PART 7: DESIGN AND CONSTRUCTION DEFECTS CLAIMS

HOW TO MANAGE CONSTRUCTION DISPUTES TO MINIMIZE SURETY AND CONSTRUCTION CLAIMS. PART 7: DESIGN AND CONSTRUCTION DEFECTS CLAIMS

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Introduction

Construction is a business fraught with risk. Disputes over even the smallest of issues can quickly escalate, with crippling consequences to the project and the parties. Over the years, the construction industry has developed various methods of contractually allocating the risk of project delay and disruption. Some of these methods include liquidated damages provisions, "no damages for delay" clauses, mutual waivers of consequential damages, provisions that limit liability, claims notice provisions, “waiver of damages clauses”, acceleration clauses, “time is of the essence” clauses, change order clauses, and provisions addressing responsibility for the adequacy of the construction plans and specifications. Parties frequently litigate the sufficiency of these risk-shifting efforts in conjunction with the underlying merits of delay and disruption disputes.

The Most Frequently-Encountered Construction Claims & Disputes

In Part 1 of our series of how to manage construction disputes to minimize surety and construction claims, we addressed the construction delay claims and the methods typically used to analyze them.

We indicated there that the most frequently encountered claims include:

1. Construction Delay Claims

2. Disruption and Loss of Labor Productivity Claims

3. Design and Construction Defects Claims

4. Force Majeure Claims

5. Acceleration or Compression of the Schedule Claims

6. Suspension, Termination and Default Claims

7. Differing Site Conditions Claims

8. Change Order and Extra Work Claims

9. Cost Overrun Claims

10. Unacceptable Workmanship or Substituted Material Claims

11. Non-payment Claims (stop notice (or Notice to Withhold) claims, mechanics’ lien (only for private construction projects) and payment bond claims)

Part 7 of this series discusses item 3 above: Design and Construction Defect Claims.

WHAT IS A CONSTRUCTION DEFECT?

According to the Insurance and Risk Management Institute, a construction defect is generally speaking, a deficiency in the design or construction of a building or structure resulting from a failure to design or construct in a reasonably workmanlike manner, and/or in accordance with a buyer's reasonable expectation. The most dangerous defects have the capacity to fail, resulting in physical injury or damage to people or property. However, many defects present no increased risk of injury or damage to other property but nevertheless cause harm to the property owner in the form of loss of use, diminution in value, and extra expenses incurred while defects are corrected. This latter type of defect is often referred to as a passive defect.

Many states have more specifically defined the term "construction defect" for purposes of applying statutes that dictate processes for remedying and litigating construction defect claims. These statutory definitions vary by state. Nevada, for example, uses the term constructional defects and defines it as follows:

“Constructional defect” means a defect in the design, construction, manufacture, repair or landscaping of a new residence, of an alteration of or addition to an existing residence, or of an appurtenance and includes, without limitation, the design, construction, manufacture, repair or landscaping of a new residence, of an alteration of or addition to an existing residence, or of an appurtenance:

Which is done in violation of law, including, without limitation, in violation of local codes or ordinances;

Which proximately causes physical damage to the residence, an appurtenance or the real property to which the residence or appurtenance is affixed;

Which is not completed in a good and workmanlike manner in accordance with the generally accepted standard of care in the industry for that type of design, construction, manufacture, repair or landscaping; or

Which presents an unreasonable risk of injury to a person or property.

For architects and other design professionals, one of the most devastating professional and business risks is from litigation alleging negligence in performing professional services. These alleged negligent acts, errors, or omissions may cause damage to owners, contractors, or other third parties, and the architect’s firm may be found liable for these damages.

WHAT ARE THE TOP CLAIMS THAT CAN BE FILED AGAINST AN ARCHITECT OR ENGINEER?

The Common Law Standard of Care

The standard of care for architects and engineers is set forth in numerous court decisions as follows:

The architects and other design professionals are under a duty to exercise ordinary, reasonable care, technical skill, and ability and diligence, as are ordinarily required of architects, in the course of their plans, inspections, and supervision during construction.

The duty owed by architects and engineers was further defined in other court decisions as follows:

An architect’s efficiency in preparing plans and specifications is tested by the rule of ordinary and reasonable skill usually exercised by one in that profession. (See, Annot., 25 A.L.R.2d 1088.) The duty of an architect depends upon the particular agreement he has entered with the person who employs him and in the absence of a special agreement he does not imply or guarantee a perfect plan or satisfactory result; rather, he is only liable if he fails to exercise reasonable care and skill. 5 Am.Jur.2d, Architects, Sec. 8.

The standard of care owed by an architect/engineer may be altered by agreement with the owner. A provision in an owner-A/E agreement by which the A/E represents that he or she will follow the highest professional standards in performing all professional services under the agreement would appear to override the standard of ordinary and reasonable skill established by the typical court decisions, at least with regard to a claim by the other party to the design professional’s contract.

Among the reasons architects have been found answerable in malpractice actions is because they hold themselves out and offer services to the public as experts in their line of endeavor. Those who employ them perceive their skills and abilities to rise above the levels possessed by ordinary laymen. Such persons have the right to expect that architects, as other professionals, possess a standard minimum of special knowledge and ability, will exercise that degree of care and skill as may be reasonable under the circumstances and, when they fail to do so, that they will be subject to damage actions for professional negligence, as are other professionals.

In performing services, an architect must possess and apply the knowledge and use the skill and care that is ordinarily used by reasonably well-qualified architects. A failure to do so is a form of negligence that is called malpractice.

The only way in which a judge or a jury may decide whether the defendant architects possessed and applied the knowledge, and used the skill and care which the law required of them, is from evidence presented in the trial by architects called as expert witnesses. The judge or jury must not attempt to determine this question from any personal knowledge he/she may have.

THEORIES OF LIABILITY

Below are the top five avenues of architect liability in New York and most other states:

1. Contract Claims. Typical contract based claims against an architect include: failure to properly design the building, failure to meet the applicable federal, state or local codes, failure to complete projects on time, work performed improperly under the architect’s direction, improper design of moisture and drainage control, leaking roofs and shrinking woodwork. In the absence of any express language specifying the standard for the architect's performance in a breach of contract claim, the courts apply a negligence standard.

In a negligence standard claim, it must be shown that the architect failed to perform in accordance with the standard of professional care usually exercised by such professionals in the community.

Caution. Avoid express warranties, if possible. Express warranties regarding the quality of architectural and engineering services to be performed may appear in an owner-architect or owner-engineer agreement. These warranties usually concern compliance with local codes, rules, and regulations, and state and federal laws. However, more often than not, qualifying language will have been inserted limiting the architect’s or engineer’s liability to compliance “to the best of his or her knowledge, information, and belief.” In the absence of any contract language or given the qualifier noted above, the architect/engineer would presumably be held to the standard of ordinary and reasonable care discussed in above under the common law standard of care.

2. Warranty Claims. New York does not provide a cause of action against architects for breach of an implied warranty. Nor does the work of an architect constitute a product for which strict liability claims could exist. The architect may, however, enter into a contract with terms that provide for the architect's liability if the architect fails to produce specific results as guaranteed in the contract, even if the architect otherwise conforms to the community standard of performance. Other states do incorporate in their statutes and in their case law the doctrine of implied warranty in connection with the delivery of professional design services.

Architects and engineers represent themselves to be competent in the preparation of plans and specifications necessary to the construction of suitable structures, including but not limited to the knowledge of and compliance with applicable building codes, and where they fail to use reasonable care to produce a satisfactory structure in compliance therewith, they may be sued for breach of an implied contract term. Himmel Corp. v. Stade, 52 Ill.App.3d 294, 367 N.E.2d 411, 414 – 415, 10 Ill.Dec. 23 (1st Dist. 1977).

To recover for breach of express warranty, a plaintiff must prove that a warranty existed, the defendant breached the warranty, the breach proximately caused the losses claimed as damages, and timely notice of the breach was given to defendant. An express warranty is not required to be in any specific form and may be either written or oral. Whether a statement is an express warranty is a question of fact to be determined by the judge or the jury.

Builders often provide homebuyers with express warranties protecting various elements of the physical construction. Additionally, express warranties are often included to disclaim or limit implied warranties of habitability, fitness, and workmanship. However, while several cases support the validity of such disclaimers, the courts have refused to answer whether they are enforceable, and it remains an open question under Colorado law. Privity of contract or standing as a third-party beneficiary of the contract is required in order to be protected by the warranty.

Breach of Implied Warranty

There are various implied warranties available in most states. Two important warranties are the implied warranty of habitability and the implied warranty of workmanlike construction.

Implied Warranty of Habitability

A buyer is "entitled to relief based on the theory of implied warranty of habitability if he proves the house was not built in a workmanlike manner or that it was not suitable for habitation." The warranty of habitability has been likened to strict liability for construction defects, and proof of a defect due to improper construction, design, or preparations is sufficient to establish liability in the builder-vendor. Courts have extended the implied warranty of habitability to situations in which a home becomes uninhabitable for reasons other than the workmanship, such as soil expansion. Id. Generally, in these cases, the breach of the implied warranty of habitability occurs in the builder's selection of the building location.

Implied Warranty of Workmanlike Construction

The warranty of workmanlike construction is another implied warranty. It does not, however, guarantee perfect construction by the builder. For construction to be done in a good and workmanlike manner, there is no requirement of perfection; the test is reasonableness in terms of what the workmen of average skill and intelligence (the conscientious worker) would ordinarily do.

Statute of Limitations for Breach of Warranty

In general, a breach of warranty is governed by the statute of limitations for contract actions and must be filed within a three-year period. Depending on the state, there are statutes that either lengthen or shorten the statute of limitations in a breach of warranty case against a design or construction professional to two years.

3. Design Liability. New York State law has established that an architect's work will be judged by the standard of ordinary and reasonable skill usually exercised by a licensed professional, unless the parties state otherwise in their contracts. This claim is essentially one for professional malpractice or negligence in the field of architecture.

To succeed on a negligence claim, the plaintiff must show (1) the existence of a duty on the part of a defendant, (2) a breach of that duty, (3) a causal connection between the defendant's breach and plaintiff's injury, (4) and injury. Generally, a duty is owed to anybody that could foreseeably suffer damages as a result of a defendant's negligent conduct.

The more complex and unusual the architect’s design, the more latitude an architect is allowed. This latitude however can be quite narrow. For example, an architect was found liable for damages to the owner for roof repairs, not because the roof was installed incorrectly, but because the design of the roof caused owner significantly increased maintenance and repair costs.

Design liability may also rest with the architect for items that are actually beyond the design of the architect. New York courts have held that an architect will be liable to the owner for any damages incurred as a result of the architect's approval of engineering drawings and a defect therein causes damage to the owner.

Some states require that an Affidavit of Merit is submitted along with the suit. New York does not have such statute. The Affidavit of Merit for New Jersey is listed below:

2A:53A-27 Affidavit of lack of care in action for professional, medical malpractice or negligence; requirements. 2.In any action for damages for personal injuries, wrongful death or property damage resulting from an alleged act of malpractice or negligence by a licensed person in his profession or occupation, the plaintiff shall, within 60 days following the date of filing of the answer to the complaint by the defendant, provide each defendant with an affidavit of an appropriate licensed person that there exists a reasonable probability that the care, skill or knowledge exercised or exhibited in the treatment, practice or work that is the subject of the complaint, fell outside acceptable professional or occupational standards or treatment practices. The court may grant no more than one additional period, not to exceed 60 days, to file the affidavit pursuant to this section, upon a finding of good cause.

In the case of an action for medical malpractice, the person executing the affidavit shall meet the requirements of a person who provides expert testimony or executes an affidavit as set forth in section 7 of P.L.2004, c.17 (C.2A:53A-41). In all other cases, the person executing the affidavit shall be licensed in this or any other state; have particular expertise in the general area or specialty involved in the action, as evidenced by board certification or by devotion of the person's practice substantially to the general area or specialty involved in the action for a period of at least five years. The person shall have no financial interest in the outcome of the case under review, but this prohibition shall not exclude the person from being an expert witness in the case. L.1995,c.139,s.2; amended 2004, c.17, s.8.

A negligence claim stemming from a construction contract may be barred by the Economic Loss Rule. This rule prevents recovery for negligence when the duty breached is a contractual duty and the harm incurred is the result of failure of the purpose of the contract. However, when a contract neither encompasses a duty nor requires that specific work be done, any work undertaken by a professional must be done in a reasonable manner. Failure to do so could result in an award of actual damages on a negligence claim.

