March/April 2005 Newsletters

 

Katz & Stone, L.L.P. Construction Newsletter
March/April 2005

MISSISSIPPI COURT OF APPEAS HOLDS THAT WHERE COST TO REPAIR WOULD CONSITUTE ECONOMIC WASTE, OWNER IS ENTITLED TO DIMINISH VALUE OF STRUCTURE

In Johnson v. Black Brothers, Inc., 879 So. 2d 525 (Miss. App. 2004), the Court of Appeals of Mississippi held that a homeowner who suffered damages due to defective construction by their general contractor was entitled not to the cost to repair the home — which was so high as to constitute economic waste — but was instead entitled to the diminished value of the home as-built compared to the value of the home if it had been properly constructed.

The owner contracted with the general contractor to build a private residence.  The general contractor completed the home in December 1997, but various construction defects began appearing.  Ultimately the owner sued the general contractor for the estimated cost to repair the problems.  At trial the chancellor found that the house contained a number of defects, including unconnected sewer lines, water accumulating under the house from improper site preparation, and an uneven kitchen and family room floor.

While the owner’s expert testified that the repair costs would be $228,800, most of those costs related to repairing the uneven kitchen floor, even though the court heard testimony that the uneven floors were not really noticeable and did not restrict the use of the house or make it less habitable.  The chancellor found that an award of $228,000 was not the proper measure of damages and the owner was entitled to $25,000 for the diminished value of their house (due to the uneven floor) and $33,400 for the cost to repair other defects.

The owner appealed, contending that it was entitled to $228,000 in repair costs.  But the Court of Appeals affirmed the judgment, noting that there are two measures of damages where a structure is not completed according to plans or specifications.  Those measures are: (1) the cost rule, which is the cost of repairing the defects to make the structure conform to the plans and specifications; or (2) the diminished value rule, which is the difference in the value of the property with the defective work and what the value would have been if there had been strict compliance with the contract.  The diminished value rule applies where the defects cannot be remedied without a great sacrifice of work or material, it would be impractical to repair the building, it would involve unreasonable costs amounting to economic waste, or where the cost of remedying the defects will not fully compensate the owner for damages it suffers.

Here, the repair estimate of $228,000 was over 80% of the total value of the home. The chancellor thus found that to completely redo the kitchen and family areas, which did not affect the house structurally and which accounted for the majority of the estimated repair costs, would be unreasonable.  Although the owner did not introduce any testimony as to the diminished value of the house, the general contractor’s expert did give such an estimate and the chancellor relied upon that estimate to award the owner $25,000 for the diminished value of the house.   The Mississippi Court of Appeals refused to overturn that judgment.

The Black Brother’s decision shows that construction professionals should be aware that there is not one single measure of damages for any given breach.  Where repair costs are excessively high given the value of the project as a whole, and there are no structural or other dangerous deficiencies, owners may not be able to recover repair costs. 

MARYLAND FEDERAL COURT HOLDS SURETY MAY BE BOUND BY RESULTS OF ARBITRATION BETWEEN SUBCONTRACTOR AND GENERAL CONTRACTOR

A recent Maryland federal court ruling addressed the question of whether a general contractor’s surety would be bound by the results of an arbitration proceeding involving its principal and a subcontractor.  As a result of the ruling in MPA Construction, Inc. v. XL Specialty Insurance Co., 349 F. Supp. 2d 934 (D. Md. 2004), a surety probably will be bound to an arbitration award entered against its principal so long as the surety had notice of the proceedings.

In MPA Construction, the owner awarded a prime contract for the construction of a fire station in Bethesda, Maryland.  Because the contract exceeded $100,000.00 in value, the contractor was required by the state’s Little Miller Act to furnish the owner with a payment bond, which it obtained from its surety.  The contractor later entered into a subcontract for drywall and ceiling work, which required that disputes between the contractor and subcontractor be resolved by arbitration.  When the subcontractor claimed that it had not been paid in full for its work, the contractor alleged that the owner had terminated the prime contract, in whole or in part, as a result of defective work by the subcontractor, and that the contractor was still owed payment by the owner which included monies owed to the subcontractor.

The subcontractor brought a payment bond suit solely against the contractor’s surety under the Miller Act.  The contractor moved to intervene in the suit, asserting that, should the court find that the surety was liable to the subcontractor, the surety would seek indemnification from the contractor. 

The court granted the contractor permissive intervention into the suit, since the contractor’s claim and the Little Miller Act suit had common questions of law and fact concerning whether the subcontractor fully performed its work and was owed money under the subcontract.  Rejecting the subcontractor’s claim that, as a small contractor, it would be harmed by further delay to its efforts to recover much-needed payment, the court held that the contractor’s intervention would not cause undue delay to the litigation or hardship to the subcontractor.  The court found no evidence to substantiate the subcontractor’s assertion of financial hardship, especially when the subcontractor was requesting that the court allow a costly lawsuit to proceed instead of arbitration. 

The court also stayed the entire bond suit to allow the arbitration to proceed.  The court rejected the subcontractor’s contention that the suit should be allowed to proceed simultaneously with the arbitration since the arbitrator’s decision would not be binding on the surety because the surety was not a party to the proceeding. The court, citing the law of several jurisdictions, including Maryland, held that the surety would be bound by an arbitration decision against its principal, the contractor, so long as the surety had notice of the arbitration proceeding against the principal.  

In light of the court’s decision in MPA Construction, parties should be aware that payment bond sureties most likely will be bound to arbitration awards arising out of proceedings involving their principals, even if they are not a party to the arbitration, so long as they had notice of the proceedings.

