Inside this Issue
- A1 - Economic Loss Doctrine Applied in Texas to Limit Tort Claims by Contractors against the Owner’s Design Professionals: Excellent Explanation of the Doctrine
- A2 - Alabama Joins Recent Trend Of States Finding Defective Work May Be Covered Under A Commercial General Liability Policy
- A3 - Contractor Claim Against Second Tier Sub Barred by Lack of Contract Privity
- A4 - What Constitutes a Claim Triggering Indemnification Duty?
Economic Loss Doctrine Applied in Texas to Limit Tort Claims by Contractors against the Owner’s Design Professionals: Excellent Explanation of the Doctrine
See similar articles: Economic Loss Rule
By: Scott W. Cowan, Daniel D. McMillan, Andrew D. Ness, J. Laurens Wilkes and Christopher H. Domingo - Jones Day law firm
In a June 20 decision, the Texas Supreme Court applied the economic loss rule to preclude a direct claim for negligent misrepresentation by a construction contractor against an owner's architect based on flawed design documents. LAN/STV v. Martin K. Eby Constr. Co., No. 11-0810, 2014 Tex. LEXIS 509, at *1-2 (Tex. Jun. 20, 2014). After undertaking an in-depth examination of the normative principles forming the backbone of the economic loss rule, the court departed from the Restatement of Torts ("the Restatement") and ultimately concluded that the economic loss rule barred recovery against the architect—notwithstanding the fact that the architect knew its plans would be relied upon by the general contractor in preparing and submitting its bid. In reaching its holding, the court reasoned that risk allocation in most construction situations is better left to the realm of contract law and to negotiations between the participants involved in the project.
The Eby decision is good news for design professionals, as the court ruled decisively on an issue that divides courts across the country. (See footnote 1). Still, the decision reinforces the need for design professionals, as well as owners and contractors, to address practical considerations concerning contract drafting and negotiation at the front end of the process, in order to avoid unintended consequences when a dispute arises. Indeed, Eby makes clear that parties are free to agree on a potentially different outcome than would result from the Texas Supreme Court decision by modifying contractual language. Therefore, it remains important that design professionals, owners, and contractors review contract language to ensure that construction contracts and professional services agreements contain no surprises or unintended consequences.
Background of the Eby Dispute
In 1997, the Dallas Area Rapid Transportation Authority ("DART") contracted with LAN/STV to prepare plans, drawings, and specifications for the construction of a light rail transit line running from Dallas's downtown West End to the American Airlines Center. LAN/STV agreed to "be responsible for the professional quality [and] technical accuracy ... of all designs, drawings, specifications, and other services furnished," and to be "liable to [DART] ... for all damages to [DART] caused by [LAN/STV's] negligent performance of any of the services furnished." DART incorporated LAN/STV's plans into a solicitation for competitive bids to construct the transit line, which was awarded to the low bidder, Martin K. Eby Construction Company, in 2002. Importantly, this was a traditional design-bid-build project where LAN/STV as the architect was in contractual privity with DART as the owner, and DART was in contractual privity with Eby as the contractor. Eby and LAN/STV, however, had no contract with one another.
Just days after beginning construction, Eby discovered that architectural plans provided by LAN/STV were replete with errors. According to Eby, 80 percent of the architect's drawings had to be changed, which disrupted the construction schedule and forced Eby to provide additional labor and materials. Eby filed a breach of contract action against DART as the owner, which was initially dismissed for failure to follow the contract's claim procedures. Eby continued to pursue its claim against the owner through the administrative claim process, seeking $21 million in damages. However, the administrative officer rejected Eby's claim and awarded the owner $2.4 million in liquidated damages. Eby filed an administrative appeal and eventually obtained a $4.7 million settlement in its favor.
Eby opened a second front in its battle to recover its claimed damages by filing a separate tort action against LAN/STV. Eby alleged that the architect had been negligent and had negligently misrepresented the work to be done. Only the negligent misrepresentation claim was presented to the jury, which found that LAN/STV was liable and assessed Eby's damages at $5 million. (The amount was later reduced to $2.25 million under the Texas proportionate responsibility scheme.) Both parties appealed, and, following the appellate court's affirmance, both petitioned for review. LAN/STV argued that the economic loss rule applied and that allowing tort recovery here—where relationships are contractual and certainty and predictability in risk allocation are crucial—would be highly disruptive to the construction industry. Eby argued that the economic loss rule did not apply to actions for negligent misrepresentation, as in the case at hand.
