Leapfrogging/Squeeze Out

The practice of “leapfrogging” can be pervasive on construction projects. All participants on construction projects should be aware of the associated risks and rewards. 

 

What is “Leapfrogging”?

 

“Leapfrogging” is the direct payment from a purchaser of construction services or supplies to a lower-tier subcontractor or supplier. For instance, where an owner pays a subcontractor or supplier directly, the owner “leapfrogs” the general contractor. Or, where a general contractor pays a lower-tier subcontractor or supplier directly, the general contractor “leapfrogs” the upper-tier subcontractor.

 

“Leapfrogging” can occur for a number of reasons. For example, where a general contractor is failing to pay subcontractors, an owner might issue direct payment to remove a mechanic’s lien. Similarly, where there is concern that the owner will not provide payment to its subcontractors and suppliers, the owner could issue direct payment to ensure that a future mechanic’s lien is not recorded.

 

What are the Concerns with "Leapfrogging"?

 

There are concerns for the both the purchaser and seller of construction services with this practice. From the perspective of the seller of construction services, e.g., general contractor, the concern with this practice is the disruption of the relationship with subcontractors and suppliers. For instance, if a general contractor has withheld funds from a subcontractor because of a legitimate dispute with the subcontractor’s work, the owner’s direct payment to the subcontractor removes all leverage the general contractor once had in that dispute. Now that the subcontractor has received full payment, there is no incentive to complete work or perform repairs.

 

For this reason, “leapfrogging” presents the risk to the owner of double payment. Unless the contract specifically permits this practice, direct payment to subcontractors is arguably a breach of the construction contract. Consider this example: a lower-tier subcontractor records a mechanic’s lien against a project. To clear title, and without consulting the upper-tier subcontractor, the owner issues a direct payment to the lower-tier subcontractor in exchange for removal of the lien. It turns out payment was withheld because there was a significant back charge. The owner will have to bear that cost.

 

Usually, these scenarios do not happen in isolation or with such clarity. The most common context is where the owner and general contractor are in a multi-faceted dispute. Several subcontractors have not been paid, several mechanic’s liens have been filed, the lender is screaming, communication is poor between the warring parties. Despite the allure, the owner must proceed carefully here before issuing direct payments.

 

Rampant “leapfrogging” by a general contractor also presents the risk of a “squeeze out.” Often a subcontractor’s value on a project is the subcontractor’s bench of lower-tier subcontractors and suppliers. Once the general contractor begins dealing with those lower-tier subcontractors directly, the general contractor might ask if the markup is worth it. With the aid of a termination for convenience provision (more on that here), the general contractor could try to terminate the subcontractor and enter into direct contracts with the lower-tier subcontractors, “squeezing out” the upper-tier subcontractor.

 

What are the Benefits of "Leapfrogging"?

 

There are certain benefits to all parties involved. For instance, when there is a dispute between the owner and a general contractor and payment is not flowing to subcontractors, a general contractor (or upper-tier subcontractor) will sometimes invite “leapfrogging” to get their bench of subcontractors and suppliers paid. It also reduces the amount at issue and the size of the claim. The less money at issue, the less incentive for everyone to load the cannons.

 

From an owner’s perspective, there is an obvious incentive to know that the money is going where it should. If there are concerns regarding the general contractor’s solvency and proper maintenance of the trust fund, owners will take comfort knowing that these payments are potentially eliminating future mechanic’s liens. Most importantly, payment greases the wheels. With content subcontractors and suppliers, the project moves forward.

How can "Leapfrogging" be Controlled?

 

The permission for or prohibition against “leapfrogging” will be found in the contract. A general contractor could include a provision specifically reserving the right to issue direct payment when, in the “sole opinion” of the general contractor, it believes that the subcontractor has improperly failed to issue payment. The provision would typically give the upper-tier subcontractor a very limited amount of time to object to the payment with supporting documentation, but usually the provision will anoint the general contractor the final arbiter of the dispute. As long as the general contractor made the decision “reasonably,” the payment will be charged against the amounts due to the subcontractor, even if it is ultimately determined that the payment should not have been made.

 

A subcontractor can avoid this result by including a provision in the contract that either outright prohibits direct payments or conveys to the subcontractor the ultimate authority to object to any such payments on a case by case basis. In the latter situation, the contract would provide that the general contractor must provide advance notice of its intent to issue a direct payment and provide the subcontractor a certain amount of time to formally object. In both situations, the general contractor would be permitted to hold back the funds until the dispute is resolved. In the event the parties could not resolve the dispute, some provisions specifically permit the general contractor to interplead the funds (file an action to deposit the funds with the court and let all interested parties duke it out) and charge the subcontractor the costs and attorney fees for doing so.