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Changing Horses in Midstream on a Construction Project: How to Transition from a Terminated Prime Contractor to Its Replacement

New York Law Journal

This article will discuss how an owner on a construction project can best navigate the transition from a prime contractor being terminated (i.e., general contractor or construction manager) to a replacement prime contractor. The article will not discuss (1) the advisability of terminating and replacing a prime contractor, and will assume that the owner has weighed the schedule and cost impacts and other adverse consequences of termination, or (2) the requirements of any construction loan documents pertaining to the termination or replacement. The article will also assume there is no performance or payment bond in place with respect to the prime contractor.

Termination for Cause vs. Convenience. If the contract with the prime contractor allows the owner to terminate the contract for convenience, then the owner should exercise this right, as opposed to terminating the contract for cause, primarily to preclude the contractor from delaying the transition by asserting that there was no “cause,” or that the contractor cured the defaults giving rise to the termination within the applicable grace periods. However, if the owner has not already provided the contractor with an opportunity to cure its defaults, the owner may want to do so prior to terminating for convenience in order to preserve the owner’s claims for damages arising from such defaults.

If the contract does not allow a termination for convenience, or requires a termination fee that the owner does not want to pay, then the owner must observe carefully the prerequisites for termination for cause, including sending a default notice (describing each default in detail), followed by a termination notice.

Timing of Termination. Before exercising its termination right, the owner should take certain preliminary steps, including lining up a replacement contractor. The owner may want to first engage the replacement contractor as a consultant, to evaluate the status of the project and assist with the transition, and also issue a report memorializing the existing condition of the project for litigation purposes, including photographic evidence. Alternatively, the existing project manager, if any, or a construction consultant, can provide these services.

The report should also describe the progress of the various key elements of the project, any defects or nonconformities in the work, any delays in achieving project milestones, and any other matters which might be needed in litigation with the terminated contractor or otherwise helpful in transitioning to the replacement contractor.

Before initiating discussions with potential replacement contractors or construction consultants, the owner should require them to enter into non-disclosure agreements.

Procure Project Documents; Secure Project Management Software; Take Possession of Project Equipment/Materials. Since it will be much harder to procure project documents from the prime contractor once its contract has been terminated, the owner should obtain digital and hard copies of those documents prior to termination, especially subcontracts. The owner should also sever the prime contractor’s access to any owner-provided project management software program once the contract has been terminated. In addition, assuming the contract permits the owner to take possession of equipment or materials at the project site, the owner should be poised to do so immediately upon termination, or beforehand if feasible.

Subcontractors. The owner should initiate discussions with subcontractors at the appropriate time, but it must be circumspect about sharing information with subcontractors prior to the termination of the prime contractor, and not give the prime contractor cause for claiming that the owner interfered with its subcontractor relationships.

Before engaging in such discussions, the owner should assess its contract rights vis-à-vis the subcontracts following termination. A well-crafted agreement will provide for an automatic assignment of the subcontracts, at the owner’s election and without requiring the prime contractor’s consent or execution of an assignment instrument.

Immediately after the owner has issued the termination notice, the owner should send a notice to each subcontractor informing them of the termination. If the prime contract does provide for an automatic assignment of the subcontracts, the notice should also advise the subcontractor of (1) the assignment of the subcontract to the owner or a replacement contractor (assuming the owner elects to proceed with the subcontractor), which assignment, however, should be contingent upon execution by the subcontractor of an amendment to the subcontract (discussed below); and (2) the engagement of the replacement contractor.

If the owner elects not to proceed with a particular subcontractor, the owner should issue a notice informing the subcontractor that its subcontract is not being assumed, but preserving any claims it might have against the subcontractor, as a third-party beneficiary. The owner should also notify the surety on a performance or payment bond covering the subcontract, if any, of such claims. If the replacement contractor is reluctant to assume responsibility for performance of the subcontractors, or schedule and cost risks, it can act as an “adviser” to the owner, meaning the owner will need to assume the subcontracts, stepping into the shoes of the terminated prime contractor.

