Subcontract Administration and Dispute Avoidance

Chapter 10
Subcontract Administration and Dispute Avoidance

Successful project performance depends on the legal and business relationship among the prime contractor and subcontractors and suppliers as much as any other factor. Although the prime contractor is responsible for the satisfactory and timely completion of the project, much of the work is performed by subcontractors and suppliers.

A subcontractor’s unsatisfactory performance often generates disputes among the prime contractor, that subcontractor, and the owner, and possibly other subcontractors. Disputes also arise between the prime contractor and the subcontractor from problems for which the owner may be responsible. Similarly, whenever the prime contractor fails to perform, everyone involved with the project is affected. These disputes spawn lawsuits or arbitrations. Unfortunately, formal dispute resolution, such as litigation or arbitration, is costly, time consuming, and uncertain, and rarely solves the problem when it arises.

This chapter focuses on dispute avoidance and contract administration among the prime contractor, subcontractors, and suppliers. To help identify and prevent problems from the outset, this chapter also concentrates on areas where prime contractor and subcontractor disputes often originate.

I. Dispute Avoidance Begins at the Bidding Stage

A. The Importance of Price

Price is one important consideration in selecting a subcontractor. Yet the lowest-cost subcontract may turn out to be the most expensive one if the subcontractor is unwilling or unable to do the work.

A prospective subcontractor should consider the prime contractor’s overall pricing strategy. Unfortunately, a subcontractor may never be completely sure how the prime contractor is pricing the project during the bid or proposal stage. History, however, may provide a workable indication as to whether the prime contractor can be expected to underprice the contract with the expectation of negotiating even lower subcontract prices after the award or of making up deficiencies on extras.

B. Know the Other Parties

Dealing with irresponsible or unscrupulous contractors very likely will result in disputes. Avoidance of problems begins at the bidding or proposal stage, when both prime contractors and subcontractors identify potential contractors with whom they will bid and enter into contracts for the work. As such, all contractors should consider four factors before deciding whether to contract with a particular company:

  1. Reputation
  2. Financial resources
  3. Experience and qualifications
  4. Union versus nonunion status

1. Reputation

A firm can avoid numerous headaches and possible losses simply by investigating the past performance record of a potential prime contractor or subcontractor. Unreliable contractors can be avoided at the outset by dealing with reputable individuals with a proven ability to perform, by running credit checks, and by inquiring about the experiences of other owners and contractors with that firm.

Even a cursory investigation may yield clues to potential problems. For example, engaging a subcontractor with a reputation for shoddy or defective work may force the prime contractor to remedy an unsatisfactory work product at its own expense. A subcontractor may find that a prime contractor has a history of slow performance at the start of a project, forcing the subcontractors to encounter extended schedules, frequent payment delays, or end-of-project acceleration. A particularly litigious contractor may refuse to negotiate a settlement in the event of a disagreement, disrupting the project schedule by refusing to work and possibly forcing arbitration or a court battle, and associated extra expense.

2. Financial Resources

A contractor that lacks adequate working capital brings myriad problems to the project, even without a default. For example, suppliers concerned about the contractor’s ability to pay may hold deliveries until they receive payment. Laborers may refuse to work because they are not timely paid. These problems can impact the project.

For most subcontractors, the prime contractor’s financial resources are the ultimate concern because the prime often must finance part of the performance. For instance, the contractor may be forced to finance corrective work for defects caused by other subcontractors or to continue performance in the face of differing site conditions or changes in the work while negotiations or litigation resolves ultimate entitlement to payment. If the prime contractor lacks sufficient financial resources to continue performance and pay its subcontractors and suppliers in the face of delayed payments from the owner, there is the potential of a prime contractor failure, affecting everyone involved with the project. That prospect warrants considerable attention to the reputation and resources of the prime contractors with whom subcontractors and suppliers do business.

