Inside this Issue

A1 - Indemnification Action Only Accrues for Statute of Limitation Purposes on Date Indemnitee Pays Judgment or Settlement
A2 - CGL Policy Held to Cover Costs of Correcting SubContractor’s Defective Work Including the Work Itself
A3 - Where Flow-Down Clause Limits Incorporation Of The Design-Build Prime Contract, Allocation of Liability In The Subcontract Will Govern
A4 - Piercing the Architectural Firm’s Corporate Veil

Article 1

Indemnification Action Only Accrues for Statute of Limitation Purposes on Date Indemnitee Pays Judgment or Settlement

Kent Holland, J.D.
ConstructionRisk, LLC

Where a subcontractor failed to honor its contractual indemnification obligations to defend and indemnify a swimming pool installation general contractor against claims arising out of the subcontractor’s work, the general contractor entered into a settlement with plaintiff who had been injured when diving into the swimming pool several years after construction of the pool was completed. The GC and its insurance carrier sued the subcontractor to recover their settlement costs. In defending against the suit, the subcontractor moved for summary judgment, arguing that the statute of limitations for enforcing the indemnity agreement had lapsed. This was rejected by the court, which held that the statute, which was actually a statute of repose applicable to patent defects in design and construction (4 years for patent defects and 10 years for latent defects), was not applicable to bar an action for indemnity.

As found by the court, “A cause of action for breach of an express indemnity agreement (contractual indemnity) accrues when the indemnitor sustains the loss by paying the money sought to be indemnified from the Indemnitee.” The indemnity does not accrue for statute of limitations when the original accident occurs, but instead accrues when the tort defendant pays a judgment or settlement as to which he is entitled to indemnity. Valley Crest Landscape Development v. Mission Pools of Escondido, Inc., 189 Cal. Rptr. 3d 259, 238 Cal. App.4^th 468 (2015).

The indemnification clause in question in the subcontract provided the following:

“Subcontractor [(Mission Pools)] indemnifies and holds Contractor [(Valley Crest)] harmless from and against any and all claims, demands or actions made by any person or entity, whether valid or not, arising out of the performance by Subcontractor, including, without limitation, its employees, agents, and sub-subcontractors of this subcontract. Subcontractor agrees to reimburse Contractor upon demand for any expenses, including attorney’s fees, incurred by Contractor in defending against or dealing with any such claims, demands, or actions. [¶] Subcontractor specifically obligates itself to Contractor in the following respects ... [¶] ... [¶] ... Subcontractor shall protect, hold free and harmless, defend and indemnify Contractor and Owner ... from all liability, penalties, costs, losses, damages, expenses, causes of action, judgments or other claims resulting from injury to or death sustained by any person ..., which injury [or] death ... arises out of Subcontractor’s performance of work under this Subcontract. Subcontractor’s aforesaid indemnity and hold harmless obligation shall apply to any act or omission, willful misconduct or negligent conduct, whether active or passive, on the part of Subcontractor or its agents, sub-contractors or employees.”

The subcontract was for work on a new swimming pool for a St. Regis Resort. Construction of the pool was completed in 2001. In September, an individual dived into the shallow end of the pool while under the influence of alcohol and seriously injured his spine and was rendered a quadriplegic. He filed suit against St. Regis in 2008, and later amended the complaint to add the general contractor and subcontractor as defendants. The general contractor tendered its defense to the subcontractor pursuant to the indemnity provision of the subcontract. The subcontractor never responded to the tender.

After the underlying case by the plaintiff was settled, the general contractor and its general liability insurance carrier sued the subcontractor to recover under the indemnification clause. Its general liability insurance carrier likewise sought, through subrogation under the express indemnity provision of the contract, to be reimbursed the amounts it had paid to resolve the matter.

In considering the merits of the indemnification claims (and in particular the CGL carrier claims), the court noted that although the factual basis for finding any contribution by the subcontractor in causing the injuries was slim, the equities tip against the subcontractor with regard to the subrogation claim because the subcontractor failed to comply with its obligations under the subcontract. In contrast to the subcontractor who did not even respond to the defense tender, the CGL carrier did everything it was supposed to do to fulfill its obligations under the insurance policy.

The subcontractor was found to have an obligation to accept the tender of defense when it was made and to provide a defense. The subcontractor also failed to maintain its own CGL policy that would name the general contractor as an additional insured as required by the contract. It had maintained such a policy for three years after completion of the pool but had ceased to maintain it prior to the accident. The court concluded that the “failure to fulfill its obligation to maintain insurance supports a finding that National Union was in a superior equitable position.”

