The Universal Applicability of Pass-Through Claims to All Parties to a Construction Project, Dallas | Houston | Austin

The Universal Applicability of Pass-Through Claims to All Parties to a Construction Project

By: Benton T. Wheatley and Jessica (Jessie) C. Neufeld
The Construction Lawyer
Winter 2012

In construction claims, the concept of privity presents an inherent inefficiency that public policy and jurisprudence have struggled to overcome. For example, a general contractor’s claim arising from defective plans and specifications must typically include the owner simply because the owner has privity with both the general contractor and the designer. This feature causes inefficiency by leading to two separate lawsuits (especially when the owner and design professional have used AIA forms that may require arbitration and prevent joinder) or the inclusion of the owner in the lawsuit, subjecting it to unwarranted litigation costs.

Subcontractors encounter similar difficulties when they have a claim that results from the owner’s breach of contract with its general contractor. Courts have routinely resolved this inefficiency, while preserving the concept of privity, by allowing intermediaries to present a damaged party’s claim to the responsible party via a method called pass-through claims. Pass-through claims result in claim accrual, and therefore standing on the part of the intermediary, because an intermediary suffers actual damage if it remains responsible for payment to the damaged party. A pass-through claim is defined as a claim

(1) by a party who has suffered damages;
(2) against a responsible party with whom it has no contract;
(3) presented through an intermediary who has a contractual relationship with both.

The overwhelming majority of cases concerning pass- through claims involve a subcontractor as the damaged party, a general contractor as the intermediary, and an owner as the responsible party. (This Subcontractor-Contractor-Owner pass-through claim is hereafter referred to as a “subcontractor claim.”) Although the few courts that have been asked to apply pass-through claim principles to other party classifications have allowed those cases to go forward, the applicability of pass-through claims beyond the subcontractor claim context is not widely discussed in case law or law journals. As a result, there may be reluctance on the part of practitioners to recommend this model of claim prosecution to their clients, for fear that the lack of legal authority means that the claims are not viable. However, as construction litigation costs continue to rise, and procedural safeguards (such as certificates of merit) for defendants continue to be implemented, the wisdom of requiring multiple parties be involved in multiple lawsuits to satisfy what is essentially one claim must be reconsidered.

This article argues that pass-through claims are universally applicable to all contractual relationships in a construction project scheme, whether it be a design professional asserting a claim against a general contractor, a general contractor asserting a claim against a second-tier subcontractor, or a subcontractor asserting a claim against a construction manager. What makes a pass-through claim viable is not the classification of the parties (i.e., subcontractor, contractor-owner, architect), but the unique nature of construction industry contractual relationships, the nature of the liabilities among the parties, and compliance with the procedural requirements of pass-through claims. The courts that have applied these principles beyond subcontractor claims have uniformly found the equitable nature of the claims and the public policy of judicial efficiency sufficient to allow expansion of pass-through principles to other construction industry relationships.

Equitable Subrogation: The Pass-Through Claim’s Philosophical Predecessor

Before the creation of pass-through claims, one mechanism by which parties in similar contractual relationships addressed the privity barrier was to assert a claim for equitable subrogation. This cause of action allows relief “when one person has satisfied the obligations of another and equity compels that the person discharging the debt stand in the shoes of the person whose claim has been discharged, thereby succeeding to the rights and priorities of the original creditor.” In order to establish accrual and standing, and therefore a claim for equitable subrogation, a claimant need only prove:

1. that the benefited party was primarily liable; and
2. that the party paying the debt

a. has some right or interest to protect; and
b. is not a mere volunteer acting without obligation.

Courts have allowed equitable subrogation claims in construction disputes, and in so doing have focused on typical equitable principles and judicial efficiency. For example, the Florida Court of Appeals articulated its concern over judicial efficiency in a construction-related equitable subrogation claim, stating:

[O]ne should have the right to settle a lawsuit in which there is reasonable doubt concerning liability and not be required to incur all of the expenses of litigation to conclusion before being entitled to seek subrogation. To hold otherwise would be to discourage settlements and to promote litigation, a concept which should he discouraged by the courts. We believe it is not inappropriate to hold that one who is sued . . . and who, in an effort to save his property, including the expenditure of attorney fees, enters into a reasonable settlement is not a volunteer and is entitled to seek reimbursement under the doctrine of equitable subrogation.

