COVID-19 Contract Termination – Subcontractor Attempts to Use “Flow-Down” Provision to Arbitrate Trust Fund Claims against Project Owner

By Henry L. Goldberg, Esq., STA General Counsel and Robert J. Fryman, Esq

Henry L. Goldberg
Subcontractors Trade Association
Partner,
Moritt Hock & Hamroff LLP

Robert J. Fryman, Esq
Partner
Moritt Hock & Hamro

The New York State Supreme Court recently considered what may be the first of many cases alleging effects of the COVID-19 Pandemic on a construction project.  In a case of a termination for default of a Subcontractor by General Contractor for allegedly failing to provide sufficient man power to the project, which Subcontractor contends was a result of the COVID-19 Pandemic, the subcontractor attempted to assert Lien Law Trust Fund diversion claims against the project owner in an arbitration with the general contractor. More specifically, the Court examined whether the Subcontractor could arbitrate claims against the project owner under an arbitration provision contained in the prime contract between the project owner and the general contractor, pursuant to an incorporation by reference or “flow-down” provision.

In previous Legal Logs we have discussed the effect of “flow-down” provisions in a subcontract, which incorporate certain terms and conditions of the prime contract into the subcontract.  In doing so we have always stressed the importance of reviewing and familiarizing yourself with all applicable contract documents, including the prime contract, for this very reason: which terms and provisions of the prime contract are “flowed down” to and bind you via the subcontract?

At issue in this case was the Subcontractor’s attempt to “reverse” the flow-down of the prime contract.  As the Subcontractor was not in contract with the project owner, Subcontractor argued that the “flow-down” provision of the Subcontract made the project owner subject to arbitration of claims by the Subcontractor.

The Contracts, the “Flow-down” provision and the dispute between the parties

In January 2019, General Contractor entered into a contract with project owner (“Owner”) for the construction of an affordable housing project in Brooklyn, New York. The project was to consist of the rehabilitation and development of one building into a community center and the construction of two new residential buildings.  The agreement between the Owner and the General Contractor (the “Prime Contract”) provided that any disputes arising between Owner and General Contractor that could not be resolved through mediation would be resolved by arbitration, a common dispute resolution provision.

In July 2019, Subcontractor entered into three separate subcontracts with the General Contractor, one for each of the three buildings which would comprise the project.  The Subcontracts all provided that any claims or disputes between Subcontractor and General Contractor arising out of or in connection with the Subcontractor or work at the project “shall be resolved by litigation unless [General Contractor], at its sole option, advises [Subcontractor] in writing…that [General Contractor] elects to have the claim or dispute resolved by arbitration”.

Disputes arose between the General Contractor and Subcontractor with respect to the project and the Subcontracts.  More specifically, General Contractor contended that the work of Subcontractor was defective, untimely, and unworkmanlike and that the Subcontractor failed to comply with the project schedule and failed to adequately staff the project. Subcontractor contended that due to the Covid-19 pandemic it had difficulty fully staffing the project, and more specifically, that after advising General Contractor that its crew could not proceed to the project site as several members of the crew were then exhibiting Covid-19 symptoms (in compliance with Covid-19 protocols), General Contractor terminated Subcontractor.^[1]

The Subcontractor’s Litigation, General Contractor’s Election to Arbitrate

and Subcontractor’s Attempt to Arbitrate Trust Fund Claims Against the Owner

Following the issuance of the termination for default, Subcontractor commenced a lawsuit against General Contractor.  However, pursuant to the subcontract, General Contractor elected to have Subcontractor’s claim determined by arbitration. General Contractor simultaneously commenced an arbitration against Subcontractor for damages allegedly resulting from Subcontractor’s breach of the subcontracts.

Subcontractor then filed its own arbitration demand against General Contractor alleging breach of contract and other contractual causes of action.  In its arbitration demand, Subcontractor also sought (i) a Trust Fund Accounting, (ii) to enforce the Trust Fund provisions of Article 3-a of the Lien Law and (iii) a judgment against the General Contractor and against the Owner for alleged Trust Fund diversions.  Owner then moved in the New York State Supreme Court for an order to stay the arbitration of Subcontractor’s claims against Owner contending that Subcontractor had no basis to arbitrate claims or disputes against the Owner.

