Do You Really Want Mandatory Arbitration in Your Construction Contract?

Christopher G. Hill | Construction Law Musings | May 14, 2019

If you are in construction, you have likley run across (or even drafted) a dispute resolution provision into your construction contract.  If you’ve been building for any length of time, you’ve read dispute resolution provisions containing mandatory arbitration clauses.  These clauses can be found in the AIA documents and in many of the contracts that I review for my clients in my role as construction lawyer and counselor.  More often than not, these arbitration clauses require arbitration (read “private court”) and refer to one of several sets of rules, though most likely the American Arbitration Association (“AAA”) Construction Industry rules.  In Virginia, as in most of the United States, these clauses are read liberally and enforced by courts except in limited cases such as waiver.

The main justification for requiring arbitration over litigation is to avoid the fees and expense of the litigation process.  In the right circumstances, arbitration does just that.  With a carefully drafted arbitration clauses and with the right case that requires expertise in construction that a judge does not have (they have to liten to all manner of disputes so are necessarily generalists), arbitration can and should be a streamlined and less expensive version of litigation.

However, in my time as a construction attorney, I have more often run into situations where the arbitration process is at least equally expensive and frankly not much more streamlined.  The additional administrative burden coupled with the possibility of paying for at least half of the hourly charges of one to three arbitrators is often not worth the additional expertise of those arbitrators.  Many construction claims simply come down to non-payment and whether the work was performed properly.  In my opinion, the fine judges in the Commonwealth of Virginia are more than capable of hearing this evidence and making a ruling.

Does that make arbitration the wrong choice in every instance? No.  I added “mandatory” to the title of this post for a reason.  Parties can always agree to arbitrate (or even better mediate)regardless of the contract. Even better, in our fine state where the contract is king, the dispute resolution provision can allow for a choice to be made between litigation and arbitration at the time of the claim.  This allows for flexibility and use of the appropriate tool for the job.

Where arbitration is the right way to go, that can and should be the choice, however where it is not the right way to go, mandatory arbitration clauses force the use of a process that may not be the best for either party to the contract.

Ambiguity Kills in Construction Contracting

Christopher G. Hill | Construction Law Musings | April 19, 2019

Well, I’m back and hope to have a more consistent publishing schedule moving forward.  I appreciate the continued readership through what has been a busy time for my solo construction practice over the last couple of months.  Now, back to our program. . .

Here at Construction Law Musings, I have often beaten the drum of a solid contract that leaves as little as possible to chance or the dreaded “grey areas” where we construction lawyers like to make money.  An example of the issues that can arise from ambiguity can be found in a case from 2017 in the Western District of Virginia, W.C. English, Inc. v. Rummel, Klepper & Kahl, LLP et al

In this case, English, a general contractor, entered into a contract for Quality Assurance (QA) functions with RK&K, the defendant, on a contract English entered into with the Virginia Department of Transportation (VDOT).  Needless to say, because this would not be a post at Musings otherwise, there were issues with the QA performed by RK&K leading to additional costs for English to correct certain work that did not comply with the contract documents between VDOT and English.  English sued for breach of contract based upon a term sheet, signed by the parties, from RK&K that required RK&K to indemnify English for claims by VDOT that related to RK&K’s work (the English Term Sheet).  RK&K moved to dismiss the complaint based upon a different term sheet, also signed by the parties, which stated that RK&K could not be held responsible for English’s failure to perform pursuant to the contract documents (the RK&K Term Sheet).

The Court, in looking at these seemingly (and actually) contradictory clauses in the two term sheets found that the terms of the “subcontract” (meaning the two term sheets) were ambiguous and therefor denied the motion to dismiss.  In doing so, however, the Court limited the possible liability to those negligent acts of RK&K as found in the more specific language of the English Term Sheet.  In doing so, the Court stated as follows:

Accordingly, the Court finds that the Subcontract does not, as a matter of law, preclude Plaintiff’s breach of contract and indemnity claims because the Subcontract can be reasonably interpreted to permit breach and indemnity actions against RK&K “to the extent directly caused by the negligence of subcontractor but not to the extent caused by the acts or omissions of [English] or its subcontractors or consultants of any tier.”

In short, the parties created an ambiguity between them that precluded the result the RK&K wanted and limited the result that English wanted.