4. Supervision and Inspection of Work-in-Place. If an architect assumes responsibility for performing site supervision and inspection, he/she is bound to use due care in the performance of such duties. The primary purpose of the inspection requirement is to make it a contract obligation for the architect to provide the owner with assurances that the work is being completed in conformance with plans and specifications.

However, as elaborated in case law from 1866, “the architect must be diligent in inspecting and supervising the work, but is not obligated to discover every defect in a contractor's or subcontractor's work and will not be liable for defects so long as they are not attributable to carelessness, negligence, or inattention on the architect's part.”

Regardless of limitations over means and methods as stated above, failure of the architect to abide by the contract terms of inspection can result in the architect ultimately being liable to the owner. If it can be established that the architect breached this obligation, and this breach was the “proximate cause” of a failure to discover a defect, the architect may be liable to the owner for the cost incurred in correcting the defect.

5. Certification of Progress Payments. Design professionals have become increasingly subject to claims arising out of their design and construction administration services. The obligation of the design professional to issue payment certificates has long been a tedious and dreaded task and one that often creates numerous liability problems. Although the only real purpose of issuing payment certificates is to inform the owner or lender that the contractor is entitled to payment, these certificates are often used by potential claimants as a basis for many types of legal actions. Courts in New York recognize the numerous responsibilities owners look to architects to perform. Just as courts recognize that owners may rely on architects for inspections of work, they also recognize that owners look to architects for certification of progress payments.

Should an architect improperly approve a progress payment, or prematurely release retainage, the architect may be liable to the owner for any damages suffered, as this may decrease the contractor's incentive to complete the work.

By issuing payment certificates, the design professional makes a potential claimant out of everyone involved in the construction process. Those people from whom the design professional can expect claims include prime contractors, owners, subcontractors, sureties and construction workers who have suffered personal injuries.

Claims by Prime Contractors.

The most common complaint voiced by prime contractors against design professionals is that of under certification. When a design professional under certifies a payment request, they are recommending that too little money be paid out by the owner to the prime contractor. The prime contractor might claim that the design professional was negligent and under certified the work because the design professional failed to accurately measure the progress of the work. If the design professional does under certify payment, the prime contractor may be harmed and denied needed resources to complete its work, possibly resulting in a default. In the case of defective work, the prime contractor will undoubtedly point to the payment certificates which are issued by the design professional as evidence that the owner and the design professional accepted the work.

Claims by Subcontractors.

Subcontractors often expect the design professional to act as watchdog to make sure that the prime contractors are paying them with the proceeds received from the owner. If the design professional fails to monitor the payments made by the prime contractor to the subcontractor, the subcontractor may argue that the design professional was negligent and caused a diversion of funds. By failing to monitor such payments, the design professional could be said to have denied the subcontractor of needed resources to complete its work, which could possibly lead to a default.

Claims by Sureties.

Sureties may have claims against design professionals for both over certification and under certification. If the design professional under certifies payment and causes a contractor default, the surety may be forced to complete the contractor's work. Similarly, if the design professional over certifies payment, thereby reducing the amount of retainage needed to adequately complete the job, the surety may be forced to complete the contractor's work, upon default, with insufficient funds.

Arguments for Architect Liability to the Surety

Surety actions against architects share these common arguments:

Improper Certification of Progress Payments—the approval of draw requests that result in overpayments to the contractor may result in loss to the surety if the surety has to step in and is deprived of funds that could be used to complete the project.

Contractor “Front-Loads” Pay Requests—to cut down on the expense of borrowing funds for a project, some contractors may submit pay requests beyond what the work-in-place would allow. Front-loading a contract prevents the surety from obtaining the fair value for its continuation of the contract.

Contractor Shorting Subcontractors and Suppliers—That a surety may have to make bond payments where an architect fails in its duty to discover that a contractor is not paying its subs is foreseeable to some courts.

Premature Release of Retainage—the surety may successfully sue the architect to recover the improperly authorized release of retained funds when it is discovered that the architect failed to adequately investigate whether the contractor had paid for all labor and supplies.

Errors in Contract Supervision or Inspection—Some courts recognize the surety’s right to sue an architect where it is alleged that the architect failed to adequately inspect the work, make an adequate number of inspections, and improperly authorized payment for defective work.

Failure to Report Construction Defects and Require Corrections to Defective Work—some courts hold that the architect is bound to report defective work and see that it is corrected even when there is no contractual obligation.

Deficient Design Documents—if a contractor defaults and the surety’s cost to complete the project increases because of deficient design, the surety may assert a claim. The foreseeability of harm to the surety is less certain because the surety is not the intended end-user of the design or the finished project.

Claims by the Owner.

Claims brought by owners against design professionals represent the greatest variety of potential claims. The owner may allege that the design professional negligently over certified payments or may allege that the design professional was negligent for failure to adequately supervise the work. Most owners rely upon the issuance of a payment certificate by the design professional to determine whether the contractor is entitled to payment. If the design professional over certifies payment, thereby recommending that payment be made for work that is not yet done or for patently defective work, the owner may be injured. When the design professional over certifies payment, the amount of retainage held by the owner as security for default or defective work is reduced. This, of course, could leave the owner with insufficient funds to complete the project.

In the case of defective work, the payment certificates issued by the design professional are typically used by the owner to attempt to hold the design professional responsible for the contractor's work. The owner may allege that the design professional was responsible for inspecting the work prior to issuing payment certificates to make sure that the work conformed with the Contract Documents. Owners may also view payment certificates as a guarantee by the design professional that the work was properly done.

Claims by Construction Workers.

Claims brought by construction workers against design professionals, whether for negligence, may be brought based upon the design professional's duty to issue payment certificates. A construction worker who is injured on the job site may allege, by inference, that the duty of the design professional to issue payment certificates necessarily requires that the design professional visit the site to check on the progress of the work, and that while checking on the progress of the work, the design professional has a duty to protect people on the job from any unsafe construction practices or defective conditions.

LEGAL ANALYSIS

The few cases which have addressed the duty of the design professional to issue payment certificates have analyzed that duty based upon responsibilities similar to those set forth in the standard form AIA Agreements. Despite the use of the typical disclaimer clauses used by the AIA, which protect the design professional from liability for issuing payment certificates, the design professional is often the subject of litigation.

Negligent Over certification Cases.

There have been few reported decisions in Illinois regarding the potential liability exposure of a design professional for under certifying or over certifying payment requests. Beginning with the case of City of Chicago v. Agnew, 106 N.E.2d 252, 264 Ill. 288, Illinois courts have held that contractors and sureties have standing to assert claims of "negligent over certification" against owners and others with whom they are in direct contractual privity. The law is much less clear, however, whether those same contractors and sureties would have standing to assert claims of "negligent over certification" against design professionals with whom they do not have contractual privity.

The court in Southern American Insurance Co. v. E.W. Corrigan Construction Co. et al. al., 1991 U.S. Dist. Lexis 10368 (N.D. Ill. 1991) held that the surety of a subcontractor, who defaulted on the job, could not bring an action against the architect who allegedly over certified the work of the subcontractor, thereby depriving the surety of its primary source of security to mitigate the costs of completing the subcontractor's work. The court reasoned that neither the subcontractor nor the surety had a contract with the architect and therefore the architect owed no legally cognizable duty to the subcontractor or the surety. As support for its decision, the court cited the well-known decision of Moorman Mfg. Co. v. Nat'l. Tank Co., 91 Ill. 2d 69, 61 Ill. Dec. 746, 435 N.E.2d 443 (1982), which prohibits the recovery of economic loss in tort actions.

More recently, Judge Jack Hoogasian of the Circuit Court of Lake County in Montessori School of Lake Forest v. Aetna Casualty and Surety Company of Illinois, et. al., 92 L 1027 (1994), held that a surety could bring a claim for "negligent over certification" against an architect with whom the surety had no contractual privity. In that case, the Montessori School of Lake Forest, as owner, filed a lawsuit against the General Contractor who worked on the job and its surety for defective work. The surety filed a third-party complaint against the architect alleging that the architect negligently over certified payments due the General Contractor, thereby reducing the amount of funds needed to complete the work. The architect moved to dismiss the third-party complaint on the grounds that the surety was not a third-party beneficiary to the Owner/Architect Agreement and that the surety could not recover economic losses against the architect for its alleged negligent certification of payments.

The surety filed a brief in response to the architect's motion to dismiss and argued that the surety was a third-party beneficiary to Owner/Architect Agreement because the surety was explicitly given the right to use any retainage to complete the job and was to benefit by the use of this retainage. The surety also argued that regardless of whether it was a third-party beneficiary to the Owner/Architect Agreement, the architect owed the surety an independent duty to correctly estimate the progress of the work and to only certify and approve conforming work for payment. The surety stated that the architect's representations concerning certification of payments were negligent and because the architect was allegedly in the business of supplying information, the Moorman doctrine did not apply and the surety could bring a claim for negligent over certification. The court, in an unpublished opinion, held in favor of the surety.(1)

Negligence.

The liability exposure of design professionals for negligence, based upon issuing payment certificates, can be greatly reduced provided that design professionals take particular care when negotiating their contracts with owners. The potential liability exposure of a design professional for negligence, whether brought by owners or personal injury claimants, typically depends upon whether the design professional has any responsibility for site inspection or review of the contractor's work for compliance with the Contract Documents.

In Corbetta Construction v. Lake County Bldg. Commission, 64 Ill. App.3d 313, 21 Ill. Dec. 431, 381 N.E.2d 758 (2nd Dist 1978), the Court held that the architect was negligent and liable to the owner for the contractor's defective work because the architect, who had agreed to supervise the construction, should have discovered the contractor's defective work. In Busick v. Streator Township High School, 234 Ill. App. 3d 647, 175 Ill. Dec. 423, 600 N.E.2d 46 (3rd Dist. 1992), the Court held that the architect was not liable to an injured construction worker for job related injuries because the architect had no duty to supervise the work, nor was he responsible for worker safety. In reaching its decision, the Court noted that the legal duty of a design professional to third persons, such as construction workers and other personal injury claimants, is based upon the scope of the design professional's agreement with the owner (whether the design professional has agreed to inspect and supervise the work).

HOW THE DESIGN PROFESSIONAL CAN MINIMIZE LIABILITY EXPOSURE WHILE PARTICIPATING IN THE PAYMENT PROCESS

Unquestionably, the best way for design professionals to protect themselves from liability arising out of the payment process is to avoid issuing payment certificates. Some owners may be willing to relieve the design professional of the duty to issue payment certificates and perform this task themselves, or delegate it to a construction manager, in order to retain greater control over the payment process. If an owner is willing to absolve the design professional from the headaches which typically accompany issuing payment certificates, the design professional should accept the offer. More commonly, the owner will request that the design professional issue payment certificates. The following suggestions are ones that the design professional should consider when an owner has requested that the design professional issue payment certificates.

The Design Professional Should Only Be Held To A "Negligence" Standard.

Both the B141 and A201 Agreements seek to limit the liability exposure of the design professional, for issuing payment certificates, by creating a negligence standard. These standard forms of agreement carefully provide that such certificates are based upon the "knowledge, information and belief" of the design professional, making it clear that the design professional shall be held only to the professional standard of care -- not a guarantee -- in the exercise of its certification function. Paragraph 2.6.10 of the B141 Agreement sets forth the primary duties of the design professional to issue payment certificates:(2)

"The Architect's certification for payment shall constitute a representation to the Owner, based on the Architect's observations at the site as provided in Subparagraph 2.6.5 and on the data comprising the Contractor's Application for Payment, that the Work has progressed to the point indicated and that, to the best of the Architect's knowledge, information and belief, quality of the Work is in accordance with the Contract Documents. The foregoing representations are subject to an evaluation of the Work for conformance with the Contract Documents upon Substantial Completion, to results of subsequent tests and inspections, to minor deviations from the Contract Documents correctable prior to completion and to specific qualifications expressed by the Architect. The issuance of a Certificate for Payment shall further constitute a representation that the Contractor is entitled to payment in the amount certified. However, the issuance of a Certificate for Payment shall not be a representation that the Architect has (1) made exhaustive or continuous on-site inspections to check the quality or quantity of the Work, (2) reviewed construction means, methods, techniques, sequences or procedures, (3) reviewed copies of requisitions received from Subcontractors and material suppliers and other data requested by the Owner to substantiate the Contractor's right to payment or ⁴ ascertained how or for what purpose the Contractor has used money previously paid on account of the Contract Sum."

