The Skinny on Flow Down Terms: Stronger Subcontracting Agreements

If this headline piqued your interest, it’s fair to assume you already understand how subcontracting works.

Most companies in the tech and IT industry use third parties to support them, such as vendors and subcontractors. Subcontractors are essentially an extension of the supplier, and with that comes a significant risk if subcontractors are not aligned with the service provider’s client agreement.

As a commercial technology law firm, we’ve heard several understandable concerns from our clients about the effects of their reputation and services when it comes to using third parties. That’s where flow-down terms come in.

To help prevent a future problem with subcontractors, Gouchev Law put together a list of questions to cut through the confusion and provide straightforward service delivery and flow down terms.

1. Do You Have the Correct Contracts for the Project?

2. Why are Flow Down Agreements so Important? 

3. What Gets Flowed Down?

4. What’s the Difference Between Flow Down Terms and Flow Up Terms?

5. When to You Use Service Level Agreements?

1. Do You Have the Correct Contracts for the Project?

Before we get into the subcontractor agreement, you need to have a well-negotiated client service agreement in place. Client service agreements can apply to either one-time deliverables during a limited time frame or ongoing partnerships over a long period of time via a Statement of Work or Scope of Work.

You should always sign a client service agreement before any consulting or other services begin, regardless of how large the project is or what your service agreement covers. Taking the time to prepare and negotiate a mutually beneficial client services agreement in advance clearly sets expectations and secures protection for both parties. Let’s assume that the client agreement has been signed between you (service provider/supplier) and your client.

2. Why are Flow Down Agreements Important?

In commercial contracts, the main service provider is ultimately responsible for the deliverables per the client service agreement, but a subcontractor may be needed for certain projects. The purpose of flow down clauses is a practical one because service providers don’t want to risk liability to the end client on account of something caused by the subcontractor. For example, if there is non-conforming work or intellectual property infringement, a service provider will want the right to pass that liability on to the responsible subcontractor.

It is in your best interest to fill any gaps between what you agreed to under the service agreement with your client, and what the subcontractor’s responsibilities are under the subcontractor agreement.

A subcontractor should perform their duties just as you the service provider are obligated under the client service agreement. The same terms a supplier has with their customer will flow from to a Subcontractor, thus appropriately named flow down terms.

Flow-down provisions protect parties to a service contract by making sure a subcontractor’s obligations to the main service provider are nearly identical to the ones the service provider has with the end client.

Example: Shifting the Risk in Non-Performance or Delays

The contract between you (i.e. Supplier of IT services) and your client states that you will provide the services to the client per your Statement of Work / Scope of Works (SOW). Let’s assume you assigned some of the work to your Subcontractor and, sure enough, they delayed the delivery past what was agreed to! What do you do if the customer is furious and demands an explanation?

If you had the same terms in place with your subcontractors as you do in your Client Services Agreement, then you could put the onus on your subcontractor, request the same as what the client requests you do to cure the issue and flow up the responsibility. You would be adequately protected. If you don’t have the same flow-down terms, you would be held liable under your client service agreement and would likely have no recourse with the subcontractor. That could be a significant financial loss, and it’s not something to take lightly.

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3. What Gets Flowed Down?

Typical Flow Down Terms include, but are not limited to:

• Timelines for deliverables
• Duties
• Restrictions and warranties
• Payment terms
• Audits
• Site access restrictions
• Information security and data protection
• Intellectual property ownership
• Confidentiality
• Dispute resolution
• Governing law provisions

A flow down agreement should also include your indemnification terms, liabilities, and insurance as well as change orders. Important to note is the percentage of the subcontractor’s work and the importance of that specific contractor to the project(s) can determine the negotiation leverage of the flow-down terms, and how much they can be modified.

Payment Disputes

As an example of common payment terms that are negotiated in subcontractor agreements, a flow-down payment clause may state that a subcontractor will be paid by the service providers when the service provider is paid by the client. This is a hot topic, and one of the most negotiated clauses.

Dispute Resolution for Subcontractors

Likewise, if the service provider has agreed to resolve disputes with the client through arbitration, you’ll want a subcontractor to be required to resolve disputes through arbitration as well.

Information Security and Data Privacy

Industry leaders in technology companies and IT consulting firms struggle with security breaches of sensitive data. As cloud-based technologies proliferate, the key points are crucial to keep at the forefront of your legal counsel’s agenda when it comes to service agreements and flow-down terms. GDPR, CCPA, and other data protection requirements should flow down to the subcontractor as they do to the main service provider.

Insurance Requirements

Subcontractors should carry general liability insurance as well as, ideally, technology errors and omissions insurance. This would give coverage for defending in lawsuits stemming from the subcontractor’s work product. Your client agreement may require that you only hire subcontractors who are insured. Many tech companies require their subcontractors to carry workers’ compensation insurance. Otherwise, if they get hurt on the job, you could be held responsible for their injuries.

4. What’s the Difference Between Flow Down Terms and Flow Up Terms?

We’ve established that Flow Down Terms protect the Service Provider, on the other hand, Flow Up Terms protect the Subcontractor from issues that they did not cause or for which they should not be held accountable. Flow Up Terms also address the term of IP licenses and carve-outs needed to use certain IP that is not work-for-hire or subject to the license.

5. When to Use a Service Level Agreement?

Services Levels / Service Level Agreements are a crucial element of the negotiations that affect all parties. Drafting mutually agreeable and practical service level agreements (SLAs) can be tricky. Discussions around Service Levels are something that needs to be done very early on in the project. Failure to fulfill SLAs may result in an endless amount of downtime and the potential to terminate the contract. This is particularly true for SaaS agreements.

In A Nutshell

Flow down agreements bind the subcontractor to the same standards and responsibilities that the service provider has with the client. Failure of the subcontractor to comply with the flow down terms would be a breach of contract with the supplier. Flow down terms provide rights and remedies to shift the risk to the right party to pay for the damage caused.

CASE STUDIES

Here are two good examples of what can happen when there are no flow down terms.

A service provider could not pass through a change order to a subcontractor received from the client to delete a portion of the work. The original contract required the IT service provider to do various projects in signed SOWs such as multi-cloud software management and building AWS environments. The service provider hired a subcontractor to perform some of this work and after the subcontractor performed a portion of the work and got paid for it, the client signed a change order with the service provider. This made the subcontractor’s other contracted work unnecessary. The service provider canceled the remaining work under the subcontract. The subcontractor sued for the contract balance and won the case. Canceling the remaining work was a breach of contract according to the court.

In another case illustrating the benefit of a flow-down provision, the court ruled that a no-damages-for-delay provision in the main client service agreement was binding on a subcontractor due to the flow-down clause. As a result, the subcontractor was not able to recover anything from the main service provider, which resulted in a two-year delay to the project and enormous additional and unexpected costs to the subcontractor.

How Can Gouchev Law Help?

Gouchev Law’s niche expertise in the technology industry can support you in all of your technology law and corporate needs. We offer adept guidance on Client Service Agreements, Master Service Agreements, Subcontractor Agreements, Flow Down Terms, SaaS Contracts, and intellectual property. Get in touch with our friendly, and seasoned technology attorneys today!  

 Disclaimer: The information in this article is for general information purposes only. Nothing in this article should be taken as legal advice for any individual case or situation. This information is not intended to create and viewing it does not constitute an attorney-client relationship. 

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