Under Construction - June 2016

Snell & Wilmer

Letter from the Editor

by James J. Sienicki

Welcome to the June 2016 edition of our Under Construction newsletter. Hope you are staying cool this summer.

Are you legally operating your drone on the construction site? In our Winter 2015 Under Construction newsletter, we highlighted requirements for legal operation of drones for commercial use. The follow-up article in this edition provides additional updates in light of recent developments taken by the FAA and states like Arizona affecting drone operations.

We will also take a look at new legislation and recent court opinions in Arizona affecting the construction industry and how these changes may affect your construction business. Then, we move to California and examine a recent California case evaluating the sufficiency of proof of construction claim damages, including the first case in California discussing home office overhead delay damages and the federal Eichleay formula. We conclude with an article discussing a developing issue in Utah regarding indemnification of board member/developer defendants by HOAs for attorney’s fees and costs.

We hope you will find these articles informative and enlightening. Please let us know if you want us to address a specific construction issue in a future newsletter. Cheers to a wonderful summer!

Jim Sienicki

Are You Legally Operating That Drone on Your Construction Site?

by Jason Ebe

Drones are becoming widely used on construction projects. But the mere purchase and review of the owner’s manual is insufficient for legal operation. In our article in the December 2015 Under Construction, we highlighted requirements for legal operation of drones for commercial use, such as on construction projects. These requirements include: a grant of exemption allowing such commercial use; a Certificate of Waiver or Authorization from the FAA; registration of the drone with the FAA and an FAA certified pilot.

The FAA registration system has been active since December 21, 2015. For drones acquired after that date, registration is required prior to the first outdoor flight. After completing registration, owners will receive a personal registration number which must be identified on the drone. Answers to frequently asked questions regarding the registration process can be found at http://www.faa.gov/uas/registration/faqs/.

Operators must also comply with applicable state laws affecting drone operation. For example, on May 11, 2016, Arizona Governor Doug Ducey approved SB 1449 placing further limitations on drone operation within Arizona. According to the National Conference of State Legislatures, 26 states have enacted laws addressing drone issues and an additional six states have adopted resolutions. Arizona’s law, among other things, prohibits operation of drones to intentionally photograph or loiter over critical facilities such as refineries, water and wastewater facilities, electrical transmission or distribution facilities, electronic communication stations or towers, railroads, courthouses, public safety or emergency operation facilities, military installations, and hospitals with air ambulance services, as well as operations which interfere with first responder operations.

If you are contemplating operation of a drone in your business, or are already doing so, and haven’t complied with the applicable FAA and state requirements, you need to take appropriate corrective action now. Operation in violation of these requirements could result in criminal and/or civil penalties, as well as potential breach of contract claims arising out of your use of the drone, and potential loss of insurance coverage for resultant damage from such use.

For additional information regarding drones and liability issues, check out our colleague Troy Roberts’ frequent posts on Snell & Wilmer’s Into the Breach Blog at http://www/swlaw.com/blog/data-security/.

Arizona Construction: New Legislation and Recent Court Opinions

by James J. Sienicki and Mark Molique

The first half of 2016 had a handful of legislation and court opinions discussing issues affecting the construction industry.

Legislation: House Bill 2268 Regarding 20-Day Notices on Arizona Public Projects

The Arizona legislature weighed in on how subcontractors and suppliers may give the necessary preliminary 20-day notices on public works covered by Arizona’s Little Miller Act (LMA) to preserve their bond claims. The LMA requires that prime contractors on public works projects provide payment bonds to protect subcontractors and suppliers who provide labor and/or materials. The LMA requires that subcontractors and suppliers that do not contract directly with the prime contractor send certain notices to the prime contractor to preserve their bond claim: a written preliminary 20-day notice that complies with certain subsections of A.R.S. § 33-992.01 and a subsequent 90-day notice. Subsection (F) of A.R.S. § 33-992.01(F) provides that preliminary 20-day notices for the purpose of mechanics’ liens may be given by first-class mail sent with a certificate of mailing, registered or certified mail, all postage prepaid, though the LMA referred to A.R.S. § 33-992.01, it did not expressly reference subsection F. Instead, the LMA stated that notices had to be sent by certified or registered mail. Many were under the impression that preliminary 20-day notices on public works projects could be sent by first-class mail with a certificate of mailing to preserve their bond claims.

In April of 2015, Division Two of the Arizona Court of Appeals held that Arizona Revised Statutes (A.R.S.) section 34-223(A) did not allow a written preliminary 20-day notice to be sent by first-class mail with a certificate of registration because 34-223 referenced specific sections of 33-992.01 but subsection (F) was not one of them. Thus, the mailing requirements of 34-223, which only authorized registered or certified mail, was required to preserve a bond claim under the LMA.

