Terminating a non-performing subcontractor: Lessons from the Gambler

You’ve got to know when to hold ’em;

Know when to fold ’em;

Know when to walk away;

Know when to run.

The Gambler

Kenny Rogers

            As a contractor, one of the toughest decisions you face is what to do with a subcontractor that falls behind schedule or otherwise stops performing as agreed.  In theory, its easy:  send the sub packing and hire a replacement to finish the work.  The reality, of course, is more complicated. 

            Performance problems rarely arise suddenly.  More typically, your problem-child sub has been performing poorly for some time before the sub’s performance reaches critical mass.  That period of non-performance has, almost without fail, already taken a bite out of your schedule long before the issue of whether or not to terminate the sub becomes a topic of discussion at the project meetings.  Thus, in most cases just terminating the sub and finding a replacement sub won’t solve your problem, unless you can find one who can start working tomorrow.  Even if you find a sub who can put manpower on the job right away, it will likely cost you more than the remaining contract balance of your original sub—after all, that’s why you hired the original sub and not the replacement who is now eager to explain why he bid the job so much higher than the other guy.  In the end, replacing your non-performing sub could very well end up costing you more and taking longer than it would have taken and cost to work through the issues with your problem-child sub.  For those of you running projects on a daily basis, I haven’t said anything you don’t already know. 

            It’s easy to be an armchair project manager.  No doubt, in hindsight, all of the daily excuses you were given as to why the sub couldn’t do this or had to do that (instead of what he or she was supposed to do) will look silly.  At the same time, most project managers can point to countless examples of subs who struggled to get started who ended up performing nicely.  Recognizing and describing the early signs of a sub who will never perform and distinguishing those from legitimate hiccups at the beginning of a sub’s work is incredibly difficult—and not something most lawyers are equipped to answer for you.  No one said being a general contractor was easy.  The best advice your lawyer can give you is to use your best judgment while preserving your options.       

            At some point, there comes a time when terminating a sub becomes necessary.  It may be the point at which the sub pulls its equipment off the site, stops sending crews to the job, does something which endangers worker safety, or simply falls so far behind that termination and replacement is the only way to finish the project.  Regardless of the reason you are brought to the brink, once there it is critical that you have the proper foundation in place and are fully aware of the consequences that terminating your sub will have.

Careful attention to terminating a sub is required because there are serious repercussions for wrongfully terminating a sub. It may seem antithetical that a general contractor could face repercussions if it unartfully terminates a sub who is not living up to the terms of their agreement. However, it has happened that a contractor terminates a sub for cause only to end up having pay both the terminated subcontractor for its work already completed and the replacement sub to fix the same work! There are also cases where a general contractor who terminated a non-performing sub without the right foundation in place was forced to eat the premium paid to the replacement sub to finish the work. These cases usually involve either poorly drafted contract terms or cases where the contract terms in place were not followed. These not uncommon results leave many general contractors understandably confused and frustrated. As Kenny Rogers said, the key is knowing when to hold’em; when to fold’em; when to walk away; and when to run.

Hold’em or Fold’em: Is the sub’s breach material?

          When a sub stops performing or begins performing below what the subcontract requires is the time to start considering the termination decision—whether or not you actually pull the trigger on termination. If you wait until you are ready to replace the sub, you may end up holding the bag.  As part of that consideration, you should know what a material breach of contract giving rise to the contractors legal ability to terminate a sub looks like.  Knowing this increases the chance you can control what follows thereafter.

            A critical component in framing what a material breach looks like is the agreement between you and your sub. In other words, defining the important aspects of the deal.  For example, consider a sub who is woefully behind schedule.  In some states, courts will look to see if the agreement contains the otherwise seemingly insignificant phrase “time is of the essence.”  While that phrase is archaic and in common usage only amongst lawyers, some courts have found that a subcontractor’s failure to keep the project schedule is not a material breach unless the contract states that “time is of the essence.”  Thus, a contractor who rushes to terminate a sub for failing to keep the project schedule where those magic words are not in the agreement may find the sub actually holds the upper hand in a subsequent legal skirmish.

      The reason for and the circumstances around the termination are also important factors to consider—and by consider, here I mean things you must document. For example, if a sub is behind schedule and the you decide to terminate the sub after allowing them to languish behind schedule for several months, you could walk into an unexpected barrier to later terminating for failing to keep the schedule.  The legal concepts supporting such road blocks could include the concepts of waiver (i.e., that allowing the non-performance to continue was evidence of an agreement to modify the contract), estoppel (i.e., because you continued to accept the benefit of the subs performance knowing that it was not going to be acceptable prevents you from later complaining about the prior non-performance), and/or any number of other creative theories the non-performing sub’s lawyer can devise.  In many jurisdictions, the more threatening problem will be the risk of a determination that your termination was in bad faith.  Many states provide that a termination for cause made in bad faith is a breach for which unique damages may be available to the terminated sub—including, in some states, lost profits and the sub’s attorney’s fees.  Even where a well-drafted contract provides for the conversion of a termination for cause to a termination for convenience in cases where cause is found not to exist, if the circumstances surrounding the termination do not include some substantial change in conditions which were out of your control, the sub could still be entitled to greater payments or offsets against liability than it would otherwise be entitled to recoup.   

