March 2000 Newsletters

• SURETY'S FAILURE TO NOTIFY GOVERNMENT BARS CLAIM
  
  
• IDAHO SUPREME COURT LIMITS CATEGORIES OF MECHANIC'S LIEN CLAIMANTS
  
  
• CGL INSURER HAS DUTY TO DEFEND UNSUITABLE FILL CLAIM
  
  
• MARYLAND COURT CLARIFIES 15% RULE FOR LIEN ON RENOVATION WORK
  
  

 

Katz & Stone, L.L.P. Construction Newsletter
March/April 2000
Volume X, Number II

 

SURETY'S FAILURE TO NOTIFY GOVERNMENT BARS CLAIM

Although the payment and performance bonds required by the Miller Act are intended to protect the government from a general contractor's default, it is well-recognized that the government owes a duty to the general contractor's surety once it is aware of the general contractor's default.  The courts have labeled the surety's right to recover against the government for a breach of this duty, the right to 'equitable subrogation.'  In Hartford Fire Ins. Co. v. United States, 1999 U.S. App. Lexis 3197 (Fed. Cir. 1999), a federal court of appeals demonstrated the narrow scope of this remedy.

The dispute in Hartford Fire arose out of a contract between the United States ('the government') and a Section 8(a) general contractor for the construction of a Criminal Investigation Division Field Operations Center at Fort Leonard Wood, Missouri (the 'Project').  The general contractor subsequently subcontracted various administrative tasks for the Project to a subcontractor which included obtaining surety bonds for the Project.  The general contractor and subcontractor jointly applied for and received surety bonds from the Hartford Fire Insurance Company (the 'surety').

As the Project neared completion, the subcontractor advised the government that the general contractor had failed to deposit the last two progress payments in the proper account and that, as a result, the Project's subcontractors and suppliers were in danger of not getting paid.  Four days later, the subcontractor further notified the government that the general contractor had made unauthorized withdrawals from the Project account and requested the government's intervention to ensure that the Project's subcontractors and suppliers were paid.  Despite the subcontractor's warnings of the misappropriation of progress payments, the government subsequently conducted a final inspection of the Project and made final payment directly to the general contractor.  Three weeks after the general contractor received its final payment, the surety notified the government of the numerous payment bond claims which had been made.

The surety subsequently paid the amounts due the Project's subcontractors and suppliers and filed an action against the government under the doctrine of equitable subrogation.  Specifically, the surety alleged that the government had abused its discretion and acted unreasonably to the surety's detriment by failing to take reasonable steps in its power to ensure that payments to the general contractor were used to pay subcontractors and suppliers.  In response, the government filed a preliminary motion to dismiss alleging that the surety's failure to notify the government of the general contractor's default prior to payment barred its equitable subrogation claim.  The trial court granted the government's motion.

On appeal, the court expressly recognized that under the doctrine of equitable subrogation, the surety could maintain a claim against the government if the government breached its duty to act with 'reasoned discretion' toward the surety.  However, the court held that the government's equitable duty arises only upon the surety's notification to the government that the contractor is in default.  In the present case, the court held that the subcontractor's notice to the government of the general contractor's impending default was insufficient to satisfy the requirement of notice from the surety and therefore barred the surety's claims.

The court's decision in Hartford Fire has important implications on sureties and the way they oversee bonded projects.  Sureties cannot afford to wait until bond claims are filed to put the government on notice of a contractor's impending default.  Instead, and to ensure their rights are preserved, sureties will need to more actively oversee bonded projects and directly notify the government at the earliest signs of a potential default.

 

IDAHO SUPREME COURT LIMITS CATEGORIES OF MECHANIC'S LIEN CLAIMANTS

In Great Plains Equipment, Inc. v. Michetti Pipe Stringing, et al., 979 P.2d 627, 132 Idaho 754 (1999), the Idaho Supreme Court overturned, in large part, a $3 million judgment in favor of sixteen lien claimants under Idaho's mechanic's lien statute against the Northwest Pipeline Corporation ('owner').

In Great Plains, the owner and Great Plains Pipeline Construction Company ('contractor') entered into a construction contract in which the contractor was to build 378 miles of new gas pipeline and related facilities (compressor stations, communication sites, etc.) between Pocatello and Burley, Idaho.  From the beginning, the project was plagued by delays in starting, extreme weather conditions, and project cost underestimations.  Eventually, the contractor abandoned the job, leaving numerous subcontractors, equipment lessors, insurance providers, and other vendors unpaid.  The contractor was ultimately forced into involuntary bankruptcy and the subcontractors filed mechanic's liens against the owner for the unpaid amounts.

