Cases of the Month
Significant Cases and Decisions Impacting the Construction Industry
By: Ira Genberg and Ryan Stinnett
1. Liability of Design-Build Contractor for Performance Guarantees of Owner-Specified Equipment Manufacturer, AgGrow Oils, L.L.C. v. Nat’l Union Fire Ins. Co. of Pittsburgh, 276 F.Supp.2d 999 (D. N.D. 2003).
* What the Court Considered: A design-build guaranteed maximum price contract for the construction of an oil seed processing plant provided that the contractor would purchase certain oil seed extraction equipment from a specified equipment manufacturer. The contract also contained performance guarantees from the equipment manufacturer regarding the amount of oil seeds the plant would process per day. The completed plant failed to satisfy the contractual performance guarantees and the owner sued the contractor, its surety, and the equipment manufacturer. The contractor argued that it had merely “passed through” the equipment manufacturer’s performance guarantees to the owner and that the manufacturer alone should be liable to the owner for damages arising from failure of the plant to satisfy such performance guarantees.
* What the Court Said: The design-build contractor had all-encompassing responsibility for the design and construction of the plant and was liable for breach of contract, breach of warranty, and lost revenue and profit arising from the plant’s failure to satisfy performance guarantees in the contract.
* What the Opinion Means: Under the design-build contract, the contractor had “assumed primary responsibility for the entire plant package (including design services, materials, equipment, and construction), regardless of the entity that actually provided the services, materials, and equipment or performed the construction.” The contractor warranted that all construction, services, labor, materials, and equipment used in the design and construction of the plant would conform with the requirements of the contract documents. Accordingly, the contractor was responsible for all defects, including those caused by the products supplied by the equipment manufacturer. It should be noted, however, that despite the contractor’s liability for all defects in the plant, the equipment manufacturer remained jointly and severely liable for the portion of the owner’s damages directly caused by the deficiency of the manufacturer’s equipment.
2. Finality of Architect’s Decision Regarding Conflicting Specifications and Drawings, Ostrow Elec. Co. v. J.L. Marshall & Sons, Inc., 798 N.E.2d 310 (Mass. App. Ct. 2003).
* What the Court Considered: During construction of a convention center, a controversy developed between the audio-visual subcontractor and electrical subcontractor regarding which party was responsible for supplying and installing a “backbox” to house the audio-visual system’s loud speakers. Pursuant to the construction contract and subcontracts, the dispute was submitted to the architect, who determined that the audio-visual subcontractor was responsible for the work. The audio-visual subcontractor performed the work under protest, then brought a claim alleging that the architect’s decision (1) had “no rational basis and thus was arbitrary and capricious and constitute[d] an error of law” and (2) was made in bad faith. The subcontractor sought to recover the costs of this work as a backcharge against the general contractor and its surety.
* What the Court Said: The architect’s determination was not irrational, arbitrary and capricious, or incorrect as a matter of law; accordingly, the architect’s decision was final.
* What the Opinion Means: Under Massachusetts' law, an architect’s decision is “final” or “conclusive” unless the decision is made “capriciously, or arbitrarily[,] is unsupported by substantial evidence, or is based upon error of law.” In this case, a conflict existed between the audio-visual specifications, which required the audio-visual subcontractor to provide the backbox, and the contract drawings, which stated that the electrical subcontractor was to provide the backboxes. In resolving this dispute, the architect relied on a provision in the general conditions that established a prioritization of the contract documents to reconcile any such conflict between the documents. The architect reasoned that the audio-visual subcontractor was obligated to provide backboxes because that requirement was set forth in the specifications, which were given higher priority than the drawings. Although the court recognized that the contract documents contained a “severe ambiguity,” or possibly even a “contradiction,” with regard to which party was responsible for the backboxes, there was no reason to conclude that the architect’s decision was arbitrary and capricious or without a rational basis. Accordingly, the architect’s decision was not made in bad faith and was final under Massachusetts’ law.
3. Necessity of Making Formal Declaration of Default in Order to Recover on Performance Bond, Elm Haven Constr. Ltd. P’ship v. Neri Constr. LLC, 281 F.Supp.2d 406 (D. Conn. 2003).
* What the Court Considered: Approximately two months into a construction project, a contractor sent several letters to a subcontractor and the subcontractor’s surety regarding the contractor’s displeasure with the subcontractor’s performance of its obligations under the contract. When the contractor later attempted to hold the surety responsible for the work, the surety contended that it was not liable under the performance bond because the contractor failed to provide timely notice of the subcontractor’s default. The contractor argued that its numerous letters to the surety put the surety on actual and reasonable notice of the subcontractor’s default.
