This article reviews some of the issues addressed in a standard Owner/Design Professional Agreement, outlines concerns from the Design Professional’s perspective, and discusses how the Design Professional can reduce liability on a project and ensure equitable adjustments to the contract price and schedule for changed or additional design services. The agreement contemplated by this article is one to be used as part of a traditional design-bid-build approach.
Standard of Care
When trying to hold a Design Professional liable for negligence, one of the first legal considerations is the standard of care owed. Absent an express contractual warranty, the law does not require the Design Professional to guarantee that the design will be perfect. Rather, the standard of care that the courts will typically apply is that degree of care which a reasonably careful architect/ engineer would use under like circumstances. However, nothing prevents an Owner from seeking contractual language that increases the typical standard of care owed by the Design Professional to the level of an express warranty of the design; in fact, Owners frequently attempt to do so in their proposed agreements – and courts will enforce such language. This is a danger to the Design Professional, as it is possible that the increased standard of care could go beyond professional liability insurance coverage available to the Design Professional. Thus, the Design Professional should insist on the deletion of any such guarantee as unreasonable.
Similarly, a Design Professional should insist on the deletion of any proposed language that attempts to establish a fiduciary duty between the Design Professional and the Owner, as such language also results in an increased standard of care owed on the Project.
Owner’s Project Criteria
Before commencing with design services, the Design Professional should insist upon a well-defined project criteria from the Owner, upon which it may rely for establishing the overall parameters of the project. The agreement should expressly state that the project criteria furnished by the Owner describes all of its program requirements and objectives for the project, including use, space, budget, time, site, maintenance requirements, and expandability requirements, as well as submittal requirements and other requirements governing the Design Professional’s performance of the work on the project. Ideally, the Owner’s project criteria includes conceptual documents, design criteria, performance requirements and all other Project-specific technical materials and requirements needed by the Design Professional to commence work without further information gathering after the contract is executed.
Any language that requires the design documents to reflect the Owner’s “intent” or other such wording should be deleted (as mind reading should not be a contractual requirement). The Design Professional should insist on express contractual language that states that if the Owner seeks to supplement or change the project criteria after the contract price is established or after the Design Professional commences work, then the Design Professional is entitled to an equitable adjustment to the contract price and schedule as a condition precedent to performing any such additional work.
Similarly, to the extent that the Owner changes the project budget, there should be contract language entitling the Design Professional to an equitable adjustment in the contract price and schedule, to be reflected in an executed change order, for all resulting value-engineering needed to reach the revised budget. However, if value engineering is needed because the bids from all contractors exceed the project criteria’s budget (possibly resulting from inaccurate pricing estimates by the Design Professional), then the contract should include language that states whether a Design Professional must perform that value engineering work without additional compensation. Perhaps the contract states that the Design Professional is only required to do so if the lowest responsive and responsible bid exceeds the budget by some threshold percentage. Regardless, the Design Professional should expressly limit any liability for any claims or damages sought by the Owner arising from the cost of the work exceeding the project criteria’s budget.
Equitable Schedule of Values
Owners may seek to establish a draw schedule that withholds most of the contract price until after the construction documents are 100% complete and approved and permitted by the governing building authorities, i.e. when the Owner has a work product in hand that would allow construction to commence. However, the Design Professional should insist on a payment draw schedule that equitably reflects the value and time required at all preliminary stages: schematic phase, design development phase, the staged percentage completion milestones of the construction documents, negotiation/bid review phase and contract administration. Moreover, the contract should define the work product required at each such stage, as applicable, that would trigger entitlement to each successive draw payment.
Construction Contract Administration
While the standard AIA Documents for construction contemplate intensive contract administration services to be performed by the Architect during the construction phase, oftentimes a companion AIA design agreement is not used on the same project. Indeed, even if a percentage of the Design Professional’s contract price is dedicated to contract administration, often the design agreement does not define well the Design Professional’s contract administration duties (or may not address them at all). This disconnect creates fertile ground for conflict. It is difficult, if not impossible, to predict the amount of involvement required by the Design Professional during the construction phase for some contract administration duties, such as RFIs. Accordingly, the Owner and Design Professional should attempt to define the Design Professional’s scope of contract administration services to be performed during the construction phase and break-out and identify certain contract administration services to be performed on an hourly fee basis (with a rate schedule agreed to and incorporated into the agreement).
