Kip Childs
Kip Childs is a member of Stoel Rives LLP practicing in the Construction and Design group. Kip has extensive trial experience and has been heavily involved in both prosecuting and defending construction defect, delay, impact and design claims. He regularly participates in mediations and settlement conferences, and assists clients with negotiating and drafting construction and design contracts. Kip also practices with the firm’s Business Insolvency & Financial Services practice group and has significant experience in the areas of bankruptcy, commercial and general debtor-creditor law.He has represented both secured and unsecured creditors in numerous bankruptcy reorganizations and has extensive experience litigating bankruptcy preference, lien avoidance, priority and plan confirmation disputes.
Amendment to AAA Arbitrator Disclosure Rule Imposes Duties on both Arbitrator and Parties
With an increase in the use of arbitration as the preferred method for resolving construction industry disputes has come an increase in concerns with assuring fairness in the process. To this end, one of the recent changes the American Arbitration Association made to the Construction Industry Dispute Resolution Procedures (Including Mediation and Arbitration Rules), was to modify the disclosure requirements in the arbitrator selection process.
Prior Rule 17 of the AAA Rules imposed on proposed arbitrators an obligation to make certain disclosures. That rule has now been replaced with Rule 19(a), which imposes the disclosure obligation, not only on the proposed arbitrators, but also on the parties themselves. Specifically, Rule 19(a) provides as follows:
“Any person appointed or to be appointed as an arbitrator as well as the parties and their representatives shall disclose to the AAA, as promptly as practicable, any circumstance likely to give rise to justifiable doubt as to the arbitrator’s impartiality or independence, including nay bias or any financial or personal interest in the result of the arbitration or any past or present relationship with the parties or their representatives. Such obligation shall remain in effect throughout the arbitration.”
The amended rule will help to improve the process, since it will help to avoid, not just the potential partiality of arbitrators, but also the appearance of partiality. Parties who have been accustomed to the disclosure requirement being solely the duty of the proposed arbitrators, need to be aware that the duties have been expanded.
Below is a link to the amended AAA Rule.
www.adr.org/sp.asp
Oregon Court of Appeals Provides Clarification to Contractor Negligence Claims
The Oregon Court of Appeals recently issued an opinion in Abraham v. T. Henry Construction, Inc., et al., a residential construction defect case, that helps clarify the circumstances under which a contractor may be sued for negligence. The issue of whether a contractor may be sued for negligence, as opposed to breach of contract is, in many cases, relevant to a determination of whether the owner’s claims are barred by the statute of limitations. Owners often need to rely upon a negligence claim to get past the six-year statute of limitations that applies to claims for breach of contract.
In Jones v. Emerald Pacific Homes, Inc., which was decided in 2003, the Oregon Court of Appeals held that an owner who had a contract with a contractor could sue the contractor in negligence if the contractor had breached a standard of care that was independent of any contractual duty or standard of care. Some courts generally referred to the non-contractual duty or standard of care as a “special relationship.” The Jones opinion then only begged the question of what constituted a special relationship.
In Abraham, the court held that, among other possibilities, a contractor’s duty to comply with the applicable building code constituted a duty independent of the contract and thereby created the type of special relationship necessary for asserting a negligence claim.
Abraham will be an important tool for owners seeking to pursue construction defect claims in situations in which the owner’s contract claim has expired due to the six-year statute of limitations, but only in certain types of cases. The Oregon Legislature recently passed legislation shortening the statute of ultimate repose (which is different from the statute of limitations) to six years, for medium to large commercial projects. As a result, the issue of whether a contractor may be sued for negligence, as opposed to breach of contract, will be relevant only to residential and small commercial projects and the Abraham case will be relevant only to those situations.