* What the Court Said: The contractor’s letters to the subcontractor’s surety did not constitute sufficient notice of default to invoke the surety’s obligation to perform under the performance bond.
* What the Opinion Means: The language of the performance bond obligated the surety to perform on the contract if the subcontractor was “declared … to be in default.” The contractor’s letters to the surety were only complaints regarding the subcontractor’s performance and concerns about the subcontractor’s financial status. At no time did the contractor declare affirmatively and in a precise manner that the subcontractor was in default on the contract as a whole. Letters containing “complaints and contractual threats” were not sufficient to declare a default. Instead, the contractor could have protected its interests “by stating simply in sufficiently clear, direct, and unequivocal language that [the subcontractor] was in default under the contract and that it demanded [the surety] to perform [the subcontractor’s] obligations.” This did not occur and the surety was not liable on the performance bond.
4. Surety’s Obligations Under Bond After Delay in Declaring a Default on Underlying Contract, John T. Callahan & Sons, Inc. v. Dykeman Elec. Co., Inc., 266 F.Supp.2d 208 (D. Mass. 2003).
* What the Court Considered: A subcontract allowed the contractor to declare the subcontractor to be in default “if a receiver [was] appointed on account of the [subcontractor’s] insolvency.” However, when a receiver was appointed in May 1999 to manage the subcontractor company, the contractor continued to work with the subcontractor without declaring the subcontractor in default. In February 2000, the receiver sold the subcontractor’s assets, which already had been pledged as collateral to the surety who provided the subcontractor’s performance bond. Then, in October 2000, the contractor declared the subcontractor in default for walking off the job (but not for having a receiver appointed) and called upon the surety to complete the subcontract. The surety refused to perform and argued that it was discharged from its obligations under the performance bond due to the contractor’s delay in declaring the subcontractor in default. The surety claimed that the contractor substantially increased its risk by delaying the declaration of the subcontractor’s default and minimizing the assets against which the surety could seek indemnification for payment under the bond.
* What the Court Said: The surety was required to perform its obligations under the performance bond despite the contractor’s failure to declare a default when the receiver was appointed in May 1999.
* What the Opinion Means: Generally, a material change in an underlying contract, when made without the consent of the surety, will discharge the surety’s obligations if the modification materially increases the surety’s risk. However, the contractor’s delay in this case in declaring the subcontractor’s default did not result in a material change in the underlying contract. Instead, pursuant to the performance bond, a default occurred if: (1) a receiver was appointed due to the subcontractor’s insolvency and (2) the contractor declared the subcontractor in default. The bond did not impose any time limit in which the contractor was required to declare the subcontractor in default; therefore, the contractor’s decision to wait until October 2000 to declare default was permissible under the bond and did not modify the underlying contract. The court further stated that it was not clear whether the original subcontractor continued to perform the work while operating under a receivership.
5. Failure to Provide Timely Notice of Intent to File Claims for Additional Payments and Time Extensions, MCI Constructors v. Spotsylvania County, 2003 Va. Cir. LEXIS 115 (Va. Cir. Ct. 2003).
* What the Court Considered: A contractor and county executed a $22,316,500.00 fixed-price government contract for construction of a water treatment facility. During construction, the contractor submitted numerous change orders, many of which were rejected by the county. More than one year after the agreed date for substantial completion, the contractor submitted to the county a “Request for Equitable Adjustment,” claiming entitlement to additional payment of $9,265,511.00 and a time extension of 245 days. The county argued that 93 of the contractor’s 106 claims were barred because the contractor failed to provide timely notice of its intention to submit such claims.
* What the Court Said: The contractor’s claims for additional payment and a time extension were barred because the contractor failed to give timely notice of its intention to submit such claims.
* What the Opinion Means: The construction contract stated that the contractor could make no claim against the owner, either during the prosecution of the work or upon completion of the project, unless the contractor had given the owner notice of its intention to present such claims “within ten days from the happening of the event, thing, or occurrence giving rise to the alleged claim.” The “occurrence” that triggered the contractor’s obligation to provide notice of its intention to submit a claim was the contractor learning that its proposed change orders were being denied, disallowed, or disapproved, in whole or in part, by the county or its engineer, as set forth in the contract’s change order process.
6. Recovery of Lost Anticipated Profits for Breach of Private Construction Contract, Ambrogio v. Beaver Road Assocs., 836 A.2d 1183 (Conn. 2003).
