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September 2000 Newsletters
Katz & Stone, L.L.P. Construction Newsletter
September/October 2000
Volume X, Number V
SUBCONTRACTORS SUCCESSFULLY
SUE ARCHITECT FOR CERTIFYING PAYMENTS TO AN UNBONDED GENERAL CONTRACTOR
Architects who have negligently performed their
contractual obligations on a construction project are often insulated
from the claims of injured contractors and subcontractors by the
lack of contractual privity between the parties. In the
case of Gary Boren d/b/a Reliable Plumbing v. Thompson &
Associates, 999 P.2d 438 (Okla. 2000), the Supreme Court of
Oklahoma rejected just such an argument, finding a public-project
architect liable to multiple unpaid subcontractors for negligently
certifying payments to the general contractor with knowledge that
the general contractor had not secured a payment bond as required
by state law.
In Gary Boren, the Tyrone City school board hired Thompson
and Associates (the "architect") to design and oversee construction
of a new library building. Russell McBee (the "general contractor")
was awarded a contract for the construction of the library.
The general contractor, in turn, contracted with multiple subcontractors
to provide materials and labor for construction of the library.
Oklahoma law requires general contractors to obtain both performance
and payment bonds ensuring the construction of public buildings.
The payment bond serves to guarantee payment to subcontractors
in the event of default. Although the general contractor
in Gary Boren obtained the required performance bond from
a bonding company, it failed to obtain a payment bond.
Work on the project began in August 1994. At that time,
the architect sent the general contractor a note reminding it
of the required performance and payment bonds. In response,
the general contractor sent the architect a copy of only a performance
bond; no payment bond was ever sent. The architect apparently
filed the paperwork without verifying the existence of a payment
bond and began certifying payments to the general contractor.
As the project proceeded, construction was delayed and multiple
subcontractors were not paid by the general contractor.
In December 1994, the architect became aware that there was no
payment bond in its file after one of the subcontractors requested
a copy. Although the architect temporarily withheld certification
of progress payments to the general contractor, in January 1995
the architect reversed course and began certifying additional
payments to the general contractor with full knowledge that the
general contractor did not have a payment bond in place.
The subcontractors remained unpaid and subsequently filed suit
against the architect, alleging that it was negligent in certifying
payments to the general contractor in the absence of the required
payment bond. The trial court agreed with the subcontractors,
overruling the architect's motion to dismiss the case. Ultimately,
the court found the architect liable for negligence and rendered
a judgment in favor of the subcontractors.
On appeal, the architect argued that it could not be held liable
in negligence because it had no contract with the subcontractors
and, therefore, owed no duty to act for the subcontractors' benefit.
The appellate court disagreed and affirmed the trial court's judgment
against the architect.
In reaching its decision, the court cited several principles.
First, architects must exercise ordinary professional skill in
rendering their professional services. Second, architects
in Oklahoma may be held liable to contractors for their
negligent breach of a duty created by contract, even though those
contractors have no direct contractual
relationship with the architect. The court found
that liability for negligent breach of a contract is not dependent
on the existence of a contract between the person injured and
the person causing the injury. Rather, according to the
court, such liability is simply based on whether the negligent
act caused the injury and whether it was foreseeable that the
negligent act could harm third-parties.
Applying these principles, the court concluded that the architect
in Gary Boren had a duty to refrain from paying the general
contractor without the required payment bond being secured.
The architect was aware of the statutory payment bond requirement
and should have been aware that no such bond had been secured.
The architect had the authority to withhold payments in the absence
of a payment bond but, even after becoming aware of this, continued
to authorize payments. Given the lack of a bond, the court
concluded that the unpaid subcontractors' injuries were foreseeable
to the architect.
The holding of Gary Boren represents a departure from the
general rule requiring contractual privity for the recovery of
purely economic losses. Because the applicability of the
general privity rule varies from state to state, subcontractors
outside of Oklahoma should be aware that direct legal recourse
for the negligence of an architect under the same or similar facts
may be unavailable in their jurisdiction.
ILLINOIS COURT UPHOLDS LIMITS
ON SCOPE OF "ADDITIONAL INSURED" ENDORSEMENT
In American Country Insurance Co. v. Cline,
722 N.E.2d 755, 309 Ill. App. 3d 501 (1999), the Appellate Court
of Illinois enforced a restrictive additional insured endorsement
in a commercial general liability policy. In doing so, the
appellate court held that an insurer may narrowly limit the extent
of coverage of additional insureds to liability specifically resulting
from conduct of the policy holder.
In American Country, an employee of an electrical subcontractor
was injured when forty feet of electrical conduit fell upon his
ladder, crushing the ladder and causing the employee to fall six
feet to the floor. The employee sued the general contractor
and owner on negligence theories related to allegedly unsafe worksite
conditions.
