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Walking Through a Subcontract Minefield Without Stepping on a Mine - January 2015

January 20, 2015

The typical standard form of subcontract agreement in use by general contractors throughout the country may contain a minefield of provisions which can prevent or make it difficult for subcontractors to get paid for their work or for changes in their work or for delays. Because, in most cases, general contractors are reluctant to eliminate or modify some of these provisions, it is important that subcontractors not only carefully read their subcontracts before they sign them but also that they have some general knowledge of the legal ramifications of these provisions. In this brief paper, the writer will attempt to give to the reader some practical suggestions for dealing with a number of general subcontract provisions which a general contractor will often rely upon when a dispute arises between a subcontractor and the general contractor over the subcontractor’s right to payment for extra work or delays or for an extension of time within which to complete the subcontractor’s work. Note: Although there are citations of judicial and statutory authority concerning some of the topics discussed herein, they are included solely to illustrate what the law is in a particular jurisdiction and the reader is cautioned to check the decisions of the courts and relevant statutory authority in his or her own jurisdiction to ascertain what the law is in that jurisdiction.

A. Flow Down Provisions

Most all standard form subcontract agreements contain some sort of a "flow down" provision whereby the subcontractor agrees to be bound to the contractor with respect to the subcontractor's work to the same extent to which the contractor is bound to the owner. Some of these provisions, however, are not limited to matters relating to the performance of the work but may be broad enough to be interpreted as also covering the disputes resolution provisions of the prime contract. Some courts, for example, have held that subcontractors are required to submit any of their disputes with the prime contractor to arbitration even though there is no agreement to arbitrate in the subcontract for the reason that the arbitration clause in the prime contract flows down to the subcontract.[1] Although it is not done as often as it should be, it is thus very important that subcontractors obtain a copy of the prime contract and read it before they enter into their subcontracts. This is the best way to avoid finding out later that a provision in the prime contract may preclude the subcontractor from being paid for its work or make it more difficult for the subcontractor to secure payment.

B. Pay-If-Paid and Pay-When-Paid Provisions

A "pay-if-paid" provision is generally one which expressly makes payment by the owner for a subcontractor's work a condition precedent to the right of a subcontractor to receive payment. On the other hand, a "pay-when-paid" provision normally will simply say that payment to the subcontractor will be made within so many days after the contractor receives payment from the owner but the subcontract does not contain language expressly making payment by the owner a condition precedent to the right of a subcontractor to receive payment.[2] The general rule in this country seems to be that where there is a “pay-when-paid” provision in the subcontract the right of a subcontractor to receive payment will be deferred for only a reasonable period of time after which the contractor will be required to make payment to the subcontractor not withstanding the fact that it has not received payment from the owner.[3] On the other hand, some jurisdictions will strictly enforce a “pay-if-paid” provision,[4] where payment by the owner for the subcontractor’s work is made a “condition precedent” to the subcontractor’s right to receive payment, while in other jurisdictions, “pay-if-paid” provisions have been declared to be against public policy and are unenforceable.[5] Other jurisdictions, by statute, mandate the disclosure of the due date for receipt of payment from the owner and the payment of interest to subcontractors when payment is not made by the date required by the subcontract or by statute notwithstanding the presence of a “pay-if-paid” provision in the subcontract. In jurisdictions which enforce “pay-if-paid” provisions, overcoming them can be difficult. Under what is known as the “prevention doctrine”, if it can be shown that the contractor did anything to prevent the contractor from making payment then the contractor will not be able to rely upon the “pay-if-paid” provision to deny a subcontractor payment.[6]Where there is a payment bond, some courts have said that the surety issuing the payment bond may not rely on the “pay-if-paid” provision of the contract unless there is a specific provision in the bond itself making payment by the owner a condition precedent to the right of a subcontractor to be paid. The courts of two jurisdictions, Florida and Missouri, have refused to enforce a “pay-if-paid” clause where the prime contract was a cost reimbursable type of contract containing language which the courts interpreted as meaning that the contractor must pay its subcontractors before seeking reimbursement from the owner and, consequently, the “pay-if-paid” provision was said to be in conflict with the terms of the prime contract payment provision.[7] In one other jurisdiction, Virginia, in a case involving the same contract language in the prime contract which was before the courts of Florida and Missouri, the court refused to find that the “pay-if-paid” clause was ambiguous or in conflict with the payment provisions of the prime contract which were incorporated by reference into the subcontract by reason of the “flow down provision” and the court refused to follow the Florida and Missouri decisions.[8]

If the contractor is unwilling to delete the "pay-if-paid" provision, the subcontractor might try to get the contractor to agree to add a provision giving the subcontractor the right to stop work should the owner, without the fault of the contractor, delay payment for an unreasonable period of time beyond the date when payment is due.

