Category Archives: Construction Contracts

Incorporation Clauses: Does the Subcontractor Really Assume All Obligations of the Prime Contractor?

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John Mark Goodman | BuildSmart

Many subcontracts contain a catch-all provision requiring the subcontractor to do everything the prime contractor is obligated to do under the prime contract. This is known as an “incorporation” clause because it adopts or incorporates legal rights and duties spelled out elsewhere. Here is an example of an incorporation clause: “The Subcontractor shall be bound by the terms of the Specifications, General Conditions and Supplemental Conditions and Addenda in the Contract between the Contractor and the Owner, shall confirm to and comply with the Drawings and Specifications and Addenda, and shall assume toward the Contractor all the obligations and responsibilities that the Contractor assumes toward the Owner.” 

This provision, and how broadly to read it, was explored by the Second Circuit in a decision released last week in Amerisure Insurance Company v. Selective Insurance Group, Inc., 2023 WL 3311879 (2nd Cir. 2023). The specific issue was whether the owner was an additional insured under the subcontractor’s insurance policy. The insurance policy did not name the owner as an additional insured, and the insurance provision in the subcontract required only that the prime contractor – but not the owner – be named as an additional insured. That’s where the incorporation clause came into play. 

The plaintiff argued that the owner should nonetheless be deemed an additional insured under the subcontractor’s insurance policy because (1) the prime contractor had an obligation under the prime contract to name the owner as an additional insured and (2) under the incorporation clause, the subcontractor had assumed all obligations and responsibilities that the prime contractor had to the owner. The Second Circuit rejected this argument. Under the law chosen by the parties (Virginia), incorporation clauses do not require subcontractors to assume all obligations of the prime contractor, only those relating to the nature or scope of the work undertaken. Because the insurance clause in the prime contract did not directly relate to the nature or scope of masonry work to be performed by the subcontractor, it was not incorporated into the subcontract and assumed by the subcontractor. The Second Circuit noted that it would have reached the same result under New York law since the insurance provision to be incorporated did not relate to the “scope, quality, character, and manner of the work to be performed by the subcontractor.”  

Here’s the lesson for prime contractors and subcontractors alike: If there’s an important obligation that you want to make sure is assumed by your subcontractor (or sub-sub), you should attempt to incorporate it expressly.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.

What Parties Ought To Consider When Considering Arbitration Provisions

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Zachary Davis | Ahead of Schedule

When reviewing a proposed design or construction contract, the responding party will often do a cursory check to see whether the contract proposes arbitration or litigation for dispute resolution. So long as the proposed method generally aligns with that party’s preferences, it will not look further at the specifics of the proposed process. For the uninitiated, this can lead to surprises when a dispute arises, especially when it comes to issues like whether the arbitration will be held before a single arbitrator or a panel of arbitrators, the rules that will apply to the arbitration, and the scope of discovery.

Construction and design attorneys, on the other hand, spend many working hours (and sometimes nonworking hours) contemplating these exact issues. I have developed a checklist of items that I advise my clients to consider in their arbitration provisions. The combined goal of these considerations is eliminating surprises if a dispute arises and balancing efficiency with the desire for a fair process. Typically, that checklist includes the following topics:

Rules applicable to the arbitration

The parties may—and often do—agree in their contract to the procedural and evidentiary rules subject to the arbitration. Deciding which rules will apply to the arbitration—and whether there are any exceptions to those rules (such as for discovery)—is maybe the most important provision because a dispute could proceed under very different paths depending on the rules that apply.

For instance, the American Arbitration Association’s (AAA) Construction Industry Arbitration Rules provide for relatively limited discovery (i.e., pre-hearing document exchange and depositions). While this might be appropriate for smaller disputes, it rarely is appropriate for disputes involving large, complex construction projects. The Procedural Rules of the Arbitration Service of Portland (ASP), on the other hand, provide that the scope of discovery is the same as allowed by the Oregon Rules of Civil Procedure, which grant relatively broad rights of discovery. Thus, for disputes involving large construction projects, the ASP rules are in most cases better equipped to arm the parties and the arbitrator with what they need for a fair resolution.

Of course, as addressed below, the parties can also agree to conduct discovery pursuant to the Federal Rules of Civil Procedure or corresponding state court rules notwithstanding their agreement that the AAA rules (or ASP rules or those of some other body) otherwise apply.

