Letter from the Editor

Welcome to the fall 2013 issue of Under Construction. In this issue, we focus on the economic loss doctrine and how the different courts in our firm’s footprint treat it similarly and differently. We hope you enjoy our review of recent and previous state court decisions relating to the economic loss doctrine in Arizona, California, Colorado, Nevada, New Mexico and Utah. As an encore, we have also included articles on the Arizona Prompt Payment Act and Arizona indemnity law, since these continue to be hotly and frequently contested issues.

In the first article, Dan Frost discusses the economic loss doctrine in Colorado and its important implications for construction projects in the state. Dan cites holdings by the Colorado Court of Appeals and the Colorado Supreme Court and illustrates that the range of recovery options for problems on bad projects is limited in Colorado by the economic loss doctrine. In the next article, Josh Grabel reviews the history of the economic loss rule in New Mexico and raises a number of questions about open or unresolved issues that the New Mexico courts have yet to address.

In the following article, Stewart Peay reviews Utah’s economic loss rule, which generally upholds the rights and risks bargained for in a contract in defective design or construction related litigation. Stuart Einbinder and Colin Higgins then discuss the economic loss rule in California, which addresses the distinction between suits in contract and tort. Stuart and Colin deduce that tort claims may be limited or barred in California based upon the economic loss rule and/or the separate duty rule addressed in a California case cited in the article. Robin Perkins’ subsequent article reviews a number of recent rulings by the Nevada Supreme court that uphold and even strengthen its generally recognized prohibition of negligent tort claims asserting purely economic loss in the context of commercial construction. In our final economic loss doctrine article, Ben Mitsuda reviews a recent decision by the Arizona Supreme Court that clarifies how the economic loss rule does not apply to non-contracting parties in the state, and the prior recent history of the economic loss doctrine in Arizona.

As bonus coverage to our economic loss doctrine coverage, Eric Spencer and Rick Erickson address the Arizona Prompt Payment Act arising out of a recent ruling by the Arizona Court of Appeals. They suggest that this recent decision highlights the distinction between construction and architect-engineer agreements based upon various Arizona statutes. In a separate article, Eric Spencer discusses Arizona’s recently passed bill SB 1231, which amends the state’s public anti-indemnity statutes by clarifying and expanding the situations under which the state and local governments cannot require contractors, subcontractors and design professionals to indemnify a government body for the negligence of others.

We hope you enjoy this Under Construction issue and our decision to focus on a single issue throughout our regional footprint. We would like to hear from you if you have any comments or suggestions. Enjoy the fall season!

Best regards,

Jim Sienicki

Economic Loss in Colorado

The economic loss doctrine generally holds parties to the benefits, burdens and obligations set out in their contracts and bars tort claims such as negligence, misrepresentation and theft for purely economic loss when a contract exists. This doctrine is particularly strong in Colorado and has important implication for construction disputes, where claims can often be for economic loss and not personal injury or property damage.

For example, in Hamon Contractors, Inc. v. Carter & Burgess, Inc., 229 P.3d. 282 (Colo. App. 2009) the Colorado Court of Appeals held that claims for fraud, misrepresentation and negligence arising out of alleged excessive water on a construction project were barred by the economic loss rule. Those tort claims were dismissed and attorneys’ fees were awarded against the Plaintiff in that case. 

In BRW, Inc. v. Dufficy & Sons, Inc., 99 P.3d 66 (Colo. 2004) the Colorado Supreme Court held that design professionals generally are not responsible to contractors and subcontractors with whom they have no contract for lost profits and project delay and disruption. In other words, contractors can only look to those with whom they have a direct contractual relationship for recovery when projects encounter economic problems.

Obviously, then, those wishing to take advantage of the protections of the economic loss rule on construction projects should be extremely careful in making sure that their agreements state clearly and specifically the manner in which the risks of the project are to be allocated and, even more particularly, the standard of care assumed by each party. And, since the range of recovery for problems on bad projects is limited in Colorado, it is important to make sure that there is some level of comfort with the other parties to the contract, and that where risks cannot be allocated or assigned to another party, that they be insured wherever possible.

