall not apply to retention; shall not apply to unbilled changes or to claims which have been asserted in writing or which have not yet become known; and shall be conditional upon receipt of funds.

Lee Brumitt is a director and shareholder with the Kansas City law firm of Dysart Taylor Cotter McMonigle & Montemore, P.C. He has more than thirty-four years of experience in construction law and litigation. He represents subcontractor trades and specialty contractors on public, commercial and residential projects. He currently serves as the attorney for the Kansas City Chapter of American Subcontractors Association. Lee can be reached at (816) 714-3027 or lbrumitt@dysarttaylor.com.

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Incorporation by Reference Clauses

by Masaki James Yamada is a partner at Ahlers Cressman & Sleight PLLC

Most subcontracts contain some version of what is termed an incorporation by reference, “conduit,” or “flow down” clause. Such a clause incorporates terms of the prime contract between the owner and prime contractor and makes them generally applicable to the subcontract.

Some would consider the flow down/conduit clauses to be different from incorporation clauses. Flow-down clauses typically attempt to align rights and obligations consistently throughout the chain of contracts from the prime to the various lower tiered subcontracts for any particular scope of work. A flow-down clause is essentially a promise by the subcontractor to be obligated to the general contractor the same way the general contractor is obligated to the owner. A flow down clause may read as follows:

It is agreed that Subcontractor will assume toward Contractor all obligations and responsibilities which Contractor has assumed toward Owner under the Main Contract to the extent of the work herein subcontracted, Subcontractor shall be entitled to all privileges and protection granted Contractor by Owner under the Main Contract. AGC of Washington Subcontract ¶A (2002 ed.).

An incorporation by reference provision is generally broader than a flow-down clause. Where a contractor will use the flow-down clause to pass down obligations to lower tiers, an incorporation by reference provision will typically seek to make all rights and obligations between the higher tier parties apply, as a whole, to the lower-tier relationship. An incorporation by reference clause may read as follows:

Subcontractor agrees to perform all such Work in compliance with and under the terms and conditions of the Contract Documents, and the terms, conditions, and requirements of Contract Documents are hereby incorporated into this Subcontract as if fully set forth herein.

While the differences are subtle, both types of clauses are intended to perform two functions: (1) they incorporate by reference the applicable technical provisions of the prime contract which the subcontractor must perform, and (2) impose upon the subcontractor the same rights and obligations the contractor has agreed to with the owner, usually found in the prime contract’s general conditions. The first purpose rarely causes disputes. The second is why these clauses are one of the worst contract terms for subcontractors because it frequently leads to disputes when the subcontract does not address the particular issue, but the general conditions of the prime contract contain a clause addressing that issue.

For example, Sime Construction v. WPPSS, 28 Wn. App. 10, 9621 P.2d 1299 (1980), illustrates some of the problems for lower tier contractors that are presented by incorporation by reference clauses. In Sime, a second-tier subcontractor (Sime) submitted a claim for damages to the first-tier subcontractor arising from the late delivery of revised drawings. The general contractor and first-tier subcontract knew of the delay in delivery of the drawings. Yet, the claim was rejected on the ground that Sime had failed to submit a timely notice of claim as required by the prime contract. The first-tier subcontract contained an incorporation by reference clause incorporating the notice provisions of the prime contract, and the second-tier subcontract contained an incorporation by reference clause incorporating the first-tier subcontract and prime contract.

Sime contended the notice procedures of the prime contract were not incorporated by reference into the sub-subcontract for purposes of the claim caused by the late delivery of the drawings. Sime relied upon the rule that where one contract is incorporated by reference into another for a special purpose, the incorporation is limited to that purpose. The Washington State Court of Appeals disagreed and held the incorporation clause was general and unlimited and, in that situation, both the contract specifications and procedural provisions of the prime contract are incorporated by reference. This obviously poses problems for subcontractors because (1) it means they are required to know all the general conditions and claim procedures of all the upper tier contracts and (2) it does not matter what the subcontract allows or limits, if any upper tier contract takes precedence over the subcontract terms in the event of a conflict (“order of precedence clause”).

Another problem caused by incorporation clauses is the ambiguity over which the claim dispute process is to be utilized. By its very nature, the incorporation clause is intended to impose upon a subcontractor the same liability as the prime has to the owner. This obligation is especially important in the context of disputes in litigation involving the owner, prime, and subcontractor. Unless a prime can insist that the same court or arbitrator decide both the prime-owner dispute and the subcontractor-prime dispute, the intended effect of the incorporation clause may be emasculated by inconsistent results achieved by different forums.

In an extreme case, a literal reading of the incorporation clause may actually deprive a subcontractor of a forum as occurred in 3A Indus. V. Turner Constr., 71 Wn. App. 407, 869 P.2d 65 (1993). 3A Industries involved the State of Washington McNeil Island Corrections Center project, where 3A was a subcontractor to Turner. During the course of the project, 3A filed claim against Turner for damages for delays and interference caused by Turner’s mismanagement of the project. 3A sued Turner’s payment bond pursuant RCW 39.08 (Washington’s “Little Miller Act) and sued to foreclose against the retainage pursuant RCW 60.28.

3A’s subcontract contained no arbitration clause. Turner and its surety moved the court to stay the litigation, asserting 3A was obligated to arbitrate the dispute pursuant to the incorporation clause of the subcontract. 3A argued it did not agree to arbitrate its statutory claims and that the remedies it owed Turner pursuant to the incorporation clause were limited to those relating to the scope, quality or manner of 3A’s performance of work. The trial court agreed with 3A, but the Court of Appeals found that the “rights and remedies” incorporated the subcontract included the duty of 3A to arbitrate its statutory claims with Turner if Turner so demanded.

The Court of Appeals distinguished a long line of Federal Miller Act cases requiring that waiver of the right to sue against the bond in court must be express and not merely incorporated by reference, and found that the incorporation of an arbitration clause was substantially different than incorporation of a federal disputes clause in federal cases. Although there can be no dispute that parties can agree to arbitrate, the problem this case creates for subcontractors is that—despite the valuable protections afforded by statue of a subcontractor’s right to sue the bond and retainage in court—the agreement to arbitrate can be inferred from the upper tier incorporation clause. This decision is particularly disturbing as the subcontractor’s claims were against Turner and arose from the subcontract, not from the general contract.

Because incorporation by reference clauses/flow-down clauses are seen in most subcontracts today, careful consideration should be given to them in order to appropriately apportion risks while limiting exposure to future litigation. If subcontractors are unsure about how their rights are limited or what obligations and risks they are accepting by agreeing to an incorporation clause, it is recommended that they seek legal counsel’s advice as it can potentially change all the critical provisions in the subcontract.

Masaki James Yamada is a partner at Ahlers Cressman & Sleight PLLC. His practice focuses on matters involving complex construction claims, construction contracts, construction L&I issues, construction defects, and related insurance matters. His practice also includes commercial real estate and communications law (i.e. cell towers). Yamada regularly represents general contractors, subcontractors, developers, business and property owners, and design professionals. He can be reached at (206) 529-3015 or masaki.yamada@acslawyers.com.

 

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