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.

Insurer With Excess “Other Insurance” Clause Owes No Defense Obligations

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Jessica Gallinaro | Wiley Rein

The United States District Court for the Southern District of New York, applying New York law, has held that an E&O insurer had no obligation to contribute toward the defense of an underlying matter in light of its policy’s excess “other insurance” clause. Berkley Assurance Co. v. MacDonald-Miller Facility Solutions, 2023 WL 2574133 (S.D.N.Y. Mar. 20, 2023).

The insured tendered an underlying matter, which included claims involving both property damage and professional liability, to its GL insurer and its E&O insurer. The GL insurer alone initially defended the insured in the underlying action, though the E&O insurer later provided additional counsel for the insured under a reservation of rights. The underlying lawsuit ultimately settled, with both carriers splitting the settlement equally. Thereafter, the GL insurer demanded that the E&O insurer reimburse the GL insurer for a portion of the defense costs it had incurred in the underlying action. The E&O insurer refused on the grounds that its policy included an “other insurance” clause that caused it to be excess over the GL insurer’s policy and that extinguished its duty to defend when any other insurance had a duty to defend a claim. By contrast, the GL insurer’s policy stated it provided primary coverage.

In granting the E&O insurer’s motion for summary judgment, the court concluded that the E&O insurer had no duty to defend—and therefore no duty to share the costs of the defense with the GL insurer—because of the specific language in its “other insurance” clause. The GL insurer had argued that New York law imposed a bright-line rule that “other insurance” clauses are triggered only when the different policies cover the same risk. Because the underlying action separately triggered each of the policies, such that there was no concurrent coverage, the GL insurer contended that the policies’ “other insurance” clauses were not implicated and both insurers had a duty to defend. The court, however, rejected this argument and instead applied the unambiguous language of the two contracts.

The court found that the E&O insurer’s “other insurance” language specifically defined its excess obligations in connection with claims against the insured when other carriers have a duty to defend those claims, and it was not limited to indemnification of losses. The court further noted that, while the GL insurer did not cover a loss that overlapped with the E&O’s coverage, its duty to defend encompassed the entire suit and thus overlapped with the E&O insurer. As such, the court determined that the GL insurer’s duty to defend triggered the terms of the E&O insurer’s “other insurance” clause, meaning that the GL insurer had a duty to defend the underlying action without contribution from the E&O insurer.

Finally, the court ruled that neither waiver nor estoppel prevented the E&O insurer from asserting its “other insurance” defense. The court concluded that the E&O insurer had not waived the “other insurance” defense by providing its own defense counsel in the underlying action because it participated in a limited fashion pursuant to a clear reservation of rights that preserved its coverage defense against the GL insurer. The court further determined that the E&O insurer was not estopped from asserting the defense because the GL insurer had failed to demonstrate that the E&O insurer’s limited participation in the underlying action under a specific reservation of rights caused the GL insurer to change its position to its detriment.

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.

Coverage Construction: Arizona Supreme Court’s Osborn III Opinion

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Creighton Dixon, Jeffrey Porter and Lynsie Zona | Snell & Wilmer

In Fidelity National v. Osborn III Partners LLC, the Arizona Supreme Court recently decided the question of whether mechanics’ liens filed by a general contractor are a construction lender’s “own darn fault” if the liens result in part from the lender discontinuing advances of loan proceeds to be used to pay the mechanics’ lien claimant. We’ve gathered members of our commercial finance and construction teams to help explain what the decision means for lenders, borrowers, owners, developers, and contractors.

Summary of the Opinion

The standard ALTA form of title insurance policy excludes from its coverage any defects, liens or encumbrances that were created, assumed or agreed by the insured. As the Arizona Supreme Court notes, this exclusion – “Exclusion 3(a)” – is meant to exclude coverage for matters that are the insured’s “own darn fault.”

In Osborn III, the construction lender, Mortgages Limited (“ML”), entered into a loan agreement with a developer to provide a loan for the construction of a condominium project, secured by a first deed of trust on the project. Two years later, in mid-2008, the developer defaulted by failing to make an interest payment, and ML ceased funding the loan. As a result, the general contractor for the project – Summit Builders (“Summit”) – was not paid in full and recorded a mechanics’ lien against the project. That same summer, ML went into bankruptcy, and the bankruptcy court created several LLCs – including Osborn III Loan LLC (“Osborn”) – to hold ML’s existing loans. As successor-in-interest to the lender, Osborn became the insured party on the title policy. Summit sued to enforce its mechanics’ lien at the end of December 2008. 

The title policy expressly provided for coverage if the lender’s deed of trust did not have priority over mechanics’ liens arising from work related to the project that was commenced before the policy date, even though work had indeed already begun prior to the loan closing. Although the Court did not specify the source of this coverage, filings with the Arizona Court of Appeals cite Covered Risk 11 (a) of the title policy, which protects against loss caused by lack of priority of the deed of trust caused by a mechanics’ lien for work that commenced on or before the date the deed of trust is recorded. Perhaps with that understanding, the lender settled Summit’s claims and sought coverage under its title policy.  