New Mexico’s Economic Loss Rule—It Exists, but Its Limits are To Be Determined

In Utah International, Inc. v. Caterpillar Tractor Co., 108 N.M. 539, 775 P.2d 741 (Ct. App. 1989), the New Mexico Court of Appeals adopted, for the first time, the economic loss rule in New Mexico. The defendant designed, manufactured and sold a coal hauler to plaintiff that caught on fire, damaging the hauler only. Plaintiffs brought an action for negligence and strict liability, and sought purely economic damages for replacement of the hauler and loss of use. The Court held:

In commercial transactions, when there is no great disparity in bargaining power of the parties, economic losses from injury of a product to itself are not recoverable in tort actions; damages for such economic losses in commercial settings in New Mexico may only be recovered in contract actions. We so hold in order to allow commercial parties to freely contract and allocate the risk of defective products as they wish. The buyer may bargain for additional warranties from the seller and pay a higher price, or may forego warranty protection entirely in order to obtain a lower purchase price.

Id. at 542, 775 P.2d at 744. Thus, in New Mexico, when two parties of relatively equal economic strength negotiate a contract and later have claims, New Mexico courts should not allow tort claims to proceed between the parties and should instead limit recovery to contract remedies.

Subsequently, New Mexico courts have considered the economic loss rule in other situations and limited its application to some degree. In In re: Consolidated Vista Hills Retaining Wall Litigation v. Shollenbarger Wood Treating, Inc., 119 N.M. 542, 893 P. 2d 438, 447 (1995), the New Mexico Supreme Court upheld the basic ruling from Utah International, but indicated that the economic loss rule did not apply to indemnification “because parties are still bound by their contractual agreements (including indemnification agreements) and because allowing indemnification ... would in no way blur the line between contract and tort.” 

In a 1997 case, the court held that the economic loss rule bars claims under a theory of strict liability for damages for not only the product being sold, but also to the building the product was housed in and its contents, because the particular dangers were reasonably foreseeable at the time the contract was entered. Spectron Dev. Lab. v. Am. Hollow Boring Co., 1997-NMCA-025, 936 P.2d 852. The claims in the Spectron case arose out of a unique set of circumstances where the plaintiff was an expert on the use of the “light-gas gun” and thus knew the potential damages it would suffer if the gun was defective. As a result, the Court reasoned the Plaintiff was in a unique situation to negotiate terms related to any potential damages in negotiating the contract. 

And, in a recent series of opinions, the U.S. District Court for the District of New Mexico held that the economic loss rule applied to service contracts because service contracts, like those for the sale of goods, involved the same sorts of commercial benefits from the economic loss rule. However, the Court also found that the economic loss rule would not bar a claim for professional negligence if the party providing the service was a “professional” who failed to meet an “independent duty of care.” See Farmers Alliance Mut. Ins. Co. v. Naylor, 452 F.Supp. 2d 1167, 1174 (D.N.M. 2006); Farmers Alliance Mut. Ins. Co. v. Naylor (Naylor II), 480 F.Supp. 2d 1287, 1289 (D.N.M. 2007). The Court reasoned that in such instances, it was likely the professional providing the service had a better understanding of the potential risks to the other party than the party receiving the services did, and thus that there was unequal bargaining power. Thus, whether the economic loss rule will apply in a service contract setting to bar tort claims is determined by a number of factors, including whether the “service” provided involved using professional judgment.

With this said, there are still a number of open issues related to the economic loss rule in New Mexico. How aggressively will New Mexico courts enforce the economic loss rule when it is being applied to a consumer? Who constitutes a consumer of a particular good or service, and when is there equal bargaining power? What about smaller or less sophisticated businesses? What if the contract involves non-commercial parties? As you can see, while the general rule is that it is likely the economic loss rule will apply to most commercial construction matters in New Mexico, it is not clear if it will apply to other situations.