Recent Oregon Court of Appeals Case Resolves Statute of Limitations Issues in Construction Defect Cases
The Oregon Court of Appeals recently issued a ruling in the case of Waxman v. Waxman & Assoc., Inc. that resolves two significant issues regarding the statute of limitations in certain construction defect cases. First, the court ruled that where a plaintiff’s claim is based upon breach of contract, the applicable statute of limitations is six years, not ten. And second, the court ruled that the six-year limitation period begins to run at the time of the breach (which will generally be at the time the work is completed), not at the time the breach is discovered.
With respect to its ruling that ORS 12.080 does not incorporate a discovery rule, the court recognized an exception in cases of fraudulent concealment. Specifically, the court recognized that if the defendant fraudulently concealed the contract breach, the six-year period would not begin to run until the plaintiff discovered the breach or reasonably should have discovered it. While the extent to which this exception will be used remains to be seen, it is certainly possible that it will lead to allegations in future litigation that latent construction defects of which the contractor should have been aware were fraudulently concealed and therefore subject to a discovery rule.
The six-year limitation period will not apply to all construction defect claims, but only to those that are based upon breach of contract. In some cases, owners who purchased their property directly from the builder or developer may be limited to breach of contract claims and subject to the six-year limitation period, because the availability of tort claims is uncertain under Oregon law. Such owners, however, will likely be able to pursue tort claims against other parties with whom they did not have a contractual relationship, such as subcontractors, in which case their claims would be subject to a two-year statute of limitations, but also subject to a discovery rule. Likewise, owners who purchased their properties from prior owners and not directly from the builder or developer may also be able to pursue tort claims against the builder or developer.
The Waxman ruling is certainly good news for builders, because it confirms the position they have been taking on Oregon’s statute of limitations in construction defect cases. At the same time, though, it likely raises at least one significant new issue for litigation.
Contractor Insolvencies and the Risks to the Owner/Developer
A retail construction project illustrates the risks to an owner when the general contractor encounters financial problems. As is typically the case, the general’s financial troubles started when he got behind in payments on earlier projects. As a result, the initial payments on the retail project went to pay subs and suppliers from the earlier projects, which in turn, of course, left subs and suppliers on the retail project unpaid.
This game of catch-up worked for a brief period, as do most Ponzi schemes, but during that time, the problems only compounded themselves. Not only were subs and suppliers going unpaid, but the general was also spending less and less time supervising the project and more and more time dealing with his increasing financial troubles. Among other things, the distractions caused him to fail to get signed subcontracts. Work-quality issues became common, and, in the absence of written subcontracts, change order disputes became difficult to resolve.
The owner paid the monthly draws timely, but was lax in monitoring the collection of lien releases. The general began using the owner’s payments to cover obligations from other projects and even to pay personal financial obligations. Eventually, the subs and suppliers started filing liens, and it was at this point that the owner first realized there was a problem.
The owner retained an attorney to deal with the liens and investigate claims against the contractor. In fairly short order, the contractor was terminated, which resulted in the project slowing to a halt and ultimately led to a completion delay of several months. These conditions placed the owner in default of its bank loan.
The owner’s expenses and losses included multiple items: (i) paying several of the subs and suppliers amounts that had previously been paid to the general; (ii) paying attorney fees and 18 percent interest to discharge multiple liens from the property; (iii) hiring a replacement contractor at a fee significantly greater than the amount remaining in the prior general’s contract; (iv) paying the bank’s attorney fees, along with default interest; (v) paying its own attorney fees; and (vi) responding to legal claims from preleased retail tenants who were delayed in moving into the project.
In the end, the owner’s cost overruns very well may force it into insolvency and it may, as a result, end up losing the project. While the owner certainly has claims against the general, they likely have no value in light of the general’s insolvency.
The owner could have done a number of things to prevent these problems. First, it could have investigated the contractor’s financial condition before even contracting with it. An investigation might have involved looking at the contractor’s financial statements, speaking with the owners of the contractor’s most recent projects, and ordering a Dunn & Bradstreet report. Second, the owner could have insisted on receiving lien releases from subs and suppliers as a condition to paying the general. While these steps are not foolproof, and while fraudulent tactics can be used to undermine them, a cautious owner can do a lot to avoid the problems that can result from a contractor’s insolvency.
