July/August 2006 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
July/August 2006

MICHIGAN COURT REFUSES TO INTERPRET CONTRACT PROVISION FOR DECISION BY ENGINEER AS AN ARBITRATION AGREEMENT

More and more, parties to a construction contract agree to arbitrate, rather than litigate, their disputes.  However, as demonstrated in City of Ferndale v. Florence Cement Co., 712 N.W.2d (Mich. Ct. App. 2006), an agreement to arbitrate must be set forth clearly in writing in order to be valid and enforceable.

The city retained the contractor to install new concrete for a roadway, and the surety provided a maintenance and guarantee bond for the work.  A provision of the contract established that the project engineer would determine the acceptability of the work.  Further, the engineer’s decision would be final and binding upon the parties unless it was appealed pursuant to any dispute resolution agreement entered into by the parties, or if such an agreement was not reached, then appealed to a court. 

The engineer notified the contractor that a portion of the concrete contained substantive and structural defects, and requested that the contractor perform full-depth repairs.  The contractor disagreed with the engineer’s assessment and suggested an alternative remedy.  However, the engineer rejected the contractor’s alternative remedy as it provided only a temporary solution and exposed the city to future expenses and repairs.  When the contractor failed to perform full replacement of the concrete, the city hired another contractor to perform the work.  The contractor then refused to compensate the city for the cost of the replacement contractor. 

Once the surety denied the city’s claim on the bond, the city brought suit against both the contractor and surety.  The contractor and surety filed a motion for summary disposition; they argued that, under the contract, the engineer’s determination constituted an arbitration award and the city did not seek to enforce it within one year, as required by Michigan law.  The city responded that because the engineer “ruled” in its favor, the decision became binding when the contractor failed to appeal. As such, the appeals process set forth in the contract provision controlled and the one-year limitation under Michigan law, did not apply because the parties’ contract contained no arbitration clause.  The trial court agreed with the contractor and surety.  Specifically, the trial court concluded that the engineer’s ruling constituted a final arbitration award subject to the one-year limitations period because the parties’ contract designated the engineer’s decision as “final and binding” if the appellate procedures were not followed.

On appeal, however, the appellate court found that an agreement to settle a controversy by arbitration is valid and enforceable only if it clearly provides that a circuit court can render judgment on the arbitration award.  The parties’ contract did not contain such an arbitration clause or specify that any resultant award was enforceable in court.  In particular, the court determined that the parties did not reach a dispute resolution agreement which gave the circuit court jurisdiction to enforce the agreement and to render judgment on an award issued thereunder.  As such, the court determined that the one-year statutory limitation on confirmation of an arbitration award did not apply because the parties’ contract did not provide for statutory arbitration. The court also rejected the argument of the contractor and surety that the contract’s reference to the engineer’s decision as “final and binding” should be interpreted as reflecting the parties’ agreement to binding common-law arbitration.  Given that the parties’ contract did not contain an arbitration clause or dispute resolution agreement and expressly allowed either party to appeal the engineer’s decision, the court concluded that the contract did not evidence any intent by the parties that the engineer’s decision would constitute a final and binding arbitration award.

Parties to a construction contract who desire to utilize arbitration as their dispute resolution procedure must ensure that their intentions are clearly expressed in writing.  Otherwise, as City of Florence shows, courts will not read such intentions into their contracts.

OWNER MUST SUBMIT TO ARBITRATION DESPITE NOT BEING
AWARE OF THE ARBITRATION PROVISION IN THE CONTRACT

Contracts for construction often contain arbitration provisions which require parties to utilize arbitration to resolve disputes. In fact, as Advance Tank and Construction Co., Inc. v. Gulf Coast Asphalt Co., L.L.C., 2006 Ala. LEXIS 21 (Ala. 2006) demonstrates, courts are likely to require the parties to arbitrate disputes that fall within the scope of the arbitration provision even where the arbitration provision is only contained in documents incorporated in, but unattached to, the contract and where the existence of the arbitration provision is not disclosed to the other party prior to the signing of the contract. 

In Advance Tank, a contractor entered into an agreement to construct storage tanks for the owner of a shipping terminal in Alabama.  After a dispute arose between the owner and the contractor, the owner sued the contractor alleging breach of contract and negligence.  Shortly thereafter, the contractor filed a claim in arbitration against the owner over the same dispute.

