Suppose you are working on a large new manufacturing plant. Your estimator studied the architectural drawings to prepare your company's bid. Your estimator is experienced and, having learned an expensive lesson from another job years earlier, made sure to check the mechanical drawings for rooftop penetrations. He took what he could decipher from the mechanical drawings into account when determining the number of penetrations and flashings and their effects on the roof system installation. Your company was the lowest bidder and was awarded the job.
You signed the general contractor's standard subcontract agreement that included a no-damage-for-delay clause, which stated the subcontractor was not entitled to make a claim for additional compensation for delays. Per the subcontract, your remedy in the event you were delayed was limited to a time extension to perform your work.
Once the job was underway, it became apparent there were many more penetrations and more equipment was being installed on and through the roof than were shown on the architectural or mechanical drawings. Your work was affected significantly, making the job far more expensive and requiring more time than estimated.
The general contractor was willing to consider your proposed change order for the direct costs of flashing additional penetrations that were not shown on architectural, mechanical or electrical drawings but nothing else. Citing the no-damage-for-delay provision in the subcontract, the general contractor was unwilling to consider your claim for the additional costs you incurred.
With the benefit of hindsight, you regret signing the contract with the no-damage-for-delay clause and vow you will be more vigilant in the future, but what can you do to reduce the large cost overrun you have experienced?
In a construction context, a liquidation agreement, also referred to as a liquidating or pass-through agreement, is an agreement in which the subcontractor and general contractor agree claims of the subcontractor will be passed through to and sought to be recovered from the building owner either by or in the name of the general contractor.
Although a subcontract may restrict or disallow a claim against the general contractor because of a provision such as a no-damage-for-delay clause, the prime contract between the general contractor and building owner may have no such restriction. And though the subcontractor may not be allowed to make a direct contractual claim against the building owner, the general contractor has a direct contractual relationship with the owner.
Even if there was no contractual barrier in a subcontract, a liquidation agreement can benefit the general contractor and subcontractor. Instead of one suit by the subcontractor against the general contractor and a separate suit by the general contractor against the owner, a liquidating agreement allows for one proceeding in which the subcontractor's as well as the general contactor's claims can be presented.
The U.S. government and many state and local government agencies will, when sued, assert a defense of sovereign immunity, which will preclude prosecution of a claim against the governmental entity unless sovereign immunity has been waived. To have standing to sue the sovereign on a contract claim, the plaintiff must be in privity of contract with the sovereign. A prime contractor can overcome a sovereign immunity defense because the government's contract with the prime contractor acts as the government's waiver of its sovereign immunity defense. A liquidation agreement allows a subcontractor to overcome lack of contractual privity in a similar manner.
Liquidation agreements also decrease the possibility of a general contractor becoming engaged in separate suits with the subcontractor and owner with potentially divergent outcomes.
By avoiding duplicative and overlapping litigation, a liquidation agreement can more efficiently and economically bring a claim to resolution. A liquidation agreement allows a subcontractor to have its claims based on the owner's actions, including design errors, without some of the obstacles that may be presented in the subcontract, such as a provision stating the general contractor is only liable to the subcontractor for additional costs and damages the general contractor recovers from the owner.
A general contractor can limit its liability (and the potential liability of its payment bond surety) by providing its liability is limited to the amount recovered from the owner. A general contractor also can pursue claims against the owner and can mark up the subcontractor's claim. A general contractor can limit its expense by making the subcontractor bear the expense of prosecuting a claim, or the costs of prosecuting a claim can be shared in the manner agreed by the parties.
A liquidation agreement also prevents owners from being shielded from valid claims from subcontractors based on a lack of contractual privity defense.
Although liquidation agreements typically are drafted after execution of the underlying construction contract and after problems on the job and claims have arisen, subcontractors and general contractors should include a provision in their subcontracts that contemplates the potential of a liquidation agreement to pass through subcontractor claims for which the owner is responsible.
