November/December 2004 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
November/December 2004

 

SURETY FORFEITS ALL DEFENSES TO SUBCONTRACTOR’S
PAYMENT BOND CLAIM WHEN IT FAILS TO TIMELY RESPOND TO CLAIM


In National Fire Union Insurance Co. v. Wadsworth Golf Construction Co., 2004 Md.App. lexis 137 (Md.Ct. Spec.App. 2004) the Maryland Court of Special Appeals affirmed the judgment of a trial court that entered summary judgment for $752,738.72 on the subcontractor’s bond claim after the surety ignored the subcontractor’s claim asserting breach of contract of the surety’s principal.

On November 22, 1999, the general contractor contracted with the owner to build a resort in Cambridge, Maryland. At the same time, the general contractor executed an AIA form payment bond ("bond"), posted by several sureties (the “Surety”) in the penal amount of the more than $70,000,000.00 prime contract.

The bond provided that when a claimant had properly given notice the Surety “shall promptly . . . [s]end an answer to the Claimant, with a copy to the Owner, within 45 days after receipt of the claim, stating the amounts that are undisputed and the basis for challenging any amounts that are disputed” and “[p]ay or arrange for payment of any undisputed amounts.”

The general contractor retained the subcontractor to perform the work necessary for building the resort’s 18-hole golf course, as well as excavation and rough grading work for the buildings, parking lots, and roads located on the resort. With changes, the base subcontract price was just over $5,696,318.00, not counting disputed changes of $138,714.45.

After the subcontractor completed its work, the subcontractor claimed it was owed approximately $720,963.45 and the subcontractor sent the Surety a notice of bond claim. In response, the Surety asked the subcontractor to complete a Proof of Claim form and return it with supporting documentation.

On May 3, 2002, the subcontractor forwarded to the Surety the requested Proof of Claim form and supporting documentation. The Surety wrote back that it would "immediately take[ ] this matter up” with the general contractor. However, it then failed to contact the subcontractor within the 45-day period, which expired on June 17, and ignored the subcontractor’s July 23 letter, requesting an answer.

On November 6, 2002, 181 days after the subcontractor submitted its Proof of Claim and supporting documents, it sued the Surety. The trial court found that the Surety had waived its right to challenge the $752,728.72 bond claim when it failed to answer the claim within 45 days after receiving it, and thus entered summary judgment for the subcontractor.

The appellate court affirmed this decision, finding that the subcontractor properly filed its bond claim and the Surety had not disputed the claim within 45 days after receiving it, thus waiving its right to contest the claim. The appeals court explained that the “reasonable behavior required of a surety acting in good faith is not meant to foster reluctance on a surety's part to satisfy bond claims” and approvingly quoted a U.S. District Court opinion from the Southern District of New York that "as a practical matter the suppliers and small contractors on large construction projects need reasonably prompt payment for their work and materials in order for them to remain solvent and stay in business", and held the 45-day response time mandated by Paragraph 6 of the bond gives effect to that purpose.

The National Fire Insurance decision is a tremendous victory for potential bond claimants. Many subcontractors are well aware that sureties often seem to ignore bond claims, letting the general contractor and claimant resolve the dispute. This decision puts the onus on the surety to be more than a passive observer of claims and to respond to them in a timely manner.

FEDERAL COURT DENIES MANUFACTURER’S CONTRIBUTION CLAIM AGAINST SUBCONTRACTORS DUE TO LACK OF CONTRACTUAL OR SPECIAL RELATIONSHIP BETWEEN THEM

Parties held liable to an owner for damages on a construction project often seek contribution from others who may be partly responsible for the damages. However, as demonstrated in International Paper Co. v. TCR Northwest 1993, Inc., 2004 U.S. Dist. lexis 10092 (D. Ore., May 25, 2004), if the others cannot be held directly liable to the owner, they also cannot be held liable for contribution to a third-party.

