January/ February 2002 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
January/February 2002

 

CONTRACTOR'S FAILURE TO INQUIRE INTO AN AMBIGUOUS BID PACKAGE RESULTS IN DISMISSAL OF ITS DIFFERING SITE CONDITIONS CLAIM

           On many construction projects, contractors face the risk that site conditions encountered during performance will significantly differ from the conditions they expected to find based on information presented in the bid package or other contract documents.  When the risk of a differing site condition is realized, it is natural for contractors to seek recovery of their damages based on the owner's failure to identify the true conditions of the job site.  As one contractor recently discovered, however, courts evaluating such claims do not merely examine the contents of the bid package; a successful claimant must also demonstrate that it acted reasonably in interpreting and relying upon the available information.  W.M. Schlosser, Inc. v. United States, 50 Fed. Cl. 147 (2001).

           In the case of W.M. Schlosser, a contractor contracted with the Navy for the construction of five bombproof buildings.  During performance, the contractor encountered soil that was unsuitable as fill.  The contractor contended that the on-site soil materially differed from the soil specified in the solicitation and geotechnical report.  Ultimately, the contractor sought an equitable adjustment from the Navy for the expense of exporting the unsuitable soil and importing suitable fill.  After the Navy denied the claim, the contractor brought suit in the United States Court of Federal Claims for the cost of excavating the unsuitable soil, removing it from the construction site, and importing select suitable fill.

          Prior to trial, the Navy moved to dismiss the contractor's claim, contending that the undisputed facts before the court proved as a matter of law that the contractor was not entitled to recovery on its claim.  In responding to the Navy's motion, the Court of Federal Claims first identified the elements of the contractor's differing site conditions claim.  According to the court, the contractor had to prove not only that the conditions indicated in the bid package differed from the conditions encountered during performance, but also that it acted as a reasonably prudent contractor in interpreting the contract documents.

          Having established the applicable legal requirements, the court next examined the facts surrounding the claim.  The court noted that, although there were indications in the geotechnical report that suitable fill soil was available on-site, there were also indications in the report and the specifications that suitable fill was not available.  For example, one provision of the contract stated, "Borrow material suitable backfill and fill material in the quantities required is not available on Government property."  Although poorly written, this contract provision, coupled with the geotechnical report's ambiguities as to the nature of the soil on site, put the contractor on notice that suitable fill might be unavailable and gave rise to a duty on the part of the contractor to inquire for clarification.  Given the ambiguities of the contract documents and the contractor's duty to inquire into such ambiguities, the court found that the contractor had not acted reasonably in interpreting the specifications and dismissed the claim.

          W.M. Schlosser teaches that, when bidding on a project, contractors should interpret all documents of the bid package as a whole and seek to resolve any inconsistency, ambiguity or conflict as to site conditions in advance of submitting a bid.  A contractor who ignores such questions and simply assumes a favorable interpretation may be severely disappointed if actual conditions prove to vary from its interpretation.

 

MARYLAND SUBCONTRACTOR UNABLE TO FILE LIEN ON HOMEOWNER'S PROPERTY DUE TO FULL PAYMENT TO PRIME CONTRACTOR

          Although state courts have made it clear that mechanic's lien statutes are to be construed in favor of the lien claimant, some state legislatures have made a policy decision to treat private homeowners more favorably than commercial owners and, as a consequence, have enacted provisions in their lien statutes that afford homeowners heightened protection against liens.  In Ridge Heating, Air Conditioning, and Plumbing, Inc. v. Brennen, 2001 Md. LEXIS 788 (2001), the Maryland Court of Appeals addressed one such provision, which protects a homeowner against a subcontractor's lien when the homeowner has already paid its general contractor for the subcontractor's services.

          In Ridge Heating, Timberwood Construction, Inc., as general contractor, subcontracted with Ridge Heating, Air Conditioning, and Plumbing, Inc., as subcontractor, to provide and install heating, air conditioning, and plumbing as part of the construction of an addition to a single-family home.  Due to financial difficulties, the general contractor abandoned the project in breach of its contracts with the homeowner and the subcontractor.  The homeowner retained another general contractor, at additional cost, to complete the unfinished improvements.  At the time of the original general contractor's breach, the homeowner had fully paid the general contractor for work performed on their home, including the labor and materials supplied by the subcontractor.  The subcontractor, however, had not been paid by the general contractor.  In light of the general contractor's nonpayment, the subcontractor filed suit against the general contractor for its unpaid subcontract balance and filed a mechanic's lien action against the homeowner.

