A Key Battleground: Material Price Escalations and Supply Chain Disruptions

Colm Nelson | Stoel Rives

Material price escalations and supply chain disruptions are hot topics in the industry, with many clients inquiring about their rights and how these risks should be shared. Some have even questioned whether their projects should proceed given the volatility in the market.

For instance, I saw at least one project’s price increase by over $10 million in a matter of months due to the precipitous price increase in lumber. The resulting sticker shock was mitigated somewhat by the recent drop in lumber prices. However, the developer and contractor team were not alone in asking whether the project should proceed and, if so, who carries the risk of future price changes and/or supply chain delays.

Generally speaking, under a standard Guaranteed Maximum Price (GMP) contract, such as the American Institute of Architects’ A102/A201 combination, the contractor is guaranteeing its price against price escalations – i.e., this is a contractor risk. This risk allocation can be adjusted through a variety of methods, including the use of: 1, allowances; 2, contingency; 3, savings bonus; or 4, specifically tailored risk-sharing provisions, addressing both compensation adjustments and/or time adjustments.

How allowances and contingency work in concert, and what those terms mean, differs even among sophisticated contracting parties. For many in the Pacific Northwest, an allowance is merely a placeholder for the expected “Cost of the Work.” If the allowance item costs more than the placeholder, the GMP is increased. If it is less, then the owner should get a deductive change order.

However, industry standard forms like the AIA A201 don’t treat allowances this way and in fact state that “Contractor’s costs for unloading and handling at the site, labor, installation costs, overhead, profit and other expenses contemplated for stated allowance amounts shall be included in the Contract Sum but not in the allowances” – i.e., no increase in the GMP for additional time or labor related to the allowance item.

Under the AIA approach, the contractor would get more, for example, for the price of the door, but wouldn’t be allowed to seek an increase for the time it took to install it. Contingency for some owners and contractors is simply padding to cover additional costs of the work until the GMP ceiling is exhausted. For others, contingency is solely for discrete items, and only to be used upon advance written approval by the owner. Many contractors prefer to list price escalations in materials as an approved use of contingency.

When contract discussions become logjammed over risks that neither party can control, finding an outcome where both the owner’s and contractor’s interests are aligned is sometimes the best way to advance discussions. That often means a sharing of risk to some degree, full transparency by both sides, and even sharing in any savings for effective materials and subcontractor buyouts. Alternatively, if the owner is not willing to share in the risk, which is not uncommon, it should expect the contractor to ask for a higher fee for taking on that risk, or price padding on certain line items.

Supply chain disruptions and resulting delays are treated differently and separately from price escalation risks. Unusual delay in deliveries is generally a basis for a contract time adjustment under most industry-accepted contracts. This is important to contractors because, without the adjustment, they could face liquidated damages or other delay liability.

Who pays for the extended costs resulting from the delays is a more difficult question and not squarely addressed in the AIA A201. Owners feel they are already losing money because of the late delivery (time is money), and contractors question why they should carry the costs.

Historically, given the economic risks to the owner resulting from delay, contractors typically agree to limit their recovery to a time extension and/or expressly negotiate a contingency line item to cover this risk. Also, because contractors are in a better position to control timely subcontractor buyouts and coordination of work among subcontractors, including through the use of float, some argue that contractors should carry this risk. In other words, the party in the best position to control a risk should be the party who bears it.

While not uncommon in other industries, insurance products to cover price escalations in materials are not commonly used in the construction industry. However, sensing the stress in the marketplace due to lumber prices, insurance products are now being offered for those interested in “hedging” risk against future price fluctuations. As we work through the consequential effects of the pandemic on supply chains, it will be interesting to see if the use of these products proliferates through the market. As with bonds, which are rarely used on private projects below $100 million, the cost and ability to timely collect on such products will dictate whether owners and contractors are interested in hedging their bets in this fashion.

Senate Bill 49 Establishes Lien Rights for Registered Design Professionals

Rick W. Grady and Allen L Rutz | Vorys Sater Seymour & Pease

On July 1, 2021, Governor DeWine signed Senate Bill 49 giving lien rights to Ohio architects, landscape architects, professional engineers, and professional surveyors (design professionals) beginning September 30, 2021.  The lien rights are limited to:

  • Commercial real estate projects,
  • With a written contract signed by the design professional and project owner,
  • Only to the extent of the project owner’s interest in the property, and
  • Only in the amount due the design professional under the contract.

In addition, only the design professional named in the contract – whether an individual, partnership, corporation, or association – has lien rights.  Lien rights are not available to an employee or agent of the design professional and, unlike mechanics’ liens, lien rights are not available to lower tier design professionals not in privity with the project owner. 

The design professional’s lien is junior in priority to any other valid liens (regardless of recordation date) and all previously recorded mortgages and liens. Any person with an interest in the commercial real estate may substitute financial security (e.g., a bond or escrow account) for the lien, in the amount of the lien.

To perfect the lien, the design professional must file a notarized affidavit with the county recorder. The design professional must then serve the lien affidavit on the project owner and the property owner (if different) within 30 days. Failure to properly serve the lien affidavit may result in a court considering equitable remedies for the failure. Following perfection, the design professional must commence proceedings to enforce the lien within two years, or within 60 days of receiving a Demand to Commence Suit. Otherwise, the lien is extinguished by operation of law.

