by Masaki James Yamada is a partner at Ahlers Cressman & Sleight PLLC
Most subcontracts contain some version of what is termed an incorporation by reference, “conduit,” or “flow down” clause. Such a clause incorporates terms of the prime contract between the owner and prime contractor and makes them generally applicable to the subcontract.
Some would consider the flow down/conduit clauses to be different from incorporation clauses. Flow-down clauses typically attempt to align rights and obligations consistently throughout the chain of contracts from the prime to the various lower tiered subcontracts for any particular scope of work. A flow-down clause is essentially a promise by the subcontractor to be obligated to the general contractor the same way the general contractor is obligated to the owner. A flow down clause may read as follows:
It is agreed that Subcontractor will assume toward Contractor all obligations and responsibilities which Contractor has assumed toward Owner under the Main Contract to the extent of the work herein subcontracted, Subcontractor shall be entitled to all privileges and protection granted Contractor by Owner under the Main Contract. AGC of Washington Subcontract ¶A (2002 ed.).
An incorporation by reference provision is generally broader than a flow-down clause. Where a contractor will use the flow-down clause to pass down obligations to lower tiers, an incorporation by reference provision will typically seek to make all rights and obligations between the higher tier parties apply, as a whole, to the lower-tier relationship. An incorporation by reference clause may read as follows:
Subcontractor agrees to perform all such Work in compliance with and under the terms and conditions of the Contract Documents, and the terms, conditions, and requirements of Contract Documents are hereby incorporated into this Subcontract as if fully set forth herein.
While the differences are subtle, both types of clauses are intended to perform two functions: (1) they incorporate by reference the applicable technical provisions of the prime contract which the subcontractor must perform, and (2) impose upon the subcontractor the same rights and obligations the contractor has agreed to with the owner, usually found in the prime contract’s general conditions. The first purpose rarely causes disputes. The second is why these clauses are one of the worst contract terms for subcontractors because it frequently leads to disputes when the subcontract does not address the particular issue, but the general conditions of the prime contract contain a clause addressing that issue.
For example, Sime Construction v. WPPSS, 28 Wn. App. 10, 9621 P.2d 1299 (1980), illustrates some of the problems for lower tier contractors that are presented by incorporation by reference clauses. In Sime, a second-tier subcontractor (Sime) submitted a claim for damages to the first-tier subcontractor arising from the late delivery of revised drawings. The general contractor and first-tier subcontract knew of the delay in delivery of the drawings. Yet, the claim was rejected on the ground that Sime had failed to submit a timely notice of claim as required by the prime contract. The first-tier subcontract contained an incorporation by reference clause incorporating the notice provisions of the prime contract, and the second-tier subcontract contained an incorporation by reference clause incorporating the first-tier subcontract and prime contract.
Sime contended the notice procedures of the prime contract were not incorporated by reference into the sub-subcontract for purposes of the claim caused by the late delivery of the drawings. Sime relied upon the rule that where one contract is incorporated by reference into another for a special purpose, the incorporation is limited to that purpose. The Washington State Court of Appeals disagreed and held the incorporation clause was general and unlimited and, in that situation, both the contract specifications and procedural provisions of the prime contract are incorporated by reference. This obviously poses problems for subcontractors because (1) it means they are required to know all the general conditions and claim procedures of all the upper tier contracts and (2) it does not matter what the subcontract allows or limits, if any upper tier contract takes precedence over the subcontract terms in the event of a conflict (“order of precedence clause”).
Another problem caused by incorporation clauses is the ambiguity over which the claim dispute process is to be utilized. By its very nature, the incorporation clause is intended to impose upon a subcontractor the same liability as the prime has to the owner. This obligation is especially important in the context of disputes in litigation involving the owner, prime, and subcontractor. Unless a prime can insist that the same court or arbitrator decide both the prime-owner dispute and the subcontractor-prime dispute, the intended effect of the incorporation clause may be emasculated by inconsistent results achieved by different forums.
In an extreme case, a literal reading of the incorporation clause may actually deprive a subcontractor of a forum as occurred in 3A Indus. V. Turner Constr., 71 Wn. App. 407, 869 P.2d 65 (1993). 3A Industries involved the State of Washington McNeil Island Corrections Center project, where 3A was a subcontractor to Turner. During the course of the project, 3A filed claim against Turner for damages for delays and interference caused by Turner’s mismanagement of the project. 3A sued Turner’s payment bond pursuant RCW 39.08 (Washington’s “Little Miller Act) and sued to foreclose against the retainage pursuant RCW 60.28.
3A’s subcontract contained no arbitration clause. Turner and its surety moved the court to stay the litigation, asserting 3A was obligated to arbitrate the dispute pursuant to the incorporation clause of the subcontract. 3A argued it did not agree to arbitrate its statutory claims and that the remedies it owed Turner pursuant to the incorporation clause were limited to those relating to the scope, quality or manner of 3A’s performance of work. The trial court agreed with 3A, but the Court of Appeals found that the “rights and remedies” incorporated the subcontract included the duty of 3A to arbitrate its statutory claims with Turner if Turner so demanded.
The Court of Appeals distinguished a long line of Federal Miller Act cases requiring that waiver of the right to sue against the bond in court must be express and not merely incorporated by reference, and found that the incorporation of an arbitration clause was substantially different than incorporation of a federal disputes clause in federal cases. Although there can be no dispute that parties can agree to arbitrate, the problem this case creates for subcontractors is that—despite the valuable protections afforded by statue of a subcontractor’s right to sue the bond and retainage in court—the agreement to arbitrate can be inferred from the upper tier incorporation clause. This decision is particularly disturbing as the subcontractor’s claims were against Turner and arose from the subcontract, not from the general contract.
Because incorporation by reference clauses/flow-down clauses are seen in most subcontracts today, careful consideration should be given to them in order to appropriately apportion risks while limiting exposure to future litigation. If subcontractors are unsure about how their rights are limited or what obligations and risks they are accepting by agreeing to an incorporation clause, it is recommended that they seek legal counsel’s advice as it can potentially change all the critical provisions in the subcontract.
Masaki James Yamada is a partner at Ahlers Cressman & Sleight PLLC. His practice focuses on matters involving complex construction claims, construction contracts, construction L&I issues, construction defects, and related insurance matters. His practice also includes commercial real estate and communications law (i.e. cell towers). Yamada regularly represents general contractors, subcontractors, developers, business and property owners, and design professionals. He can be reached at (206) 529-3015 or masaki.yamada@acslawyers.com.
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