In International Paper, after settling claims brought by the owners of several apartment complexes that defects in an exterior siding product had caused massive property damage at the complexes, the siding manufacturer brought claims for indemnity and contribution against the general contractors and subcontractors on those projects. The manufacturer alleged that the general contractors made numerous serious errors in directing the construction operations, and the subcontractors negligently performed framing, roofing, gutter, and painting work, both resulting in significant damage to the buildings.

The court initially dismissed the manufacturer’s indemnity claims against both the general contractors and the subcontractors, but permitted the contribution claims to stand. However, the court later dismissed the manufacturer’s contribution claim against the general contractors due to a higher court’s ruling that the circumstances under which a general contractor might incur tort liability to an owner with whom it has a contractual relationship - and thus would be liable for contribution to the manufacturer - are quite limited and exceptional. Thereafter, the subcontractors sought dismissal of the manufacturer’s contribution claim against them on similar grounds.

The court noted the subcontractors’ case presented a different issue because the subcontractors had no contractual relationship with the owners. As such, the subcontractors could only be found liable on the manufacturer’s contribution claim if they could be held liable to the owners in tort for negligent work on the projects. In deciding this, the first issue for the court was whether damage to a building resulting from negligent construction is the kind of property damage that is recoverable against the subcontractors in the absence of any contractual or special relationship with the owners, or is “economic loss” which is only recoverable if the subcontractors and the owners had such a relationship. Finding that such property damage is merely economic loss, the court held that a claim seeking recovery for a purely economic loss must be based upon some duty beyond the common-law duty to exercise reasonable care to prevent foreseeable harm. Rather, it must be based on an enhanced duty to exercise reasonable care to avoid foreseeable economic injury. However, such duty only arises from relationships in which the law imposes an obligation on the parties to protect the other parties to the relationship, such as the relationships between agents and their principals, attorneys and their clients, and architects and engineers and their clients.

The court found no evidence that the subcontractors were expected to exercise the kind of independent judgment and special knowledge involved in work performed by professionals, like engineers and architects, who may be liable in tort to the intended beneficiaries of their work. Instead, the court determined that the owners, general contractors, and subcontractors were involved in nothing other than an ordinary construction project, which did not give rise to any special, extra-contractual relationship between the owners and the subcontractors that would support potential tort liability on the part of the subcontractors. While there may be circumstances under which a contractor and its client are in a contractual relationship that gives rise to liability if negligent construction damages the structure, the more attenuated relationship between the owners and the subcontractors could not support such liability. Thus, because the subcontractors could not be held liable to the owners in tort, the court dismissed the manufacturer’s contribution claim against the subcontractors.

Many jurisdictions consider property damage arising from construction defects to be purely “economic loss.” As the decision in International Paper points out, a party suffering economic loss cannot recover therefor in the absence of a contractual or other “special” relationship with the party causing the loss. The typical construction project, however, does not create such relationships between owners and subcontractors.

 

MATERIAL BREACH OF CONTRACT GIVES OWNER THE RIGHT TO TERMINATE ITS CONTRACTOR

Generally, when one party to a contact commits a material breach of that contract, the other party is discharged from further performance. In a recent Texas case, a dispute arose between the contracting parties as to whether a contractor’s breach of contract was material. Mustang Pipeline Co. v. Driver Pipeline Co., 134 S.W.3d. 195 (Tex. 2004).

In January, an owner contracted with a contractor to construct 100 miles of pipeline by April. During the bidding process, the owner stressed that time was of the essence and the contractor adjusted its bid upward to accommodate this demand. Additionally, the contract contained several provisions contemplating possible delays and outlining procedures to ensure construction was completed on schedule. However, once construction of the pipeline began, extensive rain delayed the project, causing the contractor to cease work and request a time extension. By mid-March, the contractor informed the owner that due to the weather it was still not ready to resume work on the pipeline. At this time, the contractor had completed only 15 of the proposed 100 miles of the pipeline. As a result of the contractor’s refusal to resume work and slow progress on the project, the owner’s project engineer certified the contractor to be in default under the contract. The owner then hired another contractor, who finished the pipeline by September of that year.

