Blockchain and Smart Contracts May Solve the Unsolvable Problem in Construction

Thomas D. Franklin and Brian R. Gaudet | Kilpatrick Townsend & Stockton | August 22, 2019

Every construction project, from contract negotiation through the payment of the final pay application, suffers from the same conundrum born out of every parties’ desire for certainty and finality. That problem is the issue of the exchange of lien waivers for payment. The issue is those parties lower in the construction chain are asked to provide unconditional lien waivers (swearing that they have already been paid) as part of their request to be paid. This happens all the way up the chain until you reach the top. It is borne out of the project financer’s desire to make sure that when they issue a progress or final draw on funding that they are achieving finality on costs of construction for everything that transpired prior to that draw. This, of course, helps insure that their investment in the project is not attacked by mechanics and materialmen’s liens filed by unpaid subcontractors and suppliers down the chain. (While the financiers typically have a superior priority in the property, the financiers would rather that the borrower occupy the property and pay them back in accordance with the repayment schedule, than to foreclose, fight over priority, and suffer loss from an insufficient recovery on foreclosure or to have to hold the property for some extended period of time.)

Several states have passed laws, and in other places, parties negotiate the exchange of a conditional release in exchange for a check, which would be followed up, in theory, with an unconditional release when the check is honored by the payor bank and becomes “good funds.” A conditional release is a compromise position that is sometimes rejected and it has its own problems. Rather than relying on a single executed document, a party would need to also have proof of the funding of the check in order to know whether it may rely on the conditional release or not. This need to look to external sources is less than ideal from the finance side.

There are other imperfect solutions to this problem up until blockchain and smart contracts, which may be the perfect solution. One solution was to have the prime contractor prepay its subcontractors prior to submitting what essentially would be a request for reimbursement from the Owner for what was already spent. The subcontractors, as a precondition to receiving that payment, would have already had to prepay their lower tiered subcontractors and suppliers. In theory, that solution works. In practice, it fails. The reason it fails is that the parties with the least financial wherewithal are asked to prefund a significant payment and hope for a timely reimbursement. The larger the project, and the higher the monthly burn rate on expenditures, the more unlikely you are to succeed in this pre-payment paradigm.

Another solution, which is even more impractical in practice, is for every party on the construction project who is expected to receive a portion of a particular monthly draw to assemble in a large conference room and exchange cash for unconditional releases in an elaborate closing ceremony, each and every month. This would permit the exchange of hard currency for unconditional releases, seemingly satisfying the finance side’s desire for finality and certainty, as well as the working side’s desire to make sure they do not end up financing the project themselves. There are obvious problems with this scenario, including the logistics and time necessary to perform it, and the security risks. Through the use of blockchain, however, the parties can accomplish the same thing electronically.

What are blockchain and smart contracts? Blockchain is a cryptographic technique to validate transactions for each transaction so that there is trust in what transpired at any given moment, because the algorithm is so strong. A distributed ledger (it exists in multiple locations) for the blockchain provides an unhackable solution, as many parties possess a copy, and it would be impractical to hack all of them to change the ledger. Some blockchains integrate smart contract capability that uses software code to automatically enforce one or more contract terms before the underlying transaction takes effect. A smart contract could be used in conjunction with, or to replace, project management/finance software to set up rules for the execution of a transaction or series of transactions. This can provide enhanced visibility or other functionality in a secured way with a distributed ledger and algorithmic security. Since many possess a copy of the blockchain and understand the underlying rules of the smart contract, there are no secrets and no chance at manipulation.