Comment: This decision demonstrates an important point about indemnification clauses that I think some risk managers may be overlooking when they agree to contractual indemnification. Whereas a claim might otherwise be barred by a statute of limitations or statute of repose because it is based on a tort claim arising out of a construction project, an indemnity clause may create a wholly different cause of action that is not subject to the ordinary statutes of limitations and repose. As in this case, an indemnitte might settle a claim and bring a breach of contract action against the indemnitor for refusing to tender a defense and provide indemnification as required by the contractual indemnification clause.

About the author: Article written by J. Kent Holland, Jr., a construction lawyer located in Tysons Corner, Virginia, with a national practice (formerly with Wickwire Gavin, P.C. and now with Construction Risk Counsel, PLLC) representing design professionals, contractors and project owners. He is founder and president of a consulting firm, ConstructionRisk, LLC, providing consulting services to owners, design professionals, contractors and attorneys on construction projects. He is publisher of ConstructionRisk.com Report and may be reached at Kent@ConstructionRisk.com or by calling 703-623-1932. This article is published in ConstructionRisk.com Report, Vol. 17, No. 8 (November 2015).

Article 2

CGL Policy Held to Cover Costs of Correcting SubContractor’s Defective Work Including the Work Itself

Gail S. Kelley, P.E., J.D.
ConstructionRisk, LLC

After discovering various defects in their home, the homeowners filed suit against their builder. The builder’s insurance company declined to defend the action (“the underlying action”) on behalf of builder, alleging that the damage, which was not apparent until several years after the house was constructed, occurred after the builder’s insurance policy had been terminated. The policy at issue was a standard ISO commercial general liability (CGL) policy with products-completed operations hazard. The homeowner and builder entered into a consent judgment whereby the homeowners were assigned the builder’s right to seek reimbursement of the judgment from its insurance carrier. After some back and forth in state and federal court actions, it was held that the carrier had a duty to defend the builder. Carithers V. Mid–Continent Casualty Company, 782 F.3d 1240 (CA 11, 2015).

Mid-Continent raised three contentions in its appeal. First, it contended that it did not have a duty to defend the builder in the underlying action and if there was no duty to defend, there was no duty to indemnify the builder for damages. Second, it contended that the trial court should have allowed it to amend its answer to the complaint to include a coverage defense based on the fungus and mold exclusion in the builder’s policy. Third, it contended that the trial court improperly awarded damages for defects that were not considered property damage under the policy.

The trial court had concluded that while the policy’s coverage for “property damage” did not include the defective work of a sub-contractor, it did include damage to other property caused by a sub-contractor's defective work. Based on this conclusion, the court determined that: (1) an incorrect application of a coating caused property damage to the exterior brick; (2) inadequate adhesive and an inadequate mud base caused property damage to the tile; and (3) defective construction of a balcony allowed water to seep into the garage leading to wood rot, which caused property damage to the garage. The trial court awarded damages for the brick, the tile, and the balcony. Although the balcony was not property damage (because it was the defective work of a sub-contractor), the court found that it had to be replaced in order to repair the garage, which was property damage.

Duty to Defend

The Court of Appeals first addressed the carrier’s duty to defend, which hinged on when coverage under the policy was implicated. The carrier argued that property damage under a CGL occurrence policy occurs when the damage is actually discovered or discoverable by reasonable inspection (the so-called "manifestation" trigger). The homeowners, on the other hand, argued that the property damage occurred at the time the home was damaged, in other words, at time the defective construction was performed (the so-called "injury-in-fact" trigger).

The Court of Appeals held that the carrier had a duty to defend because it was unclear whether there would be coverage for the damages sought by the homeowners, as no Florida appellate court has decided which trigger applies. It is well settled law that an insurer's duty to defend is broader than the duty to indemnify; the duty to defend arises any time there is a possibility that a claim may be covered by the policy. In this case, the appellate court found that there was a possibility that Florida would adopt the injury-in-fact trigger and the claims would be covered, thus the carrier was required to defend the builder in the underlying action.

Coverage Trigger

The Court of Appeals did not actually decide what should be used as a coverage trigger, noting the difficulty that can arise in cases such as this one, where the property damage is latent and is not discovered until long after construction. The court simply accepted the district court’s determination to apply the injury-in-fact trigger. This meant that the property damage occurred while the builder’s CGL policy was in force.

