Will Subcontractor Default Insurance Still Have Value in the Recovering Economy?

Nicole Lentini and Rebecca Clawson Juhl | Construction Law Blog

The COVID-19 pandemic has burdened subcontractors with workforce shortages, supply chain issues, and financial difficulties. Therefore, as states lift their stay-at-home orders issued to limit the spread of COVID-19 and construction projects resume, subcontractors’ ability to complete demanding, time-sensitive projects might be impacted. Subcontractor default is already a common and costly problem for general contractors. When subcontractors fail to complete their contractual obligations, a general contractor’s profitability and reputation are greatly impacted. Effectively managing the risk of subcontractor default will be increasingly important for general contractors in the post-pandemic economy.

Subcontractor Default Insurance (“SDI”) is a non-traditional insurance product which can minimize a general contractor’s damages resulting from a subcontractor’s default. It is a two-party indemnity agreement between a general contractor and insurer. It was created as an alternative to surety bonds, with the idea that the general contractor controls the default process and remedy to help keep projects on time and within budget. Under a SDI policy, a general contractor enrolls prequalified subcontractors for either a specific project or policy term. Then, the general contractor is indemnified by the insurance company for any covered costs incurred if one of the subcontractors defaults. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.

In addition to direct costs, SDI coverage usually includes indirect expenses such as liquidated damages, acceleration of other subcontracts, increased overhead and the like. The insurer shares the risk with the general contractor through a deductible and co-pay; the general contractor absorbs some of the costs associated with a subcontractor’s default, usually up the deductible amount. SDI coverage extends to the limits of the individual policy rather than being limited to the value of the subcontract.

In order to lessen their risk, SDI carriers require general contractors to prequalify subcontractors before they can be enrolled on the policy. General contractors are in charge of this process. In order to evaluate a subcontractor both operationally and financially, subcontractors must submit the following types of information: financial statements, proof of available lines of credit, safety record, and history of claims and litigation. For subcontractors, the prequalification process is not different than that for surety bonds, except that it is executed by the general contractor instead of a professional surety underwriter.

After the COVID-19 pandemic, insurance carriers will necessarily adjust their outlook on subcontractors due to the increased risk of loss. Therefore, it will likely be more difficult for general contractors to find subcontractors able to prequalify for SDI policies and, in any event, the process will become more tedious. In addition to the aforementioned information, general contractors will probably be interested in subcontractors’ business continuity plans and specific plans to mitigate impacts like loss of employees and/or project shutdowns.

General contractors must be large and sophisticated enough to have the resources necessary to properly pre-qualify subcontractors, including assessing the financial risks of accepting subcontractors, and monitor their schedules and performance for the duration of the project. While the pre-qualification process is necessary, it is insufficient to thoroughly manage the risk. Even a subcontractor who is prequalified at the outset of a project must be managed throughout the entire course of work. A general contractor’s oversight of subcontractor performance will be even more critical in the post COVID-19 economy as subcontractors are more likely to be operationally and financially stretched thin.

In order to even qualify for SDI insurance, a general contractor typically needs minimum annual subcontractor volume in the $50-$100 million range. In fact, for SDI to be cost-effective, carriers say that annual subcontracted values must exceed $75 million. This is because SDI is expensive, usually ranging from 0.4 to 0.85 percent of total subcontract values.

Given the increased risk of subcontractor default, SDI policies will likely be even more expensive as the economy recovers from the COVID-19 pandemic. Deductibles, which are already high, are likely to increase. Currently, it is not unusual for a deductible to be in the $500,000 range. In addition to that, SDI policies have a co-pay which is paid up the retention aggregate—often three to five times the deductible. That said, SDI will still have value and provide cost savings under the right circumstances. For very large jobs, it would be worth taking on part of the financial risk of default for general contractors to accept SDI’s high deductibles because it would cost much less (now typically 50% less) than subcontractors bonding and passing along costs within their bid. Another consideration is whether the costs can be absorbed by the project. General contractors can also strategically utilize SDI to target high-risk subcontractors.