Similarly, a subcontractor with insufficient working capital may be encouraged to front-end load pay requests so that payment may be made for more than the work actually performed is worth or for work not yet performed. If an overpaid subcontractor defaults, the cost to complete the work, combined with the sum already paid to the defaulting subcontractor, may be substantially greater than the amount originally allocated by the prime contractor for the work. The difference, of course, may come out of the prime contractor’s pocket.

3. Experience and Qualifications

State and local laws may require licensing of general contractors and certain subcontractor trades. (See Chapter 6.) Such licensing requirements may provide some assurance of the contractor’s competence, but the investigation should not stop there.

Inquiry should be made into the contractor’s or subcontractor’s experience on projects of similar type and size to the one being bid or proposed. The best residential electrical subcontractor in the county may not be the best subcontractor for a high-rise hotel project. That subcontractor’s reputation may be built on its personal integrity and quality of its employees’ work, which are laudable achievements. But they do not necessarily assure that the subcontractor has the experience to manage the work of 15 other electricians and coordinate with multiple other trades—other likely requirements for a subcontractor’s work on a high-rise hotel project.

The subcontractor may find through inquiry of other subcontractors and suppliers that a prime contractor has considerable experience with one type of project, but that experience is different from the requirements of the prospective project. The subcontractor may also learn that the prime contractor is already overcommitted on existing contracts, which may affect the prime contractor’s performance on a new project.

Similarly, a prime contractor must explore the subcontractor’s experience in light of special performance requirements for the particular project. For example, if the specifications give only performance criteria, the subcontractor must be able to produce engineering and design details to timely meet the criteria. If a subcontractor proposes to sub-subcontract out the engineering or design work, it should investigate the credentials and experience of the proposed design professional.

Some building product and component suppliers condition the warranty of their products on installation or application by an approved (certified) subcontractor. In some cases, such requirements are not necessary and may serve to inflate the cost of the work. The applicable warranty and the legal basis to enforce that warranty must be reviewed before dismissing a supplier’s or manufacturer’s requirements. The prime contractor may find that its subcontractor is insolvent and that the supplier has no warranty obligation for failure of a roof or wall system because its product was installed by an unauthorized subcontractor. By contrast, if the work is performed by an approved installer, the prime contractor may be protected by both the supplier’s periodic inspections and the warranties of the product and the installation.

4. Union versus Nonunion Status

A prime contractor’s choice of a union or nonunion subcontractor generally depends on its own union status. If a union subcontractor and a nonunion prime contractor contract for a project, the subcontract should contain provisions dealing with labor relations on the work site and give the prime contractor the right to terminate the subcontractor if labor problems delay or impede the progress of the work.

A subcontractor should carefully consider its contractual right to time extensions in the event the prime contractor or another subcontractor has labor problems that affect its work. One option available to contractors is to operate “double-breasted.”1 In general, a double-breasted contractor is a union contractor that forms a second, separate company which operates “open shop.” In essence, there are two employers, one union, one nonunion. In order to establish a legally correct double-breasted operation, the contractor must conclusively establish that both entities (i.e., the union operation as well as the open-shop operation) are distinct and separate business concerns and not merely convenient distortions, or alter egos, of each other. This form gives the contractor the advantage of being able to operate without a union where this is feasible while at the same time continuing operation of the union company where the use of union labor sources is desirable or required.

Of course, double-breasted operations do not guarantee freedom from labor problems, and the cost of maintaining two separate companies may be prohibitive for some organizations. Most important, the use of a double-breasted operation also requires careful adherence to very specific and technical labor law requirements. For example, the National Labor Relations Board (NLRB) has enumerated four criteria used to determine whether the two operations are truly independent in every conceivable aspect of their operation. These are: (1) common management and supervision of operations; (2) common control of personnel policies and labor relations; (3) interrelation of operations; and (4) common ownership or financial control.2 Of these, the NLRB has held the most important factor to be the control that one party maintains over the other party’s labor relations.3

Double-breasted operations can be an effective alternative for a contractor that wants to compete with open-shop contractors in some areas while maintaining good relations with the union where union labor predominates. Contractors should seek the advice of a labor attorney before attempting to establish a double-breasted operation so as to ensure compliance with the requirements of applicable laws and regulations.

