Back-to-back agreements, by which a main contractor seeks to pass its obligations and liabilities towards the employer through to its subcontractor(s), are becoming an increasingly common feature of construction projects. While they can be a convenient means of transferring risks and obligations down the chain of responsibility, inadequate drafting can give rise to disputes which are particularly complex and difficult to resolve.
In this newsletter we discuss the key reasons why back-to-back contracts can be particularly contentious and the main drafting issues that need to be considered and addressed in order to minimise the risk of disputes.
The back-to-back scheme
Large international construction projects often require the collaboration of several participants with different capabilities. However, the owner (employer) of the project, often will require the project to be structured such that it has only a single contractual relationship (the main contract) with one of the participants (the main contractor) and not with all of them individually. From the employer's perspective, there is much attraction in structuring the project such that the main contractor acts as the single point of responsibility.
The main contractor, having assumed responsibility for all aspects of the project vis-à-vis the employer, will aim in turn to pass on its obligations and liabilities to its subcontractors so that it is left with only minimal, or no, obligations or liabilities to meet on its own.
There are therefore obvious benefits for contractors in implementing back-to-back arrangements. However, in practice drafting back-to-back agreements can be a difficult task.
Drafting back-to-back contracts
There are, in broad terms, two ways of structuring back-to-back subcontracts:
- by incorporating by reference all the terms of the main contract save for certain parts of the main contract which are expressly excluded or varied (often these are limited to clauses which are obviously not applicable to the subcontract, for example clauses relating to price); and
- by drafting a stand-alone set of terms and conditions specific to the particular subcontract.
The first approach is often seen by contractors as being the easiest and therefore most cost-efficient means of passing down liabilities. However, without careful attention such an approach can often result in difficulties. Particular care needs to be taken when drafting the back-to-back provisions. For example, a general provision stating that all references in the main contract to the "Employer" and "Main Contractor" are to be read in the subcontract as being references to the "Main Contractor" and "Subcontractor" respectively, may not be appropriate for every obligation and could result in rendering what should be an essential term of the contract either ineffective or subject to an interpretation that was never intended. Further, where there are long and detailed main contract specifications (often in the form of employer's requirements) it can be a very complex, and indeed contentious, task to separate out the obligations that are relevant to each individual subcontract; the subcontractors' greatest concern being that they will inadvertently be taking the risk for matters that are inappropriate given the size and scope of their particular subcontract.
These issues should be capable of being overcome by proper drafting of a standalone subcontract. A further obvious advantage of standalone contracts is that in executing the subcontract the parties only have to refer to the one subcontract, rather than having to also cross-refer to the main contract which itself can cause confusion. However, drafting standalone contracts should by no means be considered to be an easier task; again considerable care needs to be taken.
Common drafting issues
Irrespective of which drafting approach is taken, there are a number of issues that require particular attention:
Conditional payment clauses
A common feature found in back-to-back contracts is a provision that payment to the subcontractor will be conditional upon the main contractor receiving payment under the main contract. However, such "pay-when-paid" clauses are not enforceable in construction contracts under the laws of certain jurisdictions, including England and Wales and Singapore. Sometimes a "pay-when-certified" clause will be seen as an appropriate compromise if not also outlawed in the relevant jurisdictions, as it will shortly be in England and Wales. Even if such clauses are not prohibited under the applicable law, they are often resisted by subcontractors who expect to be paid once they have rendered due performance of their obligations under the subcontract irrespective of the position further up the chain.
General or liquidated damages?
Will the main contractor be seeking to pass on liquidated damages levied by the employer under the main contract to the subcontractor as general damages? If so, it will be desirable from a main contractor's point of view to specify in the subcontract that, without prejudice to its right to recover general damages, any claim by it for general damages may include some or all of the liquidated damages levied by the employer under the main contract. This is because it might otherwise be questionable whether the liquidated damages levied against the contractor by the employer constitute direct or indirect/consequential loss as against the subcontractor and therefore irrecoverable under the relevant exclusion clauses in the subcontract. It will, of course be necessary to apportion the full amount of liquidated damages applicable so as to provide for recovery of only those in respect of which the contractor can legitimately claim against the subcontractor.
