November/December 2006 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
November/December 2006

SUBCONTRACTOR UNABLE TO LIEN OWNER’S PROPERTY
WHERE SUBCONTRACTOR PERFORMED WORK FOR OWNER’S LESSEE

Mechanic’s lien statutes provide a valuable tool for protecting subcontractors from owners and contractors who refuse to pay their subcontractor’s for work performed.  However, as the case of R.T.B.H. v. Simon Property Group, 849 N.E.2d 764 (Ind. 2006) demonstrates, subcontractors who performs work for a lessee may in some circumstances be unable to lien the owner’s interest in the property. Typically, when a contractor performs work for a lessee, the contractor can only obtain a lien against the property interest of the lessee as opposed to the owner’s property interest.

In R.T.B.H., a lessee entered into a lease at a shopping mall with the owner—the term of the lease was twenty years with an option to renew.  The lease required the lessee to demolish a cafeteria and department store already located on the property, and construct a new retail store.  The lessee hired a general contractor, who in turn hired a subcontractor to perform window and glass work.  The lessee bore the expense of the construction beyond the initial demolition and the owner’s role in the project was limited to approval of the lessee’s plans.  Upon completion of the project, the general contractor refused to pay the subcontractor for its services and filed suit against the subcontractor for damages.   When the subcontractor filed a mechanic’s lien against the property, the contractor moved to dismiss the lien.  The trial court removed the lien and the subcontractor appealed.

The court noted that in order for the subcontractor to assert a mechanic’s lien against the owner’s property, the subcontractor must have performed its work under the authority and per the direction of the owner.  In addition, there must be more than merely inactive or passive consent on the part of the owner.  Otherwise, the subcontractor would be limited to claiming a lien against the lessee’s interest in the property. 

The court commented on three factors which must be taken into consideration when making its determination.  First, a reviewing court could evaluate the degree of the owner’s active participation in the decisions and the actual construction (i.e., payments from the owner directly to the general contractor usually satisfied active participation).  Second, the court should determine how closely the improvements in question resemble a directly bargained-for benefit.  In the instant case, the fact that the landlord could take back the building (with the improvements) in 20 years and the fact that the income from the new store would assist the lessee in making its payments to the owner were not enough to indicate that a bargained-for benefit occurred.  Third, a court should consider whether the owner actively consented to the improvements and whether the owner would be unjustly enriched by the improvements if the lessee defaulted in its lease.  In other words, if an owner leases to a tenant who is of dubious financial means while at the same time requiring the tenant to make improvements, then this would provide an equitable rationale to permit a mechanic’s lien against the owner’s property interest.  This was not the case here as the lessee was not of uncertain financial responsibility.  Ultimately, the court determined that the subcontractor could not maintain a mechanic’s lien against the owner’s property interest.

As R.T.B.H. demonstrates, subcontractors may not always be able to enforce a mechanic’s lien against the owner’s property if the party contracting for improvements is a lessee and not the owner.  Thus, as a practical matter, any party entering into a contract for construction should determine whether or not the apparent “owner” of the project actually owns the real property or is merely a tenant.  If the latter is the case, the subcontractor may not be able to claim a lien against the property unless certain factual circumstances, which tend to show that improvements were performed for the benefit of the owner and the owner took an active role in the construction of the improvements, hold true.

 

COMMERCIAL GENERAL LIABILITY POLICY COVERS
DAMAGE TO GENERAL CONTRACTOR’S NON-DEFECTIVE
WORK CAUSED BY SUBCONTRACTOR’S DEFECTIVE WORK

Although a commercial general liability (CGL) policy may not provide liability coverage for a general contractor to correct defective work performed by a subcontractor, such a policy may provide liability coverage for the cost to remedy unexpected/unintended property damage to the contractor’s otherwise non-defective work which was caused by a subcontractor’s defective work.  This point is illustrated in French v. Assurance Co. of Am., 448 F.3d 693 (4th Cir. 2006). 

In this case, a homeowner contracted with a general contractor for the construction of a single-family home.  The general contractor enlisted a subcontractor to install a synthetic stucco Exterior Insulating Finishing System (EIFS) on the house.  Five years after the homeowners moved into the house, they discovered extensive moisture and water damage to the structure and walls of their house; such damage resulted from defective installation of the EIFS. 

After the homeowner filed suit against the general contractor, the general contractor looked to its CGL carrier for coverage for both the defective EIFS and the damage caused by the water infiltration into the underlying structure and walls as a result of the defective EIFS.  The CGL carrier denied coverage based upon several exclusions contained in the CGL policy.  The CGL policy provided that the CGL carrier would defend and, if necessary, indemnify the general contractor for property damage only if such damage was caused by an “occurrence,” or if not otherwise excluded by the terms of the policy.  The CGL policy defined an “occurrence” as “an accident, including continuous or repeated exposure to substantially the same general harmful conditions.”  The CGL policy also contained an exclusion limiting coverage for property damage that was “expected or intended from the standpoint of the insured.” 

