CONSTRUCTION LAW NEWSLETTER

TEN TIPS TO MITIGATE CONSTRUCTION RISK IN GREEN BUILDING PROJECTSBy Brian K. Fielden

ISSUE 2, Q4 2010

CONTENTS

Ten Tips To Mitigate Construction Risk In Green Building Projects

Limitations On The Right To Terminate A Contract For Convenience

What the Courts Are Saying

Attorney Advertising1. U.S. Green Building Council website, http://www.usgbc.org/DisplayPage.aspx?CMSPageID=1779 (September 2010).

Owners, developers and other users of commercial real estate are increasingly incorporating sustainable practices in their construction, development and renovation programs in order to realize the benefits of going green. These benefits include savings in operational and maintenance costs, decreased insurance premiums, increased rental and tenant retention rates, greater occupant comfort and productivity and governmental financial incentives.

In addition, the federal government and many state and municipal authorities are enacting statutes, ordinances and regulations at an increasingly rapid rate, mandating compliance with green building standards. According to the U.S. Green Building Council, the LEED rating system has been incorporated in some fashion into “legislation, executive orders, resolutions, ordinances, policies, and incentives … in 45 states, including 442 localities (384 cities/towns and 58 counties), 35 state governments (including the Commonwealth of Puerto Rico), 14 federal agencies or departments, and numerous public school jurisdictions and institutions of higher education across the United States.”1

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Green building projects present unique construction risks and issues that must be thoughtfully considered and documented. Most form contracts, such as AIA forms, either do not address or adequately protect against these unique risks. While each project is different, set forth below are ten basic issues that should be considered when approaching a green building construction project.

1. Avoid inserting contractual warranties in the architect’s agreement – they may not be insurable

The architect’s scope of services should describe the process for achieving the desired level of green certification, rather than the result. Attempting to obligate the architect to achieve a certain level of certification (such as LEED Silver) could be construed as a contractual warranty, the breach of which may not be insurable under its professional liability policy (which likely covers only negligent acts or omissions).

2. Include indemnification for patent infringement claims

With the proliferation of new green products and technologies, there is a greater likelihood of patent infringement activity on green building projects. It is therefore important to require the architect to indemnify the owner for patent infringement claims arising from use of products specified by the architect. Most form design contracts (such as the AIA form) do not include this indemnity.

3. Secure ownership rights in submittal documents required for certification

Ownership of design documents is often heavily negotiated in architect agreements. If an owner is pursuing LEED or another certification that requires providing submittal documents to a third party to confirm compliance, the owner should ensure that it has absolute ownership rights in these submittal documents (regardless of ownership rights in technical design documents). Otherwise, if the owner ends up in a dispute with the architect, it may find itself unable to obtain the documents required for certification.

4. Include commissioning specifications in the architect’s scope

In order to obtain certification under certain ratings systems, such as LEED, some building systems must be “fundamentally commissioned” to ensure they are installed, calibrated and perform as intended. The architect’s scope of services must include development of the commissioning specifications and coordination of activities with the commissioning consultant.

5. Extend the traditional warranty period to include issues that occur during certification

Most construction contracts provide for a one-year warranty call-back period. For green building projects, these standard warranty periods should be extended to include issues which may arise during the certification process but after the standard one-year warranty call-back period.

6. Include key certification requirements in substantial and final completion definitions

Standard definitions of “substantial” and “final completion” in construction contracts should be revised to include key certification requirements as conditions precedent (such as delivery of required submittals and documentation or building commissioning), or additional milestones should be added for these requirements, to ensure that the project is completed in compliance with prospective certification.

7. Align final completion / final payment and/or retainage release dates with certification

Because entitlement to certain points under most green certification standards (such as LEED) can be established only after construction is completed (and facility operation has occurred for a period of time, in some cases), final completion / final payment dates should be aligned with the issuance of a certification, and/or the retainage should be held back until certification is obtained.

