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In This Issue:

  • Contractor Not Bound By Architect’s Decision on Claim
  • Cost of replacing defective work excluded under Builder’s Risk Policy
  • Defective Workmanship Potentially Covered By Insurance
  • Statute of Repose for Construction Projects Time-Bars Claim that could also be Asserted as Products Liability – with Longer Statute of Limitations Period

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Contractor Not Bound By Architect’s Decision on Claim

Contracts between owners and contractors often state that the contractor must submit any claim to the architect for final determination. Most contracts state that this must be done as a condition precedent to further review by a dispute resolution board or a court. But some contracts purport to eliminate any right of the contractor to appeal the architect’s decision or to file suit against the owner after receiving an unfavorable decision by the architect. As a result of such contracts, some A/Es have found themselves defendants in actions brought by contractors alleging that the dispute process was unfair and unenforceable because the A/E was biased against the contractor due to the A/E’s responsibility and allegiance to the owner. I have always thought it inappropriate for an owner to attempt to cut off a contractor’s rights in this manner and have advised A/E’s against allowing themselves to be put into this position because it seems almost guaranteed to lead to problems.

In the case of Blount Excavating, Inc. v. Denso Manufacturing, No. 03A01-9903-CV-00112 m 1999 Tenn. App. LEXIS 779, a contractor successfully sued to get out from under the requirements of a contract clause designating the architect’s decision as “final and binding on the parties.” The contractor’s underlying change order claim was that it had to remove 200,000 square yards more of earth than specified in the contract, due to inaccurate information provided by the owner’s architect. The architect rejected the change order. The contractor submitted a claim to the architect as required by its contract and when the claim was denied, the contractor filed suit against the owner. The owner filed a motion for summary judgment, asking the court to dismiss the suit because the contract made the architect’s decision final and precluded any further action by the contractor. The court rejected that motion and allowed the contractor’s suit to go forward. The owner then filed an “Application to Confirm Arbitration Award.” It argued that the architect’s final decision was equivalent to an arbitration award and was, therefore enforceable by the court. The court disagreed and rejected the owner’s motion.

In analyzing why it did not consider the architect’s decision to be an “arbitration award” that could be confirmed by the court, the court explained that the contract did not anywhere describe the architect as an arbitrator. Whereas arbitration requires three parties (a claimant, a defendant and a neutral), only two parties were involved in this dispute resolution because the architect was the owner’s agent. Thus, there was only the contract and the owner through its agent, the architect. The court also alluded to the fact that the architect would not be qualified in any event to be an arbitrator since the contractor’s claim for entitlement was based on alleged inaccurate site information by the architect. A party with an adverse interest in the matter cannot qualify as an arbitrator.

Risk Management Note: Owners who attempt to deprive the contractor of its day in court (arbitration or mediation) are, in the opinion of this author, ill-advised. This leads to adversarial relationships that hinder communication and good will on the project. Architects and Engineers who sign contracts agreeing to make final (non-appealable) decisions for owners are also ill-advised for the same reasons. In the case discussed, the contractor sued the owner, but A/Es are just as likely to be a target when the contractor’s rights and remedies have been unfairly cut off by an onerous contract.

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Cost of replacing defective work excluded under Builder’s Risk Policy

A construction contractor (Laquilia Construction, Inc.) poured concrete that failed to meet the specifications for minimum strength for the floor slab of a high rise commercial building. The defective concrete had to be ripped out and replaced. This replacement required reinforcing the building while the rework was performed. It also required various subcontractors to remove and later re-install their work, including HVAC ductwork, electrical fixtures and plumbing.

The question addressed by the court was whether the Builder’s Risk insurance policy issued by Travelers Insurance was required to cover the costs incurred in the re-work as insured damages. The policy stated that it insured against the risk of “physical loss or damage to the property insured, except as excluded hereunder.” The exclusions stated that the policy would not pay for:

“1. (a) Any loss of use or occupancy or consequential loss of any nature howsover caused, including penalties for non-completion or delay in completion of or delay in completion of contract or non-compliance with contract conditions;

(b) Cost of making good faulty or defective workmanship or material, but this exclusion shall not apply to physical damage resulting from such faulty or defective workmanship or material.”

