July  26, 2002

Bulletin #59, The General Contractor Steps Aside (July 26, 2002)

ZZZ Sheet Metal was the successful bidder on the HVAC system for a healthcare center. The pricing was “thin,” but ZZZ needed the work, and viewed the project as low risk. The healthcare firm building the facility was very successful, and growing throughout the region. In fact, ZZZ saw the project as a potential in-road into future projects with the owner.

Positioned contractually between ZZZ and the healthcare company was a general contractor from out of state. The contractor had a reputation for being hard-nosed and somewhat oppressive from the standpoint of its subcontractors. He let it be known in the bidding process that he was going to manage the project very tightly. ZZZ recognized that the project would pose management challenges, but was otherwise confident of its ability to handle the work.

As the starting date for the work approached, execution copies of a subcontract document arrived. The subcontract was a proprietary form much longer, and more complicated than standard AIA and AGC forms. The extra length was primarily attributable to terms imposing substantially all risks on the subcontractor, relieving the general contractor of responsibility for any liabilities, and entitling the subcontractor to payment only at the discretion of the general contractor. There were so many troubling terms that ZZZ struggled with how to respond. Faced with a time crunch on starting work, the decision was made to sign the subcontract as it had been presented and to “manage to the contract.”

Hidden within the fine print of the subcontract was some unusual language. One section of the “Claims” provision contained the following language:

“If the Subcontractor asserts a claim related in any way to the acts or omissions of the Owner, the Contractor shall have the right, in its discretion, to compel the Subcontractor to pursue its claim directly against the Owner. In such circumstances, the Subcontractor shall indemnify and hold the Contractor harmless against any expenses incurred by the Contractor with regard to any such action, and the Contractor shall have no liability to the Subcontractor, whether or not the Subcontractor is fully compensated for the applicable claim. No such action shall be commenced by the Subcontractor if the consequences of such an action would be a claim of default against Contractor under the general contract with Owner. Contractor’s determination that Subcontractor may pursue the claim directly against the Owner shall release and absolve the Contractor of any further liabilities or obligations of any kind with regard to the subject matter of the claim. It is intended that this provision shall function as a “liquidating agreement” under applicable law, notwithstanding the absence of privity of contract between the Owner and the Subcontractor.”

The project went surprisingly well for the first twelve months. However, the situation changed as the parties were proceeding into the third phase of construction. The federal government had unexpectedly announced reduced reimbursement schedules for healthcare procedures, and indicated that it would be auditing a number of large providers as to prior reimbursements. On the list of providers to be audited was the entity developing the new complex. The project stopped in its tracks. At the same time, a dispute began to emerge between the owner and the general contractor over costs previously incurred, and whether the general contractor had overspent on systems that would not be needed in a downsized facility. Apparently the owner had disclosed in its initial plans and specifications that Phase III might be delayed or canceled, but the general contractor had installed project systems to serve all three phases. One of the systems most impacted was the HVAC system being installed by ZZZ. A centralized cooling and heating component for the entire complex was already in place, which would clearly provide capacity well in excess of what the downsized project would require. For the first time in the project, ZZZ’s progress payment requests were held up, as the various parties began to posture opposite each other in the face of pending claims.

ZZZ believed that it was entitled to be paid for all of the labor and materials that it had provided under a design generated by the general contractor, the architect, and the engineer. The general contractor pointed to language in the specifications that would (arguably) make the subcontractor responsible for necessary modifications to the system to accommodate design conditions set forth in the general contract, including the possible downsizing. There was also the issue of the ongoing delay, which ZZZ recognized would significantly increase the costs of the project. The de-mobilizing and mobilizing costs alone would be significant, and the subcontractor had already purchased substantially all of the materials and equipment necessary for all three phases. ZZZ’s claim was large and growing by the day.

Faced with the rejection of its payment requests, ZZZ forwarded a letter to the general contractor setting forth its claims. The subcontractor expected a response disputing some of the claims. Instead, the general contractor delivered a letter invoking what it called the “liquidating agreement” provision of the subcontract, and instructed the subcontractor to pursue all of its claims directly against the owner. The letter recited the specific language from the subcontract, attributed the various project issues to owner-generated delays, and particularly emphasized the “hold harmless” language in the subcontract in the event that the ZZZ’s pursuit of its claims against the owner resulted in some liability of the general contractor. Concerned about the implications of the subcontract language, but also wishing to pursue its claims, the subcontractor forwarded substantially the same claims’ letter to the owner insisting that it be paid for all of its labor and materials (including stored materials), as well as delay damages. The owner’s response was that there was no privity of contract between the subcontractor and the owner, and that the subcontractor’s pursuit of any claim against the owner was invalid. The owner asserted that the “liquidating agreement” provision was not binding on the owner, and that the subcontractor’s sole remedy was to pursue its claims against the general contractor. Faced with two apparent dead-ends, ZZZ sued both the owner and the general contractor. Both parties counterclaimed against ZZZ on a variety of theories, and each affirmatively asserted that the subcontractor could not legally bring a claim against it under the contract structure.

Following a lengthy and complex lawsuit, the Court ultimately found:

  • That both the owner and general contractor were responsible for damages owing to ZZZ as a result of the delay and the higher tier disputes.
  • That the language of the subcontract created a valid and enforceable liquidating agreement that would permit ZZZ to pursue its claim directly against the owner on a pass-through basis, and that the Court could award damages against the owner despite the absence of privity of contract with ZZZ.
  • That the general contractor’s “hold harmless” provision was invalid under circumstances in which the subcontractor had compensable claims against both the owner and the general contractor.
The concept behind “liquidating agreements,” with regard to claims against higher tiers, seems sensible on its face. While the subcontractor has a direct contractual relationship only with the general contractor, claims and liabilities can arise out of the acts or omissions of numerous other parties, including the owner, architect, engineer, or construction manager. Under the theory of “liquidating agreements,” the necessity for complex and expensive “chain reaction” lawsuits would be eliminated. If the owner is the sole cause of a delay, why should the subcontractor sue the general contractor, and require the general contractor to sue the owner? Arguably, getting the general contractor out of the middle of such disputes would produce savings for all parties, and minimize the burden on the general contractor in resolving subcontractor disputes. For this reason, it is to be expected that “liquidating agreement” provisions will become increasingly common in subcontracts. However, for the subcontractor, the benefits may be illusory. Among the considerations for the subcontractor are:
  • Will the liquidating agreement be enforceable under state law in permitting the subcontractor to pursue its claims at the higher tier level?
  • Will the liquidating agreement negate or limit valid claims that the subcontractor might otherwise have had against the general contractor?
  • Is the subcontractor assuming a payment, reimbursement, or indemnification obligation to the general contractor as a condition to pursuing its claims at the higher tier level?

The cost of resolving claims at all levels continues to be a major issue for the construction industry. Arbitration clauses were a first step. Mandatory negotiation and mediation provisions were yet another step. Liquidating agreements may ultimately provide a valuable tool to accomplish the same purpose. However, at this point from the perspective of the subcontractor, such agreements should be viewed somewhat skeptically, and relied upon only after consultation with qualified legal counsel.


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