For example, a provision could state: "Contractor and Subcontractor agree that in the event the Subcontractor incurs additional expenses or damages which are attributable to the Owner, including damages for delay, loss of efficiency, disruption or due to design errors or extra work required by the Owner, the parties agree to cooperate with each other to recover valid claims from the Owner, including a liquidation agreement if necessary."
In the absence of such a provision, there is no legal obligation on either party to enter into a pass-through agreement. However, a general contractor's unwillingness to enter into a liquidation agreement is likely to lead to a suit by the subcontractor against the general contractor and increases the general contractor's potential liability to the subcontractor.
Bovis Lend Lease LMB v. GCT Venture Inc.
The 2001 case of Bovis Lend Lease LMB v. GCT Venture Inc. involved several subcontractors' claims for delay damages and extra work for additional labor, supervision, equipment and overhead, amounting to more than $4 million performed in connection with the restoration and renovation of New York City's Grand Central Terminal.
Bovis Lend Lease LMB was the general contractor and presented claims on behalf of its subcontractors to the developer, GCT Venture Inc., and the owner, the Metropolitan Transportation Authority (MTA). The defendants filed a motion to dismiss the claim on the basis that Bovis Lend Lease LMB's subcontracts precluded the subcontractors from recovering monetary damages from Bovis Lend Lease LMB for delays MTA caused. The subcontracts included a provision stating a subcontractor's only recourse if delayed was to seek a time extension. The trial court judge granted the defendants' motion, and Bovis Lend Lease LMB appealed.
The Appellate Division, First Department of the New York Supreme Court, reversed the trial court judge's dismissal and allowed Bovis Lend Lease LMB to prosecute the subcontractors' claims based on the liquidation agreement between Bovis Lend Lease LMB and the subcontractors. The appellate division judge said liquidating agreements had three basic elements:
The court went on to state there was no requirement the liquidating agreement must be part of the original subcontract and the prime contractor may assume such liability by way of a separate liquidating agreement.
Bovis Lend Lease LMB alleged it had entered into a liquidation agreement in which it admitted and acknowledged its liability to the subcontractors, liquidated the amount of its liability and obligated itself to recover the subcontractors' claims. GCT Venture and MTA asserted Bovis Lend Lease LMB had no contractual liability to the subcontractors because of the no-damage-for-delay clause in the subcontracts. Bovis Lend Lease LMB presented evidence there were an extraordinary number of extensive design changes and despite the tremendous increase in the scope and nature of the work, GCT Venture and MTA refused to allow any change to the construction schedule.
The appellate division judge stated Bovis Lend Lease LMB apparently assumed liability in a subsequent agreement and there was no reason why Bovis Lend Lease LMB could not have assumed such liability, holding the no-damage-for-delay clause did not prevent Bovis Lend Lease LMB from subsequently entering into the liquidating agreement.
The Severin doctrine is alive
In contrast to the court decision in the Bovis Lend Lease LMB case and many similar cases, some courts have found the Severin doctrine (see "The Severin doctrine") prohibits a general contractor from pursuing a delay damages claim through a liquidation agreement when the underlying subcontract contains a no-damage-for-delay provision.
Harper/Nielson-Dillingham Builders Inc. brought a claim seeking to recover delay damages on behalf of itself and a $770,565 claim of its subcontractor, Karleskint-Crum Inc. for work on a U.S. Air Force base.
The subcontract contained a no-damage-for-delay clause and stated California law governed. In an unusual twist, Harper/Nielson-Dillingham Builders argued the no-damage-for-delay clause should not prevent the subcontractor's pass-through claim because such clauses were not enforceable in contracts with California public entities and were disfavored under California law. The Court of Federal Claims ruled in its 2008 decision the no-damage-for-delay clause insulated Harper/Nielson-Dillingham Builders from any liability to Karleskint-Crum and applied the Severin doctrine to bar pass-through of the subcontractor's claim.
