An Introduction to Prime Contracts
A prime contract facilitates the relationship between the project owner and the primary contractor. The prime contactor is the company with the direct contractual relationship with the project owner. The prime contract is often a stipulation in soliciting bids or proposals. Once signed, this agreement grants the prime contractor an obligation to obtain permission from the project owner before entering into any subcontract and typically becomes a part of every subsequent sub-subcontract.
Usually, the prime contractor enters into multiple separate agreements with various subcontractors. For example, a private entity may contract with a general contractor, which can then either perform the work or subcontract it to other parties. Likewise, a public entity can enter into several contracts with a prime contractor for one large project, such as building a new ice cream factory . Ultimately, the prime contractor will hire subcontractors to build separate pieces of the factory, including a freezer system, roof, production equipment, and packaging stations.
Named parties constitute the prime contract. Project owners who usually observe prime contracts include federal agencies, municipalities, and private entities. In federal projects, the general conditions, also known as the contract requirements, outline the terms that apply to all subcontractor agreements. Some of those terms may include:
A prime contract does not have to be in writing; some are oral, and at times parties are not even aware they are prime contractors. However, it is crucial that prime contracts be clearly defined as they clearly define the obligations and expectations of each party. When there is an issue, this becomes a contract dispute. The prime contractor is typically liable for all subcontractor-related issues, including claims for defective design and construction defects.
Understanding Subcontracts
A subcontract, as the name implies, is a contract with an already contracted party. In short, the original contractor subcontracts a part of their work to another party under a new agreement. Typically, subcontracts are confined to specific parts of the scope of work and involve a few smaller contractors performing and being contracted to do various sub-parts of the primary contract. Prime contracts (more commonly called main contracts) can be described as a generic form of commercial agreement because they may relate to the sale/purchase/supply of goods or services.
Essentially, subcontracts are agreements for work done by smaller contractors that form part of a larger construction project. Their purpose is to make it easier for the prime contractor to delegate responsibility for a specific area of the work, thereby enabling the work to be completed more quickly and efficiently. Subcontracts are commonly used in the construction and IT industries, though they can apply to business in any industry.
Prime Contract versus Subcontract: An Overview
A prime contract is an agreement between the owner and the general contractor (prime contractor). A subcontract is an agreement between a prime contractor and a subcontractor. The differences between these contracts can be very subtle and sometimes obscure, but they do exist and can have a significant impact on delivery of the project and the potential for resolving disputes. While this article will highlight the most common differences, actual contract language is still controlling.
Scope of Work: From the standpoint of risk-shifting and indemnification, the scope of work under the prime contract is much more expansive than the scope of work under a subcontract. Generally, a prime contract will include a clause addressing the "scope of work" or "work" both as a general matter, and oftentimes a provision where the prime contractor specifically identifies the work to be performed by specific subcontractors. A subcontractor’s work is generally "carved out" as a subset of the general scope of work under the prime contract. This may seem innocuous, but it has important implications when considering defense and indemnity. For example, a prime contractor may have an obligation under its prime contract to defend, indemnify and hold harmless the owner, for all losses, costs and damages ("X") arising out of the project except as may be caused by the sole negligence of the Owner. For the prime contractor to be able to transfer this risk to a subcontractor, the subcontract must either mirror the prime contract language, including the term "sole negligence of the Owner", or specifically make that inapplicable to the subcontract.
Liability: This will vary from state to state and with the specific language of the contract. Generally, a prime contractor will have unlimited liability to the owner. A prime contractor is typically more concerned with the scope and weight of its potential liability to the owner under the prime contract than it is with the subcontractor’s liability under the subcontract. Since a prime contractor knows that it will be liable to the owner for the entire contract amount, and since it wants the same or similar protection from its subcontractors, the primary focus will be the ability to transfer the risk to subcontractors by using the indemnification clause. A subcontractor, on the other hand, may only be able to delegate liability to the amount of its contract with the prime contractor under the prime contract. The subcontractor also needs to consider whether there is a degree of joint and several liability between itself and the prime contractor. Note also that if a subcontractor is not expressly named, the general contractor may not be able to claim that timely notice was provided to the subcontractor. For example, if the subcontractor had a year to complete the work but the prime contract required completion of the work within nine months, the prime contractors notice of default would likely be ineffective.