Single arbitrator or panel of arbitrators?

Arbitrations may proceed before a single arbitrator or a panel of three (or more) arbitrators depending on the parties’ agreement or the rules applicable to the arbitration. A typical arbitration provision in a design or construction contract might provide for a single arbitrator for disputes below a certain dollar threshold and for a panel of three arbitrators for disputes above that threshold.

Because arbitrators are compensated by the parties for their time, arbitrating before a panel of arbitrators—as opposed to a single arbitrator—will add cost; it also will add scheduling difficulties that can push the final hearing out in search of dates that work for everyone. The parties can also agree in their contract to certain qualifications that an arbitrator must meet in order to serve. This is common in contracts involving highly technical or specialized construction. For instance, parties to an engineering, procurement, and construction agreement for a commercial solar array might agree that any arbitrator must have a background in the solar industry.

Scope of discovery

A belief has developed among many lawyers and arbitrators that one of the perceived benefits of arbitration—greater cost efficiency compared to litigation—can only be achieved when discovery is limited. AAA’s rules reflect this paradigm. The reality, however, is that in most construction disputes the documents—and particularly emails and text messages—tell the story. Thus, the party without those documents is at a significant disadvantage if the scope of discovery is limited in a manner that prevents a full and fair exchange of documentary evidence.

This issue can be avoided by prospectively agreeing that the scope of discovery will be governed by the Federal Rules of Civil Procedure (or alternatively the Oregon Rules of Civil Procedure or other state court rules in the jurisdiction where disputes will be heard). Recent amendments to the Federal Rules of Civil Procedure adopted a requirement that discovery be “proportional to the needs of the case”—thus baking into the rules a safeguard intended to limit abusive discovery practices while at the same time ensuring access to discovery based on considerations that include “the importance of the issues at stake in the action, the amount in controversy, the parties’ relative access to relevant information, the parties’ resources, the importance of the discovery in resolving the issues, and whether the burden or expense of the proposed discovery outweighs its likely benefit.” An agreement that discovery will be subject to the Federal Rules of Civil Procedure has the dual benefit of guarding against runaway discovery costs that are disproportionate to the matters at issue while ensuring fair access to information.

Maximizing opportunity for resolution in a single proceeding

Rare is the construction dispute that involves only two parties. A typical defect claim might include claims by the owner against the design team and the contractor and subcontractors. For both efficiency and avoidance of inconsistent outcomes, it is often in the parties’ mutual benefit to have all related claims consolidated into a single arbitration proceeding. The agreements between the owner and the architect and between the owner and the contractor might include a requirement for a consolidated arbitration proceeding, but what if downstream contracts do not? One way to address this scenario is to include an off-ramp in the arbitration provision that gives the owner the right to elect consolidated court litigation in the event all necessary parties cannot be joined into a single arbitration proceeding.

These are just four of the many moving parts that are important to consider when agreeing to arbitrate disputes in a construction or design agreement. Owners, designers, and contractors would all be well served to give them more than just a passing glance.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.

State Supreme Court Decision Highlights Need to Get Insurance and Indemnity Clauses Right in Construction Contracts

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Charles P. Edwards and Lara Langeneckert | Construction Law Blog

Parties to a construction contract are frequently surprised to discover that a contractual agreement to procure insurance may limit their liabilities to each other. A recent decision from the Indiana Supreme Court illustrates the effect of this rule. And, in a separate portion of the decision that will be equally significant to the construction industry, the court held that a customer’s acceptance of a contractor’s work strips third parties of the right to sue that contractor for property damage caused by the contractor’s alleged negligent workmanship. 

In light of this opinion, careful drafting of construction contracts is even more critical, particularly when it comes to the delicate interplay between insurance and indemnity clauses.

The Common and Recurring Fact Pattern

The March 2023 case, U.S. Automatic Sprinkler Corp. v. Erie Ins. Exch., involved a variation on a common and recurring fact pattern: a property owner (here, an office-complex tenant) hires a contractor (here, a sprinkler company) to perform work; the work is allegedly performed negligently and/or is defective; and the alleged negligence and/or defect causes property damage to the owner’s property and to third-party property (here, co-tenants’ property). In these circumstances, who is responsible – and to whom? Like most legal questions, the answer is “it depends.” 