The general contractor and owner sought coverage as additional
insureds under the electrical contractor's general liability policy.
The insurer denied coverage and subsequently brought a declaratory
action seeking a judicial determination that it had no duty to
defend or indemnify the additional insureds.
The central question before the court was the enforceability of
the additional insured endorsement which contained the following
restriction "The coverage afforded to the Additional Insured is
solely limited to liability specifically resulting from the conduct
of the Named Insured which may be imputed to the Additional Insured."
The trial court found the limitation of coverage unenforceable,
at least to the extent that it implied the insurer had no duty
to defend, citing the general rule that "a court is supposed to
resolve any doubt about a duty to defend in favor of the insured."
The insurer appealed.
On appeal, the appellate court reversed the trial court and enforced
the limitation in the endorsement, stating that Illinois law favors
(1) freedom of contracting between competent parties and (2) interpretations
of contract clauses which favor enforceability. In this
case the court noted that the additional insured endorsement was
added to the subcontractor's policy for a single $150 premium.
In exchange, the subcontractor received an "unlimited number of
'blanket' additional insurance endorsements for a single $150
premium." Thus, the court found that for this small additional
premium, it was only logical "that the additional insureds
would only receive coverage for a narrow class of claims."
In the final analysis, the court held that since the additional
insureds were sophisticated parties, it was reasonable to assume
that they could have negotiated any issues pertaining to insurance
coverage prior to executing the subcontract. Thus, the court
held the additional insureds were bound by the terms of the endorsements.
Under those terms, since no wrongful conduct on the part of the
subcontractor was alleged, the policy did not cover the additional
insureds and the subcontractor's insurer had no duty to defend
the additional insureds.
As a practical matter, American Country illustrates the
importance of closely examining all underlying insurance policy
documents when coverage is purportedly being provided by a third-party.
As the additional insureds discovered in American Country,
the mere fact that one is named as an "additional insured" under
a subcontractor's general liability policy is no guarantee that
the coverage being provided is consistent with that which has
been contractually promised. As is evident from the result,
the failure of the additional insureds in American Country
to properly investigate the scope of coverage being provided by
their subcontractor later proved to be a costly mistake.
4th CIRCUIT HOLDS LACK OF
FORMAL TERMINATION DOES NOT BAR PERFORMANCE BOND CLAIM
A performance bond serves as a guarantee that
work that is the responsibility of the surety's principal will
be performed. The bond typically sets forth: (1) the scenarios
which trigger the surety's guarantees under the bond; and (2)
the means by which the bond obligee may then secure completion
of the principal's work. In Siegfried Construction, Inc.
v. Gulf Insurance Co. et al., 2000 U.S. App. Lexis 1304 (4th
Cir. Feb. 2, 2000), the Fourth Circuit Court of Appeals considered
whether the bond obligee must strictly comply with the terms of
the bond in order for the surety to be held liable under the bond.
In Siegfried, a subcontractor contracted to perform drywall
and other work in the construction of a hotel in Rockville, Maryland.
The subcontractor's surety issued a performance bond on behalf
of the subcontractor which provided that, whenever the subcontractor
"shall be, and be declared by [the general contractor] to be in
default under the subcontract, . . . [the general contractor],
after reasonable notice to Surety may . . . arrange for the performance
of [the subcontractor's obligation under the subcontract . . .
."
In response to poor performance and delays caused by the subcontractor,
the general contractor sent the subcontractor a first and second
"Notice of Termination for Failure to Perform," each detailing
deficiencies in the subcontractor's work and threatening termination
unless corrective actions were taken. When the corrective
actions did not take place, the general contractor then sent a
follow-up to the second notice, advising that it intended to exercise
its right to supplement the subcontractor's workforce in order
to complete the work. Thereafter, the general contractor
sent the surety copies of the Notices of Termination and a "Notice
of Claim," in which the general contractor alerted the surety
to its threat to terminate the subcontractor, its supplementation
of the subcontractor's workforce, and the likelihood that it would
seek reimbursement of its costs in completing the subcontractor's
work. In discussing its claim with the surety's investigator,
the general contractor reiterated its request for help from the
surety to complete the subcontractor's work. The general
contractor never actually formally terminated the subcontractor.
When the surety refused to pay the general contractor's claim
for the cost of completing the subcontractor's work, the general
contractor brought suit against the surety. At the conclusion
of the trial, the federal district court issued a judgment for
the surety on the grounds that the general contractor's "Notice
of Claim" was neither a sufficient declaration of the subcontractor's
default nor adequate notice to the surety of the general contractor's
arrangement for completion of the subcontractor's work.