Coverage for Certain Defects

Coverage for the damage caused by the defective construction was claimed under the CGL policy’s products-completed operations hazard. Under the products-completed operations hazard, a subcontractor's defective work that has damaged the otherwise non-defective completed project has caused ‘physical injury to tangible property’ within the plain meaning of the definitions in the policy. While there is no coverage for repairing or removing defective work, there is coverage for the costs of repairing damage caused by a subcontractor’s defective work.

The Court of Appeals emphasized the distinction between defective work and damage caused by defective work. With respect to the damage to the brick, if the coating that caused the damage was applied by the same subcontractor that installed the brick, the damage to the bricks was part of the sub-contractor’s work, and the defective work caused no damage apart from the defective work itself. Since the homeowners presented no evidence to show that the brick installation and coating application were performed by different sub-contractors, the Court of Appeals held there was no coverage under the policy for that damage.

Likewise, if the adhesive and mud base were installed by the tile sub-contractor, the sub-contractor’s defective work caused no damage apart from the defective work itself. Since there was no evidence to show that the adhesive, mud base and tile were installed by different sub-contractors, the Court of Appeals held that there was no coverage under the policy for those damages. The Court of Appeals found that the fact that the homeowners had purchased the tile themselves, rather than the subcontractor purchasing them, made no difference to the holding.

The lower court concluded that in order to repair the damage to the garage (which the parties agreed was covered by the policy, because it had been damaged by defective construction), the balcony had to be rebuilt. Under Florida law, the homeowners had a right to “the costs of repairing damage caused by the defective work....”. Since the court determined that it was necessary to remove the balcony to repair the garage, the Court of Appeals agreed that the homeowners were entitled to the cost of repairing the balcony and that this was covered under the builder’s policy

Although the damage to the garage included wood rot allegedly caused by fungus, the Court of Appeals found that the District Court did not abuse its discretion in denying the carrier’s motion to amend its answer to assert a defense based on the fungus and mold exclusion in the CGL policy. This was because the court concluded that the carrier was aware more than a year before trial, of the homeowner’s expert witness opinion that the wood rot was caused by fungus, and did not file its motion to amend until the homeowners had presented all of their evidence at trial. Essentially the court applied the principle of laches. The carrier sat on its rights too long to enforce them so late in the litigation.

Comment:

On the issue of whether there was coverage for the damage to the tile, the appellate court found that it made no difference that the homeowner purchased the tile instead of it being purchased by the subcontractor. In reaching that conclusion, the Court of Appeals distinguished this case from a previous Florida case, Auto–Owners Insurance Co. v. Pozzi Window Co., 984 So.2d 1241 (Fla. 2008). In that case, windows that were purchased separately by the Homeowner were damaged as a result of faulty installation. The Pozzi Windows court found that this was property damage under the policy, as there was physical injury to tangible property other than the work itself.

The Carithers court instead followed a previous 11^th circuit decision, Amerisure Mutual Insurance Co. v. Auchter Co., 673 F.3d 1294 (11th Cir. 2012). In Auchter, a sub-contractor negligently installed tiles on a roof and the entire roof needed to be replaced and the court held that that the defective work was the entire roof, not just the tiles, and thus there was no coverage under the policy since the sub-contractor’s defective work (the roof) did not cause damage to any other property.

About the Author: As a professional engineer, Gail Kelley has performed structural design and analysis of post-tensioned structures, has performed constructability reviews, due diligence inspections, and condition assessments, and has provided litigation support for construction defect and delay claims in both state and federal court. She received her B.S. in Civil Engineering from Cornell University, and Master of Science in Structure and Materials from Massachusetts Institute of Technology (MIT), and she received her Juris Doctorate from American University, Washington College of Law. She provides risk management services for ConstructionRisk, LLC. This article is published in ConstructionRisk.com Report, Vol. 17, No.8 (November 2015).

Article 3

Where Flow-Down Clause Limits Incorporation Of The Design-Build Prime Contract, Allocation of Liability In The Subcontract Will Govern

Gail S. Kelley, P.E., J.D.
ConstructionRisk, LLC

In February 2002, the Inn of the Mountain Gods Resort and Casino in New Mexico (Owner) contracted with Centex/Worthgroup, LLC (Centex) for a design-build expansion and renovation project. Centex then subcontracted with Worthgroup Architects, L.P. (“Worthgroup” or “Subcontractor”) to perform the design work on the project. The subcontract included design of a Mechanically Stabilized Earth (MSE) Wall which ultimately failed. Centex sued the subcontractor, claiming over $6,000,000 in damages for redesign and repair costs.

