#55: Pass Through Claims
In the law of contracts there is a concept known as “privity,” the direct relationship between parties to the same contract. Thus, an owner and a GC are “in privity,” a GC and a subcontractor are “in privity,” but an owner and a subcontractor are not. In general, to sue someone for breach of contract you must be in “privity of contract” with that person. It follows that a subcontractor cannot sue an owner for breach of contract – or, what amounts to the same thing, for extra compensation under an equitable adjustment provision of the prime contract.
Often an owner's failure to pay for extra work will affect a subcontractor far more than it will affect the GC. A good example is a differing site condition that obliges an owner to pay extra for dealing with ledge, or groundwater, or some unforeseen subsurface problem which will cost the sitework sub a ton of extra money but “cost” the GC only his markup on the sitework sub's extra work. If the owner refuses to pay the extra costs incurred by the sub, the sub cannot sue the owner because of the lack of privity.
In an effort to fix this problem the GC and sub could agree in their subcontract (or later) that the GC will pursue the claim for the sub and then turn over any recovery to the sub. Often the subcontract will also have a “pay if paid” clause providing that the GC doesn't owe any money to the sub except to the extent it collects from the owner. These two agreements seem perfectly consistent – and from the perspective of the subcontracting parties, they are. But from the perspective of the owner, who is not a party to the subcontract, the “pay if paid” clause may mean that the GC has not suffered any damages because the GC literally doesn't owe the sub any money it hasn't collected from the owner – a good defense to the GC's lawsuit!
Before discussing the fix to this dilemma, a bit of history is in order, and specifically the case of Severin v. United States, 99 Ct. Cl. 435 (1943), which held that a GC could not recover damages from the owner on a sub's behalf unless the GC “has reimbursed the subcontractor or is liable to make such reimbursement.” The so-called Severin Doctrine named for this case has been chipped away at over the years “out of reluctance to leave subs with valid claims out in the cold,” Morrison Knudsen Corp. v. Fireman's Fund Ins. Co., 175 F.3d 1221, 1251 (10th Cir. 1999). Nevertheless, the doctrine sill retains some punch. Unless the GC is at least conditionally liable to its sub, the GC has no damages, and thus no pass-through claim to pursue.
The solution comes in the form of a “liquidating agreement,” whereby (1) the GC concedes liability to the sub for the sub's extra costs, (2) the sub agrees that the amount of that liability is equal to the GC's recovery, if any, from the owner, and (3) the GC agrees to pass through that recovery to the sub. Liquidating agreements are "a valid mechanism for bridging the privity gap between owners and subcontractors,” North Moore St. Developers, LLC v. Meltzer/Mandl Architects, P.C., 23 App.Div. 27, 30, 799. N.Y.S.2d 485 (1st Dept 2005). Where they sometimes get tripped up is on the GC's admission of liability to the sub – something that most GC's strive mightily to avoid in the initial subcontract language. For example, a no-damage-for-delay clause in a subcontract, if it releases the GC from liability completely, can bar a pass-through delay claim despite the parties' effort to undo the release after the fact through a liquidating agreement. Harper/Nielsen-Dillingham Builders, Inc. v. United States, 81 Fed. Cl. 667 (2008).
Thus far the New Hampshire Supreme Court has not been called upon to decide whether a liquidating agreement can provide a basis for a pass through claim, but virtually every state to consider the matter has concluded that it does. I expect New Hampshire will follow suit.