Normative Principles of the Economic Loss Rule
Before analyzing the issues presented, the Eby court first examined the history of the economic loss rule in Texas. In its analysis, the Texas Supreme Court recognized the absence of one rigid rule and instead identified the series of normative principles shaping the economic loss rule:
- First, there is "'no general duty to avoid the unintentional infliction of economic loss,'" with recovery of purely economic loss based on a negligence theory permitted in only limited circumstances. Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *20 (quoting Restatement (Third) of Torts: Liability for Economic Harm § 1 (Tentative Draft No. 1 2011) [hereinafter Restatement, T.D. 1]).
- Second, courts are concerned about the "'[i]ndeterminate and disproportionate liability'" that can arise for purely economic losses unaccompanied by personal injury or property damage. Id. at *11-*19 (quoting Restatement, T.D. 1, § 1 cmt. d).
- Third, economic loss is well suited to allocation by contract, including by insurance and indemnity clauses, so courts should give deference to contracts and should be reluctant to upset the allocation of risk made by a contract. at *18-*19 (quoting Restatement, T.D. 1, § 1 cmt. d).
Application of the Economic Loss Rule to Contractor Claims Against Architects
With these principles in mind, the Eby court turned to the matter at hand and examined the two issues in dispute: (i) whether application of the economic loss rule should turn on whether the claim is for negligent misrepresentation as opposed to negligent performance of services; and (ii) whether a claim involving an architect in a construction setting should be treated differently because the plans drawn by the architect are intended to be relied upon by the contractor when preparing a bid to be submitted to the owner.
With regard to the first issue, the court noted that both the torts of negligence and negligent misrepresentation are based on the same logic and that the general theory of liability is the same. The court therefore concluded that "[t]he economic loss rule should not apply differently to these two tort theories in the same situation." Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *38. Accordingly, under Texas law, a contractor will not be able to pursue a direct claim against the owner's architect on facts similar to those in Eby merely because the claim is framed as one for negligent misrepresentation rather than negligence.
As to the second issue, the court commented on the traditional contractual relationships in construction projects:
Construction projects operate by agreements among the participants. Typically, those agreements are vertical: the owner contracts with an architect and with a general contractor, the general contractor contracts with subcontractors, a subcontractor may contract with a sub-subcontractor, and so on. The architect does not contract with the general contractor, and the subcontractors do not contract with the architect, the owner, or each other.
Id. at *36. Setting aside the architect, the court broadly stated that "[w]e think it beyond argument that one participant on a construction project cannot recover from another ... for economic loss caused by negligence. If the roofing subcontractor could recover from the foundation subcontractor damages for extra costs incurred or business lost due to the latter's negligent delay of construction, the risk of liability to everyone on the project would be magnified and indeterminate...." Id.(emphasis added).
The court examined the underlying assumptions that are viewed differently in jurisdictions across the country when it comes to whether the economic loss rule precludes direct negligence claims by a contractor against the owner's design professional. The Restatement and some jurisdictions find it significant that design documents are prepared by design professionals with the knowledge that bidders, and ultimately the selected contractor, will be required to rely on them. According to the Restatement, "'the architect's plans are analogous to the audit report that an accountant supplies to a client for distribution to potential investors—a standard case of liability [for negligent misrepresentation].'" Id. at *38-39 (quoting Restatement, T.D. 2, § 6 cmt. b).
Interestingly, the Restatement distinguishes between negligence claims against subcontractors and those against architects. On the one hand, the Restatement indicates that an owner may not sue a subcontractor for negligence and one subcontractor may not sue another subcontractor for economic loss: "'A subcontractor's negligence in either case is viewed just as a failure in the performance of its obligations to its contractual partner, not as the breach of a duty in tort to other subcontractors on the same job, or to the owner of the project.'" Id. at *37 (quoting Restatement, T.D. 2, § 6 cmt. b). In this setting, according to the Restatement, "'the rule of no liability is made especially attractive by the number and intricacy of the contracts that define the responsibilities of subcontractors on many construction projects,'" and allowing such tort actions would disrupt this "'web of contracts.'" Id. at *37-38 (quoting Restatement, T.D. 2, § 6 cmt. b).