Owner/Developer Insolvencies and the Risks to Contractors
Developer insolvencies are unfortunately becoming more and more common in our current economic climate and often result in partially completed projects being stopped. The consequences to contractors can be significant. A number of recent resort projects illustrate what the contractors and subs can typically expect.
First, the obvious, immediate problem is nonpayment, which in turn requires the contractor to file a lien. After a lien is filed, the contractor has 120 days (in Oregon) to file a lawsuit to foreclose it. The commencement of the foreclosure suit is only the start of what can sometimes turn into a long and drawn-out battle with an uncertain outcome.
If the project involves conventional bank financing, as many do, the biggest battle will be between the contractor and the bank. If the contractor has prepared its lien properly (and mistakes here are common), it will normally have priority over the bank. While in some cases the contractor may be successful in moving the case along quickly, it 's not at all uncommon for such cases to drag on for a year or more, and this will likely be the situation if there are significant priority disputes.
In other economic climates, banks would often step up and pay off the construction liens, once any priority issues were resolved; however, that is not happening as often in the current climate for a number of reasons. First, many banks are dealing with their own insolvency issues, and some are operating under Federal Reserve supervision. Banks in those situations are often incapable of advancing new funds. Second, as a result of the recent significant decline in real estate values, the equity cushion that many banks thought they had when making the loan has disappeared. Absent having any equity to protect, many banks will simply elect to abandon their collateral to the construction lien claimants. And third, participation loans have become more common, with the result that the lender on a particular project might not be an individual bank, but instead a collection of banks, perhaps as many as 40 or 50. Negotiating with a single entity presents a different dynamic from negotiating with a committee.
In the course of the lawsuit, the contractor is obligated to the subs and suppliers. If the subcontracts contain pay-if-paid or pay-when-paid provisions, the general contractor may be protected, though not necessarily. Recent case law has held that a pay-when-paid provision still obligates the general contractor to pay subcontractors within a reasonable period of time and does not permit the general to delay subcontractor payments indefinitely.
Assuming the general succeeds in being awarded a judgment in the lawsuit, the next step is to schedule a foreclosure sale, and this can be done within approximately two to three months after a judgment is entered. If the bank has not stepped up and paid subcontractors by the time the foreclosure sale is scheduled, there is a good chance that it will not do so and will instead allow the sale to go forward. If the sheriff’s sale takes place, the bank is still protected, because it can later exercise its redemption rights to acquire the property for the amount that was bid at the sale.
However, if the owner believes there is equity in the project, and most owners are optimistic that there is, even in the face of an appraisal to the contrary, the owner will file a bankruptcy petition in time to prevent the sale. If the owner is a single-asset limited liability company, which is how many development projects are set up, a bankruptcy filing is an easy decision. Typically, the owner will wait until only a day or a few days prior to the scheduled foreclosure sale to file the petition.
In bankruptcy, the owner will likely propose a plan of reorganization that involves delaying completion of the project for a few years until the economy turns around, which will, in theory, give the owner time to locate new financing, complete the project, and pay everyone off. All of this, of course, means three, four, or maybe five years of delay in the contractor getting paid. Many contractors simply cannot wait that long.
The contractor can do a number of things to prevent this situation from happening. First, the contractor can investigate the owner’s financial condition before starting work. This might involve asking for financial statements, requesting confirmation from the lender that the financing has been approved, and ordering a Dunn & Bradstreet report. If there are concerns, the contractor should request that the owner post a payment bond. Second, the contractor should include strong language in the contract allowing it to stop work for nonpayment and to demand financial assurances in the event it has reason to question the owner’s solvency. Third, assuming that it has included strong language in its contract, the contractor should exercise its right to stop work promptly in the event of nonpayment. Fourth, the contractor should insert pay-if-paid provisions in its subcontracts. And finally, the contractor should act promptly and cautiously in filing its lien.
