By Michael C. Loulakis and Lauren P. McLaughlin
For contractors or engineers, dealing with pass-through claims from subcontractors or subconsultants is fraught with legal land mines and procedural traps for the unwary. Some of the most common types of disputes concerning pass-through claims involve the following scenarios. If a contractor fails to meet the notice provisions in its prime contract and dooms an otherwise valid claim from its subcontractor against an owner, the contractor can face exposure to its subcontractor. Conversely, if a contractor submits a subcontractor claim to the owner without doing proper due diligence, it could find itself subject to false claims act liability. There is also the scenario where a contractor settles with an owner without including its subcontractor’s claims — the general contractor may face liability for preventing the subcontractor’s right to recover from the owner.
There are countless other ways, however, where litigation can arise regarding how pass-through or subcontractor claims are handled. In one decision discussed below, an appeals court grappled with whether an owner could properly pass through liquidated damages to a subcontractor. In another recent decision, a general contractor properly brought a subcontractor claim to the owner and ultimately settled with the owner after the subcontractor refused to participate in defending the owner’s offset claims. After one arbitration and two appeals, the general contractor’s actions were deemed justified.
The disputes in Robert R. Schroeder Construction Inc. v. Minnesota Department of Transportation stem from a general contractor’s fixed price contract to restore a historic bridge on a state highway in Chippewa County. Robert R. Schroeder entered into a prime contract that had a liquidated damages provision of $3,000 per day for each day of delayed completion. According to MnDOT, the daily rate was based on the estimated actual damages MnDOT anticipated as a result of late completion.
Schroeder subcontracted the historic stone riprap scope of work to W. Gohman Construction Co. The subcontract contained both a flow-down clause, in which Gohman took on all the risks and obligations of the prime contract, and an indemnification clause, requiring Gohman to indemnify Schroeder for any losses or damages caused by Gohman’s failure to carry out the provisions of the subcontract. Gohman was to complete the work within 90 days but did not do so. Additionally, Schroeder complained to MnDOT that changed work mandated by its historic consultant was delaying its work.
Schroeder completed the work, but MnDOT assessed liquidated damages and refused to make final payment. MnDOT and Schroeder settled their dispute with MnDOT making partial payment to Schroeder and accepting an assignment of Schroeder’s indemnification claim against Gohman. MnDOT then sued Gohman for liquidated damages of $1.4 million less $665,262 for payments Schroeder withheld from Gohman. A trial court awarded judgment in favor of MnDOT, and the riprap subcontractor appealed.
On appeal, Gohman went to the heart of an attack on liquidated damages, claiming that it constituted an unenforceable penalty with no correlation to the owner’s reasonable estimation of damages. Gohman conceded it did not perform its work on schedule. However, Gohman alleged that its placement of riprap at both ends of the bridge could hardly have impacted the critical path or caused damages — “the public was not harmed or damaged by not seeing rough laid stones on the slopes of the roadway while they drove past going 60 miles per hour.” MnDOT argued in response that its suit was merely for indemnity that it properly was assigned by its settlement agreement with Schroeder (as opposed to liquidated damages).
The Minnesota Court of Appeals indicated it could be a case of first impression. The question posed was whether the reasonableness of liquidated damages should be assessed in the context of actual harm caused by the subcontractor or in the context of anticipatory harm that was the basis for the liquidated damages provision in the prime contract. While the court noted the subcontractor believed the liquidated damages to be inappropriate as passed down to it, the court did not believe the lower court sufficiently resolved the issue, so it sent the issue back down again for the trial court to reconsider — and potentially resolve.
Subcontractor challenges arbitrator’s award
In Roofco Inc. v. Hilbers Inc., a roofing subcontractor (Roofco) entered into a subcontract with a general contractor (Hilbers) by which Roofco agreed to construct a five-layer roof manufactured by GAF over a two-building shell being constructed by Hilbers for $107,135. Following Roofco’s performance, the owner observed water on the nearly completed roof, and its roofing consultant, John Goveia, subsequently investigated with Roofco and Hilbers in attendance. Goveia issued a report concluding the roof was defective and recommending that it be replaced.
Not surprisingly, Roofco did not concur with the Goveia report and demanded payment in full. Roofco submitted the GAF 10-year guarantee (manufacturer’s warranty), which had been preceded by a visual roof inspection by a GAF representative who noted that no roof work was required. The GAF representative did not address the Goveia report’s concerns regarding the roof’s deficiencies. The owner offered to settle the matter by paying Roofco half of the subcontract balance or about $60,000. Roofco in response hired an expert, but that expert did not produce a report. Finally, the owner and contractor agreed to settle the dispute, and Hilbers sent Roofco a check for $58,936. Roofco never cashed the check. Instead, pursuant to the subcontract’s arbitration provision, Roofco filed a demand with the American Arbitration Association seeking damages for breach of contract in the amount of $113,865 plus interest.