How would this work to solve the problem discussed above, is as follows. Using software with controlled access to the blockchain, the parties participating on the construction project would register and be invited into the project finance database. Parties lower in the chain could upload their unconditional releases, which the system would hold in escrow. The project financier (owner or lender) would pre-load the draw payment on its end either just prior to funding or before the next month of work began, so that the parties performing work could be assured that payment was locked in the system. Once the system received all of the unconditional releases required for the draw, the funding would happen through some combination of the smart contract or traditional software to enforce the rules so that the blockchain records the compliance with a perfect audit trail. The payment would not just flow from the bank to the owner. The entire distribution could simultaneously occur, with the payment simultaneously flowing throughout the entire matrix of those expecting payment. The suppliers and subcontractors would be paid at the same instance the draw was funded to the general contractor. The blockchain would be used to securely track and distribute the funding, as all parties can be assured the prerequisite conditions for proceeding were met. Because of its distributed ledger system, there would not be the ability of one party to manipulate the system. The releases could be created through the software system or smart contracts so that a party could not simply upload a blank page to trick the system. There would still need to be human oversight in determining who should be a participant in payment system, as well as validation of whether work was performed, and at what percent of completion. As this approach catches on over time, anyone who supplies or provides labor to a project would know to register on the project to secure its payment.

Certainly there are still “What ifs…” to be worked through on a per project basis, but the fundamental problem has been solved with technology that is secure, unhackable, transparent, and lightning fast.

Lump Sum Subcontract? Perhaps Not.

David Adelstein | Florida Construction Legal Updates | June 15, 2019

Lump sum subcontract?   Perhaps not due to a recent ruling where the trial court said “No!” based on the language in the subcontract and contract documents generally incorporated into the subcontract.

This is a ruling on an interpretation of a subcontract and contract documents incorporated into the subcontract that I do not agree with and struggle to fully comprehend.  The issue was whether the subcontract amount was a lump sumor subject to an audit, adjustment, and definitization based on actual costs incurred.  Of course, the subcontractor (or any person in any business) is not just interested in recouping actual costs, but there needs to be a margin to cover profit and home office overhead that does not get factored into field general conditions.  

In United States v. Travelers Casualty and Surety Company, 2018 WL 6571234 (M.D.Fla. 2018), a prime contractor was hired to perform work on a federal project.  During the work, the Government issued the prime contractor a Modification that had a not-to-exceed value and required the prime contractor to track its costs for this Modification separate from other contract costs.  In other words, based on this Modification, the prime contractor was paid its costs up to a maximum amount and the prime contractor would separately cost-code and track the costs for this work differently than other work it was performing under the prime contract.   

The prime contractor hired a subcontractor to perform a scope of fireproofing work relative to the Modification.  The subcontract amount was $646,886 and the subcontractor claimed it was due and owing $376,609 upon completing the work and filed a lawsuit against the prime contractor’s Miller Act payment bond.  

The prime contractor argued that the subcontract amount was not lump sum and was subject to definitization, auditing, adjustment, and change, although it certainly is not uncommon by any means that a prime contractor working under a cost-plus scenario to enter lump sum subcontracts.   The subcontract contained the following language:

  • The Contractor agreed to pay the Subcontractor for the complete performance of the Subcontract the sum of $646,886, subject to additions and deductions for changes agreed upon in writing…and Contractor further agreed to make all partial and final payments in accordance with the terms and provisions of the Subcontract Documents.
  • The Subcontractor had to submit a complete and accurate schedule of various parts of the Subcontractor’s work aggregating the total sum of the Subcontract, itemized and detailed as required by the Contractor and supported by such evidence as to its correctness as the Contractor may direct.
  • Each partial payment and final payment would be subject to final audit and adjustment and Subcontractor agreed to reimburse the Contractor for overpayment.
  • The Contractor was entitled to make changes in the work that could cause an increase or decrease in the work.
  • The Contract Documents including certain Federal Acquisition Regulation (FAR) clauses were incorporated into the Subcontract.

The subcontractor argued that this was not a unit cost contract, but a lump sum contract, and it did not agree to any such changes (such as those that would have removed a scope of its work).  Thus, the subcontractor completed its work and should be entitled to the subcontract amount.

The trial court did not agree with the subcontractor: “The Court finds that the Subcontract contains unambiguous language which shows the Subcontract amount was subject to definitization, adjustment, and audit, rather than being a fixed-price amount.”  United States, supra, at *6. 

Huh!!??!!