The contractor submitted a claim to Travelers for the “costs of repairing the fifth floor slab under an approved correction plan.” Included in these costs was the cost of removing and replacing the slab, shoring the full height of the building while the corrective work was performed, and the cost of the other trade contractors’ having to removing and reinstall their work. Travelers denied coverage on the basis that the claim was excluded because it was for the “cost of making good faulty or defective workmanship or material.”

In suing Travelers for coverage, the plaintiff asserted that the exception to the exclusion at part (b) above was applicable because the defective installation of the concrete physically damaged the insured property by being incorporated into the building and could only be removed at cost. In reading the exception to the exclusion, the court stated that “the exception to any exclusion should not be read so broadly that the rule – the exclusion clause – is swallowed by the exception….”

The court found that the plaintiff’s claim “falls squarely into the exclusion clause simply as a cost incurred to make good the defective concrete. If, however, the fifth floor slab had collapsed and damaged machinery, plumbing and electrical fixtures, or neighboring property, those losses would qualify as “ensuring losses” that are covered under the policy. The defective materials, themselves, would still not be covered. But where there was no collapse and no actual physical damage, the court found that “Laquila’s claim for coverage here is no more than an attempt to recover for excluded costs of making good its faulty or defective workmanship.” Pressing home its point, the judge concluded: “Were I to accept the plaintiff’s interpretation, it would result in coverage for nearly every instance of defective workmanship . . . whether or not there was any actual ensuring loss or if such loss stemmed directly from a risk expressly and unquestionably excluded by the policy. Such coverage would wrongfully insulate contractors from liability when their negligent or shoddy workmanship results in structural or other failings.” Laquila Construction, Inc. v. Pinnacle Concrete Corp. v. Travelers Indemnity Company of Illinois, 66 F. Supp. 2d 543 (D.C. Ill. 1999).

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Defective Workmanship Potentially Covered By Insurance

An insurance dispute arose when the commercial general liability (CGL) insurance company refused to defend a suit by a prime contractor against an inspection firm (SLT, Inc.) that it had hired to inspect and approve shop welds of pipe sections that were brought to the construction site for installation. Large pipe sections were purchased by the contractor from a fabricator (Progressive Fabricators, Inc.) located in St. Louis for use at a hydroelectric plant in California. SLT was to inspect the welds before the pipe sections were shipped by the fabricator to California.

SLT tendered defense of the suit to its CGL carrier, Liberty Mutual which declined to defend on the basis that the losses alleged in the complaint were not covered “property damage” and, in any event were excluded under the policy’s “impaired property” exclusion. SLT settled its case with Esicorp (the successor to the original prime contractor) for over $2 million. As part of this settlement agreement, SLT agreed to give Esicorp $125,000 in cash plus transfer to Esicorp its rights to file a lawsuit against Liberty Mutual alleging bad faith breach of its contractual duties to defend and indemnify.

In the trial court, Esicorp obtained a judgment against Liberty Mutual. On appeal the appellate court affirmed the judgment and agreed that Liberty Mutual had breached its duty to defend SLT in the underlying suit. The policy promised to indemnify SLT for non-excluded “property damage” caused by an “occurrence.” The policy defined property damage as “physical injury to tangible property, including all resulting loss of use of that property.” Esicorp’s complaint had alleged that as a result of SLT’s failure to discover defective welds in the pipes, the pipes were brought to the project and installed. When it was discovered during installation that the welds were defective, the owner suspended further work and required Esicorp to re-examine all the shop welds and repair rejectable defects.

