Time-Bombs In Your Filing Cabinet, Part II

By: Mike Pappas, Esquire

Orignially Published In The HLG Constructor, November 2007

This article is Part II in a series of articles about the dangers lurking in the files of businesses in the construction industry. This article focuses on “flow down provisions” and “incorporation provisions” pursuant to which obligations contained in other documents or contracts are imposed upon subcontractors by reference in standard subcontract agreements. These two items, often overlooked, typically explode when the project is not going well and the owner, general contractor, or subcontractor try to enforce a contract provision. At that time, it is often too late to do anything about them or take any steps to protect yourself and your business.

Flow Down Provisions

Flow-down provisions require subcontractors to assume all of the obligations and responsibilities towards the contractor that the contractor assumes towards the owner. Typically, contractors are required under the prime contract to structure their agreements with subcontractors in such a way that the contractor’s obligations in the prime contract are “flowed-down” to the subcontractors. The danger arises when subcontractors are not provided with or do not read the prime contract, and are not, therefore, familiar with the obligations contained therein.

A typical flow-down provision requires the subcontractor to “assume toward the contractor all obligations and responsibilities which the contractor assumes towards the owner and the architect.” See, AIA Document A401-1997.

For general contractors and owners, flow-down provisions provide the ability to predict and control the rights and obligations of all parties on the project throughout the course of construction. Flow-down provisions can be especially dangerous to subcontractors since they were, by their nature, negotiated long before the subcontractor was in the picture. Flow-down provisions often include terms that are not favorable to subcontractors’ positions, or which require them to assume risks that are not accounted for in their project price. Thus, it is vitally important for subcontractors to know all terms which flow-down to them on every project. Likewise, it is equally important for the general contractor to remember that flow-down clauses are two-way streets. Not only does the subcontractor assume certain obligations not specifically enumerated in the subcontract, but the general contractor also assumes obligations to the subcontractor that do not appear in the four corners of the subcontract itself.

Incorporated Documents Provisions

Incorporated document provisions typically set forth a listing of other documents that, while not attached, are made a part of the agreement. The incorporation provision creates a danger of uncertainty by including other terms into the current contract, which are often not at hand to evaluate at the time the document is reviewed or executed. The danger from incorporation provisions arises when the incorporated documents are not provided or are not read and they contain conflicting or additional terms not included in the document to which they are incorporated.

The dangers of both flow-down and incorporation provisions can be seen in the following case.

A subcontractor entered into a subcontract for a project which specifically incorporated the terms, conditions and provisions of the prime contract. The prime contract contained a flow-down provision which required subcontractors to assume all duties and obligations toward the general contractor that the general contractor assumed towards the owner. The subcontractor never obtained a copy of the prime contract. The subcontract contained a claims provision that required the subcontractor to submit its claims to the general contractor with “sufficient time to allow the contractor to submit claims to the owner.” Upon encountering a condition that gave rise to a claim, the subcontractor, believing that it was being diligent, submitted a formal written claim to the general contractor within seven (7) days of the occurrence. However, unbeknownst to the subcontractor, the prime contract required the general contractor to submit its claims to the owner within five (5) days of the occurrence or they were “forever waived.”

Based upon this requirement, the owner denied the subcontractor’s claim. Accordingly, the subcontractor filed for arbitration, which was mandated by the provisions of the prime contract. At the arbitration, the arbitrator upheld the owner’s denial of the claim, reasoning that that the subcontractor failed to comply with the incorporated provisions of the subcontract when it failed to timely submit its claim. The fact that the subcontractor did not have a copy of the prime contract and did not know of the five day notice requirement was not an excuse. To add insult to injury, the general contractor was awarded the costs of the arbitration, including its attorneys’ fees, because the prime contract had a prevailing party provision which was incorporated into the subcontract as well.

In the above case, had the subcontractor taken the time and invested the funds to obtain, read and understand the provisions of the prime contract, which were incorporated by reference into the subcontract at the time the subcontract terms were being negotiated, the loss might have been avoided. The subcontractor could have simply delivered its notice of claim within the time frame allotted, or the time frame could have been negotiated to include more days before the subcontract was executed. Additionally, needless legal fees could have been avoided had the subcontractor known and appreciated that the prime contract contained an arbitration provision and a prevailing party provision which entitled the prevailing party to recover its expenses and attorney’s fees as well.

The effects of flow-down and document incorporation provisions can be easily managed during the subcontract negotiation process. The parties, with knowledge of the provisions, can often negotiate a more equitable process which does not put the subcontractor at a disadvantage. In the event that the objectionable terms cannot be negotiated, the subcontractor, with knowledge and an understanding of all of the obligations included in subcontract, is able to more accurately determine its risk exposure, and can then price the project accordingly.

Conclusion

Flow-down and document incorporation provisions are a fact of life in the construction industry. Flow-down provisions are supposed to allow the parties to share risks and stand in relatively equal positions with respect to their counterparts on the project. They also allow for the rights and obligations of all parties on a project to be determined at the commencement of the project and for the consistent treatment of all claims or issues that arise on the project. For general contractors and owners, flow-down provisions provide predictable risk allocation and defined participation in the project by all. For subcontractors, the benefits are often lost due to failure to recognize and address obligations imposed by flow-down provisions during negotiation of the subcontract. Additionally, document incorporation clauses often incorporate documents which subcontractors never obtain, much less read and appreciate. As such, parties to these clauses are frequently surprised to discover that they are obligated to comply with terms and obligations they have never seen. Actively procuring and reviewing all documents that are incorporated into the subcontract during subcontract negotiation phase will prevent the effects of these time bombs in your files.