Utah’s Economic Loss Rule

In Utah, a plaintiff must generally in be in privity with the “original contractor, architect, engineer or real estate developer” to bring an “action for defective design or construction.” Utah Code Ann. §78 B-4-513(4). This requirement is read broadly and may only be avoided through three specific exceptions: 1) plaintiffs who bring claims for personal or property damage; 2) plaintiffs who are assignees of those in privity with the original contractor, architect, engineer or real estate developer; and 3) intended beneficiaries of those in privity with the original contractor, architect, engineer or real estate developer. 

The Utah State Legislature codified the economic loss rule in 2008 when it enacted Utah Code Ann. §78B-4-513. The Utah Supreme Court, however, had previously defined the economic loss rule in American Towers Owners Association, Inc. v. CCI Mechanical, Inc., 930 P.2d 1182 (Utah 1996). In American Towers, the Utah Supreme Court applied the Economic Loss Rule in the construction context and held that “one may not recover ‘economic’ losses [for defective design or construction claims] under a theory of non-intentional tort.” Id. at 1189. “In other words, economic damages are not recoverable in negligence absent physical property damage or bodily injury.” Id. (citations omitted).

The economic loss rule in Utah is applied to all parties involved in a construction project, including subcontractors and consultants. “All parties to a construction project, not just the buyers and developers at issue in American Towers, resort to contracts and contract law to protect their economic expectations. Indeed, this is particularly true with contractors and subcontractors whose fees are founded upon their expected liability exposure as bargained and provided for in their contracts.”  SME Indus., Inc. v. Thompson, Ventulett, Stainback and Assocs., Inc., 2001 UT 54 ¶36, 28 P.3d 669, 681 (Utah 2001). 

Third party or intended beneficiaries are not precluded from bringing claims for defective design or construction if the operative contract provides them a right to enforce that contract. “Third party beneficiaries are persons who are recognized as having enforceable rights created in them by a contract to which they are not parties and for which they give no consideration.” Id. at ¶47, 28 P.3d at 684 (internal quotations omitted). “Where it appears from the promise or the contracting situation that the parties intended that a third party receive a benefit, then the third party may enforce his rights in the courts….” Palmer v. Davis, 808 P.2d 128, 131 (Utah 1991) (citations omitted). To be a third party beneficiary under Utah law, a plaintiff must show that the contract was “undertaken for [the plaintiff’s] direct benefit and the contract itself must affirmatively make this intention clear.” Id. Thus, should a beneficiary of a design or construction contract want  the right to later pursue a claim against other parties, such as subcontractors involved in the design or construction of a project, the beneficiary must insure that its rights are clear in the operative contracts. 

In Utah, the economic loss rule upholds the primacy of the contract in defective design or construction related litigation. Regardless of what role a party plays in a construction project, i.e. owner, builder, architect or engineer, that party can presumptively expect that the rights and risks it bargains for at the outset in its contracts will be the rights and risks it holds in litigation. 

California’s Economic Loss Doctrine – Limits on Tort Recovery

In California, the economic loss rule addresses the distinction between suits in contract and tort. A contract claim can typically be pursued to recover all damages proximately caused by breach of contract, unless expressly excluded in the contract (such as a waiver of consequential damages). By contrast, an aggrieved party typically has lesser rights when bringing suit based upon a tort. In summary, the economic loss rule bars a plaintiff from suing in negligence or strict liability if the plaintiff only suffered economic loss not accompanied by personal injury or property damage.

The seminal California case on the economic loss rule is Aas v. Superior Court (2000) 24 Cal. 4th 627. In that case, a lawsuit was brought by a group of homeowners against the developer, contractor and subcontractors who built their dwellings. The homeowners alleged their homes were not built in accordance with applicable building codes and industry standards, but acknowledged that many of the defects had caused no bodily injury or property damage. The California Supreme Court discussed the distinction between contract and tort remedies, and noted that a contractual warranty is the vehicle to recover for deficient performance by a builder or contractor, whereas tort law requires resulting property damage or personal injury. Applying the economic loss rule, the Court held that the plaintiffs could not recover in negligence for the alleged defects.