On the other hand, the Restatement reaches a different conclusion when it comes to contractor claims against architects: "'Allowing a suit against the architect of a project by a party who made a bid in reliance on a defective plan does not create comparable problems.'" Id. at n. 51 (quoting Restatement, T.D. 2, § 6 cmt. b). Under this reasoning, the economic loss rule's fundamental objective—avoiding liability in an indeterminate amount for an indeterminate time to an indeterminate class—is not implicated because the only claim allowed is the contractor's claim against the design professional.
The Texas Supreme Court, however, took the opposite view, diverging from the Restatement on this point, and sided with other jurisdictions holding that the economic loss rule precludes direct claims by contractors against subcontractors. TheEby court focused less on the foreseeability that the architect's plans will be reviewed and relied upon by the contractor, but rather on the contractual position of the parties. According to the Eby court, "the contractor's principal reliance must be on the presentation of the plans by the owner, with whom the contractor is to reach an agreement, not the architect, a contractual stranger. The contractor does not choose the architect, or instruct it, or pay it." Id. at *39.
In discussing its rationale, the court noted that the Restatement, which would permit direct claims against architects in negligence, notes that if this is not desirable by the parties to the project, "'they are free to change it in the contracts that link them.'" Id. (quoting Restatement, T.D. 2, § 6 cmt. b). The Restatement worries that were the rule otherwise, unsophisticated parties might be left without a remedy because they did not have the foresight to address this contractually. Id. at *42 (citing Restatement, T.D. 1, § 3, reporter's note to cmt. f). The Eby court simply disagreed with this assumption: "We think it more probable that a contractor will assume it must look to its agreement with the owner for damages if the project is not as represented or for any other breach." Id. The court recognized that "[t]hough there remains the possibility that a contractor may not do so, we think the availability of contractual remedies must preclude tort recovery in the situation generally because, as stated above, 'clarity allows parties to do business on a surer footing.'" Id. at *42 (quoting Restatement, T.D. 2, § 6 cmt. b).
Interestingly, neither the Eby court nor the Restatement discusses the distinction between public and private contracts and how the negotiation process plays out in the real world. Construction contracts on public works contracts oftentimes must be awarded to the lowest responsible bidder, and the contract language, which is distributed with the invitation for bid, is not subject to traditional negotiation.
While the Eby decision brings a degree of clarity to the Texas construction landscape in situations like those that confronted the court, there are still circumstances where contractors may try to assert direct claims against an owner's design professionals. First, Eby does not address whether claims for fraud or intentional misconduct by design professionals are precluded by the economic loss rule (many courts carve out an exception for these claims and allow them to be brought by contractors, although there are many challenges to asserting such claims).
Second, Eby does not address how the decision will affect Integrated Project Delivery ("IPD") agreements where the owner, contractor, and design professional all sign a single contract. It remains to be seen whether Texas courts will be more inclined to permit direct claims against an architect by a contractor who is a party to an IPD contract along with the owner and the architect, should the contract itself not expressly foreclose such claims.
Third, the contractor in Eby did not allege that it was a third-party beneficiary of the agreement between the architect and the owner, so this issue was not addressed. Id. at n.6. Where the professional services contract contains an express disclaimer of third-party beneficiaries, design professionals have some extra protection from these types of direct claims that are not based on tort theories.
Implication for Drafting and Negotiating Construction Contracts
With the Texas Supreme Court's clear emphasis on the parties' bargained-for agreements, it is more important than ever for parties to focus on the drafting and negotiation of their construction contracts for traditional design-bid-build projects. Design professionals, owners, and contractors should keep the following practical considerations in mind.
Design Professionals' Perspective. There are two important provisions that design professionals like in their contracts with owners, which limit the ability of construction contractors to bring direct claims. First, design professionals like to include a contractual provision that disclaims any intent to create third-party beneficiaries. For example, Section 10.5 of the American Institute of Architects Form B201 (2007) (Standard Form of Agreement Between Owner and Architect) provides: "Nothing contained in this Agreement shall create a contractual relationship with or a cause of action in favor of a third party against either the Owner or Architect."
In the wake of the Eby decision, contractors will be incentivized to seek damages in contract that they can no longer seek in tort. A disclaimer of third-party beneficiaries can help close the door to such an argument and ensure that the design professional limits its exposure to the extent possible. Second, design professionals are sometimes able to persuade owners to include a provision in the construction contract that expressly bars direct claims from contractors related to the design professional's performance of its contract with the owner (with potential carve-outs for personal injury claims and claims for damages to the contractor's property). Such a provision is in line with the Eby holding, but it may afford even broader protection to design professionals. Of course, owners are not always willing to insert such a provision into their construction contracts.