Cost will not be the only determinative factor in evaluating SDI’s value after the pandemic. It is possible insurers will write more exclusions into policies to manage their own risk associated with impacts associated with mandated shutdowns similar to what the United States recently experienced. Accordingly, subcontractor default stemming from such a shutdown (including impacts like workforce shortages and supply chain backlogs) would unlikely be covered. SDI policies also generally do not cover defaults, which result from the following: misrepresentation, fraud, defaults occurring prior to the policy period, material breach of warranty by the contractor, contracts acquired from other entities, war and losses arising from providing professional services.

To determine whether or not SDI is a worthy investment, a general contractor must separately evaluate each project, and carefully weigh the cost, potential savings and risk involved.

A Challenge Regarding the Interpretation of a Project Condition of Approval may be Filed More than 90 Days Following the Project Approval

David Blackwell | Allen Matkins

On June 25, 2020, the Fifth Appellate District decided Honchariw v. County of Stanislaus, holding that an applicant’s challenge to a local agency’s interpretation of a project condition of approval was not barred by the Subdivision Map Act’s statute of limitations because it was not a challenge to the validity of a condition of approval. This decision is important for developers, as the 90-day statute of limitations under the Subdivision Map Act (at Gov. Code § 66499.37) and the Planning and Zoning Law (at Gov. Code § 65009(c)(1)) is extremely short, and conflicting interpretations regarding a condition may not arise until months or years later. This decision provides developers with an opportunity to challenge conflicting interpretations of a condition so long as the lawsuit is filed within 90 days after the conflict has materialized.

DISPUTED VESTING TENTATIVE MAP CONDITIONS OF APPROVAL REGARDING WATER SERVICE

In Honchariw, the County Board of Supervisors conditionally approved subdivider Honchariw’s application for a vesting tentative map in 2012. This approval followed years of litigation between Honchariw (as a prolific pro per litigant) and the County regarding this riverfront property that his family had owned for decades. A primary concern was the source of water service for the subdivided lots. The County therefore imposed four conditions to the vesting tentative map approval that sought to address this issue.

During the ensuing several years, Honchariw and County staff worked to address the property’s water supply, but in 2017, the County interpreted the subject conditions to require a fire suppression system that was contrary to Honchariw’s understanding. Honchariw argued that the County’s interpretation “came at him out of the blue” because the Community Services District’s system could not supply the required flows to make fire hydrants functional, as now required by the County. The parties continued to negotiate, with Honchariw insisting that a functional fire suppression system was not required for approval of the final map and could instead be built out as the lots were developed. The parties reached an impasse in the summer of 2017, five years after the vesting tentative map was approved.

A CHALLENGE REGARDING THE INTERPRETATION OF A CONDITION DIFFERS FROM A CHALLENGE TO THE VALIDITY OF A CONDITION

After the trial court conducted a hearing on the merits, it denied Honchariw’s petition and complaint. On appeal, the County argued that to the extent that Honchariw was challenging the project’s conditions of approval imposed in 2012, the challenge was barred by the 90-day statute of limitations set forth in Government Code section 66499.37 relating to decisions regarding subdivisions, including “the reasonableness, legality, or validity of any condition attached thereto.”

Honchariw argued, and the appellate court agreed, that his challenge was not to the validity of the subject conditions, but to the County’s “misinterpretation and misapplication” of the conditions, and that the parties’ respective stances regarding the meaning of the subject conditions were not clarified until July 2017. The court held that Honchariw’s claim did not “accrue” until then, so the filing of the lawsuit on August 25, 2017 was not time-barred by the Map Act’s 90-day statute of limitations.

NO DEFERENCE TO A LOCAL AGENCY’S INTERPRETATION OF PROJECT CONDITIONS

In the unpublished portion of the opinion, the Court sought to interpret the disputed conditions of approval, and remanded the matter to the trial court to resolve conflicting evidence in the record. In so doing, the appellate court applied the general principles for construing written instruments, provided that the principles do not undermine the purposes of the Subdivision Map Act.

The Fifth District also declared that while courts typically defer to a local agency’s interpretation of its own administrative rules, such deference was not appropriate when interpreting a subdivision’s conditions of approval, and that a court should instead “resolve any ambiguity in the conditions of approval in a manner consistent with the objectively reasonable expectations of the applicant.” Failing to do so would “undermine the purpose of the vesting tentative map statute.” The court further stated: “we are not bound to accept the local agency’s interpretation of a condition of approval simply because that interpretation is one of multiple reasonable interpretations. Such an approach would reward local agencies that draft ambiguous conditions of approval by giving them flexibility not conferred by clearly drafted conditions.”