Subcontractors routinely are required to submit progress payment applications, lien releases and change orders that contain language stating the subcontractor waives and releases claims for further payment for work performed through the date of the progress payment or related to the change order.
Subcontractors always should carefully review and, where appropriate, revise the language in a general contractor-drafted progress payment application, lien waiver or change order to be sure to not inadvertently waive or release claims for extra work; unprocessed change orders; delay or impact damages; or retainage by expansive language in the document. A subcontractor signing a payment application or series of payment applications with broad release language has resulted in barring prosecution of a subcontractor's pass-through claim based on the Severin doctrine.
MW Builders Inc. contracted with the U.S. Army Corps of Engineers for construction of an Army Reserve Center in Sloan, Nev. MW Builders subcontracted with Bergelectric to provide a complete electrical system. MW Builders and Bergelectric suffered a 140-day delay, affecting critical activities and hindering their performance because the government did not sign a line extension agreement with the local electrical utility. MW Builders brought a claim against the government under the Contract Disputes Act, and the court ruled MW Builders was entitled to recover from the government for a delay that was unnecessary and unreasonable in duration. Nevertheless, in decisions rendered in October 2017 and March 2018, the Court of Federal Claims ruled there could be no recovery of Bergeletric's claims.
The payment application waivers signed by Bergelectric covered the entire period of compensable delay for which MW Builders and Bergelectric were seeking compensation. In prosecuting their claims, MW Builders and Bergelectric said it was not their intent for the progress payment and lien releases to waive Bergelectric's pass-through claims. However, the court would not consider extrinsic evidence regarding the parties' intentions because the release language was unambiguous and applied the Severin doctrine to bar recovery of Bergelectric's claims.
In the 2017 case Turner Construction Company v. Smithsonian Institution, the court allowed general contractor Turner Construction Co. to prosecute subcontractor claims despite the subcontractors' signing a payment application and lien release. Turner Construction submitted claims on behalf of five subcontractors for about $7 million for work performed in the renovation of the National Museum of American History in Washington, D.C. The standard Turner Construction progress payment release form included language stating the subcontractor represented there were no outstanding subcontractor claims through the date of the current payment application and the subcontractor releases, waives and discharges any and all claims and demands by reason of delivery or material and/or performance of work relating to the project through the pending payment application.
Because the releases were "clearly tied" to each progress payment application, the Civilian Board of Contract Appeals allowed the subcontractor claims to be presented and did not invoke the Severin doctrine.
These cases underscore the importance of carefully checking language in progress payment and lien releases to be certain a release is no broader than covering payment for the referenced work and noting any potential outstanding claims that can be identified at that time.
Provisions to be included
A liquidation agreement should set out in reasonable detail the rights and obligations of the parties, starting with the obligation of both parties to cooperate with each other for the purpose of successfully prosecuting the claims included in the agreement. A liquidation agreement should cover:
In addition to the Court of Federal Claims and the boards of contract appeals that hear contract claims brought against federal agencies, state courts have been called to rule on pass-through claims, particularly in cases involving public projects and state agencies. Virtually every state court that has considered this issue has issued rulings allowing liquidation agreements. State decisions generally have followed federal court decisions and the cases limiting the effect of the Severin doctrine as long as the prime contractor has at least conditional liability to the subcontractor to the extent the prime contractor recovers from the owner for the subcontractor's claims.
Connecticut, in a 1996 decision by its Supreme Court, is the only state with a court decision expressly disallowing liquidation agreements as a vehicle for a party not in privity with a state agency to prosecute a claim against the government based on sovereign immunity grounds. Virginia has only permitted liquidation agreements by statute in contracts with the Virginia Department of Highways and Transportation.
The exact criteria a state court may apply when presented with a pass-through claim varies. Some states may require certain terms to be included in the liquidation agreement for it to be given full effect. Therefore, before consummating a liquidation agreement, the parties should be sure the prerequisites to prosecute pass-through claims in that state have been satisfied and the liquidation agreement has been drafted accordingly.