The agreement should expressly state that the Design Professional is entitled to an equitable adjustment in the contract price and schedule for the following items:
- as previously discussed, any change in the project criteria;
- change in the instructions or approvals given by the Owner that necessitate revisions in the design documents;
- enactment or revision of codes, laws or regulations or official interpretations which necessitate changes to previously prepared design documents;
- decisions of the Owner not rendered in a timely manner;
- failure of performance on the part of the Owner or its agents;
- preparation for an attendance at a any deposition, dispute resolution proceeding or other legal proceeding
Briefly, as the amount of Reimbursable Expenses will necessarily remain an unknown contingency, they should not be limited to a Reimbursable Expense Allowance (as is sometimes requested by the Owner), but rather should be additional compensation over and above the contract price.
The Design Professional is strongly advised to consult with its insurance broker to review the contract’s insurance requirements to determine whether its current policies comply and whether additional coverage is required. If so, the Design Professional will need to ensure that any additional premium to be paid is included in the contract price or otherwise covered as a reimbursable expense.
Limitation of Liability
As it relates to the Owner, the Design Professional should seek to limit its total liability for any and all claims or injuries arising from the project to the amount paid on behalf of or to the Design Professional by its insurer in settlement or satisfaction of such claims. If no such insurance coverage is provided with respect to the Owner’s claims, then the Design Professional’s total liability to the Owner for any and all such uninsured Owner claims should nonetheless be capped at some dollar amount, such as some percentage of the contract price that reflects the Design Professional’s profit on the Project. Such limitation of liability provisions are generally enforceable (although the Design Professional should confirm with an attorney licensed in the state whose laws govern the contract).
Instruments of Service
The contract should expressly state that all drawings, specifications and other documents and electronic data furnished by the Design Professional per that same contract are deemed to be instruments of service, and that Design Professional shall retain the ownership and property interests in them, including the copyrights. Only upon the Owner’s payment in full for all amounts due under the agreement should the Owner be granted a limited license to use the Instruments of Service in connection with the Owner’s occupancy or use of the project.
The contract must also address what happens if the design contract is terminated at any point prior to completion of the design documents. What rights, if any, does the owner have to the Design Professional’s work product under that scenario? Since the Design Professional is no longer involved in the design, if the Owner is granted license to still use the work product to complete the project, then the Owner should be required to indemnify and defend the Design Professional as a result of any claims arising from such use.
The issues outlined herein are not intended to be exhaustive. Design Professionals are strongly advised to have each design agreement separately reviewed by their construction attorney and insurance broker.
With more project owners demanding the use of Building Information Modeling (BIM), project delivery is necessarily carried out through greater contributions of design input by the general contractor and the major trade subcontractors. The design professionals are no longer the sole authors of the project design. This collaborative project delivery method has been called integrated project delivery (IPD). The contribution of design input from each of the various project players using IPD is a significant break from the traditional division of responsibility recognized in the standard design-bid-build project delivery method. Players who never participated in the project design now face potential risk of professional liability. Additionally, the new, cutting-edge technologies being used for BIM expand the types of risks born by the design professional if there are errors and omissions within the computer modeling system or the improper management of the computerized data.
What is BIM?
BIM involves computerized design software tools that help create a model that reflects all of the building components’ geometric and functional qualities. The general contractor and trade subcontractors provide product-specific information for building components and that data is inputted into the model, including performance specifications, connection details and cost data. However, the model is more than a mere representation of the design in a three-dimensional computer graphic. Embedded within the design programs are rules that define each of the components’ relation to the other components. The model is dynamic. If there is a change to one component, then the computer program would automatically and immediately revise the design to accommodate the ripple effect caused by the change. During the pre-construction phase, the project team can input different design options to facilitate value engineering and budgetary decisions, material estimation, and even long-term maintenance costs of the facility. In theory, assuming that the information provided by the various project players is accurate and the rules embedded in the model are correct, BIM should reduce errors and omissions, resulting in an aggregate reduction in professional liability and errors & omissions claims. Additionally, it should reduce the demand for change orders during the project, as the design should have fewer ambiguities and inconsistencies. Yet, if the assumptions embedded in the computerized model prove false, then the result would be a costly problem that all concerned should hope is covered by insurance.
Increasing Industry Acceptance:
IPD using BIM technology is becoming more prevalent with many predicting that it will become standard. In 2003, the U.S. General Services Administration’s (GSA) Public Building Service set a goal to require BIM on FY06 projects and beyond in support of improving design quality and construction delivery. One reason for the use of BIM was a lack of GSA staffing to review design documents and to ensure conformance to building standards. Additionally, GSA was concerned with anticipated sustainability goals for federal buildings with respect to energy efficiency and long-term maintenance costs. GSA sought to rely upon the new BIM software tools to provide solutions to these problems. Since that time, GSA has employed BIM successfully on numerous projects. The GSA is not the only project owner to use IPD using BIM technology. General Motors has constructed at least six projects using this delivery method. Also, the United States Coast Guard and the United States Army Corp or Engineers has implemented BIM software in its recent projects. The expected industry trend is that this delivery method will not be reserved only for complex projects, but rather will start being used for simpler projects on a wider scale.