C. Pass Though Claims

With respect to Federal construction, the courts have traditionally held that a prime contractor may "pass through" the claim of a subcontractor against the government,[9] and subcontractors will often enter into a "liquidating agreement" or the subcontract agreement itself will contain language giving the right to the subcontractor to pursue its claim in the prime contractor's name against the government or the owner if it is not the government. While some states allow such a procedure, other jurisdictions do not permit what has become known as "pass through claims." And, although the federal courts no longer strictly follow what is known as the Severin Doctrine under which a prime contractor is precluded from asserting claims of a subcontractor against an owner absent liability for such claims to a subcontractor,[10] many states still follow this rule. On federal contracts, as long as the prime is contractually obligated to pay over to the subcontractor whatever money it receives on behalf of the subcontractor that is sufficient.[11] By statute, there are jurisdictions which do not allow pass through claims. For example, in Virginia, by statute, a pass through claim is permissible on a contract with the Virginia Department of Transportation but not on any other type of public project.[12] There is a new statute in North Carolina which purports to allow pass through claims but, unfortunately, there is an ambiguity in the statute creating uncertainty as to its meaning and the courts of North Carolina have not yet clarified the meaning of the statute.[13] Except in the case where a subcontractor's right of recovery is strictly contingent on recovery by the contractor on behalf of the subcontractor and the forum jurisdiction still adheres to the Severin Doctrine, there really should be no bar to passing on a subcontractor's claim to the owner.[14] Many standard forms of subcontract agreements incorporate language mandating that any claims of a subcontractor involving the acts or omissions of the owner be submitted through the contractor to the owner. In those jurisdictions where pass through claims are not permitted, provisions of this nature normally will only require that the contractor forward the subcontractor's claim to the owner and if the owner denied the claim, the subcontractor will be left with no remedy for damages or extra costs incurred solely because of something for which only the owner is responsible. However, if there is some action by the contractor, such as a direction by the contractor to the subcontractor to perform work which the subcontractor claims is not within the scope of its work under the subcontract, or the contractor furnishes defective drawings to the subcontractor, the subcontractor may be able to look to the contractor for payment even though the action which caused the performance of the extra work by the subcontractor originated from the owner.

D. Waiver of Mechanic's Lien and Payment Bond Rights

In some jurisdictions, a subcontractor can waive by the terms of the subcontract its right to file a mechanic's lien or a claim against a payment bond.[15] It is also possible to waive a subcontractors right to pursue a claim against a Miller Act Payment bond provided that specific mention is made of the Miller Act.[16] In other jurisdictions, "no lien" provisions are, by statute, non-enforceable.[17] Even where there is no waiver language in the subcontract, subcontractors will often sign waivers of lien with respect to progress payments and change orders. Subcontractors need to be very careful with what they sign. Otherwise they may find out later that they have given up their mechanic's lien rights and may have waived a valid payment bond claim.

E. Notice Requirements

Many subcontract agreements have requirements that written notice be given to the prime contractor of the intent of the subcontractor to make a claim either for additional compensation or for an extension of time. While such notice requirements are not always strictly enforced, particularly on federal projects where the government has actual knowledge[18] of the circumstances giving rise to the claim and the government cannot show that it was prejudiced by the lack of knowledge of the facts which gave rise to the claim,[19] in many jurisdictions notice requirements will be strictly enforced and a subcontractor may find that it has waived a valid claim due to the its failure to give timely written notice or submit claims in a timely manner as required by the terms of the subcontract.[20] While a notice requirement can be waived, unless it can be shown that historically during a project the contractor paid the subcontractor for changes in the work or other items for which notice is required notwithstanding a failure of the subcontractor to give timely notice a case for waiver may be made out. But the safest course of action is always to give notice strictly in accordance with the terms of the subcontract whenever a subcontractor believes that an occurrence during the performance of the work has given rise to the right of the subcontractor to receive an adjustment in the subcontract price or a time extension.