A useful tool
A well-drafted liquidation agreement can be a useful, effective mechanism for subcontractors and general contractors to use when an owner (or a party for whose actions the owner is responsible) has caused a construction project to be far more costly to complete than planned, resulting in compensable damages and delays suffered by subcontractors and the general contractor.
A liquidation agreement allows the parties to be aligned in seeking recovery from the party who caused their damages rather than being opposed to each other. Subcontractors and general contractors should exercise care when drafting subcontracts, change orders, payment applications, lien waivers and releases so as not to incorporate broad iron-clad release language that could trigger application of the Severin doctrine. All releases should, at a minimum, exclude damages the general contractor can recover from the owner and be conditioned upon the general contractor's prosecution of a subcontractor's claim and liability to the subcontractor for payment received from the owner.
Stephen M. Phillips is a senior partner with Atlanta-based law firm Hendrick Phillips Salzman & Siegel P.C.
The Severin doctrine
Although liquidation agreements are widely used, all contractors must be cognizant of one legal doctrine that has been successfully used, particularly by public owners, to disallow pass-through claims. This legal principle, known as the Severin doctrine, arose from a 1943 decision by the U.S. Court of Claims in the case Severin v. U.S. The Severin doctrine requires a general contractor to have liability exposure to a valid, recoverable claim from the subcontractor to be eligible to prosecute a pass-through claim against the owner.
Severin entered into a contract with the federal government to construct a post office in Rochester, N.Y. Because of a delay caused by the government, Severin's subcontractor was delayed 13 days. Severin sought to recover $702 on behalf of its subcontractor for the subcontractor's field costs, including labor and rental of equipment, $35.10 for the subcontractor's overhead and $73.71 for Severin's overhead. Severin's subcontract included a provision stating: "The contractor [Severin] shall not be held responsible for any loss or delay caused by the Owner or any other cause beyond the control of Contractor or in any event for consequential damages."
Without considering the enforceability of that exculpatory provision, the Court of Claims, which hears claims against the federal government, interpreted the provision as releasing Severin from liability to its subcontractor so Severin had no claim to pass through to the government. Therefore, the court ruled Severin could not recover the subcontractor's damages on behalf of its subcontractor though Severin was able to recover its 10 percent markup on the subcontractor's claim.
If a prime contractor does not have liability to the subcontractor for damages the prime contractor is seeking to recover, the Severin doctrine precludes the prime contractor from obtaining any recovery from the owner for damages sustained by the subcontractor.
Applying the Severin doctrine, an unconditional release executed by a subcontractor in favor of the prime contractor would prevent the prime contractor obtaining any recovery on behalf of the subcontractor from the owner. Applying the Severin doctrine can be thwarted by a provision in a liquidation agreement stating the prime contractor remains liable to the subcontractor for presenting the subcontractor's claims to the government and the recovery obtained from the government. A conditional release, which releases the prime contractor from damages sustained by the subcontractor except to the extent the prime contractor recovers those damages from the owner, usually avoids application of the Severin doctrine. An unconditional or iron-clad release will trigger the Severin doctrine and bar a pass-through claim.
The Severin case holds that when a general contractor has no liability to a subcontractor for the owner's breach of the prime contract, the contractor cannot recover damages on behalf of its subcontractor. The key to a liquidation agreement being an effective vehicle is the prime contractor having potential liability to the subcontractor. If a prime contractor is completely or unconditionally released from liability to the subcontractor, the Severin doctrine applies and the prime contractor cannot recover from the owner. The party relying on the Severin doctrine must prove the doctrine applies. To avoid the Severin doctrine, liquidation agreements are written so the contractor remains liable to the subcontractor at least to the extent of recovery obtained by the contractor from the owner on the subcontractor's behalf.