Unintended Third-Party Beneficiaries Created Through Flow Down Clauses in Subcontracts

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Construction work done under an agreement between a general contractor and a subcontractor clearly has the property owner—the ultimate recipient of the construction work—in mind. It is somewhat counterintuitive, then, that the general rule in contract law is that the property owner is not an intended beneficiary of subcontracts between general contractors and subcontractors working on the project. Nevertheless, this is the rule followed by the majority of courts and supported by influential legal commentators. It is a rule well-settled in precedent and well-founded on policy. However, you may wish to consult with a knowledgeable construction attorney in your state to confirm that your state follows the general rule.

Attorneys relying on this well-settled rule while drafting construction subcontracts may be surprised to discover that a commonly used provision, a flow down clause, can muddy this legal analysis and create third-party beneficiary status in a property owner. This article reviews the black letter law governing property owners’ third-party beneficiary status in construction subcontracts and then examines the flow down clause and a recent Utah case that calls this rule into question when the subcontract or subconsultant agreement contains a flow down clause.

The general rule is that a party does not become a third-party beneficiary of a contract absent manifestation of the promisor and promisee’s intent to provide a direct benefit to the third party. This general rule can be difficult to apply, but its application is quite clear in situations where a property owner and a general contractor have entered into a prime contract and the general contractor then enters into agreements with subcontractors. In such circumstances, the rule is that, although the property owner is the ultimate beneficiary of the completed construction, the owner is merely an incidental beneficiary of construction subcontracts.

This majority rule is well established and seems fairly easy to apply: “the owner has no right against the subcontractor, in the absence of clear words to the contrary. The owner is [not an intended, direct beneficiary]; the benefit that he receives from performance must be regarded as merely incidental.” The general rule’s appropriateness is particularly obvious when the subcontract contains what can be called a “non-beneficiary clause”—a provision expressly stating that the subcontract is not intended to benefit any third parties. Non-beneficiary clauses are common in a wide variety of contracts, and because they clearly eviscerate the intent requirement for third-party beneficiary status, courts have treated them as determinative in destroying outside parties’ claims to third-party beneficiary status.

Despite the general rule, however, and even despite the inclusion of a non-beneficiary clause, another common subcontract provision, the flow down clause, can muddy the third-party beneficiary analysis to the point that the owner may become a direct, intended beneficiary of the subcontract. For example, flow down clauses, which extend to the engineering firm the architect’s obligations to the owner under the prime agreement, are common in subconsultant agreements and may inadvertently grant third-party beneficiary status in such subconsultant agreements to property owners.

Our experience in a recent Utah case illustrates how flow down clauses can create third-party beneficiary issues even when the contracting parties were careful enough to include a non-beneficiary clause. The plaintiff was a property owner that contracted with an architect for the construction of a hotel. The architect, in turn, entered into a subconsultant agreement with a structural and mechanical engineering firm. The subconsultant agreement included a non-beneficiary clause. The subconsultant agreement also contained a flow down clause, however, making all terms of the prime agreement applicable to the engineers’ services. To the extent of any conflict between the terms and conditions of the subconsultant agreement and the prime agreement regarding the engineer’s scope of service or requirements of performance, the prime agreement was to govern the relationship of the architect and engineer.

Although not a direct party to the subconsultant agreement with the architect, the owner brought suit on the subconsultant agreement against the engineer, alleging a number of breaches. In response, the engineer filed a motion to dismiss. The motion was based on the general rule discussed above, which is also followed in Utah, that property owners are not intended beneficiaries of construction subcontracts. For the owner to achieve third-party beneficiary status, it had to show (1) that the flow down clause in the subconsultant agreement provided it with a separate and distinct benefit from the architect, and (2) that any apparent intention to benefit the owner was not invalidated by the subconsultant agreement’s non-beneficiary clause.

The owner argued that the engineer’s obligations under the subconsultant agreement flow down to the owner pursuant to the flow down clause. Utah case law, the owner argued, supports the proposition that when a prime contract is incorporated into a subcontract the prime contract’s terms must be interpreted as if they were the terms of the subcontract. Moreover, other precedent establishes that flow down clauses in subcontracts mean that the same rights and duties should flow equally from the owner down through the general contractor to the subcontractor, as well as flowing from the subcontractor up through the general contractor to the owner.

In addition to arguing that the subconsultant agreement did not confer a separate and distinct benefit upon the owner, the engineer claimed that any benefit that potentially existed was expressly denied by the non-beneficiary clause disclaiming any contractual relationship with, or cause of action in, third parties under the subconsultant agreement. In support of this argument, the engineer pointed to a decision by the Utah Supreme Court acknowledging that a non-beneficiary clause establishes the intent of the parties to a subcontract to not create third-party beneficiary status in the owner’s assignee.

The owner attacked the non-beneficiary clause with the arguments that (a) it was not bound by the clause since it was not a signatory to the subconsultant agreement, and (b) the clause was limited by the flow down clause. The flow down clause specifically carved out certain sections of the subconsultant agreement that could not be overridden by the prime contract. Because the non-beneficiary clause was not one of these carved out provisions, this meant it could be—and was—overridden by the terms of the prime agreement.

The owner survived the motion to dismiss, leaving resolution of the issue for further litigation in the suit. When attorneys include non-beneficiary clauses in subcontracts, or in subconsultant agreements, however, they no doubt hope to prevent third parties attempting to sue on the contract from achieving legal victories even in the earliest stages of litigation. For that reason, the revelation that in some circumstances a non-beneficiary clause in a subcontract or in a subconsultant agreement that also contains a flow down clause may be insufficient to preclude a cause of action by the property owner is a significant warning to parties negotiating subcontracts or subconsultant agreements.

If the parties don’t want the inclusion of a flow down clause to have unintended collateral consequences—including the creation of a third-party beneficiary—it is important to draft the clause to make that intention absolutely clear. Parties should be aware of the interaction between the prime agreement and the subcontract or the subconsultant agreement. In this case, the heightened duties of care imposed by the prime agreement alongside some assorted services provided by the subconsultant directly to the owner were enough to avoid a motion to dismiss.

Avoiding this problem will often be simple. It is likely that a different result would have been reached if the subconsultant agreement had simply carved out the non-beneficiary clause from the flow down clause, just as it had already done for various other subconsultant agreement provisions. This would have prevented the prime agreement from overriding the non-beneficiary clause, allowing the non-beneficiary clause to provide conclusive—or at the very least, very persuasive—evidence for the engineer that the owner was not an intended beneficiary of the subconsultant agreement. Such additional caution by parties drafting construction agreements can preserve the clarity of the general rule precluding property owners from becoming third-party beneficiaries of construction subcontracts or subconsultant agreements.

Topics:  Contract Drafting, Contractors, Flow Down Clause, Subcontractors, Third-Party Beneficiaries

Published In: General Business Updates, Construction Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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