In addition to limiting the design professional's certification by a "knowledge, information and belief" standard, Paragraph 2.6.10 sets forth other protections for the design professional. As discussed in Section III (C) of this Article, Paragraph 2.6.10 attempts to absolve the design professional from having any control over the work and from making continuous or comprehensive on-site inspections. This language is important to the design professional because it specifies that any on-site visits made by the design professional are for checking the progress of the work, rather than an "inspection" of the work for compliance with the contract documents, which can give rise to a negligence or Structural Work Act claim.

Paragraph 2.6.10 also gives the design professional the right to retract his previous representations that the Work is in accordance with the Contract Documents, "subject to an evaluation of the Work for conformance with the Contract Documents upon Substantial Completion." This language, once again, illustrates the narrow purpose of the payment certificates and makes it very difficult for an owner or surety to argue that a design professional should be held liable for contractor deviations at the progress payment stage.

The significance of including exculpatory language, like that used in the AIA standard form agreements, is underscored by the fact that some owners believe that by issuing payment certificates, the design professional is giving his "guarantee" or "certifying" that the contractor has complied with the plans and specifications. Of course, if the design professional actually "certifies" that something is perfect, he is assuming a level of liability well beyond the standard of care required by the law. This is significant for insurance reasons, as well as potential liability reasons, because certificates for payment can be construed to be warranties or guarantees, especially when the certificate contains representations of fact upon which the Owner will rely, and the design professional's insurance does not typically cover claims for breach of warranty:

"This insurance does not apply to liability assumed by you under any contract; but that this exclusion does not apply if you would have been liable, in the absence of such contract, due to your own error, omission or negligent act."

When negotiating an Owner/Architect Agreement, the design professional should explain to the owner that the provisions in the B141 and A201 Agreements, which provide that payment certificates are issued based upon the design professional's "knowledge, information and belief," benefit both the design professional and the owner by triggering the design professional's insurance coverage. If the owner wants the design professional to be exposed to liability which is not covered by insurance, the design professional should request to be paid for those services and more money should be allocated for comprehensive site inspections by the design professional.

Demand a Schedule of Values.

Prior to issuing any payment certificates, the design professional should insist on receiving a detailed Schedule of Values from the contractor. The A201 General Conditions (Paragraph 9.2.1) requires that the contractor provide the architect with a detailed Schedule of Values, but does not specifically state whether the design professional's payment certificate is a representation that a certain percentage of the work is completed, or that the amount which the contractor seeks coincides with the actual amount of labor and materials put in place.

Typically, the design professional compares the percentage of work completed against the schedule of values, rather than attempting to analyze the actual value of the work. Nonetheless, some owners are now requiring the design professional to certify that the original schedule of values submitted by the contractor accurately allocates the contract sum among the various trades in order to avoid contractor front loading. An example of this type of responsibility is as follows:

Design Professional shall review and approve the Contractor's schedule of values and certify that the schedule accurately represents the amounts to which the Contractor should be entitled for the Work described in each line item and that the Contractor's schedule of values is of sufficient detail to allow the Design Professional to certify that the Contractor's Applications of Payment are accurate representations of the value of the Work put in place.

If possible, the design professional should avoid taking on this type of responsibility. The design professional's duty to issue payment certificates should only be an indication that the work "has progressed to the point indicated" (see A201, 9.4.2), and not a summary of how the money was spent. It should be left up to the owner/lender to make sure that the money paid to the contractor is used properly.

Protect Yourself From Negative Inferences.

Most lawsuits against design professionals, based upon their role in the payment process, are founded upon negative inferences typically drawn from payment certificates. It is common for contractors and owners to equate the duty of the design professional to issue payment certificates with that of inspecting the work for compliance with the Contract Documents. To avoid this negative inference, design professionals should include language in all of their contracts to make clear that they are not in charge of the work, nor required to make exhaustive or continuous on-site inspections. Both the B141 and A201 Contracts contain appropriate language like this which should be incorporated into any contract entered into by the design professional. Specifically, Paragraph 2.6.10 of the B141 and Paragraphs 4.2.2 and 4.2.3 of the A201 absolve the design professional from having any control over the work and from making continuous or comprehensive on-site inspections.

CONCLUSION

The duty of the design professional to issue payment certificates exposes the design professional to a variety of potential claims. The design professional may face claims for negligence and for alleged Structural Work Act violations, as well as claims for negligent over certification and under certification of payments. In order to minimize the design professional's exposure to such claims, the design professional should, whenever possible, attempt to utilize standard form AIA documents or incorporate the concepts discussed in this Article into any contract entered into by the design professional.

Endnotes

1. Courts in other jurisdictions have also held that design professionals may be liable for over certifying payment requests. For example, in State ex rel. National Surety Corp. v. Malavaney, 221 Miss. 190, 72 So. 2d 424 (1954), the court held that an architect was liable to a surety for negligent certification of payments. See also U.R.S. Company Inc. v. Gulport-Biloxi Regional Airport Authority, 544 So. 2d. 824 (Miss. 1989); Aetna Insurance Company v. Hellmuth, Obata & Kassabaum Inc., 392 F.2d 472 (8th Cir. 1968).

2. Paragraph 2.6.9 of the B141 and Paragraph 4.2.5 of the A201 Agreements similarly provide that "[b]ased upon the Architect's observations and evaluations of the Contractor's Application for Payment, the Architect shall review and certify the amounts due the Contractor."

DESIGN PROFESSIONAL LIABILITY ON COMPLETED WORK

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For New York Architects, Landscape Architects, Engineers, and Land Surveyors, exposure to liability on their completed projects may extend long beyond the completion of the project itself. Exactly how long design professionals can be 'on the hook' for claims has been a bit of a moving target in New York, with changes and proposed additional changes to this timeframe.

How long a design professional can be liable for claims, including claims from third-parties, has been governed by the Statute of Limitations. Generally this has provided three years for a design professional malpractice action, and six years for a breach of contract claim.

The New York State Court of Appeals in 1995 clarified this in holding that claims against design professionals is time barred three years after completion of construction. Newburgh v. Hugh Stubbins & Associates, 85 NY2d 535.

Subsequently the New York State Legislature passed CPLR 214-d, which allows a third party (any injured person who was not the client of the design professional) to bring forth claims against the design professional within three years of their loss or injury, even if such loss or injury occurs 40 or more years from completion. In fact, this regulation only looked at the length of time from the date of injury and made no reference to when the construction actually was completed.

"... a design professional ... is governed by a three year statute of limitations and the cause of action does not accrue until the injury takes place - even if the plaintiff is injured 20, 30, 50, or 100 years after the design professional has completed work on the building or structure."

The effect of this is to cause New York design professionals to be potentially liable for any injuries suffered to third persons on the completed work, even where the architect is not responsible for long term maintenance. Further, often times the design professional may not have been additionally retained to supervise the actual construction itself, or even where the architect is not responsible for long term maintenance, and in defending such a claim so many years beyond completion witness memories may fade, or witnesses may no longer be available and can have the effect of forcing New York design professionals to maintain their malpractice insurance coverage indefinitely.

In seeking to address these unintended consequences, in 2011 the New York Senate introduced S4782-2011 seeking to amend the effects of section 214(d) by among other things establish a new ten year statute of repose for professional injury or wrongful death actions brought against professional engineers, architects, landscape architects, land surveyors or construction contractors. This would eliminate the current legal landscape where the design professional has no effective time limit on how long it could remain liable to third parties beyond project completion. The legislation recognizes that the design professional has no control over the structure long after construction is complete.

S4782-2011 is still a pending bill in senate subcommittee, and has not yet been enacted into law. Design professionals in New York are encouraged to maintain their records forever, as you could need them in defending against such claims.

Architects and Design Professionals Can Be Held Liable For Defects Based On Third Party Claims

On July 3, 2014, the California Supreme Court decided the much watched case Beacon Residential Community Assoc. v. Skidmore, Owings & Merrill, LLP. The court held that the “principal architect” “owes a duty of care to future homeowners in the design of a residential building . . . even when they do not actually build the project or exercise control over construction.” A homeowners association, on behalf of its members, sued a condominium developer and various other parties for construction design defects that allegedly made their homes unsafe and uninhabitable for a significant portion of the year. Two defendants were architectural firms that allegedly designed the homes in a negligent manner but did not make final decisions regarding how the homes would be built. Applying the Supreme Court’s decision in Bily v. Arthur Young & Company (1992) 3 Cal.4^th 390, and relying on the Weseloh Family LTD. Partnership v. K. L. Weseloh Construction Company, Inc. (2004) 125 Cal.App.4^th 152, the trial court sustained a demurrer in favor of the defendant architectural firms, reasoning that an architect who makes recommendations but not final decisions on construction has no duty of care to future homeowners with whom he has no contractual relationship. The Court of Appeal reversed, concluding that the architect owes a duty to homeowners in these circumstances, both under common law and under the Right to Repair Act (Civil Code Section 895 et seq.) The Supreme Court agreed and held that the homeowner may state a cause of action against a design professional for negligence.

Skidmore, Owings & Merrill LLP (SOM) and HKS, Inc., (HKS) were architectural firms (“defendants”) who provided architectural and engineering services to the Beacon Residential Condominiums (“the Project”), a residential community in San Francisco.

The Beacon Residential Community Association (BRCA) sued SOM and HKS. BRCA alleged numerous construction defects as a result of negligent architectural and engineering design and observation. BRCA also complained of “solar heat gain,” excessively high temperatures resulting from the defendants’ approval of inexpensive and nonfunctional windows, and a design lacking adequate ventilation within the residential units. The defendants were named in three causes of action: Civil Code Title 7 – Violation of Statutory Building Standards for Original Construction; Negligence Per Se in Violation of Statute; and Negligence of Design Professionals and Contractors.

The defendants demurred to the complaint, arguing that under Bily v. Arthur Young & Co.(1992) 3 Cal.4th 370 and Weseloh Family Ltd. Partnership v. K.L. Wessell Construction Co., Inc. (2004) 125 Cal.App.4th 152, they owed no duty of care to BRCA or its members. The trial court sustained the demurrers and dismissed the case. The trial court reasoned that liability could not be premised on negligent design because without privity of contract, BRCA was required to show that the design professionals had “control” in the construction process and assumed a role beyond that of providing design recommendations to the owner. The court believed that BRCA failed to meet its burden.

The Court of Appeal reversed, holding that BRCA could state a claim based on design liability that was recognized both under common law and statutory law. The Court distinguished Weseloh, in which judgment was affirmed in favor of design engineers who were sued after a retaining wall failed. There, the outcome was premised on the evidentiary record before the court and was of limited guidance. The Court said that no California court has yet extended Weseloh to categorically eliminate negligence liability of design professionals to foreseeable purchasers of residential construction. The Court also observed that in Cooper v. Jevne (1976) 56 Cal.App.3d 860, an architect’s duty of reasonable care is logically owed to those who purchase an allegedly defectively designed and built condominium.

The Supreme Court granted review. It began its discussion by pointing out that although liability for the supply of goods and services historically requires privity of contract between the supplier and the injured party, the significance of privity has been greatly eroded over the past century. The declining significance of privity had found its way into construction law. The Court noted that it had previously found that manufacturers of defective ladders, elevators, and tires could be liable to persons who were not in contractual privity with them but foreseeably injured by their products. Courts usually apply the same rule to someone responsible for part of a house; e.g., a defective railing.

In addition, the Court said that these third party liability principles had always been applied to architects where the architect plans and supervises the construction work and provides protection to any person who is foreseeably harmed. Generally, liability for deficient goods and services hinges on whether there is a relationship between the buyer and seller. However, the Supreme Court recognized that in certain circumstances a contractual relationship is not necessarily required. In this ruling, it relied on 50-year old precedents in Biankanja v. Irving(1958) 49 Cal.2nd 647. In Biankanja, the California Supreme Court outlined several factors which determine whether a duty of care is owed to non-contracted third parties. Biankanja analyzed many factors, including whether the declared harm was foreseeable from a defendant’s conduct and how close of a connection there was between the conduct and the injuries.

The Court recognized that even though the design firms did not actually build the project, they conducted weekly inspections, monitored contract compliance, monitored design elements when issues arose, and advised the owners of any non-conforming work. In applying the Biankanja factors to these circumstances, the Supreme Court determined the homeowners were intended beneficiaries of the design work, and the design in the project bore a close connection to the alleged injuries. As a result, the Supreme Court held that the allegations in the complaint were sufficient, and if proven, established that the defendants owed a duty of care to the homeowners association.

