May 2000 Newsletters

• FOURTH CIRCUIT HOLDS MARYLAND'S 10-YEAR STATUTE OF REPOSE APPLIES TO SUBCONTRACTORS
  
  
• ILLINOIS' HIGHEST COURT UPHOLDS THE RIGHT OF AN INSURED TO CHOOSE WHICH GENERAL LIABILITY INSURER MUST DEFEND A CLAIM
  
  
• PENNSYLVANIA COURT HOLDS GENERAL CONTRACTOR DIRECTLY LIABLE TO MATERIAL SUPPLIER PURSUANT TO JOINT CHECK AGREEMENT
  
  
• NEW YORK COURT HOLDS SURETY CANNOT ESCAPE OBLIGATIONS UNDER 'PAY-WHEN-PAID' CLAUSE
  
  

 

Katz & Stone, L.L.P. Construction Newsletter
May/June 2000
Volume X, Number III

 

FOURTH CIRCUIT HOLDS MARYLAND'S 10-YEAR STATUTE OF REPOSE APPLIES TO SUBCONTRACTORS

Statutes of repose typically provide protection to those involved in the construction process, after a specified time period has passed, by cutting off all claims arising from improvements made to real property.  Based on a recent Fourth Circuit Court of Appeals decision, Maryland subcontractors may rest assured that they will receive the same protection as general contractors under the Maryland statute of repose.  Under the Maryland statute, claimants may not bring suit against architects, professional engineers, or contractors more than ten years after the improvements to real property first became available for use.  As to all other defendants, the statute provides repose twenty years after the improvements became available for use.

In Hartford Insurance Company of the Midwest v. American Automated Sprinkler Systems, Inc., a hotel experienced $1.6 million in damages due to flooding when, in 1996, cold weather caused a standpipe cap to detach and a firehose valve to crack.  The hotel management contacted the sprinkler-system subcontractor who had installed the piping in 1982 to inform it of the situation.  The subcontractor returned to repair the system.

The insurer of the hotel subsequently brought a subrogation action for the damages against the subcontractor.  The insurer claimed the subcontractor had improperly constructed and installed the standpipe system in 1982.  The subcontractor moved for summary judgment arguing the Maryland ten-year statute of repose applied and therefore barred claims brought more than ten years after completion of the improvement to the property.  The district court granted the motion and entered judgment for the subcontractor.

The insurer appealed to the Fourth Circuit and argued that the term "contractor" as used in the Maryland statute of repose is not applicable to subcontractors.  The insurer argued that the term "contractor" as used by the American Institute of Architects ("AIA") refers only to the contractor in privity with the owner - i.e. the general contractor.  As further support for its argument that the ten-year statute of repose did not apply to subcontractors, the insurer argued that Maryland's mechanic's lien statute defines the terms "contractor" and "subcontractor" differently.

The Fourth Circuit rejected the insurer's arguments and affirmed the district court's holding.  The court held the term "contractor" as used in the statute of repose includes subcontractors.  The court reasoned this result was consistent with the intent of the statute to protect all parties involved with the actual construction of improvements to real property.  The Fourth Circuit also looked to definitions of the term "contractor" in several dictionaries which further supported the proposition that the term "contractor" includes subcontractors.

In addition, the court examined the rationale of the statute of repose and found that the  legislative motivation behind granting heightened protection to architects, professional engineers, and contractors was the fact that changes in Maryland's tort law had dramatically expanded the potential for liability of parties involved in the construction process.  Thus, the court reasoned that the purpose of the statute could only be served by providing the heightened protection to subcontractors.

As the Hartford Insurance case illustrates, statutes of repose provide important protection against claims which surface well after the contractor's work has been completed.  As statutes of repose differ from state to state (e.g., Virginia's is only five years), contractors, subcontractors and their insurers would be well-advised to consult their legal counsel whenever construction-related claims are asserted years after construction has ended.