The homeowners (as assignees of the general contractor’s rights under the policy) argued that the CGL policy provided coverage for both the defective EIFS and the damage caused to the structure and walls because of the defective EIFS.  The CGL carrier argued that the CGL policy’s exclusions foreclosed coverage for all of the homeowner’s damages.

The court found that the CGL policy did not provide coverage for the defectively installed EIFS.  The court ruled that the defective installation of EIFS to the exterior of the house did not constitute an “accident,” and therefore, it did not constitute an “occurrence” under the CGL policy.  First, the court noted, “An act of negligence constitutes an ‘accident’ under a liability insurance policy when the resulting damage takes place without the insured's actual foresight or expectation. The test is a subjective one, because . . .  if it were to adopt an objective standard and hold that the term ‘accident’ as used in liability insurance policies excluded coverage for damage that should have been foreseen or expected by the insured, such insurance policies would be rendered all but meaningless.”  The court reasoned that if the damages the homeowner suffered related to the satisfaction of the contractual requirements, the damages were not unexpected.  In other words, if a general contractor delivered a house that did not meet the contractual requirements, it would not be unexpected or unforeseen that such defects would occur from the standpoint of the general contractor.  No coverage existed for this element of the homeowner’s claim.        

However, the court did find that the CGL policy provided coverage for the damage to the non-defective structure and walls of the house caused by water infiltration through the defectively-installed EIFS.  In reaching this conclusion, the court emphasized that there was no evidence or allegation that upon completion of the house, any defect existed with respect to the structure or the walls.  The record showed that the structure and the walls were subject to infiltration over a period of five years as a result of the defective EIFS exterior which allowed water intrusion into the house.  As such, there was no evidence that the general contractor could have expected or intended that that non-defective structure and walls of the house would be damaged as a result of water intrusion.  Further, there was no allegation that the general contractor either expected or intended its subcontractor would defectively install the EIFS on the exterior of the house.  As such, the court found that the water intrusion into the house was an “accident,” and therefore an “occurrence,” under the CGL policy; no exclusion in the policy precluded coverage. 

Accordingly, the court ruled that while the CGL policy did not provide coverage for the defective EIFS itself, the policy did provide coverage for the damage to the structure and walls caused by water infiltration resulting from the defective installation of the EIFS.  As a result of this case, general contractors should review their CGL policies to determine what coverage their policies provide in the event that a subcontractor’s defective work causes damage to other work on a project.  Additionally, owners should also review their contractors’ CGL policies in the event that the owner is assigned a contractor’s rights under the policy.

MISSOURI COURT FINDS CONTRACT FOR CONSTRUCTION
CONTAINING APPROXIMATE PRICE INVALID AND UNENFORCEABLE

Sometimes contracts for construction are entered into with the express understanding that the total price, or the scope of the work, will be agreed subsequent to execution of the contract.  However, if such a contract does not clearly evidence a mutuality of agreement between the parties regarding the essential terms of the contract, a court may find that the contract is invalid and unenforceable.  This principle is demonstrated in Olathe Millwork Co. v. Dublin, 189 S.W.3d 199 (Mo. 2006).

In Olathe Millwork, the homeowners entered into an agreement with a general contractor for the construction of a new home; the homeowners’ prior home was destroyed by a fire.  The agreement stated that the general contractor was to provide labor, materials and equipment for the construction of the new home.  Although blueprints were submitted to the general contractor, no specifications corresponding to the blueprints were ever prepared by an architect or an engineer and submitted to the general contractor.  Instead, the general contractor and the homeowners relied upon an itemized breakdown of allowances prepared by the homeowners’ insurance company as the “contractual specifications.”  The total cost to the homeowners for the construction of the new home was listed in the agreement as approximately $270,000.00.
 
After construction commenced, various disputes arose between the general contractor and the homeowners.  As a result, the homeowners withheld interim progress payments due the general contractor.  Eventually, the homeowners filed suit against the general contractor for breach of contract; the general contractor filed a counterclaim for breach of contract, among other claims.  The trial court found that a valid contract existed and awarded both the general contractor and the homeowners damages for breach of contract (the general contractor received an award of damages which was merely reduced by the amount awarded to the homeowners).