F. No Damage for Delay Clauses

It is not uncommon to seesubcontract provisions which state that in the case of a delay to the subcontractor’s work the subcontractor will be entitled to a time extension only and it will not be entitled to additional compensation or damages by reason of the delay. The courts have carved out a number of exceptions to the enforcement of no damage for delay clauses. If the contractor’s active interference with a subcontractor’s work is the cause of the delay a no damage for delay clause will generally not be enforced.[21] Some courts have held that where the delay is beyond the contemplation of both parties, the no damage for delay clause will be enforced.[22] Other courts will not enforce such provisions where there is fraud or bad faith on the part of the contractor. The statutes of the jurisdiction wherein the work is being performed should also be looked at to see if there is any legislation affecting the validity of the no damage for delay clause. In Virginia, for instance, the general assembly has enacted legislation making a no damage for delay clause in a public contract precluding recovery for unreasonable delays.

G. Forum Selection Clauses

A contractor's standard form of subcontract will often mandate that any litigation or arbitration of a claim against the contractor take place on the contractor’s home territory rather than where the project is located. Such provisions can make it extremely expensive for subcontractors to pursue their claims against the contractor. To require a small subcontractor in North Carolina to arbitrate a $25,000 claim before three arbitrators in California would seem to be unconscionable. Yet courts will enforce contract provisions of this nature unless, as may be the case in some states, there is legislation requiring that any disputes on a construction project be litigated or arbitrated in the jurisdiction where the project is located. But even where there is a state statute mandating that any arbitration of a dispute take place in the state where the construction project is located, if the Federal Arbitration Act is applicable, and it normally is in the case of most all construction contracts, the state statute will be trumped and must yield to the Federal Arbitration Act which has no such provision and the forum selection provision will be enforced.[23]

H. Contractual Statutes of Limitation

Some standard form subcontracts will have provisions that any litigation or arbitration against the contractor be instituted within a rather short period of time such as one year. These provisions will normally be enforced. However, on projects where there is a payment bond, the courts generally have held that the time period for bringing an action against the bond may not be shortened by contract although there may be decisions to the contrary. If there is a statute of limitations in a subcontract, the safest route to take to avoid stepping on this mine is to go ahead and file suit or file a demand for arbitration before the end of the limitation period.

I. Conclusion

In the world of construction, general contractors need subcontractors and subcontractors need general contractors but the days when the terms of a subcontract were represented by a handshake are long since gone. Because of the risks inherent in today’s construction, provisions such as those discussed in this article are there, in many cases, for the purpose of shifting risks downward to the prime’s subcontractors who, in many cases, are doing all or most of the actual work on the project. And, from a general contractor’s point of view, most of these provisions have some valid logic behind them. For instance, payment by the owner to the contractor of its monthly progress payments is more often than not the only source of funds with which to pay its subcontractors.And, while some of the types of provisions found in many standard subcontract forms may be considered to be unreasonable by subcontractors, most of these provisions have been tested in the courts where they have been found to be reasonable and enforceable except in a number of specific situations. So, as a practical matter, the negotiation of changes in, or the elimination of, provisions, which may be objectionable to a subcontractor, may not be achievable. Whenever this is the case, it is important that a subcontractor have a basic understanding of the minefield it may have to negotiate, and how it might negotiate it, when it decides to submit a bid, or enter into a subcontract, for work under a form subcontract containing all or some of these risk shifting provisions. Such an understanding may also be helpful in resolving any disputes which may arise during construction before they become major issues.

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1. Maxum Foundations v. Salus Corp., 779 F. 2d 974 (4th Cir. 1985).

2. See the leading case of Dyer Co. v. Bishop International Engineering, 303 F.2d 655 (6th Cir. 1962).

3. Id.

4. Pilar Services, Inc. v. NCI Info. Sys., 69 F. Supp. 2d 563 (E.D. Va. 2008), Moore Bros. Co. v. Brown & Root, 207 F. 2d 717 (4th Cir. 2000), M&T Electrical Contractors v. Capital Lighting & Supply, 2267 B.R. 434 (D.D.C. 2001); Architectural Systems v. Gilbane Building, 760 F. Supp. 79 (D. Md. 1991); Galloway Corporation v. S.B. Ballard Construction, 250 Va. 493, 464 S.E. 2d 349 (1995).

5. West-Fair Electrical Contractors v. Aetna Casualty & Surety Co., 87 N.Y. 2d 148, 638 N.Y.S. 2d 394, 661 N.E. 2d 967 (1995); William R. Clarke Corp. v. Safeco Inc. Co., 15 Cal. 4th 882, 64 Cal Rptr 2d 578, 938 P. 2d 372 (1997). See also N.C. Gen. Stat. § 22C-2 and Wis. Stat. Ann. § 779.135(3) which declare pay-if-paid provisions unenforceable.