At trial, the district court entered judgment in favor of the sixteen lien claimants.  On appeal, the owner challenged numerous elements of the district court decision including, most importantly, whether costs for: (a) leased equipment; (b) unpaid insurance premiums; and (c) fuel and oil charges can be recovered under Idaho's mechanic's lien statute.  Under Idaho's lien law, 'Every person performing labor upon, or furnishing materials to be used . . . in connection with any land or building development or improvement . . .  has a lien upon the same for the work or labor done or professional services or materials furnished.'   The Idaho Supreme Court ultimately concluded that the district court had erroneously awarded such costs under the statute.

In reversing the lower court, the Idaho Supreme Court stated that the operative phrase in the mechanic's lien statute required that materials were 'to be used in' the construction.  The court noted that the 'right of lien is based on the theory that the claimant has . . . contributed to the construction to improvement of the property against which the lien is asserted'.  Accordingly, the court concluded 'where the labor is not used or the materials are not incorporated into the building, structure or improvement, no lien on land or building results.'

In reaching its decision, the court analogized the use of leased equipment to the use of tools.  Under Idaho law, costs for tools which are not used and consumed in the construction of the work cannot be included in a lien.  Similarly, the court reasoned that since the leased equipment was neither incorporated into, consumed or destroyed by the construction, the leased equipment could not be considered 'materials' under the lien law.  Accordingly, the lien claimants could not recover under the mechanic's lien statute for unpaid rental charges or the 'use' value of the leased equipment.

The court next turned to the question of whether the mechanic's lien statute applied to the recovery of unpaid insurance premiums.  While the district court concluded that a portion of each insurance contract was 'consumed' during the pipeline construction and thus properly lienable, the Idaho Supreme Court disagreed.  The court held that liability insurance is neither labor nor materials consumed in the process of improving real property.  While the court acknowledged that the cost of worker's compensation insurance is recognized as 'labor' under the mechanic's lien statute, the court refused to extend the law to any other form of insurance.  Thus, the court held parties seeking to recover insurance costs could not recover these costs under the mechanic's lien statute.

Finally, the court held that a supplier of fuel and lubrication products was not entitled to recover under the statute for fuel and oil supplied to the project.  While the district court reasoned that such charges were proper since the fuel and oil were materials 'used and consumed' in the construction, the Supreme Court once again disagreed.  In reaching this conclusion the court relied on previous decisions where the court held that although costs for gasoline and oil supplied in highway construction were recoverable under Idaho's public contractor's bond statute, similar claims were not recoverable under the mechanic's lien statute because such were not 'labor or materials that are lienable under the mechanic's lien law in its relation to private structures.'

The Idaho Supreme Court ultimately reversed all lien claims against the owner.  By doing so, the court demonstrated that it would strictly interpret the mechanic's lien statute and deny recovery for any costs which are not clearly labor or materials consumed in the construction process.  The Idaho decision illustrates the important principle that not every cost incurred in construction can be recovered through a mechanic's lien.  While the decision in Great Plains was based only on Idaho's statute, given the differences in mechanic's lien law state-by-state, contractors need to be aware of the recoverable costs prior to asserting a mechanic's lien.

 

CGL INSURER HAS DUTY TO DEFEND UNSUITABLE FILL CLAIM

Contractors are not always aware that routine defective construction claims may be covered under their commercial general liability policies.  In Federated Mutual Ins. Co. v. Grapevine Excavation Inc., 1999 U.S. App. Lexis 31223 (5th Cir. 1999), a subcontractor performed excavation, backfilling and compacting work in connection with the construction of a parking lot for Wal-Mart in Burleson, Texas.  After completion of the lot, the owner discovered that the select fill used by the subcontractor did not meet specifications and had caused damage to the parking lot's asphalt surface.  As a result, the owner refused to pay the general contractor, and the general contractor in turn brought suit against the subcontractor for damages.

The subcontractor requested a defense from its insurers and one of the insurers refused to defend the subcontractor against the lawsuit.  In an ensuing declaratory judgment action to determine coverage, the insurer argued that the subcontractor's use of improper fill was an 'intentional act' and thus was not an 'occurrence' under the policy.  The district court agreed and the subcontractor appealed.

