Over the past several years, we have seen an increase in construction-defect counterclaims brought in response to contractor payment claims on newly built projects. These typically involve situations where the project runs longer and costs more than expected because of changes or unexpected events, and more recently because of labor or material shortages.
A common theme involves passive communications during the project about responsibility for delays and cost escalation, and the presentation of a late-stage “closeout claim” by the contractor. These frustrate the owner, who feels betrayed by the contractor’s last-minute move, especially at a time when the owner is working with his lender to close out the project. And when trust is broken, the gloves come off. The lawyers and consultants hired by the owner push back with a long list of gripes.
Tactically, we encourage contractors to adopt a more direct and contemporaneous approach to stating claims promptly, as situations come up. The claim should be presented in the customer service voice, and should conclude with a genuine commitment to work collaboratively with the owner to minimize impacts for all involved. This spoonful of sugar really does help the medicine go down.
Nonetheless, if a construction lien has to be filed to preserve the contractor’s security interests, counsel for the contractor should vet the lien claim with an eye on what plagued the project in the first place, and what potential counterclaims may come up, especially workmanship claims.
For Example…
The fact pattern for our example story involves a new, more robust window package introduced by the contractor for an apartment complex after the project begins. The architect agrees with and approves the change, but the lead time for new windows throws off the project schedule. The contractor knows the change will have some impact, but does not know how to value or capture the impact in real time, so the contractor defaults to informing the owner of progress on the issue in a more casual manner. For example, window issues are repeatedly discussed in the project weekly meetings, so the contractor feels satisfied that the owner is on notice of delays in the delivery of the windows.
On the other hand, the owner leaves the same meetings feeling relieved that the word “claim” never came up. Further, the contractor never delivered a formal claim notice by registered mail as required by the contract. A barrier to communications here is the fact that everyone on the project team hates the word “claim.” It is a bad word that causes team members to behave in an adversarial manner. This idea about using better windows is turning into a hassle because the city is delayed in design review approvals, and the architect needs to redesign installation details. An already tense project is now made even more difficult to close out.
At the closeout phase, at the end of the project, the contractor delivers to the owner an accounting claiming compensation for the cost and time impacts involved with switching out the window package. A construction lien has to be filed within X days after work is completed, and that lien filing surprises the owner, who feels betrayed. The owner then lawyers up, and the lawyer hires a forensic consultant to evaluate the window work, as well as the rest of the building, to support any pushback to the contractor’s lien.
The owner’s consultant tests a handful of windows and “makes them leak” at design test pressures, although there is no visible active leaking occurring at the apartments. The consultant calls for repair or removal of all the windows. While he is at it, the consultant also identifies 17 other categories of defects at the apartments—issues that were not on anyone’s radar and that the contractor believes to be aesthetic in nature, or inconsequential.
Had there been better communications throughout the project, and had there been no closeout lien claim, otherwise minor non-conformance issues would have likely gone by the wayside because the owner would have been satisfied with the overall outcome of the project. However, when trust is broken, every issue is viewed critically by the owner’s litigation team. Rather than taking a reasoned approach to the project closeout, the owner is measuring the contractor’s performance “by the book.”
Insurance Coverage Overlay
Construction-defect counterclaims similar to the above example present insurance coverage challenges because newly constructed buildings do not typically present much “physical injury to tangible property,” which is one of the definitions of the “property damage” that is covered by a commercial general liability insurance policy. For example, the new apartments do not yet have dry rot because the allegedly defectively installed windows or defective windows have not been exposed to the elements over time.
The other definition of “property damage” is “loss of use of tangible property that is not physically injured.” In some counterclaims, an owner may be claiming liquidated damages because the project runs longer than scheduled, especially if the windows have to be pulled and reinstalled because of alleged defects.
In assessing the availability of insurance coverage for these counterclaims, the contractor and its insurance carrier should be considering the following issues:
- Rip and tear coverage. Many jurisdictions consider the cost of removing and replacing otherwise good materials to “get to” and repair the defects to be “property damage” within the coverage of the policy. For example, the cost of removing otherwise non-defective siding and sheathing is “property damage” if their removal is necessary to get to and remove defective windows, however, the court may conclude that the cost of replacing the defective windows themselves are excluded by the policy because the studs are the insured window manufacturer’s products, and defects in the products themselves are excluded under the “Your Product” exclusion. Other jurisdictions have a more expansive view of the rip and tear coverage, holding that removal of the windows is considered “property damage,” regardless of a “Your Work” exclusion in the policy, if the windows need to be removed to get to and repair underlying rot damages. The parties should understand how rip and tear coverage is interpreted under state law because this kind of coverage may be the economic driver to the resolution of the counterclaim.