More than anything else, payment defaults can cause contractors significant delays. Anticipating payment issues at the contracting stage and monitoring the issues closely during performance are critical.
May a Contractor Sue the Owner's Lender?
When disputes arise between an owner and its lender, and the lender, for any number of reasons, stops funding a project, the question of whether the contractor can sue the lender sometimes arises. The theory often advanced is that the lender knew the contractor had started work and, if it did not intend to advance the loan funds, it should have notified the contractor immediately, rather than remaining silent while the contractor proceeded.
The contractor’s ability to sue the lender is limited by the absence of a contractual relationship, and while in most cases it’s unlikely that grounds will exist for a claim against the lender, there are unique circumstances that might warrant a claim. A recent Pennsylvania project provided one possible fact scenario. The project involved funding from both a bank and the City of Harrisburg. Three contractors that were unpaid on the project sued both the bank and the City alleging, among other things, that (i) the bank made payments to the developer that were supposed to go to the contractors, when the bank knew the developer was using the funds to pay his personal debts to the bank; (ii) neither the City nor the bank had adequate financial controls in place; and (iii) the audits that the City and the bank had pledged to conduct never took place. This case has not been resolved; however, since the bank has subsequently taken over the project from the developer, it’s likely that the contractors will end up being paid by the bank without having to litigate their claims.
Other possible legal theories exist for a contractor’s claims against a lender, the most likely one being promissory estoppel. A promissory estoppel claim arises when, even though two parties have not entered into a contract, one of the parties has provided assurances that the other has reasonably relied upon to its detriment. A bank’s notification to a contractor that the owner’s financing has been approved and that the bank intends to fund the project might provide the facts necessary for such a claim.
As a practical matter, the contractor will seldom need to sue an owner’s lender. If a contractor has properly filed its lien, it should have priority over the lender and should get paid out of the property. The unique situation in which the contractor might need to consider a suit is where either (i) the contractor fails to properly file its lien or (ii) the property has insufficient value to cover the contractor’s lien.
Lawsuits by contractors against an owner’s lender are rare and will only be available in limited situations. Nevertheless, they may at times be worth considering.
Bankruptcy as an Event of Default - Unenforceable Contract Provisions
Contract provisions stating that either the owner or the contractor’s bankruptcy will constitute an event of default are common. A corresponding provision typically sets out the nonbreaching party’s rights in the event of default, one being the right to terminate the contract. For all practical purposes, these provisions are meaningless and unenforceable.
Section 365 of the Bankruptcy Code deals with the debtor’s right to assume or reject executory contracts. (“Executory contracts” are essentially contracts for which performance is not yet complete. A construction contract is an executory contract.) That same section also gives the debtor the right to assign such contracts. Section 365(e)(1) states that any provision in an executory contract that permits one party to terminate the contract in the event of the other’s insolvency or in the event that the other files a bankruptcy petition is unenforceable. And section 365(b)(2)(A) similarly states that any provision in an executory contract that prohibits the debtor from assuming and assigning the contract is unenforceable.
A participant at one of our recent “Financial Defaults” seminars suggested one possible reason for using such a provision. If the contract is guarantied by a third party and the guaranty obligation is triggered only by a default under the principal contract, such a provision might work to trigger the guaranty. To us that seems unnecessary, since the guaranty could be drafted to state that it is triggered by the principal’s default.
Notwithstanding section 365’s nullification of bankruptcy default provisions, they continue to be used with presumably little effect.
Common Lien Mistakes
While the technical requirements for preparing and filing liens offer countless opportunities for mistakes, two in particular seem to predominate. The first is the failure to properly calculate the 75-day period for filing the lien. The 75-day period begins to run from the earlier of (i) the day the contractor or supplier ceased to provide labor or materials or (ii) the completion of construction. When relying upon the second prong (the completion of construction), contractors often mistakenly calculate the 75-day period from the last day they performed work on the project. Oregon courts have held that, for purposes of the lien statute, “completion of construction” refers to substantial completion, not final completion and not punch-list work. Accordingly, the 75-day period may be running while the contractor is still on site getting the project to final completion.