The court held that the negligent contractor was not liable for the property damage – either to its customer or to the third parties whose property was damaged by its defective work – but the court’s reasons for each holding differed. The court unanimously held that the contractor was not liable to its customer because the parties’ contract placed responsibility solely on insurance. And a 4-1 majority of the court held that the contractor was not liable to the third parties under the so-called “acceptance rule:” Once the customer has accepted the contractor’s work, third parties can no longer hold the contractor liable for negligence or defects in that work.

Insurance as Sole Remedy

Construction and other service contracts often contain provisions addressing the risk of loss. These provisions may limit liability for future loss, they may assign responsibility for damage caused by the work to one of the parties through indemnification, or they may require one or both of the parties to insure against future loss. Where the insurance requirement is coupled with a waiver of subrogation, courts often hold that the parties’ rights and liabilities are limited to the required insurance – even where that insurance is inadequate to insure against the full loss. 

Subrogation is a legal doctrine whereby an insurance company, after paying a loss, steps into the shoes of its policyholder to recover its money from a party responsible for the loss. Importantly, the insurance company has no greater rights than its policyholder; so, if the policyholder waives its right to recover, that waiver also applies to its insurance company.

In U.S. Automatic Sprinkler, after the sprinkler system failed and flooded the building, the customer tenant’s insurer filed a subrogation claim against the contractor sprinkler company. But, the agreement between the customer tenant and the contractor sprinkler company contained a waiver of subrogation rights providing that, “[n]o insurer or other third party will have any subrogation rights against” the sprinkler company and that the tenant “will be responsible for maintaining all liability and property insurance.” The Indiana Supreme Court held that these provisions barred the insurer’s claim, explaining:

An agreement to insure is intended to provide both parties with the benefits of insurance regardless of the cause of the loss (excepting wanton and willful acts). Otherwise, each would provide his or its own insurance protection and there would be no need for the contract to place the duty on one of them. As a result, where one party agrees to purchase insurance for the benefit of both parties, this party has no cause of action against the other regardless of their fault in contributing to or inducing the loss. And the same is true for subrogated insurers, as their rights can rise no higher than those of the insured. (internal quotations and citations omitted)

Placing the risk of loss solely on contractually required insurance may not be problematic where both parties knowingly agree and the policy limits are sufficient to cover the loss. Often, however, property owners hiring contractors to perform work on their property assume the contractor will be liable for any damages resulting from any defective or negligent work, and are surprised to discover – often after a loss – that the contractor agreement limits their recovery not only to insurance, but also specifically to their own insurance.

In another Indiana case, Bd. of Comm’rs of Cnty. of Jefferson v. Teton Corp., a county entered into a contract for renovations to its courthouse. The parties entered into a standard American Institute of Architects (AIA) form contract that contained a waiver of subrogation for all “damages caused by fire or other perils to the extent covered by property insurance.” During construction, a subcontractor caused a fire that substantially damaged the areas being renovated and other parts of the courthouse. The county’s property insurer paid the loss and then brought a subrogation action against the contractor. 

The insurer argued that the subrogation waiver applied only to the “work” under the contract and not to other parts of the courthouse that were damaged and that it insured. The Indiana Supreme Court disagreed, holding that the waiver was not so limited on its face but rather applied unambiguously to any property insurance maintained by the county. 

In light of these rulings, it is important that policyholders examine the scope of any insurance requirement and subrogation waiver.

Similarly, parties should be clear about whether the waiver applies even if the insurance obtained is insufficient to cover all of the damages. The standard AIA waiver applies “to the extent” the damages are covered by insurance, but other language may be broader. In Morsches Lumber, Inc. v. Probst, the Indiana Court of Appeals held that an agreement to insure may limit recovery to insurance even where that insurance is insufficient to cover all of the losses. The court noted, “The fact that [the party] failed to take out a policy sufficient to cover the cost of the undertaking is a cost he will have to bear.” 

Provocative Move: No Liability to Third Parties

The more controversial portion of the U.S. Automatic Sprinkler decision is the 4-1 majority’s conclusion that the sprinkler contractor also was not liable for damage to the property of the other tenants with which it did not have a contract. The majority based that conclusion on Indiana’s common-law “acceptance rule,” which shields contractors from liability to third parties after the work is completed and the owner has accepted the work. 

The tenants sought to invoke an exception to this rule for “injury or damage to a third person … where it was reasonably foreseeable that a third party would be injured.” The majority, however, rejected this argument, holding that this exception applies only where personal injury “is a foreseeable consequence of a contractor’s allegedly negligent work.” The majority held that the exception did not apply to claims for property damage.

