3/15/2017

Navigating The “Flow-Down” Of Risk Through Multiple Contract Layers

Thomas J. Madigan
Partner, Pepper Hamilton LLP
ConsensusDocs Construction Law Newsletter, Volume 3, Issue 1, February 2017

As the name implies, flow-down clauses seek to “flow” (i.e., allocate) obligations and risk from one contract tier to the next. The ostensible purpose is to ensure that the respective obligations of the parties line up, that is, that each party’s obligation to its contracting partner is the same all the way up and down the chain, from the supplier to the subcontractor to the general contractor to the owner. In theory, this should avoid inconsistent contractual obligations and place the risk of nonperformance on the party actually performing the work. When precisely drafted and properly managed, flow-down clauses can fairly and effectively allocate the risk of performance through multiple layers of contracts and subcontracts. Too often, however, flow-down clauses utilize confusing or conflicting boilerplate language and are included without regard to actual differences in contractual responsibilities and scopes of work. When sloppily put together and not properly followed, they can create a confusing morass or stop the flow of risk in the middle of the stream, unable to reverse course or continue down river.

One commonly used flow-down provision is the “incorporation by reference” of upstream contracts and specifications. It is not uncommon to see these clauses purporting to reference the entirety of the prime contract and specifications, all addenda and supplementary contract documents, and make all of them “a part of” the lower-tier contract by reference. Whether due to time pressure or lack of sophistication, rather than identify and reference those portions of the upstream contracts that apply to the lower-tier work, each successive subcontract simply repeats the incorporation by reference. Whenever a lower-tier contract or supply agreement incorporates an upper-tier contract by general reference in this manner, there is significant risk that the terms of the lower-tier agreement conflict in some important respect with the blindly incorporated upstream documents. Pursuant to established rules of contract construction, these conflicts will often be resolved against the party that drafted the contract — which, in most cases, will be the upstream contractor. As a result, the incorporation may be ineffective and fail to “flow down” any provisions that are inconsistent with the terms of the lower-tier contract.

When it is important to ensure that obligations and remedies are strictly aligned, it should been done explicitly by restating or specifically referencing the pertinent provisions of the specifications in the material terms and conditions of the lower-tier contract, rather than by relying on broad incorporation of upstream documents “available for review.” Subcontractors and suppliers are also well advised to avoid general terms of incorporation in favor of more precisely tailored language, either specifically identifying the particular parts of the upstream contracts and specifications that apply or, at a minimum, including conditional language that limits the incorporation “to the extent the terms of the prime contract apply to the subcontractor's work.” This caution applies not just to apparent conflicts between express terms (for example, in the number of days in which payment is to be made or the length or extent of warranties), but to the exclusion of inapplicable terms, particularly with respect to the division of work. Inclusion of an order of preference clause that resolves conflicts between the documents is also advisable.

One area in which the coordinated flow down of obligations and remedies is most critical is changes in the work. Most, if not all, prime contracts and subcontracts employ a contractual mechanism for implementing changes that involves a linear, sequential process, starting with notice that the work is out of scope and ending with either an executed change order or directive to proceed while a claim is resolved through the dispute resolution process. These provisions should be consistent from contract tier to contract tier so that, if the process is followed, no additional or changed work should be performed at any level without notice and a change order or a directive to proceed with immediate submission and prompt resolution of a claim. However, during the hustle and bustle of construction, these procedures are not always scrupulously followed, particularly when a project has fallen behind schedule. In the rush to get back on schedule, the owner can resort to “just get it done and submit a potential change order (PCO)” directive. This “just get it done” directive is repeated down the line until it reaches the subcontractor expected to do the work; each tier thereby effectively increasing the scope of its work on faith that a change order will be granted. Unprocessed PCOs may continue to accumulate until the owner ultimately announces its intention to “settle up” at or near the end of the project — at which time it also reveals its claim of entitlement to offsets or back charges.

The general contractor who has “flowed down” the owner’s directives to proceed and submit PCOs is now in a precarious position. The subcontractor will assuredly argue that the general contractor has acknowledged that the work was out of scope and that it is entitled to a change order from the general contractor, regardless of the general contractor’s ability to obtain a corresponding change order from the owner. In such circumstances, the subcontractor has an argument that the general contractor has assumed the risk of nonpayment. Any attempt to rely on the subcontractor’s failure to follow the change order process will be vulnerable, as courts may not strictly enforce notice and authorization requirements that the general contractor itself has failed to abide. If the general contractor has repeatedly directed the subcontractor to perform work with the promise that it will be “sorted out” later, the contractual requirement of prior written authorization may be deemed to have been waived.