C. Subcontract Bids—Potential Issues

When is there an enforceable agreement between a prime contractor and subcontractor? The simple answer is only when both parties have signed the subcontract agreement. But this simple answer may also be wrong.

For example, a prime contractor that has relied on a subcontractor’s telephone bid may be entitled to enforce that bid even though the parties have not signed an agreement. A letter of intent, or a telephone conversation, may give rise to binding obligations such that a refusal to execute a subcontract agreement following a letter of intent or a telephone bid may itself constitute a breach.

Oral agreements can be binding, although they may not be enforceable in certain transactions. When a transaction involves primarily the sale of goods, the Uniform Commercial Code (U.C.C.) generally governs the creation of a binding contract. The U.C.C. requires that the parties agree to certain material terms, even though disagreement may still exist with respect to other important terms of the “contract.”4

1. Enforcement of Subcontractor Bids

Practically every contractor has had a subcontractor or supplier revoke its bid or proposal after the contractor has entered into a contract with a third party in reliance on the subcontractor’s bid. This issue has generated substantial litigation between prime contractors and subcontractors, especially when severe inflation affects the construction industry.

Many early cases held that the subcontractor was not bound to the prime contractor; or, similarly, the supplier was not bound to the subcontractor, unless the parties had actually signed a contract.5 Therefore, bids and proposals could be withdrawn up until the point where the parties were bound by formal documents.

In recent years, many courts (but not all) have held that a subcontractor is bound to the prime, when notified within a reasonable time after award that the prime relied on the bid in obtaining the prime contract award and intends to use the subcontractor for the project.6 What constitutes a reasonable time for acceptance of an offer depends on the circumstances.7

The trend toward binding subcontractors to the prime contractor based on the bidder’s proposal, even without a contract document, is a response to the hardship a contractor faces when it is awarded a contract based on the subcontractor’s proposal, and then the subcontractor is not obligated to proceed with performance. Many contractors seek to avoid this problem by requiring that bidders also agree that their proposal will not be revoked for the same period of time allowed for award of the prime contract in the owner’s bid documents.

When a contractor is forced to hire a replacement subcontractor to perform the work following the original subcontractor’s repudiation of its bid or proposal to the contractor, the damages can be significant.8 Over the past five decades, courts have generally applied the same measure of damages in such instances.9 Typically, a contractor may recover the difference between the original subcontractor’s bid and the amount paid to the replacement subcontractor. This measure of damages, which is sometimes called “expectation damages,” places the contractor in the same position that it would have occupied if the original subcontractor had performed as promised.

2. Subcontractor Rights against the Prime Contractor

Although subcontractors may be responsible to prime contractors that rely on their bid, prime contractors are less frequently bound to the subcontractors whose bids were relied on by the prime.10 The fact that the prime contractor used the subcontract bidder’s proposal in its bid to the owner does not ordinarily provide the subcontractor with rights equivalent to those that the prime contractor may have to bind the subcontractor to a contract. But each set of circumstances must be judged on its own merits.

An argument has successfully been made that if the prime contractor sends the subcontractor a letter of intent or a clear statement that it intends to have the subcontractor perform the proposed work for a mutually acceptable price, and the subcontractor begins performance in reliance on the prime’s request, then there is a basis to find that the parties have entered into a contract, even though it is not completely reduced to writing. Under such circumstances, a subcontractor may be entitled to recover damages for breach of contract if the prime contractor later withdraws its commitment.

The fact that the parties have not executed a formal contract is not necessarily controlling. If the circumstances indicate that a subcontractor intends to perform a specifically identified scope of work on mutually agreeable basic terms of price and time, and if the subcontractor begins performance pursuant to such terms without objection from the prime contractor, there is support for a finding that the parties are bound to each other. Thus, the subcontractor may be entitled to a remedy for breach when it is later not allowed to complete the work.

