The Perils of Liquidation

Taft Stettinius & Hollister LLP | February 16, 2016

Liquidation is one of those odd legal terms that has multiple meanings, some intuitive and others unexpected. In non-legal parlance, liquidation is what happens when you don’t pay your loan shark, or when you cross James Bond. Legal terminology has an analogous usage, such as liquidation of a business in bankruptcy proceedings. But it also has an entirely different meaning that is of great importance in the construction industry — liquidation of damages. Ironically, liquidation of damages is one of the ways that a contractor may prevent liquidation of its business.

Management of consequential damages must be a cornerstone of every contractor’s risk management program since consequential damages can pose an existential risk to even a strong contractor. While the dividing line in court decisions between the two main types of recoverable damages — direct and consequential — is anything but clear or consistent, generally direct damages are those that always result from a particular kind of breach, such as the cost of replacing work that was not performed correctly. Consequential damages arise from particular circumstances affecting the damaged party, such as lost profits and other economic damages suffered by the project owner from loss of use of the project when it is not completed on time.

Consequential damages may arise in various circumstances but by far the most common is delay in achieving substantial completion (the point in time at which the owner may use the work for its intended purpose). Since delays are not a rare occurrence on construction projects, contractors ignore this risk at their grave peril. Any deficiency in a contractor’s performance can be financially painful to the contractor, but consequential damages carry unique risks because of the potential for the loss to be entirely out of proportion with the size of the project and any profit that the contractor could have expected to earn. In one notorious case involving delay in completion of an access point to an Atlantic City casino, the contract was for $24 million and the contractor’s fee was 2.5% ($600,000). After the work was delayed and the contractor was found to be responsible, the owner was awarded almost $15 million in consequential damages — dozens of times the contractor’s fee. Fortunately, in that case the contractor was relatively large and the loss did not result in its liquidation, but other contractors and subcontractors have not been so lucky.

This result — unlimited consequential damages — was the norm in standard form contracts, including AIA, until 1997. Since then, all AIA forms have contained mutual waivers of consequential damages, and other forms, including ConsensusDocs, have followed suit, with modest differences (e.g., ConsensusDocs does not waive consequential damages covered by the contractor’s insurance).

But such a complete waiver creates a risk in the opposite direction. If the owner’s facility cannot be occupied on time, the owner may incur serious business losses with no avenue of recovery against the contractor. Owners became concerned that under a complete waiver, contractors did not have any real incentives, other than their reputations, to complete projects on time. The contractor would not be liquidated, but maybe the owner would!

So it was time for the other kind of liquidation to make an entrance — to take an uncertain sum of money and fix it at a specific number. When an accident victim files a suit the claim is unliquidated, but it becomes liquidated when a jury assigns a specific dollar value to it. Similarly in the construction industry, when parties agree in advance on the dollars that an owner will receive due to any future delay in completion that is the fault of the contractor, it is known as liquidated damages (“LDs”). LDs are often negotiated on a per-day basis but may also specify cliff dates when a lump-sum amount is payable if the contractor’s delay prevents the owner from achieving a major business milestone like the holiday selling season or a scheduled performance.

The law relating to liquidated damages is very technical and varies substantially among the states. While most states have abandoned earlier general hostility toward liquidated damages, such clauses are still found to be unenforceable with some frequency. If an owner sets liquidated damages higher than actual expected losses in order to penalize the contractor for late performance, enforcement is unlikely, as one of the criteria used by most courts is that the specified damages cannot exceed a reasonable estimate of what the actual damages will be, determined at the time of contracting (a prospective approach). Some states look retrospectively, however, to see if the specified damages are in the same range as the actual damages turned out to be.

On the other hand…

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Efficient Proximate Cause Doctrine in California

Kenneth Kan | Property Insurance Coverage Law Blog | February 22, 2016

How should coverage be determined if a loss is caused by a combination of both covered and excluded risks?

Two months ago, in Vardanyan v. Amco Insurance Company,1 a California Court of Appeal issued an important decision addressing this issue. The court reaffirmed that where there are multiple causes of damage to an insured’s property, with some covered and some excluded, the loss is covered if the most important or predominant cause is a covered risk. The holding is based on the efficient proximate cause doctrine codified in Insurance Code section 530, which provides:

An insurer is liable for a loss for which a peril insured against was the proximate cause, although a peril not contemplated by the contract may have been a remote cause of the loss; but he is not liable for a loss of which the peril insured against was only a remote cause.2

Moreover, the appeals court in Vardanyan relied on the California Supreme Court decision in Sabella v. Wisler, which established the general rule:

In determining whether a loss is within an exception in a policy, where is a concurrence of different causes, the efficient cause–the one that sets others in motion–is the cause to which the loss should be attributed, though the other causes may follow it, and operate more immediately in producing the disaster.3

What prompted the appeal by the insured in Vardanyan, a case involving collapse of the insured’s house, was an erroneous jury instruction proposed by the defense and given by the trial judge. The appeals court found that jury instruction as essentially circumventing the efficient proximate cause doctrine. The case is an important read to understand how the efficient proximate cause doctrine works and is applied. Policyholders in California can thank…

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PIB. And It’s Increased Movement Into Window Defect Claims

Gregory T. Hanson | Gordon & Rees LLP | February 17, 2016

Polyisobutylene, or PIB, is a synthetic rubber commonly used as an edge sealant in Insulating Glass Units (IGU’s).  IGU’s consist of multiple glass panes within a window frame (e.g. “double-glazed” and/or “triple-glazed” windows), and serve the purpose of insulating building interiors from both sound and thermal transmission. These IGU’s are typically separated by “spacer bars” and sealed at the outer edges of the panes to the spacer bars between those panes. PIB is the most commonly used primary sealant for this purpose. There are multiple manufacturers of PIB, just as there are many manufacturers of windows/IGU’s which incorporate the PIB edge-sealant into their finished products.