Owners' Perspective. The Texas Supreme Court suggests that the new Eby rule results in seamless liability: "[I]f the architect is contractually liable to the owner for defects in the plans, and the owner in turn has the same liability to the contractor, the contractor is protected." Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *39-41 & n.55. But there is not always true seamlessness, a situation to which owners must be alert. The contractor may be able to recover against the owner for breach of contract or breach of the implied warranty of the correctness of the plans and specifications where there is a defect attributable to the architect or engineer.
The owner may then bring a claim against the design professional for indemnity or breach of the design professional's contract with the owner. However, the design professional's contract and indemnity provisions in favor of the owner may be worded to impose liability only to the extent the design professional fails to meet the standard of care for professional liability.
This standard of care does not require perfection. Thus, a situation may arise where the owner is liable to the contractor because of a defective specification or design error, yet be unable to pass the liability on to the design professional where the design, though deficient, does not fall below the standard of care. When this happens, the owner is stuck holding the bag.
Because of this potential gap, owners may seek to impose as much contractual liability on the design professional as possible—including contractual liability not governed by the standard of care. Design professionals frequently claim that such contractual liability is not insurable and therefore they cannot agree to accept liability beyond the standard of care.
The Eby court does not address this dynamic when it relies on the Restatement, which suggests that a party to a construction contract "'has a full chance to consider how to manage the risks involved, whether by inspecting the item or investment, obtaining insurance against the risk of disappointment, or making a contract that assigns the risk of loss to someone else.'" Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *18 (quoting Restatement, T.D. 1, § 1 cmt. c). Nonetheless, owners frequently try to expand the scope of the design professional's liability to better protect the owner and to narrow the potential gap between the owner's potential strict liability to the contractor for breach of contract or implied warranties, and what can be pushed back to the design professional due to its errors or omissions.
Contractors' Perspective. As the Eby decision notes, a contractor has a direct claim against the owner when there are defects in the design furnished by the owner. To the extent Eby cuts off under Texas law a contractor's ability to sue a design professional for negligence or negligent misrepresentation, contractors may look to explore whether the owner-design professional contract expressly denies third-party beneficiary status to contractors and whether pursuing such a claim is possible.
In many cases, contractors are content to sue the owner directly and to wait and see whether the owner brings in the design professional, a development that contractors usually view as favorable as the owner and design professional end up pointing fingers at each other. On negotiated contracts, some contractors do not balk at including provisions that preclude direct claims against the owner's design professional because the contractor knows that it has a direct claim against the owner for defects in design.
The Eby decision provides clarity as to the application of the economic loss rule in Texas and puts a premium on the contract drafting process. Parties to construction contracts must review contracts carefully and negotiate accordingly.
- According to the Ebydecision, courts across the country that have considered the issue are divided 10–8 on whether the economic loss rule applies to bar the claims brought by the contractor against the design professional. Eby, No. 11-0810, 2014 Tex. LEXIS 509, at *47 & n.60. Jurisdictions applying the economic loss rule on these facts to preclude such claims include Colorado, the District of Columbia, Illinois, Nevada, Ohio, Utah, Virginia, Washington, Wyoming, and now Texas. Id. at n.60. Jurisdictions refusing to apply the rule include Arizona, Florida, Massachusetts, Minnesota, Pennsylvania, Rhode Island, South Carolina, and West Virginia. Id.
About the Authors:
The authors are attorneys with the law firm of Jones Day.
This article was originally published by Jones Day, which retains copyright to the article.
For further information
Laurens Wilkes, Esq.
This article is published in ConstructionRisk.com Report, Vol. 16, No. 9 (November 2014).
Copyright 2014, ConstructionRisk, LLC
Alabama Joins Recent Trend Of States Finding Defective Work May Be Covered Under A Commercial General Liability Policy
By: Heather Howell Wright, Esq.
The Supreme Court of Alabama recently held in Owners Ins. Co. v. Jim Carr Homebuilder, LLC that a contractor’s commercial general liability (“CGL”) policy provided coverage for property damage caused by the defective work of subcontractors. The Jim Carr Court decided that although faulty workmanship by itself may not constitute an “occurrence” (which is required to trigger coverage) under a CGL policy; faulty workmanship that results in property damage will be considered an “occurrence”. Through this decision, the Alabama Supreme Court joined the recent (but not uniform) trend in other jurisdictions that recognize that defective work may be covered under a CGL.