Payment Terms: With limited exceptions, a prime contractor is only entitled to payment from the owner upon successful completion of its work. A prime contractor will therefore require its subcontracts to mirror the prime contract payment terms so that it will be ensured of getting paid by the owner before having to pay its subcontractor. The prime contractor may also require "pay when paid / pay if paid" terms so that it isn’t required to pay its subcontractor until it receives payment under the prime contract. A subcontractor, on the other hand, may want to obtain progress payments for the work "in place" or materials stored at the site, regardless of whether the prime contractor has been paid by the owner. This can be particularly important to subcontractors if the prime contract requires retainage withholdings. These issues are extremely important for design professionals, who may be paid in full under their contract for preparation of their documents, but may not be entitled to get paid if the contractor fails to pay the owner after design completion.
Negotiation / Leverage: Again, this will vary from state to state. However, in general, the prime contractor holds the leverage since it can live without performing work, while most subcontractors have no way of obtaining project work other than on the terms of the prime contract. As a result, the subcontractor should pay particular attention to indemnity and insurance provisions in the contract terms, and negotiate these provisions as much as possible. The prime contractor will generally want to avoid mutual indemnity, solvent and solvent indemnity, and will strongly oppose the inclusion of punitive damages provisions, delay damages and consecutive damages.
Examples: A prime contractor might be liable to the owner for all of the consequential damages caused by delay, even those caused by the subcontractor. The prime contractor might then try to shift this back to the subcontractor through liquidated damages provisions or additional back-charging rights. If the prime contractor is liable to the owner for ninety percent of the damage and its subcontractor is only liable for twenty-five percent, the prime contractor may effectively be able to shift all of its potential liability to its subcontractor.
Conclusion: The bottom line is that the prime contract and subcontract should be viewed as two components of the same chain of contracts. While there are certainly core differences, the goal should be the same: perfect performance. However, since the devil is often in the details, a subcontractor cannot risk an assumption of responsibility that might not be in its interest.
Contractors’ Legal Obligations
The legal implications of a prime contractor and subcontractor relationship are significant. Laws vary by state and sometimes even by municipality, so it is critically important to consult with a local attorney in the drafting and enforcement of contracts. However, from a global perspective, there are certain generalizations that can be made. The relationship between a prime contractor and its subcontractor is typically governed by three types of agreements: 1) the prime contract, which is the agreement between the owner and the prime contractor; 2) the purchase order or subcontract agreement, which is the agreement between the prime contractor and the sub; and 3) the prime contractor’s agreement with the surety, if there is one.
A subcontractor’s primary obligation is to perform and deliver to the prime contractor whatever work or goods the prime contractor requests. A subcontract usually includes guarantees to the prime contractor of quantity and quality, compliance with website specifications and plans, timeliness, adherence to local laws and ordinances, and holding harmless and indemnifying from liability for all losses arising from the performance of the work. All of these obligations are intended to protect the prime contractor from the consequences of subcontractor errors. Thus, if a subcontractor breaches any of its obligations or warranties, the prime contractor is likely to bring a lawsuit against the subcontractor in contract for breach. The remedy for breach of contract is money damages. Specifically, because the sub promised to deliver timely, good-quality work, the prime contractor will expect to have gotten work in kind as a result, so the prime contractor is usually entitled to recover what it spent to procure such goods or services elsewhere.
In addition to suits for breach of contract, there are also suits for breach of warranty, although lawsuits alleging violation of an expressed warranty are not as common as those for breach of contract. For each element of such claim, the plaintiff must prove there was a specific warranty, that warranty was breached, that they sustained damages as a result (and those damages can be consequential, in that they stemmed from the breach rather than the quality deficiencies of the product or service itself).
