The Top Five Do’s And Don’ts of a Subcontractor Pass Through Claim
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An all too common situation on construction projects involves subcontractor claims for additional costs caused by the owner. These can often involve differing site conditions claims, claims related to design errors or omissions by the owner’s design professionals, or owner-caused delays. In these instances, the subcontractor has no direct contractual relationship with the owner by which to assert its claim directly against the owner. Because a subcontractor does not have the legal right to pursue its claim for additional costs from the owner directly, in order to recover from the owner, a subcontractor must instead do so via a “pass through claim” through the prime contractor to the owner, without violating the Severin doctrine, and addressing four other crucial factors.
What Is A Pass Through Claim?
In the pass through claim scenario, the prime contractor asserts the subcontractor’s claim against the owner on the subcontractor’s behalf, with the costs of pursuing the claim and any recovery to be allocated between subcontractor and contractor by agreement. Depending on the significance of the claim, successful pursuit of a pass through claim can be the difference between a project that is profitable and one that is a financial disaster. While pass through claims are common in the construction industry, particularly on government projects, there are a number of important issues that need to be taken into account to try to maximize the ability to successfully pursue a pass through claim.
Key Pass Through Claim Do’s And Don’ts
1. Do document the agreement
It is important to document the manner in which the pass through claim will be pursued in a written agreement between the subcontractor and prime contractor. This is important to ensure that the subcontractor has the legal right to enforce the contractor’s obligation to pursue the pass through claim on its behalf, and to try to avoid later disputes by addressing up front in the agreement how potential issues that may arise will be handled. This type of agreement is commonly referred to as a “liquidation agreement” by which the subcontractor and prime contractor settle (or liquidate) the claim as between themselves, and document the manner in which they will pursue the pass through claim against the owner.
2. Don’t violate the Severin doctrine
One of the most critical aspects of a liquidation agreement for pursuit of a pass through claim is that the agreement must be structured in a way to avoid application of the Severin doctrine, which can completely negate a pass through claim. The Severin doctrine is named after the case of Severin v. United States, 99 Ct. Cl. 435 (1943), which involved a prime contractor’s attempt to assert its subcontractor’s claim on a pass through basis to the government. However, the underlying subcontract provided that the prime contractor would not be held liable to the subcontractor for any delay or damages caused by the owner. Based on that subcontract provision, the court ruled that the prime contractor could not recover from the government on the subcontractor’s pass through claim because the subcontractor had waived the right to recover from the contractor for the owner-caused delay in the underlying subcontract. In other words, because the prime contractor had no obligation to the subcontractor for the owner-caused delay, the prime contractor had no claim to pass through to the government in the first instance.
The key to avoiding application of the Severin doctrine is that the subcontractor must not completely release the prime contractor from the subcontractor’s claim. Instead, the liquidation agreement must include a provision making clear that the prime contractor will remain liable on the subcontractor’s claim, even if only to the extent of the prime contractor’s recovery from the government on the claim. If the prime contractor is released entirely from the subcontractor’s claim, the Severin doctrine is likely to apply to bar the pass through claim.
3. Do make clear who prosecutes and who pays
Another key element of a pass through claim is how and by whom it will be presented and prosecuted against the owner, and who will bear the costs of doing so, including attorney’s fees and expert costs. The liquidation agreement should clearly identify how and by whom the dispute will be primarily presented. For example, the claim may be presented and prosecuted by the prime contractor as part of its other claims against the owner, with the contractor largely in control of the prosecution of the pass through claim. Or, the claim may be presented by the prime contractor in name only, but with the subcontractor solely responsible for the actual presentation and prosecution of the claim against the owner. As part of these negotiations, consideration should be given to an effort to clearly spell out each party’s role and responsibilities in connection with the pass through claim presentation.
As part of that, it is an unavoidable fact that most construction claims of significance require the assistance of attorneys and experts to most effectively pursue the claim. Whether the responsibility for such fees and costs is the sole responsibility of each party, is based on some sort of ratio of claim amounts, or is based on some other understanding, the liquidation agreement should address the responsibility for these fees and costs between the parties on the front end to avoid the potential for significant disputes later on in the process.
4. Do identify who has the authority to settle
Another key area that should be addressed is the authority to settle the pass through claim. Sometimes the prime contractor may retain the sole right to settle the claim, with the subcontractor to be bound by the decision unless it was made in bad faith. Other times, the subcontractor may retain the right to approve any settlement, or the right to otherwise dispute the decision before it is finally made by the prime contractor. From the subcontractor’s perspective, it is important to try to retain at least some approval right on settlement, particularly if the subcontractor is funding the attorney’s fees and costs for prosecution of its pass through claim. This may not always be possible, however, as the prime contractor is likely to want to retain final authority in order to retain its ability to agree to a reasonable total contract close-out offer by the owner and not be held up by a particular subcontractor claim. Because most disputes settle at some point prior to trial or final arbitration hearings, this is a key area that must be negotiated and addressed in the liquidation agreement as chances are it will come into play at some point in the process.
5. Do clearly address the allocation and payment of any recoveries
As important as the allocations of costs and the right to settle, is the manner in which any recoveries on the pass through claim will be allocated and when they will be paid. This is especially important where the subcontractor’s pass through claim will be presented among a number of other prime contractor direct claims and/or other subcontractor pass through claims. From the subcontractor’s perspective, it is important in such a situation that the prime contractor have the obligation to present the subcontractor’s pass-through claim distinctly from its own claims or other subcontractor pass-through claims to better allow for identification of recoveries specific to the subcontractor’s claims. In the absence of a judgment or arbitration award that makes allocations by claim, it can be difficult to determine what portion of the judgment or award is attributable to the subcontractor’s claim. As a fall back in such situations, a ratio of recovery based on the percentage of the subcontractor’s claim to the total claim may be an alternative. It is also important to spell out when the prime contractor’s obligation to pay the subcontractor arises, whether at the time of judgment or arbitration award, or whether only after actual collection of monies on the judgment or award. Again, these issues should be addressed in the liquidation agreement to try to avoid later disputes regarding the allocation and payment of recoveries.
As can be seen, there are a number of critical issues that should be addressed to try to maximize a subcontractor’s ability to successfully pursue a pass through claim against a project owner. While this blog identifies and highlights certain of the key issues, because the law varies in different jurisdictions (with some states more hostile to pass through claims than others), and the specific facts and circumstances of a particular project are always important, an experienced construction law attorney should always be consulted in connection with the pursuit of specific pass through claims.