Similarly, a pay-if-paid clause may be of little use to the general contractor in this circumstance as their enforceability varies from jurisdiction to jurisdiction. Where disfavored, courts tend to treat them as timing mechanisms (establishing when payment is due, as opposed to whether it is earned), unless the clause clearly shifts the risk of nonpayment by making the receipt of payment from an upstream contractor (or owner) an express condition precedent to the obligation to make payment to downstream subcontractors or suppliers. In the event of an indefinite delay or outright refusal to make payment by an upstream party, a “reasonable” period for making downstream payment is inferred, but the obligation to pay is not excused. Even when the clause is drafted with sufficient precision to create a condition precedent to the obligation to make payment, it may not be enforced when the basis for nonpayment is the upstream party’s own failure to perform, as courts are reluctant to enforce conditional payment provisions in situations where the unpaid party bears no responsibility for the condition giving rise to the withholding of payment. Quinn Constr., Inc. v. Skanska USA Building, Inc., 730 F. Supp. 2d 401 (E.D. Pa. 2010). See also S. Main St. Redevelopment v. R/C Theatres Mgmt. LLP, 2013 U.S. Dist. LEXIS 34391 (M.D. Pa. 2013); McDermott v. Party City Corp., 11 F. Supp. 2d 612 (E.D. Pa. 1998) (where a party claiming that a condition precedent has not been satisfied is himself the cause of the nonoccurrence, he cannot claim the nonoccurrence to his advantage); BRUNER & O’CONNOR § 8:49 (“Courts are reluctant to enforce conditional payment provisions in situations where the unpaid subcontractor bears no responsibility for the condition giving rise to the [owner’s] payment defense.”). Thus, a prime contractor facing a situation where the owner is asserting large offsets or withholdings against accumulated PCOs may not be able to utilize the pay-if-paid clause to proportionately withhold payment to subcontractors for unrelated work in an effort to mitigate its own loss. Pencoyd Iron Works v. Axis Constr. Servs., LLC, 2012 Phila. Ct. Com. Pl. LEXIS 23 (Pa. C.P. 2012) (recognizing that a contractor breaches contract if it receives payment from an owner specifically for the work performed by a subcontractor but withholds that money from the subcontractor under the auspices of a pay-if-paid clause); Rainbow Roofing Co. v. Perrotto Builders, Ltd., 2013 Pa. Super. Unpub. LEXIS 3378 (Pa. Super. 2013) (owner withheld some payment from the general contractor, but had paid the contractor for the subcontractor’s work, and the contractor was thus “required to pay [the subcontractor] the remaining balance on the subcontract because the [owner] paid for that work.”)

While being a “team player” is generally a useful approach, contractors and subcontractors should require compliance with the contractual change order and claim resolution process. When confronted with a “just get it done” directive, the general contractor should follow the contract provisions and provide notice that it considers the requested work to be additional or changed and include an estimated cost to perform the work. From the subcontractor’s perspective, in addition to providing written notice that it considers the work to be additional or changed and providing an estimate of the cost to perform, it should also notify the general contractor that it considers the “just get it done” directive to be an acknowledgement that the work is additional and a promise that a change order will be issued in accordance with the estimate provided, regardless of the general contractor’s ability to obtain a change order from the owner and without offset by any withholdings or claims the owner may assert against the general contractor. The notice should also state that the subcontractor is proceeding with the work in reliance on this understanding and that, if there is any disagreement, the general contractor needs to notify the subcontractor immediately.

The initial urge of the general contractor may be to try to “finesse” the situation by passing down the “just get it done” directive with no commitment of payment beyond whatever it may eventually get from the owner. This can be a risky maneuver, as trying to play both sides against the middle in this situation may result in the general contractor bearing the risk alone. If the work is clearly changed, the general contractor should request a change order before proceeding. If there is a real urgency that makes this impractical, it should at least confirm in writing that it is proceeding in reliance on the assurance that the work will be paid for as additional. If there is a dispute over entitlement or cost, the general contractor should request that the owner issue a directive to proceed and promptly submit a claim on behalf of itself and the subcontractor(s) called on to do the work. It also should be clear about the situation with its subcontractors. If there is a question regarding whether the work is within the subcontractor’s scope, or is otherwise not compensable, the general contractor should utilize the change directive process, instruct the subcontractor to submit a claim, and then timely and diligently prosecute that claim to the owner.

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