II. Preparation of the Subcontract Agreement

The “subcontract,” for purposes of this discussion, refers to the contract between parties at any level below the contract to which the owner is a party (usually referred to as the prime contract). The subcontract includes the contract between the prime contractor and a subcontractor, and contracts between a subcontractor and sub-subcontractor at all levels. Contracts with vendors that only supply materials or equipment and do minimal or no work on the project site are usually subject to Uniform Commercial Code, as discussed further in Chapter 8.

At the outset, a firm should decide whether to draft its own subcontract or use a standard subcontract form. Form subcontracts developed by industry trade organizations, such as the American Institute of Architects (AIA), ConsensusDocs, and the Engineers Joint Contract Documents Committee (EJCDC), are widely utilized in the industry.11 Form subcontracts have the advantage of being relatively inexpensive and fairly widely accepted.

In addition, a contract form developed by an industry group may offer the advantage of providing a series or family of relatively coordinated documents that address a variety of needs and reflect “buy-in” from multiple segments of the construction industry. For example, the ConsensusDocs 70012 Series of subcontracting documents includes a variety of forms, such as:

  1. ConsensusDocs 705 Invitation to Bid/Subbid
  2. ConsensusDocs 706 Subcontract Performance Bond
  3. ConsensusDocs 707 Subcontract Payment Bond
  4. ConsensusDocs 710 Subcontractor’s Application for Payment
  5. ConsensusDocs 750 Standard Agreement Between Constructor and Subcontractor
  6. ConsensusDocs 751 Standard Short Form Agreement Between Constructor and Subcontractor (Where Constructor Assumes Risk of Owner Payment)
  7. ConsensusDocs 752 Standard Subcontract Agreement for Use on Federal Government Construction Projects
  8. ConsensusDocs 760 Subcontract Bid Bond

Unlike the AIA form contract documents, which are typically revised on a ten-year cycle, the ConsensusDocs forms have been revised and updated on an as-needed basis since their initial publication in 2007. Since 2007, new ConsensusDocs forms have been added, such as ConsensusDocs 752 form subcontract, which was specifically developed for federal government construction projects.

The AIA contract document A401 (2007 ed.) (Standard Form of Agreement between Contractor and Subcontractor) is the construction services form subcontract within the AIA family of documents. The AIA A401 form expressly incorporates AIA A201 General Conditions of the Contract for Construction into the subcontract.13 Given the periodic revisions to the AIA forms, parties using the AIA form subcontract need to confirm that they reference the correct version of AIA A201. Some other AIA G series, Architect’s office and project (or project administrative forms) forms, such as the bond forms (AIA A312 (1984 ed.)), the lien waiver form (AIA G706A), change order forms (AIA G701 (2001 ed.)), and application and certification for payment form (AIA G702 (1992 ed.)), are commonly used by contractors and subcontractors.

The Engineers Joint Contract Documents Committee (EJCDC) issued a construction subcontract form in 2013 that is identified as C-523 Construction Subcontract on Basis of Stipulated Price (2013). It is intended to be used with other EJCDC owner-contractor documents such as the Standard General Conditions of the Construction contract (C-700).

Care should be taken in using these or any other industry forms in the contractor-subcontractor relationship where such forms are designed for the owner-prime contractor relationship. Whenever standard forms are used, they still should be carefully reviewed, as these forms may not address specific items of concern to the contracting parties, or may contain terms unnecessary for the particular project or contractual relationship. For that reason, some contractors may choose to develop their own forms; however, the software packaging of the modern standard forms also allows for modification or adaptation to address particular concerns or needs.