This case will affect how design professionals allocate risk of future residential projects, perhaps requiring their principals to insure them. However, design professionals are now larger targets in construction defect lawsuits, especially where there is a large design issue and a developer withdraws insurance coverage.

Undoubtedly, plaintiffs will attempt to expand architect/design liability in situations involving general contractors, subcontractors, and materials suppliers. This would have the greatest affect in situations involving a single family home where the architect is in privity of contract with the owner.

We expect that architects will now require that they be listed on the developer’s insurance policy(ies) and be contractually indemnified by the developers. As construction cases are getting increasingly more difficult to settle due to the lack of or exhaustion of insurance, expanding the liability of design professionals will give an added source of funding to settle cases. We expect a great deal of activity in this matter both in terms of litigation and in terms of insurance products being available to developers, contractors, design professionals and owners.

The Spearin Doctrine protections can be lost by contractors if they assume design responsibility

A recent decision by a federal judge in the Eastern District of Kentucky should remind contractors that the Spearin Doctrine protections can be lost by contractors trying to be helpful. In American Towers, LLC v. BPI, Inc., (U.S. D.C. E.D. Ky. Aug. 4, 2014), American Towers, an operator of wireless communications towers, accepted a bid from BPI to construct a new tower. After breaking ground on the project, BPI discovered a problem with American Towers’ plans for the access road to the tower. BPI proposed a solution that American Towers approved. Less than one (1) year later, the access road collapsed.

American Towers sued BPI for breach of contract, and BPI moved for summary judgment. BPI argued that its contract with American Towers required American Towers to issue written instructions regarding how to proceed after BPI discovered the flaw in American Towers’ original plans. BPI argued in the classic tradition of Spearin that American Towers was obliged to consult an engineer before telling BPI what to do and that American Towers must therefore bear the consequences of its own design failure.

The court recognized that BPI’s contract provided that when BPI encountered a problem, it need only inform American Towers and wait for instructions. However, BPI “apparently did more than the contract required” and “proposed a new plan to American Towers.” Because BPI’s contract required it to complete its work with the “highest degree of skill and care,” and an expert witness for American Towers opined that such a degree of skill required BPI to consult an engineer, then BPI could be liable for the design flaw. The court therefore denied BPI’s motion for summary judgment and has sent the case to a jury trial to determine BPI’s level of responsibility for the road collapse.

The American Towers case provides a clear cautionary tale for contractors. Where a contractor has agreed to construct according to an owner’s design plans, and a contractor finds a design flaw in those plans, in order to protect itself, the contractor should hold owner to its required contractual duty to provide the plans. Where a contractor has the expertise to provide suggestions to the plans which could keep the project on track and save the owner significant costs in delays, the contractor should still require the owner to seek the necessary review and approval by qualified experts. In this case, had BPI demanded that American Towers consult with an engineer to certify the sufficiency of the plans, BPI probably would not have been liable to American Towers.

In every construction project the particular facts of the problem should be reviewed in conjunction with each party’s contractual requirements to determine the best course of action. Usually, such problems can be resolved or mitigated with a quick phone call and a short review of each party’s obligations. Taking such action during the project can significantly reduce the likelihood of litigation costs and potential liability as exemplified by the American Towers case.

A CONSULTING ENGINEER / ARCHITECT’S PROTECTION FROM A NEGLIGENCE CLAIM BY A CONTRACTOR

The case of Recreational Design & Construction, Inc. v. Wiss, Janney Elstner & Associates, Inc., 2011 WL 5117163 (S.D.Fla. 2011), is a recent case discussing whether an independent engineering firm hired as a consultant by an owner can be liable to the general contractor for professional negligence under Florida law. In this case, the City of North Miami Beach (“City”) hired a contractor to perform all design and construction services for a water slide project (“Contractor”). The City also hired a separate engineering firm to evaluate and perform inspections of the contractor’s work (“Engineer”). The engineering firm hired another engineering firm as a subconsultant to perform the engineering inspections (“Subconsultant”).

The Subconsultant issued a report to the Engineer that was provided to the City explaining that the water slide the Contractor designed and started to construct was structurally unsafe. The report recommended repairs to be implemented on the slide. The City rejected the Contractor’s work based on the Subconsultant’s recommendation and required the Contractor to implement the repairs before completing the work.

The Contractor, instead of suing the City, sued the Engineer and Subconsultant for professional negligence (also known as professional malpractice) to recover its costs in reconstructing the slide and implementing the repairs recommended to the City. Both the Engineer and Subconsultant moved to dismiss the Contractor’s complaint arguing that they did not owe a duty of care to the Contractor; therefore, they could not be liable in negligence to the Contractor under the law. The Southern District of Florida agreed with the Engineer and Subconsultant and dismissed the Contractor’s complaint with prejudice.

In order to be liable for professional negligence, a plaintiff must prove the following elements against the defendant-professional: 1) the defendant owed a duty of care to the plaintiff; 2) the defendant breached its duty of care; and 3) the breach of the duty of care proximately caused damages to the plaintiff. See Recreational Design & Construction, 2011 WL at *2 citing Moransis v. Heathman, 744 So.2d 973, 975 n.3 (Fla. 1999). The element of duty, however, is a question of law in Florida and must be determined by the court before a negligence case proceeds to the jury or trier of fact. See Wallace v. Dean, 3 So.3d 1035, 1046 (Fla. 2009).

The Contractor relied on the Florida Supreme Court’s ruling in A.R. Moyer, Inc. v. Graham, 285 So.2d 397 (Fla. 1973), in arguing that the Engineer and Subconsultant owed the Contractor a duty to perform its work and issue recommendations to the City with reasonable care and due diligence. In A.R. Moyer, the Florida Supreme Court held that a general contractor can maintain a cause of action against a supervising architect for the architect’s negligent performance of a contractual duty (even though the contractor has no contractual privity with the architect). Particularly, the Florida Supreme Court found that the following circumstances would present a professional negligence cause of action by the contractor against a supervising architect or engineer:

“(a) supervising architect or engineer is negligent in preparation of plans and specifications; (b) the supervising architect or engineer negligently causes delays in preparation of corrected plans and specifications; (c) the supervising architect or engineer negligently prepared and negligently supervised corrected plans and specifications; (d) the supervising architect or engineer negligently failed to award an architect’s certificate upon completion of the project; (e) the architect or engineer was negligent in exercise of supervision and control of contractor.” A.R. Moyer, 285 So.2d at 402.

Of importance, the “professional defendant [in A.R. Moyer] was an architect whose responsibilities on the relevant project were to prepare the designs and plans for the project, approve the overall structural components or framework for the project, and supervise the general contractor’s execution of those plans, including having the authority to halt the contractor’s work.” Recreational Design & Construction, 2011 WL at *4. In other words, A.R. Moyer dealt with more of a traditional architect or engineer that, among other things, served as the architect / engineer-of-record for the project and had detailed contract administration services that enabled them to make decisions that could effect the contractor, which is why the Court described the professional as a supervisory architect or engineer.

But, in Recreational Design & Construction, the Engineer and Subconsultant, were really nothing more than a consultant providing expert-related services issuing recommendations, advice, or suggestions to the City in which the City could accept or reject. The Engineer and Subconsultant did not serve as the engineer-of-record. They did not design the plans for the City’s project. They did not issue specifications for the project. They were not performing supervision to ensure that the Contractor’s construction complied with their design (since they were not the designer). And, they did not have authority to halt the construction of the project or issue corrective details directly to the Contractor. Instead, as previously mentioned, their services were truly within the realm of consulting services in which it was up to the City to determine how it wanted to utilize any suggestions, advice, or recommendations. For these reasons, and because the role of the Engineer and Subconsultant in this case was substantially different than the role of the architect in A.R. Moyer, the Southern District held they did not owe a duty of care to the Contractor. See also McElvy, Jennewein, Stefany, Howard, Inc. v. Arlington, Elec., Inc., 582 So.2d 47 (Fla. 2d DCA 1991) (finding that architect did not owe duty to subcontractor because architect was required to issue advice to owner regarding interpretation of architect’s design, but it was the owner responsible for making the ultimate decision based on the advice of the architect).

An architect or engineer that is serving as the architect / engineer-of-record for a construction project may want to implement certain language in their contract with the owner that while it will render certain advise, recommendations, or suggestions to the owner regarding its design and specifications and interpretations thereof, it is the owner that is required to render the ultimate decision regarding the advice, suggestions, and recommendations. This way, if the contractor does pursue a professional negligence claim against them, they can argue they were not a supervisory architect or engineer and should not be deemed to owe a duty to the contractor because it was the owner that made the ultimate decision that affected the contractor.

Also, owners on construction projects sometimes hire other consultants or experts to assist in the construction of their project. For instance, sometimes owners hire a building envelope consultant or a glazing consultant, etc. These consultants sometimes worry about the contractor asserting a negligence claim against them based on their advice, suggestions, and recommendations made to the owner. These consultants, however, should be able to rely on the arguments in Recreational Design & Construction to support they do not owe a duty to the contractor. These consultants can also employ the same contractual language suggestions above so that their contract specifically expresses that it is the owner that is required to act on the advice, suggestions, and recommendations of the consultant so that it remains understood that the owner, and not the consultant, has ultimate control over the contractor’s work.

RISK MANAGEMENT TO REDUCE THE RISK OF LOSS

Whether, and to what to extent, coverage applies in liability policies for claims alleging construction defects is a matter of serious debate both in insurance circles and in the courts. We wrote few weeks ago about some earthshaking decisions reached by the majority of the jurisdictions during 2013 and 2014, finding construction defect coverage under a contractors’ CGL policy. These policies, however, are subject to numerous exclusions and Anti-Indemnification Statutes, Right to Repair/Cure and Statutes of Limitations and Repose. In fact, the defendants in many of these cases have been successful in defeating claims using the defenses of the statutes of limitations and repose.

Among the more frequently addressed exclusions are the so-called “business risk” exclusions, which include the “damage to property”; “damage to your property”, and “damage to your work” exclusions. Other potentially applicable exclusions concern prior work; contractual liability; EIFS; mold; owned property; earth movement, and known or continuing injury or damage. Claims for damages resulting from defective drywall began to appear in about 2005, and courts have frequently addressed whether the standard pollution exclusion, in addition to the above-mentioned exclusions, bars coverage for such claims.

The subtleties of each claim, different facts and precise policy language all contribute to the disparity. And, in some cases, the decisions are simply not reconcilable. Legislation enacted by various states concerning the right to repair/cure, statutes of limitations and repose, and anti-indemnity statutes, are pertinent to the institution of a construction defect lawsuit.

Owners of construction projects face many risk management challenges – whether building new, adding on to existing facilities, or performing rehabilitations. For a project owner, managing construction risk is significantly different from managing risks inherent in their daily operations. One difference of particular concern is professional liability risk associated with execution of design and other professional services.

Construction-related professional liability insurance is rapidly changing and has often been underinsured relative to the exposures created when commencing a new project. Even on a modestly sized project, an owner can have significant exposure to cost overruns, time delays, and re-work from faulty design, negligent construction management, or errors from other disciplines performing professional services on the project. Losses suffered by project owners can prove to be very costly, confusing to litigate, and difficult to calculate. The following example illustrates the complex nature of these exposures.

A city medical center and its board of trustees issued separate contracts for the design and construction of a two-year, $150 million expansion to its children’s hospital wing. The architect was responsible for procuring all design services and was required by the owner to evidence $5 million in professional liability insurance limits from their annual practice professional liability insurance program. The project took three months longer than anticipated and went over budget by $10 million. Along with the delay and cost overruns, numerous other problems were discovered in the HVAC and electrical systems – all attributable to the design team.

The total damages alleged by the owner were $17.5 million. During discovery it was found that the prime architect only had $4 million remaining in its practice professional liability program because of defense and claim payments from the firm’s engagement on other projects during the policy period. The other liable members of the design team (the mechanical and electrical engineers) each had their full professional liability limits of $1 million available. However, after defense costs eroded the remaining limits during litigation, only $5 million in combined policy limits were available from the architect’s and the design firm’s insurance policies. Furthermore, the firms had little or no assets to collect beyond their professional liability policies. The medical center settled immediately for the $5 million in remaining policy limits and incurred a $12.5 million loss to its bottom line.