At the bottom of the construction hierarchy sits the subcontractor’s liable party – the party who is liable to the sub for the sub’s failure to properly perform and deliver in accordance with the obligations provided in the contract, specifications, standard operating procedures and local ordinances. Not unlike the legal implications between the prime contractor and the subcontractor, there are typically three agreements that govern the relationship between a subcontractor and its vendor. Those include an agreement between the sub and its vendor, the vendor’s agreement with its vendor, and the sub’s agreement with its surety. The sub is best advised to seek a third-party beneficiary clause from any vendor or subcontractor, wherein all parties agree that the sub’s agreement with such entity is intended to confer rights on the prime contractor.
Navigating Prime Contractor-Subcontractor Dynamics
As prime contractors serve as the initial point of contact between the government and subcontractors to satisfy a government contract, the success or failure of both the prime contractor and subcontractors depend on the prime contractor’s ability to manage and maintain its relationships with each. A prime contractor needs to have the appropriate systems in place to manage contract terms and performance, to communicate with the subcontractor, and to address any disputes that may arise between the parties.
The first issue that can affect the prime contractor’s relationship with its subcontractors is the prime contractor’s overall contract and subcontract management system and whether the system(s) are functioning properly. Internally, the prime contractor’s system(s) should be set up to monitor the subcontracts in order to ensure compliance with the prime contract terms. Externally, the prime contractor’s system(s) should provide a single point of contact for communicating with subcontractors regarding contract administration matters. While most of the day-to-day handling of subcontracts will be delegated to a functional department (e.g., procurement), the prime contractor will want to maintain oversight—at least at the project manager level—of the scope of work, payment and billing issues, performance monitoring, and compliance with other important requirements of the government contract (e.g., small business subcontracting plans) and of the subcontract. When the prime contractor has appropriate systems in place and functions that are cross-trained on prime contract and subcontract administration, it can better position itself to manage subcontractor issues and maintain subcontractor relationships. To reaffirm the importance of these systems, the government specifically lists key subcontract requirements in Section H of the Uniform Contract Format in connection with "Management and Administration of Subcontracts," such as retaining the right to terminate or replace subcontractors and impose rotating subcontracts, review of progress payments, and inspection of the subcontractor’s accounting records and facilities.
A prime contractor will also want to have an early warning system in place to alert project managers of problems or concerns impacting subcontract performance, or of disputes developing between the prime and the subcontractor or between subcontractors. If this is not handled early, it might be too late to make any adjustments to remedy the problem short of termination of the subcontract. The prime contractor should focus on obtaining, as early as possible, information regarding the subcontractor’s schedule, performance, quality assurance processes, compliance with the terms of its subcontract, and subcontractor payments . For example, the prime contractor should routinely review subcontractor billings to ensure that they are consistent with the subcontract price and payment schedule, and that the materials, labor, and other costs are reasonable based upon the work performed and in accordance with the terms of the subcontract. The prime contractor should also confirm that the subcontractor is satisfying any certification obligations, including those for small business subcontracting and/or Davis-Bacon Act compliance. Early detection of a subcontractor problem may allow the prime contractor to effectively manage and resolve any issues and reduce or eliminate the need for a more drastic remedy such as an action against the bonding company for performance. However, if a situation arises where this occurs, the prime contractor will need to notify the Surety within the required timeframes to ensure that the Prime Contract is protected.
While good contract management and early warning systems can prevent performance issues from developing into disputes, the inevitability of change on government contracts makes it likely that the prime contractor and its subcontractor will encounter a dispute at some point. Thus, it is of critical importance that the prime contractor includes a dispute resolution process in each subcontract. A well drafted dispute resolution clause states the method of resolution (e.g., negotiation, mediation, arbitration, litigation), any time limits (e.g., 30 days to resolve a dispute), and any preconditions to bringing a claim (e.g., a claim for payment must be submitted to the prime within 15 days of the event giving rise to the claim). Depending on the size of the subcontract at issue, the prime contractor can negotiate to include a dispute resolution process that specifically references ADR. This is important because it will be more difficult for a prime contractor to impose an ADR procedure on a large subcontractor without expressly including it in the subcontract. It may be easier for lower tier subcontracts.