The majority noted that, “imposing third-party liability on companies – like U.S. Automatic Sprinkler – would force them to insure against a risk the amount of which they may not know and cannot control.” But, contractors insure against such risks every day in the form of commercial general liability (CGL) insurance, which applies to liability for bodily injury or property damage caused by an occurrence and generally includes so-called products and completed operations coverage. And, the majority of states – including Indiana – hold that faulty workmanship may be an “occurrence” when it causes such injury or damage. 

In U.S. Automatic Sprinkler, Justice Christopher Goff dissented from the majority’s application of the “acceptance rule,” concluding that there is no sound basis for the majority’s distinction between foreseeable personal injury and foreseeable property damage. Justice Goff posited that, “[r]easons of fairness and incentives support the general rule that those who negligently harm the person or property of others should bear the cost. There is no persuasive reason to give contractors special immunity from liability after negligent work has been accepted.”

The majority seems to have reached the conclusion that property insurance, not liability insurance, should be primarily responsible for property damage. Property insurance policies, however, contain exclusions that may apply to bar coverage in this context. For example, many all-risk property insurance policies exclude damage caused by faulty design or construction. One can imagine a scenario where faulty construction causes damage to the property of a third party whose property insurer denies coverage based on this exclusion. If the negligent contractor is not liable, then its liability insurer will not pay for the loss either, leaving the injured third party without recourse.

What About Indemnity? 

Under U.S. Automatic Sprinkler, a contractor may not be liable to third parties for property damage caused by its negligence or defective work after the customer’s acceptance of that work. The customer, however, may be liable to those third parties. In those circumstances, parties who hire contractors to perform work should consider adding indemnity language to cover future claims based on the work. Such indemnity typically is covered by the contractors’ CGL insurance as an “insured contract.” Indemnity in these circumstances places liability for defective work where it belongs – on the contractor who performed it and on its liability insurance.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.

Arizona’s Implied Warranty of Workmanship and Habitability Cannot Be Disclaimed or Waived Under Any Circumstance

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Jason Feld and Stephanie Wilson | Kahana Feld

Arizona residential construction and single-family home production is growing at a rapid pace. And just as fast as the homes are sold, homeowners are constantly seeking warranty repairs from their homebuilders. Despite having strong purchase documents with express warranty language, the Arizona Supreme Court in Zambrano v. M & RC, II LLC, 254 Ariz. 53 (2022) adopted a bright line rule that regardless of the contract, the implied warranty of workmanship and habitability (“implied warranty”) cannot be disclaimed or waived under any circumstance.  The Arizona Supreme Court opinion provides clear guidance of the law in this area on the scope of the implied warranty in contracts between homebuyers and builder/vendors, specifically on the issue of whether an express warranty can negate and effectively waive the common law implied warranty – which is a definitive violation of public policy.

The Zambrano decision involved a licensed real estate broker who bought a new single family home for herself in a newly constructed master planned community in Surprise, AZ. Zambrano entered into a valid sales contract with Scott Homes (homebuilder) which contained a stand-alone 45-page pre-printed form express warranty. The express warranty was to be the “only warranty applicable to the home.”  The contract further clarified that the buyer was expressly disclaiming (and, thus, waiving) the implied warranty. The sales documents and express warranty were signed and authorized by Zambrano. A short time later, the home developed alleged “design and construction defects” that were “either time barred or outside the coverage” of the express warranty. Zambrano filed suit for the alleged defects based on the implied warranty. Scott Homes filed summary judgment based on the Zambrano’s waiver and disclaimer of the implied warranty in the purchase agreement. The trial court granted summary judgment and the matter was appealed up to the Arizona Supreme Court.

The Arizona Supreme Court decided the issue if an express warranty can essentially trump the common law implied warranty. The Court adopted a bright line rule holding that any disclaimer or waiver of the implied warranty is unenforceable as matter of law and as a matter of public policy. The Court further held that the implied warranty could not be disclaimed or waived unless and until the Arizona legislature expressly declared it to be a right that buyers could waive or disclaim. The Court concluded that “[e]enforcing the disclaimer and waiver here would grievously injure homebuyers and the public welfare as doing so would likely spell the end of the implied warranty . . . .”   The Court acknowledged that it had “considered leaving open the possibility that a sophisticated homebuyer in some settings could negotiate to waive the implied warranty,” but rejected “that idea.”  The Court observed that “it would be next to impossible for courts to decide whether a homebuyer was sophisticated enough” and the Court nevertheless concluded that “even sophisticated homebuyers need the protection offered by the implied warranty.” 