This not uncommon scenario raises some questions: Are insurance solutions available that offer construction owners better control over the cost, scope and security of professional liability coverage? Could the medical facility have financed this exposure with an insurance product and collected its own insurance proceeds rather than incur this loss? The answer is ‘yes,’ and the following information outlines these solutions.

TRADITIONAL SOLUTIONS

Most projects constructed in the U.S. use some form of the design-bid-build delivery system. In that type of scenario, the owner assumes a central role by virtue of contracting separately with design entities and contractors. The owner first hires a designer to provide the design and later the general contractor is hired to build the project. The illustration below depicts this standard relationship.

Since the design-bid-build delivery system separates the design contract from the construction contract, the owner serves as an intermediary between the design and construction entities and takes on significant risk by contracting directly with the architect. Other delivery systems, such as design-build (D/B) or engineer-procure-construct (EPC) and emerging methods such as integrated project delivery (IPD), public private partnerships (P3) and LEAN construction, also pose various professional liability challenges and exposures. This article focuses on the design-bid-build delivery.

The most common and simplest mechanism for an owner to mitigate the professional liability risk associated with its project is to contractually require the primary design professionals to maintain annual practice policies at prescribed limits. These policies provide professional liability coverage with limits that the owner deems adequate to cover claims that might arise from the design team’s work on the project. However, coverage under the design professional’s policy is in the name of the design professional and does not provide any protection directly to the owner, which cannot be named as an additional insured. Renewal of the annual practice policy by the design professional is not guaranteed and could be terminated prior to a contractually agreed post-completion insurance requirement. Claims made on projects unrelated to the owner’s project (as shown in the hospital project claim scenario) may erode or exhaust the limits of liability available under the design professional’s practice policy. This could leave the owner with an uninsured design professional and no source of recovery.

A second approach is for the owner to purchase a project specific professional liability policy (PSPL) that covers the prime architect and its sub-consultants for the specific job. This option provides dedicated limits to the project, includes an extended reporting period for post-project completion, and replaces the design professional’s annual practice policies, although the annual policies possibly could be excess of the PSPL for the designer’s interests. While a viable risk management solution, there are drawbacks in this approach.

The cost of PSPL programs is significant due to the insurance industry’s experience, which has historically been unprofitable. The cost can often be 1-1.25% of the construction value of a project. The policy does cover the design professionals for the specific job; however, it does not typically extend to construction management. The policy is purchased for the design team and therefore is defended by the insurance carrier for the design team and not the owner. Defense costs can often erode the limits of these policies rather quickly allowing for smaller-than-anticipated recoverable indemnification amounts for the owner.

THE OWNER’S PROTECTIVE ALTERNATIVE

A third option to mitigate project professional liability exposures is for the owner to purchase an owner’s protective policy. The policy appeals to owners that directly subcontract the design separately from the construction under the design-bid-build delivery system, as discussed earlier. The owner’s protective policy addresses financial risks associated with the performance of professional services through dedicated project-specific limits similar to the PSPL. However, this solution provides the project owner with protection when a subcontracted design professional or other project consultant’s professional liability coverage is insufficient or not available. The owner still requires the primary design firm to evidence its annual practice professional liability policy at minimum limits via the contract as outlined in the first option above, but the owner then purchases a protective policy to sit excess over the design firm’s annual policy. The named insured on the policy is the project owner allowing control over the insurance acquisition and claim process.

The protective policy is a first-party indemnification policy and third-party professional liability policy intended to indemnify the owner for economic damages, bodily injury, and/or property damage due to the negligent performance of its subcontracted design professionals and provide coverage for the owner from third-party claims.

In a first-party loss scenario, the owner notifies its protective policy carrier at the same time that it brings a claim against its subcontracted design professional. The protective policy is then triggered when the design professional’s limits are exhausted.

For a third-party claim, the owner notifies the carrier when it receives notice of a claim from a third party which triggers coverage under the protective policy. As stated above for first-party losses, the policy sits in an excess position above the subcontracted design professional’s annual practice policy, and if there is no underlying insurance available at the time of a claim or the limits have been exhausted from claims on other projects (again, as seen in our previous example), the protective policy will drop down and pay on a first-dollar basis or excess of any self-insured retention specified on the policy. For third-party claims, the protective policy responds in excess of a self-insured retention.

The policy covers retroactively the design phase, runs through the construction period, and an extended reporting period (ERP) in which to report claims. The ERP is for work that was undertaken during the active policy period or any design or work performed to put the project to its intended use.

Owners also benefit by broadening the field of acceptable design firms as they can lower the required limits of insurance of their subcontractors/consultants knowing they have the protective coverage in place. At the same time the owner can have confidence that the subcontractors/consultants are delivering the appropriate standard of care because their annual practice policies remain in place and are subject to first-dollar exposure.

The owner’s protective policy is often purchased for projects greater than $50M in hard construction costs. It can be put in place for a variety of projects, including commercial, institutional, schools and colleges, hospitals, airport expansions or renovations, rail, roads/highway transportation or other civil projects, correctional facilities, casinos, hotels and resorts, residential/commercial grade-construction, water, waste water and sewage, and municipal facilities.

This insurance approach, while dedicating broader limits to a specific project, is typically much more cost-effective than buying PSPL coverage due to the first-dollar nature of the PSPL vs. the excess approach used with an owner’s protective policy. The unique first-party and third-party coverages put the owner in a very favorable recovery position in the event of a loss and provides enhanced control over the claim process. With the current state of economic uncertainty and expense management protocols, the owner’s protective policy has quickly become the coverage of choice for managing owners’ professional liability exposures on construction projects.

While risk management challenges for the owner of a construction project can be significantly different from those encountered in daily operations, multiple solutions exist to manage professional liability exposures. Losses from the negligent performance of professional services are extremely costly, complex and can destroy the success of a construction project. Purchasing an owner’s protective policy or another risk transfer mechanism to protect your project – and your bottom line – is a viable solution that should be considered well in advance of contract development.

There are also a growing number of newer and lesser known risks, inherent in the growth of technology and sustainability. With new innovative products, processes, and performance expectations in projects where there are no precedents, the standard of care must now also be defined anew. Because architects contract directly with owners, an architect may be exposed to the risk of a suit for breach of fiduciary duty. There are also important issues now raised by electronic data – including the requirements of the rules of discovery and what must be produced in the event of litigation. In addition, the existence of Metadata or hidden data in documents can divulge information detrimental to one’s firm. There are new liabilities associated with the protection of client confidential data and information as well.

The Risk of the A/E Professional Not Playing Well With Others

Consultants are routinely retained by design professionals. Their relationship means that the design professional has vicarious liability for any damage caused by the consultant’s negligence. Insured design professionals will want to review their consultant’s insurance status since they will serve as their insurer if that status is inadequate. If a design professional agrees by contract to limit the liability of a consultant, the design professional may find that the risk of the consultant’s negligence has been shifted to the design professional and the design professionals’ insurer. When design professionals serve as sub-consultants to other professionals (or subcontractors to construction contractors), it is important to examine the primary design professional’s coverage or the construction contractor’s coverage to determine where there are gaps in coverage that could result in the sub-consultant becoming the target of a claim.

Joint ventures, from a legal standpoint, are similar to partnerships, the main difference being that a joint venture usually has a more limited scope or purpose. If a professional liability claim is filed against a joint venture, one or all of the members can be held liable for any judgment rendered against it. Some broad policies provide automatic joint venture coverage while other insurers exclude joint ventures from the basic policy. Coverage for joint ventures with other design professionals may be available by special endorsement for specific situations to provide for the insured’s legal liability for professional services performed on behalf of the named joint venture. Coverage for other participating firms in the joint venture would not be provided by such an endorsement. Each member of a joint venture should obtain evidence from the other joint venture partner(s) that their policies have been properly endorsed as needed to cover participation in the joint venture, usually accomplished by obtaining a certificate of insurance and a copy of the joint venture endorsement.

In any joint venture situation where firms rely on their separate policies, it is best for the policies to be with the same carrier with similar limits and deductibles for all firms. Otherwise, some firms may serve as “deep pockets” for others.

Project Team Agreements

Strategic Alliances are business ventures and must be protected by insurance with the same concern as with any joint venture or partnership. Clients, or other parties, claiming harm from the actions of a strategic alliance may be able to recover from any member of the alliance. From the injured party’s perspective, the alliance may be viewed as one integrated responsible entity. Whenever a contractor’s responsibility and liability goes beyond construction to project design or construction management, the need for contractors to carry professional liability insurance becomes more critical.

All strategic alliance partners may be held liable for the actions of all, but each looks to the others to be responsible for their own areas of expertise and obligations. From a professional liability perspective care must be taken to match final liability with eventual responsibility. It is far more practical and better protection for the interests of the strategic alliance to be covered by a separate professional liability insurance policy. As a result, coverage disputes and internal indemnification or contribution obligations can be minimized.

Project professional liability insurance covers the design team participants, even those who are uninsured. The policy covers the design professional and named professional consultants for the term of the project plus a pre-determined discovery period after completion of construction. Depending on the insurance carriers of those firms covered by a project policy, coverage may then revert to the individual firms’ professional liability policies.

Project insurance is intended to cover only one project and is usually paid for by the owner who wants coverage beyond that normally carried by the firms. A Project policy ensures that a separate annual aggregate limit is available for that particular job and that the limit is not reduced by claims against a firm arising out of other design work. Project insurance is useful when the project is of such increased scope that it drastically affects the cost of basic coverage and as a way to get coverage for underinsured or uninsured consultants. From the design professional’s standpoint, the billings associated with a project-insured project (and the cost of any claims) do not affect the premium set for the firm’s practice policy. A broker is necessary to compare coverage.

Expanded project delivery approaches have begun to receive coverage for design professionals practicing in roles such as design/builder, construction manager, and land developer. While some companies offer endorsements for these services to the basic policy under some conditions, potential gaps should be investigated to prevent uninsured liability. For example, a construction manager acting as advisor (CMa) to the owner is covered under most professional liability policies; the construction manager constructor (CMc)—acting as a general contractor—is not.

Integrated Project Delivery (IPD) is another new concept and thus exposure in the architect’s potential risks today. Insurers are determining how best to approach this new collaborative multi-dimensional approach to projects. The concept of sharing more information and cooperation between unrelated entities flies in the face of traditional boundaries between owners, architects, engineers and construction companies. Insurers are still trying to assess the new risks presented by IPD.

Settlement Issues require both the insurer and the insured to be involved. Professional Liability policies generally require consent of an insured before the insurer can settle a professional liability claim against an insured. An architect may strongly believe that there was no negligence or error in the design or supervision work performed but the insurer may still want to settle. If the architect refuses to settle and subsequently a judgment is entered against the architect for an amount greater than the suggested settlement, the architect may have exposure for the excess amount. Often called a “hammer” clause, an architect needs to be aware of the implications of that clause. In many cases, the insurers will either limit the architect’s exposure to a percentage of that excess amount or may eliminate the exposure entirely.

Similarly, an architect cannot negotiate the terms of any settlement without the insurer’s permission. Any attempt to settle a case in this way will result in no coverage for the claim because the policy requires the insured to cooperate with the insurer. In any attempt to settle a potential claim before a suit is filed, be sure to get the permission of the claims adjuster from the insurance company even if the amount is less than the deductible.

A Common Problem with Insurers –The Reservation of Rights Letter

It is common when submitting a potential professional liability claim to an insurer that the insured will receive back a “reservation of rights” letter from the insurer. That letter basically points out exclusions or other conditions of the policy that might preclude coverage of the claim presented. It will say that they will defend all allegations of the claim unless and until it is evident that an exclusion will eliminate coverage entirely. The insurer is “reserving their right” to deny coverage later, once all the facts are uncovered affecting the claim.

Two Case Studies

I. Professional Liability

An architect was retained to provide architectural and engineering services for a sports facility in a northern state. The prime architect then retained a local architect and structural engineer. The design team provided a performance specification for a standing seam metal roof.

About three years after substantial completion, a section of the dome blew off during a windstorm. The roof was repaired for $250,000. The sports dome’s property insurer paid for the repairs and two years later filed suit against the prime architect. The city filed their own lawsuit, claiming $5,000 in damages, which was the amount of their deductible, and other unspecified damages. Both suits alleged negligence, breach of contract, and breach of warranty.