Regardless of whether an industry standard or a custom drafted document is used, an adequate subcontract form should, at a minimum, accomplish the following:

  1. Define the exact undertakings of the subcontractor so that there can be no dispute about the scope of work the subcontractor is to perform, including standard of quality and performance time.
  2. Detail the terms and conditions of payment, including the method of computing progress payments, terms of payment for stored material, due dates for pay requests, handling of interim retainage, and final payment.
  3. Anticipate areas of trouble or dispute, and define the consequences if work is not properly or timely performed.
  4. Specify the relief that the innocent party is entitled to receive.
  5. Avoid favoring one party to such an extent that the other party will decline to sign the proffered form or refuse to perform under its terms. A subcontract should be tailored to fit the needs of a particular project.

A collection of uncoordinated provisions from various unrelated form contracts can result in a monster that may create substantial unanticipated problems for both parties. Such monsters typically are created in one of two ways. The first is a “cut-and-paste” operation by which various provisions are borrowed from different subcontracts and brought together in one document without being reconciled or analyzed for consistency. The second is an “inclusion” operation, by which the contractor includes (either expressly or by reference) in its subcontract the general and special conditions of the prime contract, terms and conditions that it has prepared specially, and perhaps some other standard-form document, such as the contractor’s project procedures. The justification for an inclusion contract rests on the theory that more is better. The result is often a hodgepodge of documents that are not consistent or coordinated.

Instead, a subcontract form should be prepared by someone competent for the task, and modified as needed for the conditions of each project. Also, it should be reviewed periodically in light of lessons learned through experience and changes in the law. Unlike terms of many public contracts, which are set by law or regulation, there are no “standard” subcontract terms for private contracts. The following points should be considered in drafting the terms of a subcontract.

A. “Flow-Down” Obligations

A flow-down clause, which contractually ties, for instance, the subcontractor to the prime in the same manner as the prime is bound to the owner, is imperative.14 One example of a basic, yet enforceable, flow-down clause reads: “[C]ontractor shall have the same rights and privileges as against the Sub-contractor…as the Owner in the General Contract has against the Contractor.”15 Since subcontractors at every level are bound together on the project by a series of contracts, all subcontracts should contain flow-down clauses. The absence of a flow-down clause can leave the contractor exposed to liability but unable to demand of the subcontractor the performance that it is required to undertake.

In return for this protection, the prime contractor will generally provide the subcontractor with the same rights that the prime has against the owner up the contract ladder, including making claims, protesting, and providing notices to the owner. In other words, the rights and duties flow both ways—upward to the prime contractor as well as downward to the subcontractors at each level. This tends to keep the parties on an even basis, even though there is no privity of contract (direct contractual relationship) between the owner and the subcontractors.

B. Scope of Work

Every subcontract must have a clear and defined scope of work. From a practical standpoint, it is very difficult to define all of a subcontractor’s work in a description of the scope of work in a subcontract. Therefore, the subcontract form should refer to all of the applicable contract documents between the owner and prime contractor in defining the subcontract scope of work.16

The general contract bid items are often too general to incorporate by reference into the subcontract as the definition of the scope of work. This practice should be avoided. Instead, the work description must explicitly define responsibilities for the scope of work and must also define the responsibilities each contractor assumes for its own activities.

The scope of work for a project is not simply the items of performance that are subcontracted out for a particular project. A scope of work provision also includes the responsibilities for the facilities and for contract administration. Therefore, a detailed description of the actual work to be performed by the subcontractor on a project, including incorporation of the owner’s description of the work from the general contract, must be supplemented with provisions that address other requirements and contingencies.

If a general contractor divides a certain item of work between subcontractors, two additional considerations arise. First, extreme care must be used to define each subcontractor’s scope of work to ensure that no aspect of the work is omitted. Second, the contractor must realize that responsibility for coordinating the efforts of these subcontractors will usually fall on the contractor that has divided the work. Efforts to avoid this responsibility through the use of subcontract disclaimers may not be effective because the necessary authority is not clearly and expressly delegated to make the assignment of responsibility effective.

C. Payment Obligations

The prime contractor’s obligation to make progress payments or pay retainage to the subcontractor before the prime receives corresponding payment from the owner can be fraught with problems and lead to significant disputes. At the outset, the terms and conditions of payment should be clearly and unambiguously set out in the subcontract agreement. Industry form subcontracts may provide a model for such payment terms.