* What the Court Considered: Several months after construction of an office building, the owner noticed “moisture seepage, slippery conditions, offensive odors and bubbling in the flooring in the surgical areas of the office.” As a result, “unsafe and unhealthy conditions” caused the owner to close one of the surgical rooms in the office. The owner discovered that improper ventilation of the concrete slab under the flooring had caused the moisture seepage. The owner then sued the contractor, seeking lost profits (among other damages), alleging that the contractor breached the contract by failing to properly supervise a subcontractor’s installation of the office flooring. The contractor argued that lost profits were not recoverable as damages for the breach of a construction contract.
* What the Court Said: The owner was entitled to recover lost profits for breach of the construction contract, unless such profits were found to be too speculative and remote.
* What the Opinion Means: Under Connecticut law, a plaintiff may recover two components of damages for breach of construction contract: (1) direct damages, composed of “the loss in value to [the plaintiff] of the other party’s performance caused by its failure or deficiency;” and (2) “any other loss, including incidental or consequential loss, caused by the breach.” Such consequential damages include “any loss that ‘may fairly and reasonably be considered [as] arising naturally, i.e., according to the usual course of things, from such breach of the contract itself.’” Unless prospective profits or lost profits are “too speculative and remote,” such damages are allowable as an element of damage whenever their loss arises directly from and as a natural consequence of the breach of a construction contract.
7. Recovery of Lost Anticipated Profits on Government Contract with “Minimum Dollar Value Guarantee of Services,” Appeals of Jim Phillips Contracting, Inc., 2003 WL 22682625, IBCA No. 4319 (2003).
* What the Board of Contract Appeals Considered: A contractor and the Bureau of Land Management (“BLM”) executed an indefinite delivery/indefinite quantity road construction government contract. The contract contemplated five years of roadwork, with a guaranteed “minimum dollar value guarantee of services” of $655,000.00 for the term of the contract. The initial contract period was for one year with four one-year extension options. Although the contract was executed in February 1999, BLM did not issue a task order to begin building the roads until October 1999. By the time the contractor had mobilized at the site, snow had covered the ground and BLM issued a winter suspension order. BLM did not issue a subsequent order to presume work until August 2002. The contractor refused to accept BLM’s resumption order, claiming that the contract had expired because BLM had not exercised its option to renew the contract for a second year. The contractor then filed a claim for the entire $655,000.00 guaranteed under the contract.
* What the Board of Contract Appeals Said: Despite having performed no work under the contract, the contractor was entitled to $75,000.00 in damages for lost anticipated profits.
* What the Opinion Means: BLM failed to exercise its contract extension option and the contract expired after one year. Accordingly, BLM breached the contract by failing to order the amount of work it had contracted to purchase. The Board of Contract Appeals noted that if BLM had successfully terminated the contract for convenience prior to the expiration of the first year, or if there had been no guaranteed minimum amount of work promised by the government, the contractor’s only entitlement would be to profits on whatever work actually was performed prior to such termination for convenience. However, because BLM breached the contract by failing to order the “minimum dollar value” of services guaranteed by the contract and sought a termination for convenience only after the contract had lapsed by its own terms, the contractor was entitled to lost anticipated profits.
8. Surety’s Right to Equitable Subrogation under Bond, Pennsylvania Nat’l Mut. Cas. Ins. Co. v. City of Pine Bluff, et al., 2004 U.S. App. LEXIS 559 (8th Cir. 2004).
* What the Court Considered: Three months after terminating a government contract, the city notified the contractor’s surety of such termination and stated that the city had received approximately $2.8 million in claims from unpaid subcontractors who had supplied labor and materials on the project. Ten days later, the surety sent a letter to the city requesting that the city not release any funds allocated to the project without the surety’s written consent, stating that the surety was investigating unpaid subcontractor claims, and asserting potential subrogation rights to contract funds. Despite receiving this letter, the city approved a $2 million settlement and release with the contractor and the contractor’s creditors. The surety then sought equitable subrogation from the city for the amounts the surety paid to the subcontractors who possessed valid bond claims. The city argued that the surety was not entitled to equitable subrogation because the surety’s settlement with one of the subcontractors included a partially conditional payment based upon the surety’s success in its lawsuit against the city.
* What the Court Said: The surety was entitled to equitable subrogation from the city for the full amount the surety paid to the subcontractors.