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LIMITATIONS ON THE RIGHT TO TERMINATE A CONTRACT FOR CONVENIENCE

Most construction contracts contain specific provisions allowing termination of the contract for cause or convenience. Considering the current economic challenges facing many construction projects, the termination right, if exercised properly, is a powerful tool. If exercised carelessly, however, it can lead to a claim for wrongful termination. This article explores the limitations on the right to terminate a contract for convenience in light of Questar Builders, Inc. v. CB Flooring, LLC, 978 A.2d 651 (Md. 2009).

TERMINATION FOR CAUSE OR FOR CONVENIENCE?

When faced with a potential contract termination, there are a number of items for owners, contractors or subcontractors to consider. As a threshold matter, the terminating party must decide between cause or convenience based on underlying facts giving rise to termination. That decision affects both the termination process and the parties’ respective rights and obligations.

A termination for cause allows the terminating party to pursue contract damages (such as delay or failure to complete work). If the grounds for termination are weak or uncertain, the terminating party may consider terminating for convenience, making a clean break and avoiding the inevitable arguments of wrongful termination. Also, a termination for convenience will cut off the other party’s right to unearned profit and other consequential damages, assuming that the contract has been properly drafted to avoid those damages (most form contracts, including the AIA forms, allow unearned profit if the contract is terminated for convenience). As explained further in the next section, however, the terminating party might be required to show that it exercised the termination for convenience right in good faith.

The terminating party should also keep in mind that terminating for convenience will likely cut off its rights to post-termination contract damages (such as delay damages or completion costs), although the terminated party would still be liable for defective work prior to the termination. Also,

By Michael P. O’Day

8. Include carveouts for foreseeable consequential damages

Failing to achieve a certain standard or certification can have significant financial consequences, such as the loss of available tax incentives. Appropriate carveouts from consequential damages clauses should be incorporated in form agreements and negotiated on a project-by-project basis to protect against foreseeable damages.

9. Protect against the unavailability of sustainable materials required for certification

Because the use of specific sustainable materials is typically an essential requirement for certification, unavailability of sustainable materials should be a non-compensable delay. Owners should also require contractors to follow proper quality control procedures to ensure sustainability requirements are being followed. For example, contractors should submit a staging site plan that designates areas where deliveries of materials (such as FSC-certified

wood) will be temporarily staged for review and approval to ensure their compliance with applicable sustainability and project requirements before they are installed.

10. Ensure proper builders’ risk insurance is obtained

Sustainable materials and methods may come at costs that are higher than standard, and standard builders’ risk policies may not provide coverage for their replacement. Obtain adequate coverage that will ensure that, following a loss, the project may be rebuilt to targeted sustainability standards.

Brian K. Fielden is a partner with DLA Piper practicing construction law, both transactional and litigation. Mr. Fielden has been accredited as a LEED® AP (BD+C) by the Green Building Certification Institute and has experience representing owners pursuing LEED® certification. You can reach him at brian.fielden@dlapiper.com.

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if an owner needs a contractor’s surety to complete or correct incomplete or defective work post-termination, the owner should carefully read the terms of the bond before making a decision. Most performance bonds require the contractor to be in “default” of the underlying contract in order to trigger surety bond obligations.

A termination for cause also likely requires specific notice as well as a cure period. Because courts generally disfavor contract terminations, they strictly construe and enforce the contractual requirements for termination. Accordingly, the failure of the terminating party to follow the notice and cure provisions may give rise to a claim for wrongful termination.

Properly drafted contract provisions may allow a termination for cause to convert to a convenience termination if it is later determined that there was no default (so long as the obligation of good faith and fair dealing is satisfied, as explained further below). This is sometimes referred to as a constructive termination for convenience. The reverse situation is not always true. Some courts have found that once a party declares a termination for convenience, it cannot later change its mind and assert a default to recover damages for contract breach.

Questar Builders v. CB Flooring: LIMITING THE RIGHT TO TERMINATE FOR CONVENIENCE

The plain meaning of “termination for convenience” is that a party may terminate a contract without cause. This does not mean, however, that a contract may be terminated for any reason whatsoever, including no reason at all. The court in Questar Builders recently found an implied obligation of good faith and fair dealing limiting the right to terminate private contracts for convenience.