Hilbers responded, asserting that Roofco’s work was defective, Roofco had failed or refused to defend it against the owner’s concerns stated in the Goveia report, and Roofco’s conduct had forced it to negotiate a settlement with the owner. It argued that Roofco was not entitled to the full subcontract price as it claimed, but rather was “entitled to no more than $51,094.50,” which was the amount previously tendered to Roofco minus offsets for removing Roofco’s mechanic’s lien.
Roofco argued that it was not objectively reasonable for Hilbers and the owner to withhold half of the subcontract price for alleged roof defects and that it was entitled to the full contract price. The arbitrator issued an interim award denying Roofco’s claim. The arbitrator noted that Roofco had attempted to satisfy the owner’s concerns with the GAF 10- and 20-year guarantees but did not address the issues raised by the Goveia report. Moreover, while Roofco finally retained an expert and performed an inspection, the expert did not issue a report that could be reviewed by the owner and perhaps be used as the basis for a settlement. Thus, Hilbers was forced to obtain the most favorable bargain it could with the owner after notifying Roofco and giving it the opportunity to participate.
The arbitrator noted it was “tempting” to treat the case as a battle of the experts but observed that the “battle” was not held at a time when the Goveia report could have been addressed. Instead, Roofco’s expert report was not provided until years later, in 2021, in preparation for arbitration. The arbitrator observed that the outcome of the dispute might have been different had Roofco “engaged in dialogue” with Hilbers regarding the Goveia report; there might have been no need to arbitrate the dispute, or the result of arbitration might have been different. The arbitrator concluded that “trying to evaluate whose expert is correct now ignores the dynamics that occurred in 2016 when (Hilbers) was desperately trying to obtain (Roofco’s) input so that the former's dispute with the owner could be resolved.” The arbitrator denied Roofco’s claim and did not award it any further payment under the subcontract.
Roofco next filed a petition to vacate the arbitration award in the trial court. It contended the parties framed the issue as a choice between awards to Roofco of $113,865 or $51,094.50, and therefore the arbitrator exceeded his authority by denying Roofco’s claim in its entirety. Roofco further argued that the arbitrator “in effect rewrote the contract between the parties” because no subcontract provision authorized him to “forfeit” amounts owed to it under the subcontract. Hilbers contended the issue submitted to the arbitrator was “what amount, if any, Roofco was entitled to from Hilbers.”
The trial court issued a tentative ruling denying Roofco’s petition, and it affirmed the tentative ruling following a hearing. The court reasoned that the arbitrator did not exceed the scope of the issues submitted to arbitration by awarding it less than the minimum amount to which Hilbers acknowledged Roofco was entitled under the subcontract. The court also denied Roofco’s argument that the arbitrator essentially remade the subcontract by issuing an award that was not expressly authorized by a provision of the subcontract.
Roofco appealed to the 3rd District Court of Appeal of California. As it did in the trial court, Roofco contended the arbitrator exceeded his authority by violating an unambiguous limitation set by the parties in their submissions to arbitration. It argues that the parties agreed to a “high-low” arbitration, in which “the dispute that was submitted to arbitration was whether Hilbers owed Roofco not more than $51,094.50, or whether it owed Roofco $106,023, or whether it owed Roofco some amount in between the two.”
The court noted there was no express agreement to enter into a high-low arbitration and that the arbitration provision broadly granted the arbitrator the authority to resolve disputes relating to the subcontract. In other words, one cannot infer a high-low arbitration agreement (floor and ceiling cap) based on inferences from the pleadings.
In applying the broad arbitration provision, the arbitrator made multiple findings about the nature of Roofco’s breach. He found that Roofco had persistently refused to address the Goveia report, despite repeated requests that it do so, and when it finally retained an expert, the expert did not issue a report that could be reviewed by the owner or that could be the basis for a settlement. Accordingly, Hilbers was “forced to obtain the best bargain it could with the owner to resolve the dispute after giving notice to (Roofco) to participate.” Based on these findings and implied interpretation of the contract, the arbitrator decided that it was “just and fair under the circumstances existing at the time of arbitration” to deny Roofco’s claim.
Analysis and takeaways
These are two fairly atypical cases, but they underscore two very worthwhile points. First, handling claims both upstream and downstream must be done with extreme caution to avoid liability. Second, unexpected things happen in litigation, and that is why most people decide to settle disputes. In the first decision, the owner took an assignment of claims the general contractor had against the subcontractor — and attempted to pass down the liquidated damages to the subcontractor in a separate proceeding. It is unusual for an owner to take an assignment of claims against a subcontractor. Additionally, some would argue it would make more sense to collect the liquidated damages against the general contractor who agreed to the risk of late completion in its prime contract. By taking an assignment of the general contractor’s claims against the subcontractor, the owner may now find itself without a remedy.
In the second decision, the record does not disclose why the arbitrator, the trial court, or the appellate court did not believe that Roofco should at least be entitled to the amount initially tendered to Roofco ($60,000). But because of the subcontractor’s unique argument that a high-low arbitration had been established by the pleadings, the general contractor in that case had to defend its actions in settling with the owner three different times — first in arbitration, and then in two subsequent appeals. More to the point, parties need to make decisions very carefully when handling claims of subcontractors/subconsultants, owners, and contractors.
This article is published by Civil Engineering Online.