July 9, 2020

Subcontractor Terminations Are Deadly Serious: Think Ahead, Think Twice, and Think Again

By: Neal J. Sweeney, Partner, Jones Walker LLP.

A contractor signs up a sub on a project with high hopes for success. Despite that enthusiasm, the contractor must plan for the worst and recognize that the sub may fail to perform, go into default, and need to be terminated.  Termination is a very big deal in construction — for the project, for the sub, and for the contractor. Unlike claims limited to time or money, termination is final and frequently results in putting the sub out of business. 

On the front end, the subcontract should include rights and procedures for the contractor to deal with sub performance failures, including termination, as well as, less severe alternatives to termination.  During construction, the contractor must try to address sub performance problems before they become a crisis, and try to resolve them with limited disruption to the work.  Sometimes the only alternative is termination. This article highlights critical subcontract terms that must be addressed at the front end, as well as, steps and approaches for dealing with a poorly performing sub who may be able to cure their default and those that require termination.

Think Ahead and Reflect That Thought in the Subcontract

A contractor is at risk if it fails to give itself in the subcontract rights and tools to deal with poor sub performance and the possibility for termination. The subcontract should have a range of rights and alternatives independent of the prime contract and the owner’s rights of termination that the contractor can rely upon to independently deal with its subcontractor. The contractor should not blindly rely on owner termination rights to deal with its subs.

The subcontract termination clause should be thought of as a prenuptial agreement in which the parties address ahead of time the parties’ rights and responsibilities in the event one or both of the parties wants to part ways. There are essential elements that should be in every termination clause, in addition to the termination for default clause:

  • Flexibility.  The contractor must not limit its options to the extreme step of termination when a sub is performing poorly.
    • The contractor should have the right to supplement the sub’s workforce, unilaterally deduct work, and then back charge the sub as well as to issue joint checks.
    • These are steps that may help the struggling subcontractor with minimal disruption to the project or legal risk to the contractor. Whether and how much the contractor should do depends on the circumstances and whether the sub is bonded.
    • Such measures may be appropriate for a bonded sub, but the surety should be put on notice and/or surety consent obtained in advance.
    • If the sub is not bonded and is judgment-proof, it may make sense to do more to support the sub in order to continue to use the sub and maintain valuable sub-subcontractors, PO’s, and an existing labor force, etc. while reserving rights against the sub.
  • Termination for Convenience.  Often referred to as “T4C.”  This gives the contractor the right to unilaterally terminate the sub without the need to prove default and without liability for lost profits. T4C comes with the obligation to pay the sub’s reasonable costs, plus some mark-up.
    • This is like a no fault divorce – no one is at fault.
    • This is a potentially valuable tool that allows the contractor to get a troublesome sub off the project without having to wait for or prove a default.
    • The contractor should have a separate T4C clause and separate T4C rights independent of the owner’s clause and rights.
  • Constructive Termination for Convenience.  This states that if the sub is terminated for default, and the termination is later ruled (by court or arbitration) to be wrongful, the termination is automatically converted to a T4C, and so the liability of the contractor is limited.
    • This clause may be a single sentence, but has substantial legal and financial implications.
    • Although a Constructive T4C clause is powerful protection, the contractor should not implement a termination for default unless it is convinced termination for default is appropriate and necessary.
    • In some cases, when the contractor was found to have acted in bad faith, courts have refused to give the contractor the protection of a Constructive T4C.
  • Procedural Considerations.
    • Obvious bases for termination for default can be listed, but the clause should be open-ended to include “other material breaches of the subcontract.”
    • Required notices and reasonable time frames for notice, cure period, meetings, and the final termination should be stated.
    • In the event of a termination for default or T4C, the sub should be required to assign all of its PO and sub-subcontracts at the option of the contractor.
    • Finally, the obligations of the parties upon termination should also be addressed – turnover documents, disposition of equipment, etc.

During Performance, Think Twice and Proceed Carefully Before Implementing a Termination

If the worst case scenario unfolds and the sub cannot or will not perform, the contractor should act early, but not overreact.  Because termination may be necessary, the contractor should also carefully document the ongoing situation and meticulously follow all subcontract and performance bond (if there is one) procedures.

Assisting Sub Performance – Bonded/Solvent vs. Unbonded/Insolvent

The contractor should consider opportunities and steps to resolve the sub’s performance problems, if practical.  Whether to make such efforts and how to implement them will differ, depending on whether the sub is bonded or insolvent.  If the contractor directly or indirectly paid to get a bond, the contractor understandably wants the surety to support the sub’s performance.  However, if the contractor has a sufficient subcontract balance, it is often easier for take steps than waiting for the surety to do so, provided the surety is put on notice and consents to steps that could be characterized as overpayment. Advance payments and early release of retention to a bonded sub without the surety’s consent may compromise the contractor’s right to claim against the bond later, if the sub is terminated.