 

ILLINOIS' HIGHEST COURT UPHOLDS THE RIGHT OF AN INSURED TO CHOOSE WHICH GENERAL LIABILITY INSURER MUST DEFEND A CLAIM

When a general contractor has been named as an additional insured to a subcontractor's  general liability insurance policy, the general contractor's intent is that the subcontractor's policy cover any claim falling within its scope, without involving the general contractor's own policy.  In an attempt to effectuate this intent, general contractors will endeavor to have the subcontractor's insurer provide a defense while at the same time notifying their own insurer that they do not intend to seek that insurer's coverage.  In the insurance industry, this practice is known as a 'targeted tender.'

In John Burns Construction Company v. Indiana Insurance Company, the Illinois Supreme Court recently addressed in an unpublished opinion whether an insured can choose which general liability insurer would defend a claim when the insurance policy invoked by the insured contains an 'other insurance' clause.  'Other insurance' clauses typically provide that, if other primary insurance is available to an insured for a loss, each insurer will cover the loss in equal shares.  Affirming that an insured has the right to choose which of several available insurers must defend a particular claim, the court clearly stated that the 'other insurance' clause in an insured's policy does not supersede the insured's right to tender defense of a claim to one insurer alone.

In John Burns, John Burns Construction Company, the general contractor, entered into a subcontract with Sal Barba Asphalt Paving, a paving subcontractor, to pave a parking lot at a commuter railroad station.  As required by the subcontract, the subcontractor added the general contractor to its liability insurance policy as an additional insured.  After the paving had been completed, a person using the rail station slipped and fell in the parking lot the subcontractor had paved, and subsequently sued the general contractor for his injuries.

The general contractor requested that the subcontractor's insurer defend and indemnify it against the claim and indicated that it looked solely to the subcontractor's insurer for its defense.  The general contractor further indicated that it did not want its own liability insurer to become involved in the suit.  The subcontractor's insurer initially refused to defend the general contractor.  After the general contractor instituted suit against the subcontractor's insurer for its failure to defend, the subcontractor's insurer changed its tune, taking the position that although it had a duty to defend, the general contractor's insurer was required to share equally in the defense by virtue of the 'other insurance' clause in its policy.  The other insurance clause provided that, if other primary insurance was available to the general contractor for a loss, each insurer would cover the loss in equal shares.  The subcontractor's insurer prevailed in two lower Illinois courts and the case was subsequently appealed to the Illinois Supreme Court.

The Illinois Supreme Court reversed the two lower courts, holding that the general contractor, as the insured, had the right to choose which of its insurers would be required to defend and indemnify it and that the 'other insurance' clause did not limit the general contractor's right to select which insurer was required to cover the claim.  The court based its decision on the notion that an insured may knowingly forego an insurer's involvement by instructing the insurer not to involve itself in the litigation.

The court held that the 'other insurance' clause in the general contractor's policy did not overcome the general contractor's right to select which insurer would be required to defend the claim.  Citing several previous cases, the court noted that 'other insurance' clauses only come into play as a method of apportioning coverage expenses among several insurers when the insured has in fact triggered coverage from several insurers.  According to the Illinois Supreme Court, the presence of such clauses does not, in itself, automatically trigger the coverage of all available insurers when the insured has purposefully chosen to restrict tender of a claim to a single insurer.

As the court's decision in John Burns illustrates, the validity an insured's right to make a 'targeted tender' of claims to an insurer or insurers of its choice continues to be upheld.   The mere presence of an 'other insurance' clause does not allow the targeted insurer to seek contribution from an insurer whose coverage the insured has purposefully declined to invoke.

 

PENNSYLVANIA COURT HOLDS GENERAL CONTRACTOR DIRECTLY LIABLE TO MATERIAL SUPPLIER PURSUANT TO JOINT CHECK AGREEMENT

Contractors often use joint check arrangements as a means of inducing suppliers to furnish materials to a financially weak or unproven subcontractor.  Contractors utilizing this practice need to take special care to avoid incurring direct liability to suppliers.