This year, the Arizona legislature passed House Bill 2268, effective August 6, 2016, amending A.R.S. § 34-223 of the LMA. The amendments provide that the preliminary notice can be sent by any method provided in A.R.S. § 33-992.01(F), which allows the notice to “be given by mailing the notice by first-class mail sent with a certificate of mailing, registered or certified mail, postage prepaid in all cases, addressed to the person to whom notice is to be given at the person's residence or business address.” The subsequent 90-day notice also required by the LMA can now “be given by any means that provides written, third-party verification of delivery to the contractor at any place the contractor maintains an office or conducts business, or at the contractor's residence.” 2016 Ariz. Legis. Serv. Ch. 237 § 1 (H.B. 2268). Until House Bill 2268 becomes effective, preliminary 20-day notices on public projects need to be sent via certified or registered mail.

Appellate cases:

In S&S Paving & Const., Inc. v. Berkley Reg'l Ins. Co., No. 1 CA-CV 15-0239, __ Ariz. __, __ P.3d __, 2016 WL 2756428, at *3 (App. May 12, 2016), the Arizona Court of Appeals held that a subcontractor, S & S Paving and Construction, Inc. (S & S), could not pursue a claim of bad faith against a surety that issued a payment bond pursuant to the Little Miller Act. S & S sent a demand letter to the surety and, at the surety’s request, filled out a proof of claim. The surety informed the subcontractor that it would investigate the claim, including discussing the claim with the prime contractor. The correspondence from the surety included the typical language included by sureties that nothing in the correspondence tolled the statute of limitations. The surety never communicated with S & S again. The statute of limitations for bringing a claim against the bond passed. S & S then sued the surety, bringing claims for breach of contract and bad faith, alleging that the surety had a duty to investigate whether S & S’s claim was valid.

The Arizona Court of Appeals held that the surety could not be liable for bad faith on a public project because the Little Miller Act was the statutory remedy that provided S & S with “a complete and valid remedy.” The court distinguished the result in Dodge v. Fidelity & Deposit Co. of Maryland, 161 Ariz. 344, 778 P.2d 1240 (1989) which held that the surety that issued a performance bond on a private, residential project could be liable to the homeowner for the tort of bad faith for failing to pay a valid claim when the project’s contractor failed to complete the job. Unlike the private project in Dodge, the Little Miller Act was “a carefully crafted statutory scheme that seeks to balance the competing interests inherent in public works projects.” S&S Paving & Const., 2016 WL 2756428, at *3. Nothing in the statute required the surety to do any pre-litigation investigation of the validity of the claim. S & S was required to bring its suit against the surety within the limitations period provided by the statute. For public works controlled by the Little Miller Act, that limitations period is “one year from the date on which the last of the labor was performed or materials were supplied .. . . .” A.R.S. § 34-223(B).

In City of Phoenix v. Glenayre Elecs., Inc., 1 CA-CV 14-0739, 2016 WL 2912619, at *1, __ Ariz. __, __ P.3d __ (App. May 19, 2016), a worker who performed pipe installation and repair for the City of Phoenix developed mesothelioma allegedly as a result of exposure to asbestos years earlier when performing the work. He sued the City of Phoenix, who in turn brought claims for defense and indemnity against the various developers and contractors responsible for planning, designing and constructing the projects.

The Arizona Court of Appeals affirmed the superior court’s dismissal of the City’s claims, holding that the eight-year statute of repose found in A.R.S. § 12-552 barred the claims. The statute of repose bars any action or arbitration based in contract against a person who sells real property or performs design or construction services improving real property. The City of Phoenix argued that A.R.S. § 12-510 exempts governmental entities from the limitations periods and thus, the statute of repose in A.R.S. § 12-552 did not apply. The Court of Appeals noted that the beginning phrase in A.R.S. § 12-552 provides that the statute of repose applied “notwithstanding any other statute.” Thus, the statute of repose in § 12-552 trumped the governmental exemption of limitations in § 12-510. While the statute of repose protects the contracting parties, subcontractors and suppliers are not so protected. Owners sued by third parties for wrongs for which the owner alleges it is free from fault may pursue subcontractors or material suppliers without direct contractual relationships with the owner based on common law indemnity principles. See, e.g., Evans Withycombe, Inc. v. W. Innovations, Inc., 215 Ariz. 237, 243, ¶ 24, 159 P.3d 547, 553 (App. 2006).