IMPLICATIONS OF HONCHARIW

Although the facts of this case are limited to the Subdivision Map Act’s 90-day limitations period, the Planning and Zoning Law has similar language regarding actions to “determine the reasonableness, legality, or validity of any condition attached to a variance, conditional use permit, or any other permit” (Gov. Code § 65009(c)(1)(E)), thus the rationale in Honchariw would arguably be applicable to disputes regarding the interpretation of basically any project condition of approval.

This decision thus provides developers with a litigation option in the event of a dispute regarding the interpretation of one or more conditions of approval long after the project is approved.

Although the unpublished portion of the opinion cannot be cited as authority, it is provocative in its refusal to provide deference to a local agency’s interpretation of a project condition that it imposes and its admonishment of local agency attempts to impose ambiguous conditions that the agency can interpret to its advantage following the project approval.

The Impact of COVID-19 on the Construction Industry: Planning for the Inevitable

Neil Keenan, William Abramovicz and Matthew Bedan | Forensic Risk Alliance

The COVID-19 pandemic continues to impact all facets of the global economy, disrupting supply chains and work forces, and straining contractual relationships between businesses. These issues are especially important in the construction industry, which traditionally relies on precise schedules of workers and material, and endeavors to limit potential delay claims in order to ensure profitability. These critical schedules are being impacted in a variety of ways, including changing government executive orders, sick or quarantined workers, and supply chain interruptions. In many cases, COVID-19 orders from public officials impose new job site standards, such as mandatory social distancing, use of personal protective equipment, and quarantine periods for workers crossing state lines. In many areas, projects are shut down completely. For example, 85% of New York City operating sites were on pause by mid-April. As the industry reacts, we can expect an uptick in related litigation in the form of breach of contract actions and force majeure claims.

It is critical for construction firms to plan for this disruption to protect assets, ensure business continuity and renegotiate project planning and financing, with labor shortages among the primary concerns. This may be caused by the illness itself, mandatory state/local government quarantines, or even union guidelines encouraging workers to stay at home. This was the case when the North America’s Building Trades Unions (NABTU) and the Center for Construction Research and Training (CPWR) urged anyone feeling sick to not go to work on March 11 this year. Travel restrictions could similarly limit the availability of high-skilled personnel who are essential for the completion of specific key tasks, like experts traveling from one project to another to help teams on the ground resolving technical issues. In addition, certification visits and inspections may be delayed or canceled, resulting in delays for otherwise functioning construction sites.

The pandemic is squeezing supply chains and creating difficulties including late or canceled deliveries, and price escalation from suppliers. The consequence is that many construction sites have been shut down for an indefinite period of time. On March 27, ABC News reported that Ken Rigmaiden, the general president of the International Union of Painters and Allied Trades, estimated that “half of the construction sites in the country have shut down since the COVID-19 pandemic began.” These closures generate significant unanticipated costs that could grow due to extended periods of storage for some materials and equipment, which were delivered before the shutdown but have not yet been installed. There are also many construction sites with dangerous or valuable materials that must be secured and maintained around the clock, quarantine orders notwithstanding. Finally, late payments from customers may have a significant impact on firms and their capacity to finance the goods and services required to complete a project. As much of the world economy remains locked down, alternative financing sources begin to diminish, further endangering projects.

As COVID-19 testing increases and the required personal protective equipment becomes more readily available, we can expect work to resume on many sites, but not without glitches. In the short term, demand for construction materials and skilled resources likely will remain high. Shortages of key variables combined with cash flow and financing difficulties will result in additional costs and delays, potentially further fueling the litigation wave.

Businesses should remain aware of fraud risks inherent to the unprecedented situation.  The shortage of supplies and materials could lead suppliers to break contractual terms related to pricing so they could sell their goods to other customers willing to pay a higher price. This period of inactivity is also favorable to assets misappropriation. For example, inventory checks should be performed before and after the shutdown, as the risk of materials disappearing or being diverted would increase.