Evolving Contractual Relationships:
The construction industry is only beginning to catch up with the contractual liability issues that arise from the non-traditional roles played by the various project participants. For example, there has been the 2008 release of the ConsensusDOCS 300 Series for use on IPD projects using BIM technology. Also, the American Institute of Architects (AIA) has developed IPD Agreements AIA C196-2008 Standard Form of Agreement between Single Purpose Entity and Owner for Integrated Project Delivery and AIA C197-2008 Standard Form of Agreement between Single Purpose Entity and Non-Owner Member for Integrated Project Delivery. The AIA contractual agreements incorporate a separate Exhibit (AIA Document E202 – 2008) that might also be used with their other, more traditional contract documents on IPD projects using BIM technologies. The new AIA documents allow the parties to define the standard of care for BIM, as such would be difficult to define given the short history of this technology. They also attempt to allocate responsibility for managing the computer model, e.g. data storage, transferring model files, granting and withholding access to model files, validating completeness and usability of files, among other things. Also, the Exhibit provides a chart listing standard building components that is to be filled out by identifying who will author each listed element of the model design. These contractual means of defining the standard of care and allocating responsibility may impact a design professionals’ liability for professional negligence.
Professional Liability Concerns for General Contractors and Trade Subcontractors:
The collaboration of general contractors and trade subcontractors in the design on IPD projects may result in liability exposure arising from errors in each parties’ contribution that result in defects in the project design. Accordingly, these parties must approach the IPD similarly to a design-build project and obtain professional liability coverage and errors & omissions insurance. Moreover, the general contractor must recognize that it would face contractual liability to the owner for the errors contributed solely by its subcontractors – errors which could be very difficult to detect by the general contractor. Thus, the general contractor would be well advised to demand in its subcontracts that those subcontractors who contribute to the project design obtain coverage. Yet, the specific type of coverage that expressly contemplates the allocation of responsibility and risk inherent in IPD may not yet be on the market.
Expanded Liability Concerns for Design Professionals:
The consensus seems to be that IPD using BIM technology will result in an overall reduction in design errors. Yet, to the technophobe, an over-reliance on computer models with decreasing human over-sight could also spell disaster. What responsibility should the design professional have for errors in the data inputted by the various parties? What if there are errors in the rules embedded in the model or the internal mechanisms for transferring data or any other number of possible computer glitches? The contract with the company creating the modeling software likely limits liability for such errors to an amount far less than the damage that could be created by the error. The design professional must consider insuring that gap. To address these questions and issues, the design professional should discuss the potential IPD exposures with their broker and to what extent they are insured for same.
IPD not only requires additional contributions to design from the contractor, but may also involve greater involvement by the design professionals on the construction side. Design professionals may find themselves more active in the development in the means and methods of construction given the overall integrated approach on these types of projects. “Means and methods” are often excluded in professional liability policies. This raises the question of whether the design professional should purchase general liability insurance to cover damages resulting from negligent construction practices.
IPD using BIM technology is changing the relationships between the various players on such construction projects. As a result, the standard construction contracts and their allocation of responsibility and risk may no longer be equitable or reflect reality. Accordingly, before participating in this type of project, all parties should consult with their attorney to review their contracts to address these issues. In addition to the need for revised construction contracts for these types of projects, all parties are strongly advised to meet with their insurance brokers and discuss the new risks arising from this project delivery method.
Frequently, general contractors will work with the same subcontractor or supplier on two separate, unrelated projects. When that happens, the situation may arise that on the first project (Project A), the subcontractor defaults on its contract, resulting in a back-charge that exceeds the subcontractor’s contract balance, i.e. the subcontractor owes the general contractor money. On the second project (Project B), the subcontractor satisfactorily completed its work and is due money from the general contractor. It may seem obvious that the general contractor would have a right of set-off, allowing the general contractor to deduct the amount due from the subcontractor on Project A from the amount that the general contractor otherwise owes the subcontractor on Project B. Seemingly, the general contractor should only have to pay the net difference or be able to avoid paying the subcontractor anything if the back-charge on Project A exceeds the amount due on Project B. However, as outlined in this article, that seemingly straight-forward right to “net out” the competing claims might not always be available.
