Effectively Transferring Risk Through Incorporation by Reference Clauses

Incorporation by reference clauses are tools commonly used by contract drafters to extend the terms, obligations, rights, and remedies from one contract to another.  In construction contracts, these clauses are most often seen in subcontract agreements and bonds.  In subcontracts, incorporation by reference clauses are intended to bind the subcontractor to the general contractor in the same manner as the general contractor is bound to the owner. Contractors of both tiers should be aware of certain tricks and traps involving these clauses if they wish to draft them in a way that will ensure their enforceability.

Most sophisticated subcontract agreements include a definition of the assigned scope of work under the subcontract.  Often, for ease of reference elsewhere in the subcontract, the scope of work is defined and subsequently abbreviated as “The Work”.  In addition to terms discussing the scope of the Work, general contractors often seek to incorporate obligations relating to schedule, coordination, applicable standards of care, and warranty from the prime contract into the subcontract. One way to accomplish this incorporation is a standard incorporation by reference clause.  An example of language used in contracts to achieve this incorporation is as follows:

“In addition to Subcontractor’s obligations and duties under this Subcontract, the terms of the Prime Contract, as referenced and incorporated in the Subcontract Documents, apply to the Work of the Subcontractor, and Subcontractor is bound and obligated to the Contractor with respect to the Work to be performed by the Subcontractor hereunder by the same terms and conditions by which Contractor is bound and obligated to the Owner under the Prime Contract.”

This language comes from a contract on a project that had a contract price of approximately $400 million.  The general contractor is a sophisticated contractor that performs work all over the world.  However, for use in Texas, the clause has serious flaws.

Texas courts have examined this type of contract language and found it to be ineffective for incorporating certain types of obligations and assignment of risk downstream. Courts will examine the language used and determine its meaning in line with context and essential terms used by the parties.  In the clause above, the Contractor specifically references “The Work” in two places.  Certain cases decided by Texas courts have looked at clauses referencing the “Work” and determined that–because Work is a defined term with a specific meaning–the reference to the Work means that the clause only incorporates performance obligations relating to the Work itself.

If a contractor using a clause like the one above wants to incorporate various risk-shifting clauses like notice requirements, acceptance of unknown conditions, limitations on change orders, or waivers of damages for delay, it may find itself facing an unenforceability argument from its subcontractor’s counsel.  That argument exists because “the Work” relates to performance obligations and compliance with the technical specifications and clauses in the general conditions that enable performance like submittal requirements, inspection of work in place, and other constructability clauses.

In order to incorporate non-performance clauses that are intended to shift risk downstream, such as a no damages for delay clause, the courts have held that the incorporation by reference clause must be express.  To be express, the clause must clearly state which obligations are being incorporated.

One manner of incorporation by reference that has been held to accomplish this broader incorporation is as follows:

“The Subcontractor shall be bound to and obligated to perform all of the terms and provisions of the General Conditions, the Drawings and the Specifications of the Contract with Owner in the same manner as the Contractor is bound to the Owner, with like force and effect and in all respects as if the same were set out in full herein and attached hereto.”

This clause does not reference the Work and it expressly states that each obligation between the General and the Owner is incorporated as if the entire Prime contract were attached to the subcontract.  This clause still has a weakness that might render it unenforceable depending on the facts of a particular dispute and the interpretation of a judge asked to examine the clause.  In the first line, the clause addresses performance of obligations.  “Perform” implies action rather than merely acceptance of risk.  If a court were seeking to follow existing precedence about performance obligations, that word might render the clause unenforceable for the reasons addressed.

A better option for Contractors seeking to incorporate risk-shifting clauses is to expressly reference those clauses in the subcontract, provide a copy of the prime contract to the subcontractor before execution of the subcontract, and place that express reference in the subcontract in parallel provisions with the prime contract.

While a clause that reads “Subcontractor expressly agrees to incorporate all performance and risk-shifting clauses from the prime contract into the subcontract and agrees to bind itself to the Contractor in the same manner as the Contractor is bound to the Owner, with complete alignment of all rights, responsibilities, and obligations, as if each term of the prime contract were written into this Subcontract Agreement verbatim” might be fully enforceable, there is still a chance that a court will find the reference not express enough.

Should a Contractor wish to incorporate a clause from the prime contract into a subcontract, it should do so by referencing the exact clause or identifying each clause so incorporated in the contract or in an exhibit thereto.  Because risk-shifting clauses have the potential to impose harsh results on an unsuspecting subcontractor, Texas law requires the subcontractor being asked to assume that risk clearly understand which risks are being transferred down from the contractor.