Under New York Case Law, Subcontractors' Direct Claims Against Prime Contractors May Be Covered by a Pass-Through Clause
By Charles Fastenberg
Building & Bonding: The Construction Group Newsletter
"Pass through" clauses are a well-established vehicle for resolution of a subcontractor's claims. Under such clauses, the subcontractor's claim is "passed through" to the owner by the prime contractor (or construction manager) acting on the subcontractor's behalf—i.e., the claim is presented to the owner by the prime contractor for the subcontractor's account, with any proceeds that are recovered credited to the subcontractor. In return for the prime contractor's undertaking to assert the claim on the subcontractor's behalf, the subcontractor agrees to forego, or "liquidate," such claim as against the prime contractor, except to the extent of the amounts recovered.
"Pass through" clauses are mutually beneficial to both the subcontractor and the prime contractor. Since the subcontractor does not have a contractual relationship with the owner, it may not proceed against the owner directly. It needs the prime contractor's contractual relationship with the owner as the basis for seeking a recovery from the owner. In turn, since the prime contractor is not deemed to be the party responsible for the subcontractor's damages, and in fact stands to have the claim "liquidated" so far as itself is concerned, the prime contractor has a strong incentive for passing the claim through to the owner.
Given this brief outline of pass-through clauses, it is natural to assume that such clauses apply only in fact patterns in which the subcontractor attributes its damages to the culpable acts or omissions of the owner. This assumption is buttressed by New York case law, which refers to pass-through agreements as a principal remedy for a subcontractor who alleges that its damages originated with the owner.1 Under these cases, not only may the subcontractor not sue the owner directly, but, conversely, it also may not sue the prime contractor for damages alleged to have been caused by the owner.2 Passing the subcontractor's claim on to the owner is viewed as the most feasible means of affording the subcontractor a remedy with respect to owner-caused damages.
However, an intriguing question is presented whether, in certain circumstances, a subcontractor's direct claims against a prime contractor or construction manager also may be subject to a pass-through clause. The specific fact pattern in which this question arises is that in which the governing contract documents provide that "all claims" must be presented for resolution by the contractor to a designated dispute resolution body or to the owner itself, either as a condition precedent to an action at law or as a binding substantive remedy. At first glance, the requirement that a subcontractor's claims against a prime contractor be presented by the prime contractor to a third party seems highly anomalous, if not altogether unworkable. Such a procedure would call for the prime contractor to simultaneously act as both the proponent and the opponent of the claim—i.e., to "work both sides" of the claim at once. In those fact patterns in which claims must be presented to the owner for resolution, another potentially challenging aspect is that the owner might have no stake in the claim and thus might view it as an extraneous issue.
Notwithstanding these apparent difficulties, in BAE Automated Systems, Inc. v. Morse Diesel International, Inc.,3 a New York federal court held that a subcontractor's direct action against a construction manager may not proceed until the claim is first presented by the construction manager to a Dispute Review Board ("DRB"), in accordance with provisions in the prime contract and subcontract calling for the construction manager to present "all Project-related disputes [and] claims . . ." to the DRB for non-binding adjudication as a condition to an action at law.
In BAE, the subcontract specifically incorporated the above dispute resolution procedure, and also provided that the subcontractor must "pursue and exhaust" such procedure before commencing any actions at law arising from the project.4 The subcontract further provided that "Construction Manager agrees to pass on to the Owner all proper claims submitted by Subcontractor under the disputes procedure of the Prime Contract . . . ." The court read this pass-through language as "requiring" the subcontractor to submit its claims to the construction manager for presentation to the DRB.5 The subcontract additionally provided that "Construction Manager shall have no liability or obligation to the Subcontractor beyond what is recovered from the Owner on behalf of the Subcontractor . . . ."6
In opposing the construction manager's motion to stay the subcontractor's action for failure to submit its claim for presentation to the DRB, the subcontractor contended that the pass-through applied only with respect to its claims alleging culpability of the owner, as opposed to direct claims against the construction manager. The subcontractor specifically maintained that if its claims against the construction manager were required to be passed through to the DRB, this would "force [the construction manager] to 'pass on' claims against itself, and prohibit [the subcontractor] from recovering for damages caused by [the construction manager's] breaches."7 The court rejected this argument on the ground that the pass-through clause "merely provides the mechanism for invoking the dispute resolution procedure—it does not define its scope."8 The court further held that there was a clear contractual intention to include the subcontractor's claims against the construction manager within the scope of the dispute resolution clause and the pass-through clause.