Time Bombs In Your Filing Cabinet - Part I

By: Mike Pappas, Esquire

Orignially Published In The HLG Constructor, September 2007

Undoubtedly, if your filing cabinets are like those found in most businesses, they are likely to contain items that are long forgotten. However, because of the nature of many businesses, there may be several items located in your filing cabinets that could cause you tremendous distress and cost you or your businesses a tremendous amount of money.

The next several issues of the HLG Constructor will contain a series of articles regarding the “time-bombs” in your files. This edition will focus on personal guarantees included in credit agreements, confessed judgments/promissory notes, and in bonding agreements with sureties. Future editions will cover the unexpected effects and obligations of “flow-down” provisions, incorporation clauses, and warranties.

The personal guarantee is often overlooked or misunderstood at the beginning of a project or business relationship. Even if it were considered at the outset, its importance is often erroneously minimized and it often ends-up filed away and forgotten. This seemingly harmless document typically explodes when the project is not going well or the business is having cash-flow problems. At that time, it is often too late to do anything about it or take any steps to protect yourself and your business.

Personal guarantees are promises or undertakings that an individual or individuals will satisfy an obligation that an entity has undertaken but fails to satisfy. Personal guarantees are typically made by principals or officers of companies and are most often encountered in credit applications from suppliers. These guarantees are usually signed when the company is young or when a new supplier is needed. Personal guarantees are also commonly found in promissory notes, settlement agreements, and fee arrangements.

From the creditor’s perspective, a personal guarantee is a form of collateral from an actual person for the extension of credit to a business since businesses, other than sole-proprietorships, are usually legal fictions. Possessing a personal guarantee gives the creditor a person to go after if the business fails to pay its obligations. While most personal guarantees are executed by corporate officers or principals, many times, they are executed by the treasurer or comptroller of a company. Sometimes unwitting employees sign and submit credit applications, not realizing that they may be obligating themselves personally in the event of non-payment by the company.

Moreover, many sureties require personal guarantees from the principals of the business for which they provide a bond. Often these personal guarantees accompany indemnification agreements which require the business to repay the surety for any money that the surety has to pay on behalf of the business. Accordingly, when the indemnification provisions include personal guarantees by the principals or corporate officers, they become liable in the event that the surety pays. Additionally, most indemnification obligations also provide for reimbursement of costs associated with claims made against the bond including attorney’s fees, court costs, investigation costs, and expert fees.

Problems arise from personal guarantees when the business fails to fulfill its obligations and the creditor or surety looks to the person that signed the guarantee to fulfill the obligation. Many times the creditor or surety is forced to go to the personal guarantee because the business has fallen behind on payments or has failed to pay altogether. Typically, the principals of the business may also be experiencing financial hardships at the same time. Nevertheless, the personal guarantee will operate to endanger the personal assets of the person that signed the guarantee (the guarantor).

Courts have upheld personal guarantees by corporate officers and company principals for centuries. Barring the existence of fraud in inducing the guarantor to enter in the obligation, they are very difficult to defeat and are typically upheld. Even if a corporate officer leaves the company, their personal guarantee obligations may continue. Accordingly, corporate officers or principals should carefully note each time they undertake a personal obligation on behalf of the business and should consider a means of protecting their personal assets beyond the traditional formation of LLC’s, LP’s or Corporations.

In the worst cases, the guarantor was an accounts payable clerk who signed a credit application from a vendor and was sued by the vendor to recover when the company has not paid. The good news for this employee is that the courts have traditionally not enforced such obligations on the employee if the employee did not receive consideration for undertaking the obligation. The bad news for the employee is that the courts across the country are not clear on their application of this maxim or on how to define adequate consideration in this situation. The worst news for these employees is typically they will have to hire their own lawyer to defend them from the lawsuit as the company cannot afford to defend them or the company’s lawyer cannot represent both the employee and the company due to conflicts of interest.

There are additional steps that can be taken to minimize the impact of personal guarantees or eliminate them altogether. First, as many of these guarantees were made at the outset of a business relationship with vendors, suppliers, or sureties as collateral, they can be revisited or renegotiated at your request, once the company establishes a track record with the creditor. Many suppliers, vendors, and sureties will release the personal guarantee based upon your company’s good payment history and credit relationship. However, don’t expect to get a surety to release a personal guarantee which protects a bond it has already issued and for which payment obligations may still exist unless you are willing to offer some other sort of collateral to cover the obligation.

Sometimes, vendors and suppliers will release the personal guarantees in exchange for faster payment terms and/or a higher finance charge on payments beyond a certain age. If your company has always paid its bills on time with a vendor, they will likely be willing to work with you. Nevertheless you should remember that credit managers and sureties are inherently averse to risk. So, be prepared to make your case by showing your payment history with them and possibly other vendors as well.

When you are successful at renegotiating your credit agreement, care should be taken to assure that the personal guarantee is actually and finally released and the credit agreement is actually modified to reflect the release of the personal guarantee. An attorney should review any modifications to personal guarantees to verify that that they comply with and are not contradictory to any contractual and legal requirements. Any modifications to personal guarantees should also be signed and witnessed by both parties.

Conclusion

Personal guarantees are an unavoidable certainty in the construction industry today. They are an effective way for vendors, suppliers, and sureties to secure their risk when providing services, materials or bond coverage. Personal guarantees are so prevalent in the everyday business of the construction industry they are often quickly forgotten or their possible importance is minimized until a company experiences cash-flow issues or a project goes terribly wrong. Fortunately, through understanding the obligation included in each personal guarantee and careful planning you can avoid surprises and minimize the impacts of personal guarantees. Moreover, by proactively revisiting your existing personal guarantees with suppliers, vendors, and sureties, you may be able to avoid personal obligations altogether.