Why Owners Should Oversee Construction Subcontracts
This article explains why owners should participate actively in the development of subcontracts under a construction management agreement.[1] Owners often pay too little attention to this part of the subcontracting process and yield too much control to the construction manager.
While this conduct is more prevalent where the construction manager is acting as the principal under the subcontracts, not as the agent of the owner, or is otherwise assuming certain cost, schedule or other risks related to the subcontractors’ performance, the owner’s lax attitude will sometimes also surface when the owner is the named principal under the subcontract. This attitude can engender problems for the owner, as explained further below.
Reasons Owners Should Care About Subcontracts
There are a number of reasons the owner should care about the contents of subcontracts, and not rely upon the “flow down” or “incorporation by reference” clause in the subcontract.
One of the principal reasons is that if the owner terminates the construction manager agreement, the owner or a replacement construction manager may inherit some or all of the subcontracts, and may not have sufficient leverage to remove or improve unfavorable terms in the subcontracts.[2]
With respect to any such termination, the owner should ensure that the subcontract permits the construction manager to (1) assign the subcontract to the owner or its designee, without obtaining the subcontractor’s consent, and (2) nullify any termination of the subcontract effectuated upon the termination of the construction manager agreement (either automatically or by notice from the construction manager).
The assignment provision should state that the owner can effectuate the assignment by simply notifying the subcontractor (i.e., without the construction manager’s confirmation). Also, to avoid any doubt as to whether the incorporation by reference of the construction manager agreement into the subcontract survives the termination of the construction manager agreement, the subcontract should provide that if the construction manager agreement is terminated for any reason, its terms nonetheless remain in full force and effect as so incorporated.
Another important reason is that the owner may want to seek recourse directly against the subcontractors (either in addition to or in lieu of the construction manager). Therefore, it is important that the owner be named in the subcontract as a beneficiary under the subcontractor’s warranties and guaranties (and other provisions intended to benefit the owner), as an additional insured and indemnitee, and as a co-obligee under payment and performance bonds. The owner may also be required, by a lease or mortgage, to extend the same protection to the lessor or mortgagee.
Naming the owner as a beneficiary under the subcontractor’s warranties and guaranties, however, may be insufficient if the subcontract provisions are weaker than those in the construction manager agreement. Rather than relying solely on the “flow down” clause in the subcontract, the owner should ensure that the subcontract’s warranty and guaranty terms are at least as strong as the similar terms in the construction manager agreement.
With the owner being designated as an indemnitee and beneficiary under the subcontract, it is important to add a statement that such a designation should not be deemed to create contractual privity between the owner and the subcontractor or otherwise give rise to any obligations or liability on the part of the owner in favor of the subcontractor.
Finally, certain provisions may be (1) mandated pursuant to governmental incentive programs benefiting the project, in which case the owner should not rely on the construction manager to ensure that those provisions are included in the subcontracts, or (2) advisable in order to take maximum advantage of laws governing the subcontracts.
For example, in jurisdictions where a prompt payment act has been enacted, affording certain protection to subcontractors, the statute may allow the parties to a subcontract to supersede some of the statute’s provisions by including appropriate language in the subcontract, but some construction managers may be using a subcontract form that predates the passage of the act, and, thus, does not contain such superseding language.
General Practice
The general practice is that the construction manager will use its own subcontract form, and even if the owner does review the form, the owner may not review the actual subcontracts before they are executed, or obtain copies of the executed subcontracts.
There are several problems with this practice, from the owner’s perspective. First, even if the subcontract contains a customary provision incorporating the construction manager agreement by reference, it is very possible that the construction manager will not provide a copy of the construction manager agreement to the subcontractor, which would make it more difficult to bind the subcontractor to provisions in that agreement.
Second, even if the subcontractor is given a copy of the construction manager agreement, the inclusion of the customary incorporation by reference provision may not be sufficient to bind the subcontractor to certain key terms in the construction manager agreement, especially those not involving the scope, quality, character or manner of the work.
Third, even though the approved form of subcontract may be attached as an exhibit to the construction manager agreement or otherwise established as the prescribed form, the owner should still review the actual subcontract agreements before they are executed to ensure that no material changes were made to the approved form.[3]
Finally, the owner’s failure to obtain copies of the executed subcontracts can present problems if the owner terminates the construction manager but wants to continue working with the subcontractors under their existing subcontracts, or the owner seeks to enforce the subcontract provisions benefiting the owner.
How to Correct Problems With General Practice
Given the construction manager’s desire to work with its own form of subcontract, the owner should provide a rider to be annexed to each subcontract, which incorporates important concepts found in the construction manager agreement[4] and addresses weaknesses in the construction manager's form of subcontract, some of which are discussed above (e.g., liquidating agreements; offset rights granted to the construction manager; failure to name the owner as an indemnitee or third-party beneficiary; and language containing negative implications harmful to the owner).
The construction manager agreement should require that the construction manager employ the subcontract form and rider annexed as exhibits.
The construction manager should provide to each subcontractor a copy of the construction manager agreement, redacted to prevent disclosure of monetary and other confidential terms.
The owner should review the final, execution version of the subcontracts to ensure that any changes made by the construction manager to the standard form are acceptable. For large projects with a multitude of subcontracts, the owner may choose to review just the more significant subcontracts. In most construction management pricing structures, there is transparency as to subcontract prices as part of the cost of the work. In a situation where there is no such transparency, the subcontracts can always be redacted to remove the pricing information.
The owner should obtain copies of the executed subcontracts (again, redacted if appropriate).
Conclusion
For the reasons described in this article, owners need to be more involved in the development of subcontracts under a construction management agreement, even where the construction manager is acting as the principal under the subcontracts or is otherwise assuming certain risks related to the subcontractors’ performance. More oversight by the owner at the subcontracting stage can prevent or ameliorate problems arising later, when a poorly drafted subcontract may cost the owner both time and money.
"Why Owners Should Oversee Construction Subcontracts," by Michael A. Scheffler was published in Law360 on December 3, 2019.
[1] The same principles discussed here also apply to subcontracts under general contractor agreements, albeit to a lesser extent given the differences between the two contracting models.
[2] Some examples of these unfavorable terms are: (i) a “liquidating agreement” (or “pass-through”) provision, (ii) a cross-default between the subject subcontract and other subcontracts between the construction manager and the same subcontractor, (iii) a clause permitting the CM to offset against payments due to the subcontractor on the owner’s project, amounts that the subcontractor may owe the construction manager on a different project, and (iv) terms containing negative implications harmful to the owner (e.g., a provision exculpating officers of the owner from liability to the subcontractor, or limiting the subcontractor’s recourse against the owner to the owner’s interest in the property creates an unwarranted implication that the owner may have privity with or be liable to the subcontractor under the subcontract).
[3] While the construction manager agreement may require the owner’s approval for any such material changes, it is better to discover them before the subcontract is executed, especially if the owner or a replacement construction manager “inherits” the subcontract and has no leverage to require modifications.
[4] For example, sales tax exemption, MWBE requirements, lease requirements, LEED certification, and wraparound insurance.