In Glen-Gery Corp. v. Warfel Constr. Co., 734 A.2d 926; 1999 PA Super 175 (1999), a Pennsylvania appeals court considered the question of whether a general contractor is directly liable to a material supplier under a joint check agreement even if the amount owed the supplier would exceed the subcontract price.  Glen-Gery involved the construction of the Nitrauer Elementary School ('school project' or 'project') in Lancaster, Pennsylvania.  The Warfel Construction Company ('general contractor') was the general contractor on the project and accepted Lawver Masonry's ('subcontractor') $741,000 bid to be the unit masonry and architectural precast subcontractor on the project.  The subcontractor in turn utilized Glen-Gery Corporation ('masonry supplier') as its supplier of block and other specialized masonry products for the project.

Shortly after signing the subcontract and purchase order, the subcontractor met with the general contractor and acknowledged that it was 'broke.'  As a result, the subcontractor requested that the general contractor pay for materials and the subcontractor's labor expenses on a weekly basis.  Upon hearing of the subcontractor's financial troubles, the masonry supplier requested that the general contractor execute a joint  check agreement.

Under the proposed joint check agreement (which the masonry supplier prepared) the general contractor agreed to issue joint checks (payable to subcontractor and masonry supplier) to cover the cost of 'all materials purchased by [subcontractor] for incorporation to [the school project].'  The agreement essentially provided that the masonry supplier would supply the subcontractor with materials on credit and would be compensated by the general contractor via joint check for all amounts reflected on the masonry supplier's invoices.

Shortly after the parties executed the joint check agreement, the subcontractor filed for bankruptcy and the general contractor began issuing the subcontractor and its masonry supplier joint checks.  Almost six months into the project, however, the general contractor met with the subcontractor to discuss the payment status of the subcontract.  The general contractor informed its subcontractor that the subcontractor had exceeded the $741,000 subcontract amount and would not be paid any more money.  As a result of this development, the subcontractor stopped working on the project and sent the general contractor a termination notice.

The general contractor then requested that the subcontractor supply it with information indicating outstanding amounts due and owing the subcontractor's suppliers.  Because the general contractor had already paid more than the subcontract amount, the general contractor refused to pay $62,000 in masonry supplier invoices.  The general contractor further questioned whether the materials invoiced were actually used on the project.

At trial, the court entered a verdict in favor of the general contractor.  The trial court held that because the masonry supplier authored the joint check agreement, it would construe that agreement against the supplier.  Moreover, the trial court indicated that the agreement was merely a payment mechanism that did not bind the general contractor to pay more money to the masonry supplier than it owed the subcontractor under its $741,000 subcontract.

On appeal, the Pennsylvania Superior Court reversed and remanded the trial court's decision.   The appellate court noted that '[t]he parties' joint payee check agreement was a measure purposefully intended to create additional security for a materials supplier of a soon-to-be-bankrupt/insolvent subcontractor,' and determined that under the agreement the general contractor clearly and unambiguously had agreed to pay the masonry supplier for 'all materials' the masonry supplier provided the subcontractor for use in the school project.  The Superior Court then remanded the case for the trial court to determine (1) whether the material indicated in the invoices was purchased by the subcontractor; and (2) whether the subcontractor purchased the material for incorporation into the school project.  The court ordered that if both questions were answered in the affirmative, the masonry supplier was entitled to a judgment for the unpaid invoices plus accrued interest.  Alternatively, the court ordered that verdict be entered for the general contractor if the trial court determined that the materials invoiced were not supplied to the subcontractor for use in the school project.

The Glen-Gery case illustrates that contractors should not assume that a document entitled 'joint check agreement' is a mere payment mechanism which does not create direct liability to the supplier or jeopardizes a favorable subcontract price.  Instead, contractors should carefully scrutinize all joint check agreements drafted by others, or better yet, prepare and utilize their own form agreement.