Section 11.3 of the AIA Standard Subcontract Form of Agreement (AIA Document A401 (2007 ed.)) provides that if the prime contractor does not receive payment from the owner for any reason that is not the fault of the subcontractor, the prime contractor shall, upon demand, pay the subcontractor the amount computed for the progress payment in accordance with the subcontract. This provision places the risk of nonpayment by the owner on the prime contractor. Subsection 8.2.5 TIME OF PAYMENT of ConsensusDocs 750 (Standard Agreement between Constructor and Subcontractor) similarly places the risk of nonpayment by the owner on the prime (general) contractor. Both of these industry documents reflect an allocation of the risk of nonpayment consistent with the rationale that the prime (general) contractor is in the best position to evaluate both the owner’s willingness and ability to pay for the work within a reasonable period of time.17

In contrast, “pay-when-paid” and “pay-if-paid” clauses seek to place the risk of nonpayment for work on the subcontractor or supplier. Case law and statutory law vary significantly from jurisdiction to jurisdiction regarding the interpretation and subsequent enforceability of contractual “pay-when-paid” and “pay-if-paid” clauses. In drafting or reviewing contracts, it is imperative to be familiar with the law in the applicable jurisdiction regarding treatment of these types of payment clauses. It is also important to understand the differences between these payment provisions.

1. Pay-When-Paid Clauses

A pay-when-paid clause generally obligates the prime contractor to make payment to the subcontractor when it is paid by the owner or within a reasonable time period after receipt of corresponding payment from the owner. One example of a pay-when-paid clause is: “The total price to be paid to subcontractor shall be $…no part of which shall be due until five (5) days after owner shall have paid contractor therefor…”18 The variations on this theme are almost unlimited. In spite of this clause, the prime contractor in the Thomas J. Dyer case was not released from its payment obligation even though the owner filed bankruptcy before final payment. The court in that case held that the payment clause failed to express that the parties’ intent was to shift the risk of the owner’s nonpayment from the general contractor to the subcontractor.

a. The Case against the Pay-When-Paid Clause

There are a number of reasons why the pay-when-paid clause should not be applied to excuse payment under all circumstances. First, the intent of the parties must be examined. In most cases, the subcontractor is not in privity of contract with the owner, and usually has no opportunity to deal directly with the owner in the proposal or bid phase or at any time during performance. The subcontractor looks to the general contractor for coordination with other trades and for use of site facilities, for scheduling, for interpretation of the plans and specifications, and for payment for the work. If the parties intend that the subcontractor will look only to the owner for payment, that intention must be clearly expressed in the subcontract.

Second, the payment clause in the subcontract must be examined. Look for specific circumstances mentioned in the subcontract, such as the delay of progress payments because of default of the subcontractor in the AIA A401 contract, or a reference to the owner’s insolvency as a condition excusing nonpayment. If the payment clause deals with the amount, timing, method of payment, and other essential provisions, without reference to specific conditions excusing payment, then a court will likely decide that payment to the subcontractor is not conditioned on payment from the owner under all circumstances.19

Some courts have found that wording which fails to explicitly state that the parties to the agreement meant to shift the risk of the owner’s nonpayment to the subcontractor simply means that the prime contractor must pay the subcontractor in a reasonable period of time.20 As one court stated, “if such was the intention of the parties it could have been so expressed in unequivocal terms.”21 Accordingly, many courts have held that pay-when-paid provisions are unenforceable as against public policy when they require a subcontractor to wait indefinitely or forgo payment under circumstances that the subcontractor cannot control.22 Finally, a number of states have enacted statutes that declare these clauses to be unenforceable under mechanic’s lien laws or as a matter of public policy.23 When undertaking to perform work in a new jurisdiction, it is important for both the prime contractor and the subcontractor to determine how payment clauses are interpreted in that state. The fact that two states share a border does not mean that payment clauses will be interpreted and enforced in the same way.