In Jimenez v. Superior Court (2002) 29 Cal. 4th 473, the California Supreme Court further analyzed the reach of the economic loss rule in a construction defect case. A group of homeowners filed an action against manufactures of windows installed in their homes alleging the windows were defective and caused damage to other part of the homes. The defendants argued the product was the entire house in which the windows were installed, and that damage caused to other parts of the house by the allegedly defective windows was damage to the product itself and therefore barred by the economic loss rule. The Court rejected this argument, holding that while a tort claim could not be pursued for defects in the windows themselves, the defendants could be sued in tort for harm to other portions of the homes caused by the defective windows. 

In the context of residential construction, the Aas ruling was largely overruled by the California Legislature with the adoption of California Civil Code sections 895 et seq. This legislation established claim and repair procedures for residential construction defects, and permits defect claims to be pursued without personal injury or property damage. However, the economic loss rule is still well and alive in the context of commercial construction projects in California.

In addition, California courts have added another important limitation to the pursuit of a tort claim. In Weseloh Family Ltd Partnership v. K.L. Wessel Construction Co. (2004) 125 Cal.App.4th 152, the California Court of Appeal held that a design engineer hired by a subcontractor did not owe a duty of care to the general contractor or the property owner. In that case, the owner contracted with a general contractor to construct an automobile dealership. The general contractor hired a subcontractor to build retaining walls, and the subcontractor in turn hired a design engineer to perform design work. Neither the owner nor general contractor had privity of contract with the design engineer. After the retaining walls failed, the owner and general contractor sued the design engineer for negligence. The trial court granted the design engineer’s motion for summary judgment on the ground that the design engineer did not owe a duty of care to the owner or general contractor. The Court of Appeal affirmed. The Court held that whether a duty will be found between a defendant not in contractual privity with the plaintiff involves balancing various factors, including (1) the extent to which the transaction was intended to affect the plaintiff, (2) the foreseeability of harm to the plaintiff, (3) the degree of certainty that the plaintiff suffered injury, (4) the closeness of the connection between the defendant’s conduct and the injury suffered, (5) the moral blame attached to the defendant’s conduct, and (6) the policy of preventing future harm.” Based upon a balancing of these factors, the Court held that no duty existed. Of course, these six factors are fairly subjective, and whether or not a duty exists in other contexts will be dependent upon the particular facts.

In conclusion, construction participants in California need to be aware of the limitations on tort claims. Notably, tort claims may be barred based upon the economic loss rule and/or the duty rule articulated in Weseloh.

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. 

 

Application of the Economic Loss Rule in Arizona Since Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

In a recent ruling, the Arizona Supreme Court clarified that the economic loss rule does not apply to non-contracting parties.  See Sullivan v. Pulte Home Corporation, 667 Ariz. Adv. Rep. 36 (Ariz. 2013).  This ruling both clarifies and expands upon the Court’s seminal ruling on the application of the economic loss rule to construction contracts, in Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

Flagstaff Affordable Housing Ltd. v. Design Alliance, Inc.

In Flagstaff Affordable Housing, the Arizona Supreme Court held that the economic loss rule applies to construction contracts and that parties to such contracts are solely limited to contractual remedies for purely economic damages.  Thus, at its core, the economic loss doctrine in Arizona “precludes tort recovery for [economic] losses absent personal injury or damage to other property” and “limit[s] a contracting party to contractual remedies for the recovery of economic losses unaccompanied by physical injury to persons or other property.” Flagstaff Affordable Housing Ltd., 223 Ariz. 320, 322-23 (2010).

The Court reasoned that the policies of contract law – encouraging parties to order their prospective relationships, allocate the risks of future losses, and identify available remedies – are particularly applicable to construction defect cases.  As a result, the goals of contract law “are best served by allowing the parties to specify the consequences of a breach of their agreement.”  Id., at 323.  The Court concluded that, “in construction defect cases, the policies of the law generally will be best served by leaving the parties to their commercial remedies when a contracting party has incurred only economic loss, in the form of repair costs, diminished value, or lost profits.”  Id., at 326.