Shortly after the claims were filed and while warranty work was being performed on the dome, it was determined that there were structural problems with the standing seam roof. In addition, the city identified problems with the parapet walls, the placement of the vapor barrier below the roof, and the attachment of the standing seam metal roof. The city also raised concerns about snow accumulation and resulting avalanches. The city subsequently increased the amount of their lawsuit to $8 million. The contractors and the roof manufacturer were added as codefendants.

The city later decided that they would pursue a complete replacement of the roof structure and installation of snow fences, ground level roofs, and landscaping to address avalanching, recover their out-of-pocket expenses of $1.7 million, and made their total claim for $6.7 million.

The design team argued that as much as $2.5 million of the city’s replacement costs amounted to betterments or improvements. The design team also raised some legal defenses such as the contractual statute of limitations in AIA Document B141,

Standard Form of Agreement Between Owner and Architect. Using standard form agreements such as those developed by The American Institute of Architects (AIA) and the Engineers Joint Contract Documents Committee (EJCDC) may help reduce risks.

After negotiation, the design team settled the city’s claim for $2.4 million. Legal fees, expert expenses, and the policyholder’s deductible added $1,270,000 to the cost, bringing the total cost for this claim to $2,670,000. The case and settlement was covered and paid by the firm’s professional liability insurance carrier, less the firm’s deductible.

Large public-use centers can result in severe claims. Clearly, there should be some re-evaluation of the design team’s risk management practices. Whether they adequately assessed their risks prior to taking on this project, had sufficient experience with this project type, gave adequate consideration to the geographic and weather considerations that might increase risks, and whether it was the right design, performance specifications, and materials for such a structure or appropriate all should have been thoroughly considered. In the end, implementing good risk management practices while ensuring adequate professional liability coverage and an appropriate deductible will protect the firm.

II. Commercial General Liability

Commercial general liability (CGL) insurance provides coverage primarily for liability arising out of non-professional acts (violations of the personal, business, or property interests of private citizens) that result in bodily injury, property damage, or personal and advertising injury. CGL insurance is designed to cover an insured’s liability arising out of incidents on the insured’s premises or from the nonprofessional aspects of the insured’s practice.

An example of Bodily Injury/Property Damage, one component of CGL, involved a surveyor working on an airport runway. The surveyor left his tripod and prism standing upright on the side of the runway when he left for lunch. A small Falcon 900 airplane came in for landing and the leading edge of the right wing, which was extended over the edge of the runway, clipped the equipment. The surveying equipment created a dent in the leading edge, but there were no injuries. However, the repairs to the plane and other expenses, such as down time, parts, and labor, totaled more than $114,000. This claim illustrates the importance of having an established risk management program - and having adequate general liability coverage.

A design firm’s professional liability policy provides coverage for that firm’s professional negligence. A design firm’s CGL policy provides coverage for the firm’s non-professional negligence. In the surveyor’s claim example, a compelling argument could have been made that the damage arose out of the surveyor’s professional services and, therefore, should have been covered by the PL policy. The surveyor’s claim example illustrates a situation where the CGL insurance carrier could argue that the claim should have been covered by the surveyor’s PL policy while the PL carrier could have argued the same against the CGL carrier. One way to minimize the risk of this situation is to have both the CGL and PL policies with the same insurance carrier.

The focus would then shift to resolving the claim instead of debating which policy should respond to the claim.

Another example of a general liability claim would be if a visitor walks into an insured design professional’s office lobby and slips on the marble flooring after a rain storm and breaks her ankle. The injury occurred on the named insured’s premises and the injured woman would make a claim against the insured for her medical expenses resulting from her broken ankle. This example illustrates the importance of maintaining safe building premises and CGL coverage. It should be noted that this coverage does not cover the insured or the insured’s employees since those claims would likely be covered by workers’ compensation insurance.

Subcontractor's Claim Against Structural Engineer For Negligent Misrepresentation Dismissed

When confronted with extra costs on construction projects caused by architects and engineers who were hired by the owner (and have no contract with the contractor), contractors are generally inclined to seek direct recourse against the perceived wrongdoers. Generally, unless there is some personal injury or property damage involved, however, the "economic loss rule" precludes the contractor from suing an entity with whom it lacks privity of contract.

In the words of one court:

[t]he Economic Loss Rule is a judicially created doctrine that marks the fundamental boundary between contract law, which protects expectancy interest created through agreement between the parties, and tort law, which protects individuals and their property from physical harm by imposing a duty of reasonable care. . . .Simply put, the Economic Loss Rule holds that “economic damages are not recoverable in negligence absent physical property damage or bodily injury.

SME Indus., Inc. v. Thompson, Ventulett, Stainback & Assoc., Inc., 28 P.3d 669; 2001 Utah LEXIS 90 (Utah 2001); citing, W. Page Keeton, et al., Prosser & Keeton On The Law of Torts §92, at 657 (5^th Ed. 1984); 86 C.J.S. Torts §26 (1997).

Many other jurisdictions have similarly invoked the economic loss rule to bar negligence and malpractice claims by contractors against architects and design professionals. See, e.g., Berschauer-Phillips Const. Co. v. Seattle Sch. Dist. No. 1, 881 P.2 986, 992 (Wash. 1994); Fleischer v. Hellmuth, Obata & Kassabaum, Inc., 870 S.W. 2d 832, 837 (Mo. Ct. App. 1993); Floor Craft Floor Covering v. Parma Cmty. Gen. Hosp. Assoc., 560 N.E. 2d 206, 212 (Ohio 1990); Bernard Johnson, Inc. v. Continental Constructors, Inc., 630 S.W. 2d 365, 374 (Tex. App. 1982); Blake Constr. Co. v. Alley, 353 S.E. 2d 724, 727 (Va. 1987); Rissler v. McMurry Co. v. Sheridan Area Water Supply Joint Powers Bd., 929 P 2d 1228, 1235 (Wyo. 1996); 532 Madison Ave. Gourmet Foods, Inc. v. Finlandia Ctr., Inc., 750 N.E. 2d 1097, 727 (N.Y. 2001) (the court applied the economic loss rule to bar negligence claims by nearby businesses when a wall collapsed at a construction site, forcing the closing of the entire street in front of the construction site for several weeks).

We have reported cases involving the economic loss rule in many states and the new "independent duty doctrine" in previous posts. Recently, relying on the "economic loss rule," the Nevada Supreme Court barred a suit by a subcontractor against a structural engineer for negligent misrepresentation and professional negligence. See Halcrow, Inc. v. Eighth Judicial District Court of the State of Nevada, 302 P.3d 1148 (2013).

A. New Harmon Hotel in Las Vegas to be Razed

This dispute arises out of the litigation involving the ill-fated 46-story hotel and casino in Las Vegas called the Harmon Hotel. Construction of the Harmon Hotel was halted when parties discovered flawed steel reinforcements in the hotel structure. The rebar had been improperly installed in places and was simply missing in several areas, and ultimately the hotel has to be demolished.

The contractor, Tutor Perini Building Corporation ("Tutor Perini")[2], and the owner, MGM, filed suit against each other over responsibility for the expected $500 million loss. Trial is scheduled for later in 2014. In August 2013, the Clark County District Court granted MGM's request to raze the partially-built structure prior to trial. Tutor Perini had opposed this request, arguing that it needed to carry out additional tests on the structure to help prove its case.

B. General Contractor Sues Rebar Installer and Rebar Installer Sues Structural Engineer

As part of the lawsuit against MGM, Tutor Perini sought indemnity from its rebar installation subcontractor, Pacific Coast Steel ("PCS"). PCS, in turn, filed a complaint against the project's structural engineer, Halcrow, Inc., for professional negligence. Halcrow was a subconsultant to the architect of record and had no contract with either Tutor Perini or PCS. The Nevada trial court ruled that the economic loss rule barred PCS's professional negligence claim against Halcrow, but allowed PCS to amend its complaint by adding a claim against Halcrow for negligently misrepresenting the status of its site inspections and on-site adjustments to the steel installation. PCS claimed that the reinforcing steel was omitted due, in part, to Halcrow's negligent inspections of the steel and its recommendations as to how to correct the reinforcing steel issue.

Negligent misrepresentation refers to false statements made, in this instance, by the engineer in the course of his or her work that are relied upon by another party in making business decisions. This allegation is different from a professional negligence claim that the licensed architect or engineer failed to exercise the care that a reasonably prudent, similarly situated professional would exercise under similar circumstances.

C. Nevada Supreme Court Does Not Permit Subcontractor Suit Against Designer

The engineer, Halcrow, petitioned the Nevada Supreme Court to reverse the trial court ruling that allowed PCS to amend its complaint to add a claim against Halcrow. Halcrow asserted that the negligent misrepresentation claims were also barred by the economic loss doctrine. PCS maintained that an exception to the economic loss doctrine existed here because (1) Halcrow owed PCS a duty to act with reasonable care in communicating information to PCS about the steel installation, (2) Halcrow failed to conduct timely inspections in accordance with the representations that inspections would take place, and (3) Halcrow erroneously stated that on-site adjustments would rectify the errors in its plans. PCS asserted that, since it relied on Halcrow's representations regarding the steel installation inspection correction process, Halcrow should be held liable.

The Nevada Supreme Court ruled that allowing third parties to use negligent misrepresentation tort theory against design professionals without allowing them to sue for professional negligence would essentially nullify the economic loss rule. The court reasoned that such a rule would allow any third party to recast a barred professional negligence claim as a negligent misrepresentation claim. The court acknowledged that there are certain exceptions to the economic loss rule, but negligent misrepresentation claims do not fall in such a category because "contract law is better suited" for resolving such claims.

Ultimately, the court, reiterated the importance of relying on contract law to resolve complex commercial construction disputes:

The parties' disappointed economic expectations are better determined by looking to the parties' intentions expressed in their agreements.... Thus, requiring parties that are not in direct privity with one another but involved in a network of interrelated contracts to rely upon that network of contracts ensures that all parties to a complex project have a remedy and maintains the important distinction between contract and tort law. Halcrow, 302 P.3d at 1153.

In other words, contract remedies (breach of contract) are preferred over tort remedies (professional negligence and negligent misrepresentation) in construction cases because the outcome is more predictable and the remedies can be negotiated as part of the contract bargaining process.

Comment: PCS's success on the merits of its amended complaint is difficult to envision. How failing to conduct timely inspections could constitute negligent misrepresentation is confounding. The dispute revolves around allegedly defectively installed rebar, and the rebar supplier will ultimately be brought into the suit by those parties with which it contracted. MGM, for example, has the option of filing a third-party complaint against the architect, who can then in turn bring in the structural engineer. Although Halcrow might be dismissed from this action, it will probably become part of the lawsuit that is scheduled to occur later this year.

Summary of Nevada Law on the Economic Loss Doctrine in the Context of Commercial Construction Disputes

The Nevada Supreme Court has addressed the economic loss doctrine in the context of commercial construction disputes in a number of cases over the past several years. Nevada’s general rule, as detailed below, is that the economic loss doctrine bars recovery in tort for negligence claims asserting purely economic loss. The overarching rationale is that parties in contractual privity with one another, or part of an interrelated network of contracts, should rely exclusively upon those contracts for all remedies because the intentions and provisions set forth therein can best determine a party’s “disappointed economic expectations.” Halcrow, Inc. v. Eighth Judicial District Court, 129 Nev. Adv. Op. 42, 302 P.3d 1148, 1153 (2013).

The Nevada Supreme Court first addressed the economic loss doctrine in the commercial construction context in Calloway v. City of Reno, 116 Nev. 250, 993 P.2d 1259 (2000). In Calloway, the plaintiffs, owners of townhomes, filed suit against various subcontractors alleging negligence, among other contractual claims for alleged faulty construction (asserted prior to the enactment of Nevada’s construction defect statutory scheme codified as Nevada Revised Statute, Chapter 40). The Supreme Court concluded that because plaintiffs failed to allege any personal injury damage or any damages to property other than the defective entity itself (the townhomes), the plaintiffs suffered purely economic loss, which is not properly addressed by tort law. Id. at 1269. The Court held that “[c]ontract law is designed to enforce the expectancy interests created by agreement between the parties and seeks to enforce standards of quality.... In contrast, tort law is designed to secure the protection of all citizens from the danger of physical harm to their persons or to their property and seeks to enforce standards of conduct. These standards are imposed by society, without regard to any agreement. Tort law has not traditionally protected strictly economic interests related to product quality—in other words, courts have generally refused to create a duty in tort to prevent such economic losses.” Id. at 1265-66. Accordingly, the Supreme Court rejected plaintiffs’ negligence claims against the subcontractors, setting the general standard in Nevada that the economic loss doctrine bars negligence claims against contractors and subcontractors in the commercial construction context. Id. at 1270.