b. The Case for the Pay-When-Paid Clause

Some states have taken a stance more favorable to the prime contractor and upheld a subcontract payment provision making the owner’s payment to the prime contractor a condition precedent to the prime’s obligation to pay the subcontractor for work performed.24

As an example, a prime contractor was excused from the obligation to pay until it had received payment when the subcontract provided: “[P]ayments will be made [to the subcontractor] from money received from the owner only and divided pro rata [among] all approved accounts of subcontractors, labor and materials.”25 This payment clause set up a fund consisting of money received from the owner, out of which subcontractors were to be paid, and made the fund the only source from which the subcontractors were to be paid. This provision was enforced as a pay-when-paid clause, relieving the prime contractor of the obligation to advance monies for progress payments to the subcontractor, because it showed the intent of the parties that the subcontractors’ payments were to come only from the fund created by payments from the owner. The subcontractors were not relying on the prime contractor’s credit for payment.26

2. Pay-If-Paid Clauses

In an effort to avoid making payments to subcontractors even though payment has not been received from the owner, some prime contractors include a provision in their subcontracts making payment by the owner a “condition precedent” to the prime’s obligation to pay its subcontractors.27 Such a provision is referred to as a “pay-if-paid” clause, under the theory that the contractor’s payment obligation only arises if it is paid by the owner. To be enforceable, such a contract payment provision must clearly show that the express condition is the mutual intent of the parties and that the parties recognize that payment may not be received from the owner so that the subcontractor assumes this risk as a part of the negotiated contract.28 The arguments for or against a “pay-if-paid” clause are essentially the same as those set forth above in the discussion of “pay-when-paid” clauses.

Several courts recently have held that a subcontractor still may seek payment from a prime contractor, even with a valid pay-if-paid clause, when the contractor prevented the condition precedent from occurring. This is known as the Prevention doctrine.29 For example, in the Northeast Drilling case, the prime contractor’s subcontract contained a valid pay-if-paid clause. The prime contractor failed to submit change order requests for additional work that the subcontractor had performed. As a result, the owner never paid the prime contractor for the additional work the subcontractor had performed, and the prime contractor never paid the subcontractor. The court found that the prime contractor’s actions in failing to submit the change order requests prevented the prime contractor from using the pay-if-paid defense during the subsequent nonpayment action brought by the subcontractor.

3. Changes to the Payment Terms Must Also Account for the Surety

After the subcontract is signed, there remains a potential for problems in the implementation of the agreement. The obvious problems are caused by a delay in payment or a dispute over the amounts earned for progress payments or for extra work. Careful draftsmanship and thoughtful consideration in advance will provide the parties with contract terms to measure and guide their performance. The subcontractor and prime contractor may find, however, that unexpected circumstances during performance may require a change in their expected payment procedures. Unexpected results may follow if the parties’ actions to accommodate the new circumstances are not carefully considered. For example, the prepayment of a subcontractor may discharge the subcontractor’s performance bond surety from liability. If a subcontractor falls behind schedule and is financially unable to increase its workforce to regain the lost time, the prime contractor may consider prepaying the subcontractor to finance the additional crews needed to regain the schedule while expecting to deduct the amounts advanced from later progress payments.

In one case, a prime contractor agreed to this arrangement but failed to obtain the approval of the subcontractor’s payment and performance bond surety.30 When it sued the surety for the amounts prepaid to the subcontractor, the surety defended on the basis that the prepayments materially altered the subcontract and operated to discharge the surety from its obligations.31 The prime contractor’s payment bond surety may take the same position if the prime contractor is in default of its payment obligations after agreeing to alter the payment terms of its contract without obtaining the surety’s prior consent.

Some courts require that a surety show injury or prejudice in addition to a material alteration of the contract in order to be discharged from bond obligations.32 The lesson for all parties is that payment terms must be considered carefully when initially entering into the contract, and any change in those terms must be reviewed for its impact on the present obligations between the parties and the rights and obligations of sureties and other payment guarantors that may be affected.