The language in the subcontract was relatively standard subcontract language included in most subcontracts.   The changes clause is standard that allows the contractor to increase or decrease the work and the subcontractor is required to proceed with any changes.  The schedule of values language is standard, which is nothing more than an administrative vehicle for purposes of allocating payment based on percentages of work performed.   The overpayment clause is relatively standard.  As the subcontractor argued, the subcontract amount was not based on specific unit costs measured against a specific unit of measurement.  The subcontract did not unequivocally state that the subcontractor would be paid a cost of the work plus a specific markup for profit and overhead.   Nothing of the sort and nothing identifying what should be construed a permissible cost of work versus an impermissible cost of work so that the subcontractor could specifically track its costs of work.  There was nothing that identified the subcontract amount would be reconciled based on the subcontractor’s actual costs of the fireproofing work.  If it did, then the argument that it was not a lump sum amount makes sense.  But, what is there to audit?  The subcontractor’s actual costs should be less than the fixed amount in light of a profit and overhead margin.  The subcontract did not identify what this margin should even be.  If it were a unit cost contract, that margin would be built into the unit costs.  If it were a cost of the work subcontract, as mentioned, it would clearly specify what the agreed markup was and the permissible costs of work to be tracked.  Also, nothing in the subcontract mentioned the subcontractor would only be paid its time and materials based on a specific labor rate where the profit and overhead would be built into the labor rate.

As it pertains to the FAR clauses, the trial court held that, “Incorporation by general reference only incorporates the quality and manner of the subcontractor’s work from the prime contract, not the rights and remedies he may have against the prime contractor.”  United States, supra, at *8.   This makes sense and, for this reason, the trial court held that the general incorporation by reference language only incorporated the FAR clause or the Modification at-issue only if they refer to the quality and manner of the subcontractors’ work.  Based on this, the trial court explained that language in the Modification requiring the prime contractor to track its costs was incorporated  into the subcontract because it related to the manner in which the work was to be completed.  This does not make sense as the prime contractor is tracking the fireproofing costs by buying out that scope at a fixed amount.  

The trial court’s interpretation based on rather common and standard subcontract language could ultimately turn every fixed price subcontract that requires an audit as a requirement of the subcontractor to track actual costs without any true understanding as to how actual costs are determined, reconciled, or what the appropriate markup should even be.

A Teaming Agreement is Still a Contract (or, Be Careful with Agreements to Agree)

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

I have discussed teaming agreements in this past here at Construction Law Musings.  These agreements are most typically where one of two entities meets a contracting requirement but may not have the capacity to fulfill a contract on its own so brings in another entity to assist.  However, these agreements are contracts and are treated as such here in Virginia with all of the law of contracts behind them.

One illustrative case occurred here in Virginia and was decided by the Virginia Supreme Court.  That case is CGI Fed. Inc. v. FCi Fed. Inc. While this is not strictly a “construction” case, it helps lay out some of the pitfalls of teaming agreements in general.

In this case, the parties entered into a fairly typical small business (FCI) Big Business (CGI) teaming arrangement for the processing of visas for the State Department.  The parties negotiated the workshare percentage (read payment percentage) should FCI get the work and the teaming agreement set out a framework for the negotiation of a subcontract between FCI, the proposed general contractor, and CGI, the proposed subcontractor. After a while working together, FCI submitted a proposal to the State Department and as part of the negotiations of this proposal, the work percentage for CGI was lowered in exchange for some management positions for CGI relative to the work by amendment to the original teaming agreement.  However, one day later FCI submitted a proposal to the State Department that not only didn’t include the management positions, but further lowered CGI’s workshare.

However, FCI did not stop there.  After resolving some bid protests, FCI began negotiations with CGI at an even lower percentage than that of the proposal or the amended teaming agreement.  CGI began work under a temporary agreement, was paid more than $2 million for its work and was subsequently terminated by FCI for cause.  CGI filed suit against FCi, asserting: (1) breach of contract because FCi failed to extend a subcontract with a 41 percent workshare and 10 management positions to CGI; (2) unjust enrichment because CGI allegedly spent $300,000 assisting FCi on the proposal that would result in a $6 million profit for FCi; and (3) fraudulent inducement, seeking lost profits.  The jury awarded CGI close to $12 million but the Circuit Court vacated the verdict and entered judgment for FCI and CGI Appealed.