Given these factors, the time to begin addressing the decision to terminate is the first time a sub fails to meet the requirements of the agreement. That, of course, does NOT mean you have to threaten termination the first time the sub shows up an hour late. It means you, as the general contractor, need to understand the situation and, ultimately, the consequences of termination if the non-performance continues. It also means you need to be sure not to waive or otherwise give up your rights in case those early signs end up being just the beginning of your headache with that sub. And, it means you should not forget how messy termination is. In other words, you should strive to work it out with your sub rather than escalate problems to the point where termination and replacement is the only viable option.

Walk away or run: Is it worth pursuing a lawsuit—or is it cheaper to pay-off a bad apple?

The second part of the termination problem is what to do after a non-performing sub is terminated; whether to pursue damages regardless of whether you terminate or allow the sub to finish at an additional cost to you. In general, you, as the general contractor, have the right to expect performance of your subs and, if they don’t, to be placed in the position you would have been in had the subs performed as they promised.  The real world, however, is a lot messier. 

            Often, the remedies available to you, as the general contractor, are modified by the subcontract.  In most cases, that leaves you with the upper hand.  For example, if your standard agreement provides you can recover your actual costs incurred to complete a non-performing sub’s scope plus attorney’s fees, you may well have incentive to go to court or arbitration and seek those damages.  If, on the other hand, you signed a sub-friendly agreement, you may not have the right to collect attorney’s fees or anything more than the subcontract amount.  In the most egregious cases, I have seen a subcontract (that general contractors actually signed) which purported to waive the general contractor’s right to compensatory damages—compensatory damages being the direct harm caused by the sub’s own breach!  While I doubt any court would enforce that agreement, it reveals the messiness of such lawsuits.  And the messier they are, the more they cost to litigate or arbitrate.  Without a contract providing for full recovery of your additional costs to complete the terminated-sub’s scope plus attorney’s fees, the reality is most general contractor-subcontractor disputes are best left alone–depending, of course, on the amount at stake.  The very real risk is you could easily spend as much or more in court costs, expert witnesses, and attorney’s fees than you could recover.

            The problem doesn’t end there.  Sometimes, even when you are willing to walk away and let bygones be bygones, the non-performing sub will force you to run.  By that, I mean you may be willing to walk-away from your claims against the sub and eat the additional costs to hire a replacement sub to finish the original sub’s scope; but the original sub is unwilling to relinquish its alleged claims to be paid for work that it claims to have completed.  These situations are unfortunately common.  And very often require one party to either file suit or become entangled in litigation to resolve.  If you find yourself in this situation, one key thing to remember is the end game. 

Litigation is a funny thing. By that I mean that, left unchecked by reason, it can take on a life of its own. Not only does it distract you from your business but it can also transform your goals and objectives. Feelings often get hurt; allegations get made in pleadings and at depositions which bear no resemblance to the way things really happened on the project. In any event, it’s not uncommon for litigants to cease looking for a way out and start looking to extract punishment, the proverbial pound of flesh, from the other party. When that happens, the cost and distraction of litigation can be detrimental to not only the project but your business as a whole. The best advice may be to simply stop the bleeding and write a check to get out of the chaos. A tough pill to swallow. Especially when you believe the whole mess started because the other person failed to do what they agreed to do. Nevertheless, the sunk cost or “justice” you seek to recover is rarely justification to continue at full speed toward a cliff.

If you’re gonna play the game . . . you gotta learn to play it right

            Managing risk requires keeping your head on a swivel.  When you are negotiating with subs everyone involved tends to see rainbows and unicorns.  Terms regarding termination are rarely discussed and are usually afterthoughts.  This should be used to your advantage.  When a sub is looking to add backlog, they rarely object to standard, commercially reasonable terms which provide you a full recovery in the event of termination.  Accordingly, there is little excuse to not have such terms in your standard subcontract agreement.  Including such terms, as a matter of course, will go a long way to enabling your project managers to adequately deal with subs who fall behind schedule or otherwise fail to perform.  Project managers have a lot on their plate when it comes to the daily administration of subcontracts.  And insisting on standard, favorable terms and conditions in your subcontract agreements will go a long way in making their job more manageable.

            One objection I hear to including such terms is that project managers often feel including such “dark” language in subcontracts spoils the partnering and team atmosphere of successful projects.  Without doubt, building a workable project atmosphere is critical, and that “team” environment is an important part of the bigger picture.  However, including adequate termination language in a subcontract neither requires the sub’s termination if they begin to languish nor should be viewed as draconian.  It should, however, provide a framework to address non-performance.  And it should prompt a project manager to address in writing a sub’s non-performance when it is recognized.  Addressing such situations doesn’t require the project manager to write a threatening letter or email.  But it should prompt the project manager to bring the sub in for a discussion.  That discussion should lead to either a viable, written recovery plan to bring the sub back into compliance or a written contract modification whereby you are sure to preserve your right to later force compliance and/or terminate the sub if the problems continue to spiral out of control.   

 by Zach Jones, esq.  All rights reserved.  Zach is a construction lawyer in Tennessee, at the firm of Jones Law, PLLC.  He may be reached by email at zjones@JonesAdvice.com.

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