Subcontractor filed a motion for summary judgment, asserting that the prime contract’s limitation of liability clause, which was incorporated into the subcontract through a flow-down clause, limited Centex’s ability to recover damages to the proceeds of Subcontractor’s insurance. The trial court held for the subcontractor, apparently on the basis that the limitation of liability clause in the prime contract applied to the subcontract by virtue of a flow-down clause. This was reversed on appeal, with the court holding that the prime contract limitation of liability clause did not flow down to the benefit of the subcontractor. Centex/Worthgroup, LLC v. Worthgroup Architects, L.P., 2015 WL 5316873.

When the MSE Wall began to fail in April 2004, Owner demanded that Centex remedy the defects and repair the damage to adjacent structures. Despite having demanded that the subcontractor redesign the wall and repair the damage caused by its failure, Centex spent over $6,000,000 for others to redesign and repair the wall. Centex requested payment from the subcontractor’s insurance carrier and received $3,000,000---that being the policy limit.

Centex then sued the subcontractor seeking over $6.5 million, on the grounds that the subcontractor refused to adequately reimburse the prime for the costs of the required redesign and repairs. The subcontractor filed for summary judgment, asserting that its monetary obligations to the prime had been satisfied by the payment of the insurance proceeds. The trial court granted Subcontractor’s motion and the prime contractor appealed.

In coming to its decision to reverse the trial court ruling, the Appeals court examined the wording of both the prime contract and the subcontract. The court started with the limitation of liability clause in the prime contract, which provided:

In addition to all other insurance requirements set forth in this Agreement, Design/Builder shall require its design professional Subcontractor(s) to obtain and maintain professional errors and omissions coverage with respect to design services in accordance herewith.... coverage shall be for each such design professional Subcontractor in an amount not less than $3,000,000. Owner agrees that it will limit Design/Builder liability to Owner for any errors or omissions in the design of the Project to whatever sums Owner is able to collect from the above described professional errors and omissions insurance carrier.

The subcontract included a flow-down clause, which stated:

Worthgroup shall, except as otherwise provided herein, have all rights toward Centex which Centex has under the prime contract towards the Owner, and Worthgroup shall, to the extent permitted by applicable laws and except as provided herein, assume all obligations, risks and responsibilities toward Centex which Centex has assumed towards the Owner in the prime contract with respect to Design Work.

However, the subcontract also included a general liability clause, Section 1.4.2(b), which made Worthgroup responsible for any redesign costs and additional construction costs required to correct Subcontractor’s errors and omissions and specified that the subcontract did not preclude “pursuit of available insurance proceeds.”

Applying rules governing the applicability of the flow-down clause that are widely accepted in other jurisdictions, the court determined that the subcontract’s terms regarding liability governed. This was supported by three reasons given by the court. The first reason was the wording of the flow-down clause, which limited the incorporation of the prime contract into the subcontract by stating that Worthgroup "shall, except as provided herein, assume all obligations, risks and responsibilities toward Centex which Centex has assumed towards the Owner ..." Where a specific clause of the subcontract addressed risk allocation, therefore, it would take precedence over prime contract language which would not be flowed down.

Under the prime contract, Centex's liability to the Owner for design defects was limited to the proceeds of the subcontractor’s errors and omissions insurance. The limitation of liability would not flow-down to the benefit of the subcontractor, however, because Section 1.4.2(b) of the subcontract specifically addressed the allocation of liability of the subcontractor’s liability to Centex. The subcontract stated that the subcontractor would be liable for any redesign and additional construction costs required to correct the subcontractor’s errors or omissions. No mention was made of any limitation upon that responsibility.

The court noted that even without the flow-down clause’s wording, the subcontract’s allocation of liability would still prevail under general contract interpretation principles. It is a common rule that when the prime contract has been incorporated into a subcontract through a flow-down clause, and the specific provisions of the subcontract conflict with the prime contract, the terms of the subcontract prevail.

The general language of a standard incorporation clause cannot trump the specific language of the subcontract. Thus, the express allocation of liability in the subcontract prevailed over the limitation of liability clause in the prime contract.

Finally, the subcontract's terms governed under the order of precedence that the parties had agreed to. The subcontract required that all terms of all documents be considered as complementary, but if it was not possible to reconcile conflicting provisions, the order of precedence of the documents was to be:

(1) the most current Construction Documents; (2) modifications to the subcontract; (3) the subcontract, unless the prime contract imposed a higher standard or greater requirement on the parties, in which case the prime contract; (4) the prime contract.