The owner then filed a motion in the trial court to prevent the contractor from pursing arbitration.  Subsequently, the contractor filed a motion in the trial court to compel the owner to submit to arbitration.  The trial court denied the contractor’s motion and issued an order enjoining the contractor from pursuing arbitration.

On appeal, the owner raised several arguments as to why it should not be compelled to submit to arbitration.  First, the owner argued that the contract itself did not actually contain a provision requiring arbitration.  However, the court found that the contractor’s proposal was incorporated into the contract, and the proposal specifically incorporated the contractor’s “Terms & Conditions.”  The Terms & Conditions stated that all disputes between the contractor and the owner arising out of the contract were to be settled by binding arbitration.  Therefore, the court found that the contract contained a provision requiring the parties to arbitrate any disputes arising out of the contract.

Second, the owner argued that it did not assent to the arbitration provision because the Terms & Conditions were not physically attached to the contract when the owner signed the contract.  Further, the contractor failed to tell the owner about the binding arbitration provision contained in the Terms & Conditions.  Thus, the owner explained that it was not actually aware of the arbitration provision and could not be compelled to submit to arbitration.

The court first noted that a party is responsible for reading the contract.  The court continued, “When a competent adult, having the ability to read and understand an instrument, signs a contract, he will be held to be on notice of all provisions contained in the that contract, including an arbitration provision, and will be bound thereby.”  The court also noted that the United States Congress has precluded states from treating arbitration provisions in a contract differently from other contract provisions.  As such, the contractor did not have an express duty to disclose to the owner the existence of the arbitration agreement contained in the contract.

Ultimately, the court found that the contract incorporated the contractor’s proposal, which incorporated the Terms & Conditions, requiring the parties to arbitrate all disputes.  Therefore, the court held that the owner was required to submit to arbitration because the owner was presumed to have read the entire contract, including any documents incorporated therein even though not physically attached to the contract, and the contractor was under no duty to disclose the existence of an arbitration agreement.

Advance Tank provides two warnings to owners and contractors whose contracts incorporate documents containing separate terms and conditions.  First, all parties involved should ensure that they have read the entire contract and all documents incorporated into the contract (whether or not the documents are physically attached to the contract) as a court will likely hold the parties to the terms and conditions wherever those terms and conditions may be found.  Second, all parties involved should be aware of whether or not the contract requires the parties to arbitrate all disputes arising out of the contract.  If there is a provision requiring the parties to submit to arbitration, a court is likely to enforce such a provision, even against parties who were not aware that such a provision was contained in, or incorporated into, the contract.

MANUFACTURER NOT ENTITLED TO A SETOFF AGAINST SUBCONTRACTOR WHERE SUBCONTRACTOR FILED NOTICE OF CLAIM OF LIEN

When a contractor defaults on a project, the owner is often left to complete the project on its own.  In the case of a bankrupt contractor, the owner most likely will have to pay all costs to complete the work itself, with little hope of reimbursement. As the domino effect goes, subcontractors will often not be paid by the bankrupt contractor and will lien the property as a result. And in the event that the costs to complete the project exceed the contract amount, the owner must be aware that some mechanic’s lien statutes prevent the owner from setting-off the cost of completing the project against the amount claimed in a subcontractor’s lien.  The case of O&M Industries v. Smith Engineering Co., 360 N.C. 263, 624 S.E.2d 345 (N.C. 2006) illustrates this point.

In O&M Industries, a manufacturing facility in North Carolina hired a contractor to design and construct a regenerative thermal oxidizer system. The contractor then hired a subcontractor to construct and deliver the oxidizer unit. After shipping the oxidizer and completing performance under the subcontract, the subcontractor learned that the contractor was having serious financial difficulties. In order to protect itself, the subcontractor served a Notice of Claim of Lien on the manufacturer. Despite receipt of the Notice, the manufacturer made two more payments to the contractor, the total of which far exceeded the amount claimed by the subcontractor in the Notice. Soon after the manufacturer made these payments, the contractor filed for bankruptcy.  Since the contractor still owed the subcontractor the entire amount claimed in the Notice, the subcontractor filed suit against the manufacturer for making improper payments to the contractor.

During trial, the manufacturer argued that it was not obligated to pay the subcontractor in spite of the fact that the manufacturer had been served with the Notice. The manufacturer claimed that it was entitled to a complete setoff of the amount owed to the subcontractor for wrongful payment because the cost of completion of the project exceeded the amount otherwise owed to the subcontractor. The trial court rejected that argument and awarded judgment to the subcontractor. However, on appeal, the Court of Appeals agreed with the manufacturer that it was entitled to a setoff for the cost to complete the work and reversed the trial court’s ruling.  The subcontractor appealed to the North Carolina Supreme Court.