 

NEW YORK COURT HOLDS SURETY CANNOT ESCAPE OBLIGATIONS UNDER 'PAY-WHEN-PAID' CLAUSE

Construction contracts between general contractors and subcontractors often contain provisions commonly referred to as 'pay-when-paid' clauses.  A 'pay-when-paid' clause attempts to limit the general contractor's liability for payments to subcontractors in situations where the owner defaults and fails to pay the general contractor for amounts otherwise due the subcontractor.  These clauses have been the subject of many judicial decisions in recent years and in Blandford Land Clearing Corp., et al. v. National Union Fire Ins. Co., 698 N.Y.S.2d 237 (1999), the New York Court of Appeals considered a surety's attempt to rely on the equivalent of a 'pay-when-paid' clause contained in the subcontract as a defense to a subcontractor's claim on the bond.

In Blanford Land Clearing Corp., the general contractor and the owner entered into a contract for the construction of a shopping center in Bronx, New York.  The owner defaulted and refused to pay the general contractor.  At the time of the default, the subcontractor was owed approximately $500,000 for work performed on the project.  Because the general contractor had not yet received payment for the subcontractor's work, the general contractor refused to pay the subcontractor by relying upon the terms of the subcontract which expressly stated that for payment purposes, the general contractor is acting as 'agent of owner' and that payment from the owner to the general contractor was a condition precedent to the subcontractor receiving payment.

The subcontractor filed suit against the general contractor's payment bond surety.  In response, the surety argued that the terms of the subcontract, which were incorporated into the terms of the payment bond, extinguished any obligation the surety had to pay the subcontractor until the owner made payment to the general contractor.  The surety's motion to dismiss the subcontractor's claim on this basis was granted by the trial court.

The subcontractor appealed, contending that the surety could not evade its obligation to pay the subcontractor under the payment bond and the 'agent of owner' provision was merely a thinly disguised 'pay-when-paid' clause that was void against public policy and unenforceable pursuant to New York state law.  In response, the surety  argued that its obligation to pay the subcontractor was coextensive with that of the general contractor and, absent payment from the owner to the general contractor, it had no obligation to satisfy the subcontractor's claim.

The Court of Appeals rejected the surety's argument and held in favor of the subcontractor.  The court began its analysis by recognizing that the surety's payment bond represented an 'unqualified promise' to make payment to any 'claimant,' i.e., subcontractor, that had entered into a direct contract with the general contractor.  According to the court, the only manner in which this obligation could be removed was if the general 'contractor promptly makes payment, directly or indirectly, for all sums due.'  Thus, the court expressly rejected the surety's attempt to narrow its obligation under the bond and held that the bond imposes a broader obligation upon the surety than the subcontract does upon the general contractor.  The court further stated that if the surety wanted to limit its obligation to pay the subcontractor to that of the general contractor, it could have modified the terms of the bond.  Absent such language, the court held that the bond's unconditional promise to 'pay for labor, materials and equipment furnished for use in performance of the construction contract' required the surety to pay the subcontractor the amount due and owing.

The court further rejected the surety's attempt to rely on the 'agent of owner' language of the subcontract as a basis to deny payment by holding that to enforce such a provision would violate established contract principles.  Additionally, the court stated that such a clause would not be effective to release the general contractor, and therefore the surety, from its contractual obligation to the subcontractor, as the general contractor's attempt to label itself as the 'agent of owner' for payment purposes would offend public policy and could not be enforced.

The court's decision in Blanford Land Clearing Corp. demonstrates the judiciary's general reluctance to allow sureties to rely on pay-when-paid clauses as a defense to payment bond claims.  Given that New York state law renders pay-when-paid clauses void against public policy, there is probably little the surety could have done to avoid the result in this case.  Nevertheless, sureties in states where pay-if-paid clauses are enforceable would be well-advised to modify payment bond language to clearly and expressly make their obligations co-extensive with that of the general contractor, and subcontractors must be aware of the potential effect.