There, Questar (the general contractor) hired CB Flooring to install carpeting in connection with the new construction of townhomes. The subcontract

allowed Questar to terminate for convenience. After the parties executed the subcontract – but before CB Flooring began any work at the project – the interior design plans changed. CB Flooring submitted a proposed change order increasing the contract price by approximately $100,000, which Questar claimed was excessive and was an improper attempt by CB Flooring to correct alleged mistakes in the original bid price. Even before receiving CB Flooring’s proposed change order, however, Questar already had provided the revised drawings to another subcontractor for pricing. That subcontractor provided Questar a lower price. Questar then terminated CB Flooring’s subcontract and hired the other subcontractor to perform the carpeting work. Questar claimed in the termination letter that CB Flooring breached the subcontract and that, in any event, it had the right to terminate for convenience. CB Flooring sued Questar for wrongful termination. The trial court found that CB Flooring did not breach the subcontract and Questar had improperly terminated the subcontract, and it awarded CB Flooring expectation damages. Questar appealed.

On appeal, Maryland’s highest appellate court held that an implied obligation of good faith and fair dealing limits a terminating party’s discretion to terminate for convenience. The court reasoned that if a party can terminate a contract for any reason whatsoever (including no reason at all), the contract may be illusory (i.e., a promise that does not actually bind the promisor to do anything). Under Maryland law, illusory contracts are not enforceable.

According to the standard in Questar Builders, once the terminated party makes a prima facie showing that the termination was not done in good faith, the burden shifts to the terminating party to prove good faith by a preponderance of the evidence. To meet its burden, the terminating party must show that the termination was exercised in accordance with the reasonable expectations of the other party in light of the terms of the contract. An objective standard applies. Accordingly, the terminating party must be prepared to show a good faith basis – merely relying on “no reason at all” is not enough.

GOOD FAITH REASONS TO SUPPORT A TERMINATION FOR CONVENIENCE

Whether a termination for convenience was exercised in good faith involves detailed factual determinations. The Questar Builders court provided some guidance in this regard – stating that a termination for convenience provision is a risk-allocating tool that permits termination where a contractor “determined that continuing with the Subcontract would subject it potentially

…the termination right, if exercised properly, is a powerful tool. If exercised carelessly, however, it can lead to a claim for wrongful termination.

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to a meaningful financial loss or some other difficulty in completing the project successfully.” A terminating party acts in good faith if its determination of the risk of continuing with the contract is commercially reasonable. These risks involve some change in circumstances and may include a) deterioration of the parties’ relationship; b) impossibility of performance (e.g., discovery of unknown or concealed condition); c) delay in completing the work; d) non-responsiveness of the other party; e) insolvency or other factors impairing party’s ability to perform; or f) deletion of the scope of work from the project.

BAD FAITH REASONS THAT DO NOT SUPPORT A TERMINATION FOR CONVENIENCE

The court in Questar Builders discussed certain reasons for termination that may violate the implied covenant of good faith and fair dealing. These include terminating a contract to obtain better pricing from another party, evade contractual dispute resolution provisions or avoid issuing a valid change order. A terminating party also is prohibited from creating an inconvenience for the other party as an excuse for terminating the contract. The covenant of good faith and fair dealing prohibits one party from frustrating the purpose of the contract. Terminating a contract on a “mere wish or caprice” runs afoul of the implied covenant of good faith and fair dealing.

PRACTICAL CONSIDERATIONS BEFORE TERMINATING A CONTRACT FOR CONVENIENCE

Before declaring a termination for convenience, a party should consider the following factors that

may give rise to a claim for wrongful termination or breach of the implied covenant of good faith and fair dealing.

■ Review the contract procedures for termination. The notice requirements are not mere technicalities. Courts strictly enforce them.

■ State the basis for the termination in writing. This includes citation to the specific contract provision(s). Be clear.

■ Identify the risk(s) of proceeding with the contract. If you cannot articulate any commercially reasonable risk, you probably should not terminate the contract.