As a result, the general contractor was held to have neither met
the conditions nor followed the means of completion prescribed
by the bond.
On appeal by the general contractor, the Fourth Circuit reversed
the lower court's judgment. As to the bond conditions, the
court held that the general contractor's repeated notices to the
subcontractor, and "Notice of Claim" to the surety, advising that
the subcontractor's work was defective and threatening to terminate
the subcontractor for default, was a sufficient declaration of
the subcontractor's default to meet the requirements of the bond.
Importantly, the Fourth Circuit held that the general contractor
was not required to formally terminate the subcontractor to declare
its default.
Furthermore, the court found that the "Notice of Claim" sufficiently
informed the surety that the general contractor was supplementing
the subcontractor's workforce and was in fact taking steps to
complete the subcontractor's work. Moreover, the court noted
that the general contractor had informed the surety's investigator
that it needed the surety's assistance in completing the subcontractor's
work. As a result, the Fourth Circuit concluded that the
general contractor had in fact provided adequate notice of its
arrangement to complete the subcontractor's work to the surety,
thus complying with one of the completion alternatives prescribed
by the bond.
The Siegfried decision indicates that the Fourth Circuit
will not apply bond requirements against contractors narrowly,
but rather will look to all surrounding circumstances for evidence
of substantial compliance with those requirements. Moreover,
Siegfried rejects the notion that contractors must formally
terminate subcontractors in order to invoke the protections of
a surety performance bond. It should be noted, however,
that it is unclear whether all courts would decide these issues
as the Fourth Circuit did. Therefore, contractors and owners
are well-advised to follow all termination procedures exactly
as set forth in their bonds and contracts and/or to seek the advice
of counsel.
MARYLAND COURT HOLDS SUBSTANTIAL
COMPLIANCE WITH LICENSING REQUIREMENT IS SUFFICIENT
Building contractors must comply with licensing
requirements or risk forfeiting the right to enforce contracts
through the judicial system. In Dereggi Constr. Co. v.
Mate, 130 Md. App. 648 (2000), a Maryland contractor entered
into a contract to build a custom home. The contractor did
not have a Montgomery County building contractor's license at
the time of the agreement as required under the County's Code.
However, the contractor obtained a license before actual commencement
of the construction work. As the construction of the home
neared completion, a disagreement arose between the parties.
The owner contended the contractor had failed to fully complete
the home as required by the contract while the contractor claimed
that additional work performed during the construction of the
home remained unpaid.
The contractor filed a petition to establish a mechanic's lien
to collect the amount allegedly due. The owner then moved
to dismiss the petition on the grounds that the contract was void
and unenforceable because the contractor had not obtained a building
contractor's license prior to entering into the contract.
The circuit court granted the owner's motion to dismiss and the
contractor appealed.
In considering the contractor's appeal, the Maryland Court of
Special Appeals recognized that where a statute is regulatory
in nature, protects the public, and does not merely raise revenue,
the unlicensed party may forfeit the right of assistance of the
courts in enforcing the contract. After considering the
specific statute in question, Section 31C-2 of the Montgomery
County Code, the court held the statute in question protected
the public by ensuring that builders are capable of both complying
with the laws and fully performing the contracts they enter.
Further, the court determined the licensing fees in this case
did not merely raise revenue as the fees only reimbursed the costs
of administering the Montgomery County licensing scheme.
Notwithstanding the above, the appellate court concluded that
substantial compliance with the licensing statute is all that
is required because the legislative purpose of the statute could
be realized without enforcing all of its requirements. In
reaching this decision, the court reasoned that: (1) the criminal
and civil penalties for an unlicensed contractor are sufficient
incentives to draw compliance and (2) inequity and hardship would
result if contractors could not obtain relief where they diligently
performed a contract.
Accordingly, the Maryland Court of Special Appeals remanded the
case to the lower court to determine whether the building contractor
did in fact substantially comply with the licensing statute.
While the court did not provide much guidance to the lower court
as to its definition of "substantial compliance," the court suggested
that compliance which "affords the public the same protection
that strict compliance would offer" might be sufficient.
Thus, it remains to be determined whether a contractor's failure
to obtain a contractor's license at the time of contract formation
but before performance of the contract will be deemed "substantial
compliance" with the statute.
The Dereggi Construction case illustrates the importance
of strictly complying with contractor licensing statutes.
While Maryland requires only "substantial compliance" with its
licensing requirements, other states may require strict or absolute
compliance. Given the potentially drastic consequences which
could result from non-compliance, contractors must keep abreast
of, and endeavor to strictly comply with contractor licensing
requirements in all jurisdictions in which they operate.
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