Over the past year or more, we are seeing an increased incidence of “PIB movement” claims arising in construction defect cases. Owners, developers, general contractors, and the window manufacturers themselves, are filing claims in increasing numbers against the manufacturers of PIB products based upon the products migrating from their appropriate placement at the edge of the windows, into and obscuring the IGU’s fields of vision. This is particularly true in the cases of multi-unit, multi-story HOA complexes, where double and triple-glazed windows are becoming commonplace.

As these claims continue to grow in number, further investigations are being performed to determine if the migrating PIB is in fact due to a product defect, if the PIB is being improperly installed, and/or if its use is contraindicated in high-heat environments. The jury is still out on the answer to these questions, but for now, building professionals of all ilks would be well advised to take a hard look at the causes of this growing PIB issue prior to installing PIB-edge-sealed windows into their respective upcoming projects.


Calculating Actual Cash Value, Part 18: Minnesota

Shane Smith | Property Insurance Coverage Law Blog | February 21, 2016

In Minnesota, The broad evidence rule determines “actual cash value.”1

In Wilcox v. State Farm Fire and Casualty Company,2 the Minnesota Supreme Court recently ruled that in the absence of specific language in a policy identifying a method of calculating actual cash value (“ACV”), the trier of fact must determine whether depreciation of embedded labor components “logically tend[ed] to the formation of a correct estimate of the loss.”

The Wilcoxes property was damaged by hail and they filed a claim against their insurer, State Farm Fire and Casualty Company (“State Farm”). State Farm provided the Wilcoxes with an estimate of the ACV of the damaged property. In the estimate, State Farm calculated the replacement costs of individual items (i.e. roof flashing, siding, fascia, gutters, and window screens). Then, State Farm subtracted the pre-loss depreciation of some, but not all, individual items. For example, State Farm depreciated the cost of removing and replacing certain materials, such as siding. State Farm, however, did not depreciate the cost of the new siding separately from the cost of the labor required to install the new siding on the home (the “embedded labor costs”). Rather, State Farm calculated the removal and replacement of the siding as a single cost, then depreciated the removal-and-replacement cost as a whole. The court referred to the cost of labor to repair or replace the damaged property as “embedded labor costs.”

The Wilcoxes alleged that State Farm breached the terms of their homeowners policy when calculating the ACV of the damaged property. Their policy did not define ACV or how it was to be calculated. The Wilcoxes argued that State Farm could not depreciate labor costs embedded in the cost of repairing or replacing damaged property.

The district court certified the following question to the Minnesota Supreme Court:

May an insurer, in determining the “actual cash value” of a covered loss under an indemnity insurance policy, depreciate the costs of labor when the term “actual cash value” is not defined in the policy?

The Minnesota Supreme Court reformulated the question as follows:

When a homeowner’s insurance policy does not define the term “actual cash value,” may the trier of fact consider labor-cost depreciation in determining the “actual cash value” of a covered loss when the estimated cost to repair or replace the damaged property includes both materials and embedded labor components?

The Minnesota Supreme Court answered…

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Arbitration Means Arbitration Even If It Is About Arbitration

Larry P. Schiffer | Squire Patton Boggs | February 19, 2016

No one should doubt that the federal policy in favor of arbitration is broad and deep. It is evident in how difficult it is to vacate an arbitration award or avoid having to arbitrate a dispute where there is a broad arbitration provision. A recent case makes this even clearer.

The parties to a series of reinsurance treaties arbitrated the extent of the reinsurer’s obligations to respond to an underlying asbestos settlement. A final arbitration award was issued and confirmed by the court. Years later, the cedent billed the reinsurer for asbestos claims for the same insured under the same policy. The reinsurer rejected the billings claiming that the matters had been resolved in the earlier arbitration and brought suit to declare that it had no further obligation. The cedent, which had demanded arbitration on the unpaid billings, sought to compel arbitration.

The court granted the motion to compel arbitration and dismissed, without prejudice, the declaratory and injunction action brought by the reinsurer. Emplrs Ins. of Wausau v. Cont’l Cas. Co., No. 15-cv-226-wme, 2016 U.S. Dist. LEXIS 18850 (W.D. Wisc. Feb. 17, 2016). Why? Because of the presumption in favor of arbitration under the FAA.

The court found that the broad arbitration clause required any dispute be determined by the arbitrators in the first instance. That included whether the cedent was in compliance with the earlier arbitration award or the affect of the prior award on the unpaid billings. Whether, as the reinsurer characterized it, the cedent was trying to compel the reinsurer to re-arbitrate a dispute that had been finally determined years earlier or whether the reinsurer’s failure to pay the new billings was a new and different dispute, were matters for the arbitrators to determine, not the court.

The court made clear that it was not deciding whether the dispute was entitled to a new arbitration or even re-arbitration of the prior award. It simply concluded that…

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