Businesses with ongoing construction projects’ top priority should be to document every event causing a delay or cost increase. Documenting this evidence daily is critical to establishing a potential claim—or defending against one—and later quantifying damages. At FRA, we have experience establishing and supporting—or defending against—such claims, including preparation of economic damages and quantum models, and providing forensic analysis of overcharges, improper payments, questionable or unsupported costs and other allegations. For example, we recently assisted an NYSE-listed real estate development firm with a multi-million dollar dispute involving one of its construction sites in India. This review included key vendor analysis, tax and royalty payments, daily construction reports, actualized project schedules, personnel interviews and onsite visits spanning multiple cities, which resulted in evidences of invoice padding. FRA has also achieved remotely what others could not, by deploying remote data collection, remote transaction testing, remote interviews, and other remote procedures. We plan to continue using these solutions in order to help our clients navigate through this pandemic and beyond.

Plot Twist: Construction Industry Groups Applaud Court’s Decision to Defer to OSHA

Lexie R. Pereira | Forum on Construction Law

Construction industry association groups applaud the June 11, 2020 U.S. Court of Appeals for the District of Columbia’s decision, which denied the AFL-CIO’s (American Federation of Labor and Congress of Industrial Organizations) emergency petition for a writ of mandamus against OSHA (Occupational Safety and Health Administration).1 In what some may call a surprising turn of events, the construction industry is celebrating deference to OSHA.
The administrative petition, filed on May 18, 2020 by the AFL-CIO, together with 23 national unions, was intended to compel OSHA to issue an emergency temporary standard (“ETS”) to protect U.S. workers against COVID-19. OSHA is authorized to issue an ETS upon its determination that an ETS is “necessary” because “employees are exposed to grave danger” in the workplace. 29 U.S.C. §655(c); see In re AFL-CIO, USCA Case #20-1158, (D.C. Cir. 2020). The court stated that OSHA is owed “considerable deference,” especially in these unprecedented times, and found that it acted reasonably when it determined not to issue an ETS at this time. In re AFL-CIO, USCA Case #20-1158, (D.C. Cir. 2020).
Construction industry association groups, such as the Associated Builders and Contractors and National Association of Home Builders, are happy with the decision because they considered an ETS to be an inappropriate measure in such turbulent times. Following the decision, OSHA will continue to develop guidance documents. Not only does this approach allow the agency to swiftly adapt to new COVID-19 information released by other government officials and scientists, it also allows OSHA to continue to rely on the Centers for Disease Control and Prevention.
The problem with this approach, as alleged by AFL-CIO, is that these guidance documents are not mandatory. As follows, AFL-CIO and its supporters are disappointed with the decision, claiming that OSHA’s guidelines are too flexible in that they do not pose a threat of OSHA action for an employer’s noncompliance. Given that OSHA in-person checks of construction sites have fallen to about 16% of pre-COVID-19 inspection levels, the concern may not be unfounded.2 Construction workers, perhaps to a layperson’s surprise, were among the most universally essential workers during the pandemic. This fact can be concerning since, as mentioned by Gaetano Piccirilli and Patrick McKnight in an earlier Dispute Resolver blogpost, construction workers had one of the highest mortality rates during the 1918 Flu pandemic. The combination of higher risk and less frequent OSHA visits may be a reason complaints have increased nearly tenfold.3 In fact, the AFL-CIO’s petition set forth that thousands of workers have been infected on the job.
Nonetheless, construction sites are certainly not going unwatched. Instead, the decrease of OSHA visits is most likely replaced with an increase of state and local inspections. States like Massachusetts, for example, have implemented their own Mandatory Workplace Safety Standards and sector-specific workplace protocols, including Safety Standards for Construction. And although nobody knows exactly how to proceed during COVID-19, after the U.S. Court of Appeal’s decision, at least some construction industry groups are comfortable leaving it up to the “experts.”
Learn more about the scope of OSHA, the extent it preempts (and does not preempt) state and local government action, and what state and local governments are doing to ensure the safety of workers within their jurisdictions at an upcoming ABA webinar on June 29 at 1 pm ET. More details here: https://www.americanbar.org/events-cle/mtg/web/401521567/.