There are several different factors that can frustrate the general contractor’s right of set-off. In some jurisdictions, state statutes may prohibit the general contractor from withholding from the subcontractor the amounts received from the owner for the subcontractor’s work, such statutes holding that those funds are held in trust for the benefit of the subcontractor. Some states might even find the withholding of funds received by the owner for the subcontractor’s work to be statutorily criminal. On projects covered by a payment bond, courts in some jurisdictions have held that even if the general contractor has a contractual right to set-off, the Surety may not. As a result, in those jurisdictions, notwithstanding the contractor’s contractual right of set-off, the subcontractor may be entitled to recover the full amount on Project B (from our scenario above) from the Surety without any deduction of the amounts the subcontractor owes on Project A. Given that the general contractor must almost always indemnify the Surety, such a result has the practical effect of eliminating the contractual benefit of a right of set-off. Additionally, in certain circumstances, by the discretion afforded to judges under the rules of civil procedure, courts have required the two competing claims to be handled by separate lawsuits independently and without regard to the general contractor’s claim of set-off. This article discusses these scenarios and others that impact the right of set-off.
Projects Protected by Payment Bonds
Basic surety law holds that a surety assumes only the liability of its principal and generally has the same defenses against a subcontractor suing on a payment bond as the principal/ general contractor. So, it would seem that if a general contractor has a contractual right of set-off against amounts otherwise owed to a subcontractor on a bonded project, the surety’s liability to the subcontractor on that bonded project should be reduced by the amount of the set-off. However, a federal district court in Virginia disagreed when addressing that situation on a federal project on which a federal Miller Act payment bond was issued. In U.S. ex. rel. Accoustical Concepts, Inc. v. Travelers Casualty and Surety Company of America,635 F. S. 2nd 434 (E.D. Va. 2009), the court held that general principals of suretyship law that conflict with the Miller’s Act’s terms and purposes (i.e. ensuring that subcontractors are paid promptly for labor, materials and services furnished on federal construction projects) must give way to the Act.
In Acoustical Concepts, a subcontractor sued the surety on a Miller Act payment bond to recover amounts due on a federal project. The general contractor (the principal on the bond) had a claim against the same subcontractor on an unrelated non-federal private project. Accordingly, the general contractor and its surety set-off those claims against the amounts otherwise due on the federal project. In doing so, the general contractor and surety relied upon a provision in the subcontract on the federal project that expressly stated that the general contractor had the right to do so. Specifically, the contract provision stated:
Before paying any amount due to the Subcontractor as provided hereinabove, the Contractor is hereby authorized to deduct therefrom and offset an amount equal to any and all sums or obligations owing by the Subcontractor to the Contractor and … any and all claims liquidated or unliquidated, by the Contractor against the Subcontractor , arising hereunder, under any other contract or agreement between the Subcontractor and the Contractor….
Again, the court rejected the surety and general contractor’s argument, based in part on its determination that neither the Miller Act nor the subject payment bond made any reference to the contractual set-off provision or its effect. The court reasoned as follows:
Were defendants [general contractor and Surety] allowed to interpose a setoff defense involving facts and circumstances relating to a non-federal project, plaintiff subcontractor would be forced to litigate with defendant sureties a dispute that plaintiff has with its general contractor that is nowhere a part of the payment bond or the Miller Act. The result can only be the kind of delay and complexity the Miller Act was designed to avoid. By contrast, preventing sureties from asserting a setoff defense leads to the sensible result – contemplated by the Miller Act – that a subcontractor [on a federal construction project] receives timely payment for providing labor and materials to [that project]. Defendant sureties may then seek to recover from [its principal] the full amount paid to plaintiff [subcontractor], and [the general contractor/principal] may then litigate the unrelated, non-federal dispute with plaintiff. In other words, the result reached here maintains a sharp division between the Miller Act’s remedy for subcontractors on federal construction projects and disputes between subcontractors and prime contractors arising from non-federal construction projects that are not governed by the Miller Act.
The argument can be raised that courts would apply this same reasoning in cases involving the states’ various Little Miller Acts on non-federal public projects or with respect to projects protected by statutory private payment bonds.
State “Trust Fund” Statutes
Several states have enacted statutes that hold that money received by the general contractor from the owner for the labor, materials, and services provided by subcontractors and suppliers (and lower-tiered subcontractors and suppliers) are held by the general contractor in trust for their benefit. The purpose of such legislation is to ensure that the subcontractors and suppliers that actually provide the work get paid. They may also potentially result in the frustration of the general contractor’s right of set-off.
The New York Lien Law, Article 3A §§70-79 is an example of a state trust fund statute. Section §70, states as follows:
The funds … received by a contractor under or in connection with a contract for an improvement of real property, or home improvement, or a contract for a public improvement in this state … shall constitute assets of a trust…. (Emphasis added.)
