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Flow-Through Claims: 10 Key Liquidating Agreement Considerations

Published:

July 17, 2024

Author(s):

• John V. O’Dea, KC
• Anna Wadden

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In a typical construction project, the owner has a contract with the prime contractor, the prime contractor has a contract with the subcontractors – but the subcontractor has no contract with the owner. How does the subcontractor recover damages against the owner for owner-caused losses, such as delays? One potential route is to permit the subcontractor’s claim to “flow through” the prime (in some provinces, “principal” or “general”) contractor’s claim against the owner. Unfortunately, there is a dearth of Canadian court decisions about flow-through claims to provide guidance. Fortunately, in May 2024, the Ontario Superior Court of Justice issued its decision in Walsh Construction v. Toronto Transit Commission that provides clarification around the availability of flow-through claims – and the risks of liquidating agreements.

Routes to Recovery

Here’s a typical scenario:

• The prime contractor enters a contract with the owner for work on a building.
• In turn, the prime contractor enters subcontracts with various subtrades.
• The project is plagued with delays and the prime contractor and its subcontractors experience increased costs as a result of the delays.
• The prime contractor claims damages for owner delay that created a domino effect of delay not only to the prime contractor but also to the subcontractors.
• The prime contractor claims damages on behalf of the subcontractors.

The subcontractor has no contract with the owner, so the owner has no contractual liability to the subcontractor. As a result, the subcontractor has only two potential routes to recovery from the owner – both via the prime contractor:

Third Party Action. The subcontractor can sue the prime contractor and it can third party the owner – but this assumes the prime contractor is agreeable to doing so.

Flow-Through Claim. The subcontractor and the prime contractor can settle the claim between themselves, then the prime contractor can advance the claim against the owner on behalf of the subcontractor in a flow-through claim. But there’s one essential pre-requisite for a flow-through claim: the prime must have actual or potential liability to its subcontractor(s) for the damages at issue in the flow-through claim. The Walsh decision illuminates the rationale for this pre-requisite: if the prime contractor has no liability to the subcontractor, it has no motivation to analyze subcontractors’ claims and to minimize or eliminate them – despite being in the best position to do so.

10 Key Liquidating Agreement Considerations

While the subcontractor requires the prime contractor’s cooperation to advance a claim against the owner, the prime contractor similarly can’t carry a subcontractor’s claim without some form of support from the subcontractor. For a flow-through claim to succeed, there must be some form of agreement between the subcontractor and the prime contractor, sometimes referred as a liquidating agreement. “Liquidating agreements” are a U.S. tactic adopted in Canada to settle the rights and obligations between the prime and the sub-contractors and protect the prime contractor from liability – but at the same time, assert the subcontractors claim against the prime contractor. But as the Walsh case demonstrates, this can be tricky – and risky. Here are 10 key considerations when entering into a liquidation agreement to support a successful flow-through claim.

1. Preservation of Actual or Potential Liability

It’s not enough that the prime contractor merely include the subcontractor’s claim in the prime contractor’s claim against the owner. The subcontractor’s loss isn’t a loss suffered by the prime contractor. It’s crucial that the contractor remain liable to the subcontractor(s) for the damages at issue in the flow-through claim. In Walsh, the prime contractor settled all its claims with most subcontractors for which it advanced a flow-through claim against the owner, paying them what it owed under the subcontracts and receiving in exchange a release for any and all claims relating to the owner’s project. The prime contractor retained either all or a portion of any possible flow-through claim amounts. Accordingly, the Court found the prime contractor had no remaining liability to the subcontractors. Any payment to the subcontractors was completely dependent on the success of the claim against the owner: if there were no success, there was no liability – and the Court found the flow-through claims therefore failed to meet the essential pre-requisite. To support a successful flow-through claim, the agreement must document the prime contractor’s liability to the subcontractor on that claim. If the prime contractor is to advance a claim on behalf of a subcontractor, the prime contractor must remain liable to the subcontractor, even if the subcontractor’s recovery is limited to what the prime contractor recovers.

 2. Agreement to Advance Claims

The agreement should document the subcontractor’s claim being advanced by the prime contractor and an acknowledgement by the prime contractor that it will include the subcontractor’s claim in its claim to the owner based on an assessed value agreed between the subcontractor and the prime contractor.

3. Contract Consistency

The prime contract and the subcontract will be interpreted in accordance with its specific terms as informed by the statutory regimes and the realities of the construction industry. Any flow-through claim must be consistent with the terms of the prime contract and the subcontract.

4. Litigation & Settlement Authority

Consider the roles and responsibilities of each party and document them in the liquidating agreement. Think forward and consider all scenarios. If the prime contractor starts an action against the owner and advances a flow-through claim on behalf of the subcontractor, who is responsible for preparing and presenting the case? What happens if through discovery the prime contractor or subcontractor are potentially liable for damages? Who is funding the litigation?  Most disputes are settled prior to trial, so who has authority to settle the claim? How will settlement funds be allocated? Who is responsible for legal fees?

5. Indemnity

If the prime contractor takes carriage of the claim that includes a flow-through claim against the owner, the prime contractor will be entitled to an indemnity from the subcontractor based on some agreed formula. Further, the prime contractor will want to limit its exposure to the subcontractor if the flow-through claim fails. Alternatively, the subcontractor can participate in the litigation bearing its own costs related to the flow-through claim.

6. Consultation

The subcontractor might want to include a provision that the prime contractor must consult the subcontractor before agreeing to settle the flow-through claim with the owner.

7. Cooperation

Similarly, the prime contractor might include a provision that the subcontractor cooperates with it in advancing the flow-through claim against the owner; this support is often critical to the success of the flow-through claim.

8. Owner Notice

The parties to the liquidating agreement ought to consider whether to disclose the liquidating agreement to the owner, particularly since the owner could make an argument that it’s nothing more that a Mary Carter agreement and, because of non-disclosure, can be challenged.

9. Recovery

Is the prime contractor paying out the subcontractor’s damages, or is the prime contractor advancing the claim on behalf of the subcontractor to recover? Are the prime contractor and subcontractor settling all rights and obligations between them in exchange for a release of liability? This goes to the next consideration.

10. Scrutiny of Claims

Even with a liquidating agreement, before the prime contractor advances the subcontractors’ claim, the subcontractor’s claim is still subject to scrutiny.

Please contact your McInnes Cooper lawyer or any member of our Construction Law Team @ McInnes Cooper to discuss how to increase the odds your flow-through claim will be a success.

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