Approximately one year after the purchase of a $1.2 million home, Pat and Thomas Johnson began to experience water leaks through the roof, walls, and floors. The Johnsons sued the general contractor, Jim Carr Homebuilder (“Jim Carr”), who had employed subcontractors to perform all of the actual construction work on the project. The case was sent to arbitration, and a $600,000 arbitration award entered against Jim Carr. In support of the damages award, the arbitrator found, among other things: (1) flashing was either not installed or improperly installed by subcontractors; (2) brick was improperly prepared for installation by subcontractors resulting in excessive absorption of water from the mortar; (3) sufficient weep holes were not installed in the brick or were covered by mortar by subcontractors; (4) windows and doors were not properly installed by subcontractors; and (5) part of the roofing was not properly installed by a subcontractor.
Jim Carr filed a claim with its CGL insurance carrier, Owner’s Insurance Company (“OIC”) and sought coverage from OIC to pay the arbitration award. OIC filed a declaratory judgment action – a lawsuit where a court is asked to determine the rights and obligations between the parties without ordering that anything be done or damages be paid – asking the Court to determine whether OIC had an obligation to pay the arbitration award. OIC argued that it had no obligation to pay because property damage covered under the CGL can only be damage to something other than the work being performed by the contractor. Since Jim Carr constructed the entire home, OIC argued that the CGL did not provide coverage for any damage to the home.
The Court rejected OIC’s argument, pointing out that under OIC’s interpretation of the CGL there would “be no portion of the project that, if damaged as a result of exposure to such a condition arising out of faulty workmanship of the insured, would be covered under the policy.” The court instead held that faulty workmanship that leads to any property damage – including property damage to the project itself – will qualify as an “occurrence” under the standard CGL policy.
The Court also considered whether the “your work” exclusion precluded coverage even if the defective work qualified as an “occurrence.” The standard form CGL policy excludes “‘property damage’ to ‘your work’ . . . and included in the ‘products-completed operations hazard.’” The Jim Carr Court held that the “your work” exclusion does not apply at all if the policyholder purchases “completed operations” coverage. Because Jim Carr had purchased a completed operations coverage endorsement, the “your work” exclusion was not applicable.
The Court held that the entire arbitration award should be covered by the insurance policy. This is a significant holding for construction industry policyholders. In light of the Jim Carr decision, Alabama policyholders should consult their insurance agents to insure that the language of their CGL policy reflects the court’s treatment of the “your work” exclusion and includes coverage for completed operations. Each reader should be aware that the state courts are varied in the application of this doctrine, and it is not safe to assume that every state will hold the way the Alabama court did in this case.
About the Author:
Heather Wright is an attorney with the law firm of Bradley Arant Boult & Cummings. This article was originally published by the law firm, which retains the copyright
This article is published in ConstructionRisk.com Report, Vol. 16, No. 9 (November 2014).
Copyright 2014, ConstructionRisk, LLC
Contractor Claim Against Second Tier Sub Barred by Lack of Contract Privity
James Rhodes, Esq.
ConstructionRisk Counsel, PLLC
A federal district court, applying Nebraska law, dismissed several causes of action by a prime contractor against its second-tier subcontractors due to the lack of a contractual relationship between them (in legal terminology, “privity of contract”). Under Nebraska law, one cannot generally sue an entity for professional negligence if there is no contractual relationship between the parties. The court held here that the prime contractor’s causes of actions against these second-tier subcontractors amounted to an “end-around” of this requirement. The court found that the prime contractor’s claims—including breach of implied warranties, equitable indemnity, and equitable subrogation—amounted to claims of professional negligence that were barred by the lack of contract. Hawkins Construction Company v. Peterson Contractors, Inc., 970 F. Supp. 2d 945 (D. Neb. Sept. 4, 2013).
Hawkins Construction entered into a highway construction contract with the state of Nebraska that included increasing the bearing capacity and stability of a Mechanically Stabilized Earth Wall (an “MSE Wall”). Hawkins (the prime contractor) then entered into a subcontract agreement with Peterson Contractors, Inc. (the subcontractor) including the MSE Wall component. The subcontractor in turn entered into two agreements with subcontractors of its own, Geopier and GIE (the second-tier subcontractors). The prime contractor alleged that the subcontractor and the second-tier subcontractors all failed to properly design and build the improvements to the MSE Wall; the prime contractor subsequently remediated the work through its own personnel after the subcontractor’s refusal.