Subsequent Analysis of the Economic Loss Rule

In the few years since Flagstaff Affordable Housing was published, Arizona courts have applied the economic loss rule in a variety of situations.  A summary of the more significant cases is provided below:

  • In Cook v. Orkin Exterminating Co., the Arizona Court of Appeals applied the rule to preclude claims for fraud in the inducement and misrepresentation.  227 Ariz. 331, 332, ¶ 4, 335, ¶ 20, 258 P.3d 149, 150, 153 (App. 2011); see also Maricopa Investment Team, LLC v. Johnson Valley Partnership LP, 2012 WL 5894849 (Ariz. App. 2012) (applying the economic loss rule to bar plaintiff’s fraud in the inducement claim).
  • In Miidas Greenhouses, LLC v. Global Horticultural, Inc., the Arizona Court of Appeals held that the economic loss rule did not bar plaintiff’s claims where it sufficiently pled damages to other property.  226 Ariz. 142 (2010).
  • In Carioca Company v. Sult, the Arizona Court of Appeals (in a Memorandum Decision) held that the economic loss rule barred the plaintiff’s tort claims, relating to an agreement to transport dirt off a construction site, even though the parties lacked any formal written contract.  2010 WL 2606623 (Ariz. App. 2010).
  • In Shaw v. CTVT Motors, Inc., the Arizona Court of Appeals held that the economic loss rule does not apply to private causes of action under the Arizona Consumer Fraud Act.  232 Ariz. 30 (App. 2013).

Sullivan v. Pulte Home Corporation

In July 2013, the Arizona Supreme Court again weighed in on the economic loss rule in Sullivan v. Pulte Home Corporation, 667 Ariz. Adv. Rep. 36 (Ariz. 2013).  In Sullivan, Pulte Homes (the Defendant) built a new home and sold it in 2000. The original buyer re-sold the home to the Sullivans (the Plaintiffs) in 2003. The Sullivans discovered certain retaining wall defects in 2009 and filed the lawsuit in 2010, which alleged both implied warranty and tort claims.  The trial and appellate court held that Arizona’s statute of repose barred the contractual implied warranty claims, but did not bar the tort claims.

The trial court also dismissed the negligence claim under the economic loss rule.  However, on appeal, both the Court of Appeals and the Arizona Supreme Court ruled that the economic loss rule did not bar the Sullivans’ negligence claim because there was no direct contract between Pulte and the Sullivans.  In its ruling, the Supreme Court expressly clarified the strong implication of Flagstaff, holding that the economic loss rule does not apply to non-contracting parties.  The Court reasoned that the doctrine is intended to protect the “expectations of contracting parties, but, in the absence of a contract, it does not pose a barrier to tort claims that are otherwise permitted by substantive law.”

The application of the economic loss rule, as recognized in Sullivan, will lead to some undesirable results for contractors and home builders.  For example, the Court of Appeals recognized that under this new rule original home buyers will have fewer remedies than a subsequent purchaser, since only subsequent purchasers can assert both implied warranty claims and tort claims.

In addition, CGL carriers may begin denying coverage over any contract claims (including implied warranty claims) where a direct contract exists and the economic loss rule applies.  See e.g. Desert Mountain Properties Ltd. Partnership v. Liberty Mut. Fire Ins. Co., 225 Ariz. 194 (App. 2010) (declining to hold as a matter of law that all CGL insurance policies do not cover liability arising out of contract, but noting that parties are free to write such exclusions into their policies).  This again could lead to the strange result where CGL coverage exists to defend claims from a subsequent purchaser, but not for the same claims by the original purchaser.

As a result, developers, contractors, subcontractors and design professionals need to be aware of the potential consequences of Sullivan v. Pulte Homes in Arizona.  At the very least, construction industry professionals should be thinking of ways to restructure construction and buyer-seller agreements to include contractual limitation periods or waivers and assignments of rights to make construction defect claims, all to try and better define contractual obligations and duties of reasonable care assumed by all parties in the chain of ownership and occupancy.