The lesson?  In my mind it is that the expensive proposition of litigation can be made less so with clearer contracts.  While this is a fairly extreme example (there are 2 contradictory written term sheets), ambiguities in construction contracts give lawyers room to argue where clarity simply gives lawyers room to point to the contract.  The second is almost always a better situation for a construction professional than the first.

Design Professional Asserting Copyright Infringement and Contributory Copyright Infringement

David Adelstein | Florida Construction Legal Updates | April 7, 2019

Standard form construction contracts between an owner and design professional will address copyright protection, as well as other contractual protections, associated with a design professional’s “instruments of service.”   An owner negotiating an agreement with a design professional should consider alternative language that broadens the scope of the contractual license given to it with respect to the use of the design.  Regardless, a design professional’s copyright infringement claim is still a challenging claim to ultimately prevail on.   While a design professional may likely survive the motion to dismiss stage in a copyright infringement claim, whether it survives the summary judgment stage is another, more challenging, story.

To state a claim for copyright infringement a plaintiff [design professional] must assert [and prove the following two prongs]: ‘(1) ownership of a valid copyright, and (2) copying of constituent elements of the work that are original.’” Robert Swedroe Architect Planners, A.I.A., P.A. v. J. Milton & Associates, Inc., 2019 WL 1059836, *3 (S.D.Fla. 2019) quoting Feist Publ’ns, Inc. v. Rural Tel. Serv. Co., Inc., 499 U.S. 340, 361 (1991).  

In the first prong, the design professional must establish it complied with statutory formalities to own a valid copyright. Id.

In the second prong, the design professional must establish that the defendant copied constituent elements that are original.  Id.

There is also a claim known as contributory copyright infringement.  

Contributory copyright infringement occurs where a party with knowledge of infringing activity materially contributes to the infringing conduct of another.” Robert Swedroe, 2019 WL at *4.   Actual knowledge is not required – it just needs to be shown the defendant had reason to know (i.e.,knew or should have known) of the copyright infringement.  Id. (citations omitted). 

For example, in Robert Swedroe, an architectural firm was hired by a developer to prepare plans and specifications in connection with a residential building project.  The contract was based off an AIA B141 agreement between an owner and architect. The architect was to initially prepare plans to obtain approval of the governing Planning Board and, upon approval, prepare the permit plans for the residential building.    Once the Planning Board approved the project, the developer sold the property to another developer. The new developer, however, hired another architectural firm–that was provided and had access to plans from the initial architect–with the intent on moving forward with the design and construction of the residential building.

The original architect submitted its technical drawings and architectural work to the United States Copyright Office and obtained a Certificate of Registration.   (Notably, this satisfied the first prong on the copyright infringement claim as the original architect satisfied statutory formalities).  The original architect sued the new developer and new architect for copyright infringement asserting the new architect copied original elements of its design for the residential building project.  The original architect also sued the new developer for contributory copyright infringement.  The new architect and new developer moved to dismiss the copyright infringement claims. Although the trial court denied the motion to dismiss, the original architect will still need to support the burden of its copyright infringement claims.  For more information on the difficulties proving a design professional’s copyright infringement claim, review this article.  

Illinois Supreme Court: Subcontractors No Longer Subject to Claims for Breach of the Implied Warranty of Habitability

Jeremy P. Brummond and Patrick J. Thornton | Lewis Rice | April 29, 2019

Recently, in Sienna Court Condominium Association v. Champion Aluminum Corporation, et al., the Illinois Supreme Court (“the Supreme Court”) held that if a purchaser of a newly constructed condominium or residence does not have a contract with a subcontractor who provided work as part of the building’s construction, then the purchaser cannot assert a claim for breach of the implied warranty of habitability against that subcontractor. The Supreme Court’s holding in Sienna was a major victory for subcontractors and suppliers in the residential construction industry in Illinois. It was a loss for purchasers, owners, and homeowner associations, particularly those whose possible relief against the developer or general contractor with whom they have contracted is no longer viable because that party is defunct or bankrupt.