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OHIO COURT HOLDS THAT CONTRACT RETAINAGE IS NOT DUE IF PARTY SEEKING PAYMENT BREACHES ITS DUITES TO PERFORM WORK NECESSARY TO RELEASE RETAINAGE

In Stone Excavating, Inc. v. Newmark Homes, Inc., 2004 Ohio 4119 (Ohio App. 2004), the Court of Appeals of Ohio noted that contract retainage may not be payable if the party seeking payment breached a promise to which the retainage applies.  But if a party prevents its subcontractor from finishing the work, the Court noted that that party cannot use the failure to complete the work as a reason to refuse to release contract retainage.

The dispute in Stone Excavating arose out of a contract under which the subcontractor agreed to install streets, water, and sewer lines and construction site pads at several residential property subdivisions being developed by the developer.  The contract was in several writings, supplemented by oral agreements and the court found the contract time called for completion within two years of beginning work.

The subcontractor’s work was to be performed in a series of progressive steps, culminating in the installation of a second finished layer of asphalt on the new subdivision streets.  The subcontractor began work in 1997 and completed all steps except the last, installing the second layer of asphalt, by spring of 1998.  As the subcontractor completed its work, it applied for payment and developer paid the amount due, less the six percent retainage.

The subcontractor, approximately six months after completing its other work in 1998, began asking the developer for permission to apply the second layer of asphalt.  Each time, however, the developer declined, citing the need to complete its other work, which had been subject to numerous delays. It is undisputed that performing the other work could damage the second layer of asphalt.

Finally, in October 2001, four years after the work started, the developer asked the subcontractor to return and  apply the second layer of asphalt.  The subcontractor refused, citing ongoing work commitments.  The developer then performed that work itself, as well as certain other "bond work" repairs and then refused to release the subcontractor’s retainage.

After a bench trial, the trial court granted judgment for the subcontractor for the retainage, $31,466.08, less a small set-off for the bond work the developer performed.  On appeal, the Court of Appeals of Ohio held that the trial court’s decision was based on the erroneous conclusion that subcontractor had substantially performed its work and thus was entitled to have its retainage released.

The court noted that "substantial performance" means, roughly, full performance such that the parties largely get what they bargained for, even if there was not complete and final performance in every particular.  Here, the subcontractor neither applied the second layer of asphalt nor completed the required bond work it had not substantially performed.

The court, however, held that the trial court's error did not require that judgment be reversed because the developer refused to let the subcontractor complete the work.   The court noted that contract retainage may be treated as a penalty or as liquidated damages.  In either case, though, if the party holding the retainage wishes to keep it and not pay the retained amount, it must show that the party seeking retainage breached a promise to which the retainage applies.

But the court also noted that a party to a contract who prevents performance by the other party cannot rely on that non-performance to claim a breach.  Here, the developer indisputably refused to allow the subcontractor to apply the final layer of asphalt within the two-year contract period.  Thus, the subcontractor’s failure to perform that work (and the related bond work) could not be used by the developer to show non-performance.

The court thus affirmed judgment for the subcontractor, calling the trial court’s award “sensible as well as just.”  Stone Excavating illustrates that subcontractors must be careful when deciding whether to refuse to perform work they would otherwise be obligated to perform and should adequately document their efforts to comply with their contractual duties and any resistance they encounter from the developer or owner.  Failure to do so, or deciding to refuse to return to complete work, may mean forfeiting any outstanding retainage that might otherwise be due.

 

PROVING CONTRUCTIVE ACCELERATION CLAIMS CAN BE DIFFICULT FOR CONTRACTORS.

When claiming constructive acceleration contractors must prove that any time extensions received were inadequate to remedy their excusable delays. This lesson is illustrated in the case of Fraser Construction Co. v. United States, 384 F.3d 1354 (Fed Cir. 2004).  

In Fraser, the government contracted with a contractor to excavate material from the bottom of a shallow lake.  The contract period was from May to September of 1993.  To facilitate excavation, the water level of the lake was lowered, leaving only a small stream running through the lakebed which the contractor diverted with a dike.  The contractor designed the dike to withstand water flow substantially higher than the average water flow for the lake. 

Shortly after the project began, the lake began experiencing high water flows because of rain in the region.  The high water flows overran and destroyed the dike and caused damage to the work site.  The contractor experienced delays associated with repairing the dike and inundation of the work site.  The contractor requested a time extension which the government denied but later granted.  The contractor contended that the extensions that were later granted were not sufficient to compensate it for the extra expenses it had incurred in dealing with the high water flows, because upon being told that it would not receive time extensions or that those extensions would be dealt with later, it was forced to continue its operations at a substantial additional cost. The contractor further argued that many of the time extensions that it was ultimately granted were of no use to it because they were not granted on a timely basis. 

The court rejected the contractor’s argument that the extensions were not timely, finding that it was standard practice for parties to negotiate after the fact to determine the number of days to extend the contract period.  The court found it significant that the government followed the standard procedure for reviewing extension requests and had daily discussions with the contractor regarding delays and progress on the project. 

The court also rejected the contractor’s claim that the government forced it to accelerate its performance by pressuring it to work through delays that should have resulted in an extension.  The contractor’s evidence of constructive acceleration consisted of a letter from the government urging the contractor to adhere to the contract schedule and threatening termination if it did not.  An expression of concern about progress combined with a refusal to issue extensions can be the equivalent of an order to accelerate.  However, this letter was sent by the government before the contractor ever made a claim for excusable delay based on high water flow.  Also, the delays which precipitated the government’s letter were due to subcontractor problems not associated with high water levels. 

As a result of this case, contractors should be aware that when making claims for constructive acceleration, they must prove that extensions granted by the government were not sufficient to offset excusable delays.  Furthermore, time extensions do not have to be granted immediately and the mere failure to grant extensions does not, by itself, constitute constructive acceleration so long as the procedures set forth in the parties’ contract for time extensions are being followed.