The New York Lien Law then outlines a statutory cause of action to enforce such a trust.
This statute was addressed in the New York federal case of Universal Maintenance, Inc. v. Amherst Painting, Inc. 1997 WL 160157 (W.D.N.Y.). In that case, the subcontractor sued the general contractor for amounts due on Project A – amounts that the general contractor had already received from the owner for the work performed by the subcontractor. The subcontractor argued that the funds received by the general contractor were held in trust pursuant to the New York Lien Law. The general contractor filed a counterclaim and raised as a defense that it had a right of set-off for back-charges arising from that same Project A, as well as, a back-charge arising from an unrelated subcontract on Project B. The court ruled that the general contractor indeed had a right of set-off as it related to the back-charges arising from the same Project A, holding: “the relief available in a Lien Law trust action encompasses the contractor’s right as trustee to offset against the trust fund amounts sums due from the subcontractor to the contractor with respect to the project.” Id. at 7 (Emphasis added). However, the court struck the general contractor’s counterclaim and defense of setoff for back-charges arising from the unrelated Project B, holding as follows: “The policy reasons for allowing the contractor to set off sums due from the subcontractor apply only to claims for sums due with respect to the project in question, not unrelated projects.” The court reasoned that a set-off claim arising from the unrelated Project B was not a compulsory counterclaim (i.e. one that must be brought in the same lawsuit pursuant to the rules of civil procedure) and can be pursued in another forum.
New Jersey has a similar trust fund statute which applies to public projects (“The New Jersey Trust Fund Act”) which states as follows:
All money paid by the State of New Jersey … or by any county, municipality or school district in the state, to any person pursuant to the provisions of any contract for any public improvement … shall constitute a trust fund in the hands of such person as such contractor, until all claims for labor, materials and other charges incurred in connection with the performance of such contract shall have been fully paid.
The federal district court of New Jersey addressed that statute in the context of this article’s two-project set-off scenario in a March 27, 2008 opinion and order granting a motion for partial summary judgment filed by the subcontractor in Atlantic City Associates, LLC v. Carter & Burgess Consultants, Inc. Civil Action No.: 05-3227. In that case, we again have the scenario of the general contractor having a back-charge claim against the subcontractor on Project A and, as a result, claiming a right of set-off against amounts the general contractor otherwise owes to the subcontractor on Project B. Also, the general contractor was paid in full by the public owner for the work performed by the subcontractor on Project B. Further, the following contractual provision was contained in the governing subcontracts that expressly granted the general contractor this right of set-off on unrelated projects:
The Subcontractor agrees … that Contractor shall have the right to set off against any moneys due Subcontractor under this Subcontract any claim or claims against Subcontractor, whether arising under this Subcontract, or any other Subcontract or Subcontracts between the parties hereto.
Notwithstanding an express contractual right to do so, the federal district court rejected the general contractor’s claim to a right of set-off on unrelated projects as a matter of law. The court reasoned, in part, as follows: “The Trust Fund Act provides that ‘… the funds in the hands of the prime contractor constitute a trust fund to inhibit their diversion for purposes unconnected with the public project.'”
In an attempt to circumvent The New Jersey Trust Fund Act, the general contractor argued that the above-cited contractual right to set-off on unrelated projects constituted a waiver by the subcontractor of any rights otherwise bestowed by the Act. However, the court rejected that argument stating that the contract language was not “clear and unmistakable” evidence of the subcontractor’s knowing waiver of its statutory rights, in part because the contractual provision did not reference the statutes. It should be noted, however, that the case holding suggests that, with more specific waiver language, a subcontractor can waive such statutory rights.
Set-off as a Felony Crime?
It would be difficult to be more severe than Florida which makes the misapplication of construction funds a statutory felony. Florida Statute §713.345(1)(a) states as follows:
(1)(a) A person, firm, or corporation, or an agent, officer, or employee thereof, who receives any payment on account of improving real property must apply such portion of any payment to the payment of all amounts then due and owing for services and labor which were performed on, or materials which were furnished for, such improvement prior to receipt of the payment. This paragraph does not prevent any person from withholding any payment, or any part of a payment, in accordance with the terms of a contract for services, labor, or materials, or pursuant to a bona fide dispute regarding the amount due, if any, for such services, labor, or materials.
(b) Any person who knowingly and intentionally fails to comply with paragraph (a) is guilty of misapplication of construction funds, punishable as follows: 1. If the amount of payments misapplied has an aggregate value of $100,000 or more, the violator is guilty of a felony of the first degree, punishable as provided in s. 775.082 [i.e. by a term of imprisonment not exceeding 30 years].