Brief History of the Implied Warranty of Habitability in Illinois

The implied warranty of habitability protects the first purchaser of a new residence against latent defects that would render the residence not reasonably fit for its intended use. Illinois first started recognizing the implied warranty of habitability in 1979 in its Supreme Court’s decision in Peterson v. Hubschman Construction Co., 76 Ill. 2d 31 (1979). The Court found that the warranty was necessary for public policy reasons in order to respond to changes in the home construction market. By that time, homes had become, essentially, mass produced “from a model or from predrawn plans.” Buyers had “little or no opportunity to inspect” but were forced to “rely upon the integrity and the skill of the builder-vendor…The vendee has a right to expect to receive that for which he has bargained and that which the builder-vendor has agreed to construct and convey to him, that is, a house that is reasonably fit for use as a residence.” The Illinois Appellate Court for the First District (“the First District”) soon thereafter recognized an expansion of the implied warranty and held in Tassan v. United Development Company, 88 Ill. App. 3d 581 (1st Dist. 1980), that if the buyer contracted directly with a developer rather than a builder, then the developer-vendor similarly made an implied warranty of habitability to the buyer that the buyer could enforce against the developer.

However, it was unclear whether the implied warranty of habitability applied to subcontractors and suppliers with whom the buyer did not contract. Initially after Peterson, in Waterford Condominium Association v. Dunbar Corporation, 104 Ill. App. 3d 371 (1st Dist. 1982), the First District held that the implied warranty of habitability did not apply to the subcontractors of a builder-vendor. But the following year in Minton v. The Richards Group, 116 Ill. App. 3d 852 (1st Dist. 1983), the First District ruled to the contrary and held that where the purchaser of a newly constructed residence “has no recourse to the builder-vendor and has sustained loss due to the faulty and latent defect in their home caused by the subcontractor, the warranty of habitability applies to such subcontractor.” Although Minton’s reasoning would later be rejected in Lehman v. Arnold, 137 Ill. App. 3d 412, 417-18 (4th Dist. 1985) and Bernot v. Primus Corp., 278 Ill. App. 3d 751, 754-55 (2d Dist. 1996), asserting a claim for breach of the implied warranty of habitability against a subcontractor (and defending against such claims) was nevertheless common in Illinois over the past 35 years—until Sienna.

Sienna Court Condominium Association v. Champion Aluminum Corporation

In Sienna, a condominium association governing a two-building, 111-residential-unit property in Evanston, Illinois sued the property’s developer, general contractor, subcontractors, and others, alleging that latent defects resulted in water infiltration and other conditions that rendered the individual units and common areas unfit for their intended purposes. Unfortunately for the association, the developer and general contractor went bankrupt, which drastically limited any potential recovery from those entities. The subcontractors moved to dismiss the claims against them, which motion was denied, but the Circuit Court certified questions related to Minton under Rule 308 for an immediate appeal. The Illinois Supreme Court was asked to address whether, under Minton, “a plaintiff homeowner’s claims against a subcontractor for breach of an implied warranty of habitability are barred where either the plaintiff has potential recourse from insurance policies or where actual proceeds are received by the plaintiff from a warranty escrow account.” Instead, the Supreme Court considered an issue presupposing and underlying those questions: whether the purchaser of a newly constructed home may even assert a claim for breach of an implied warranty of habitability against a subcontractor who took part in the construction of the home, where the subcontractor had no contractual relationship with the purchaser. The Supreme Court held that the purchaser may not assert that claim and thus overruled Minton.

The condominium association, in Sienna, argued that the Supreme Court should recognize that the implied warranty of habitability is essentially a duty owed by every contractor, subcontractor, and supplier that performs work or provides material related to the construction of a residence. The association further argued that it (or any homeowner) “should be allowed to proceed directly against a subcontractor under a claim that is ‘analogous to a strict liability claim tort claim.’” The Supreme Court rejected that argument, reasoning that an implied warranty arises only by virtue of a contractual relationship between two parties: the home purchaser and the seller. Even if the warranty is not explicitly written in and expressed in the parties’ contract, the law recognizes that by virtue of the contract, only the seller has implicitly agreed to provide a home that is reasonably fit to be inhabited as a residence.

The Supreme Court further reasoned that the implied warranty is not analogous to a strict liability tort and does not exist independent of that contract, because it would be barred by the economic loss doctrine (better known in Illinois as the “Moorman doctrine”). The economic loss doctrine provides that a plaintiff cannot recover purely economic loss under the tort theories of strict liability, negligence, and innocent misrepresentation. Fireman’sFund Ins. Co. v. SEC Donahue, Inc., 176 Ill.2d 160, 164 (1997) (citing Moorman Manufacturing Co. v. National Tank Co., 91 Ill.2d 69 (1982)). An “economic loss” includes damages for inadequate value, costs of repair and replacement, or consequential loss of profits. Moorman, 91 Ill. 2d at 82. As alternatively explained:

The [economic loss] rule acts[DHL9] as a shorthand means of determining whether a plaintiff is suing for injuries arising from the breach of a contractual duty to produce a product that conforms in quality or performance to the parties’ expectations or whether the plaintiff seeks to recover for injuries resulting from the breach of the duty arising independently of the contract to product a nonhazardous product that does not pose an unreasonable risk of injury to person or property.

