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In This Issue:

  • No Compensation owed to contractor who performed extra work without written authorization
  • Additional Insured Endorsement Limited
  • CGL Policy does not cover contractor’s defective work
  • Liquidated damage assessment against contractor

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About this Newsletter

This newsletter is edited by J. Kent Holland, Jr., Esq., and published by e-mail once per month. Archived issues (plus this current issue) are maintained on our website at http://www.constructionrisk.com. The formatting on the website is easier to read and print. Electronic newsletters provide prompt information but, unfortunately, cannot be formatted into a professional looking layout. At our website you will find an extensive library of risk management materials, including articles indexed by subject matter. It is organized as a construction risk management portal to make it easy for you to find all kinds of valuable information on the web. And it’s completely free – offered as a public service by J. Kent Holland, Jr., an attorney with 20 years of legal experience as a construction lawyer and risk management professional.

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NO COMPENSATION OWED TO CONTRACTOR WHO PERFORMED ADDITIONAL WORK WITHOUT WRITTEN AUTHORIZATION

It is surprising how many cases there are in which a consultant or contractor performs additional services or work for an owner without first adhering to notice and approval requirements of the contract. Failure to obtain authorization for additional work from the owner’s designated representative can, and often does, bar entitlement to be paid for the extra work.

In the case of F. Garofalo Electric Co., Inc. v. New York University, et al., 705 N.Y.S. 2d 327 (March 14, 2000), the electrical contractor, Garofalo, alleged that it performed additional work and furnished additional materials in reliance upon oral representations by NYU and its construction manager, MDI, to pay for such extra work. Plaintiff’s complaint alleged breach of contract by both NYU and MDI. It also alleged that MDI was negligent. The defendants asked the court to grant motions of summary judgment against the complaint. The appellate court agreed that the plaintiff could not maintain a claim for negligence against MDI because New York did not recognize a cause of action for economic loss caused by allegedly negligent performance of contractual duties. Moreover, the court held that the plaintiff was not a third party beneficiary of the contract between NYU and MDI, and therefore had no rights under that contract to sue MDI.

NYU argued that it was entitled to summary judgement because plaintiff had failed to provide the contractually required contemporaneous written notice and documentation of its claims for extra work, and that they were therefore barred. In opposition to the motion, plaintiff didn’t argue that it complied with the contract’s notice requirements or obtained a signed contract modification. Instead, it argued that NYU, through MDI, its agent, had abandoned, waived or modified the requirements. Its basis for this argument was its assertion that MDI’s project manager orally instructed plaintiff to perform the extra work and keep track of hours and materials, and said, “it would be taken care of at the end of the job.” “Further, plaintiff pointed to the deposition testimony of MDI’s vice president, wherein he stated that MDI basically instructed plaintiff to ‘proceed with the work’ without the paperwork required by the contract. Lastly, plaintiff maintained that its foreman and sub-foreman prepared Foreman’s Daily Reports and submitted them to MDI on a daily or weekly basis and that these reports were sufficient to meet the contract requirements.”

In rejecting all of these arguments by the plaintiff, the court explained: “The contract’s notice and documentation requirements for extra work and delay damages are condition precedents to plaintiff’s recovery and the failure to strictly comply is deemed a waiver of such claims. Plaintiff conceded . . . it did not strictly comply with the contract’s mandates. Therefore, plaintiff clearly waived its claims.” Even if MDI had, as alleged by the plaintiff, orally instructed plaintiff to perform the extra work and modified the contractual requirements, the court said this would not relieve the contractor from meeting the requirements. According to the court, “The record reveals that MDI’s authority was clearly and unambiguously limited by the express terms of both the contract and the construction manager’s agreement and, as such, it lacked authority to waive or modify the notice or documentation requirements in plaintiff’s contract.”

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Risk management Note: It is vitally important that parties to contracts understand the principles explained in this case. When the contract states it can only be modified in writing, it means what it says. Courts enforce these provisions even in situations where the results might appear to be “unfair” and the owner might appear to receive a windfall by not having to pay for work. Although this case dealt with a construction subcontractor, the same principles and law apply equally to consulting contracts. If a consultant is asked by an owner to perform services that it deems are “additional services” beyond the scope of the “basic services” for which it was to compensated, it must adhere to the requirements of the contract to provide the owner with written notice that the services are “additional.” It will also have to meet any contractual requirements mandating that the notice be given to a specified representative of the owner for approval. Finally, it will have to adhere to contractual requirements concerning the documentation of costs associated with the additional services.