Fidelity denied the lender’s claim, however, arguing that the lender triggered Exclusion 3(a) because the lender’s decision to withhold project funding “created” the mechanics’ liens. 

Rejecting two frameworks established by federal courts, Arizona’s Supreme Court held that its prior opinion in a homeowner’s title insurance claim matter provided appropriate guidance in disputes as to the application of title policy Exclusion 3(a) in the context of construction lending in its recent Osborn III opinion. Accordingly, Arizona courts will rely on a causation framework to determine if the insured “created” or “suffered” a defect, encumbrance, or adverse claim – such as a mechanics’ lien – excluded from insurance coverage by Exclusion 3(a).

The Osborn III Court relied on its prior opinion in First American Title Insurance Co. v. Action Acquisitions, LLC, in which the Court held the created-risk exclusion in the purchaser’s homeowner’s title policy applied to its loss of title when the purchaser paid a grossly inadequate price for the home at a sheriff’s sale, which led to the sale being set aside. As in Action Acquisitions, the Fidelity National Court found the language of the title policy exclusion to be unambiguous, meaning that Exclusion 3(a) is applicable if the insured’s actions caused or allowed the defect. Significantly, this analysis does not consider the insured’s intent in creating the defect or whether the insured engaged in misconduct – such as a contractual breach – related to the defect.

The rejected federal frameworks would have imposed other factors into the analysis into application of Exclusion 3(a). However, the Osborn III Court opted instead for a causation framework, similar to a proximate cause analysis in tort law, which relies on examining the sequence of events: The insurer has the burden of proving that the insured’s actions actually caused a defect, encumbrance, or adverse claim so as to trigger Exclusion 3(a).

What does Osborn III mean for Lenders and Borrowers?

This decision will have ongoing relevance for construction lenders. Although the title policy in Osborn III was issued nearly 17 years ago, Exclusion 3(a) and Covered Risk 11(a) remain essentially the same despite ALTA’s recent revisions to its form policies.

The Osborn III Court was clear: Timing is key when it comes to Exclusion 3(a). The current economic climate is prompting construction lenders to look closer at the default provisions in their loan documents, and although construction lenders are always concerned with ensuring loan advances are used to pay contractors, Exclusion 3(a) provides one further reason.

What does Osborn III mean for the Construction Industry?

Osborn III is a 2023 opinion about a 2008 dispute. And even more dramatically – the matter is still not resolved! The Supreme Court remanded to the trial court to evaluate three factual issues. This opinion is a timely reminder that in order to avoid decades (plural) of litigation, keep good records. For example, the Court could not determine on the record before it the key timeline of events (e.g., did Developer fail to pay Contractor because Lender withheld funding, or did Developer fail to pay Contractor before Lender withheld funds). A clear record will help facilitate resolution of disputes. This is important as nearly everyone is better off promptly resolving a dispute and getting back to their respective core businesses (e.g., construction or lending, not litigating). 

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.

Liability in Washington: Who Pays for Construction Defects that Pose Safety Risks?

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Matthew Mues | Davis Wright Tremaine

The rule of thumb in Washington state has been that contractors and developers cannot be held liable in negligence for construction defects.[1] However, an unpublished decision filed December 12, 2022, by the Washington Court of Appeals in SOP, LLC v. DWP General Contracting, Inc. casts new light on this line of thought.[2]

In SOP, a subsequent owner of an apartment complex brought claims for breach of contract and negligence against a number of entities involved in the original development and construction of the complex for construction defects in the apartments. The subsequent owner’s claims were dismissed on summary judgment by the trial court. The Court of Appeals upheld the ruling.

Regarding the breach of contract claim, the Court of Appeals determined that although the addendum to the purchase and sale agreement (“PSA”) assigned “all construction warranties” to the subsequent owner, the PSA itself stated that the seller of the complex made no warranties regarding the building and, thus, there were no warranties to assign.[3]

As for the negligence claim, the Court of Appeals did not reject it outright on the grounds that there are no negligence claims against developers or contractors in Washington for construction defects. Rather, it started its analysis by stating that the “economic loss rule is no longer the correct analysis” for determining whether a negligence claim can be brought in a construction defect case. It clarified that “[w]here a court must determine whether a plaintiff is limited to contract remedies or whether they may recover in tort, ‘the court’s task is not to superficially classify the plaintiff’s injury as economic or noneconomic.'”[4] Instead, the “court must apply the independent duty doctrine.”[5]

The Court of Appeals then stated as follows:

In the construction context, a party owes a duty in tort independent of the contract where it creates a defect that causes a significant safety risk and its professional role puts it ‘in the best position to prevent harm.’[6]

It then went on to cite to cases where plaintiffs were able to maintain negligence claims against engineers for causing harm involving safety risks (e.g., fire on the Seattle monorail; structural engineering errors that led to defects that rendered a building dangerously unsafe in a large seismic event), due to the duty of those engineers to exercise reasonable skill and judgment in performing engineering services to avoid safety risks.[7] However, in SOP, the Court of Appeals did not limit the duty to prevent safety risks to engineers.