This provision arguably limits a general contractor’s right to withhold payment for a back-charge (i.e. a bona fide dispute regarding the amount due) to only the project on which that back-charge arose. This is because the statute limits bona fide disputes to “disputes regarding the amount due, if any, for such services, labor, or materials”. A strong argument can be made that this language could be interpreted to mean “such” services, labor, or materials provided on that project only. If so, there would not be any right to set-off on unrelated projects if the contractor has received payment for the work by the subcontractor on the unrelated project on which the subcontractor performed satisfactorily; it would be criminal to withhold such payment because of a claim on an unrelated project. A general contractor could try to argue otherwise, but at the risk of committing a statutory felony crime punishable by jail time.
Rules of Civil Procedure – Court’s Discretion to Require Separate Trials
The rules of civil procedure might also assist a subcontractor to avoid a general contractor’s right of set-off on unrelated projects. If the subcontractor sues a general contractor for amounts owed on a project, and the general contractor has a back-charge arising from that same project, the general contractor must assert the back-charge through a counterclaim in that same lawsuit; it is deemed a compulsory counterclaim. However, the same is not true for a back-charge arising from a separate contract. In such instances, the general contractor’s counterclaim is deemed a permissive counterclaim. It is within the court’s discretion whether a permissive counterclaim is to be addressed in the same lawsuit or separately.
This scenario was addressed in Turner Construction Co. v. E&F Contractors, Inc., 939 So. 2d 1108 (Fla. 3rd DCA 2006). In that case, the general contractor conceded that the subcontractor was due the amounts sought, but for the general contractor’s claim to a right of set-off for back-charges arising from three other unrelated projects. Importantly, the subcontractor had filed four separate lawsuits – one for each of the projects. In the lawsuit at hand, the general contractor claimed that its back-charges on the other three projects exceeded the amount that the subcontractor was owed on the subject project. Accordingly, the general contractor filed a counterclaim and affirmative defense in the subject lawsuit, asserting a claim of set-off arising from its back-charges on the other projects.
The trial court struck the general contractor’s defense of set-off and entered a final summary judgment in favor of the subcontractor. The appellate court affirmed that decision holding as follows:
The affirmative defense of set-off in the instant case is in the nature of a permissive counterclaim, and is the subject of other pending suits between the parties…. It is within a trial judge’s discretion to sever a permissive counter-claim from the main claim if there is no evidence of prejudice…. Here, the trial court’s order does not prejudice [the general contractor] because [the general contractor] still has the opportunity to fully litigate its set-off claims in the pending lawsuits arising out of its other subcontracts with [the subcontractor]…. Furthermore, the trial court’s order striking the set-off claim promotes the interests of judicial economy, and avoids the potential of inconsistent rulings.
Based upon the results of this case, legal counsel for subcontractors facing this scenario may want to consider filing separate lawsuits. The lawsuit concerning the project on which the back-charge arose may take years to litigate given the likelihood of numerous contested factual issues that must be investigated through discovery. Conversely, the lawsuit concerning the project on which the amount due is undisputed (but for the set-off claim arising from the other project) could be won through summary judgment much sooner. The subcontractor might be able to collect quickly on the undisputed project, allowing it to build its legal war chest to fight the battle on the disputed project.
While it may seem absurd to require Party A to pay Party B when Party B owes Party A, the courts may nonetheless require it depending upon which states’ law governs, whether the job is bonded, or other circumstances. Accordingly, when there are set-off claims arising from separate and unrelated projects, it is strongly recommended that parties consult and retain local counsel.
Often when acting as the prime on a construction project, the design professional is asked to review, comment or even craft insurance and bonding specifications for the project. With an increasing number of general contractors and subcontractors experiencing financial difficulties due to the poor economy over the last couple of years, it becomes increasingly important for owners to protect themselves as much as possible through commercial general liability (CGL) policies and performance bonds. This article distinguishes between the nature of liability insurance and suretyship, analyzes the scope of coverage and protections afforded by each – including recent case law that arguably expands CGL coverage – and discusses how owners and general contractors might better protect themselves using these tools. This article also includes a brief description of owner-controlled insurance policies (OCIP) which may be appropriate for large construction projects.
The Nature of Liability Insurance and Performance Bonds Distinguished
A performance bond issued by a Surety is not insurance. Liability insurance is a contract pursuant to which the insurer agrees to indemnify and defend the insured against certain claims for damages, specifically losses covered under the insurance policy, for which the insured is otherwise liable to third parties. If the insurer pays out under the policy, it may not later seek indemnity from the insured. This is not the case with a performance bond. A performance bond is a three-party agreement issued by a Surety who guarantees to an obligee (i.e. the protected party) that the principal (i.e. the entity whose performance the Surety guarantees) will complete the work required under the bonded contract. Also, if the bond incorporates by reference the bonded contract, the Surety may become liable for post-completion damages such as repairs necessitated by latent defects.