Lack of Contract Privity
The prime contractor then sued all three contractors, as well as their insurers, in federal court, citing over a dozen legal theories of liability. The defendants sought to dismiss many of these claims. The court gave particular consideration to one of the second-tier subcontractor’s arguments that several of the counts should be dismissed to the lack of a contractual relationship with the prime contractor. The defendant argued that several claims by the plaintiff, including claims for implied warranties, equitable indemnity, and equitable subrogation, were in essence claims for professional negligence.
The defendant then pointed to Nebraska legal precedent holding that “professionals are not liable in negligence to third parties with whom they are not in privity of contract.” It should be noted that the damages sought by the prime contractor appeared to the court to be for the remediation to the work itself, as opposed to injuries or other property damage stemming from the improper work.
The plaintiff responded that despite any express agreement, the second-tier subcontractors were nonetheless subject to an implied warranty that their professional services would be performed in a reasonably good and workmanlike manner. The plaintiff also argued that it had a “special relationship” with the second-tier subcontractors through working directly with these companies on the project and in relying on their design documents. Lastly, the plaintiff tried to distinguish equitable indemnification and equitable subrogation actions from professional negligence.
The court rejected these arguments, typifying these prime contractor claims as an “end-around” to the bar on professional negligence actions against third parties. The court was also skeptical of the plaintiff’s claim to the second-tier subcontractors for “negligent misrepresentation,” which also appeared to amount to a professional negligence action. However, the court allowed the plaintiff the opportunity to amend its complaint to try to meet the higher threshold needed to allege a fraud or misrepresentation action.
This case illustrates efforts by prime contractors to apply various legal theories in an attempt to hold third party design professionals accountable for negligent work. In the absence of a contract that can enforce the expectation that work is performed to the professional standard of care, many prime contractors have turned to various tort theories as an alternative way to recover for remedial work. These efforts have received divergent treatment in different states, and plaintiffs should scrutinize which legal theories are available against third parties in these situations.
This article is published in ConstructionRisk.com Report, Vol. 16, No. 9 (November 2014).
Copyright 2014, ConstructionRisk, LLC
What Constitutes a Claim Triggering Indemnification Duty?
Kent Holland, Esq.
ConstructionRisk Counsel, PLLC
After a contractor settled a construction defect claim with the project owner, it sought indemnity from its subcontractor for the costs incurred in rectifying the construction. The subcontractor successfully argued in a lower appellate court that no “claim” had been made by the owner that would trigger the indemnity obligation, and that even if the indemnity obligation had been triggered, the statute of limitations for enforcing the indemnity had elapsed. The Supreme Court of Michigan, reversed and held that the owner’s demand that the prime contractor correct the defective work constituted a “claim,” and there was no dispute that the prime suffered loss as a result of correcting the work when its subcontractor refused to do so. The court found that the subcontractor “twice breached the contract: first when it failed to install the roof system in accordance with the relevant plans and specifications, and then later when it refused to indemnify [the Prime] for the corrective work required to remedy its nonconforming installation.” The statute of limitations was held to run from the date the sub breached its indemnity obligation. The decision explains in some detail the broad meaning of the word “claim” and also the broad duties included in the indemnity obligations. Miller-Davis Company v. Ahrens Construction, Inc., 848 N.W. 2d 95 (Mich. 2014).
In this case the subcontract in question incorporated by reference the AIA A 201 prime contract, and a written guarantee of the subcontractor’s work on the YMCA Natatorium. It obligated the Sub to “bear costs of correcting such rejected Work… and to correct at its expense any work ‘found to be not in accordance with the Contract Documents within one year of Substantial Completion.’” After the project achieved substantial completion, the YMCA experienced excessive condensation in the natatorium due to certain construction defects including inch-wide caps in roof insulation, and many gaps and tears in the vapor barrier.
The prime contractor notified the sub that the roof system was not installed in accordance with the plans and specifications. It declared the sub in default, and demanded that it devise a corrective action plan and perform the necessary repairs. When the subcontractor failed to do the rework, it was default terminated. The prime then entered into an agreement with the YMCA to perform the corrective work. After completing that work, it sought to recover its costs from the subcontractor and its bonding company for breach of contract, and it sought indemnification and bond collection.