Interestingly, the dissent relied upon long-established public policy behind the freedom to contract and a “sophisticated” homebuyer who “seeks to purchase a customized home that presents specific risks for which the homebuyer prefers to negotiate unique coverage in an express warranty.” The dissent went further to state “a homebuyer who prefers a contractual term that is less protective than the implied warranty as to one section or component of the home, in exchange for greater and broader protection in another area of the home,” and a homebuyer who “negotiate[s] a reduced purchase price in exchange for a warranty more limited than the implied warranty.” However, the majority of the Court emphatically deferred any change in the law on circumventing the common law and public policy implications of implied warranty to the legislature.

The major take-away is that without legislative intervention, the implied warranty cannot be waived, disclaimed or modified under any circumstances in Arizona irrespective of a valid contract and express warranty.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.

Efforts Expected of a Contractor When Efforts Clauses Are in Dispute

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Tamara L. Boeck | Stoel Rives

You will often see in construction contracts terms directing the contractor to use “best efforts” or “reasonable efforts” or “commercially reasonable efforts,” but what do they mean?

Take as an example a project that is past the preliminary hurdles. The project is progressing in good faith, although not perfectly, on the critical path. Everyone wants to “make it work.” But as often happens, not everything in the supply chain and schedule works as the best laid plans outlined, let alone perfectly. In fact, the project is delayed. Where the cause of the delay is not force majeure, or other excusable delay by the contractor, and where the contractor has some fault, what types of actions must the contractor take to satisfy the ‘efforts clause’ under the contract?

First, it depends which jurisdiction governs the contract. Some courts do not distinguish between “best efforts” or “reasonable efforts” or even “commercially reasonable efforts,” while other jurisdictions do make distinctions. Therefore, evaluate the case law in the jurisdiction in which you are trying to enforce your terms.

Second, is your jurisdiction one that has concluded that “best efforts” language alone does not create a fiduciary relationship between the parties, or does it view that language as approaching or reaching a heightened obligation of performance by the contractor? And in what context will the court evaluate the contractor’s obligations?

For instance, courts will often evaluate a variety of factors, such as whether the contractor is a specialist, whether it’s financially strong enough to “do more” than another or even average contractor, whether it holds a particular expertise in the locale or subject matter, the material costs associated with expected performance versus the original benefit of the contract, whether additional performance is available in a reasonable time frame and cost, whether there are any “industry” or locale expectations or practices, whether the issue has arisen for this contractor in the past such that an expectation of performance is warranted, and whether any discussions of the subject performance or other negotiations by the parties occurred prior to the contract execution.

Many courts will very specifically evaluate the circumstances of the project and the parties’ positions, and not constrain interpretation to the express terms of the contract. Know if your jurisdiction views its analysis more broadly or will hold the parties to the corners of the contract in a more limited manner. Of course, as with any contract, even the “best efforts” or “reasonable efforts” or “commercially reasonable efforts” clause must be reconciled with other clauses in the contract, to the extent possible for a reasonable reading of the terms.

Third, courts have acknowledged that these clauses do not mean that the contractor must use every conceivable effort to perform, and most courts do not determine that a contractor must ignore its own interests or perform itself into bankruptcy just to satisfy its contractual terms. Contractors should be aware that diligence is absolutely required, but it is typically evaluated within the parameters of reasonable conduct for that contractor, for the project it agreed to perform. Or in the case of “commercially reasonable efforts,” a more objective standard may be used to evaluate the contractor’s performance.

Finally, most courts will also evaluate whether the contractor performed its own evaluation in “good faith” to meet the efforts clause requirements. Was the contractor objectively evaluating its performance and not taking any action that would undermine the owner’s benefit of the bargain? Though the contractor is not a fiduciary, it must do more than just promise to act in good faith; it usually must take demonstrative action to fulfill the contractual duties. The bottom line: Any dispute arising out of such efforts clauses is a question of fact for the arbitrator/judge or jury. If your contract includes any efforts clauses, consider including in the contract reasonable benchmarks to define the efforts each party is expecting of the other.

When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.