MTR Builders, Inc. v. Jahan Realty Mgmt. Corp., 1 CA-CV 14-0650, 2016 WL 1425797, at *4 (Ariz. App. Apr. 12, 2016) is an unreported case that involves a recurring fact pattern between owners and contractors. A contractor sought payment from the owner prior to obtaining a third-party inspection and a certificate of completion on a job as the parties’ contract required. The owner objected to the payment application on these grounds. Ultimately, the inspection was successfully conducted and the certificate obtained but the contractor did not resubmit the payment application. The owner did not make payment and the contractor sued the owner for breach of contract and violation of the Prompt Pay Act. Owner countersued for breach of contract alleging deficiencies in the work. While this decision does not establish new precedent, it does provide some insight into the interplay of several interrelated construction issues involving Arizona’s private Prompt Pay Act, A.R.S.§ 33-992.01, et seq., breach of contract claims, and the result in American Continental Life Insurance Co. v. Ranier Construction Co., 125 Ariz. 53 (1980), a case decided before Arizona passed the Prompt Pay Act. Arizona’s Supreme Court held in American Continental that a contractor’s failure to seek a final certificate of payment, which the contractor understood to be futile, was made a condition precedent in the parties’ contract and barred the contractor’s recovery against the owner for work performed, despite the fact that the contractor had reached substantial completion.

In MTR Builders, Inc. the owner moved for judgment as a matter of law based on the result in American Continental because the contractor sought final payment prior to obtaining the inspector’s final approval or the necessary certificate of completion. The superior court denied this motion. The superior court did, however, grant the owner’s motion for summary judgment on the contractor’s Prompt Pay claim. After the jury returned a verdict in favor of the contractor, the parties cross-appealed the superior court’s rulings on these motions.

The appellate court held that an owner may be liable for breach of contract even though the owner did not violate the private Prompt Pay Act in A.R.S. § 32-1129.01. The court reasoned that the Prompt Pay Act did not replace traditional contractual remedies. In doing so, the court rejected the owner’s argument that the superior court’s decision that the owner had not violated the Prompt Pay Act meant that, as a matter of law, the owner had not breached the parties’ contract. The appellate court affirmed the dismissal of the contractor’s Prompt Pay Act claim because the contractor had submitted the payment application prior to obtaining inspection and the certificate of completion, steps contemplated by the parties’ contract and the Prompt Pay Act.

The appellate court also distinguished the result in American Continental. The court held that the contract in American Continental made obtaining the certificate of final payment a condition precedent to the contractor’s right to payment. The court reasoned that “the contract language [in MTR Builders], when viewed as a whole, is not a strict condition precedent contract.” Instead, the appellate court determined that the contract provided the contractor an express remedy to recover for work it actually performed to the inspector’s satisfaction and allowed the contractor to seek damages in the event of owner’s breach of the obligation to pay. The fact that the contractor sought payment before obtaining the inspection and the certificate of completion did not bar the contractor’s recovery.

The case provides important lessons for owners and contractors, both in crafting effective contract language and complying with the obligations contained in the contracts as they are written. Owners need to timely object to any written request for payment coming from a contractor so as to not violate the Prompt Pay Act. Owners also need to take care that any objection they raise provides them an adequate legal protection before deciding to not pay for work that a contractor actually performs. Owners should be cautious in relying solely on the result in American Continental to avoid paying for work a contractor actually performs. In light of the Arizona Prompt Pay Act, courts may distinguish or overrule American Continental or limit it to its unique facts and specific contractual language.

Contractors should be sure to resubmit payment applications once they clear up any objections raised by an owner to a payment application. Ultimately, whether you are an owner or a contractor, it is critical to read and understand your contract, comply with its express obligations, and also understand the Arizona Prompt Payment Act. Here, the jury ended up awarding the contractor $50,000 for the work the jury found the contractor performed, and the superior court awarded the contractor over $100,000 in attorney’s fees because it prevailed at trial. That’s an expensive lesson.

California Court Reviews Sufficiency of Proof of Construction Claim Damages and Adopts Eichleay

by Michael J. Baker

In a wide-ranging review of proving construction delay and impact damages, the California Court of Appeal in the case of JMR Construction Corp. V. Environmental Assessment and Remediation Management, Inc. (EAR), 198 Cal.Rptr. 3rd 47 (2015), evaluated whether it was appropriate to use a modified total cost calculation to prove construction delay and disruption damages, evaluated what is sufficient evidence for an appropriate allocation of delay damages for extended field overhead, analyzed the impact of concurrent delay without a construction schedule analysis in assessing those damages; and, for the first time in a California published decision, adopted the Federal Eichleay formula to calculate home office overhead delay damages.

