Introduction to Pass-Through and Liquidating Agreements
The Pass-Through Claim
As is typically the case in the construction context, the project owner—whether a governmental entity or simply a private property owner—enters into a contract with the prime contractor, who is then responsible for the overall coordination of the project at hand. The prime contractor then hires the various subcontractors to perform specified jobs. The prime contractor thus operates at the center of the owner/prime contractor/subcontractor trio because it alone has contractual privity (meaning a contractual relationship) with both the individual subcontractors and the project owner. Subcontractors, lacking a contractual relationship with the owner, have no privity of contract with the owner, and this fact can prove problematic for a subcontractor who believes they have a claim for damages against the property owner. Indeed, the lack of privity can leave a subcontractor without recourse against the owner, which may cause the subcontractor to seek relief from parties other than those ultimately responsible for the subcontractor’s loss.
Enter the pass-through claim to the rescue. A pass-through claim is a claim:
(1) by a party that has suffered damages;
(2) against a responsible party with whom it has no contract;
(3) presented through an intervening party, such as a contractor, who has a contractual relationship with both. Stated differently, the claim is presented, or “passed through,” by an intervening party who is in privity with both the other parties.
Pass-through claims are premised on the concept that the owner is liable to the prime contractor for harm to the subcontractor. Additionally, the prime contractor’s right of recovery is premised on the fact that they are liable to the subcontractor for harm caused by the owner. Thus, so long as the owner’s actions make both the owner liable to the prime contractor and the prime contractor liable to the subcontractor, a pass-through claim may be asserted.
The practical effect of a pass-through claim is the prevention of inefficiencies that result from the privity doctrine. Without a mechanism by which to avoid this doctrine, the subcontractor would have to sue the prime contractor, who in turn would have to sue the owner. Pass-through claims have been asserted against the federal government, various states, municipalities, and private individuals.
The Pass-Through Agreement/Liquidating Agreement
A pass-through agreement, also called a “liquidating agreement,” is used frequently by contractors and subcontractors in addressing construction disputes. These agreements are in essence a form of settlement agreement in which a dispute between two parties is settled (“liquidated”) based on terms that establish the rights and obligations of the involved parties. What is being “passed-though” in a liquidating agreement is not simply the subcontractor’s claim against the property owner, but also the prime contractor’s liability to the subcontractor on that claim. Such agreements not only contain the prime contractor’s assent to turn over to the subcontractor whatever recovery, if any, it secures from the owner, but they also limit the exposure of the prime contractor to the subcontractor should the pass-through claim fail.
Liquidating agreements facilitate the ability of the prime contractor to present a pass-through claim directly to an owner because the parties will already have established the procedures needed to “sponsor” the subcontractor’s claim and bring it directly against the owner. The prime contractor can either bring the claim personally on behalf of the subcontractor, or the subcontractor can prosecute the claim in the prime’s name. The agreement does not settle the issue of liability or damages between the subcontractor and owner, but merely sets a limit upon recoverable damages once the owner’s liability and damages, if any, are established in court.
The liquidating agreement also implies a covenant of good faith and fair dealing. This covenant requires the prime contractor to take all reasonable steps to protect the subcontractor’s rights to an eventual recovery, if any, from the owner. Courts have interpreted this covenant to mean that the prime contractor has a duty to make a good faith effort to present the subcontractor’s claim in a fair and serious manner.
Pass-through agreements can take many forms. Although oral pass-through agreements have been enforced, a written agreement is much more legally sound. There is no requirement that a liquidating agreement be part of the original subcontract. Rather, “the general contractor may assume liability for pass-through claims of the subcontractor by way of a separate liquidating agreement.” Rad & D’Aprile Inc. v. Arnell Constr. Corp., 2015 NY Slip Op. 25191 (June 5, 2015). That being said, a subcontract agreement is drawn up long before litigation and may not reflect the needs and wants of the parties by the time a claim has presented itself. Thus, a separate agreement that includes a provision iterating the parties’ intent to supersede any conflicting subcontract provisions is advisable. Courts have accepted that a pass-through agreement may alter the rights and obligations of the parties as imposed by the subcontract. HOH Co. v. Travelers Indem. Co., 903 F.3d 8, 12 (1990).
A well-drafted liquidating agreement provides that the subcontractor will release (liquidate) all claims it may have against the prime contractor in exchange for the prime contractor’s promise to pursue the subcontractor’s claim against the owner. A well-drafted liquidation agreement will hit upon numerous important points, but it must provide for three basic elements, as noted in Rad & D’Aprile, supra, as follows:
(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.
Why They Are Needed
Pass-through claims and agreements are an efficient and practical way to streamline the litigation process and facilitate the resolution of contractual disputes. Without a liquidation agreement in place, the subcontractor would be obligated to bring its claims directly against the prime contractor, who in turn would have to sue the owner. This arrangement requires the involvement of additional parties, and as a result is expensive, time-consuming, and could erode potential recovery. Pass-through agreements thus provide a vehicle for dispute resolution between a prime contractor and a subcontractor where the parties jointly focus on recovery from the owner.
Liquidating agreements enable the prime contractor and subcontractor to align their common interests in a single claim against the owner instead of litigating amongst themselves and eroding their potential recoveries. The prime and subcontractor can work together in a non-adversarial fashion to present the testimony and documents that support their claim against the owner. This provides both strategic and financial benefit. The benefit to the prime contractor is that it quantifies and contains its liability, and eliminates the chance that the prime will have to engage with litigation or arbitration not only with subcontractor, but also with the owner. The benefit to the subcontractor is that it is able to proceed directly against the owner. A subcontractor with a small claim relative to an over-all project claim may benefit from the greater resources available to a prime contractor while minimizing its own costs. Pass-through agreements also may be useful to the subcontractor where the prime contractor is experiencing financial hardship, or where the subcontractor knows that the prime contractor is not at fault. When parties align to bring claims in a harmonized fashion, there is less of a chance of inconsistent judicial results or recovery. This in turn promotes judicial efficiency. From the prime and subcontractors viewpoint, an additional benefit of pass-through claims and agreements is that it prevents owners from avoiding liability to subcontractors due to the privity “shield.”