The Indemnification Clause
In determining whether the trial court was correct in finding the Sub liable to the Prime for over $348,000 under the indemnity agreement, the Supreme Court first explained the workings of the indemnity clause of the contract and emphasized that the state law provides contracting parties broad discretion in negotiating the scope of indemnity clauses. The only legal restriction, said the court, “is the prohibition on indemnification against the ‘sole negligence’ of the contractor, which is not at issue here.”
The language of the clause provided in relevant part as follows:
“You [subcontractor] agree to defend, hold harmless and indemnify [prime contractor] … from and against all claims, damages, losses, demands, liens, payments, suits, actions, recoveries, judgments and expenses including attorney’s fees, interest, sanctions and court costs which are made, brought, or recovered against [prime contractor], by reason of or resulting from, but not limited to, any injury, damage, loss, or occurrence arising out of or resulting from the performance or execution of this Purchase Order and caused, in whole or in party, by any act, omission, fault, negligence, or breach of the conditions of this Purchase Order by the Subcontractor….” (emphasis by court).
The question for the court was whether the “all” in the above-quoted language included the amounts that the prime contractor incurred in costs for the corrective work that the owner demanded by performed. The related question was whether the demand for corrective action constituted a “claim” within the meaning of the indemnity clause.
With regard to the word "all,” the court quoted from earlier case law, that, “there cannot be any broader classification than the word ‘all.’ In its ordinary and natural meaning, the word ‘all’ leaves no room for exceptions.”
With regard to whether the requirement to perform corrective work constituted a claim within the context of the indemnity agreement the court first pointed out that even without getting to the question of whether it was a “claim,” the indemnity clause also required indemnity for “damages, losses, demands,” or “expenses,” resulting from “any act, omission, fault, negligence, or breach” by the subcontractor.
The court also cited AIA A201, Section 4.3.1, which was incorporated into the subcontract, and defines a claim as “a demand or assertion by one of the parties seeking, as a matter of right, … relief with respect to the terms of the Contract,” as well as “other disputes and matters in question … arising out of or relating to the Contract.”
The court concluded that a straight forward reading of the negotiated Agreement for Corrective Work confirmed that the YMCA possessed a claim or demand against the prime contractor that was resolved at the contractor's expense by this settlement agreement.
The court further concluded, “The indemnity provisions do not require Sherman Lake YMCA to prove liability or initiative a lawsuit or arbitration proceeding against [prime contractor] to seek indemnification from [subcontractor] for the corrective work it performed under the Agreement….”
Having determined that the subcontractor breached its contractual duty to indemnity the prime contractor, the court then rejected the subcontractor's argument that the suit against it should be dismissed based on the running of the statute of limitations from the date that the original work was completed. Instead, the court concluded that the relevant breach of contract in this case was not the breach of the defective work, but rather the subsequent breach when the subcontractor refused to honor its obligations under the indemnity agreement.
Several lessons are learned from this case. It is important to carefully read and understand the significance of the wording of indemnity clauses, and to negotiate narrower obligations if that is what is intended. The clause in this case was as broad as could be legally permitted. It covered all damages even if they were caused in part by the indemnified party. It covered first and third party claims. It was not limited to wrongful acts or negligence of the subcontractor. The explanation of what constitutes a “claim” is also quite important. It is not uncommon for a party to receive a demand to take corrective action to repair damages from defective work without its client filing a formal claim or suit. They merely assert a right to corrective work and the contractor has little choice but to do it. The court recognized that the subcontract indemnification clause in such a situation entitles the prime to recover its corrective action costs from the subcontractor who performed the defective work. Recognizing that the statute of limitations does not begin to run until the subcontractor breaches its indemnity obligation may potentially allow claims to be brought long after substantial completion of the project.
About the author: Article written by J. Kent Holland, Jr., a construction lawyer located in Tysons Corner, Virginia, with a national practice (formerly with Wickwire Gavin, P.C. and now with Construction Risk Counsel, PLLC) representing design professionals, contractors and project owners. He is founder and president of a consulting firm, ConstructionRisk, LLC, providing consulting services to owners, design professionals, contractors and attorneys on construction projects. He is publisher of ConstructionRisk.com Report and may be reached at Kent@ConstructionRisk.com or by calling 703-623-1932. This article is published in ConstructionRisk.com Report, Vol. 16, No. 9 (November 2014).
Copyright 2014, ConstructionRisk, LLC