Orginally posted Wednesday, 16 January 2013

Written by John Sier

The creation of a third-party beneficiary status must be intentional and typically requires contract language specifically identifying the third-party beneficiary to a contract. This principle can work to the Owner’s benefit when attempting to avoid non-lien contractual claims by subcontractors, but it can be detrimental in attempting to pursue a subcontractor for defective work where the general contractor/construction manager is no longer viable—as in a recent Texas decision [McGregor Enterprises, Inc. v. Hicks Construction Group, Inc., et al, 2012 TX APP LEXIS 87 (Jan. 5, 2012)].

The Owner of a hotel signed a “standard” contract with a construction manager for the renovation and addition to an existing hotel. As the project neared completion, the relationship between the Owner and the construction manager broke down, and the Owner terminated the construction manager on April 1. On April 18, the subcontractor submitted a final invoice directly to the Owner for the completed work, and the Owner paid the subcontractor directly.

The Owner subsequently sued the construction manager and the subcontractor for breach of contract, as well as negligence and breach of express and implied warranties. After the action was concluded as to the construction manager, the subcontractor moved for dismissal of the action by the Owner, since there was no direct contract between the Owner and the subcontractor, and therefore, there could be no breach. The trial court and the Seventh District Court of Appeals in Texas agreed and dismissed the action. While the parties agreed that there was no written contract between the Owner and the subcontractor, the Owner claimed to be a third-party beneficiary of the subcontract, which would have entitled the Owner to bring suit to enforce the terms of the subcontract. The subcontract was the Associated General Contractors short form subcontract [which can be used in conjunction with the ConsensusDOCS forms] and contained language stating:

SUBCONTRACT WORK To the extent terms of the agreement between the Owner and Contractor (prime agreement) apply to the work of Subcontractor, Contractor assumes toward Subcontractor all obligations, rights, duties, and redress that Owner assumes toward Contractor. In an identical way, Subcontractor assumes toward Contractor all obligations, rights, duties and redress that Contractor assumes toward Owner and others under the prime agreement.

Even though there was language indicating recognition of the prime agreement, the language did not expressly identify the Owner as the third-party beneficiary of the subcontract. Without a clear intention to create that third-party beneficiary status in favor of the Owner, the court fell back on the general presumption against third-party beneficiary status.

The Owner further asserted that the final payment made directly by the Owner to the subcontractor after termination of the construction manager created an enforceable contract. However, the court found that no subcontract work was performed subsequent to the termination of the construction manager, and there was no record of any assignment of the subcontract to the Owner. The court declined to imply a contract where the terms were unclear. In the absence of any contractual right, the court found that the subcontractor necessarily could not have breached any express warranties since those warranties would have been in the contract with the construction manager. Likewise, the court declined to impose any implied warranties on the subcontractor, which is a typical outcome in many states because the Owner is considered to have a remedy against the construction manager, so there is no need to create implied warranties.

Similarly, the Owner’s negligent workmanship claim was dismissed by application of the economic loss rule as interpreted in Texas. The economic loss rule generally precludes an action for negligence in a commercial setting, where the losses directly relate to the subject matter of the contractual relationship. Texas applies the economic loss rule in cases involving defective products and where there is a failure to perform a contract. Since this was fundamentally an action for breach of contract, the court dismissed the negligence claim against the subcontractor. [Note: Some states preclude an action for negligence in the absence of an independent duty owed by the contractor or subcontractor outside of the contractual relationship. 2300 Pennsylvania Avenue, LLC v Harkins Builders, Inc., 2012 U.S. Dist. Lexis 28137 (E.D. Va. March 2, 2012).]

In short, the Owner had no right of recovery against the subcontractor based on contract or negligence theories in the absence of particular language in the subcontract or other document providing the Owner with the status of a thirdparty beneficiary. Neither court focused on the language of the prime agreement, but it likely also contained language along the lines of that in the ConsensusDOCS 200:

13.1 EXTENT OF AGREEMENT Except as expressly provided, this Agreement is for the exclusive benefit of the Parties, and not for the benefit of any third party. This Agreement represents the entire and integrated agreement between the Parties, and supersedes all prior negotiations, representations, or agreements, either written or oral. [Similar language is at Paragraph 14.1 of the 500 Agreement]

The ConsensusDOCS 200 also provides:

5.3 BINDING OF SUBCONTRACTORS AND MATERIAL SUPPLIERS The Constructor agrees to bind every Subcontractor and Material Supplier (and require every Subcontractor to so bind its subcontractors and material suppliers) to all the provisions of this Agreement and the Contract Documents as they apply to the Subcontractor’s or Material Supplier’s portions of the Work. [Identical language is at Paragraph 5.3 of the 500 Agreement].

There is not express language in either the 200 or the 500 Agreement creating third-party beneficiary status in favor of the Owner such that would enable an Owner to proceed directly against a subcontractor or supplier in the event that the contractor or construction manager is no longer a viable entity responsible for contract performance or warranty repairs. Third-party beneficiary status and the ramifications can change from state to state, so it remains critical to consult with experienced construction counsel regarding the advisability of the Owner being an express third-party beneficiary of subcontracts and supply agreements on a construction project.

John Sier, with the firm of Kitch Drutchas Wagner Valitutti & Sherborook in Detroit, Michigan, is Associate Counsel to COAA.