When consultants and contractors run afoul of the contract requirements, it is sometimes because the individuals running the job are not adequately familiar with the contract terms. In other instances it is because the parties have developed a comfortable relationship that has led to informality and apparent waiver of contract requirements. As explained by this court, however, the requirements are not actually waived in the absence of a written modification to the contract. From my experience, I don’t think that project owner’s intentionally lull consultants and contractors into performing services with the intent not to pay for them. But what sometimes happens is that when the contractor or consultant submit claims to the owner at the end of the project, the owner retains counsel who determines that the parties did not adhere to the notice and documentation requirements. In fulfilling their zealous representation to the owner, they advise the owner that because these requirements were not met, the claimants’ have legally waived their right to be paid for the additional work. There are even reported court cases in which the owner counter-claimed against the plaintiff and recovered progress payments it had made on work that had been performed with its knowledge but without written authorization of the designated owner’s representative. When it comes to construction contracts, the devil’s in the details.

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ADDITIONAL INSURED ENDORSEMENT LIMITED COVERAGE

Contractors are often required by contract to name the project owner as an “additional insured” under a commercial general liability (CGL) policy and this is routinely done. Subcontractors are sometimes required to name both the general contractor and project owner as additional insureds under their CGL policy. Design professionals, on the other hand, rarely are able to provide additional insured status to the owner under the professional liability policy. For a good explanation of this distinction, see the Zurich Insurance Architectural/Engineering Briefings at Vol.2, No.1 (February 1997), http://www.zurichamerican.com/za/news/nwslttrs/archeng/2-97.htm

An additional insured endorsement can provide broad coverage to the additional insured or it can carefully limit the coverage to only those damages that arise from the named insured’s acts and omissions. In American Country Ins. Co. v. Cline, No. 1-98-2021, 1999 Ill. App. LEXIS 853, the court held that an additional insured endorsement effectively limited the coverage to only those damages arising out of the insured subcontractor’s own conduct and did not extend coverage to the owner or general contractor for damages arising out of their own conduct. The endorsement provided the following:

“The coverage afforded to the Additional Insured is solely limited to liability specifically resulting from the conduct of the Named Insured which may be imputed to the Additional Insured. This endorsement provides no coverage to the Additional Insured for liability arising out of the claimed negligence of the Additional Insured, other than which may be imputed to the Additional Insured by virtue of the conduct of the Named Insured.”

An employee of the electrical subcontract sued the project owner and general contractor for their active negligence in causing an electrical conduit pipe to fall on his ladder, resulting in his fall to the floor. Both the owner and contractor gave the claim to the subcontractor’s insurance company, American Country Insurance Company (“American”). American refused to defend the case since the employee alleged active negligence of the owner and contractor, and the endorsement limited coverage only to liability caused by the insured and imputed to the additional insureds. The issue to be decided by the appellate court was whether American correctly interpreted and applied the language of the endorsement.

The court found that the coverage was not illusory and meaningless even though the language of the endorsement strictly limited what would be covered. This is because it would cover claims from the vicarious liability of the owner and contractor arising out of actions of the subcontractor. The narrow coverage seemed appropriate to the court, particularly in view of the small price of $150.00 paid for the endorsement. In addition, “this limitation on coverage recognizes that businesses in the construction industry carry coverage for liability arising out of their own work, and assumes that [Contractor] would have its own general liability coverage. If an additional insured seeks the same level of coverage that it already receives from its own insurer, then insurers like plaintiff should receive a larger premium payment.” The court concluded that the terms of the endorsement reflect the fact that the insurance company was only willing to provide coverage of its own insured’s actions.

Another issued determined by the court was whether the endorsement violated public policy. Since the insurance company had filed the endorsement with the state insurance commissioner of Illinois and it had not been rejected by the Insurance Department, this was one indication that the endorsement was not contrary to public policy. In addition to this, the court found that the parties were sophisticated commercial entities that negotiated their insurance policy and endorsement. This bound the owner and contractor to their decision accepting the endorsement.

Since the endorsement was enforceable as written, the court found that the insurance company had no duty to defend the contractor and owner in the suit by the subcontractor’s employee. That employee’s suit alleged negligence only on the part of the contractor and owner, and not the insured subcontractor. Thus there was no negligence of the named insured imputed to the others. The claim, consequently, was not covered by the endorsement.