■ Collect any written project records that support termination and continue to maintain contemporaneous project records. This was an important factor in Questar Builders. The trial court did not find any contemporaneous project records to support Questar’s claim that it lost confidence in CB Flooring’s ability to complete the job, and the court resolved the conflicting testimony about oral conversations in favor of CB Flooring.

■ Document any attempts to resolve issues short of termination. They will come in handy if a dispute over termination arises.

■ Balance the potential for a claim of wrongful termination against the need to terminate. No one wants to be sued just like no one wants to get terminated.

Michael P. O’Day practices business and commercial litigation and arbitration, with a focus on construction law. He is based in Baltimore and may be reached at michael.oday@dlapiper.com.

WHAT THE COURTS ARE SAYING

ConneCtiCut: LEGISLATURE LOWERS STATUTORY RETAINAGE LIMITS

2010 Connecticut S.B. 131, Public Act No 10-148 (Conn. Gen. Stat. § 42-158K)

Legislation recently enacted in Connecticut to lower the statutory limit on retainage on private construction projects is in effect as of October 1, 2010. The limit, previously set at 7.5 percent, is now

5 percent. The law, passed in June 2010, applies to projects valued at $25,000 or more and includes residential projects intended for occupancy by four or more families. By enacting this law, Connecticut joins the growing number of states who are considering, or who have already enacted, legislation to reduce retainage limits on private projects. For example, Kansas passed a law in April 2010 limiting retainage to 2.5 percent for properly performing

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contractors and subcontractors. In other states, legislation is currently pending to reduce retainage on private projects (for instance, California S.B. 629, limiting retainage to 5 percent; Colorado H.B. 10-1162 limiting retainage to 5 percent on the first half of a project, then 2.5 percent for the remainder). Owners, contractors, and subcontractors should carefully watch these developments and make sure their contracts comply with existing law.

KentuCKY: GENERAL CONTRACTOR’S FAULTY WORKMANSHIP STANDING ALONE IS NOT “OCCURRENCE” WITHIN MEANING OF CGL POLICY

Cincinnati Ins. Co. v. Motorists Mut. Ins. Co., 306 S.W.3d 69 (Ky. 2010)

The Kentucky Supreme Court recently held, consistent with the majority of the courts to address the issue, that a general contractor’s faulty workmanship standing alone is not an “occurrence” within the meaning of its CGL policy. In Cincinnati Ins. Co., the court held that, even though the contractor presumably did not intend to build a defective home, the construction was within the contractor’s control and therefore not “accidental” from its perspective. Stressing the critical role of “fortuity” in any analysis of liability insurance, the court concluded that the fortuity principle dictated that outcomes within the insured’s control are not accidental. Here, the insured was in control of the construction process from beginning to end and had the opportunity to repair defects or to select more reputable subcontractors. According to the court, the consequences of the insured’s failure to do so should not be placed upon insurers that had agreed only to insure against truly unforeseen and unplanned events; any other result would convert the CGL policy into a performance bond.

MassaCHusetts: LEGISLATURE ENACTS PROMPT PAYMENT LAWS

Ch. 293 of the Acts of 2010 (M.G.L. c. 149 §29E)

The Massachusetts legislature recently enacted prompt payment laws which apply to all private construction contracts whose original contract price is $3 million or more. Residential projects of four dwelling units or less are excluded. The law specifies “not to exceed” periods for approval and payment of applications for payment. Owners must approve or reject a payment application within 15 days and pay within 45 days after approval (the approval/rejection period is extended by an additional 7 days per tier, cumulative for each tier below the owner). Proposed change orders must be approved or rejected within 30 days. Rejections of payment applications and change orders must be in writing

with an “explanation of the factual and contractual basis for the rejection and shall be certified as made in good faith.” Also, “pay when paid” contractual provisions are unenforceable, subject to certain exceptions. This law applies to contracts signed on or after November 8, 2010. Therefore, owners and contractors alike should carefully review this law and modify their form contracts to avoid violating these important statutory provisions.