The Subcontractor’s “Reverse Flow-Down” Argument for Arbitration Against the Owner

Subcontractor opposed the application to stay the arbitration of its claims against the Owner arguing that under the provision of the Prime Contract which were “flowed down” into the Subcontract, the Owner had agreed to arbitrate disputes.  Subcontractor contended that the Owner’s agreement to arbitrate claims and disputes arising under the Prime Contract also included the Subcontract and claims arising under the Subcontract.

While a valid flow-down clause in a subcontract could incorporate a dispute resolution provision for arbitration set forth in a prime contract and make it binding on the subcontractor (i.e., to compel the subcontractor to follow the arbitration or alternative dispute resolution process specified in the prime contract) in this case, what the Subcontractor attempted to do was argue the reverse.  Subcontractor argued that by virtue of the Owner and the General Contractor agreeing to arbitrate disputes between each other in the Prime Contract, the Owner had also agreed to arbitrate claims brought by other parties, such as the Subcontractor.

The Court, however, disagreed, noting that the Owner was not a party to the Subcontracts and that the Prime Contract specifically provided that it “shall not [be] construed to create a contractual relationship of any kind…between Owner and a Subcontractor or a Sub-Subcontractor”.

Ultimately, the Court granted a stay of the arbitration of Subcontractor’s claims against the Owner finding that (i) there was no agreement to arbitrate between the Owner and the Subcontractor; (ii) while the Prime Contract between General Contractor and the Owner contained an arbitration provision, Subcontractor was not a party to the Prime Contract, (iii) the dispute that Subcontractor sought to arbitrate did not arise out of nor was it related to the Prime Contract, and (iv) the dispute which Subcontractor sought to arbitrate was related to the Subcontracts between General Contractor and Subcontractor and Owner were not a party to those Subcontracts.

MHH Commentary

While incorporation by reference or flow-down provisions in contracts can, in certain instances, be “two-way streets” flowing obligations, rights and remedies both upstream and downstream, careful attention must be paid to the express language and intent of those incorporation by reference or flow-down provisions to determine exactly which rights, remedies and obligations are “flowed-down” and how far those extend.  This is all the more important in the case of dispute resolution provisions, such as mediation and arbitration provisions.  Such provisions typically arise only as a function of contract and must be expressly agreed to by the party to be charged with an agreement or obligation to arbitrate or mediate their disputes.

In certain cases, such as here, claims against different parties will require resort to more than one forum or dispute resolution mechanism, such as arbitration against one party but litigation against the other.  The Subcontractor’s attempt to include its Article 3-a trust fund claims against the Project Owner in an arbitration with the General Contractor (as provided under its subcontract) was rejected by the Court.  However, this does not leave Subcontractor without rights or remedies under the Trust Fund provisions of Article 3-a as against Owner (such as trust fund accounting and/or for potential trust fund diversions) – the Subcontractor can pursue its trust fund rights and remedies against the Owner separately in court.

Careful review and consideration of the applicable contract documents, legal rights and remedies (and applicable statutes of limitations, to ensure timeliness) as well as evaluating the value and potential expense of pursuing certain rights and remedies against different parties prior to commencing an arbitration or litigation is key to effectively (and efficiently) preserving and asserting your rights and remedies under your subcontract, the prime contract and applicable law.

As always, if you have any questions, please feel free to contract us.

[1] As an affordable housing project, the project at issue was deemed “essential work” and allowed to operate at reduced staffing levels pursuant to the Executive Orders of New York Governor Andrew M. Como issued as part of the New York PAUSE Orders in response to the COVID-19 Pandemic.  However, such work was subject to strict guidelines and protocols to mitigate the spread of COVID, including with respect to preventing potentially symptomatic workers from being on site.