Contractor’s Failure to Timely Submit Claims as Committed in Pass-Through Agreement Results in Direct Liability to Subcontractor Beyond Subcontract Terms

Construction and Procurement Law News, Q2 2019

Firm Alert

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A recent opinion issued by a trial court in New York, Rad and D’Aprile, Inc. v. Arnell Construction Corp., demonstrates the risks of a general contractor’s failure to pursue a subcontractor’s claims pursuant to a pass-through, or liquidating, agreement between the parties.

In 2001, prime contractor Arnell Construction Corp. (“Arnell”) entered into an agreement to build two sanitation garages in Brooklyn for New York City’s Department of Sanitation. Arnell subcontracted the masonry work to Rad and D’Aprile, Inc. (“Rad”). Rad’s commencement of work was delayed because the City had not yet obtained ownership or access to the entire site. Once work began, Rad’s work continued to be impacted by the City’s site access restrictions. Rad notified Arnell of a claim for delay and inefficiencies in the performance of work, and requested additional compensation under the subcontract.

Rad’s subcontract contained a no-damages-for-delay provision. Nevertheless, in 2002, Arnell sent a letter to Rad confirming Arnell would increase Rad’s subcontract price by $100,000, and that Rad’s “additional costs, due to delays,” would be incorporated into Arnell’s claim to the City. Rad prepared its nearly $2.1 million claim in coordination with Arnell, and submitted it formally to Arnell in October 2005. Rad continued to ask Arnell about the status of its claim from 2006-2008, and Arnell continued to tell Rad that the claim was being reviewed by the City. In fact, after the project was completed in December 2007, Arnell waited three years – until December 2010 – to assert its $15 million claim to the City. Arnell’s claims were dismissed as beyond the prime contract’s six-month statute of limitations provision.

During Arnell’s appeal of the dismissal, in 2013 Arnell and the City reached a settlement for a substantial discount on Arnell’s claims. Arnell received approximately $3.6 million, consisting of its prime contract balance and the release of security in lieu of retainage. Arnell’s settlement included dismissal with prejudice of all other claims – including Rad’s claim. Arnell did not inform Rad of the settlement. In 2014, Rad brought an action against Arnell alleging Arnell breached the subcontract, breached its fiduciary duty to pass Rad’s claims through to the city, breached its duty of good faith and fair dealing with respect to the pass-through claims, and owed Rad under the theory of quantum meruit.

After filing its action, Rad learned of Arnell’s settlement with the City. Rad then amended its action, alleging breach of the subcontract as well as Arnell’s letter promising to pass Rad’s claims through to the City. The court dismissed Rad’s claims of breach of contract and breach of fiduciary duty as untimely and barred by New York’s statutes of limitation. The court also dismissed Rad’s claim under the theory of quantum meruit because the claims arose under a valid and enforceable subcontract, but were time-barred.

However, the court granted summary judgment in favor of Rad’s claim for breach of the duty of good faith and fair dealing by Arnell. The court found that (1) Arnell’s pass-through letter to Rad was a liquidating agreement (also known as a pass-through agreement) that required Arnell to take proper steps to protect and assert Rad’s claim to the City; (2) the letter created a new, separate and later-dated agreement between the parties, overriding the no-damages-for-delay provision in Rad’s subcontract; and (3) Rad’s claim of breach of the duty of good faith and fair dealing by Arnell was timely, because it only accrued after the statute of limitations on Arnell’s claims against the City expired without Arnell appropriately asserting Rad’s claim pursuant to the pass-through agreement.

As a result, the court held that Arnell’s breach of the covenant of good faith and fair dealing “by failing to timely present a subcontractor’s claims to the owner, pursuant to the liquidating agreement, will result in a general contractor’s liability for the subcontractor’s full damages.” Rad was therefore entitled to seek its full damages based upon Arnell’s breach.

The Rad and D’Aprile opinion provides valuable lessons for general contractors seeking to limit liability against subcontractors, and for subcontractors seeking to preserve their right to assert entitlement to damages for owner-caused delays. General contractors often use pass-through, or liquidating, agreements as an effective solution to resolve subcontractor claims. They are also often included in the subcontract via a disclaimer to pay any subcontractor claims arising from owner actions, but only to the extent paid by owner, and agreeing that the contractor will in good faith present a valid claim to the owner on the subcontractor’s behalf. Pass-through agreements provide the benefit of aligning the general contractor and the subcontractor’s interests in pursuing a claim against an owner, allowing the general contractor and subcontractor to productively collaborate in the assertion of a strong claim against the owner.

Pass-through agreements are not, however, without risk. Notably in the Rad and D’Aprile action, the court held that Arnell’s pass-through agreement superseded and modified Rad’s subcontract terms by promising to pursue recovery for Rad’s “additional costs, due to delays.” This indicated, “independently of the subcontract, that Rad’s delay damages would be paid to Rad in this manner.”

Of course, the general contractor should reasonably pursue the subcontractor’s claim according to the pass-through agreement – something Arnell clearly failed to do, both by misleading Rad as to the status of the claim submission and by allowing its claims against the City to become time barred. Once a general contractor agrees to pass through a subcontractor’s claims to the owner, the general contractor would be wise to communicate with (and even, in some circumstances, include) the subcontractor in its claim and settlement negotiations. A pass-through agreement can provide the general contractor a powerful tool in the form of subcontractor support and assistance, both in preparation for and prosecution of claims against the owner, and it is usually in the general contractor’s best interest to leverage this subcontractor support.

General contractors should use caution when negotiating a pass-through agreement to protect against any argument that the pass-through agreement binds the general contractor to additional substantive obligations above and beyond the terms of the subcontract.

For subcontractors, Rad’s experience offers a valuable lesson in preserving the right to assert claims pursuant to a pass-through agreement. First, a subcontractor should understand the general contractor’s deadline to submit claims under the prime contract, as the contractor’s deadline will be a key factor in the subcontractor’s potential recovery. Second, a subcontractor should confirm and verify with the general contractor that the subcontractor’s claim has been received and included in the general contractor’s submission to the owner. And third, a subcontractor should consider whether to assert a formal claim against a general contractor prior to the expiration of the applicable statute of limitations on subcontract claims, to avoid the expiration of statute of limitations deadlines pending resolution of pass-through claims.

Pass-through agreements can be a useful and productive form of dispute resolution on construction projects. That said, general contractors and subcontractors should be aware not only of their benefits, but also their risks – risks that may be mitigated by careful agreement drafting and sophisticated claims management.