March 22, 2021 Construction Law 101

Liquidating Agreements: Bridging a Contractual Gap

Peter K. Doely

When something goes wrong on a construction project, the parties must determine not only who should answer for it, but they must address the Gordian knot of how to make them do so. The responsible party may not necessarily have direct contractual obligations to the party who suffered from the issue, and that may stymie an otherwise justified recovery. Commonly, this is a subcontractor which suffered from an owner's actions. In order to remedy this situation, the subcontractor may enter into a liquidating agreement with an intermediary party which can assert a claim on its behalf-allowing the subcontractor to recover, compelling the owner to pay, and keeping the party in the middle (relatively) unscathed.

The Issue: Lack of Privity

On a construction project there is a tangle of contracts which lay out the various parties' rights and obligations. While project delivery methods (and correlated contractual arrangements) come in various forms, two common methods are design-bid-build and construction manager at risk. For each of these delivery methods, one entity - a general contractor or a construction manager (CM) - will enter into a contract with the owner of the project. The general contractor or CM will then separately enter into subcontracts with various subcontractors.

The owner's actions during construction of the project may impact a subcontractor. For example, if the owner provides the wrong structural steel design, that error may cause additional costs for the steel subcontractor. Or there may be an event for which the owner is responsible which impacts a subcontractor such as flooding due to a differing site condition that may cause additional costs for the excavation subcontractor.

In these scenarios, the subcontractors incurring additional costs lack privity of contract with the owner, the party ultimately responsible for those costs. So, although the owner has harmed the subcontractors, they cannot assert a breach of contract claim directly against the owner.

The Solution: the Liquidating Agreement

In order to seek recovery for such claims, the subcontractor may enter into a liquidating agreement with the general contractor.  The general contractor will then pursue the "pass-through" claim on the subcontractor's behalf. A liquidating agreement lays out how a pass-through claim will be pursued. As explained by one court:

Liquidating agreements have three basic elements: (1) the imposition of liability upon the general contractor for the subcontractor's increased costs, thereby providing the general contractor with a basis for legal action against the owner; (2) a liquidation of liability in the amount of the general contractor's recovery against the owner; and, (3) a provision that provides for the "pass-through" of that recovery to the subcontractor.<\/blockquote>

In addition to the basic elements, liquidating agreements can-and should-address other rights and obligations between the parties. For example, they should address: how to allocate responsibility for prosecuting the pass-through claim, including settlement, trials, and appeals; how the parties will pay for attorneys' fees or other costs; how the parties will share any recovery; how to handle any counterclaims; and, indemnification.

The Place: A Settlement Agreement or in the Subcontract

Liquidating agreements are commonly negotiated after a dispute arises as a type of settlement agreement. In entering into the agreement, the subcontractor and general contractor seek to avoid duplicative litigation/inconsistent results and focus their energy on pursuing the party ultimately responsible: the owner. In addition, the parties can craft the agreement so that it caters to the particular pass-through claim at issue and other circumstances surrounding the dispute (such as accounting for the general contractor's own, related claims against the owner).

Alternatively, parties can include a liquidating agreement in their subcontract before a dispute even arises. In such a situation, the liquidating agreement is more exculpatory in character. One should not assume that a subcontract will contain a liquidating agreement, but, when one is included, it is likely found in the dispute resolution or changes provisions. Liquidating agreements in subcontracts need not be lengthy, provided the basic elements are present. The following is one example, though others abound:

Subcontractor's right of recovery arising from acts of Owner shall be limited to that amount which is recovered from Owner. Contractor shall not be liable to Subcontractor for any amount except those paid to Contractor by Owner for Subcontractor. Subcontractor waives any right to further payment arising out of the acts of Owner, other than to the extent that Contractor may receive amounts from Owner on behalf of Subcontractor, which amounts shall be paid to Subcontractor.<\/blockquote>

The parties may, however, find augmentation necessary to add or fine-tune specific terms after a dispute arises.

The Warning: the Severin Doctrine

While a liquidating agreement is an efficient mechanism for relief, the parties need to be aware of potential issues. Liquidating agreements were, in fact, developed in order to address a limitation on recovery now known as the Severin doctrine from the case Severin v. United States. Under this doctrine, if the general contractor has no liability to the subcontractor for the owner's actions (because, for example, there is a no damages for delay clause in the subcontract or the claim was unconditionally released), the general contractor cannot pursue a claim against the owner on behalf of the subcontractor. So, the subcontractor should make sure that the general contractor remains liable to the extent that the general contractor makes any eventual recovery from the owner. The subcontractor could include, for example, the following: Contractor is liable to Subcontractor for its damages but only to the extent Contractor receives payment from Owner for Subcontractor's damages.

Conclusion

Liquidating agreements can overcome legal hurdles to recovery and provide effective relief for subcontractors on a project. In crafting such an agreement, the parties must ensure that they include the basic elements so their agreement is effective, and they should carefully specify how to otherwise allocate costs, responsibilities, and recoveries.

Entity:
Topic:

Peter K. Doely

Maslon LLP, Minneapolis, MN, Division 9 (Subcontractors and Suppliers)