D. Subcontractor Termination

1. The Right to Terminate

a. Express Termination Rights (Default Clause)

Virtually all construction contracts expressly recognize the right to terminate the contract upon the default of either party under certain circumstances. These provisions also recognize the right of the non-defaulting party to recover damages flowing from the default and resulting termination. For example, Section 7.2.1 of AIA Document A401 (2007 ed.) provides that the contractor may terminate the subcontractor upon 10 days notice if the subcontractor “repeatedly fails or neglects to carry out the Work in accordance with the Subcontract Documents or otherwise to perform in accordance with this Subcontract.”33

Similarly, subsection 10.1.1 of ConsensusDocs 750 sets forth the following initial steps in the termination process:

NOTICE TO CURE A DEFAULT If the Subcontractor persistently fails to supply enough qualified workers, proper materials, or equipment, to maintain the Progress Schedule, or fails to make prompt payment to its workers, subsubcontractors, or suppliers, or disregards Laws or orders of any public authority having jurisdiction, or otherwise is guilty of a material breach of a provision of the Agreement, the Subcontractor shall be deemed in default of this Agreement. If the Subcontractor fails within three (3) Business Days after written notification to commence and continue satisfactorily correction of the default with diligence and promptness, then the Constructor shall give a second notice to the Subcontractor and its surety, if any to correct the default within a two (2) Business Day period. If the Subcontractor fails to promptly commence and continue satisfactory correction of the default following receipt of such second notice, the Constructor without prejudice to other rights or remedies, shall have the right to any or all of the following remedies:34

Section 11.02 of EJCDC C-523 (2013) contains a similar statement of the contractor’s right to terminate the subcontractor for performance failures. All three industry form subcontracts also expressly set forth the grounds for nonpayment by the contractor that entitle the subcontractor to terminate the contract with the prime contractor.

b. Implied Termination Rights

Even in the absence of an express termination provision, there generally exists an implied right to terminate a contract and sue for damages if the other party has materially breached the contract. It is nonetheless important that the prime contractor have the right to terminate a subcontract (and that a subcontractor be able to terminate a sub-subcontractor’s right to proceed) under certain circumstances, and this right must be spelled out in detail, with notice requirements and cure rights specifically delineated.

c. Alternatives to Termination

The subcontract termination clause should provide flexibility to the prime contractor, so that the extreme act of termination is not the contractor’s only option in dealing with a subcontractor’s default. The subcontract must expressly reserve the prime contractor’s right to pursue alternatives in lieu of termination, such as paying the subcontractor’s suppliers and subcontractors or supplementing the subcontractor’s workforce. A termination for default is the construction industry equivalent of capital punishment. It is an option not to be invoked lightly, and only after careful consideration of other options.

Although the discussion that immediately follows focuses on the prime contractor/subcontractor relationship, the principles stated apply equally to a subcontractor/sub-subcontractor agreement. Likewise, some of the options to termination are discussed in the Default Clause Checklist, in Section II.D.2 of this chapter.

d. Consequences of Improper Termination

Whether the subcontractor was actually in default at the time of termination is usually a fact question. The facts will determine the propriety of the termination. If the termination was proper, then the prime contractor will be entitled to damages, including the cost of completion; if improper, then the subcontractor may recover as damages the profit it would have received if allowed to complete the work. If there would be no profit pursuant to the subcontract, the subcontractor may recover damages based on an equitable theory of value of goods or services provided (quantum meruit) basis. If the subcontract contains only a “termination for default” option, the prime contractor may be exposed to significant subcontractor claims if the termination is later deemed improper, even if the prime contractor acted with a good-faith belief that the termination was justified.

2. Considerations in Drafting Subcontract Default Clause

Some of the considerations that should be addressed when drafting or reviewing a subcontract default clause are set out in the following checklist. Use this checklist to determine if and how the subcontract addresses major issues in a default situation: