July 2000 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
July/August 2000
Volume X, Number IV

 

COVERAGE DENIED - GENERAL BUSINESS INSURANCE POLICY DOES NOT COVER LIABILITY ARISING FROM TESTING SERVICES

To meet the needs of insureds, the insurance industry has developed numerous policies that provide coverage for a variety of potential damages.  The standard comprehensive general liability insurance policy typically obtained by most businesses provides coverage for a wide array of risks; however, such policies also exclude coverage for certain types of identifiable risks that may be specifically covered by other types of insurance policies.  The issue of whether certain liabilities are excluded from coverage has received extensive consideration from the courts.  In National Ben Franklin Insurance Co. v. Calumet Testing Services, Inc., 191 F.3d 456 (7th Cir. 1999), the court considered a policyholder's attempt to obtain coverage under its comprehensive general liability policy for the potential liability arising from allegations of professional negligence resulting from the explosion of a pressure tank at the Beta Steel Plant in Portage, Indiana.

Beta Steel had retained Calumet Testing Services ("Calumet") to inspect the thickness of a pressure tank and a weld placed on the tank to correct a pinhole leak.  A Calumet technician performed an inspection and issued an examination report stating that "no indications were noted and the weld was accepted."  A subsequent explosion killed three people and numerous lawsuits were filed alleging that Calumet negligently inspected and tested the pressure tank.  National Ben Franklin (the "insurance company") had previously issued Calumet a comprehensive general liability policy and sought a declaration from the court that this policy did not provide coverage for the pending lawsuits.

The insurance company's argument was based upon an exclusion contained in the policy that stated "this insurance does not apply to "bodily injury" "property damage" "personal injury" or "advertising injury" for which the insured may be held liable because of the rendering or failure to render professional services in the performance of any claim, investigation, adjustments, engineering, inspection, appraisal, survey or audit services."  (emphasis added).  Focusing upon this exclusion, the court stated that the intent of the above-quoted language was to exclude coverage for liability arising out of the policyholder's providing or failing to provide "professional services."  Therefore, the court held that the coverage issue ultimately depended upon whether the claims against Calumet arose from its providing professional services.

Citing an often-quoted definition of "professional services," the court stated that "a professional act or service is one arising out of a vocation, calling, occupation, or employment involving specialized knowledge, labor, or skill, and the labor or skill involved is predominantly mental or intellectual, rather than physical or manual."  Under this definition, the court concluded that the services provided by Calumet to Beta Steel prior to the explosion clearly fell within the definition of professional services, as the interpretation of the testing undoubtedly involved professional knowledge, experience, and training.

The denial of coverage in Calumet Testing illustrates the limits of coverage provided by the comprehensive general liability  policy.   Calumet's  apparent  failure  to  appreciate  the professional services exclusion and to obtain the appropriate "errors and omissions" or "professional negligence" insurance resulted in its exposure to a substantial uncovered risk.  In order to be adequately protected against foreseeable business risks, it is essential that insureds fully appreciate the limits of coverage of their comprehensive general liability policies and be certain they have obtained the appropriate supplemental coverages.

 

SUBCONTRACTORS MAY RECOVER UNABSORBED OVERHEAD FROM THE GOVERNMENT EVEN THOUGH PRIME CONTRACTOR FINISHES ON TIME

When the prime contractor finishes on-time, can a subcontractor on a public project recover its unabsorbed home office overhead costs when the progress of its work was delayed by government fault?  That was the question to which a federal court answered "yes" under the particular circumstances of the recent case, E.R. Mitchell Construction Company v. Danzig, Secretary of the Navy, 175 F.3d 1369 (Fed. Cir. 1999).

In April 1992, the federal government awarded a contract to E.R. Mitchell Construction Company for the construction of a clothing issue facility at the Marine Corps Recruit Depot at Parris Island, South Carolina.  As prime contractor, Mitchell subsequently entered into a subcontract with a mechanical subcontractor for the performance of  heating, air conditioning, plumbing, and sanitary sewer work.  The prime contractor and its subcontractors developed an agreed-upon schedule for completion of the work.  The government then approved the schedule, which required the mechanical subcontractor to provide manpower for each element of its work within certain specific time periods and to complete its entire scope of work by March 8, 1993.  Under the schedule, the prime contractor had a completion date of June 4, 1993.

In October 1992, the mechanical subcontractor notified the prime contractor that the specifications and drawings applicable to its work were defective.  Subsequently, while the government decided how to cure the defects, the mechanical subcontractor was effectively placed on standby for a period of 60 days.  During this period, the mechanical subcontractor's use of manpower was substantially diminished from what had been planned.  Ultimately, the government changed the specifications and drawings, and modified the contract price to compensate various contractors for direct costs incurred in carrying out the changes.  Notwithstanding the disruptions and changes resulting from the defective specifications, the prime contractor completed the project in advance of the required completion date.

The mechanical subcontractor subsequently submitted a request for an equitable adjustment to recover unabsorbed home office overhead costs incurred during the 60-day period that it was unable to proceed with its mechanical work.  The claim was passed through to the government.  The contracting officer denied the claim and, at trial, the Armed Services Board of Contract Appeals affirmed the contracting officer's decision.  Specifically, the Board found that the government could only be liable for a subcontractor's unabsorbed home office overhead costs when the prime contractor's performance was in fact delayed by the government.

On appeal, the Court of Appeals for the Federal Circuit reversed the Board's decision.  In reaching its holding the court addressed and dismissed several arguments raised by the government.

First, the government argued that it should not be held liable for the mechanical subcontractor's overhead costs because there was no direct contractual relationship between it and the subcontractor. Accordingly, the government reasoned it was powerless to control the schedule of the mechanical, or any given subcontractor.  In making this argument, the government cited the well-established legal doctrine that the government can only be liable for subcontractor costs when the prime contractor is itself liable for those costs.  In this case, however, because the government never raised this "lack of privity" defense during the trial before the Board, the court found that the government had waived the defense.

Second, the government argued that a prime contractor cannot recover for a subcontractor's unabsorbed home office overhead costs unless the prime contractor has itself been delayed in the performance of its contract.  The court rejected this argument as well reasoning that without lack of privity as a defense (which the government waived) there was no independent basis for the court to deny a subcontractor its unabsorbed overhead simply because the prime contractor completed its contract on time.  As further justification for its decision, the court noted that the government had approved of the mechanical subcontractor's schedule.

In a limited sense, Mitchell represents a victory for subcontractors on public projects seeking to recover indirect costs incurred due to government fault.  While the court clearly held that a subcontractor's right to recover unabsorbed overhead costs is not automatically dependent on whether the prime contractor's performance was delayed by government error, subcontractors should recognize that the court limited its decision to the particular facts presented in the case, specifically the government's waiver of the privity defense and its express approval of the construction schedule.   Accordingly, the court's holding in Mitchell does not guarantee subcontractors will be successful in recovering unabsorbed overhead claims directly against the government in all cases.  To avoid the consequences of the privity defense, subcontractors in such cases might consider including some or all of their unabsorbed overhead costs as a part of a disruption or interference claim.

 

4TH CIRCUIT ANNOUNCES EXCEPTION TO ENFORCEMENT OF SUBCONTRACT "PAY-IF-PAID" CLAUSE

In Moore Brothers Co. v. Brown & Root, Inc., 2000 U.S. App. Lexis 5651 (4th Cir. 2000), the Fourth Circuit U.S. Court of Appeals affirmed a U.S. District Court decision that under Virginia law a general contractor may not use a  "pay-if-paid" clause as a defense to a subcontractor's payment claim if the general contractor was partly responsible for the fact that the condition precedent to payment never occurred.  This decision thus marks a judicially-recognized exception to the enforcement of conditional payment clauses which make the general contractor's receipt of payment a condition precedent to the subcontractor's ability to recover payment.

Moore Brothers arose out of the construction of the Dulles Toll Road Extension (the "project"), a privately-owned and operated toll road connecting Dulles Airport and Leesburg, Virginia.  The road was built (and is operated) by the Toll Road Investors Partnership II ("Owner"), who awarded the general construction contract to Brown & Root, Inc. ("General Contractor").  The General Contractor, in turn, entered into subcontracts with Moore Brothers Co. Inc. and The Lane Construction Corporation, ("Subcontractors") to build parts of the road.

The subcontracts between the parties contained a "pay-if-paid" clause stating that "payment by Owner to General Contractor is a condition precedent to any obligation of General Contractor to make payment hereunder [and] General Contractor shall have no obligation to make payment to Subcontractor for any portion of the Sublet Work for which General Contractor has not received payment from the Owner."

The prime construction contract contained provisions for additional payment if the Owner ordered changes constituting a "change in scope" of the work.  Early drafts of the prime contract also contained several specific "change illustrations" which expressly set forth the type of situation in which the General Contractor would be entitled to additional payment.  Included among the change illustrations were design enhancements to the pavement sub-base material, which, as designed, the General Contractor knew were on the 'marginal end' of what might be needed to construct the project.  However, in an effort to reduce the project's cost and assist the Owner to qualify for financing, the Owner and General Contractor consciously deleted the change illustrations from the prime contract.