The BAE holding did not go so far as to dismiss or preclude the subcontractor's claims since, as indicated, it only stayed the action pending the subcontractor's compliance with the contractually mandated dispute resolution procedure. More recently, however, in Dart Mechanical Corporation v. XL Specialty Insurance,9 the U.S. District Court for the Eastern District of New York dismissed a subcontractor's delay and impact claims based on reasoning similar to that in BAE, though it did not cite BAE.
The Dart Mechanical case arose from a project for the New York City Transit Authority ("NYCTA"). Similar to the BAE case, the general contract as well as the subcontract in Dart Mechanical provided that "all disputes or claims arising under, or related to the Subcontract" shall be submitted "to the Contractor for presentation to, and determination by, the Chief Engineer [of the NYCTA] or the Contractual Disputes Review Board . . . ."10 However, whereas the dispute resolution procedure in BAE was only a condition precedent to a subsequent court action, the dispute resolution procedure in Dart Mechanical represented the subcontractor's "sole remedy," subject to a right of limited judicial review.11
In Dart Mechanical, the general contractor for the project was terminated by the NYCTA and replaced by a new contractor, XL Specialty Insurance ("XL"), who had been retained by the terminated contractor's performance bond surety. As part of the takeover of the work, the terminated contractor and its replacement, XL, released the NYCTA from all existing claims, including the claims of the plaintiff-subcontractor Dart Mechanical. In opposing XL's dismissal motion based on the release, Dart Mechanical contended that its claims were against XL, not against the NYCTA and, accordingly, that the claims were not covered by the release. The court did not specifically rule on the issue concerning the scope of the release. Instead, it dismissed the claims on the "overlooked" ground of waiver—that Dart Mechanical had waived its claims against XL by failing to submit the claims to XL for presentation under the dispute resolution procedure.
As reflected by the BAE and Dart Mechanical cases, though intended to facilitate the resolution of disputes, the interplay between dispute resolution clauses and pass-through clauses can have the substantive consequence of precluding subcontractors' claims against prime contractors or construction managers without the actual merits of the claim being heard. The interaction between these two clauses should be carefully considered in any construction management, general or prime contract as well as any subcontract.
Charles Fastenberg practices in the area of construction industry litigation, including matters involving public improvement projects for the City of New York and other public entities in New York. Over the course of his 25-year involvement in this area, he has represented developers and owners, design builders, contractors, subcontractors, surety and insurance companies and all other entities involved in construction or development projects.
- See Barry, Bette & Led Duke, Inc. v. State of New York, 240 A.D.2d 54, 669 N.Y.S.2d 741 (3d Dep't 1998), rev'g 169 Misc. 2d 594, 645 N.Y.S.2d 713 (Ct. Cl. 1996).
- See Triangle Sheet Metal Works, Inc. v. James H. Merritt & Co., 79 N.Y.2d 801, 580 N.Y.S.2d 171 (1991).
- BAE Automated Systems, Inc. v. Morse Diesel International, Inc., 2001 U.S. Dist. LEXIS 6682 (S.D.N.Y. May 21, 2001).
- 2001 U.S. Dist. LEXIS 6682, at *5.
- Id. at *6.
- Id. at *8.
- Id. at *11.
- Dart Mechanical Corporation v. XL Specialty Insurance, 2008 U.S. Dist. LEXIS 106614 (E.D.N.Y. Sept. 30, 2008).
- 2008 U.S. Dist. LEXIS 106614, at *11. The NYCTA's dispute resolution clause was upheld by the N.Y. Court of Appeals in Westinghouse Electric Corp. v. New York City Transit Authority, 82 N.Y.2d 47, 603 N.Y.S.2d 404 (1993).
- 2008 U.S. Dist. LEXIS 106614, at *11.