While Calloway did leave open the possibility for exceptions to this general bar, it did foreclose the “foreseeability exception,” holding that purely economic loss, even if foreseeable, falls outside the purview of tort recovery. Id. at 1270. And in this vein, after Calloway, the Supreme Court did uphold a bright-line exception to the general bar in the context of construction defect litigation, finding that negligence claims are not prohibited in construction defect actions arising under Nevada Revised Statute, Chapter 40. “[A] negligence claim can be alleged in a construction defects cause of action initiated under Chapter 40.” Olson v. Richard, 120 Nev. 240, 89 P.3d 31, 33 (2004). The Supreme Court concluded that because “NRS 40.640 states that a contractor is liable for any construction defects resulting from his acts or omissions or the acts or omissions of his agents, employees, or subcontractors. This language in no way limits a homeowner’s recovery to construction defects covered by a contract or warranty. Thus, we presume that the Legislature envisioned that Chapter 40 would provide more than just contractual remedies.” Id. at 33.

The Supreme Court has more recently considered the economic loss doctrine as it applies specifically to design professionals within a commercial construction context. Terracon Consultants Western, Inc. v. Mandalay Resorts, 125 Nev. 66, 206 P.3d 81 (2009). In Terracon the Court determined whether the doctrine applies to preclude “negligence-based” claims against design professionals who provide services in the development, construction, or improvement of commercial properties. Id. at 83. The Court concluded, yes, such negligence based claims are precluded by the doctrine when the alleged damages are purely financial. Id. at 83, 89. The Supreme Court held that “[i]n the context of engineers and architects, the bar created by the economic loss doctrine applies to commercial activity for which contract law is better suited to resolve professional negligence claims. This legal line between contract and tort liability promotes useful commercial economic activity, while still allowing tort recovery when personal injury or property damage are present. Further, as in this case, contracting parties often address the issue of economic losses in contract provisions.” Id. at 89. The Court determined that “the work provided by construction contractors or the services rendered by design professionals in the commercial building process are both integral to the building process and impact the quality of building projects. Therefore, when the quality is deemed defective, resulting in economic loss, remedies are properly addressed through contract law.” Id. at 90.

Very recently, the Supreme Court in Halcrow, Inc. v. Eighth Judicial District Court clarified its holding in Terracon. The Court was presented with the question of whether the more specific “negligent misrepresentation” claim qualifies as an exception to the general economic loss doctrine bar. Halcrow, Inc. v. Eighth Judicial District Court, 129 Nev. Adv. Op. 42, 302 P.3d 1148, 1150, 1152 (2013). The Court declined to acknowledge a negligent misrepresentation claim as an exception to the general bar, and concluded that a negligent misrepresentation claim is an unintentional tort which cannot form the basis of liability solely for economic damages in claims against design professionals in commercial construction disputes. Id. at 1154. The Court found no material distinction between a professional negligence claim (asserted in Terracon) and the negligent misrepresentation claim at issue in Halcrow, noting that the evidence necessary for each claim in the commercial construction context is almost identical. Id. at 1154. The Supreme Court stated that “[a]llowing one and not the other would create a loophole in Terracon’s objective of foreclosing professional negligence claims against commercial construction design professionals and would, essentially, cause the economic loss doctrine to be nullified by negligent misrepresentation claims.” Id. at 1154.

Therefore, Nevada continues to uphold and further solidify its generally recognized prohibition on negligent tort claims asserted for purely economic losses arising in the commercial construction context.

Texas Supreme Court Shields Design Professionals From Tort Liability to General Contractors based on Economic Loss Theory. May Still Be Liable based on Other Legal Theories.

Occasionally contractors have attempted to assert claims against design professionals in an attempt to recover increased costs incurred on a construction project. These claims have usually been couched as negligence or negligent misrepresentation causes of action because the contractors typically have no contractual relationship with the design professionals. Until a few weeks ago, it was unsettled whether such claims were legally viable in Texas, but the Texas Supreme Court answered the question recently in the negative: contractors cannot recover economic losses from design professionals based on alleged negligence or negligence misrepresentation. See LAN/STV v. Martin K. Eby Construction Co., No. 11-0810, 2014 WL 2789097 (Tex. June 20, 2014).

In LAN/STV, the contractor, Martin K. Eby Construction Co., Inc. (“Eby”), constructed a light rail transit line for DART and then sued the architect, LAN/STV, for increased construction costs and delay damages allegedly caused by errors in the architect’s plans and specifications that DART used to solicit construction bids. At trial, the jury found that LAN/STV was liable for a portion of Eby’s damages based on negligent misrepresentation. Both parties appealed, and the Dallas Court of Appeals affirmed the judgment. On appeal to the Texas Supreme Court, the dispositive issue was whether Eby’s recovery from LAN/STV for negligent misrepresentation was barred by the “economic loss rule.”

What is the economic loss rule?

Because the rule has been applied to a diverse range of situations, the economic loss rule actually encompasses several different formulations based on the particular situation. The formulation relevant here is that a party who lacks privity with another will be precluded from recovering purely economic losses from that party based on a negligent performance of services. The rule is not absolute. Despite the rule, Texas courts have nevertheless permitted, at least in some circumstances, a contractual stranger to recover economic losses from another based on a negligent failure to provide services. See, e.g., Grant Thornton LLP v. Prospect High Income Fund, Ltd., 314 S.W.3d 913, 920 (Tex. 2010) (holding that an accountant may be liable to a strictly limited group of investors for negligent misrepresentations in a corporate audit report, despite lacking contractual privity with the accountant). Thus, whether the rule applies in a particular context depends on whether the underlying rationales supporting the rule justify its application.

Two principal rationales have been proffered to support the rule. First, because the physical consequences of negligence are self-limiting but indirect economic losses are not, allowing recovery of economic losses could result in liability “in an indeterminate amount for an indeterminate time to an indeterminate class.” Id. at *3 (internal quotations omitted). In other words, precluding recovery of pure economic losses is necessary to shield the tortfeasor from virtually unlimited liability—and therefore liability that could greatly exceed the culpability of the conduct. Second, risks of economic losses tend to be especially well suited to allocation by contract. Id. at *4 (quoting Restatement (Third) of Torts: Liability for Economic Harm § 1 cmt. c (Tentative Draft No. 1, 2012)). Therefore, application of the economic loss rule should be applied where the parties are adequately able to determine by contract how economic loss should be allocated.

The question then in LAN/STV was whether these rationales justified application of the economic loss rule in the design-bid-build context.

The rationales for the economic loss rule support insulating design professionals from tort liability to general contractors

The Texas Supreme Court concluded that the underlying rationales supported application of the economic loss rule to preclude contractors from recovering economic loss damages against design professionals based on negligence or negligent misrepresentation. According to the court, if any party in the construction chain could recover economic loss damages from any other party in the chain due to negligence, “the risk of liability to everyone on the project would be magnified and indeterminate.” Id. at *7. Application of the rule would therefore serve to avoid indeterminate and excessive liability.

The ability to allocate the risk of any economic losses by contract also supported application of the rule in this context—and was apparently the rationale that carried the day. In the court’s view, the contractor was freely able to protect itself from its economic losses through its contract with the owner, and in fact it did, which it acknowledged was customary in the industry. See LAN/STV at *8. The court opted for the clarity achieved by restricting the available remedies to those provided by contract because such “clarity allows parties to do business on a surer footing.” Id.

What does this ruling mean?

The bottom line is that now, in a typical design-bid-build scenario, the owner alone holds the right to seek economic damages such as additional costs of completion from the design professional. While this is welcome news for the Texas design professional community, it is not the end of the story.

As you may know, Texas law has long provided that owners do not implicitly guarantee the sufficiency of the project architect’s specifications used to solicit construction bids from prospective contractors. See Lonergan v. San Antonio Trust Co., 101 Tex. 63, 74-75 (1907). This means that in most cases if a contractor’s price to complete increases because of a design defect, the contractor typically cannot look to the owner to cover that increased cost unless it follows a contract provision for additive change orders. LAN/STV now adds to this a bar precluding the contractor from recovering the increased cost of construction due to inadequate or defective design from the architect. With this additional avenue of recovery squashed, sophisticated contractors may seek to recover increased construction costs from the owner through larger price adjustment requests in the change order process. As such, due to more aggressive change order demands from contractors, design professionals will likely in turn see an increase in demands from owners seeking to recover these increased costs from the design professionals.

Further, nothing in LAN/STV expressly precludes contractors from attempting to recover property and personal injury damages from architects—e.g., on-site materials destroyed or lost by an alleged design defect. Architects should therefore continue to account for potential liability to contractors for these types of damages.

Finally, despite LAN/STV’s holding, contractors may argue that design professionals can still be liable under a fraudulent or negligent misrepresentation theory based on certain direct representations from the architect to the contractor—i.e., a representation the architect made to the contractor on the construction site rather than simply the representations embodied in the architectural plans. In other words, LAN/STV leaves plenty of room for contractors to argue that its holding is limited to tort claims arising out of plans and specifications. Therefore, at least until a consensus emerges regarding the scope of the LAN/STV holding, the best practice for design professionals is to limit their direct communications with the contractors and sub-contractors to follow the procedures negotiated in the governing contracts. In other words, design professionals should still adhere to long-standing simple advice—don’t say something that you may regret later.

A New Jersey Case on the Economic Loss Rule

A federal district court in New Jersey recently held that the economic loss rule does not apply to bar a contractor's negligence claim against the design professional for a project if there is no contract between the contractor and the design professional. Based on the holding in SRC Construction Corp. of Monroe v. Atlantic City Housing Authority, any participant on a construction project in New Jersey may have a remedy in tort.

By its classic definition, the economic loss rule operates to limit a Plaintiff to a recovery of the economic damages that flow from a breach of contractual expectations. Its effect is to prevent contract based actions from being converted into tort claims with more subjective and, often times, higher damages calculations. While there are different permutations of this rule, the concept is generally the same from state to state.

In SRC, the Atlantic City Housing Authority entered into a contract with the contractor to build a senior living center. The Housing Authority also entered into a separate contract with a design professional to design and administer the project. The contractor alleged that the architect increased the contractor's performance costs by delaying the acquisition of building permits, submitting drawings that did not meet the building codes, failing to timely respond to the contractor's request for information, and verbally ordering changes that were not honored by the Housing Authority. Because the contractor did not have a contract with the architect, it made allegations of negligence to claim its losses. The architectural firm defending the case maintained that the economic loss rule precluded the contractor's claims and, in the alternative, that the contractor's claims were barred because it had the same causes of action in contract against the owner.

The court undertook a review of New Jersey state law on the economic loss rule and affirmed the long held belief that the concept was designed to maintain the distinction between contract and tort claims. The only exception - which did not apply here - is if the Plaintiff can establish an independent duty of care separate from the contract between the parties. Plaintiffs should not otherwise be permitted to enhance the benefits of the bargain they struck in the contract by bringing an action in tort. The SRC court illustrated the distinction using two cases analyzed in the New Jersey Supreme Court opinion in Salvatel v. GSI Consultants.

The court held in New Mea Construction v. Harper that a claim against a builder that installed lesser grade materials was effectively a breach of contract action; and attempts by the Plaintiff to cast it as negligence were improper under the economic loss rule. Conversely, homeowners were permitted to pursue the subcontractor in negligence for faulty workmanship since they had no contract with that subcontractor in Juliano v. Gaston.

Based on this analysis, the SRC court determined that a claim for negligence was not barred by the economic loss rule because there was no contract between the contractor and the architect. Because there was no contract, the tort claim cannot be a "contract claim in tort clothing" and the negligence claim was an independent and valid cause of action. Similarly, the assertion that the existence of a similar claim against the owner affords the architect protection is without merit.

This decision is reminiscent of a similar case in Pennsylvania: Bilt Rite Contractors, Inc. v. The Architectural Studio. Both carry some level of common sense with them. The lack of a contract between a design professional and the contractor does not mean that the design professional has no impact on the contractor's performance. While design professionals have long tried to insulate themselves from these types of claims, courts are increasingly holding design professionals accountable for mistakes they make in design or contract administration.