The Supreme Court began by examining the mechanic’s lien statute. The state constitution mandates that the legislature must create a mechanic’s lien statute in order to protect subcontractors and suppliers of materials and labor who work on credit. An adequate lien statute encourages such extensions of credit, which, in turn, promotes a healthy construction industry. In light of the remedial nature of the mechanic’s lien statute, the court found that the statute must be construed broadly to protect subcontractors.

In construing the specific sections of the statute relating to wrongful payments, the court noted that the statute created a risk shifting mechanism for subcontractors. Prior to service of Notice, the subcontractor bears the risk of non-payment by the general contractor. Upon service of Notice, the burden shifts to the owner. At that time, the owner is placed on notice of the contractor’s possible breach and must take adequate precautions to protect the subcontractor. 

Here, the Supreme Court found that the manufacturer had a duty under the mechanic’s lien statute to retain funds up to the amount claimed in the Notice. When the manufacturer made further payments to the contractor, the manufacturer became personally liable to the subcontractor. Although the manufacturer could complete the project at its own cost, this would not relieve the manufacturer of any liability towards the subcontractor. Therefore, the Supreme Court upheld the trial court’s ruling in favor of the subcontractor.

It is important for owners and subcontractors to understand that a mechanic’s lien statutes often are construed to favor the subcontractor.  In North Carolina, prior to Notice being served, the owner bears no liability for payments made to a defaulting contractor.  Once Notice has been served, the owner bears complete liability for wrongful payments made to the contractor.

 

SUBCONTRACTOR PARTIALLY WAIVES LIEN RIGHTS BY EXECUTING A PROGRESS PAYMENT REQUEST WITH LIEN WAIVER LANGUAGE

A subcontractor who executes a lien waiver as part of a progress payment request may partially waive its right to file a mechanic’s lien for additional work it performs on a project.   This lesson is illustrated in the case of RMF Industrial Construction, Inc. v. Reliant Energy Seward, L.L.C., 2006 U.S. Dist. Lexis 6056 (W.D. Pa. 2006).

In this case, a power plant owner retained a contractor for the construction of a new power plant. The contractor entered into a purchase order agreement with a subcontractor to erect and install circulating fluidized bed boilers and associated systems for the power plant. Over the course of the project, the subcontractor executed lien waivers as part of its monthly progress payment requests to the contractor.

As the work progressed, the subcontractor experienced delays and incurred additional expenses on the project as a result of harsh winter conditions, a lack of site maintenance and schedule delays caused by the contractor. The contractor eventually terminated the subcontractor from the project. As a result, the subcontractor filed two mechanic’s liens against the owner to lien the power plant property in the amount of the additional expenses the subcontractor incurred on the project.  The owner responded by filing a motion to reduce the amount of the subcontractor’s mechanic’s lien to the extent of the waivers executed by the subcontractor.

The subcontractor argued that the lien waiver language in the progress payment applications did not apply to additional/unforeseen expenses incurred due to various problems outside the subcontractor’s control. The owner argued that the subcontractor waived its right to lien the property when it submitted monthly progress payment requests with the lien waiver language. The owner further argued that the subcontractor waived its lien rights, except to the extent of the subcontractor’s right to claim a lien for certain contract work or change order work which was expressly reserved by the lien waiver language. 

The court found that the disputed amounts did not arise out of contract work; such amounts were not within the original scope of work outlined in the purchase order agreement.  Further, the court noted that under the subcontract the contractor had the sole authority to authorize a change order, but never issued the subcontractor a change order to increase the scope of work.  As a result, the disputed amounts did not arise out of change order work performed by the subcontractor and did not fall under the exception contained in the lien waiver language. 

Accordingly, the court ruled that the subcontractor, by executing the lien waivers, waived its right to file a mechanic’s lien for the additional work it performed on the project.  The court found that the subcontractor partially waived its right to place a lien on the power plant because the additional expenses incurred by the subcontractor were not covered by the exceptions contained in the lien waiver language.  As a result, the court ordered the subcontractor to reduce the amount of its mechanic’s lien. 

Accordingly, subcontractors should be careful to ensure that partial lien waivers do not foreclose the ability to file a mechanic’s lien for additional work performed on a project.