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CGL POLICY DOES NOT COVER CONTRACTOR’S DEFECTIVE WORK

To what extent may defective workmanship of a contractor be covered under a commercial general liability (CGL) policy. Contractors have occasionally argued successfully that property damage or personal injury was imminent as a result of their defective work, and that the repair to the work must be deemed to be insured damage. More often that not, these kinds of claims are denied.

In Erie Insurance Property & Casualty Co. v. Pioneer Home Improvement, Inc., No. 11278000 (W.Va. Dec 10, 1999), the Supreme Court of West Virginia reviewed the question of whether defective workmanship could be a covered loss under the policy. A homeowner sued the insured general contractor for defective performance. The general contractor tendered the claim to its insurance company to defend. The insurer declined coverage on the basis there had been no “occurrence” causing property damage. Second, it argued that an exclusion to the policy negated any potential coverage. The policy expressly excluded coverage for “that particular part of the any property that must be restored, repaired or replaced because your work was faulty.”

In evaluating the language of the policy, the court explained that a CGL policy does not insure against “damages in an action for breach of contract and faulty workmanship on a project where the damages are the cost of correcting the work itself.” Instead, the policy is to cover liability arising out of personal injury or property damage to others caused by the insured’s conduct. This is how the court explained it:

“Pioneer [the contractor] purchased a CGL policy. These policies do not insure the work or workmanship which the contractor or builder performs. They are not performance bonds or builders’ risks policies. CGL policies, instead, insure personal injury or property damage arising out of the work. The ‘completed operations hazard’ coverage applies to collateral property damage or personal injury caused by an occurrence ‘arising out of your work that has been completed or abandoned.’”

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LIQUIDATED DAMAGE ASSESSMENT AGAINST CONTRACTOR UPHELD

When the amount of damages is difficult to predict, a liquidated damages clause will generally be upheld unless the court determines that the clause was intended to be a penalty rather than liquidated damages. In Safeco Credit v. U.S., 44 Fed.Cl. 406 (1999), a contractor was assessed damages by the Department of Navy for late completion of a contract. The contractor argued that the delays were caused by 53 contract modifications by the Navy. The Navy granted time extension change orders for the specific phase of the project that was affected by each change order. It did not, however, specifically agree to extend the start date or date of completion of any other phase of the project that might arguably be affected by the delayed completion of the first phases.

Contractor argued that if the Navy extended the time for completing one phase, it must be assumed that the time for starting and completing the next phase would likewise be granted a time extension. Moreover, the contractor argued that the dollar amount of the liquidated damages was punitive rather than reasonable, and did not follow the rules and procedures of the Navy’s contract manual. In reviewing whether the Navy had properly assessed liquidated damages and denied the contractor’s claim for equitable adjustment for delay to the overall project, the court stated that the contractor has the burden to establish that the liquidated damages clause was intended to operate as a penalty. To prove that, it is necessary to ask three things:

(1) Did the parties intend liquidated damages or a penalty?

The terms of the contract are the best evidence of the party’s intent.

(2) Was the amount of damages that would be caused by a breach uncertain in amount or difficult to determine?

The more difficulty there would be in proving that a loss has occurred or the amount of the loss in the event that it occurs, the easier it is to show that the amount fixed as liquidated damages is reasonable. The court evaluates this question based on the reasonable expectations of the parties as of the date the contract was executed.

(3) Does the amount of damages bear a reasonable relationship to actual damages that could be sustained in the event of a breach?

The amount is reasonable if it approximates the loss anticipated at the time the contract is executed, even though it may not approximate the actual loss.

In this case, the court found that the contractor failed to prove that the liquidated damages clause operated as a penalty. The amounts were based on the Navy Contract Manual, but to the extent that they differed, the Navy had followed required Navy procedures to justify the higher amounts set. On the issue of whether the project completion date should have been extended due to the extensions on the individual phases, the court found that the change orders were self contained and that “the terms of the contract modifications at issue here make it clear that a change in the completion date for one phase of the contract does not lengthen the period of time in which a subsequent phase was to be completed, unless expressly provided.” No provision was made for any cumulative impact. For these reasons, the court granted the Navy’s motion for summary judgment against the contractor.

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Editor: J. Kent Holland, Jr. 703-827-4114