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Contract Flow Down – Part I

Typical subcontract agreement forms incorporate the written promises found in other documents by explicitly referring to those documents, which normally include the prime contract agreement, plans and specifications, general and special conditions, and other promises made by the prime contractor to the owner.The prime contractor references those documents in its written subcontracts in order to be certain that its subcontractors provide everything they are obligated to provide to the owner with respect to any subcontracted portions of the work. For example, if the prime contractor has agreed to give the owner the right to audit records of time and materials, then the contractor must ensure its subcontractors are contractually required to provide it with all the same records it is required to produce for the owner. As such, typical subcontract agreements will not merely refer to the prime contract documents, but also will provide the promises in those documents are passed down to subcontractors in what is generally referred to as a “flow-down” clause.

For example, a contractor was unable to pass through to a subcontractor a change order it received from the project owner to delete a portion of the work. The original contract required the contractor to remodel a shopping mall, including the removal and reinstallation of the storefront signage. The contractor hired a subcontractor to perform the signage work. After the subcontractor removed the signage and had received half the contract amount, the owner decided to buy new signage, and signed a change order deleting re-installation of the old signs from the project. The prime contractor cancelled the remaining work under the subcontract, but the subcontractor sued for the contract balance and won the case. The subcontract hadn’t provided for change orders, so cancelling the remaining work was a breach of contract.

A simple solution would be to include a flow-down clause in the written subcontract providing that the subcontractor would be bound to the contractor in the same manner, and to the same extent, as the contractor is bound to the owner under the prime contract documents, with respect to the subcontracted portion of the work. By referring to the prime contract documents, the written subcontract would have put the subcontractor on notice of the promises contained in those documents that related to its work, not only including the change order provisions, but also including standards of care and warranty obligations, limits on remedies, insurance requirements, and requirements for payment forms, waivers and releases. Further, by expressly providing that the subcontractor is bound in the same manner (and to the same extent) as the contractor is bound to the owner, the contractor can be reasonably certain that all of those promises become affirmative obligations of the subcontractor.

The appropriateness of a flow-down approach largely depends on the appropriateness of burdening the seller with review of the contract documents. For large subcontracts, flow-down may be the simplest approach for both the buyer and the seller to ensure a mutually profitable bargain. For a small purchase order, on the other hand, it is probably more reasonable to put the burden on the buyer to determine its own requirements, than to burden the seller with sifting through the project manual to ensure its product will meet all the specifications and warranties required by the prime contract documents.

A flow-down clause doesn’t just “incorporate” the prime contract documents by referring to them; it typically goes further by providing that the individual promises in the referenced documents apply as between the contractor and the subcontractor to the same extent as they apply between the owner and the contractor. Otherwise, a court may find that prime contract documents are only incorporated into a subcontract for a limited purpose.

No Damage for Delay Clauses

More expansive flow-down clauses, on the other hand, will not only pass through to the subcontractor all of the obligations that are owed to the owner, but will also be interpreted to provide the prime contractor with defenses for its own misconduct (not involving the owner). For example, no-damage-for-delay terms in the prime contract will not only exculpate the owner for owner-caused delays, but also will exculpate the prime contractor for its own failures in managing the project when those same terms are “flowed-down” to a subcontractor, as illustrated by a case brought against a general contractor that caused a two year project delay.

The general contractor argued that the subcontractor was only entitled to an extension of time based on no-damage-for-delay terms in the prime contract documents which, it argued, were applicable to the subcontractor because of the flow-down provisions in the written subcontract: “Contractor shall have the same rights and privileges as against the Sub-contractor herein as the Owner in the General Contract has against the Contractor… The Sub-contractor agrees to be bound to the contractor by the terms of the contract documents and assume toward the contractor all of the obligations and responsibilities that the contractor by aforesaid document assumes toward the Owner.” The court ruled that “because the general contract accords the project owner protection from an action brought by the general contractor for delay damages, it necessarily follows that the subcontract accords the same protection to the general contractor vis a vis the subcontractor,” and dismissed the subcontractor’s claims.

The case illustrates dangers inherent in flow-down clauses for subcontractors. Unlike a general contractor, a project owner will not ordinarily bear responsibility for sequencing and scheduling the work of subcontractors, or for providing sufficient work and storage areas, or for providing temporary facilities. Thus, a no-damage-for-delay clause in a prime contract, which prevents recovery against the owner for delays, will subject the prime contractor to a completely different, and ordinarily much smaller, group of risks than the same clause in a construction subcontract, which would prevent recovery against the prime contractor.

Or consider hold harmless and insurance terms. A general contractor that is directly involved in supervision of the project site and coordination of subcontractors is much more likely to have actual liability for an accident than a project owner that does not have active operations at the project site. A subcontractor might not object to contract terms that pass through an obligation to name an owner as an additional insured on its general liability policy, at least where the owner will not have active operations at the project site. Nonetheless, the same subcontractor probably should object to an additional obligation to also name the general contractor as an “additional insured,” because the potential for liability is much, much higher.

Part II of Contract Flow Down Issues in the June 3 issue of Risk Management will cover precedence clauses, inappropriate flow-down, protections for subcontractors and negotiating tips for subcontractors.

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