By: Bradley Sands Associate, Jones Walker LLP.
Subcontractor claims happen. When those subcontractor claims are prompted by owner actions or responsibilities, the general contractor must always be vigilant to plan for and work to avoid a two-front war in which the general contractor is pushing the owner for recovery while at the same time disputing the subcontractor’s entitlement.
Cooperation between the general contractor and the subcontractor and avoiding that two-front war can be accomplished through pass-through claims and ideally liquidating agreements. A pass-through claim is a claim by the subcontractor who has suffered damages by the owner with whom it has no contract, presented by the general contractor. A liquidating agreement or subcontract “liquidating language” goes a step further than simply a pass-through claim by “liquidating” the general contractor’s liability for the subcontractor’s claim and limiting the general contractor’s liability to the value recovered against the owner. The distinction between pass-through claims generally and use of liquidating agreements or language is described in greater detail below.
Pass-through subcontractor claims are routine in construction and an important, common sense approach to deal with ever-present changes and the unexpected that can have cost and time implications. Despite the common sense basis for subcontractor pass-through claims, there are important legal considerations that must be addressed, and critical planning required, starting with the subcontract clauses.
This article only focuses on the critical general principals of pass-through claims and liquidating agreements. It is not possible to address in this brief article the many specific requirements or nuances that may be involved, depending on what federal or state law applies and whether the project is public or private.
Passing-Through a Claim Alone Does Not Resolve a General Contractor’s Liability
A pass-through claim can be as simple as the general contractor presenting the subcontractor’s change order to the owner for approval and payment. A pass-through claim may also be a formal agreement between the general contractor and subcontractor to prosecute the subcontractor’s claim in litigation or arbitration.
Passing-through a subcontractor’s claim to the owner does not in itself resolve liability for the general contractor. If the owner rejects or defeats the subcontractor’s claim during the change order or formal dispute process, the subcontractor may still assert the claim against the general contractor. In order to stop the claim from coming back to the general contractor, the general contractor can enter a liquidating agreement with the subcontractor, or rely on “liquidating language” in the subcontract when passing-through the claim.
A liquidating agreement is a separate agreement from the subcontract that satisfies legal prerequisites for passing-through a subcontractor’s claim and resolving the general contractor’s liability. Subcontract “liquidating language” accomplishes the same purpose as a liquidating agreement. A liquidating agreement, or subcontract “liquidating language,” will generally condition and limit the general contractor’s liability to the amount recovered from the owner.
A liquidating agreement and “liquidating language” provides the general contractor the practical benefit of a release of liability to the subcontractor’s claim without the adverse legal consequences of a full release on the general contractor’s ability to pass the claim through. If a subcontractor completely releases the general contractor from liability, the general contractor may not be able to prosecute the subcontractor’s claim against the owner. Liquidating agreements and “liquidating language” seek to avoid the fate of subcontractor claims in the old Federal government contracts case Severin v. United States, 99 Ct. Cl. 435 (U.S. 1943), cert. denied, 322 U.S. 733 (1944).
In Severin, the subcontractor provided the general contractor a release from the subcontractor’s claim as part of their pass-through arrangement. The court found that because the general contractor was released by the subcontractor, the general contractor had no damages and could have no damages to “pass-through” to the owner. If you see the term “Severin Doctrine,” it is referring to how a release by the subcontractor of the general contractor prevents the pass-through of that claim.
“Liquidating language” or a liquidating agreement provide the general contractor with the practical equivalent of a release while avoiding a real release and running afoul of the Severin Doctrine. If that sounds like legal mumbo jumbo, it is. But, addressing the arguably hyper-technical requirements for an effective liquidating agreement may be critical to an enforceable liquidating agreement.
What Does a Liquidating Agreement or “Liquidating Language” Require?
The law governing pass-through claims and liquidating agreements can vary greatly from state to state and as compared with Federal law that governs Federal government contracts. Some states may have no law or only a few case decisions on these subjects. Federal procurement law, on the other hand, has tremendous experience with and case decisions involving subcontractor pass-through claims and the requirements for an effective liquidating agreement. As is often the case when dealing with construction or public contracts, state courts will often look to guidance from and adopt legal principles from Federal government contracts law.
Generally speaking, having liquidating language in the subcontract is important protection and leverage for the general contractor, but prospective and generic liquidating language may not meet the test for an enforceable liquidating agreement on a specific subcontractor claim. This is particularly true of the often imposed requirement that the general contractor admit liability for the subcontractor claims.
Requirements for an Enforceable Liquidating Agreement
As noted, the requirement varies depending on the controlling law, but what law there is on the topic generally requires the following elements to an enforceable liquidating agreement. Remember that either the project owner or subcontractor can potentially challenge the enforceability of a liquidating agreement. The owner might argue that the subcontractor released the general contractor from any liability and so there is no longer a claim. The subcontractor may argue that because the liquidating agreement is invalid, it can still separately pursue the general contractor for the full value of the subcontractor’s claim.