Contractors are also occasionally tripped up in calculating the 75-day period on projects that have been stopped, perhaps because the owner has temporarily run out of money. They sometimes mistakenly assume that the 75-day period has not started to run yet because the project has not been completed. ORS 87.045 provides that where work on a project has ceased, it shall be deemed completed 75 days after cessation. Accordingly, when work on an uncompleted project stops for an extended period, liens need to be filed within 150 days (the project will be deemed completed 75 days after work stops, and the lien then needs to be filed within 75 days thereafter).
The second-most common mistake with liens is the failure to segregate materials and labor, combined with the failure to serve a notice of right to lien. While an Oregon lien for labor has priority over a prior recorded lien (the most concerning one being a bank’s trust deed), a lien for materials generally has priority over a prior lien only if the supplier provided a notice of right to lien within eight days of delivering materials (the notice only protects materials provided within eight days of the notice). While material suppliers do a good job of providing notices of right to lien, contractors and subcontractors often do not, even though they are providing both labor and materials. Oregon courts have held that where a contractor has failed to provide a notice of right to lien, and has subsequently failed to segregate the labor and materials in the lien, the entire lien will be treated as if it were for materials, which results in its being subordinate to any prior liens. In most cases, for practical purposes, this will render the lien worthless. If the notice of right to lien has not been given, but the materials and labor are segregated, at least the claimant has preserved its priority for the labor portion of the lien.
Our best practical advice about liens is to not wait until the 75th day to file, but to instead file well before the deadline. We’ve seen many liens disqualified because someone was unfortunately wrong about when the 75-day period started to run. Likewise, we always advise segregating labor and materials when preparing a lien. A lien without priority is often the equivalent of having no lien at all.
Terminating a Contractor for Default - Caution Is the Rule
Risks of Termination
While most construction contracts permit the owner to terminate a contractor in the event of default, any owner will be well counseled to exercise such rights cautiously. The risks of termination are both practical and legal. Terminating the contractor will almost certainly result in delays. Finding a replacement contractor can be difficult, particularly if the project suffers from defective work. The cost of a replacement contractor can be significantly more than the amount left in the contract, and this in turn can lead to financing problems and perhaps even result in a default of the construction loan. The owner might not have the ability to assume the subcontracts, which could require any replacement contractor to also find subs to take over uncompleted work. Enforcing warranties later on could be difficult due to disputes over who was responsible for which portion of the work. And perhaps most concerning of all is that in most cases, the termination is likely to generate a lawsuit in which the contractor will be seeking all sorts of damages, including lost profits on this and possibly other projects.
Faced with these risks and problems, owners often elect to continue with a defaulting contractor, sometimes even in the face of enormous problems. Nevertheless, there are circumstances when termination needs to be considered and exercised. Careful planning, detailed analysis, and good documentation are critical.
Importance of a Well-Drafted Contract
Termination needs to be considered at the contracting stage, and well-drafted default and termination provisions are critical. The contract needs to set out clear, objective standards for what will constitute events of default and reasonable, but not overly burdensome, notice provisions. Many contracts will provide that the contractor is entitled to notice and an opportunity to cure. The time periods for curing need to be spelled out and should not be unreasonably short or long.
Termination for Convenience Provisions
Owners should try to include in their contracts provisions allowing them to terminate the contract for convenience. Such provisions are common in most public construction contracts. Owners should resist provisions that require the owner to pay the contractor some amount of unearned overhead and profit and instead commit only to payment for compensation earned up to the point of termination, plus reasonable winding-down (demobilization) expenses.
Right to Supplement Work Provisions
Owners might also consider trying to include in their contracts a provision authorizing them to supplement the contractor’s work force in the event of default. Such a provision essentially permits the owner to hire additional work crews to supplement the contractor’s work force. Any such provisions need to be drafted carefully, and such an arrangement presents its own set of risks and problems, but is a less risky option than termination and one that, in appropriate circumstances, might be of real benefit to the owner.