By allowing equitable subrogation claims, courts have acknowledged the inefficiency of forcing, for example, a subcontractor to sue its general contractor in order to recover for damages caused by the owner. Instead, the damaged party can accept payment from the intermediary for those damages and, in doing so, create accrual and standing for an equitable subrogation claim that the intermediary could assert against the responsible party. Furthermore, there are no party classification restrictions in equitable subrogation jurisprudence, beyond the substantive issues of claim accrual, standing, and the claim elements described by the court in Kala. Finally, a party ultimately determined to be liable is not in any manner prejudiced by allowing such a claim to go forward because all of the defenses that would have been available to a defendant if it had been sued in the first place are still available in defense of a subrogation claim.

However, equitable subrogation has its limitations. For a claim to accrue, a debt must actually be paid by the intermediary while acting under some compulsion. Once the claim has been paid, the intermediary is damaged and has standing to bring the equitable subrogation claim. By relaxing the payment requirement, pass-through claims further streamline this process, thereby enhancing the judicial efficiency inherent in the equitable subrogation claim, while continuing to serve the same fundamental principles of equity that long-standing cause of action was intended to achieve.

The Philosophical Shift: The Intermediary’s Claim Accrues via Agreement as Opposed to Payment

In approving a pass-through claim as a valid cause of action, the Tenth Circuit articulated equitable subrogation’s main deficiency in the construction law context: the intermediary must pay the damaged party before its claim against the responsible party accrues. The Tenth Circuit noted that it would be easy to forecast the financial ruin of intermediaries if a rule existed that required them to have paid the damaged party in full before they could in turn receive payments from the responsible party for the damaged party’s work. Thus, enter the pass-through claim.

The pass-through claim removes the payment barrier by enabling the intermediary’s claim to accrue, not upon payment to the damaged party, but upon the execution of an agreement whereby the intermediary contractually agrees to be liable for the damaged party’s yet unpaid claim. In determining that “[i]t is not necessary to have paid a cost in order to have ‘incurred and recorded’ it.” the court concluded that “incurring” a future contingent cost equated to damage for the purposes of claim accrual and standing.

Courts have emphasized the importance of continuing liability in taking the step from paid to will pay in order for the intermediary’s claim to accrue, and for that party to have standing. A pass-through claim is permitted in Texas as long as the intermediary remains liable to the damaged party bringing the claim. Continuing liability is usually expressed either in the existing contract between the parties or in a separate agreement. The agreement that a party must enter into in order to assert a pass-through claim, which is typically called (and hereafter referred to as) a liquidation agreement, contains three main elements:

1. The imposition of liability upon an intermediary for a damaged party’s increased costs, thereby providing the intermediary with a basis for legal action against the responsible party;
2. A liquidation of liability in the amount of the intermediary’s recovery; and
3. A provision for the pass-through of that recovery to the damaged party.

The element of continuing liability provides the intermediary with standing to bring the claim and thereby avoids upsetting the proverbial privity applecart.

Numerous legal opinions and law reviews have discussed the general elements of pass-through claims and liquidation agreements, the Severin Doctrine, and the exceptions to it. At the root of all of these discussions is [t]he crucial issue . . . of determining whether the prime contractor has expressly negated any liability to the subcontractor for the damages sought to be recovered.” The concept of continuing liability, and not the classification of the parties, is the most important factor in determining claim accrual and standing, and should be the focus of any court examining the viability of a pass-through claim.

In his law review note in 1983, Henry R. Kates examines the numerous exceptions to the Severin Doctrine and notes that most post-Severin courts have been engaged in “results oriented analysis,” which is “based on nothing more than legal fiction.” Instead of focusing on party classification or privity, Kates suggests a practical solution requiring only that the named plaintiff in a suit be a real party in interest as defined in Federal Rule of Civil Procedure 17(a) A party qualifies as a real party in interest if, according to substantive law, it is entitled to enforce the right asserted. Under this theory, a two-part test must be satisfied in order for a pass-through claim to be valid.

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