An effective liquidating agreement typically has three prerequisites: (1) the general contractor retains liability for the claim, (2) the claim is liquidated (meaning the claim amount is certain), and (3) the general contractor is obligated to pay the subcontractor the monies collected from the owner for the subcontractor’s claim (i.e. payment terms). A liquidating agreement with these prerequisites allows a general contractor to prosecute the subcontractor’s claim against the owner with the general contractor’s liability predetermined.
“Liquidating Language” in a Subcontract
Subcontractor requests for additional time and costs are routine, so there is no reason to wait for a specific subcontractor claim to think about pass-through claims and “liquidating language”. Although it is preferable to have a separate liquidating agreement for any claim moving to formal dispute resolution (litigation or arbitration). General contractors should consider including “liquidating language” in the subcontract for both the change order and formal dispute clauses. Proper “liquidating language” should make a clear distinction between subcontractor claims related to the owner and those related to the general contractor, but give the general contractor the extra time required to meet its deadlines after receipt of the subcontractor’s submission.
The subcontract “liquidating language” should also make clear that it only applies to subcontractor change order requests or claims involving the owner. Sweeping language that the general contractor has no liability for any claims, including claims based solely on the general contractor’s conduct may render the “liquidating language” invalid. The subcontract should require the subcontractor to conform to the relevant notice requirements and other procedures in the general contractor’s contract with the owner. Any notice or conditions precedent requirements for approving a change order or asserting a claim in the contract with the owner must be addressed in the subcontract. Finally, the critical element is language that requires the subcontractor to be bound to the results obtained from the owner, regardless of the manner in which the claim is passed-through.
The subcontract should also contemplate formal disputes (litigation, arbitration or administrative appeals on public contracts) with the owner and tie pass-through subcontractor claims to that procedure. The subcontract should require the subcontractor to preemptively consent to join any litigation or arbitration proceeding against the owner for a dispute involving the subcontractor’s claim. The general contractor does not want to get stuck litigating against the owner in one forum and have to deal with the subcontractor in another court or arbitration.
Example “liquidating language” for a general contractor to pass-through its subcontractor’s request for a change order to the owner is the following:
Subcontractor agrees that Subcontractor is only entitled to the amounts the General Contractor receives from the Owner for any Subcontractor change order request caused by, or the responsibility of, the Owner. Subcontractor shall provide all documentation to General Contractor to support Subcontractor’s change order request in accordance with the General Contractor’s contract with the Owner, and at least five (5) days before the end of the applicable time limit provided in the General Contractor’s contract with the Owner for initiating such requests. Subcontractor shall be bound by any determination made by the Owner that effects Subcontractor’s rights.
Example “liquidating language” for a general contractor to pass-through its subcontractor’s claim against an owner in a formal dispute is as follows:
In the event the Subcontractor has a claim for which the Owner may be responsible, the General Contractor, in its sole discretion, may initiate with the Owner, at the Subcontractor’s expense and which shall include attorney’s fees, any dispute or claim procedures provided for in the General Contractor’s contract with the Owner for the use and benefit of Subcontractor; otherwise Subcontractor shall have full responsibility for the preparation of its claims and shall bear all expenses thereof, including attorney’s fees. General Contractor shall be liable to Subcontractor only to the extent of the amount, if any, actually awarded as a result of the disputes process. Subcontractor shall be entitled only to the amount, if any, actually awarded as a result of the disputes process, and such amount when received by General Contractor from the Owner shall satisfy and discharge General Contractor from any and all liability to Subcontractor for or on account of the acts or omissions of the Owner or its Architect or Engineer. Subcontractor agrees to be joined in said proceedings regardless of location.[1]
Most standard form construction contracts, including ConsensusDocs, do not provide “liquidating language” with the necessary prerequisites to assert the subcontractor’s claim against the owner and limit the general contractor’s liability, and need to be supplemented. ConsensusDocs 750, the standard form construction agreement for a constructor (i.e. the general contractor) and subcontractor, does not restrict the subcontractor’s entitlement, and the general contractor’s liability, to amounts received from the owner. ConsensusDocs 750 only contemplates that the parties may agree on pass-through claims.
Nonetheless, ConsensusDocs 750 properly obligates the subcontractor to differentiate claims against the owner from claims against the general contractor.[2] And ConsensusDocs 750 requires the subcontractor to submit its claim with sufficient time to allow the general contractor to meet the deadlines in the general contractor’s contract with the owner after receipt of the subcontractor’s claim.
Terms of a Liquidating Agreement
Liability for the Claim. The general contractor must show contractual liability. In many circumstances due to the applicable law, a general contractor that has not sustained damages may not bring suit on a subcontractor’s behalf for additional costs caused by the owner. So exculpatory language in the subcontract such as a “no damages for delay” clause could invalidate a liquidating agreement in some circumstances. Each claim must be evaluated on a case-by-case basis.