Arizona Court to Architect: You Have One Less Payment Tool than Your Contractor Counterparts

Architects occasionally get into payment disputes with project owners in much the same way as general contractors do.  When that relationship sours, and litigation becomes necessary to secure payment, architects and contractors alike can be expected to invoke any payment right at their disposal, whether that be a contract claim, lien right or any other applicable remedy against an owner.   Yet those payment remedies substantially diverge, according to the Arizona Court of Appeals, when it comes to the Arizona Prompt Payment Act (hereinafter “Act”). 

Contractors routinely invoke that Act, not only to take advantage of the 1.5% monthly interest rate applicable to past-due invoices, but to preclude owners from disputing invoices that are deemed “certified and approved” under the statute.  In other words, a contractor can preclude an owner from raising various defenses to non-payment if the owner did not timely object to the invoice(s) within 14 days of receipt or refused payment for reasons other than as specified in the Act.  If architects were also covered by the Act, architects could equally benefit from these protections in their own payment disputes.  However, the Act is off limits for architects (and, by implication, to other design professionals) according to the recent decision issued in RSP Architects, Ltd. v. Five Star Dev. Resort Communities.

RSP attempted to invoke the Act in the course of its payment dispute with Five Star.  The parties vehemently disagreed about who owed who what.  For its part, Five Star argued that RSP overbilled it and submitted improper invoices that were not in accordance with the contract.  RSP responded that, according to the Act, its invoices could not be disputed by Five Star this late in the game.  However, Five Star convinced the trial court that the Act had no applicability to architects in the first place. 

The Court of Appeals agreed with Five Star based on how construction and architect-engineer agreements are treated differently under various Arizona statutes.  For example, not only does the anti-indemnity statute (A.R.S. § 32-1159) differentiate between “construction contracts” and “architect-engineer professional service contracts,” but contractors and architects are regulated under entirely different chapters in Title 32.  The court therefore held that the legislature could not have intended to include architect agreements within the Act’s definition of a “construction contract,” despite the fact RSP’s scope of work under its AIA B151 agreement included “construction administration” duties.  (The court held that such duties were not outside the norm of what architects normally perform.)  Without the Act as its trump card, RSP not only lost its $591,554.67 breach of contract claim, but had to pay Five Star over $300,000, the vast majority of which accounted for attorneys’ fees.

The lesson of RSP Architects is that if design professionals desire statutory prompt payment protections on par with those available to contractors, they must convince the legislature.   That same legislature, under SB 1231, just eased indemnification requirements on public projects at design professionals’ urging.  A return trip to the legislature next session thus may be necessary for those design professionals who believe they are entitled to have as many arrows in their quiver as contractors enjoy under the Prompt Payment Act. 

Arizona Contractors and Design Professionals Receive Additional Protections Under Arizona’s Public Anti-Indemnity Statutes

For good reason, much of the focus for Arizona contractors during the recently-concluded legislative session was on transaction privilege tax (TPT) reform.  That bill, HB 2111, was ultimately signed by the Governor, but only after an uneasy compromise was reached between contractors and various municipalities that stood to lose revenue if all prime contracting were taxed at the point of sale for materials.

Yet there was at least one bill affecting contractors, not to mention design professionals, which moved steadily through the Arizona legislature with far less controversy. In general, SB 1231 amended Arizona’s public anti-indemnity statutes by clarifying and expanding the situations under which the state, and local governments, cannot require contractors, subcontractors and design professionals to indemnify a government body for  the negligence of others. The changes to A.R.S. § 34-226 (public buildings and improvements) and § 41-2586 (state procurement code) were few in number but will have significant consequences for the construction industry.

Prior law provided that a provision in a construction contract or architect-engineer contract that required a contractor/design professional to defend or indemnify a government body from loss or damage resulting from the government’s own negligence was void and unenforceable. That law was strengthened in 1996, but since that time contractors, and especially design professionals, have felt that the anti-indemnity policy had been gradually undermined by some local governments, therefore making it more difficult to conduct business in Arizona. SB 1231 made several changes that its proponents contended would bring the public policy back into balance.

As an initial matter, various definitional changes in the law were clearly meant to benefit design professionals in Arizona. For example, the “architect-engineer professional service” contract covered under prior law was replaced with the broader concept of a “design professional services” contract, which now brings land surveying, geologist services and landscape architectural services within the protection of the statute.