While performance bonds are usually obtained by the general contractor for the protection of the owner, general contractors may also require their subcontractors to obtain performance bonds. Owners too may require the general contractor to demand its subcontractors to provide performance bonds. While doing so will increase the contract price, it has the benefit of excluding lower quality and financially struggling subcontractors who cannot obtain such bonding, as well as provide the bond protection.
Unlike liability insurance, if the Surety is required to incur costs to complete the contract or otherwise pay out under the performance bond due to the principal’s default of the underlying contract, the Surety will seek indemnity from the principal. Moreover, as a condition of issuing the performance bond, the Surety likely will have required a general agreement of indemnity from not only the principal, but the individual stakeholders of the principal corporate entity and their wives. Also, the Surety has no duty to defend its principal against claims made against the performance bond.
It is important for the parties protected by the bond to recognize this distinction because it should alert them of the need to have counsel review the performance bond form being used on a project. Given the additional liability exposure to the principal under a performance bond and those individuals who signed a general agreement of indemnity to obtain the bond, the principal has an obvious incentive to propose a bond form that provides as little protection as possible. As discussed below, the protection afforded by a performance bond may differ significantly depending upon the bond form used.
Performance Bond Coverage
Again, a performance bond is a means of guaranteeing the completion of a construction project upon the default of the principal. The Surety is lending its credit to the principal. The amount of protection afforded by a performance bond is the reasonable amount to complete the project in excess of the principal’s available contract balance up to the penal sum of the bond
However, the Surety will not be liable to the obligee for all damages arising from the principal’s default. Absent certain language in the bond form, there may be several types of contractual damages for which the principal may be contractually liable but that the performance bond will not cover. Unless the bonded contract is expressly incorporated into the performance bond, the Surety may not be liable for the correction of defective work or the performance of contractually required warranty work. Also, in certain jurisdictions, even though a principal is adjudicated liable for actual delay damages resulting from its breach of the contract, the Surety will not be held liable for such damages under the performance bond absent express terms in the bond form stating otherwise. See American Home Assurance Co. v. Larkin General Hospital, Ltd, 593 So. 2d 195 (Fla. 1992). Similarly, a performance bond Surety may not be held liable for lost profits or rents on the project arising from the principal’s breach of the bonded project – again, even if the principal is found liable for such damages – absent express terms in the bond form stating otherwise. The scope of the performance bond will be limited to its express terms. However, through the negotiation of the bond form, the terms might be expanded to include these types of contract damages, thus expanding the obligee’s protection beyond merely the completion or correction of work.
Commercial General Liability Coverage
As commonly understood, the purpose of CGL insurance is to provide protection for personal injury or for property damage caused by an occurrence, such as the negligent performance of construction work, but not for the replacement and repair of such negligently performed work or the cost to complete unperformed work. For example, if a roofing contractor negligently constructs a roof on a building which results in damage to property located inside the building, then a CGL policy issued to the roofing contractor may cover the damage to the property inside the building but not the cost to replace the roof.
However, CGL policies may include riders and endorsements that limit coverage otherwise provided by a standard policy, such as exclusions for mold or residential construction. Such exclusions could be devastating if they are indeed a potential risk. Design professionals working as the prime on a project should strongly encourage their owner clients to have the controlling CGL policy reviewed before the contract is entered. Most construction contracts merely require that a certificate of insurance be provided to establish proof of insurance. However, the certificate of insurance does not identify the scope of coverage. Only through a review of the insurance policy itself can the scope of coverage be determined.
Recent Expansion of Commercial General Liability Coverage
While a standard CGL policy is not typically understood to cover the cost to repair and replace the insured’s own defective work, a Supreme Court of Florida case holds that such a policy issued to the general contractor may provide coverage for the cost to repair and replace the damage to a completed project caused by a subcontractor’s defective work. U.S. Fire Ins. Co. v. J.S.U.B., 979 So. 2d 32 (Fla. 2007). The court’s analysis of the CGL policy could be argued in other jurisdictions beyond Florida.
In the J.S.U.B. case, a general contractor constructed homes on soils that were not adequately compacted (such compaction being the responsibility of one of the subcontractors), resulting in settlement cracks to the homes, as well as, items placed in or affixed to the homes, such as wallpaper. The insurer argued that workmanship deficiencies that resulted in later damage to the homes constructed by the insured/ general contractor should not be considered the result of an accident and, thus, should not be deemed an “occurrence” which is covered by the insuring agreement. However, the court disagreed and determined that there was coverage for the damaged homes.