Liquidating the Claim. A subcontractor’s claim must be liquidated to a certain amount. In certain circumstance based on applicable law, this amount can be limited to “the amounts recovered from the owner.” In other circumstances, the general contractor must retain some liability for the subcontractor’s claim, regardless of the outcome with the owner. Again, each claim must be evaluated on a case-by-case basis.
Payment Terms. The general contractor must pass-through recovery of the subcontractor’s claim to the subcontractor. The payment terms should provide the timing and amount that will be paid to the subcontractor upon claim award or settlement. The payment terms should also consider addressing the various potential outcomes, including setoff for counterclaims from the owner against the general contractor, distribution of monies received from other claims asserted by the general contractor, allocation of litigation costs, and how to address settlement offers.
As in a liquidating agreement, typical “liquidating language” in a subcontract likewise seeks to limit the general contractor’s liability to the subcontractor to the amount received from the owner for the subcontractor’s claim, and the subcontractor is only entitled to receive reimbursement for its claim from the general contractor in the amount received from the owner.
Why Pass-Through a Claim Using a Liquidating Agreement?
Passing-through a claim without a liquidating agreement or relying on subcontract “liquidating language” leaves a general contractor exposed to the subcontractor’s claim after resolution with the owner. Essentially the subcontractor can take a second bite of the apple against the general contractor if the subcontractor’s claim is not paid to the subcontractor’s satisfaction by the owner.
As a result, the benefits to a general contractor for passing-through a subcontractor’s claim with a liquidating agreement are fairly obvious. First, the general contractor can limit its liability to the subcontractor to a sum certain, and in many cases the general contractor’s liability can be limited to the amount recovered from the owner. The subcontractor’s claim was caused by the owner, so the owner should pay the subcontractor’s claim, not the general contractor. Second, the general contractor can avoid a two-front war for the subcontractor’s claim and potentially reduce litigation costs (i.e. attorneys’ fees).
But the subcontractor does not have the same obvious benefits for agreeing to a liquidating agreement, at least in theory. A subcontractor may not care who pays its claim, the general contractor, the owner, or a combination of both. And a subcontractor may be in a dispute to have its claim paid regardless of whether the dispute is against the general contractor or the owner.
As a practical matter, however, there are potentially significant benefits from a liquidating agreement to a subcontractor. One benefit to a subcontractor is that by joining the general contractor’s claims against the owner, the subcontractor can bolster its owner claim. The two claimants can rely each other’s case to demonstrate entitlement to their claims. Repetition of similar allegations against the owner from the general contractor and subcontractor could prove persuasive to an arbitrator or jury, particularly if project documents show the same issues harmed both the subcontractor and general contractor.
A second benefit to a subcontractor is the subcontractor can rely on the general contractor’s resources and ride the general contractor’s coattails for claims against the owner. The general contractor will typically have larger claims to pursue against the owner than the subcontractor, and therefore the general contractor will expend more resources on its claim, including attorneys’ fees and expert consultant analysis to demonstrate and prove entitlement and quantum. The subcontractor merely has to tag along with the general contractor and provide support to the general contractor where relevant.
A third benefit to a subcontractor is that joining the general contractor against the owner may present the subcontractor the best opportunity to resolve its claim more expeditiously and without a “fight”. A liquidating agreement removes the general contractor as an adversary to the subcontractor’s claim. A general contractor is often the party best suited to defend against, and possibly even defeat, a subcontractor’s claim. The general contractor should have greater personal knowledge of the subcontractor’s performance, and therefore be in a better position than the owner to defend against a claim from the subcontractor.
There certainly are reasons why subcontractors may not prefer to enter a liquidating agreement: fear the general contractor will not adequately represent the subcontractor’s interests in the dispute, possible delays to resolution and payment, complicating the subcontractor’s claim with other claims from the general contractor, and loss of trust with the general contractor as a result of the project. But despite these potential negatives, a liquidating agreement is often the best course of action for a subcontractor for the benefits stated in this article, among other reasons.
Conclusion
To avoid a two-front war, a general contractor should always consider whether a subcontractor’s claim is appropriate for pass-through to the owner and via a liquidating agreement or by relying on the subcontract’s “liquidating language.”
A formal claim-specific liquidating agreement is typically the last step in formalizing cooperation and alignment between the general contractor and subcontractor. But, getting to that last step starts with properly scoping a general contractor’s work and then agreeing to reasonable, well-defined contracts with the owner and subcontractors with appropriate risk terms and dispute resolution procedures. Cooperation between the owner, general contractor, and subcontractors with non-contentious change order requests based on unambiguous contract terms can often stop shots from being fired and quell the start of a two-front war in the first place.
[1] See, e.g., Interstate Contracting Corp. v. City of Dall., 135 S.W.3d 605, 608 (Tex. 2004).
[2] ConsensusDocs 750, Section 5.3.2 (Revised October 2018).
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The views expressed in this article are not necessarily those of ConsensusDocs. Readers should not take or refrain from taking any action based on any information without first seeking legal advice