Once the lien is satisfied (i.e., paid in full) the design professional must record a written release within 30 days. When a claim is satisfied or extinguished, any person with an interest in the property may record an affidavit stating that the claim was satisfied or that the lien was released by operation of law. This is true regardless of whether the design professional records a release. However, the fact that the lien is satisfied or extinguished does not affect any other right or action by the design professional. For example, the design professional may still bring a claim for breach of contract.

Wind Before Storm May Blow Away Flood Exclusions

Elliot Karzner and Alycan A. Moss | Property Insurance Law Observer

Flood exclusions may not apply when floods are preceded by winds strong enough to independently cause the loss, according to a recent decision issued by the Western District of Louisiana. In Doxey v. Aegis Security Ins. Co., No. 2:21-CV-00825, 2021 WL 2383834 (W.D. La. Jun. 10, 2021), an insured sought coverage for wind damage sustained to his home by Hurricane Laura under a property insurance policy that excluded coverage for damage “caused by, contributed to or aggravated by” flooding. The policy also contained an anti-concurrent causation clause, which excluded losses caused by excluded perils “regardless of any other cause or event contributing concurrently or in any sequence to the loss.” The insurer denied coverage under the flood exclusion on the grounds that the covered structures were completely displaced and destroyed by the storm surge that followed the wind.

In support of its denial of coverage, the insurer provided an engineering report, which concluded that “it is more probable than not” that the covered structures were first damaged by winds and then “completely displaced and destroyed by the estimated 16.6 foot storm surge.” To contest the denial, the insured relied on an affidavit from an engineer, who opined that the wind force was sufficient to total all of the structures before the storm surge arrived.

Applying Louisiana law, the court denied both parties’ motions for summary judgment. The court noted that, according to the insured’s expert, the wind – a covered peril – was powerful enough to independently destroy the insured property before the arrival of the flood. Therefore, a question of fact existed as to whether the storm, an excluded peril, in any way caused or contributed to the loss. Accordingly, the court allowed the coverage dispute to proceed to trial.

Following the Doxey ruling, insurers should be cautious about relying on anti-concurrent causation clauses to deny coverage if a possibility exists that a covered peril was sufficient to independently cause the loss before the excluded peril arrived. In the context of flood exclusions, this means verifying that the winds preceding the flood left enough of the property intact that the subsequent flood at least contributed to the claimed loss.

Colorado Supreme Court Holds Insurers Are Not Entitled to Intervene Where Insured Assigns Its Rights to Third Party

Luke Mecklenburg and Anna Adams | Snell & Wilmer

In a 4-3 decision in Auto-Owners Insurance Co. v. Bolt Factory Loft Owners Association, Inc., the Colorado Supreme Court held that an insurer who is defending under a reservation of rights is not entitled to intervene where the insured has entered into a Nunn-type Agreement to assign its bad faith claims to a third party and then proceeds to an uncontested trial. The majority affirmed the Colorado Courts of Appeals’ decision, but on different reasoning.

The dispute at issue began when Bolt Factory Loft Owners Association sued contractors over construction defects. The contractors in turn filed third-party claims against subcontractors, including Sierra Glass Company, which was insured by Auto-Owners Insurance Company. The insurance company accepted its obligation to defend Sierra Glass subject to a reservation of rights.

Bolt Factory settled with all parties except Sierra Glass. Auto-Owners declined Bolt Factory’s $1.9 million settlement offer—an amount within the policy limits. Sierra Glass then retained its own counsel and entered into a pre-trial agreement with Bolt Factory. This agreement, generally known as a Nunn Agreement in Colorado, provided that Sierra Glass assigned its bad faith claim to Bolt Factory and, in exchange, Bolt Factory agreed to pursue Auto-Owners directly for payments of the excess judgment. But unlike most Nunn Agreements, where parties typically enter into a stipulated judgment and potentially agree to have the amount of damages determined by an independent factfinder, Bolt Factory and Sierra Glass proceeded to a two-day trial at which Sierra Glass contested none of Bolt Factory’s claims. During a pretrial conference, Bolt Factory stated it planned to call four witnesses to testify on liability and damages during the trial, and Sierra Glass said it “will probably not be posing a defense to those claims or assertions that are made in this case.”

When it learned of this plan, Auto-Owners moved to intervene to protect its interests and contest liability and damages—essentially to put on the defense Sierra Glass wouldn’t. But the district court denied the motion to intervene, reasoning that Auto-Owner’s interest in the matter was contingent on its obligation to defend under its policy and it would have a chance to challenge its liability under that policy in later suits. At the bench trial, Sierra Glass presented no defense. The district court entered judgment in favor of Bolt Factory and against Sierra Glass for nearly $2.5 million.

A division of the Colorado Court of Appeals affirmed the district court’s decision denying Auto-Owners’ motion to intervene. The court of appeals reasoned that based on its reservation of rights, Auto-Owners lacked sufficient interest in the litigation to satisfy Rule 24’s requirements.

