Legal Spotlight

  

Bond producers and surety company representatives, as well as contractors and subcontractors, are often--and correctly—urged to carefully and thoughtfully review and understand contract documents before signing such contracts. This process of careful contract review is a critical risk management tool for the success of a construction firm. Each firm has a different appetite for risk, but whatever that appetite is, each construction firm should sign only those contracts/subcontracts for which it understands and knowingly accepts the risk allocation.

Subcontractors, and their bond producers and surety underwriters, should be particularly aware of the language of specific flow-down and incorporation-by-reference clauses before signing any subcontract or issuing bonds for such subcontracts. The flow-down and incorporation-by-reference language often significantly impacts a subcontractor’s project risks. Flow-down provisions require the subcontractor to assume towards the prime contractor the obligations the prime contractor has assumed towards the owner. Incorporation-by-reference clauses expressly incorporate as part of the subcontract the documents of the prime contract. The main purpose of these provisions is to maintain consistency between the obligations of the prime contractor to the owner, and the obligations of the subcontractor to the prime contractor for subcontract work.

Therefore, a subcontractor’s contract review process should include the documents comprising the owner-contractor agreement as well as the subcontract agreement. While subcontractors are seldom successful in eliminating such clauses from their subcontracts, subcontractors should insist on reviewing the prime contract during contract negotiations in order to (1) determine if it wants to assume such risk; and (2) attempt to clarify or delete prime contract provisions that are inconsistent with the subcontract agreement.

Flow-Down Clauses

Flow-down clauses, also called pass-through clauses, are included in almost all construction subcontracts. While such language sounds relatively harmless, flow-down clauses are a powerful subcontract provision and can easily change a subcontractor’s risk profile under its subcontract.

The language in flow-down clauses varies, with varying effect on the subcontractor’s risk, so it is critical to understand how they function. Flow-down clauses can be limited to scope of work or can be much more general, binding the subcontractor to the agreement between the contractor and the owner. A clause that is limited to scope-of-work issues will identify the work to be performed by the subcontractor and provide that, with regard to the designated work, the subcontractor is obligated to the contractor in the same manner and to the same extent that the contractor is obligated to the owner. For example, such a scope-of-work flow-down clause might read as follows:

This clause transfers the risk of performance to the subcontractor. It does not transfer the risk for all other obligations contained in the prime contract. AIA Document A401-2007, Standard Form of Agreement Between Contractor and Subcontractor, contains a reciprocal flow-down provision in Article 2, Mutual Rights and Responsibilities:

Consideration of a reciprocal flow-down provision is important because a subcontractor may seek to enforce the flow-down provision to its benefit.

Another example of a flow-down clause follows:

This flow-down clause benefits only the prime contractor. Subcontractors should seek clauses that require the prime contractor to assume to the subcontractor the obligations that the owner owes to the prime contractor.

Both this example and the AIA flow-down provision, set forth above, contain an “order of precedence” clause to provide that, in the event of conflicting language in the prime contract and the subcontract, the language of the subcontract will prevail over conflicting provisions in the prime contract. On the other hand, some subcontracts specify that, in the event of a conflict among contract documents, including the prime contract, the provision that is more burdensome on the subcontractor controls.

How might a broad flow-down provision play out under a specific subcontract? Disputes relating to flow-down provisions can arise concerning, among other things, indemnity, insurance (what types and limits must be maintained) and dispute resolution (the locale and whether disputes will be resolved by arbitration or litigation).

A particular concern for subcontractors are notice requirement provisions. If the prime contract provides for specific time frames during which notice must be given to preserve change order remedies, and those notice provisions flow down to the subcontract but are not specifically set forth in the subcontract, an unwary subcontractor could inadvertently waive entitlement to a valid claim by failing to provide timely notice.

Incorporation-by-Reference Clauses

First cousin to the flow-down clause is the incorporation-by-reference clause. Subcontracts often incorporate prime contracts by reference. A prime contract can be incorporated into a subcontract by listing it as one of the subcontract documents or the subcontract might contain an explicit incorporation provision. Specific provisions might be incorporated or the prime contract might be incorporated into the subcontract in its entirety. An incorporation-by-reference clause that incorporates all obligations, both performance and financial, might provide as follows:

Often certain ambiguities exist with regard to incorporation-by-reference provisions. When a standard provision is used, one issue that arises is exactly what is incorporated into the subcontract from the prime contract. Are only the technical specifications and drawings applicable to the subcontractor’s specific work incorporated or is the entire range of prime contractor obligations, including obligations to give notice, liquidated damages, waiver of claims, arbitration and insurance requirements incorporated as well? Signing a subcontract without reviewing one of the essential subcontract documents—the prime contract--is an unwise risk management practice.

Final Thoughts and Recommendations

If a subcontract provides, as most do, that the prime contract is a contract document and the prime contractor is entitled to the same rights and remedies against the subcontractor as the owner has against the prime contractor, the subcontractor should request a copy of the prime contract before signing the subcontract. Reviewing the significant risk allocation clauses, including indemnity, insurance, change orders, payment, liens, termination, and dispute resolution, is simply good risk management. By not reviewing the prime contract, a subcontractor through a flow-down or incorporation-by-reference clause might unknowingly, and unhappily, agree to a provision that has nothing to do with the subcontractor’s work. If a subcontractor is unsure about anything in the prime contract or any of the documents comprising the subcontract, she or he should consult the firm’s construction attorney.

And it should be well noted that courts in different jurisdictions might interpret a specific flow-down or incorporation-by-reference clause differently. A subcontractor will generally be held to the terms of an incorporated prime contract whether or not the subcontractor has read the prime contract. With either a flow-down or incorporation-by-reference provision in a subcontract, an order-of precedence clause should clarify which document will govern should any inconsistencies exist. Forewarned is forearmed.