          Citing a provision in Maryland's lien statute known as the "residential exception," the homeowner opposed the subcontractor's lien, arguing that, because they had fully paid the general contractor, they were not liable for the subcontractor's work.  The trial court agreed with the homeowner and dismissed the case, holding that the residential exception precluded subcontractor liens from attaching to single-family dwellings if the homeowner has fully paid its general contractor.  Upon appeal to the Maryland Court of Appeals, the subcontractor argued that the trial court had given the residential exception too broad an application.  The subcontractor argued that the residential exception was inapplicable to its lien because the exception only applied to liens based on new home construction, and not to liens based on an addition to an existing home.

          Under Maryland's lien statute, "every building that is either newly erected or repaired to the extent of 15% of its value is subject to a lien "for the payment of all debts."  Under Maryland law, the lien remedy clearly extends to debts owing to subcontractors (of whom the owner may be completely unaware).

          According to Maryland's residential exception, a homeowner is only liable to a subcontractor for work performed or materials furnished on a single family dwelling to the extent of the homeowner's contract balance with the general contractor at the time the subcontractor gave notice of its intent to file a lien.  This exception was designed to protect homeowners from the risk of double-payment for the same work (once to the general contractor according to the general contract and a second time to a subcontractor because of a lien).

           In Ridge Heating, while acknowledging that the scope of the mechanic's lien remedy should be liberally construed to protect subcontractors who enhance the value of property, the court also recognized the importance of construing the residential exception broadly in favor of homeowners.  The court rejected the subcontractor's argument that the residential exception only applied to new homes, and not to homes repaired, rebuilt or improved.  As the court explained, the crucial distinction under the mechanic's lien statute was "between homes improved to the extent of 15% of their value and homes improved to less than 15% of their value, not merely between new and improved homes."  Noting that Maryland courts have consistently been reluctant to construe the mechanic's lien statute against homeowners, the court reasoned that since subcontractors were better able than homeowners to bear the risk of loss, applying the residential exception to large improvements as well as new home construction, was "a fair and reasonable balance of the competing interests of homeowners and subcontractors."  Indeed, to hold otherwise would create "a risk of double payment for homeowners considering expensive improvements."  In the court's opinion, this would harm the construction industry, which profits from improving homes.  Since the homeowner had fully paid the general contractor, the Court of Appeals affirmed the dismissal of the lien, thereby forcing the subcontractor to look solely to the general contractor to collect its outstanding balance.

          The Ridge Heating decision illustrates the heightened obstacles that subcontractors sometimes encounter when performing work on single-family dwellings.  In states that protect homeowners against the risk of paying twice for a subcontractor's work, subcontractors face an increased risk of nonpayment when the general contractor cannot afford to finish a job or simply has a history of withholding payment from subcontractors.  In these situations, the law places the risk of loss on the subcontractor and will not force homeowners to choose between paying twice for the same work or losing their house.  If subcontractors on home construction projects are concerned about being paid or the financial soundness of their general contractor, Ridge Heating illustrates that alternate payment arrangements (such as a joint-check agreement) should be seriously considered to eliminate the risk that their sole remedy will be against an insolvent general contractor.

 

MATERIAL SUPPLIER VIOLATES FALSE CLAIMS ACT WITHOUT EVER CONTRACTING WITH THE GOVERNMENT

           Many states have enacted a law, commonly referred to as the False Claims Act, that imposes civil penalties on any person or entity which knowingly presents, or causes to be presented, a false claim for payment to a state or local governmental body.  It is not unusual for public-project subcontractors and second-tier suppliers to write off such laws on the theory that they are not providing labor or materials directly to a governmental body and, therefore, they are not submitting claims for payment to a governmental body.  As demonstrated in City of Pomona v. Superior Court, 89 Cal. App. 4th 793 (2001), however, contractors and suppliers do not need a direct contractual relationship with a governmental body to be found liable under a False Claims Act.

In City of Pomona, a supplier in California sold piping and other water distribution parts through catalogues provided to distributors.  In its catalogues, the supplier represented that its products complied with certain industry corrosion standards.  In 1991, without modifying the representations in its catalogues, the supplier began selling piping and other parts that failed to meet these corrosion standards.

Over the next six years, the City of Pomona purchased the supplier's products from a distributor through the supplier's catalogues.  After the city learned that the catalogues' representations concerning compliance with industry standards were false, the city brought an action against the supplier for allegedly violating the California False Claims Act ("the Act").

At trial, the court found no violation of the Act, holding that the city had failed to prove the supplier submitted a false claim because the supplier's false representations were made generally in its catalogues, not specifically within the city's purchase orders or the distributors' invoices to the city.  Upon dismissal of its action, the city appealed the trial court's ruling to the California Court of Appeals.

