What is a flow-down clause, and why are they used?
The ultimate driver behind any project is the requirements of the employer. It is the employer that requires the delivery of the project, it is (usually) the employer that specifies the scope of works and it is the employer that must be satisfied by the quality of the work that is eventually delivered. To that end, a great deal of time, effort and money is usually invested in the negotiation and agreement of a contract between the employer and the main contractor under which the main contractor bears the responsibility of delivering the project on time and in accordance with the scope of works.
In a minority of cases, the main contractor will carry out the entire scope of works itself, meaning that there is a neat and tidy “one stop shop” for both project responsibility and project delivery. However, the main contractor will rarely carry out all of the works itself and a number of subcontractors will typically be engaged by the main contractor to carry out elements of the work on its behalf. Therefore, the person delivering the works was often not involved in the process of negotiating the main contract at all, has not seen that contract and is accordingly unaware of the employer’s specific requirements.
Whilst a subcontractor will usually be required to provide a collateral warranty to the employer, it may only be bound to the obligations set out in its subcontract with the main contractor, which could range from anything between a letter of instruction to a full, formal agreement. Particularly where the subcontract is nearer to the informal end of that scale (a letter of instruction or purchase order, for example), it is likely that the obligations of the subcontractor to the main contractor fall short of those of the main contractor to the employer. These discrepancies will often not just be limited to the specification of the works and the key dates for delivery, but will often include other obligations that the main contractor has to the employer such as those in respect of intellectual property, health and safety performance or site security.
The party that is most obviously disadvantaged in that scenario is the main contractor. If the subcontractor’s works are delivered in accordance with the subcontract but do not fully meet the requirements of the main contract, then it is the main contractor that will be liable to the employer for the discrepancy. This liability cannot be passed on to the subcontractor, who has of course complied with its own obligations. It is clearly in the main contractor’s interest, therefore, to find a way of closing off any gaps between the subcontractor’s obligations and its own and well drafted flow-down provisions can help to achieve that.
That having been said, it is also in the employer’s interest to ensure that its requirements are passed down the chain to the subcontractor. Notwithstanding the risk of (main) contractor insolvency, which the employer will usually carry, the employer’s right to sue the contractor in respect of a breach of the main contract is scant consolation for poor performance and/or late delivery. Put simply, an employer would rather have delivery of a successful project than the right to sue on a failure. If subcontractors are obliged to deliver their works as per the requirements of the main contract, the chance of the final product falling short of the employer’s requirements is diminished and any collateral warranties provided to the employer by those subcontractors become more valuable.
Types of flow-down clause
There are many ways to draft a flow down clause, but the objective is always the same – to make sure that the obligations of the subcontractor to the main contractor mirror the obligations of the main contractor to the employer.
The key question when drafting such clauses is the extent to which the subcontract in question should incorporate terms of the main contract. If a subcontractor is effectively taking on the entirety (or even the bulk) of the main contractor’s work scope, it makes sense to look for a full flow-down of the main contract.
Achieving a true flow-down or “back-to-back” arrangement would involve incorporating into the subcontract all of those provisions imposing rights or liabilities which are relevant to the subcontractor. This can be done by way of an over-arching clause, stating that the subcontractor has reviewed and agrees to be bound by the obligations imposed on the main contractor under the main contract, such as:
“The Subcontractor has received a redacted copy of the Main Contract, has reviewed the Main Contract and finds the terms and conditions stated therein to be acceptable. The Subcontractor agrees to be bound to the Contractor for all those obligations under the Main Contract with respect to the Subcontract Works as the Contractor is bound to the Employer under the Main Contract and, with respect to the Subcontract Works, the Contractor shall have the same rights with respect to the Subcontractor as the Employer has with respect to the Contractor under the Main Contract. All provisions in the Main Contract that are applicable to the Subcontractor and the Works are incorporated by reference herein. Should there be a conflict between the Main Contract and this contract; the terms in the Main Contract shall prevail”.
In reality however, a subcontractor will rarely be taking on a sufficient proportion of either the main contractor’s scope of works (or, a subcontractor might argue, the profits generated by the project) to justify a wholesale incorporation of the main contract terms. In these circumstances, a flow-down clause would ideally be drafted to address the specific terms of the main contract that apply to the subcontract. These specific provisions might include such things as payment, disputes, variations, termination, key dates, insurance, intellectual property and liquidated damages.