The subcontractor may, of course, resist inclusion of this item aslikely to tempt the contractor to seek to levy the full amount of liquidated damages against an individual subcontractor. Instead, the subcontractor may prefer to negotiate a rate of liquidated damages that covers all of the subcontractor's liability for the relevant breach (e.g. delay) under the subcontract. While liquidated damages carry certain advantages for the main contractor, particularly in terms of certainty of recoverable damages and not having to prove actual loss, the main disadvantage lies in the risk that the rate of subcontract liquidated damages will not ultimately cover the actual loss and/or damage sustained by the subcontractor's breach.
It is imperative that deadlines in the subcontracts are aligned to those in the main contract, for example in terms of document approvals, delivery/completion dates and claims notification periods. Some form of early warning procedure may be desirable.
Gaps in the claims procedures across the two contracts are of particular risk to main contractors. This is because in many contracts the main contractor's right to claim in full against the employer will be contingent on complying with the main contract notice requirements. Those notice requirements therefore need to be adequately reflected in the subcontract. In particular, the main contractor will need to ensure that it is not prevented from claiming in full against the employer by reason of not receiving the necessary claim details from the subcontractor in time, while remaining liable to the subcontractor for the same claim.
To avoid such a predicament, main contractors will need to ensure that the subcontract contains notification periods that are shorter than those provided for in the main contract, so as to ensure that the main contractor has sufficient time to pass on a subcontractor's notice of claim to the employer. In addition, the subcontract should require the subcontractor to provide exactly the same information about the claim as the main contractor is required to provide under the main contract.
In a back-to-back scheme, a dispute between the main contractor and the employer is likely to have significant implications for the relationship between the main contractor and the subcontractor, and vice versa.
Depending on the nature of the subcontract, claims that are commonly passed up and down the chain include those relating to defects, performance failures and delays, and variations (both in terms of scope and valuation). In all cases, the main contractor will want to ensure that it is not shouldered with a liability in respect of matters outside its control that it cannot pass on to its respective counterparts. The main contractor's greatest concern will be to ensure that it is not exposed to differing decisions by the courts or tribunals appointed under the two contracts.
The following are some of the main issues that will need to be considered:
- To what extent should the findings of a dispute adjudication board or arbitral tribunal in a dispute between the employer and the main contractor be binding between the main contractor and the subcontractor and vice versa? This is something that is likely to be strongly resisted by subcontractors and employers respectively.
- Clauses providing that a party is to be bound by the outcome of proceedings under a contract to which it is not party could be acceptable if that party is given a contractual right to participate in the main contract proceedings. In this regard, consider whether the third party should be given the right to participate directly (preferable for the main contractor and subcontractor) or indirectly (preferable for the employer) in those proceedings.
- Under what circumstances will the main contractor be obliged to pursue the subcontractor's claim against the employer and what is the sanction for a failure to pursue such a claim? This is a common concern of subcontractors as the main contractor may often be less interested in pursuing claims in which it has little or no interest, particularly if it has a commercial interest in maintaining good relations with the employer in order to secure future projects.
The FIDIC Subcontract
In response to industry demand, FIDIC is in the process of preparing a Subcontract for Construction for Building and Engineering Works Designed by the Employer to be used for subcontracts intended to be back-to-back with the FIDIC 1999 Red1 and Pink2 books. In November 2009 FIDIC released a test edition of the Subcontract for comment. The test edition is largely well-drafted however certain of the pass-down provisions could do with some revision in the final version that is due to be published for use this year. The dispute resolution clauses in the test edition attempt to address the three issues referred to above however, regrettably, they are somewhat lacking and contain substantial risks for both the main contractor and the subcontractor. Again, it is hoped that these issues will be resolved in the final version. For a more detailed commentary on the FIDIC test Subcontract please click here.
A rigorous drafting process across all subcontracts
There is no one-stop solution to the various possible pitfalls associated with back-to-back contracts. Whichever approach to drafting back-to-back contracts is chosen, the decision should never be based with the intention of short-cutting what should necessarily be a rigorous drafting process. Both main contractors and subcontractors will have a vested interest in ensuring that the subcontract is properly drafted. In addition, where there are a number of subcontracts the main contractor will need to ensure that its main contract obligations are properly allocated between the various subcontractors and none unwittingly omitted.