The appellate court rejected the trial court's decision and restored the city's action.  Noting that California's Act is based on the federal False Claims Act, the court first concluded that, like the federal Act, California's Act was intended to reach all types of fraud that might result in financial loss to government.  To violate the Act, a claim submitted to a governmental entity need not be false itself so long as it is underpinned by fraud.  Therefore, according to the court, a person may be liable for presenting a false claim for payment under the Act even though the person did not directly apply for or obtain any government funds.

The court then considered and rejected the supplier's defense that it was not liable under the Act because it had no knowledge that the city would be the end user of products it supplied to its distributors.  The court found that, because the supplier intended to attract customers such as the city with its catalogues and sales literature, the supplier was liable for the fruits of its marketing.  In the court's eyes, no other finding would serve the purposes of the Act.

Finally, examining the circumstances presented in City of Pomona, the appellate court held that, by taking orders for the materials advertised in its catalogues and supplying distributors with such materials for purchase by the city, the supplier caused its distributors to submit false claims for payment to the city.  The court reasoned that the distributors' claims were false for two reasons.  First, the city would not have entered into a contract with the distributors to buy the supplier's products had it known that the supplier's products did not meet industry standards.  Second, while the distributors billed the city for products the city ordered from the catalogues, the products that the city received and paid for did not match the specifications in those catalogues.

Although City of Pomona deals specifically with California's False Claims Act, there is good reason to believe that other states, particularly those whose laws are based on the federal Act, would also construe their laws to extend liability to persons or entities that have no contractual relationship with, or do not directly present claims to, a governmental body.  Accordingly, contractors and suppliers who indirectly furnish services or materials to public bodies need to be as careful about submitting claims for payment as though they were submitting such claims to the government itself.

 

CLAIM AGAINST CONTRACTOR FOR DEFECTIVE WORKMANSHIP NOT COVERED BY GENERAL LIABILITY INSURANCE POLICY

           Think your construction company's general liability insurance policy covers you in the event of a lawsuit for defective or unworkmanlike work?  Think again.  As illustrated by the recent case of Devoe v. Great American Insurance, 50 S.W.3d 567 (Tex. App. 2001), an insurance company providing a general liability insurance policy is not likely obligated under such a policy to defend or indemnify an insured contractor when the claim asserted against the contractor is based on the quality or workmanship of the contractor's work.

In Devoe, certain homeowners ("owners") contracted with a custom homebuilder ("contractor") to construct a new home.  The contractor was insured under a general liability policy.  As work progressed, the owners registered a number of complaints concerning the contractor's performance, including improper and deficient workmanship and the contractor's failure to complete the home in the agreed-upon time.  The owners filed suit against the contractor alleging a breach of contract by failure to construct the home in a good and workmanlike manner.

Upon commencement of the owners' suit, the contractor requested that its insurer defend and indemnify it based upon the general liability.  The insurer declined to defend on the basis that the claims asserted by the owners were not covered by the policy.  When the contractor failed to appear for trial of the suit, the owners were granted a default judgment and attorney's fees.  After the contractor failed to pay the judgment, the owners filed suit against the insurer, seeking recovery as beneficiaries under the terms of the insurer's policy.  The trial court, however, ruled in favor of the insurer on the ground that the insurance policy did not cover defective workmanship.

Upon the owners' appeal to the Texas Court of Appeals, the court considered the specific question of whether the contractor's "shoddy workmanship" was covered by the insurer's policy.  Noting that the policy, by its terms, applied only to claims for bodily injury or property damage "caused by an occurrence" and that the policy defined "occurrence" as an "accident," the court found that it did not cover claims for shoddy workmanship.

In reaching this decision, the court noted that the owners did not allege any event or series of events that could be construed as an accident.  Indeed, in the eyes of the court, the house was constructed over a period of time as a voluntary and intentional act by the contractor.  As such, the alleged deficient and substandard construction did not constitute an "accident" or an "occurrence" under the plain meaning of those terms even if the resulting, poorly constructed home was unexpected, unforeseen, or unintended by the contractor.

The court's decision in Devoe is typical of most courts' interpretation of general liability insurance policies covering injury or damage caused by an occurrence.  Even when not expressly defined by such policies, an "occurrence" is normally deemed to require some kind of accidental event and a contractor's unworkmanlike performance is normally considered an intentional, rather than an accidental act.  As many courts have noted, a contractor's general liability coverage is not the same as a performance bond.