On the other hand, if the sub is not bonded and is insolvent, it may be in the interests of the contractor to take greater measures to support the sub because standing idly by and watching the insolvent sub fail to perform may only hurt the project, and hurt the contractor, without the hope of ever collecting any damages from the insolvent sub.

Deducting Sub Scope

Another option to mitigate the impact of an underperforming sub without becoming directly involved with the subs finances or work is to unilaterally delete portions of the work. It is best to delete and takeover discrete portions of the work that are easily identifiable and distinct by type of work and/or location from the work that remains the sub’s responsibility. If the contractor deletes and takes over sub work, it should carefully document what work is being undertaken, be reasonable and well documented with costs, and consider warranty implications.

Termination for Convenience?

Using a termination for convenience (T4C) with a poorly performing sub is potentially a major concession and should only be applied when necessary. In theory, even with a T4C, the contractor maintains claims for defective work, delays, etc. in a T4C, but that needs to be expressly stated in the T4C documentation. In addition, the contractor has the obligation to make appropriate payments under the T4C clause, subject to setoffs.  If the sub recognizes it is at risk of a termination for default, may have liability, and otherwise wants to avoid the dispute, it may be possible to negotiate a no cost T4C or otherwise limit any payments to the cell by agreement.

Implementing a Termination for Default, and Should You?

Due to the unintended negative impacts a sub termination may have on the project and the potential liability for a wrongful termination, the contractor must carefully prepare for, carefully assess all risks and options before executing a sub termination.

Understand that there can be very different answers to the legal question “Are you legally justified to terminate?” versus the practical question of whether “Should you terminate?”  Legal justification does not necessarily mean it is in the best interest of the project or the best interest of the contractor to terminate. The value of the claim against the terminated and its surety may be counterbalanced or outweighed by more immediate, negative consequences of termination. Some things to consider:

  • The cost of a replacement subcontractor.
  • The delays to the project before the replacement can be hired and begin work.
  • Resulting claims from other subcontractors due to delays due to the termination.
  • The impact on long lead items within the terminated sub’s scope.
  • The loss of favorable PO’s and sub-subcontracts held by the terminated sub.
  • Complications with warranty and other long-term liability issues.

These considerations may indicate that the contractor is better off reserving its rights against the sub, but not terminate and allow the sub to complete, or may confirm the need to terminate. The key is to evaluate these considerations fully and candidly to make certain termination will be an improvement rather than create more problems.

Dealing with the Surety

The contractor cannot assume that a performance bond means that it has no worries. First of all, the contractor must comply with all the requirements and procedures of the subcontract and the bond to preserve rights against the surety.  Even if those rights are preserved, a performance bond is not like an insurance policy. The surety has all of the defenses of the sub, plus its own defenses under the bond such as lack of notice or overpayment to the sub.  If the surety believes that the sub was not responsible for the delays or other material breaches that were the basis for the termination, the surety may refuse to step in.

Documenting the Process and Good Faith

In anticipation of a claim by the sub of wrongful termination and to be able to prove justifications for its actions and subsequent litigation or arbitration, the contractor must carefully document the circumstances, and process that led to the termination. Ideally, that documentation will indicate a good faith effort by the contractor to work with the sub and to mitigate impact on the project, so it is clear the contractor only terminated because it had no other reasonable choice.

The contractor should meticulously follow all the procedures in the subcontract or the performance bond. Ideally, the contractor should go the extra mile. If the notice period is five days, but the contractor can afford to allow 10 days, the contractor should do so. Any written responses from the sub to a cure notice should be fairly reviewed and a request by the sub for a meeting should be granted, if time allows.  Be aware the sub terminations are frequently overturned because of the failure of the contractor to follow the prescribed procedures.

For a credible claim against the sub and the surety for completion costs, the contractor’s diligence and documentation should carry through the procurement of a replacement sub and the completion of the work. The contractor needs to be able to document that the completion costs were reasonable and necessary. In this regard, it is important to make sure that any extra scope given the replacement sub is not charged against the terminated sub.  The costs actually incurred into a claim package that is ready for audit.

Then Think Again

Subcontractor termination is serious business and should not be undertaken lightly. The potential impact of a termination to the project, to the sub, and to the contractor can be immense and very damaging. Following a termination for default, disputes are inevitable.  Litigation and arbitration are highly probable to follow.  But sub termination may be absolutely essential for the success of the project and the survival of the contractor. The lesson is not to never terminate. The lesson is to recognize it as a potential necessity, address it in the subcontract, be vigilant against failing sub performance, explore measures to address problem without termination, and when termination is necessary, implement documentation properly.

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.