The law also expands the range of activities that will fall within the public anti-indemnity statutes.   For contractors, the covered construction activities will now include “relocation” in addition to construction, alteration, repair, maintenance, moving, demolition and excavation activities already mentioned in the statute. Those activities are now covered if performed on a “structure, street, roadway, appurtenance or facility” in addition to a “development or improvement to land.”  For design professionals, who again receive the lion’s share of benefits under SB 1231, covered services now include planning, design, construction administration, study, evaluation, consulting, inspection, surveying, mapping, material sampling, testing or any other “professional, scientific or technical services.” These design services may be performed in conjunction with any “study, planning, survey, or environmental remediation” in addition to the activities applicable to contractors.  In other words, the expanded definitions mean that more contractors and design professionals, in a greater variety of situations, will be shielded from defense and indemnity obligations in public contracting. 

On the surface, SB 1231 reflects the principle that contractors and design professionals should be held accountable for their own negligence but should not be responsible to defend or indemnify a government body for losses beyond their control. 

Thus, on one hand, SB 1231 clarifies that a government body may require indemnification for negligence, recklessness or intentional wrongful conduct committed by a contractor, subcontractor or design professional or any persons “employed or used” by them.  Subcontracts or design consultant agreements may be similarly structured.  Furthermore, nothing prohibits a requirement that one be named as an additional insured under a general liability insurance policy or a designated insured under an automobile liability policy. Outside these specified exceptions, however, a government body may not otherwise require a contractor, subcontractor or design professional to indemnify, defend or insure against losses caused by others. Thus, SB 1231 not only incorporates the existing prohibition against defending or indemnifying the government for its own negligence, the new law expands this concept to include a prohibition against defending or indemnifying any others on the project who are not in contractual privity with the contractor, subcontractor or design professional.    

Importantly, SB 1231 also addresses the perception that some local governments have undermined this anti-indemnification policy in recent years. The law declares that “the regulation and use of indemnity agreements ... are of statewide concern” and therefore prohibits any further regulation by counties, cities, towns or other political subdivisions. This preemption provision will no doubt affect a handful of Arizona cities and counties that incorporate broad indemnity provisions in their standard contracts.  For example, a form City of Chandler Services Agreement recently provided that “contractor’s duty to defend, hold harmless and indemnify the City of Chandler ... shall arise in connection with any claim ... to have resulted from any acts, errors, mistakes, omissions work or services ... including anyone ... for whose acts contractor may be liable, regardless of whether it was caused in part by a party indemnified hereunder, including the City of Chandler.” That broad scope of indemnity will no longer be enforceable under the new law which was effective September 13, 2013.

The rationale for SB 1231 was simple, according to its sponsors. Contractors and design professionals were often faced with a difficult choice when presented with broad indemnity contracts: either refuse to sign the agreement and lose the business, or reluctantly sign onto an agreement knowing that their insurance will not even cover negligent acts committed by others not in privity with them. Subcontractors and design consultants were no doubt affected as well because contractors and design professionals often flowed-down these indemnity obligations via subcontract, or design consultant agreement.  Such broad indemnity provisions, in the view of the bill’s sponsors, deterred talented contractors and design professionals from doing business in Arizona. 

It remains to be seen whether SB 1231 will foster the change in public contracting its sponsors envisioned. In the meantime, contractors, subcontractors and design professionals may want to be on the lookout if asked to sign a form government contract that has yet to be updated to meet the new law. 

Topics:  Economic Loss Doctrine, Indemnification, Prompt Payment

Published In: Civil Procedure Updates, General Business Updates, Construction Updates, Commercial Real Estate Updates, Residential Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Snell & Wilmer | Attorney Advertising

Don't miss a thing! Build a custom news brief:

Read fresh new writing on compliance, cybersecurity, Dodd-Frank, whistleblowers, social media, hiring & firing, patent reform, the NLRB, Obamacare, the SEC…

…or whatever matters the most to you. Follow authors, firms, and topics on JD Supra.

Create your news brief now - it's free and easy »