Strict Compliance with Contract Termination Provisions
When problems arise during the course of a project that might warrant termination, the owner needs to refer to the contract and follow all of the notice and pre-termination procedures precisely. At the same time, though, the owner’s initial response should be to consider options other than termination. One step might be a meeting with the contractor to discuss the defaults and to try to reach an agreement on a schedule and procedure for curing them. In the course of pursing termination alternatives, the owner needs to notify the contractor that efforts to resolve the defaults short of termination will not result in a waiver of the defaults or of any rights. If the owner agrees to give the contractor additional time for curing defaults or agrees to other concessions, the agreement needs to be spelled out clearly in a writing that clarifies precisely what the owner has agreed to and when the owner will be permitted to proceed with termination. Any such agreement will effectively result in an amendment of the contract and will therefore warrant the same attention to detail that went into drafting the original contract.
Continue Reading...Owner/Developer Bankruptcies - What the Contractor Can Expect
What should a contractor expect when the owner files for bankruptcy? That’s a difficult question to answer briefly. Our best advice is to see a bankruptcy attorney quickly. Bankruptcy is a highly technical area of law that few attorneys understand. It’s wholly unreasonable to expect that a nonattorney could navigate his or her way through the system.
We emphasize the word “quickly” for good reason. When a project owner files for bankruptcy, it is very likely that major decisions about what will happen with the project and how contractors will be paid will be made immediately, often within less than a week. Those issues and others will need to be addressed in a series of what are commonly referred to as “first-day orders,” and the hearings on such matters are sometimes held literally on the first day after the petition is filed.
Rather than providing a technical explanation of the important Bankruptcy Code provisions, we will instead simply provide some highlights of issues that are likely to come up, along with a few practical pointers. Our goal is to provide only an idea of what to expect.
The Automatic Stay
An automatic stay goes into effect immediately upon the filing of a bankruptcy petition. The stay prohibits creditors, such as contractors, from taking any action to collect amounts due from the debtor and is very broadly construed. Violations of the stay are often met with sanctions.
Construction Liens and Bankruptcy
Notwithstanding the automatic stay, section 362(b)(3) of the Bankruptcy Code permits creditors to file liens for the purpose of continuing the perfection of an existing lien. Since, under Oregon law, a contractor’s lien originates when a contractor starts work or a supplier begins delivering materials, contractors and suppliers are permitted to file construction liens after the owner has filed for bankruptcy, notwithstanding the automatic stay. However, in states in which a construction lien does not exist until it is filed, contractors are not allowed to file liens after the owner has filed for bankruptcy.
Once the lien is filed, the contractor has two options: (i) the contractor may file a motion seeking relief from the automatic stay for the purpose of foreclosing the lien or (ii) the contractor may serve the debtor (or, in some cases, the bankruptcy trustee) with a notice under section 546(b)(2), which, as with filing an action to foreclose, serves to continue the lien until the automatic stay is terminated. If the second option is followed, the contractor needs to file a lawsuit to foreclose the lien within 30 days after the automatic stay’s termination, which will typically be the end of the bankruptcy case.
Assumption or Rejection of Contract
As discussed in an earlier blog, a provision in a construction contract providing that the owner’s bankruptcy filing will constitute an event of default is likely unenforceable. Instead, the debtor will be free to either assume or reject the construction contract at any time before confirmation of a plan of reorganization. In many cases that could be several months. The contractor may ask the court to shorten the time for the debtor to assume or reject the contract, and courts are typically asked to do that with respect to construction contracts.
To assume a contract, the debtor is required to cure all defaults, which would obviously mean paying the contractor, and all of the contractor’s subs and suppliers, in full. In addition, the debtor is also required, as a condition of assumption, to provide adequate assurances that it will be able to make future payments on the project.
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