ByTodd R. Regan, Gordon Rees Scully Mansukhani, LLP
From a general contractor’s perspective, the use of so-called risk transfer clauses in subcontracts serves to allocate the risks passed down from the project owner amongst the various project participants. Contractors will point out that these clauses assign the risks and responsibilities to the parties who are best equipped to manage them on a day-to-day basis. However, from a subcontractor’s perspective, the use of these clauses, which are often nonnegotiable, can seem like a heavy-handed effort to push all of the project risk down to the trade contractors, while insulating the general contractor from any risk. For surety professionals to better understand the use of and concerns regarding risk transfer clauses, it is helpful to consider both the GC and subcontractor perspectives.
These types of clauses, which are in common use in the construction industry, include such things as “pay-if-paid” provisions, “no damages for delay” clauses, strict indemnity requirements, and “flow down” clauses incorporating by reference the terms of the owner-contractor agreement. Absent such provisions, a general contractor may have reason to fear being squeezed in the middle, with exposure to its subcontractors for types of claims and categories of damages that are barred by its contract with the owner. On the flip side, these types of provisions may have the impact of forcing subcontractors to assume the risk of events that are largely outside of their control, such as when, or if, the owner makes payment.
While these clauses can seem unfairly lopsided and may at times lead to inequitable results, by and large, they will be strictly enforced by courts in accordance with their express terms. As such, it is imperative that subcontractors understand and evaluate the risks they are assuming when entering into agreements with general contractors. Given the fact that general contractors often resist any effort to negotiate these terms, in some instances, subcontractors may need to be prepared to walk away from a proposed job rather than assuming an unreasonable and uncontrollable risk.
Pay-if-paid clauses allocate the risk of owner nonpayment between the prime contractor and the subcontractors. These provisions are broad and could come into play in the event of an owner financial default (for example, an owner’s insolvency or a dispute between the owner and its lender impacting the flow of financing), or in the event of a dispute with the owner concerning the general contractor’s right to payment for additional work. Generally speaking, courts will enforce these provisions as written, as long as they contain language making the general contractor’s prior receipt of payment from the owner an express condition precedent to its obligation to tender payment to the subcontractor, and language expressly allocating the risk of owner nonpayment to the subcontractor. In the absence of such express language, courts in some jurisdictions have treated these provisions as “pay-when-paid” clauses, which merely impact the timing of the general contractor’s obligation to pay its subcontractors, but not the ultimate obligation to make payment.
From a general contractor’s perspective, such provisions are reasonable since, in their absence, the contractor may assume the entire risk of nonpayment due to owner financial default, while still owing payment in full to its subcontractors. In this way, the use of a pay-if-paid clause can be justified as a means of spreading the financial risk of owner nonpayment proportionally amongst each of the project participants, rather than requiring the prime contractor to carry the entire risk.
GIVEN THE FACT THAT GENERAL CONTRACTORS OFTEN RESIST ANY EFFORT TO NEGOTIATE THESE TERMS, IN SOME INSTANCES, SUBCONTRACTORS MAY NEED TO BE PREPARED TO WALK AWAY FROM A PROPOSED JOB RATHER THAN ASSUMING AN UNREASONABLE AND UNCONTROLLABLE RISK.
However, from a subcontractor’s point of view, a pay-if-paid clause may force it to take on a risk that it has little to no ability to manage. Oftentimes, a subcontractor will not even know when or if an owner has released payment. Furthermore, an owner may withhold payment for a myriad of reasons having nothing to do with the subcontractor’s performance, such as incomplete or defective work performed by other subcontractors, the prime contractor’s failure to manage and coordinate the work, or the assessment of liquidated damages resulting from delays caused by others. In addition, the subcontractor will likely have no control over when, or if, the prime contractor seeks owner approval of change orders for additional work the subcontractor is required to perform. When faced with a broadly worded pay-if-paid clause, a subcontractor risks that the prime contractor may not even seek payment from the owner for change order work the subcontractor has performed and may have no incentive to pursue affirmative claims for recovery on behalf of its subcontractors. However, failing to present its subcontractors’ claims for payment to the owner could subject a contractor to claims for bad faith.
No damages for delay clauses will also typically be enforced pursuant to their express terms. Oftentimes such clauses will limit the subcontractor’s recovery to a percentage of any delay-related damages the prime contractor is able to recover from the owner. While such a provision protects a contractor from owing its subcontractors delay damages that cannot be recovered from the owner, it may unjustly prevent a subcontractor from being reimbursed for costs incurred through no fault of its own. For example, when the delay is arguably caused by the prime contractor’s own mismanagement or by the default of another subcontractor, delay damages may be difficult to recover from the owner.
Although these clauses are typically enforced as written, courts in certain jurisdictions recognize exceptions for such things as uncontemplated delays, delays caused by a breach of a “fundamental obligation” under the contact, unreasonable delays amounting to an abandonment of the contract or delays due to bad faith, fraud, or willful and/or grossly negligent conduct. However, these exceptions are narrowly construed, and a subcontractor seeking to take advantage of these exceptions is likely to face an uphill, lengthy and expensive legal battle.
Subcontractors may also be caught unaware by broad “flow down” clauses, which incorporate all of the terms of the owner-contractor agreement, even though the subcontractor may never have received a copy. These clauses will generally be enforceable and could impose unknown additional obligations on subcontractors, including such things as stringent notice of claims provisions, higher standards of performance, additional warranty obligations, broad indemnity terms, and dispute resolution procedures. Far too often subcontractors implicitly accept such provisions without ever having received a copy of the prime contract.
Despite this parade of horribles, subcontractors can take some solace in knowing that certain protections are generally considered nonwaivable, even by the most lopsided contract. For example, in most jurisdictions courts will not enforce an advance waiver of a subcontractor’s right to file a mechanic’s lien or to file a payment bond claim. However, a periodic lien waiver applying to all previously performed work (even disputed change orders) most likely will be enforced and should be closely scrutinized before execution. Furthermore, although subcontractors may be forced to accept broad indemnity obligations for all damages “arising out of” the performance of their work, most jurisdictions have so-called “anti-indemnity” statutes invalidating clauses that would require a subcontractor to indemnify a contractor for damages caused by its own negligence.
In addition, many jurisdictions have enacted prompt payment statutes providing important protections to subcontractors. For example, the Massachusetts Prompt Pay Act provides that change orders are automatically “deemed approved” if not specifically denied in writing with a certification of good faith within 30 days. Similarly, a subcontractor’s payment application is “deemed approved” and must be paid if not properly rejected within the statutory time period. In New York, all funds received by the project owner from a lender and all payments received by the general contractor are deemed “trust funds” to be used for the payment of subcontractors and suppliers. In addition, subcontractors have the right to obtain detailed information about how trust funds paid to the general contractor were used. Project owners and general contractors can be held personally liable for misuse of trust funds.
Subcontractors must take note that many of the most notorious risk allocation provisions in subcontracts will be enforced as written, although they can take heart in knowing that certain statutory protections cannot be overridden by even the most onerous contracts.
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Todd R. Regan is a partner in the law firm of Gordon Rees Scully Mansukhani, LLP (grsm.com). For more than 20 years he has dedicated his practice to the construction and surety industries. He has significant experience in litigating construction disputes throughout the Northeast and frequently appears before the State and Federal Courts of Connecticut, Massachusetts, and New York. Regan serves on the NASBP Attorney Advisory Council. He can be reached at tregan@grsm.com or 860.494.7494. This article was originally published in the spring 2025 issue of NASBP Surety Bond Quarterly magazine and is re-published with NASBP’s permission.