The subcontractor argued that the prime contract imposed a higher standard than the subcontract, and the prime contract must therefore govern the subcontractor’s obligations. The court rejected that argument and concluded that the obligations of the prime agreement did not “impose a higher standard or greater requirement” and that the requirement set by the subcontract would thus take precedence.

Under the limitation of liability clause in the prime contract, the design-build team’s liability to the Owner was limited to the proceeds of the subcontractor’s insurance, while under Section 1.4.2(b), the subcontractor’s liability to the prime was for the entirety any construction or redesign costs incurred as a result of its errors and omissions. Since the subcontractor had much greater potential liability under Section 1.4.2(b) of the subcontract than it would have under the limitation of liability clause of the prime contract, it could not be concluded that the prime contract imposed a higher requirement. The greater liability imposed by the subcontract terms and conditions therefore took precedence so that the subcontractor was liable for the greater amount of liability.

Comment: Flow-down clauses and their interpretation are a common source of disputes with respect to construction contracts. As this case demonstrates, there are a number of grounds on which a subcontract can be held to govern over the prime contract. The general rule is that if the subcontract has clearly stated the parties’ intentions at the time of contracting, a flow-down clause cannot be read to render those clear intentions meaningless. In many cases, this works to the subcontractor’s advantage, as the subcontract may be more protective of their interests. In this case, however, it worked against the subcontractor as the wording of the flow-down clause, as well as the wording of the order of precedence clause in the subcontract, made the potential protections of the limitation of liability clause in the prime contract unavailable and inapplicable to the subcontractor.

Article 4

Piercing the Architectural Firm’s Corporate Veil

See similar articles: Corporate Veil | Pierce Corporate Veil

Kent Holland, J.D.
ConstructionRisk, LLC

The sole shareholder/director/officer of an incorporated architectural firm was held jointly and personally liable to pay a judgment awarded against the corporation. The corporation was found to have been operated as the alter ego of the individual. Among the points cited by the court for piercing the corporate veil were that when it entered into the contract with the real estate developer that subsequently filed suit against it for breach of contract, the firm was grossly undercapitalized and the individual had been using the firm “as a mere instrumentality or as his alter ego.” “He did not observe the ‘required corporate formalities’.” The court also found that a “fraudulent transfer” took place when, after judgment was obtained against the firm, the individual created a new architectural firm and transferred the old firm’s assets to it. This case is a bit unique due to the reported egregious circumstances, but it certainly provides some useful insight into things a sole owner of a small firm should not do if he or she wants to avoid being tagged with personal liability for actions done under the auspices of the corporation. Green v. Ziegelman, 2015 WL 2142690 (Michigan 2015).

The plaintiffs in the action argued at the trial court that the corporation was a sham that existed solely to meet the architect’s person needs and shield him from liability. The corporation had represented itself to plaintiffs to be an ongoing concern that was capable of doing the design and construction management for a significant development project. It turned out that the firm had not done any significant work for over fifteen years, and because it had no revenue from operations, the firm was entirely dependent on the individual architect for cash to pay its expenses. The evidence showed that over the years, the architect, in his personal capacity or through another entity, had lent over $630,000 to the corporation to cover its expenses. He never required the firm to execute a note or repay any of the funds. The individual also caused another of his entities to lease space to the corporation for approximately 20 years without any lease and without any payment of rent.

The appellate court affirmed the trial court’s decision to pierce the corporate veil. The court stated, “The fact that [the corporation] was entirely dependent on [individual architect’s] support to continue its operations-such as they were—also strongly suggests … that [the corporation] existed merely to serve as [architect’s] alter ego.” The architect used the firm “to pay his automobile lease and insurance, cell phone bill, travel expense, and used it to purchase thousands of dollars of supplies for his sculpting hobby. He claimed that he intended to sell the sculptures on behalf of his architectural firm, but admitted that he had not sold any sculptures.”

The appellate court stated, “There was also evidence that [architect] had not properly maintained [the corporation’s] corporate formalities over the years. He did not keep minutes for any meetings of shareholders, directors, or officers.” He also did not formalize transactions in which he and another entity loaned money to the corporation. “The lack of formality … suggests that [architect] himself disregarded [the corporation’s] separate existence whenever it was convenient or suited his needs, but asserted its separate existence when it benefited him personally, such as for tax purposes.”

For the reasons above cited, the court affirmed the trial court’s decision that the individual operated the corporation as his alter ego or as a “mere instrumentality” and that personal liability was justified.

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ConstructionRisk.com Report (November 2015)