This article was written for the ConsensusDocs newsletter and first appeared here

During a construction project, it is not uncommon for disputes to arise between a general contractor and a subcontractor.  Frequently, these disputes involve claims for extra work and delay damages that can be attributed to the owner of the project due to deficient design or unforeseen conditions.  When these occasions arise, the parties can often resolve these claims without the need for litigation or arbitration by entering into a “liquidating agreement.”

What is a Liquidating Agreement?

Because there is no direct contractual relationship between a subcontractor and an owner, there does not exist a legal basis for a subcontractor to assert a breach of contract claim against a project owner.  In legal parlance, this is known as “lack of contractual privity.”  A liquidating agreement bridges this contractual gap and allows a subcontractor to pass its claim against the owner through the general contractor.  Essentially, with a liquidating agreement, the general contractor acts as a conduit for passing through the subcontractor’s claim.

How the Courts Treat Liquidating Agreements

Liquidating agreements have traditionally been upheld by the New York courts, which have permitted a general contractor to prosecute a subcontractor’s claim against the owner.  There is no set form that a liquidating agreement has to take.  Some courts have recognized that a liquidating agreement can be comprised of several documents written over a period of time.  Nonetheless, it is important to note that a pass-through provision or a liquidating agreement is something that must be clearly spelled out in the parties’ contract or by a separate agreement.  A general incorporation by reference provision of the owner’s contract in the subcontract usually will be insufficient to establish a valid liquidating agreement.  Similarly, a provision in the subcontract that defers the general contractor’s obligation to pay until payment is received from the owner, (i.e., a “pay-when paid” or a “pay-if-paid” clause) also will likely not be deemed to be a valid liquidating agreement.  In order to be enforceable, the courts of New York have held that a liquidating agreement must:

1. Impose liability upon a party (i.e., general contractor) for a third party’s; (i.e., subcontractor) increased cost, and provide the first party with a lawful basis for legal action against the party at fault (i.e., owner);
2. Liquidation of liability in the amount of the first party’s (general contractor) recovery against the party at fault (owner); and
3. A provision for the pass-through of that recovery to the third party (i.e., subcontractor).

When to Enter Into a Liquidating Agreement

“Pass-through provisions” which are similar to liquidating agreements can be included in the  subcontract at the time the parties enter into their agreement.  You may think of a “pass-through provision” as a mini liquidating agreement that typically is not as comprehensive as a stand-alone liquidating agreement.

Liquidating agreements are often entered into separate and apart from the subcontract after a dispute has arisen and there is the absence of a well-defined pass-through provision in the subcontract.  Including a pass-through provision in a subcontract and entering into a separate liquidating agreement with a subcontractor at a later point in time both have their pluses and minuses.  Having a pass-through provision agreed to early on in the parties’ relationship provides the general contractor with a certain amount of security and leverage with the subcontractor in the event that a dispute arises.  Conversely, the general contractor should recognize that it has now undertaken the responsibility to pass through the subcontractor’s claim to the project owner.  A subcontractor’s claim that is poorly documented or factually inaccurate may cause the owner to develop a poor opinion of any claim of the general contractor that may be submitted along with the subcontractor’s claim.

These potential pitfalls could be avoided by waiting until a dispute arises before entering into a liquidating agreement.  In doing so, the general contractor will likely have a better understanding of the subcontractor’s claim and be able to make a more informed decision about whether to enter into a liquidating agreement.  On the other hand, by waiting to enter into a liquidating agreement, the subcontractor’s position may become so entrenched and the parties so adverse that forming a liquidating agreement becomes an impossibility.  Experience has demonstrated that a better course of action from a general contractor’s perspective is to have a comprehensive pass through provision in the subcontract that clearly identifies that the subcontractor’s recovery will be limited by whatever recovery the general contractor receives from the owner.

Benefits of a Pass-Through or Liquidating Agreement

One of the chief benefits of entering into a liquidating agreement is that such agreements avoid a subcontractor’s dispute being litigated or arbitrated during the same time that a general contractor may be in a battle with the project owner.  The avoidance of having simultaneous suits  prevents the circumstance where a general contractor is taking a position with an owner that may negatively impact its position with a subcontractor, or vice versa.  By including the subcontractor’s claim with the claim of the general contractor as part of a liquidating agreement, the general contractor is maximizing or preserving the value of its claim, along with the value of the subcontractor’s claim.  Another added benefit of a liquidating agreement is that it defers resolution of any disputes with the subcontractor until disputes with the owner are resolved.  At the end of the day, a pass-through provision or liquidating agreement is one of the best tools for avoiding inconsistent results and conflicting liability with the subcontractor and the owner.

Central Elements of a Liquidating Agreement

Liquidating agreements, like all other contracts, are subject to negotiations between the parties. In order for a liquidating agreement to adequately protect the interest of the general contractor, it should contain the following elements:

1. It should state that the general contractor will pursue the subcontractor’s “reasonable” claims against the owner;
2. The general contractor does not verify the subcontractor’s claim;
3. The subcontractor will reasonably assist, at its own costs and expense, with its claim;
4. The subcontractor will be bound by any determination that is binding upon the general contractor with respect to the subcontractor’s claim; or
5. At the very least, the subcontractor will not commence suit or arbitration against the contractor until any dispute with the owner is resolved;
6. Any suit or arbitration that the subcontractor is permitted to commence or has commenced will be stayed pending the resolution of the dispute with the owner;
7. Any proceeds of any proceedings against the owner will be distributed between the contractor and the subcontractor on a basis that is set forth in the liquidating agreement; and
8. The agreement should provide that the general contractor has the sole authority and discretion to settle the subcontractor’s claim.

Closing Thoughts

The importance of having a well written pass-through provision in a subcontract or separate stand-alone liquidating agreement in place with a subcontractor cannot be overstated.  While not a total guarantee that such agreement will prevent litigation with a subcontractor, they substantially reduce the likelihood of such disputes taking place.

For more information, please contact Gerard Onorata.