Minnesota: CONSULTANT’S REPORT OF MOLD PUT OWNER ON NOTICE OF DEFECTIVE CONSTRUCTION, RESULTING IN TIME-BARRED CLAIM

Buscher v. Montag Development et. al., 770 N.W.2d 199 (Minn.App. 2009)

A recent Minnesota Court of Appeals opinion shows why project owners should properly investigate water-related problems with qualified experts: if the true cause of the problem is not initially determined, project owners can be faced with time-barred claims. In Buscher, homeowners hired a contractor to renovate a stucco house in 1998 and discovered a series of water-related problems in 2002, which they repaired. Finding evidence of mold, they retained an indoor-air-quality expert, who concluded the mold was associated with “damp building materials and finishes,” but that mold results were “mostly within the normal range,” although he did find elevated mold levels in several areas. While the consultant found no “serious envelope problems,” he put the homeowners on notice that “stucco wall failure does not produce elevated mold levels until the wall system is almost completely decayed.” However, the homeowners did not perform invasive investigation of the walls. Two years later, the homeowners discovered significant water damage in the walls, which was determined to be caused by defective construction. The Court of Appeals upheld a trial court’s ruling that their claim against the contractor for this damage was time barred because they “knew or should have known” about this injury during the initial investigations. Thus, the statute of limitations began to run at that time and had since expired.

oHio: CONTRACTOR MAY NOT PURSUE CLAIM AGAINST OWNER’S LENDER WHERE LENDER PROVIDED VERBAL ASSURANCE OF ADEQUATE FUNDS

GEM Industrial, Inc. v. SunTrust Bank, et al, 2010 WL 1244286 (N.D. Ohio March 31, 2010)

The Northern District of Ohio recently showed why it is important for contractors to obtain binding agreements from lenders when seeking assurances of payment (and why lenders must be very careful when talking with contractors on

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distressed projects). In this case, a struggling owner building an ethanol production plant requested payment deferral from its mechanical contractor. The contractor, who contractually could stop work if it did not receive financial information confirming owner’s ability to pay, requested a meeting with the owner’s lenders, who verbally assured the contractor it would be paid. The owner subsequently filed bankruptcy, and the contractor sued the lenders for breach of contract, promissory estoppel and negligent misrepresentation. While the court found that the lenders made an oral promise to pay that did not fall within the statute of frauds, the court also found that the promise was not enforceable because the parties had not agreed to the essential terms of the contract (e.g., price, duration, timing of payments). Granting summary judgment to lenders, the court held that the contractor’s agreement was with the owner, and conversations with the lenders did not create legal liability on their part.

soutH Carolina: NEGLIGENT APPLICATION OF STUCCO RESULTED IN “OCCURRENCE” OF WATER INTRUSION, PROVIDING COVERAGE UNDER CGL POLICY

Auto Owners Ins. Co. v. Newman, 684 S.E.2d 541 (S.C. 2009)

In Auto Owners Ins., the South Carolina Supreme Court ruled that, although a subcontractor’s negligent application of stucco did not on its own constitute an “occurrence” triggering coverage under a contractor’s CGL policy, the continuous moisture intrusion resulting from the subcontractor’s negligence was an “occurrence” falling within the CGL policy’s initial grant of coverage for the resulting “property damage” to the home’s framing and exterior sheathing. The court rejected the argument that the property damage was nevertheless barred under the standard exclusion prohibiting coverage for “property damage expected or intended from the standard of the insured.” The court stated it was unreasonable to believe that the contractor expected or intended its subcontractor to perform negligently, and thus could not have “expected or intended” the resulting property damage. However, the court held that an exclusion prohibited recovery for the cost of removing and replacing the defective stucco itself, even if replacing the defective stucco was incidental to repairing coverage damage. The exclusion in question does not cover damages “claimed for any loss, cost or expense … for the repair, replacement, adjustment, removal or disposal of … ‘Your product’; … ‘Your work’; or … ‘Impaired property’; if such product, work or property is withdrawn … from use … because of a known or suspected defect, deficiency, in adequacy or dangerous condition in it.”

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