After deleting the illustrations for the benefit of the lender, the General Contractor then incorporated the same change illustrations in a "Policy and Procedures" letter given to the Subcontractors.  The General Contractor did not inform the Subcontractors that the change illustrations (and the potential need for additional 'change in scope' work) had been hidden from, and therefore were not adequately funded by, the lenders.  Thereafter, when the need for a thicker pavement sub-base became apparent, the General Contractor ordered the Subcontractors to proceed with the additional work.  When the Owner refused to pay for the additional work (because the financing did not cover the extra cost) the General Contractor did not pay the Subcontractors relying on the "pay-if-paid" clause as a defense.

The General Contractor and the Subcontractors initiated arbitration against the Owner and ultimately obtained an arbitration award for the costs associated with completing the additional work.  However, because funding was not available for the extra work, the Owner did not have the funds to pay the General Contractor the arbitration award, and the General Contractor maintained the subcontracts' "pay-if-paid" clauses absolved it of any responsibility to pay the Subcontractors.  The Subcontractors then filed suit against the General Contractor.

After concluding that the General Contractor's own actions contributed to the non-occurrence of the condition precedent, the district court applied the "prevention doctrine" ("Doctrine") to the General Contractor's actions.  Under the Doctrine, a condition precedent to performance may be waived or excused if the promisor prevents or hinders fulfillment of the condition to his performance.  The district court found, and the Fourth Circuit affirmed, that the General Contractor misled the lenders regarding the potentially costly design changes, making it less likely that the lenders would arrange additional financing.  As a result, the court concluded that the General Contractor had wrongfully "hindered" fulfillment of the condition precedent.  As such, the General Contractor was deemed to have waived the condition precedent to payment and could not use the "pay-if-paid" clause as a defense to the Subcontractors' payment claims.

As a practical matter, the Moore Brothers decision delineates a clear exception to the enforcement of an otherwise valid "pay-if-paid" clause.  The Fourth Circuit's recognition that a general contractor's actions may be considered in evaluating whether to enforce a "pay-if-paid" clause provides subcontractors a potentially broad and useful tool to defeat the operation of such clauses.  On a broader scale, Moore Brothers reinforces the principle that a general contractor may not use its own misconduct as a means to escape liability it may otherwise have towards its subcontractors.

 

VIRGINIA COURT RESOLVES TIE BIDS IN FAVOR OF VIRGINIA CONTRACTOR ON PUBLIC PROJECT

In Centex Construction Co., Inc. v. Norfolk Airport Authority, a Virginia circuit court held that a contractor incorporated in Virginia will be awarded a public contract when its bid ties another contractor incorporated outside of Virginia.  In Centex, construction contractors incorporated in Virginia and Nevada both submitted bids on a Norfolk Airport Authority project.  Each bid was $30.8 million.

To resolve the tie, the court considered the Virginia Public Procurement Act § 11-47(A) (the "Act") which provides two rules of preference for resolving tie bids on public projects.  The Act states that a preference shall be given to the bid that provides "goods, services or construction produced in Virginia" or that was submitted by "Virginia persons, firms, or corporations."  If neither of the rules of preference apply, then the tie shall be decided by lot.  The Airport Authority determined that the contract should be awarded to S.B. Ballard Construction, the Virginia contractor.  Centex, the Nevada corporation, challenged the decision in the Virginia Circuit Court.

Centex first argued that because both itself and the competitor were "producing" construction in Virginia for the project, both contractors should be considered equal in preference under the Act.  As a result, Centex argued the default rule of selecting bidders by lot should apply.  The court disagreed and found that the statute provided two separate rules of preference for resolving a tie and that each must be considered in applying the statute.  The court stated that Centex's interpretation would lead to an "illogical result" as all tie bids on Virginia public construction projects would result in an automatic selection by lots because construction is always "produced" in Virginia.  Accordingly, the court held that merely because both contractors intended to perform construction in Virginia, this did not trigger the default provision.

The court also considered the Act's second rule of preference for contractors incorporated in Virginia in resolving the tie.  To avoid the obvious consequence of the Act, Centex argued that while it was not a Virginia corporation, its hiring of Virginia persons and firms as subcontractors to perform the project qualified it as a Virginia corporation for purposes of the second rule of preference.  The court disagreed, finding that the Act does not require that courts delve into the particular circumstances surrounding each contract to discover if there is a connection between the contractor and Virginia.  Such an interpretation would treat the Act as though it only required the corporation to be a Virginia resident.  The court refused to adopt this interpretation and concluded that the state legislature would have included the term "resident" if residency, and not incorporation had been intended.  In ruling against Centex, the court held that this rule of preference will be determined strictly based on whether or not the contractor is incorporated in Virginia.

Lastly, the court expressed that the state legislature had a rational basis for resolving ties on public contracts in favor of Virginia corporations.  The court noted that the influx of companies incorporated in Virginia brings economic benefits to the state in the form of corporate taxation and increased employment.  Thus, it is not unreasonable to resolve tie bids in favor of Virginia corporations.