Covenant of Good Faith and Fair Dealing Applied to Pass-Through Agreements
Pass-through claims are claims by a party that has suffered damages but does not have a contractual relationship with the entity that caused the damages. In the construction industry, subcontractors commonly have claims for additional costs based on actions or inactions by the owner. However, since the subcontractor is not in privity of contract with the owner, it has no direct cause of action against the owner other than, perhaps, on a nongovernment project, a lien claim. In such cases, subcontractors may seek to pass the claim through the general contractor, who is in privity with the owner, to the owner.
Indeed, many construction contracts require the subcontractor, in such cases of owner-caused damages, to pass the claim through the general contractor to the owner. And since the harm visited on a subcontractor by the owner usually also affected the general contractor, the subcontractor’s claim is packaged together with the general contractor’s claim, which is usually greater, for presentation to the owner and, if not resolved, litigation with the owner.
AGREE TO AGREE
In these situations, the general contractor invariably controls the preparation, presentation and prosecution of the combined claim. The general contractor will select experts, engage counsel and interact directly with the owner and, if necessary, initiate and prosecute litigation.
For both general contractors and subcontractors involved in a pass-through claim situation, the best practice is to enter into a pass-through agreement, which sets forth the parties’ rights and responsibilities and addresses issues such as allocation of attorney and expert fees and litigation costs, routine information sharing, decision making as to settlement and allocation of settlement proceeds.
This is particularly important for subcontractors, because their claim is usually smaller than that of the general contractor, and subcontractors essentially find themselves riding the coattails of the general contractor. Some general contractors will actively involve and keep subcontractors abreast of developments in the prosecution of the joint claims; others will not and will pay token service to involving the subcontractor and then, after the case is settled or resolved, present the subcontractor with a breakdown showing the subcontractor’s share of costs and of the recovery from the owner to be paid to the subcontractor. This latter situation will likely produce a disappointing result for the subcontractor.
A recent case from New York, Rad and D’Aprile Inc. v. Arnell Construction Inc., demonstrates the worst-case situation of the general contractor abdicating its responsibilities to a subcontractor to whom it was entrusted with a pass-through claim. Arnell involved the circumstances of a classic owner-caused delay not barred by a no-damage-for-delay clause: the project was delayed/impacted because New York City did not have title to the project site, and, as such, the entire site was not available to the contractors for construction.
As such, the general contractor suffered delay damages as well as its subcontractor. Hence, the subcontractor passed its claim for delay damages through the general contractor, with the general contractor’s similar claim, to the city. The general contractor, however, failed to timely file an action against the city, resulting in the dismissal of the action and the subcontractor’s pass-through claim, and then the general contractor settled the claim without notice to the subcontractor and would not provide any compensation to the subcontractor from the settlement.
Subcontractor sued general contractor. General contractor sought to dismiss the action on a variety of grounds. The court denied the motion and, importantly, did not rely on a provision in the parties’ contract, but relied on a covenant implied by common law in contracts. This covenant is known as the covenant of good faith and fair dealing, which “embraces a pledge that neither party shall do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract. It encompasses any promises that a reasonable person in the position of the promisee would be justified in understanding were included.”
Relying on the implied covenant of good faith and fair dealing, the court held that the general contractor’s failure to timely file litigation and to settle the case without consulting with the subcontractor and not sharing any of the proceeds constituted a breach of this covenant. Although this holding is based on common sense, it is important because the court relied on the implied duty of good faith and fair dealing to substitute and reach a just result where apparently express contractual duties of the general contractor to the subcontractor were absent.
SPELLING IT OUT
Arnell thus teaches that the best practice is to draft a thorough pass-through agreement that spells out the parties’ obligations to one another and the consequences otherwise. However, the implied covenant of good faith and fair dealing works as a check on roughshod practices, such as evidenced in Arnell, in order to incorporate promises that reasonable persons would expect to be included.
Another drafting suggestion gleaned from Arnell is to include a provision in the pass-through agreement which expressly states that the parties agree that they owe to one another the express duty of good faith and fair dealing. Such a provision would bolster the position of the subcontractor, and reasonable general contractors should not balk at its inclusion if, indeed, they are operating in good faith and because the duty is otherwise implied at law.