Subcontract Amendment. Each subcontract being assumed should be reviewed carefully to determine if any modifications are necessary. Of course, the owner’s success in making such modifications will depend upon the strength of the owner’s leverage vis-à-vis the subcontractors. Ideally, in addition to those modifications, each subcontract should be amended to:

  • reflect the fact that the agreement with the prime contractor has been terminated, but provide that the provisions in that agreement and the “Contract Documents” as described therein, which had been incorporated by reference in or attached to the subcontract, remain in full force and effect, except as may otherwise be provided in the amendment;
  • reflect the fact that the subcontract has been assigned to the owner or the replacement contractor, but that the assignment is contingent upon execution of the amendment by the subcontractor, and provide that the subcontractor will “attorn” to the owner or replacement contractor, as the “Contractor” under the subcontract;
  • provide that the owner has no responsibility or liability towards the subcontractor with respect to any default by the prime contractor;
  • provide for the discharge of any mechanic’s liens filed by the subcontractor;
  • instruct the subcontractor to deal directly with the replacement contractor, reserving, however, to the owner whatever rights the replacement contractor is not authorized to exercise on behalf of the owner;
  • include a confidentiality provision, preventing the subcontractor from disclosing to the terminated contractor the contents of the amendment or any other matter;
  • require the subcontractor’s cooperation in any litigation between the owner and the terminated contractor;
  • address the role of the owner’s project manager, if any; and
  • incorporate representations by the subcontractor as to important matters, including the following (subject to qualifications set forth in the amendment, with copies of written evidence attached, or described in the amendment and delivered to the owner), with the understanding that the replacement contractor and the owner’s construction lender, if any, among others, will have the right to rely upon such representations:
    • true, correct and complete copies of the subcontract, sub-subcontracts and purchase orders between subcontractor and its sub-subcontractors or suppliers, change orders and other relevant documents have been delivered by the subcontractor to the owner;
    • the aggregate amount of the payments received by the subcontractor, and the unpaid balance remaining;
    • any current or projected deviations from the current work schedule;
    • there are no outstanding delay claims, other than (i) those reflected in pending change order proposals, which should be identified, or (ii) those already accommodated in the current work schedule;
    • there are no outstanding defaults by the prime contractor;
    • the subcontractor has not received any notice of default from the prime contractor, nor has any claim been asserted by the prime contractor against the subcontractor;
    • the subcontractor has not received any notice of default from any sub-subcontractor or supplier, and no claim has been asserted by a sub-subcontractor or supplier;
    • there are no outstanding defaults by any sub-subcontractor or supplier;
    • there are no outstanding payment claims made by any of the subcontractor’s laborers/employees; and
    • all representations and certifications made by the subcontractor under its subcontract are true and correct in all material respects as of the date of the amendment.

If there are any performance or payment bonds pertaining to a subcontract, the owner may need to get the surety’s consent to the amendment.

Replacement Contractor. It would be preferable to have the agreement with the replacement contractor ready for execution prior to terminating the original contractor’s agreement. In the new agreement, the replacement contractor should acknowledge having received the relevant project documents.

The most recent project budget (or schedule of values) and project schedule should be attached as exhibits to the agreement, and the agreement should set forth the then current status of the principal elements of the project.

The replacement contractor should acknowledge in the agreement that it has conducted appropriate due diligence about the project, including inspection of the project and familiarizing itself with the project site logistics.

The agreement should also require that the replacement contractor cooperate with the owner in effectuating the transition from the terminated contractor, including entering into an attornment agreement with the construction lender, if requested.

Finally, the agreement should require that the contractor obtain the owner’s consent before conducting any meetings or communications with the terminated contractor or, prior to the termination, with any subcontractors.

CIP Insurance. In the event that the contractor being terminated had procured a Controlled Insurance Program (CIP) for the project, the owner will likely need to replace the contractor’s CIP with its own CIP, or separate insurance policies providing similar coverage. It is important that the replacement coverage be secured before terminating the contractor. When the owner calculates the additional costs it may incur in terminating the contractor, it should include the portion of the premium paid for the contractor’s CIP which is not recoverable.

Subcontractor Default Insurance. Similarly, if the contractor had obtained Subcontractor Default Insurance (SDI) for the project, the owner should consider whether it will want performance bonds or other security, as a replacement for the SDI once the contractor has been terminated (if the contractor was terminated because it became insolvent, and the owner has been named as a beneficiary under the SDI, it is possible that the SDI coverage will remain in place after such termination).

Conclusion

There are many twists and turns in the road to replacing the prime contractor in the middle of a construction project. The steps outlined in this article are intended to aid the owner in navigating this road. The owner’s adherence to these steps will not necessarily eliminate all potential pitfalls, but it should at least facilitate the transition.

“Changing Horses in Midstream on a Construction Project: How to Transition from a Terminated Prime Contractor to Its Replacement,” by Michael A. Scheffler was published in the New York Law Journal on May 21, 2020.

Reprinted with permission from the May 21, 2020, edition of the New York Law Journal © 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, contact 877-257-3382 or reprints@alm.com or visit www.almreprints.com.