* What the Opinion Means: Equitable subrogation is a doctrine that permits a surety to acquire and assert the rights of those parties whom the surety pays, such as the subcontractors in this case. Under Arkansas law, when a surety completes work or pays laborers and material suppliers, equitable subrogation permits the surety to proceed against retainage and remaining contract funds for reimbursement. A “prerequisite to equitable subrogation is the surety’s full satisfaction of any underlying debt or obligation.” The surety had two obligations under its bond: (1) performance of the work and (2) payment for labor and materials. The city unilaterally removed the first obligation by terminating the contract; accordingly, the surety was only responsible for satisfying the payment portion of its bond. The surety satisfied its obligation under the payment bond because, despite the fact that one contractor maintained a “derivative interest” in the lawsuit as a result of its conditional payment settlement, neither the contractor nor the city owed any payments to subcontractors as a result of the surety’s settlement with such subcontractors.
9. Waiver of Right to Subrogation for Damage to Pre-Existing Property Covered by Owner’s Property Insurance, Walker Engineering, Inc. v. Bracebridge Corp., 102 S.W.3d 837 (Tex. App. 2003).
* What the Court Considered: A contractor and owner executed a contract for improvements to an existing building and construction of new buildings. An electrical subcontractor that was performing improvements to the existing building negligently damaged a nearby waterline. An ensuing water leak and flooding caused extensive damage to the building, the building’s fixtures, and personal property in the building. The owner had a property insurance policy on the pre-existing building that covered the water damage. The owner also maintained a builder’s risk policy for the new construction and improvements to the existing building. The parties agreed that the electrical subcontractor’s negligence was the sole cause of the owner’s damages. However, the subcontractor argued that a contractual waiver of subrogation provision, along with the owner’s property insurance that covered the pre-existing portions of the building at the time of loss, operated to bar the owner’s recovery of damages from the subcontractor.
* What the Court Said: The owner waived its right to recover against the subcontractor for the property damage from the flooding because such damage was covered by the owner’s pre-existing property insurance.
* What the Opinion Means: In this case, the construction contract incorporated the 1987 AIA A201 “General Conditions of the Contract for Construction.” Paragraph 11.3.7 of the General Conditions stated that the owner and contractor waived all rights against subcontractors of the other party “for damages caused by fire or other perils to the extent covered by property insurance obtained pursuant to this Paragraph 11.3 or other property insurance applicable to the Work.” The owner argued that it did not waive its right to sue the subcontractor for any loss that was covered by its pre-existing property insurance because such insurance was not “applicable to the Work.” However, the court explained that the owner’s pre-existing property insurance was “applicable to the Work” because that clause refers to insurance “applicable to the location of the work or the building containing the work as that is the type of insurance contemplated by [the waiver clause].” Accordingly, the owner’s waiver of subrogation extended to losses under both the builder’s risk policy for new construction and improvements and its pre-existing property insurance policy for the building.
10. Applicability of Federal Arbitration Act to Dispute Arising from Construction Project, Harbar Constr. Co. v. Willis, 2003 Ala. Civ. App. LEXIS 511 (Ala. Civ. App. 2003).
* What the Court Considered: An Alabama contractor built a construction project in Alabama for an owner that resided in Alabama. However, the majority of the goods used in the construction were shipped into Alabama from other states. When the contractor allegedly failed to repair certain items that were found to be defective during a preoccupancy inspection, the owner sued the contractor for breach of contract, breach of warranty, negligence, and wantonness. The contractor argued that the parties were compelled to arbitrate the dispute under their contractual arbitration clauses because the transaction at issue triggered the Federal Arbitration Act (“FAA”).
* What the Court Said: The parties were required to arbitrate, rather than litigate, the dispute because the contracts underlying the project “evidenc[ed] a transaction involving commerce” within the meaning of the FAA.
* What the Opinion Means: The “Commerce Clause” gives Congress “the power to regulate local business establishments purchasing substantial quantities of goods that have moved in interstate commerce.” Alabama courts consider five factors in determining whether a transaction affects interstate commerce: (1) the citizenship of the parties; (2) the source of the “tools and equipment” necessary to consummate the transaction; (3) the “allocation of cost of services and materials;” (4) the subsequent movement, if any, of the “object of the services” across state lines; and (5) the “degree of separability from other contracts” involved in the transaction. In this case, the transaction affected interstate commerce because the majority of the materials used to construct the project were shipped into Alabama from other states.
Ira Genberg is a Senior Partner at the Smith, Gambrell & Russell, LLP law firm in Atlanta, Georgia, and also General Counsel for Associated Owners & Developers (AOD), McLean, Virginia. Ryan Stinnett is an Associate at Smith, Gambrell, & Russell, LLP. For more information or if you have any questions, contact us at: firstname.lastname@example.org.