In reaching its holding, the court found that settlement damage to the homes caused by improper compaction of the underlying soil was an “occurrence”. As defined in the policy, an “occurrence” is “an accident, including continuous or repeated exposure to substantially the same general harmful conditions.” The court held that when the term “accident” is undefined in a liability policy, as was the case, the term includes not only “accidental events” but also damages or injuries that are neither expected nor intended from the viewpoint of the insured – such as the negligence of its subcontractors. The court also recognized that there is a difference between a claim for the costs of repairing or removing defective work, which is not a claim for “property damage,” and a claim for the costs of repairing damage caused by the defective work, which is a claim for “property damage.” As for the “your work” exclusion, the operating policy included the following exception to that exclusion: “Paragraph (6) of this exclusion [i.e. the “your work” exclusion] does not apply to ‘property damage’ included in the ‘products-completed operations hazard.” The operating policy had products-completed operations hazard coverage.
The more expansive coverage provided by the Florida court’s interpretation of the post-1986 ISO CGL policy arguably overlaps the protections afforded by a performance bond. Given the indemnity obligations of the principal on the bond, it should be expected that principals will likely use this case law to shift liability away from its Surety and towards the CGL carrier when there is damage to the project due to a subcontractor’s deficient work.
It should be noted that the ISO has begun to issue an endorsement that may be included in a CGL policy which arguably eliminates coverage for the cost to repair and replace the damage to another subcontractor’s work necessitated by the insured’s negligent performance, thus negating the Florida court’s expanded interpretation of the standard post-1986 standard ISO CGL policy. Such an endorsement is not in the owner’s or general contractor’s interest. Accordingly, if an insurer has included this endorsement as a part of the CGL policy, an owner and general contractor would be advised to determine if the endorsement can be stricken and, if so, find out the cost for doing so and perform a cost/risk analysis. Further, the case high-lights the importance of obtaining products-completed operations hazards coverage as part of the CGL policy, i.e. coverage for occurrences that arise after the project is complete.
Additional Insured to a CGL Policy
Owners should be advised to demand that they be named as an “additional insured” on all CGL policies protecting the project. Further, they should ensure that the insurer actually issues the endorsement naming them as an additional insured, as an action against a potentially insolvent subcontractor for breach of contract for failing to obtain the contractually required endorsement may not afford a sufficient remedy. An additional insured can make a direct claim against the policy and sue for a declaratory judgment establishing coverage. Absent being named an additional insured, only the insured can sue the insurer before the insured’s claim is resolved. Additionally, many states allow the prevailing party to recover their attorney’s fees in an action to recover against their own carrier for an insured loss.
Owner-Controlled Insurance Policy
An owner-controlled insurance policy (OCIP), often referred to as a “wrap-up” policy, is a policy obtained by an owner to provide coverage for all of the project participants on very large construction projects or a combination of related projects. Such a policy typically provides commercial general liability insurance for all parties, as well as, workers compensation, employer’s liability, personal injury and property coverage. Such policies can also include professional liability and builder’s risk coverage. The potential advantage of OCIP is to avoid multi-insurance lawsuits seeking recovery for various claims between the owner, architect, engineer, contractor, subcontractors and suppliers. However, unlike individually obtained policies, OCIP coverage typically expires at the end of the project – before liability exposure of project participants ends. Accordingly, the owner may be advised to require project participants to obtain additional coverage in excess of the wrap-up policy to address that concern. Given the complexities of these wrap-up policies, they should be purchased only after consulting with an experienced insurance broker and legal counsel.
While owners may believe they have protected themselves by requiring CGL insurance and a performance bond for a project, a design professional acting as prime should advise their owner clients to conduct a more thorough review and negotiated modification to the insurance policy and bond form with the help of their legal counsel and insurance broker. Further, owners should be advised of the possible advantages of obtaining an OCIP or “wrap up” policy. Doing so can significantly expand their protections and increase the likelihood of a successful and profitable project.
 The standard CGL policy form (such as a post-1986 standard ISO or Insurance Services Office, Inc.) provides coverage under its insuring agreement for the “sums that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damages’ caused by an ‘occurrence'”. Exclusion (j)(6) of that same policy form excludes from coverage “property damage to that particular part of any property that must be restored, repaired or replaced because ‘your work’ was incorrectly performed on it.”
 Florida statutes allows state agencies to obtain OCIP coverage for certain public projects of an estimated total cost of $75,000,000 or, with respect to the construction or renovation of two or more public schools during a fiscal year, $30,000,000 or more. See §255.0517 “Owner-controlled insurance programs for public construction project.”