Instead, it first acknowledged that the entities involved in the original development and construction had “no independent tort duty to avoid construction defects.” But then, in response to the subsequent owner’s position that the defects have caused it to face extensive repairs to various parts of the structure, it went on to state that the subsequent owner “presented no evidence that the defects in Phase 2 caused or could cause significant safety risks to a large number of people” and that “none of the defendants here were responsible for the design of Phase 2 such that they were in the best position to prevent major safety risks.”[8]

Takeaways

The Court of Appeals’ reasoning in SOP raises the question of whether a developer or contractor could be held liable in negligence for construction defects. That is, if (1) a developer or general contractor arguably causes or contributes to construction defects, (2) those defects cause or “could cause” safety risks, and (3) the developer or general contractor was arguably in a position to prevent such risks, could they be liable in negligence to an owner of a building, structure, or home? We shall see how this plays out at the trial court level and whether we will gain clarity on this issue from the Washington Court of Appeals or Supreme Court in the years to come.

[1] See, e.g., Stuart v. Coldwell Banker Commercial Group, Inc., 109 Wn. 2d 406, 411, 745 P.2d 1284 (1987).

[2] 24 Wn. App. 2d 1046 (2022), 2022 WL 17590865.

[3] The subsequent owner made another argument that the warranties for a different phase of the project (Phase 1) applied to the phase at issue (Phase 2) due to option language, which stated that the sale of Phase 2 would occur on the same terms as the sale of Phase 1, which had construction warranties. The Court of Appeals disagreed, citing to the express language in the PSA itself stating that seller “makes no representations or warranties” regarding the Phase 2 property and that the addendum assigned warranties for just the Phase 2 property. 2022 WL 17590865, *3 – *4.

[4] Id. at *4, citing Affiliated FM Ins. Co. v. LTK Consulting Servs., Inc., 170 Wn. 2d 442, 449, 243 P.3d 521 (2010).

[5] Id.

[6] Id. at *5, citing to Affiliated,170 Wn. 2d at 453.

[7] Id., citing to Affiliated,170 Wn. 2d at 456-57, and Pointe at Westport Harbor Homeowners’ Ass’n v. Engineers Northwest, Inc., P.S., 193 Wn. App. 695, 700, 704-05, 376 P.3d 1158 (2016).

[8] Id.

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.

ChatGPT: US lawyer admits using AI for case research

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Kathryn Armstrong | BBC

A New York lawyer is facing a court hearing of his own after his firm used AI tool ChatGPT for legal research.

A judge said the court was faced with an “unprecedented circumstance” after a filing was found to reference example legal cases that did not exist.

The lawyer who used the tool told the court he was “unaware that its content could be false”.

ChatGPT creates original text on request, but comes with warnings it can “produce inaccurate information”.

The original case involved a man suing an airline over an alleged personal injury. His legal team submitted a brief that cited several previous court cases in an attempt to prove, using precedent, why the case should move forward.

But the airline’s lawyers later wrote to the judge to say they could not find several of the cases that were referenced in the brief.

“Six of the submitted cases appear to be bogus judicial decisions with bogus quotes and bogus internal citations,” Judge Castel wrote in an order demanding the man’s legal team explain itself.

Over the course of several filings, it emerged that the research had not been prepared by Peter LoDuca, the lawyer for the plaintiff, but by a colleague of his at the same law firm. Steven A Schwartz, who has been an attorney for more than 30 years, used ChatGPT to look for similar previous cases.

In his written statement, Mr Schwartz clarified that Mr LoDuca had not been part of the research and had no knowledge of how it had been carried out.

Mr Schwartz added that he “greatly regrets” relying on the chatbot, which he said he had never used for legal research before and was “unaware that its content could be false”.

He has vowed to never use AI to “supplement” his legal research in future “without absolute verification of its authenticity”.

Screenshots attached to the filing appear to show a conversation between Mr Schwarz and ChatGPT.

“Is varghese a real case,” reads one message, referencing Varghese v. China Southern Airlines Co Ltd, one of the cases that no other lawyer could find.

ChatGPT responds that yes, it is – prompting “S” to ask: “What is your source”.

After “double checking”, ChatGPT responds again that the case is real and can be found on legal reference databases such as LexisNexis and Westlaw.

It says that the other cases it has provided to Mr Schwartz are also real.

Both lawyers, who work for the firm Levidow, Levidow & Oberman, have been ordered to explain why they should not be disciplined at an 8 June hearing.

Millions of people have used ChatGPT since it launched in November 2022.

It can answer questions in natural, human-like language and it can also mimic other writing styles. It uses the internet as it was in 2021 as its database.

There have been concerns over the potential risks of artificial intelligence (AI), including the potential spread of misinformation and bias.

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.