In reviewing the responsibilities of Liberty Mutual, the appellate court explained that an insurance company has two distinct duties. The first is to defend the insured in any lawsuit seeking damages that would be covered losses. The second duty is to indemnify the insured for covered losses. The duty to defend is broader than the duty to indemnify. If the complaint against the insured alleges facts that give rise to a claim potentially within the policy’s coverage, the insurer has a duty to defend. In the Liberty Mutual policy, coverage was to be provided for property damage that was defined as “physical injury to tangible property, including all resulting loss of use of that property.” The court concluded that “it was reasonably apparent to a liability insurer from these allegations that “property damage” to the pipe system, and perhaps to surrounding project property and equipment, would likely result from this type of on-site repair operation. Thus, while “most of the damages alleged in Esicorp’s complaint appeared to be economic losses, not covered property damage” the complaint included allegations giving rise to a claim “potentially within the policies’ coverage.” The duty to defend was thereby triggered.

The case goes on from here to describe in greater detail the extent of the insurance company duty, including whether it can be held liable for more than the policy limit, and how to ascertain liability when the underlying damages arise out of some combination of covered and non-covered claims. Esicorp, Inc. v. Liberty Mutual Insurance Company, 193 F.3d 966 (8th Cir, 1999).

Risk Management Note: It is interesting how the decision of this case contrasts with that of the court in Laquila Construction, Inc. v. Pinnacle Concrete Corp. v. Travelers Indemnity Company of Illinois, discussed above. Here the court concluded that allegations of potential property damage resulting from defective inspection services of SLT could potentially be covered under the CGL policy. In contrast, the court in Esicorp found no potential coverage under a policy where repairs were conducted before the defective materials could fail and thereby cause damage to other property.

What is not explained in the court’s analysis is how there could be any potential coverage under a CGL policy for what appears to be allegations of negligence by a professional services provider. Generally, errors and omissions insurance that is afforded by professional liability policies would be more appropriate to cover negligent acts, errors and omissions in the performance of professional services. Even where there are professional liability endorsements in CGL policies, those policies will not provide coverage for purely economic damages – there must first be actual property damage or bodily injury.

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Statute of Repose for Construction Activities Time-Bars Claim that could also be Asserted as Products Liability – with Longer Statute of Limitations Period

A plaintiff filed suit for negligence as well as products liability against a firm that designed, manufactured and installed precast concrete products for a parking garage. The court dismissed the suit because it was filed beyond the six years permitted under the state’s statue of repose applicable to services on construction projects. The plaintiff argued that the statute of repose was inapplicable because the damages arose not out of construction services but out of products liability. The statute of limitations for filing products liability claims had not yet expired when the suit was filed because it permitted suit to be filed up to two years after discovery of the defects. It provided no absolute deadline – but rather a moving date that depended upon the date a plaintiff discovered the defect.

The statute of repose bars “all actions against any architect, contractor, builder or builder vendor, engineer, or inspector performing or furnishing the design, planning, supervision, inspection, construction . . . of any improvement to real property … [filed] six years after the substantial completion of the improvement . . .” In rejecting the plaintiff’s assertion that the manufacturer was not one of the named entities to be protected by the statute of repose, the court focused on the nature of the activity performed. Instead of looking only at the label placed on the party performing the work, the court stated it was necessary to “look to whether that individual’s actions fall within the statute’s protected class of activities.” Since in this case, the defendant engaged in “design” and “construction” it was entitled to protection under the statute of repose. Two Denver Highlands Ltd. Partnership v. Stanley Structures, Inc. No.98CA2177, 2000 Colo. App. LEXIS 16 (Jan 20, 2000).

Risk Management Note: A key used by courts in deciding if an item is a service or a product is whether it is an off-the-shelf item that is made by a party that has little or no on-site activity. If the party that creates the product also installs it, the court is more likely to find this to be construction work. On the other hand, if a party simply supplies a product that someone purchases, takes to the site and then installs it, the courts are more likely to be found to be a product and, therefore, no protection is afforded by the statute of repose for construction activities. Interestingly, mere size and cost of the item is not necessarily determinative. In some instances, for example, huge water tanks have been considered to be products if they are manufactured off-site and later bolted down to a concrete pad on- site, because they are considered mobile and the on-site installation was a minor part of the total cost. Also, the more site-specific design and customization of the item there has been, the more likely that the court will find this be to construction activity protected by the statute of repose.

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