Care needs to be taken when drafting flow-down clauses and whilst there is a temptation to see them as a quick drafting short cut this is a trap for the unwary. Incorporation of terms by reference in this manner requires clear wording to be effective, and this is particularly so where the term to be incorporated comprises an exclusion or limitation of liability. A poorly drafted flow-down clause, instead of creating a “back-to back” arrangement can result in uncertainty as to the terms of the subcontract and the extent to which the terms of the main contract are incorporated. Such uncertainty can act as a barrier to the parties resolving contractual issues which may arise and in the worst cases can even result in satellite disputes as to the terms of the contract.
Drafting effective flow-down clauses - potential pit falls
The approach most suitable in each case will depend on the circumstances, the nature of the project and the proportion of the work being subcontracted. However, irrespective of which approach is taken, there are a number of issues that may arise in using a flow-down provision. In order to maximise the effectiveness of the flow-down arrangement, the parties should be mindful of the following:
- The subcontractor should be given enough time to properly consider both the main contract and the subcontract. The process of considering a flow-down arrangement will likely not only include the parties’ legal teams, but also their internal commercial and risk management teams. This will take time and the process will be much more beneficial in the long run if it is not unduly rushed, enabling the parties to come to a more effective agreement at the outset.
- The main contract and the subcontract should ideally be negotiated in parallel. It is much easier to negotiate the back-to-back arrangement if both contracts are negotiated in tandem and the subcontractor is not ultimately just “lumbered” with terms that were agreed prior to its involvement. If a term is poorly drafted in the main contract, incorporating it into the subcontract can be more detrimental than beneficial. Any term in the main contract that would be a potential “deal breaker” to a subcontractor should be flagged up early in the process, as it may be that the employer can offer some flexibility. This is particularly important where a particular, specialist subcontractor offers a unique service and is integral to the project.
- If the main contract has already been entered into, a flow-down provision is required in the subcontract but there is a provision in the main contract that the subcontractor will not accept, it may be prudent to find out whether or not the employer would grant a waiver in respect of that particular provision.
- The parties also need to recognise that in some instances that whilst flow-down of a particular term in the main contract is desirable, it may not always be appropriate for it to flow-down without any amendments. For example, an obligation on the contractor to hold professional indemnity insurance should flow down to a subcontractor with material design responsibility. However, if the subcontractor’s design scope is smaller than that of the main contractor it may be appropriate for the subcontractor to hold a lower value of cover. Similar considerations may apply in relation to the level of caps on liability.
Consider the practicalities
A well thought out flow-down provision will not only set out the relevant clauses of the main contract, but will also include additional provisions which explain how the subcontractor is expected to comply with the obligations being passed down. By way of an example:
- The works involve the refurbishment of a manufacturing facility that is divided into six individual units. The employer wishes to minimize the impact of the work on production and the main contract therefore provides for the release of the units in sequence to the main contractor. There are no staged completion dates by which each individual unit must be completed, but there is a long stop date by which all of the works must be complete.
- Under the main contract, if the main contractor serves written notice on the employer that it will be ready to commence work on a unit within five days, and if the employer then fails to offer vacant possession of the unit before those five days have expired, the main contractor is entitled to additional cost and an extension to the long-stop completion date for the whole of the works.
- The works in question are subcontracted out by the main contractor under a subcontract which includes a flow-down provision. The flow-down provision simply recites the relevant clauses of the main contract, including those concerning the abovementioned notice periods and extensions of time.
- If, on June 1st, the subcontractor serves notice on the main contractor that it will be ready to commence works on June 6th, then it will be entitled its additional costs and an extension of time under the subcontract should the unit in question not vacant and available on that day.
- The main contractor must then serve its own notice on the employer on June 1st to ensure that the liability for any delay is passed “up the chain”. Should, the main contractor not serve its own notice on the employer until - for example - June 3rd, then the main contractor would find itself liable to the subcontractor for two days delay under the subcontract with no recourse to the employer should the employer not make the unit available until June 8th as per its obligation under the main contract.
A very well drafted flow-down provision will have considered the application of the main contract and identified the possibility of the main contractor being caught out. In this case, the subcontract might include a requirement that the subcontractor give the main contractor at least ten days notice, rather than five, before vacant possession of a unit is required. This would enable the subcontract to bridge the gap between the obligations in the main contract and the subcontractor’s performance.
There is clearly a place for well drafted flow-down provisions in subcontracts and the potential value of such terms is clear, provided that they are appropriate to a particular project. When negotiated and drafted properly, a flow-down provision can provide certainty to the subcontractor, security to the main contractor and comfort to the employer.
That having been said, getting the flow-down arrangement absolutely right is as much down to the principles of pragmatism and timing as it is to good legal drafting. All parties must be afforded the requisite time to consider the terms of both the main contract and the subcontract, as well as how the interface between the two will operate in practice. The negotiations should be geared towards the achieving the most effective arrangement for all parties, not merely the out-sourcing of risk.