Texas Recognizes “Pass-Through Claims”

In the construction industry, you have Owners, General Contractors, and Subcontractors. The big contract is between the Owner and the GC, with separate contracts between the GC and the Subs. The question is, when can a Sub and an Owner go at each other for breach of contract? Before this case the answer was “they can’t” because there is no contract directly between the two of them. But in 2004 the law changed. Substantially. Formally. The Texas Supremes decided that Texas law recognizes “pass-through claims.”

The Texas Supreme Court opinion in this case runs about 28 pages, and it is a very detailed review of this legal issue–pass through claims–by other courts around the U.S., followed by some very detailed logic as to why those cases are good/bad or right/wrong. But let’s cut to the chase here. Let’s start by defining what a “pass through” claim is, and is not, and then we’ll look at the new rule established by this case.

In the most typical situation, you have three parties (sometimes referred to as a “three ring circus”). Let’s call them “GC”, “Sub” and “Owner.” GC and Sub have a written contract. GC and Owner have a written contract. There is no contract between Owner and Sub. Owner does something (or fails to do something) that causes Sub damages. It is basically a breach of the contract between Owner and GC, but since there’s no contract directly between Sub and Owner, how is this handled?

One way would be for the Sub and the GC to sue each other on the claim, based on the contract between the GC and Sub, with the GC then suing the Owner, based on the separate contract between the GC and the Owner. But a second way is for the Sub to “pass through” its claim to the GC, with the GC suing the Owner based on the Sub’s claim.

First, here’s the Court’s formal definition of a pass-through claim. It is a claim: (1) by a party (Sub) who has suffered damages; (2) against a responsible party (Owner) with whom it has no contract; and (3) presented through an intervening party (GC) who has a contractual relationship with both.

Typically the GC remains liable to the Sub, but only to the extent the GC receives payment from the owner. The GC and Sub often enter into a “liquidation or consolidation-of-claims” agreement that sets out the manner and procedure by which the GC presents and pursues the Sub’s claim to the Owner. These types of agreements may be in the original contract, or they may be entered into later (as in after the trouble has shown up).

A “liquidation agreement” is where: (1) the GC acknowledges its liability to the Sub, thereby providing the GC with a basis for legal action against the Owner; (2) the GC’s liability is limited to the extent of the GC’s recovery from the Owner; and (3) the GC agrees to pass its recovery to the Sub. The Sub releases all claims it may have against the GC in exchange for the GC’s promise to pursue those claims against the Owner and remit the recovery to the Sub.

Now, right off the bat a red flag should go up here. Isn’t it in the GC’s best interest to deny the Sub’s claim, and fight it, so that the GC isn’t liable in the first place? Anytime 3 parties are involved, and it’s 2 vs. 1, the “1” is automatically in a weaker position, just from a practical standpoint. So owners would theoretically want to prevent this from occurring. But irrespective of red flags and desires, the answer to the red flag question is “yes, perhaps, but….”

But (1) the contracting industry has broadly accepted pass-through claims across the U.S.; and (2) the contractor is not the Sub’s pawn, as in the GC does not have to enter into a pass-through arrangement if it disputes the Sub’s claims, nor assert them against the Owner; and (3) they do not create a false impression of adversity between the GC and Sub; and (4) a GC exposes itself to counterclaims by the Owner if it pursues a pass-through claim, and to penalties assessed by the Court (although the GC may “elect to delegate” to the Sub the cost of prosecuting the Sub’s claim).

So what happens if the Owner doesn’t agree that the GC is even liable to the Sub for the Sub’s claim being asserted against the Owner via pass-through? Thus saith the Texas Supremes, “If the owner disputes that this requirement has been met, it bears the burden of proving, as an affirmative defense, that the pass-through arrangement negates the contractor’s responsibility for the costs incurred by the subcontractor.” To defeat a pass-through claim on its face, an Owner must prove that the GC would not be liable to the Sub if it refused to present the pass-through claim or to remit the recovery to the Sub.

Before we get too carried away, note this limitation on the reach of this decision: “In articulating this rule, we explicitly confine our rationale to construction contracts involving owners, contractors and subcontractors.” Otherwise, the parties have to be parties to the same contract in order to go at each other for breach of contract. We lawyers call this “privity of contract.”

And there you have it, a very important pronouncement from the Texas Supremes that Texas recognizes pass-through claims.

Interstate Contracting Corp. v. City of Dallas, Texas, Case No. 03-0152, Texas Supreme Court, decided April 16, 2004.

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