By Morgan A. Stewart, partner, Manly, Stewart and Finaldi
Since the construction of multifamily projects typically involves several parties, it is crucial to craft your contracts with the utmost care. Failure to do so could greatly increase your risk of contractual liability to third parties, particularly when those provisions known as flow down clauses are involved.
It is common presumption that a multifamily developer who has signed an agreement with a general contractor is bound solely to the terms of the prime contract, unless expressly stated. And conversely, that subcontractors are only liable for the obligations set forth in the contract between them and the general contractor. However, the reality is often far more ambiguous. Contracting parties need to be especially wary of flow down clauses, which are commonly included in standard industry form contracts such as AIA forms. Also referred to as conduit or pass-through clauses, these provisions bind subcontractors to the rights, duties and obligations set forth in the prime contract.
The risks of signing a contract with flow down clauses are typified in the following case. Unaware that the lenders had pulled funding for a 1,500-unit retirement community project underway in Ohio, the subcontractors continued construction until the general contractor received official notification to suspend work on it. The subcontractors filed mechanic’s liens for approximately $9 million shortly thereafter, but the lenders filed a complaint for foreclosure of the mortgage and other related claims in the same week. The subcontractors argued that their liens had priority over the construction mortgage, but the trial court ruled in favor of the lenders in 2011 and the appellate court upheld the decision in 2013.
At the crux of the Ohio case was the interpretation of the flow down provision included in the subcontract agreements. The subcontractors contended that the clause bound them solely to the obligations set forth in the prime contract related to the scope, quality, character and manner of work to be performed. However, the courts ruled that the provision clearly bound the subcontractors to all the terms of the prime contract, which meant they contractually agreed to subordinate any lien claims to the lenders’ construction mortgage.
The forgoing example illustrates how conduit clauses can serve to bind subcontractors to all the terms of the prime contract, but the opposite can also hold true. Multifamily developers are also at risk when it comes to these provisions, as subcontractors can use the flow down clauses to enforce terms that are favorable to them in the prime contract.
A prime example is when a developer and general contractor negotiate for a specific limitation included in the prime contract that is not intended to be passed through to the subcontractor. If the subcontract agreement contains a conduit clause that is not drafted clearly enough, the limitation included in the prime contract may indeed flow down to the subcontractor. Issues can arise in regard to a number of terms, including attorney fees, granting or limitations; caps on damages; responsibilities and who bears them; loss of use; and indemnity provisions.
The best course of action for all parties is to carefully review all contract terms, especially granting language and limiting language, before signing. Multifamily developers should be sure to craft the prime contract to narrow the scope of what does and does not apply to subcontractors or other parties. They may also want to work with the general contractor to craft the subcontract agreements and review those during the course of the buyout process.
Taking the utmost care when drafting flow down clauses can help multifamily developers as well as subcontractors avoid a complicated maze of legal entanglements if any issues of contractual liability arise.
Morgan Stewart is a partner with Manly, Stewart and Finaldi—an Irvine, CA based law firm that specializes in real estate. He devotes his practice to advising national multi-family and commercial real estate clients on legal issues including construction litigation, insurance bad faith, general corporate formation issues, contract negotiation and development, and personal injury. As an emerging leader in the industry, Morgan’s reputation for detailed and thorough counsel has allowed his clients to focus on their core business, while avoiding costly and unnecessary legal action.