On appeal the general contractor argued, among other arguments, that the trial court erred in finding that the parties had entered into a valid contract.  Specifically, the general contractor argued that an express contract did not exist because the essential terms of the agreement for construction of the new home had been reserved for future determination—the parties had not reached an agreement as to the contract price and the scope of the plans.

The Court of Appeals of Missouri first noted that in order for a valid contract to exist, mutuality of agreement must exist.  Mutuality of agreement requires “a mutuality of assent or a meeting of the minds to the essential terms of the contract.”  The court continued, the long standing rule in Missouri is that a contract must include a definite price to be valid and enforceable.  Further, a valid contract does not exist if the essential terms of the contract are reserved for the “future determination of both parties.”

After restating these general principles, the court addressed the general contractor’s argument that the parties had not entered into a valid and enforceable contract.  First, the court observed that the parties used an approximate value as a place holder for the true contract price because they did not know the final cost of the new home.  Second, the court found that the parties had not reached a clear agreement as to the specifications for the work to be performed because no specifications were ever submitted to the general contractor.  Third and finally, the court noted that the new home that was eventually built was substantially larger and contained many upgrades as compared to the itemized allowances prepared by the homeowners’ insurer.  Therefore, the homeowners and the contractor did not have a valid contract.  The trial court erred in finding that a valid contract existed.

As Olathe Millwork demonstrates, courts are not likely to find that two parties have entered into a valid and enforceable construction contract where there is no mutuality of agreement regarding essential terms of the contract such as the contract price or the scope of the work to be performed pursuant to the contract.  Therefore, any party who enters into an agreement for construction without defining all essential terms should be cognizant that such an agreement may not be valid and enforceable.

 

D.C. COURT APPLIES ECONOMIC LOSS DOCTRINE
TO BAR NEGLIGENCE CLAIM BY SUBCONTRACTOR’S
SURETY AGAINST SUPPLIER AND THE SUPPLIER’S SURETY

In most cases, an act of negligence by a contractor on a construction project also constitutes a breach of its contract.  However, as established in RLI Insurance Co. v. Pohl, Inc., of America, 2006 U.S. Dist. Lexis 45958 (D.D.C. July 7, 2006), the economic loss doctrine prevents the recovery of certain damages under the tort claim of negligence even though such damages would be recoverable under a breach of contract claim.

In RLI, the subcontractor was retained by the general contractor to install zinc panels on the façade of the owner’s building.  Pursuant to the subcontract, the subcontractor’s surety issued a performance bond.  The subcontractor then contracted with the supplier to fabricate the panels, and the supplier’s surety also issued a performance bond.  After the panels were installed, the owner and general contractor discovered defects in the panels and demanded that they be replaced.  The subcontractor subsequently defaulted, and the subcontractor’s surety was called upon to complete performance.  The subcontractor’s surety demanded that the supplier replace the rejected panels, but the supplier refused unless new panels were ordered and paid for in full.  To satisfy the owner, the general contractor ultimately ordered replacement panels directly from the supplier, paid full price, and charged the subcontractor’s surety for such cost.  The subcontractor’s surety then brought suit against the supplier and the supplier’s surety alleging negligence, among other claims; the defendants moved to dismiss that tort claim. 

In its negligence claim, the subcontractor’s surety alleged that the defendants owed a duty of care to ensure that the contract between the subcontractor and supplier was successfully completed, and that the defendants breached such duty by negligently fabricating the zinc panels.  As a result the defendants would owe certain amounts to cover the costs to repair or replace the panels.  However, the court ruled that the negligence claim failed because such damages are not recoverable in tort under the District of Columbia’s economic loss doctrine.  The economic loss doctrine provides that a plaintiff cannot recover, in tort, for purely economic losses (i.e., the loss of value or use of a product itself, the cost to repair or replace the product, or the lost profits resulting from the loss of use of the product).  This is particularly true where a contract exists that governs the available remedies for such losses.   Here, the court concluded, the subcontractor’s surety sought such purely economic losses, in the form of the costs to repair, cure, remedy and replace the defective panels.  Moreover, there was a contract in place between the subcontractor and supplier which governed the supplier’s obligation to properly fabricate the panels, as well as any breaches of that obligation.  Accordingly, the court dismissed the subcontractor’s surety’s negligence claim because District of Columbia law does not allow for the recovery of purely economic losses in a contract setting under a theory of negligence.

As RLI shows, even if a contractor’s negligent acts cause a breach of a construction contract, the injured party cannot necessarily recover the same damages under a negligence claim as compared to a breach of contract claim.  If the economic loss doctrine applies, as it does in most states, a plaintiff can only seek purely economic losses through its contractual remedies. Where there is no privity of contract between the plaintiff and defendant, economic losses cannot be recovered in tort.