The owner sued the original contractor for breach of contract, claiming the contractor failed to timely complete the pipeline. The contractor countersued, claiming that the owner wrongfully terminated the contract prior to the end of the contract period. The trial court found that the owner could not recover against the contractor because the owner failed to get a jury decision that the contractor’s breach was material. The Texas Court of Appeals affirmed the trial court’s decision. The Texas Supreme Court, however, found that the contractor materially breached the contract by ceasing work on the pipeline and falling behind the construction schedule. As a result of this material breach, the court ruled that the owner was discharged from its duties under the contract and was free to terminate the contract and recover damages from the contractor. The court found it significant that the contract emphasized timely completion and contained clauses outlining contingencies and procedures to ensure the project was completed on schedule. The court also observed that the contractor failed to provide the requested assurances or an updated construction schedule to show that it could in fact finish the project by the April deadline. When the owner terminated the contract with the contractor, the contractor had about 40 days before the deadline to complete 85 miles of pipeline. Thus, it was not possible that the contractor would have been able to cure its breach and complete the construction on time. Therefore, the court ruled that the contractor had committed a material breach, thereby discharging the owner’s duties under the contract allowing it to terminate the contract and recover damages.

An owner or contractor seeking to invoke provisions in their contract such as termination clauses should always first determine that the contractor or subcontractor they are attempting to terminate has not only breached its contract, but materially breached its contract. If a material breach of contract has not occurred the contractor will not have grounds from which to terminate the subcontractor.

 

“NO DAMAGES FOR DELAY” CLAUSE DOES NOT PRECLUDE RECOVERY OF DAMAGES FOR ACTIVE INTERFERENCE

When a construction contract contains a “no damages for delay” clause, parties need to be aware that, in Virginia, such language does not limit liability for damages involving active interference. One recent case illustrates this point as it relates to a contract claim resulting from a failed construction project. Dennis Stubbs Plumbing v. Travelers Casualty and Surety Co., 2003 U.S. App. lexis 11231 (4th Cir. 2003).

A prime contractor entered into a public construction contract to build a new building at a college. As required by state law, the prime contractor obtained a payment bond for the protection of subcontractors and materialmen. The prime contractor’s subcontract with its plumbing subcontractor contained a “no damages for delay” clause. This clause provided that the subcontractor’s sole and exclusive remedy for delay damages caused by the prime contractor was a time extension. The subcontractor brought suit against the surety seeking additional costs incurred on the project caused by the prime contractor. The subcontractor claimed damages for additional field supervision and labor costs due to interference from the prime contractor as well as damages resulting from poor scheduling, acceleration and extended home office overhead. The trial court held that the “no damages for delay” clause precluded the subcontractor’s recovery. On appeal, the Fourth Circuit examined the issue of whether a “no damages for delay” clause prohibited the subcontractor from recovering these damages.

The surety contended that the contract language made it clear that delay damages resulting from the actions of the prime contractor were not recoverable. The subcontractor responded that the type of damages claimed were not actually delay damages, but rather damages due to active interference by the prime contractor. Furthermore, the damages and additional costs it sustained were a direct result of the prime contractor’s gross mismanagement of the project and active interference with the subcontractor’s work.

The court observed that requiring additional time to complete the project probably amounted to simple delay damages, but that increased difficulty in performing work due to active interference did not qualify as delay damages. The court noted that Virginia law recognizes a distinction between delay damages and damages resulting from active interference and allows recovery for the latter. The court found that the damages in this case were a result of the wrongful acts of the prime contractor, amounting to active interference to the subcontractor’s work. Thus, the damages for active interference and additional work caused by the wrongful acts of the prime contractor did not fall within the scope of the “no damages for delay” clause of the contract. Therefore, the court ruled in favor of the subcontractor and allowed the suit to proceed against the surety despite the existence of the “no damages for delay” clause in the contract.

Subcontractors should be aware that even with “no damages for delay” clauses in their contracts claims for additional costs may still be brought when such damages are the result of active interference by a contractor.