The United States Fifth Circuit Court of Appeals reversed.  While the court recognized that according to Texas law, which governed this case, intentional and voluntary acts are not deemed to be an 'occurrence,' negligent acts can be considered an 'occurrence' if the resulting damages were unforeseen or unexpected by the insured.  In the construction context, damages have been held to be unforeseen if the contractor's defective work resulted in harm to a third-party's work.

Using this rationale, the Fifth Circuit found the allegations against the subcontractor were an 'occurrence' under the policy.   First,  the  court  noted  there were  no  allegations that  the subcontractor intentionally used substandard materials for filling the lot.  Second, the subcontractor's use of the wrong fill damaged the work of the paving subcontractor and, therefore, these damages could be deemed to be unforeseen.

The Fifth Circuit also rejected the insurer's argument that coverage was barred by the 'contractual liability' and 'impaired property' exclusions.  The contractual liability exclusion bars coverage when the allegations against the contractor result solely from an agreement to assume the liability of a third-party.  In this case, the allegations against the subcontractor included both contractual indemnification and negligence.  Because the complaint alleged negligence, and not solely indemnification, the contractual liability exclusion was held not to apply.

The court also rejected the insurer's assertion of the impaired property exclusion which bars coverage in situations where the damaged property can be restored merely by 'either repair, replacement, adjustment, or removal of the work' by the contractor or by fulfilling the terms of the agreement.  In this case, the court held the exclusion did not apply because the damage to the paving subcontractor's work could not be restored by correcting the inadequacies of the fill.

The Federated Mutual case illustrates the general principle that defective construction work which damages another trade's work may be covered under the contractor's commercial general liability policy.  While such policies generally do not cover the cost of repairing the insured's defective work, when the work of other trades is damaged, the policies often must respond.

 

MARYLAND COURT CLARIFIES 15% RULE FOR LIEN ON RENOVATION WORK

Section 9-102(a) of the Code of Maryland was recently revised to allow contractors to establish liens on any building repaired, rebuilt or improved to the extent of 15% of its value.  Formerly, the threshold was 25%.  In the case of O-Porto Construction Co. v. Devon/Lanham, L.L.C., 129 Md. App. 301 (1999), the Maryland Court of Special Appeals addressed the question of whether a particular subcontractor whose own work did not equal or exceed 15% of a building's value could still establish a lien on the building when the total value of all renovations exceeded the 15% threshold.   After examining prior caselaw and the extensive legislative history of Section 9-102(a), the court clarified that any contractor working on a property that has been repaired or improved to the extent of 15% of its value is entitled to a lien, regardless of the value of the individual contractor's work.

In 1998, O-Porto Construction Company ('the contractor') filed a complaint in the Circuit Court for Prince George's County, seeking to establish a lien on a commercial property for unpaid concrete work.  The contractor's work represented a small portion of a property-wide renovation undertaken by the owner, Devon/Lanham, L.L.C. ('the owner').  After purchasing the property for $2,600,000.00, the owner had spent $2,694,581.00 in renovations.  As a result, the owner acknowledged that the total cost of all renovations exceeded 15% of the property's value but argued that, because the contractor's work alone did not exceed that threshold, no lien could be established under Section 9-102(a).  The Circuit Court agreed with the owner and dismissed the contractor's complaint, taking the position that the 15% threshold of Section 9-102(a) had not been met and, therefore, the contractor had no right to establish a lien on the property.  The contractor appealed to the Court of Special Appeals.

On appeal, the owner relied on a previous decision of the appellate court, Westpointe Plaza II Ltd. Partnership v. Kalkreuth Roofing & Sheet Metal, Inc., 109 Md. App. 569, 580 (1996), in which the court had stated that, in order to establish a lien under Section 9-102(a), a contractor must demonstrate 'that its repairs constituted at least [fifteen percent] of the value of the building repaired.'

The Court of Special Appeals disagreed that Westpointe Plaza controlled the outcome of the contractor's suit, stating that the general language relied upon by the owner was not meant to decide the precise question presently before the court.  Then, tracing the legislative  history of Section  9-102(a)  from its  original  enactment in 1898,  the court  found that  previous  versions of  the statute had always clearly indicated that the cost of all renovations to a property were to be considered when determining whether the applicable percentage threshold had been satisfied.

The holding in O-Porto Construction clarifies any confusion which may exist over the proper application of Maryland's 15% rule.  As the court held, any contractor working on property that has been repaired or improved to the extent of 15% of its value is entitled to establish a lien under Maryland law, regardless of the value of the individual contractor's work.