The Court affirmed the Circuit Court on all counts.  First it found that the teaming agreement (the details of which are well laid out in the opinion) contained too many contingencies to be an enforceable contract for any particular subcontract provisions and that:

Taken together, these provisions make clear the parties never agreed to the final terms of a subcontract and expressly conditioned the formation of a subcontract on future events and negotiations. Thus, just as FCi could not have relied on this agreement to require CGI to perform work as subcontractor, CGI could not rely on the agreement to obtain work from FCi as a subcontractor. The court will not impose a subcontract on parties to a teaming agreement when they have expressly agreed to negotiate the material terms of a subcontract in the future.

Therefore, no breach of contract action could be sustained.

The Court then went on to find any possible damages for fraud in the inducement to be speculative because any lost profits by CGI based on its inducement to agree to a subcontract in the future (namely the teaming agreement) had no provision by which any lost profits could be quantified.

FInally, the Court affirmed the vacation of the verdict for unjust enrichment by finding that the teaming agreement was an enforceable, mutual, express contract and that

CGI elected to sue for tort and contract damages and as a consequence, “affirme[d] the contract” and “consent[ed] to be bound by its provisions.” Ewig v. Dutrow, 128 Va. 416, 424, 104 S.E. 791, 793 (1920). Accordingly, the parties’ express contract remains in effect. FCi’s conduct in procuring this contract does not change the nature of CGI’s unjust enrichmentclaim — an alternative cause of action for breach of contract. CGI may not recover on a quasi-contractual claim that is otherwise precluded by a contract which CGI has affirmed.

The Court then reasoned that because CGI affirmed the express contract, the method of inducing CGI into the teaming agreement (whether fraudulent or otherwise) is irrelevant.  An express contract cannot be the basis for an unjust enrichment or other quasi contractual claim.

In short, the Court is telling all of us that until the subcontract is executed and the terms made plain, perform at your own risk.

Of course I recommend that you read the opinion in its entirety and perform your own analysis of the case and any teaming agreement with the help of experienced construction counsel.

Breach of Contract Exclusion Precludes Coverage

Larry P. Schiffer | Squire Patton Boggs | August 14, 2019

Liability insurance policies are meant to cover claims brought against insureds by third-parties alleging a fortuitous event that causes damages. But most liability policies have exclusions that preclude coverage for certain events. For example, many policies exclude coverage for property damage to property owned by the insured. Another exclusion precludes coverage for damages resulting from the assumption of liability in a contract or agreement. And the one we will concentrate on in this post is the exclusion for breach of contract claims. The Sixth Circuit Court of Appeals recently addressed these exclusions.

In Maxum Indemnity Co. v. The Robbins Co., No. 18-3776 (6th Cir. Aug. 12, 2019) (Not Recommended for Publication), the policyholder leased a tunnel boring machine to a third-party for a construction project. The machine apparently failed. The lessee brought an arbitration under the lease against the policyholder for breach of contract. When the policyholder asked its insurance company to defend and indemnify, the insurance company brought a declaratory judgment action claiming that it owed neither a duty to defend nor a duty to indemnify. The district court granted the insurance company’s motion for judgment on the pleadings. The Sixth Circuit affirmed.

The policyholder’s main argument was that it was impossible to tell from the arbitration demand all the allegations and damages and that the court should have looked at additional evidence to determine if there was a duty to defend. In granting judgment on the pleadings to the insurer, the district court had focused on several exclusions, including the owned-property/work exclusion and the assumption of liability exclusion, but also found that the insurance policy specifically excluded contractual damages, which is what the lessee was seeking.

