Construction and the Law in Texas

Construction projects and the relationships of the various parties involved in a project begin with contracts of various levels and tiers. For general contractors, all the terms and conditions of these contracts are important. However, certain clauses, the language used, and the legal effect of the terms contained in the clauses, are worthy of sharp focus and careful attention because of the manner in which the clauses assign risk. In this column I will focus on two such clauses: The flow-down and incorporation by reference clauses.

Flow-down clauses typically attempt to align rights and obligations consistently throughout the chain of contracts from the prime to the various lower tiered subcontracts for any particular scope of work. In a prime contract, the flow-down clauses typically will take the form of a covenant, or promise, that the general contractor makes to the owner that all subcontracts will contain parallel obligations between the general contractor and the subcontractors as exist between the owner and the general contractor.

An incorporation by reference provision is generally broader than a flow-down clause. Where a flow-down clause will typically seek to create the means for a particular obligation between contractors of one tier to specifically flow-down to lower tiers, an incorporation by reference provision will typically seek to make all rights and obligations between the higher tier parties apply, as a whole, to the lower-tier relationship.

In Texas, the law allows separate agreements may be incorporated by reference into a signed contract. The law does not require any magic words for an incorporation by reference clause to be enforceable. As long as the lower-tier subcontract clearly refers to the incorporated document, and evidences intent to incorporate its terms into the subcontract, the court will enforce the obligations contained in the incorporated contract. If the prime contract is incorporated by reference into a subcontract of any tier, both documents must be read and construed together. This means that the courts will hold each party to the obligations between the parties, but that any conflicts in the contracts will be reconciled so that the obligations makes sense based on the relationships of the parties. In construing subcontractors’ rights and duties under their subcontracts, courts try to ascertain and give effect to the intentions of the parties as expressed in the subcontract – the prime contract will take a backseat.

In using both types of clauses, contractors should be cognizant of the need to use specific language that clearly states the intent of the clauses and the specific obligations to be transferred. Typically, a flow-down clause will be incorporated into a specific risk-shifting clause in an attempt to place the risk on the downstream parties. For example, the risk associated with performance of a scope of work will often be the subject of a flow-down provision. For example, a clause might read: “Subcontractor agrees to assume all obligations for the Work as generally described above and more particularly described in the plans and specifications.” This clause transfers the risk of performance to the lower-tier contractor. It does not transfer the risk for all other obligations contained in the prime contract.

If a contractor seeks to flow-down more than a particular scope of work, it must be careful not to employ general language that ties the flow-down provisions to the “Scope of Work,” “Work,” the “Plans and Specifications,” or similarly limiting language. Referencing “Work” or “Plans and Specifications” or other performance terms will not effectively transfer risks for financial, dispute resolution, or other non-performance obligations.

If the contractor wants to flow-down the obligations for notice of claims or other non-performance obligations, the clauses musts specifically address those obligations. A clause that would solve this problem might read as follows: “In addition to Subcontractor’s obligations and duties under this Subcontract, the terms of the Prime Contract apply to the Subcontractor, and Subcontractor is bound and obligated to the Contractor hereunder by the same terms and conditions by which Contractor is bound and obligated to the Owner under the Prime Contract.”

A well drafted incorporation by reference provision can also accomplish the transfer of risk downstream. A poorly drafted incorporation by reference provision can result in no risks being transferred. An example of such a clause is one that requires subsequent language in other clauses to actually refer to the prime contract. This is an example of such a clause: “The terms of the Prime Contract, as referenced in the Subcontract Documents, apply to the Work of the Subcontractor.” This clause, which would appear in the opening paragraphs of a subcontract, does not actually incorporate anything. It requires specific reference within the subcontract to incorporate obligations. Without those specific references, this clause accomplishes nothing. Further, it refers to “the Work” and would further limit its applicability to only performance obligations as discussed above.

A better incorporation by reference clause would not require further reference or address “the Work.” A better clause for those seeking to incorporate all obligation, both performance and financial, would read as follows: “The terms of the Prime Contract are incorporated into this Subcontract by reference, in their entirety, and Subcontractor is bound and obligated to Contractor in the same manner for all obligations as Contractor is bound to Owner.”

– As seen in the October issue of Texas Contractor.