If a dispute arises between the prime contractor and a subcontractor, the prime contractor should try to resolve the matter amicably without abandoning its contractual rights. The prime contractor might consider sending a written request to the subcontractor to promptly resolve the dispute, or if the parties cannot reach agreement, to schedule a "meet and confer" between senior personnel from both contracting organizations.
If a subcontractor does not timely respond to the prime contractor’s request, or if the parties are unable to amicably resolve a dispute, the prime contractor should consider a "final" formal demand letter to the subcontractor requesting resolution of the claim. In addition, a final demand for subcontractor performance, payment, or cure should be sent before resorting to the remedies available to the prime contractor under the subcontract and the prime contract.
Effective Contract Management Strategies
Successful contract management is critical to the execution of a project, regardless of whether you are executing a prime contract or a subcontract. A few best practices for effective contract oversight include:
1. Prime Contractor Oversight
Prospective prime contractors should review and analyze the prime contract prior to submitting a bid. When possible, knowledgeable personnel should review all prime contract terms and conditions before determining the price, scope of work and schedule for the project. Once the prime to whom the successful bid is awarded has negotiated and signed the contract, it is imperative that the contractor’s project team carefully review the document to determine if there are any unintended inconsistencies in the prime contract. Then, the prime contractor should develop policies and procedures for the management of the project, including contract administration. For example, does the project team need to track the statutory value of lien rights in the state in which the project is located? Must staff members be careful not to use too many unreasonable force majeure days if you are the prime?
2. Subcontractor Oversight
Just as the prime contractor should review and analyze the prime contract in advance of submitting a bid, a prospective subcontractor should review the prime contract prior to entering into a subcontract. A subcontractor must obtain a copy of the prime contract from at least one of the bidders on the prime contract from whom the subcontractor is soliciting a bid. The subcontractor should review the prime contract to determine if there are any inconsistencies or clarifications that need to be made prior to executing the subcontract. Once the subcontract has been executed, the subcontractor should then determine its own policies and procedures. The subcontractor should address contract administration issues, including quality control, schedule management, insurance/R.W. Davis Hold On accounting and payment provisions, etc. The subcontractor should also ensure that the project team is aware of the prime contract, particularly the prime contract’s dispute resolution terms as well as any joint check provisions.
Typical Problems and Solutions
Both prime contractors and subcontractors may face common challenges that can impact the successful execution of a prime contract or subcontract. For the prime, one of the most common issues is scope creep, or the change in a project or contract that requires more materials or labor than what was originally planned. This can be the result of a number of factors, including poor initial planning, an incomplete scope of work, or unrealistic budget expectations. Instances of scope creep can make it difficult for a prime to manage a project, and can result in ill-defined performance and real liability if the situation escalates into a legal dispute. Fortunately, there are a number of solutions to minimize the risk of scope creep. The prime can draft clear and well-defined prime contracts and subcontracts, and perform comprehensive, ongoing evaluations of all aspects of the project to identify any issues as soon as possible. The prime can also develop processes for approaching scope changes appropriately, and track potential change orders immediately upon noticing scope creep so that it does not derail the rest of the project. Subcontractors, too, must be alert to scope creep, as well as the associated risks of a prime contract. If a subcontractor pursues scope changes through a contractor , the original prime may push back on the change order request because it may be out of scope of the primary relationship between the prime and the sub. Even when a prime is receptive to scope changes, this can create a ripple effect on the procurement process. The challenge of scope creep can be extraordinarily difficult to navigate, especially if the prime is unwilling to accept the change order passes the buck to a subcontractor for those additional costs. One solution for subcontractors is to be proactive in communication, whether with the prime or another party to the contract or project, to make sure that all parties are aware of scope changes as they arise. Subcontractors can also make clear to their prime contractors if additional materials or labor will be required, and they should keep (and catalog) clear, detailed, and accurate records of manpower. It is vital for subcontractors to maintain precise records of their progress and expenses, as primes will usually examine those records to support, deny, negotiate, or approve a change order request. Documentation thus becomes comprehensive proof of the initial understanding of the subcontractor’s role in the project, and may help to resolve issues before they become a larger legal matter.