“Leapfrogging”--Owner Direct Payment To A Subcontractor
Direct payment by an owner to a subcontractor holds a number of benefits for each party. But there are some fairly significant risks not immediately apparent, and getting it wrong can constitute a breach of contract.
Cash flow is the lifeblood of the building industry.
The owner pays the contractor who pays the subcontractor. The subcontractor looks to the contractor alone for payment. Absent unusual circumstances (such as an owner guarantee or subcontractor mechanics lien), the owner has no direct liability to an unpaid subcontractor. The owner who disregards the terms of a contract by paying a subcontractor directly (“leapfrogging”) does so at its peril; the owner risks having to also pay the contractor for the same work or overpayment.
Sometimes the owner-contractor agreement allows the owner an optional right to pay a subcontractor, the contractor crediting the owner with such payment. Leapfrogging can be a useful job management tool (particularly for a construction manager) to encourage earlier subcontractor performance, allay a subcontractor’s fears of a contractor’s shaky finances, and separate the owner from close-out issues between contractor and subcontractor. Leapfrogging should be on a one-off basis, else a direct relationship can be created between owner and subcontractor. Direct payment should only be made with the contractor’s and subcontractor’s written consent expressly limiting the owner’s obligations.
Optional direct payment provisions are not without other risks. A bankruptcy trustee may contend that the contractor’s estate was reduced by the direct payment and the subcontractor granted a preference. Leapfrogging may abridge another subcontractor’s mechanics lien rights or rights under a trust fund statute. A performance bond surety for a defaulting contractor may refuse to credit the direct payment as against the contractor’s account. The owner must consider these issues before leapfrogging.
He who has money makes the rules.
Owner direct payment reduces the contractor’s leverage against the subcontractor. The owner may sacrifice the contractor’s interests by leapfrogging. This happens when the owner making the direct payment negotiates only with the subcontractor the terms of the lien waiver (conditioned on receipt of payment). The owner may safeguard only owner interests, allowing the subcontractor to reserve rights against the contractor despite the direct payment.
On the other hand, a subcontractor accepting a direct payment may find that it faces an argument that its receipt of a joint check without reservation satisfies all outstanding subcontractor claims. The subcontractor must reserve rights in the lien waiver as to unpaid retainages and other claims.
No one should stand idly by when the owner wants to make a direct payment. Leapfrogging requires each party involved—owner, contractor, and subcontractor—to protect its respective interests.
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