6. See Moore Brothers Co. v. Brown & Root, Inc., 207 F. 3d 717 (4th Cir. 2000); OBS Co. v. Pace Construction Corp., 558 So. 2d 404 (Fla. 1990) (Rule has been modified by statute).

7. OBS Co. v. Pace Construction Corp., 558 So. 2d 404 (Fla. 1990); MECO Systems, Inc. v. Dancing Bear Entertainment, 42 S.W. 3d 794 (Mo. Ct. App. 2001)

8. Universal Concrete Products Corp. v. Turner Construction Company, 595 F. 3d 527 (4th Cir 2010).

9. See International Technology Corp. v. Winter, 523 F. 3d 1341 (Fed. Cir. 2008)

10. J.L. Simmons Co. v. United States, 304 F. 2d 886 (Ct. Cl. 1962). See also U.S. Industries v. Blake Construction Co., 671 F. 2d 539 (D.C. Cir. 1982)

11. Id.

12. Va. Code § 33.1-387.

13. NC Stat. § 143-134.2.

14. See United States v. Blair, 321 U.S. 730, 64 S. Ct. 820 (1944), where the Supreme Court allowed a contractor to recover costs incurred by a subcontractor. The Court said at 64 S.Ct. 824: “Clearly the subcontractor could not recover this claim in a suit against the United States, for there was no express or implied contract between him and the Government. Merritt v. United States, 267 U.S. 338, 45 S.Ct. 278, 69 L.Ed. 643. But it does not follow that respondent is barred from suing for this amount. Respondent was the only person legally bound to perform his contract with the Government and he had the undoubted right to recover from the Government the contract price for the title, terrazzo, marble and soapstone work whether that work was performed personally or through another. This necessarily implies the right to recover extra costs and services wrongfully demanded of respondent under the contract, regardless of whether such costs were incurred or such services were performed personally or through a subcontractor. Respondent's contract with the Government is thus sufficient to sustain an action for extra costs wrongfully demanded under that contract.”

15. See e.g. Va. Code § 143-3(c).

16. United States for the use of DDC Interiors v. Dawson Construction Co. Inc., 895 F. Supp. 270 (D. C. 1995).

17. See Mich. Corp. Laws Ann. § 570-1115; Blount Bros. Corp. v. Lafayette Place Assoc., 399 Mass. 632, 506 N.E. 2d 499 (1987); National Glass Inc. v. J.C. Penney Properties Inc., 336 Md. 606, 650 A. 2d 246 (1994).

18. See George Sollett Construction Co. v. United States, 64 Fed. Cl. 229 (2005). Also compare Brinderson Corp. v. Hampton Roads Sanitation District, 825 F. 2d 41 (4th Cir. 1987), where the court permitted recovery under the differing site condition clause of the contract despite the contractor’s failure to give written notice based on the fact that the owner had actual knowledge of the condition with Commonwealth v. AMEC Civil, LLC, 280 Va. 396 (2010), where the Court held that the notice requirement under a contract with the state was mandatory and could not be waived because it is an essential condition precedent to recovery on a claim against the state under its limited waiver of sovereign immunity.

19. Id.

20. See, for example, City of Richmond v. A.H. Ewings Sons, Inc., 201 Va. 862, 114 S.E.2d 608 (1960); Service Steel Erectors Co., v. SCE, Inc., 573 F.Supp. 177 (W.D. Va. 1983) and McDevitt & Street Co., v. Marriott Corp., 713 F.Supp. 906 (E.D. Va. 1989), where the contractor was held to have waived its right to additional compensation for a change in the size of elevators because of its failure to submit its cost proposal within 21 days as required by the contract.

21. J.A. Jones Const. Co. v. Lehrer McGovern Bovis, Inc., 89 P. 3d 1009 (Nev. 2004); Algernon Blair, Inc. v. Norfolk Development & Housing Authority, 200 Va. 815, 108 S.E. 2d 259.

22. See Abax Inc. v. New York Housing Authority, 723 N.Y 52d 490 (App. Dist. 1st Dept. 2001) and G.M. Harston Const. Co., Inc. v. City of Chicago, 371 F. Supp 2d 949 (N.D. Ill 2005).

23. See e.g. OPE International LP v. Chet Morrison Contractors, Inc., 258 F. 3d 443 (5th Cir. 2001); R.A. Bright Construction, Inc. v. Weis Builders Inc., 402 Ill. App. 3d 248, 930 N.E. 2d 565 (Ill. App. 2010) and M.C. Construction Corp. v. Gray Company, 17 F. Supp. 541 (W.D. Va. 1998)