A majority of the Colorado Supreme Court affirmed, but on different reasoning than the court of appeals. First, the court affirmed that the agreement between Bolt Factory and Sierra Glass was a permissible Nunn Agreement even though it was unclear from the record why the parties conducted a one-sided trial instead of just stipulating to judgment on Bolt Factory’s claims.

Second, the court concluded that even though Auto-Owners was proceeding under a reservation of rights, it retained a broad duty to defend under Colorado law. But the court agreed that Auto-Owners ability to defend itself was not impaired by denying it the chance to intervene because it could still challenge its liability in subsequent suits. Indeed, as the state court appeals were pending, Auto-Owners filed a declaratory judgment action in the United States District Court seeking a declaration that it did not owe any obligations or payments to Sierra Glass under the insurance policy and that Sierra Glass had breached the policy.

Third, the Supreme Court concluded that allowing an insurer like Auto-Owners to intervene would undermine the purpose of the Nunn Agreement, which provides an insured an opportunity to “protect itself in the face of an insurer’s unreasonable refusal to settle within policy limits.” According to the court, allowing the insurer to intervene could create potential conflicts based on information the insurer could discover about its insured in the case and use in a later declaratory judgment action regarding coverage.

On these bases, the Supreme Court affirmed the propriety of this modified Nunn Agreement and the district court’s refusal to allow Auto-Owners to intervene in the uncontested trial that arose from that agreement. Of note, however, the majority emphasized that (1) the judgment in the uncontested trial was no more binding on Auto-Owners than a stipulated judgment would have been, and (2) although this approach was permissible, “courts are free to require the use of a stipulated judgment” such as that considered in Nunn, “rather than proceed with an uncontested trial.” Hence, as the dissent observed, it is unclear why anyone would use this procedure again rather than simply stipulating to judgment and proceeding to assert bad faith claims against the insurer, as approved in Nunn. But with all that said, Bolt Factory remains an interesting case study in the extent to which Colorado courts will condone and/or expand upon the types of agreements first approved in Nunn.

Number of “Occurrences” for Determining Policy Limits in California Construction Defect Cases

Kelly Smith | Snell & Wilmer

Insurance policies generally have different policy limits depending on the number of “occurrences.” For example, the amount of money recoverable under an insurance policy may be $5 million per occurrence with a $20 million aggregate limit. Therefore, when determining policy limits, deductible liability or considering settlement in a construction defect case, the parties should consider two questions. First, what constitutes an occurrence in the construction defect context? Second, how do courts determine the number of occurrences?

First, parties should be aware that what constitutes an occurrence typically will be defined by the applicable policy. In construction defect cases, insurance policies commonly define an occurrence as “an accident, including continuous or repeated exposure to the same or similar harmful conditions” which results in property damage. See, e.g., Safeco Ins. Co. of America v. Fireman’s Fund Ins. Co., 148 Cal.App.4th 620, 631 (Cal. App. 2007); Tidwell Enterprises, Inc. v. Financial Pacific Ins. Co., Inc., 6 Cal.App.5th 100, 107 (Cal. App. 2016). However, parties should look to the definition of an occurrence in the specific policy applicable to their project to determine coverage.

Second, parties should be aware that courts generally determine the number of occurrences under an insurance policy (and thus policy limits) based on the causes of damage, not the type or amount. For example, in Landmark American Ins. Co. v. Liberty Surplus Ins. Co., a subcontractor’s defective work caused water intrusion in several areas of a casino. 2014 WL 12558121, at *1 (C.D. Cal. Apr. 9, 2014). The California court found there were two separate occurrences—(1) improperly installed handrails and (2) defective installation of window systems and sliding doors. Id. at *6. The court explained that if a single injury, like water intrusion, has multiple causes, there have been multiple occurrences under an insurance policy. Id. at *5. If, however, widespread water intrusion had been caused by only the failure to apply sealant, that would likely have constituted a single occurrence. Id. at *6.

Similarly, in Liberty Mutual Fire Ins. Co. v. Bosa Devel. California II, Inc., a developer and insurance company were disputing how many occurrences arose under an insurance policy after defects were discovered in a condominium project. 2020 WL 1864645, at *1 (S.D. Cal. Apr. 13, 2020). The developer argued there was one occurrence—its negligent supervision of multiple subcontractors. Id. at *6. The court disagreed and held there were three occurrences: (1) the negligent installation of concrete flatwork, balconies, and waterproofing, (2) defective plumbing installation, and (3) selection of improper building materials. Id. at *8. The court struck down the developer’s argument, explaining that if a general contractor’s general negligent supervision constituted a single occurrence, “there would never be more than a single occurrence in the course of a single construction project, no matter how disparate the harms.” Id.

Accordingly, parties involved in a construction defect case should pay close attention to the cause of the alleged damages. If all damage arises from a single source or process, that may constitute a single occurrence for purposes of determining policy limits. Conversely, if there is a single type of damage caused by multiple failings, that may constitute more than one occurrence and trigger higher policy limits. Consultation with a knowledgeable insurance coverage attorney may be an appropriate first step.