In affirming, the circuit court noted that the exclusions relied upon by the district court were not applicable, but that reliance was harmless error. First, the exclusion for damages as a result of an assumption of liability in a contract was irrelevant, said the court, because neither the lessee or the insurer argued that the policyholder assumed liability under the lease. Second, the exclusion for damages to property owned or rented was inapplicable according to the court, because even though the policyholder owned the tunnel boring machine, the lessee was not seeking damages for the machine, but was seeking damages for the policyholder’s failure to provide a working machine as promised in the lease.

The affirmance, instead, was based on the breach of contract exclusion. That exclusion specified that the insurance policy did not apply to any claim or suit for breach of contract, regardless of the nature of the damages. The exclusion also stated that no duty to defend arose for excluded claims for breach of contract. The circuit court rejected the policyholder’s argument that the difference between pleadings in arbitration and litigation required the district court to consider additional documents. The court was not persuaded that the differences between arbitration and litigation were as stark as the policyholder alleged. Nevertheless, the court reviewed the evidence provided by the policyholder and found that none of it described damages outside breach of contract damages.

Notably, the court declined to consider an itemized list of damages required by the arbitration panel because the policyholder had that list before the district court decided the insurance company’s motion and failed to provide that list to the court. While it is possible, said the court, that the district court might have found a duty to defend based on certain descriptions that could be seen as consequential property damage, the policyholder was the victim of its own delay. “[A]n appellate court does not exist to give litigants a second bite at the apple.”

Accordingly, the district court’s judgment was affirmed and no insurance coverage was available to the policyholder.

Pay-if-Paid Clauses: A Surety’s Defense for Payment Bond Claims?

Robert Cox | Williams Mullen | August 14, 2019

A construction project can be a breeding ground for general contractor versus subcontractor payment disputes. Whether it is payment for extra work subject to the project owner’s approval, slow pay or no pay by the project owner, and the general contractor has provided a payment bond, the payment bond surety is often the target of a subcontractor’s lawsuit for payment. When the general contractor’s subcontract includes a pay-if-paid clause, however, and the project owner has not paid the general contractor the monies the subcontractor claims to be due, may the payment bond surety rely on that conditional payment clause as a defense to the subcontractor’s lawsuit?

The answer is probably yes, but depending on the jurisdiction it is not always yes.

The Surety and Its Principal

A basic principle of suretyship law holds the traditional payment bond surety to be a secondary obligor with the defenses available to its principal (often the project’s prime contractor) likewise available to the surety. This principle is often generalized by characterizing the surety as standing in the shoes of its principal for its rights and obligations under the payment bond. (Of course, there may also be defenses unique to the payment bond surety arising from the specific terms of the payment bond, such as timely notice of a claim.)

This Construction Alert focuses on the subcontract that includes a pay-if-paid clause and whether the payment bond surety can rely on that subcontract clause as a defense to a subcontractor’s lawsuit for payment under the payment bond.

The Pay-if-Paid Defense for the Surety

In an often cited case from the U.S. Court of Appeals for the Fourth Circuit, Moore Brothers Company v. Brown & Root, Incorporated, 207 F. 3d 717 (4th Cr. 2000), subcontractors on a private toll road construction project in Northern Virginia sued the general contractor and its payment bond surety for payment after performing additional change in scope work. The project owner did not have funds to pay the general contractor for the added work; consequently, the general contractor did not pay its subcontractors for the added work, citing to its subcontracts’ pay-if-paid clauses. In defense of the subcontractors’ lawsuit for payment, the general contractor’s payment bond surety likewise cited to the subcontracts’ pay-if-paid clauses contending the general contractor had no obligation to pay until the project owner paid the general contractor, therefore the surety, standing in the shoes of its principal, was under no obligation to pay the subcontractors under the payment bond.

The federal circuit court, finding there to be no Virginia law on the validity of the surety’s defense, ruled the payment bond surety could not rely on the subcontracts’ pay-if-paid clauses as a defense to the subcontractors’ payment bond claims. Even though the payment bond incorporated the subcontracts containing the pay-if-paid clauses, the federal court found two bases to hold the surety liable: 1.) there was no indication in the payment bond language that the surety’s obligation to pay “sums justly due” incorporated the contingency of payment first by the project owner to the general contractor, and 2.) three other jurisdictions had rejected a payment bond surety invoking a conditional payment clause defense otherwise available to the surety’s principal. The federal court held “[a]s a surety who did not include an express “pay when paid” condition precedent in the contract payment bond, [surety] may not assert the “pay when paid” clause contained in the subcontract between the claimants and the principal as a defense to its liability to pay on the bond.” 207 F.3d at 723-24.