- Attorneys’ fees as damages. Some jurisdictions consider attorneys’ fees to be covered damages. For example, in my home state of Oregon, a subcontractor’s attorneys’ fee exposure to the general contractor, developer, and to the owner are characterized as “consequential damages” covered by an insurance policy to the extent the subcontractor is at fault for defective work and property damages.
- Liquidated damages. Courts go both ways on whether an award of liquidated damages to the owner arising out of project delays are covered by insurance. For example, a Pennsylvania court, in Mattiola Constr. Corp. v. Commercial Union Ins. Co. (2002 Pa. Dist. & Cnty. Dec. LEXIS 183, *20), held that liquidated damages are covered loss of use damages where the insured subcontractor accidentally cut structural parts of a bridge, causing completion of the project to be delayed. However, a Connecticut court ruled the opposite way on this issue in O&G Indus. v. Litchfield Ins. Grp., Inc. (2015 Conn. Super. LEXIS 1148, *28), holding that the contractual liability exclusion in the policy precludes coverage for liquidated damages for delays in completing the project even though the accidental explosion resulted in bodily injuries and physical damage to the project. In our window example, the apartment building may not get completed on time because of delays in repairing the windows and resulting damages. The coverage exposure for liquidated damages should be carefully evaluated as these damages can be significant depending on the extent of the delay and who the jury determines is at fault for the delays.
Coverage Challenges
A focal policy exclusion applicable to newly built projects is exclusion (j)(5) in the standard form liability insurance policy, which excludes coverage for property damage to “that particular part” of real property on which the contractor is performing operations during the course of the work, if the property damage arises out of those operations. Whether and how (j)(5) applies to a given claim depends on when and where the damages occur. For example, Washington courts have consistently held that exclusion (j)(5) clearly excludes all damages that occur during the course of the work regardless of whether the damages occur in the vicinity of the cause of the loss; to personal property adjacent to the project; and regardless of whether the damages occurred on or off the project site.
One of the more important and often missed risk transfer considerations for damages that start to occur during the course of a project is whether the claim is potentially covered by builder’s risk property insurance, which is typically purchased by the owner. Builder’s risk coverage is typically written on manuscript forms, meaning each policy is different, so the policy should be carefully examined to determine what it covers and what it excludes. The most common type of builder’s risk insurance excludes coverage for loss “due to defects of material workmanship, design, plan, or specification,” but the policy covers property damage to the project resulting from the defective work.
In our scenario, the builder’s risk coverage may be triggered if it can be demonstrated that defective windows caused water leakage into the wall cavities during construction of the project. The cost of repairing the windows themselves may be excluded, but the cost of removing the siding and repairing insulation and framing may be covered by the builder’s risk policy.
Triggering builder’s risk coverage is especially helpful in these circumstances because the standard forms of commercial construction contracts include a waiver of subrogation provision by which the owner and the contractor waive claims against each other to the extent losses are covered by builder’s risk. Furthermore, a loss covered by builder’s risk policy does not count against a contractor’s loss record. Finally, since builder’s risk is property insurance, the adjustment of a claim occurs more promptly than it takes to resolve a disputed liability claim, so the owner and contractor avoid spending time and resources litigating fault. In sum, the owner and contractor are money ahead to the extent the loss is covered by builder’s risk.
The Best Solution
Of course, the best way to mitigate against construction-defect claims is to maintain a vigorous quality assurance program and to get the project completed according to plans and specifications, on time, and on budget. However, given the challenges in meeting this goal even during normal times, the better way to deal with delay and impact issues is to address them squarely as they come up.
For example, a claim letter submitted per contract requirements does not need to be seen as a hostile act; it can include helpful corrective ideas and should conclude with a sincere commitment by the contractor to actively work with the owner and the rest of the team to mitigate impacts. The key for the contractor to maintaining trust is transparency and candid communications with the owner. No one likes surprises, so when cost or delay situations come up, those should be addressed head on, by the book, and with an eye towards collaborative resolution.
Finally, when a lien claim appears necessary, the contractor may be feeling disappointment and upset about having to go through the legal system to get paid. Valid as those feelings may be, counsel for the contractor should help the contractor evaluate whether its house is really in order before filing the lien so as to anticipate pushback. Counsel should vet whether the work strictly meets the requirements of the contract documents. Were there issues with the window installers (i.e., short crews, supervisory turnover) that were glossed over during the project? Can the contractor prove that it was not concurrently at fault in causing the delay?
There may be good reason to proceed with a lien, however, the contractor is better off understanding where the pitfalls lie, with eyes open, before poking the bear. Aside from whether insurance may be available to pay for construction-defect counterclaims, counsel should also address the financial and emotional toll that the claims process takes on the contractor’s organization.
Spending time in a fight looking backwards takes away from everyone’s productivity and energy. In this regard, it is very important for counsel to conduct a thorough analysis, quickly, before filing the lien, to help the contractor consider whether it is really worth it, and how much it is really worth.