Court Rejects Bid for OSHA COVID-19 Emergency Standard, CONSTRUCTION DIVE (June 12, 2020).
OSHA Construction Safety Inspections Plunge 84% in Pandemic, BLOOMBERG LAW (May 14, 2020).
Id.

Do We Need Blockchain in Construction?

Cristina Savian | AEC Business

Blockchain technology claimed to have the potential to disrupt many aspects of how companies do business. And like other emerging technologies, I have been exploring its uses, benefits and assessing its potential opportunities in the construction industry. If like me, you have been wondering what it is and if its applications are limited to financial services and cryptocurrencies; you will be pleasantly surprised to discover that it has a lot more applications with exciting opportunities for our sector too.

Blockchain could have a significant impact on our industry.  In writing this article I have discovered that the Australian government is full steam ahead, that many organisations are currently building their own blockchain networks and that it is something that businesses right across the built environment should be preparing for now.  But more on that soon, first we need to define what blockchain is.

Blockchain is a nascent technology that can simplify and secure transactions among parties. It is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network. An asset can be tangible (a house, a car, cash, land) or intangible (intellectual property, patents, copyrights, branding). Virtually anything of value can be tracked and traded on a “block” with its most significant benefits removing the need for a middle-man to “secure” the transaction, hence promising to remove/or reduce the cost of brokers, bankers, lawyers, retailers significantly. This is because “the system” acts as security, as it is decentralised and not stored in any single location. Participants in the network called “miners” confirm the transactions, or “blocks.” So there is no need for a trusted third-party intermediary. Blockchain can thus have powerful applications in all those transactions where we currently need an intermediary, such as payments, supply chains, voting and much more.

“Blockchain is the first native digital medium for value, just as the internet was the first native digital medium for information.”

Harvard Business Review

Blockchain is built on four main concepts:

  1. It is a distributed ledger, so every user of the network has simultaneous access to a view and verify the information stored.
  2. Cryptographic functions ensure the integrity and security of the information.
  3. Participants confirm changes directly with one another. This replaces the need for a third party to authorise transactions.
  4. It can run additional business logic “known as smart contracts” that allows the agreement on and automatic enforcement of the expected behaviour of a transaction or asset embedded in the blockchain.

It all sounds exciting, and I am sure like me you are immediately grasping the potential of removing intermediary in the construction lifecycle aiming at simplifying the landscape as well as reducing costs, increase efficiency and reducing time to value. But how do we identify the need for one? How do we put this into practice? How can this new technology be of any use for the construction sector?

Late last year I attended MelBIM in Melbourne, and I had the pleasure to finally meet in person another digital construction trailblazer like me Belinda Hodkinson. Belinda did an excellent presentation on the uses of Blockchain technology in construction and the superb work Australia is doing in embracing the potential of this new technology. I had the pleasure of interview Belinda for this article “strickly following social distancing rules”.

Q.What is Australia doing in terms of blockchain?

Belinda: “It is an exciting time, the Minister for Industry, Science and Technology (Hon Karen Andrews) and the Minister for Trade, Tourism, and Investment (Hon. Simon Birmingham) have jointly announced the development of a National Blockchain Roadmap for Australia. This was announced in early February 2020, with the release of the National Blockchain Roadmap. The detail of the roadmap has 12 signposts to reach from 2020 – 2025 based on forming the National Blockchain Steering Committee through to enabling digital trade infrastructure.  This does not come without challenges, though, as we have noticed with our COVID-19 restrictions, a lot of Australian Law is not written to support technological advancements. The exciting part is the government agencies that have been clarifying and, in some instances, changing to enable the use of blockchain or more specifically crypto-currencies and DLT (Distributed Ledger Technology) which is helping to allow the growth within the country.”

Q.What does this mean for the construction industry?

Belinda: “There are many areas that this technology can assist in our industry; the easiest way to categorise them is by the type of blockchain;

  • Public – Open network and anyone can download the protocol and read, write or participate.
  • Private – Managed by one entity this is an invitation-only network where participants require permission to read, write or audit the blockchain.
  • Consortium/Federated – Generally the same as a private blockchain except it is managed by several entities. The general relationship can be that some aspects of the chain (root hash) may be open to the public.