Other federal and state courts considering the same issue have not followed the Fourth Circuit Court’s ruling in Moore Bros.  For example, in Wellington Power Corporation v. CNA Surety Corporation, 217. W.Va. 33, 614 S.E. 2d. 680 (2005), West Virginia’s Supreme Court of Appeals held that a pay-if-paid subcontract clause did not violate West Virginia’s public bond statute for public construction projects, and a pay-if-paid clause that prevents a subcontractor from proceeding against the general contractor in the absence of the project owner’s payment also prevents the subcontractor from proceeding against the general contractor’s payment bond surety. See also, Travelers Casualty & Surety Company of America v. Sweet’s Contracting, Inc. 2014 Ark. 484, 450 S.W. 3d. 229 (2014) (Principal’s subcontract incorporated into bond included a pay-if-paid clause, and in suretyship the principal’s contract and the bond are to be constructed together as one instrument; thus the surety may invoke all defenses available to the principal.).

In BMD Contractors, Inc. v Fidelity and Deposit Company of Maryland, 679 F. 3d. 643 (7th Cir. 2012), the federal appellate court, citing Indiana law, ruled a surety must only answer for the debts of the principal and cannot be liable where the principal is not. The federal court specifically addressed the Fourth Circuit’s ruling in Moore Bros. and rejected the reasoning, noting Moore Bros. mistakenly assumes that the purpose of a payment bond is to insure subcontractors against nonpayment under any circumstances, rather than when payment is in fact due under the contract.

Similarly, in Great Lakes Travel Hotel Supply Company v. Travelers Casualty and Surety Company of Americas, 2013 WL 12122069 (E.D.MI. 2013), the federal district court, relying on Michigan law and general suretyship principles, held that a surety can assert any defense that its principal can assert; including a subcontract pay-if-paid clause in defense of a subcontractor’s payment bond claim. In so ruling, the federal court did note that Miller Act cases can be the exception and cited to several cases holding sureties cannot assert pay-when or pay-if subcontract clauses in defense of subcontractors’ Miller Act payment bond claims. See also, United States for Use and Benefit of Walton Technology, Inc. v Weststar Engineering, Inc, 290 F.3d 1199 (9th Cir. 2002) (“When and if paid” terms did not amount to a clear and explicit waiver of subcontractor’s Miller Act rights, and payment bond surety could not rely on the contingent payment terms as a defense.).

More recently, a Virginia state trial court has considered the issue whether a payment bond surety can rely on the pay-if-paid clause in its principal’s subcontract to defend against a subcontractor’s payment bond claim. The Virginia trial court answered “yes” to the issue, and, in so ruling, wrote, “In sum, the Court does not find any provision of Virginia statutory or case law which reveals a public policy that condemns or restricts a surety’s reliance on a pay-if-paid clause negotiated by its principal.” IES Commercial Inc. v The Hanover Insurance Company (Roanoke City Case No. CL 16-108, May 3, 2016) The trial court found “no compelling reason” to single out the pay-if-paid defense from other defenses available to the surety by adding a requirement that it be expressly stated in the subcontract and the payment bond as Moore Bros. commanded.

Conclusion

Those courts allowing the surety to plead the pay-if-paid clause as a defense, assuming there is no waiver or other legal excuse against the defense, rely upon the traditional suretyship principle that in general, a surety may plead any defense available to its principal, and the liability of the surety is co-extensive with the liability of the principal on the bond and can be extended no further. To single out the pay-if-paid defense, as a defense that must be spelled out in the bond in order to preserve it, as in Moore Bros., while not requiring the same of all other surety defenses defies logic and the traditional principles of suretyship.