HANDLING COMPLEX CONSTRUCTION DEFECT CLAIMS INVOLVING MULTIPLE CARRIERS AND MULTIPLE POLICIES

https://sites.google.com/site/metropolitanenvironmental/handling-complex-construction-defect-claims-involving-multiple-carriers-and-multiple-policies

COMPLEX CONSTRUCTION CLAIMS

In many cases we had to assist the insurers or the insureds with damages to multiple homes in subdivisions or in a high rise building(s). The presence of multiple buildings or units, the significant amounts of damage money at stake, and the presence of numerous carriers who advocate their separate, conflicting viewpoints makes the handling of such construction defect cases very challenging.

The level of complexity in defective construction claims may result in especially complicated issues for a variety of reasons:

Carriers have been developing special policy formats for this market, including "wrap-up coverage”; with a wrap-up program, the owner furnishes a single insurance program for all parties involved in the project(s) for the duration of the project term. This insurance relates to the exposures of the project and protects the project owner, contractors, and all tiers of subcontractors.

Some carriers have new contractual provisions - such as policy limitations, which, in effect, provide CGL coverage on a "claims made" basis or preclude application of a "continuous trigger" - in effect which may be difficult to coordinate with traditional formats used by other carriers.

Other policy provisions which apply generally-- such as deductibles, self-insured retentions (SIRs), and the definition of a "claim"— require special analysis in the context of demands being made by a large group of homeowners and insurance carriers with competing interests and policy formats.

WHAT IS A CONSTRUCTION DEFECT?

According to the Insurance and Risk Management Institute, a construction defect is generally speaking, a deficiency in the design or construction of a building or structure resulting from a failure to design or construct in a reasonably workmanlike manner, and/or in accordance with a buyer's reasonable expectation. The most dangerous defects have the capacity to fail, resulting in physical injury or damage to people or property. However, many defects present no increased risk of injury or damage to other property but nevertheless cause harm to the property owner in the form of loss of use, diminution in value, and extra expenses incurred while defects are corrected. This latter type of defect is often referred to as a passive defect.

Many states have more specifically defined the term "construction defect" for purposes of applying statutes that dictate processes for remedying and litigating construction defect claims. These statutory definitions vary by state. Nevada, for example, uses the term constructional defects and defines it as follows:

“Constructional defect” means a defect in the design, construction, manufacture, repair or landscaping of a new residence, of an alteration of or addition to an existing residence, or of an appurtenance and includes, without limitation, the design, construction, manufacture, repair or landscaping of a new residence, of an alteration of or addition to an existing residence, or of an appurtenance:

Which is done in violation of law, including, without limitation, in violation of local codes or ordinances;

Which proximately causes physical damage to the residence, an appurtenance or the real property to which the residence or appurtenance is affixed;

Which is not completed in a good and workmanlike manner in accordance with the generally accepted standard of care in the industry for that type of design, construction, manufacture, repair or landscaping; or

Which presents an unreasonable risk of injury to a person or property.

Whether, and to what to extent, coverage applies in liability policies for claims alleging construction defects is a matter of serious debate both in insurance circles and in the courts. We wrote few weeks ago about some earthshaking decisions reached by the majority of the jurisdictions during 2013 and 2014, finding construction defect coverage under a contractors’ CGL policy. These policies, however, are subject to numerous exclusions and Anti-Indemnification Statutes, Right to Repair/Cure and Statutes of Limitations and Repose. In fact, the defendants in many of these cases have been successful in defeating claims using the defenses of the statutes of limitations and repose.

Among the more frequently addressed exclusions are the so-called “business risk” exclusions, which include the “damage to property”; “damage to your property”, and “damage to your work” exclusions. Other potentially applicable exclusions concern prior work; contractual liability; EIFS; mold; owned property; earth movement, and known or continuing injury or damage. Claims for damages resulting from defective drywall began to appear in about 2005, and courts have frequently addressed whether the standard pollution exclusion, in addition to the above-mentioned exclusions, bars coverage for such claims.

The subtleties of each claim, different facts and precise policy language all contribute to the disparity. And, in some cases, the decisions are simply not reconcilable. Legislation enacted by various states concerning the right to repair/cure, statutes of limitations and repose, and anti-indemnity statutes, are pertinent to the institution of a construction defect lawsuit.

IS THERE AN OCCURRENCE AND PROPERTY DAMAGE WITHIN THE POLICY PERIOD?

Is There An Occurrence?

The first step in any coverage analysis is to determine whether the underlying claim or suit comes within the scope of the insuring agreement of the policy including, under a commercial general liability policy, whether the injury or property damage was caused by an occurrence. “Occurrence” is generally defined as an accident, including continuous or repeated exposure to the same or similar general harmful conditions. Despite what may be similar policy language and fact patterns involved in these claims, the interpretation of what constitutes an occurrence in the context of a construction defect claim often varies widely from one jurisdiction to the next.

Is There Property Damage?

In order to trigger coverage under a commercial general liability policy, the insured’s liability must be based on actual physical injury to tangible property or an actual loss of use of such property. Where the construction claim against the contractor does not involve tangible, physical injury, courts have found no covered property damage. Most courts have also held that claims limited to fixing or replacing all or part of defective construction and/or claims of diminution in value, because of defective construction work or materials with no physical injury, are not claims for property damage. Defective work or materials in and of themselves do not constitute property damage.

For example, the plaintiff must allege that the buildings experienced cracks in the walls, settling of the slabs, soil subsidence, and separation in floor and walkways, just to name few damages that courts have found that they constitute damage within the meaning of the policy. Costs

Theories of Trigger of Coverage

After an occurrence and property damage is determined, the next question is how many policies and how many insurers will be liable for the damages or for coverage for the damages, i.e., who pays? This is accomplished by applying several theories of trigger of coverage. Trigger of coverage relates to when injury or damage is deemed to have taken place, so as to implicate a particular policy period. Construction defect claims typically do not concern a discrete catastrophic event, but more frequently, latent or progressive damage that may take place over an extended period of time. As a result, the determination of when property damage occurred and which policies must respond in the context of a construction defect claim often results in thorny disputes between insurers and policyholders.

Because comprehensive general liability policies insure against damage or injury that occurs during the policy period, courts generally hold that the time the construction defect-related injury or damage occurs is the time the complaining party is actually damaged, not the time when the faulty work was performed. Courts have adopted several different theories for determining when a coverage-triggering event occurred and which policies may have to respond. The five trigger theories that typically apply to construction defect losses include:

The Manifestation Trigger: The policies in effect at the time the property damage becomes apparent or is discovered provides coverage. This theory allows for a single policy to be put “on the risk” and “triggered”, with a duty to defend and be held liable for when the injury is manifested or “discovered”. This theory is much in use in the United States.

The Exposure Trigger: The policies in effect at the time of actual exposure to the damage causing substance or event provides coverage. This theory also results in multiple policy periods being triggered where an exposure may take place over several years. The exposure trigger theory has been applied to a variety of insurance decisions including asbestos, silica, pharmaceuticals, and chemicals.

The Actual Injury or Injury-In-Fact Trigger: The injury-in-fact trigger theory holds that coverage is triggered by the existence of bodily injury or property damage during the policy period. Each insurance policy “on the risk” during the time period when damage actually occurs is triggered. Based on the evidence submitted, injury-in-fact may be determined as occurring at any time from exposure through manifestation. The actual injury/injury-in-fact theory requires the policy holder to prove the discrete injury or damage during the insurance contract period. Nine states use this theory for CGL insurance liability. They include: Minnesota, Hawaii, Arkansas, Alabama, Nevada, Oregon, Texas, Washington, and North Carolina.

The Continuous Loss Trigger Theory: carriers on the risk from the initial exposure through manifestation are considered to be triggered. All policies in effect over a span of time, beginning from the first exposure to injurious conditions, continuing through any period of latency while the resulting damage remains undiscovered and is progressing, and ending at the time the injury manifests itself to the insured, are implicated. See Montrose Chemical Corp. v. Admiral Ins. Co., 10 Cal.4th. 645, 1995. The Court said that there is limitation on potential indemnity, where the damage must occur during the policy period and as a result from the accident or continuous or repeated exposure or conditions. The policy on the risk at the time the policyholder first obtains knowledge of “bodily injury” or “property damage” is the last policyholder that can be triggered. Many states follow this continuous loss trigger model in CGL third party liability claims as well. Including: Colorado, New Jersey, Pennsylvania, Indiana, Illinois, Massachusetts, Georgia, Kansas, South Carolina, Wisconsin, Missouri, and Tennessee.

The Double Trigger Theory. A variation on the continuous or “triple” trigger theory is the “double” trigger theory, applied by at least one court. Zurich Ins. Co. v. Raymark Indus., Inc., 118 Ill.2d 23, 112 Ill.Dec. 684, 514 N.E.2d 150 (1987), aff'ing 145 Ill.App.3d 175, 98 Ill.Dec. 512, 494 N.E.2d 634 (1986). Interpreting an earlier version of the uniform CGL policy that defined “bodily injury” as “bodily injury, sickness, or disease,” the Illinois Supreme Court found adequate medical evidence in the record that “bodily injury” in the form of lung tissue damage occurs at the time of exposure, “disease” exists when the condition is manifest or reasonably capable of clinical detection, and “sickness” includes the claimant's disordered, weakened, or unsound state before clinical manifestation.

ALLOCATION OF LOSS

After all the contributing insurers and policies are determined, the final question is how much each insurer and each insurance policy will pay. Because construction defect claims often implicate consecutive policy periods, the total amount of coverage available to respond to a claim may exceed the total amount of damages. In such circumstances, the damages must be allocated among the triggered policies or policy years. The issue of how a loss should be allocated in a construction defect claim is closely tied to the applicable trigger of coverage, and the resolution of one typically compels consideration of the other.

Courts have applied two main methods for determining how policies will contribute to the damages: the pro-rata allocation and the all sums allocation method.

Pro Rata – Policies respond in a particular policy period in proportion to the “time on the risk” and the total number of years triggered by the loss. Under this approach, each triggered policy is responsible for a portion of damages based on the years it was on the risk in comparison to the total number of years triggered by the loss. This approach is tied to policy language limiting exposure to those damages that take place during the policy period. For this approach to apply, the damage must be continuous and indivisible.

Complex construction defect cases typically involve multiple parties, often with overlapping responsibilities, whose actions are alleged potential causes of some or all of a claimant’s damages. If the case is decided by a jury, then the common law negligence procedure guides the percentage contribution from each defendant. For example, pursuant to Colorado’s Pro Rata Act, each party’s damages liability is determined by multiplying the damages attributable to an indivisible injury to which that party contributed by the percentage fault the jury allocates to that party.

All Sums – Policies in a particular policy period may respond in full, subject to their limits. This approach is based on the “all sums” language in policies and allows an insured to pick which policy years that will respond to a loss. This method is also called “joint and several liability” method and allows an insured to choose the insurance to which the losses are allocated and the deductible which must be paid.

Anti-Indemnification Statutes, Right to Repair/Cure and Statutes of Limitations and Repose

Outside the case law which impacts the analysis of insurance coverage for construction defect claims, many states have also enacted legislation which further defines, creates or restricts rights among owners, developers, and contractors. This statutory framework may include ant indemnity statutes, “right-to-repair” or “right-to-cure” statutes, and statutes of limitation and repose.

Transfer of risk by contract, via indemnity or hold-harmless agreements, is a common practice in the construction industry. In response to such contractual arrangements, many states have case law or statutory regulations that set up anti-indemnity rules for construction projects, to strictly regulate and in some cases prohibit contractual risk transfer.

Several states have passed legislation, known as “right-to-repair” or “right-to-cure” statutes.

The intent of these statutes is to protect the construction trade and offer an alternative to immediately proceeding to costly litigation. Key provisions of these statutes include:

Requiring written notice regarding alleged defects from homeowners to builder, with such notice usually required up to 90 days prior to proceeding with filing a suit.

Allowing the builder to inspect the premises.

Providing for a response to the homeowner’s claim, including an offer to repair, pay a monetary compromise, or decline the claim.

Limitations for the “reasonable” cost of repairs and possible reimbursement of legal fees.

Requirement that the right-to-repair provisions are stated in the sales contract.

A “statute of limitations” is a period of time in which a claim may be brought, beginning from the time of discovery of an injury. A “statute of repose” acts as a bar on any claims, and usually starts on a certain date, such as the close of escrow, transfer of title or occupancy, varying by state. Where the periods of time differ, the statute of limitations may be tolled or extended for reasons set forth in the statute. Most states have many, often overlapping statutes of limitations.

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