I expect private and the consortium type networks will be the first forms of blockchain for the construction industry as it will be a change management process. As the industry becomes confident, we will start to graduate into more public solutions.”

Q.I can certainly see the potential, but you lost me at the “root hash”. Can you give some real example of applications without going into the technical details?

Belinda: “An excellent example in the use of the private blockchain is when Walmart used IBM Hyperledger fabric to track food from the source. If we looked at this in our industry, the Environment Protection Agency could track items like soil contamination to reduce incidents where new allotments may unexpectedly use contaminated soil. Another example could be to track raw materials through the lifecycle to ensure the finished product has been produced to our Australian Standards and not compromised with lower-performing compounds. The list is astronomical and would add fantastic value to the integrity of our final products. Not to mention the safety it adds, being able to track back through the material used on projects.
An excellent example of the consortium type of blockchain would be for large public construction projects. They have multiple departments involved, and if it is a Public-Private Partnership or Alliance contract, the number of entities will expand to private partners too. Speaking to members of a state treasury a few months ago, they said there are many material deliveries, trades etc. that still suffer not getting paid for their work quickly enough. Creating this type of blockchain has the potential to verify delivered or completed works by multiple sources and have payments issued in a shorter timescale. This could be activated through the use of a Smart Contract.”

Q. Can you explain what a smart contract is?

Belinda: “Sure. A smart contract has three elements;

  1. It is an agreement between two parties,
  2. It is when the transaction can be processed digitally over the blockchain, and
  3. The transaction is only to occur when the conditions of the agreement are met.

In construction, an example could be the agreement between the construction joint venture (CJV) and the service provider such as a plasterer. The plasterer may require payment by CJV with work completed as for agreed milestone. In simple terms, the contract may say: When the plastering is completed to a level and digitally confirmed by both parties “the plasterer and CJV on the blockchain” payment to the plasterer can be release. Noting that digital confirmation on the blockchain could be as easy as an app on a tablet or smartphone.”

Q.Many thanks for your insights! A final comment, the potential for both small and large construction projects is enormous, so how do we get to there?

Belinda: “Good question! Smart contracts are currently not legally binding. They are machine-readable and need to be executed by a human to make legal. It sounds a little familiar, doesn’t it?, particularly with the recent laws changed for COVID-19, now allowing virtual meetings for local councils and state parliament politicians to work remotely. OK, so it is a little far from that, but hopefully, you can see the parallels to digital uses. The in-between method to a smart contract is what is called a Ricardian contract. Which is generally the same as a smart contract, but the arrangement is both machine and human-readable. It defeats the purpose a little, but it does allow for an intermediate solution until we are comfortable that the machine-readable and executed contract is doing as we expect and that a human is responsible for it. In terms of how it will change what we do now, I think primarily, the biggest change will be the technology helping to establish transparency on the execution of a large project. At the moment with Ricardian contracts, the machine version will be running in parallel with the human-readable version. The change is in the way the contract is worded, verified, and executed.

Like much many new emerging technology, the implementation of blockchain in the construction industry brings a lot of potential use cases, benefits but also challenges that need to be weighted with the overall short-term and long-term costs of its implementation.

As one of the largest in the world economy, construction plays an important economic role. As we have seen during the current pandemic, it also plays an essential societal role – receiving high praise from politicians and officials for its contribution to increasing the capacity of hospitals and by building required temporary facilities. In many countries, public construction has been one of the few activities that have been maintained, highlighting its essential service vital role to our modern society. But with profit margin being at its historical low, this pandemic put even more pressure in the sector which was already struggling. Now more than ever; it is necessary to bring innovation into the industry. This crisis has fast-tracked digital transformation in many areas, and I am confident we will see this trend finding its forceful way into our industry too. It is now imperative to leverage its benefits through the means we procure, deliver and maintain our built assets. The need for accurate and reliable ‘digital’ information that stakeholders can “trust” to make key, faster and better decisions throughout the construction lifecycle has never been so critical, and blockchain has undoubtedly the potential to bring those much-needed productivity improvements our construction sector is seeking to compete on a global scale.