2314 Lincoln Park West Condominium Association v. Mann, Gil, Ebel & Frazier, Ltd., 136 Ill. 2d 302, 309 (1990).

A claim for breach of the implied warranty of habitability relates to injuries arising from alleged defects in quality, not defects creating an unreasonable risk of injury to person or property. Thus, under Moorman, the implied warranty of habitability cannot be characterized as a tort. Further, the Supreme Court stated in Sienna that to “allow what is, in effect, a tort claim to be brought directly against subcontractors by homeowners would undermine and, in some instances, render pointless these contractual obligations and restraints.”

Implications of Sienna

As a result of Sienna, purchasers of condos (and their associations) or of residences no longer have the ability to assert a claim for breach of the implied warranty of habitability against subcontractors if those parties do not have a contract. If the developer or general contractor with whom the purchaser has contracted is defunct or bankrupt, the purchaser might not be able to recover anything from an entity that participated in the construction of the home. However, in Sienna, the condominium association was able to recover approximately $308,000 from the developer through a warranty escrow fund that the developer had been required to establish under a City of Evanston ordinance. Going forward, similar local ordinances could be passed and/or enforced to require the establishment of warranty escrow funds, particularly if the developer had created a limited liability company for the project with the intention of shutting it down upon project completion.

Federal Court Rules Contractor Is Not Intended Third-Party Beneficiary under Owner-Engineer Agreement

Amandeep Kahlon | Buildsmart | April 23, 2019

In March, a Massachusetts federal court addressed whether a design-builder contractor could recover for breach of contract under an intended third-party beneficiary theory against a design firm hired by the project owner to complete 30% designs. In Arco Ingenieros, S.A. DE C.V. v. CDM International Inc., a Salvadoran contractor entered into a design-build agreement with the U.S. government to build eight schools and a health clinic in El Salvador as part of a hurricane relief effort.

The design-build agreement included 30% designs, which were to form the design criteria for the project. The agency had contracted separately with a U.S. engineering firm via a task order to complete the 30% designs. After construction started, the contractor alleged the designs provided by the agency were defective and did not actually constitute 30% designs. Ultimately, the contractor filed suit against the agency and the engineer. As one theory of liability, the contractor claimed to be a third-party beneficiary under the task order between the agency and the engineer. The engineer moved to dismiss the contractor’s complaint arguing that the contractor was not an intended third-party beneficiary under the task order.

The federal court agreed and entered an order dismissing the contractor’s breach-of-contract claim against the engineer. The court reasoned that nothing in the task order evidenced an intent that the engineer’s design work was to benefit the contractor. While the contractor may have been an incidental beneficiary of the task order, the task order language provided that the engineer’s express purpose under the agreement was to provide design services to the government agency only. The statements in the separate design-build agreement that the contractor could rely on the 30% designs produced under the task order did not alter the task order’s intent. The court found this approach consistent with other federal decisions holding that general contractors are generally not intended beneficiaries of owner-architect agreements.

While not surprising, the federal court’s decision in this matter demonstrates the complexity of commercial contract disputes in the construction industry. With owners, engineers, contractors, and subcontractors all entering into different interrelated agreements, there is always potential that a particular contract or subcontract will be detrimentally impacted by another party’s failure to perform under a different agreement on the project. For owners, they can manage these risks by making all downstream parties insert language into their contracts that shows the owner is an intended third-party beneficiary.

For contractors, engineers, and other parties that are more parallel in the contracting hierarchy, it may be more difficult to contract around these risks. A contractor can mitigate this risk by seeking indemnification or other protection from the owner or other direct contractual party for interference, negligence, or delays by non-parties. Additionally, the design-builder contractor here could have considered the 30% designs more closely, rather than relying on the owner’s representations, and the contractor could have requested an opportunity to review the design task order to evaluate the risks of relying on potentially defective design criteria.