The dispute arose from a public works project involving the construction of a dental clinic at the Presidio of Monterey. The owner, the United States Army Corps of Engineers, retained JMR Construction Corp. (JMR) as general contractor for the project. JMR, in turn, entered into various subcontracts, including separate electrical and plumbing subcontracts with EAR. While the project was ongoing, JMR (1) communicated with EAR about alleged delays, deficient and late submittals, and improper plumbing work, and (2) retained certain funds otherwise due to EAR under the subcontract. After the project was completed, JMR filed suit against EAR and its surety for breach of contract and for breach of the performance bonds. JMR alleged it was damaged as a result of EAR's failure to perform under the two subcontracts. EAR filed a cross-complaint for recovery of retention funds withheld under the two subcontracts. After a court trial, JMR was awarded damages which included an offset for retention funds JMR withheld under the two subcontracts. On appeal, EAR argued that there was no substantial evidence supporting the trial court's finding that it was liable to JMR for delay on the project and argued that the court erred by using the Federal Eichleay method of calculating extended home office overhead damages. EAR also argued that the court erred by utilizing the modified total cost method of calculating disruption and delay damages. The Appellate Court upheld the trial court.

This case is significant in that it identifies and discusses what is sufficient substantial evidence to support and prove recovery of delay damages and an allocation of such damages among the parties. Here, the court allowed a modified total cost recovery so long as there was substantial evidence of a causal relationship between the extra costs incurred by JMR, general contractor, and the breach of contract by EAR, the subcontractor. The court applied the four-part test for total cost recovery (1) the impracticability of proving actual losses directly; (2) the contractor's bid was reasonable; (3) the contractor's actual costs were reasonable; and (4) the contractor was not responsible for the added cost. The court noted and emphasized that recovery should be applied only to the smallest affected portion of the contractual relationship that can be clearly identified. Here, the general contractor established through expert testimony specific portions of mechanical and electrical work which impacted the general contractor's drywall work in almost every room of the project and the trial court found this testimony to be credible and permitted a modified cost recovery. The Appellate Court accepted that an exact causal relationship was not necessary to establish impact but instead impact was established by the totality of the circumstances through testimony of percipient witnesses and experts. It is important to note here that the subcontractor did not have an opposing expert witness testify at trial.

The court also affirmed damages regarding the apportionment of overhead based on something as simple as an expert assigning percentages of delay to various parties without any definitive construction schedule analysis. The court let stand the general contractor's and its expert’s opinion that the subcontractor, EAR, was responsible for 75 percent of 142 days of delay shared between the subcontractor EAR and another subcontractor. This calculation was accepted by both the trial and appellate courts without the aid of expert schedule analysis. This is a significant shift in the typical accepted approach, i.e., it now appears that an exact schedule analysis may not be necessary after all. Moreover, as if the departure from using a schedule analysis was not enough of a surprise, the court also allowed and upheld an award of general delay damages to the general contractor based on a (speculation?) amount it would have allegedly won from the owner but for the subcontractor's delays. Therefore, the subcontractor was responsible for the general contractor's delay costs.

In another interesting twist, in determining and assigning responsibility for the allocable cost of overhead to the multiple entities responsible for the extended time of performance, the court accepted the general contractor’s expert’s calculation of assessing the damages based on a ratio of outstanding submittals per entity. Remarkably, the trial court accepted that whoever submitted the most submittals likely caused most of the delay. The appellate court affirmed that this analysis was sufficient to support the damages. This runs counter to the industry consensus opinion that there is not necessarily a causal connection between the quantity of submittals and length of delay. Nevertheless, this type of calculation was upheld here. It is obvious to most everyone in the industry that one crucial submittal by one subcontractor could be much more impactful than 15 or more insignificant submittals from a different subcontractor, but the general contractor was able to employ this method here and convince the trial court. Again, it is important to note that the subcontractor here did not offer any opposing experts and thus the general contractor’s and its expert’s testimony was unopposed.

Finally, in a matter of first impression, we now have a case in California which accepts the Federal Eichleay formula as a measure of extended home office overhead, subject to the Federal Eichleay conditions. The court set forth the three Eichleay requirements for its application. The contractor must establish: (1) a government cause a delay; (2) that the contractor was on "standby"; and (3) that the contractor was unable to take on other work. Note, the court required conformance with all three elements, most notably the requirement to prove that but for the delay, the general contractor could not go after new work. While the case is one of first impression in California regarding Eichleay, use of the formula is still debated because to recover the contractor has to open up their financials and prove that it could not get work.

This case is both a benefit and a burden. On the one hand the Court’s approval of the method here of proving damages using a modified total cost method and apportioning delay damages among contractors is helpful and instructive as to what constitutes substantial evidence to support such damages; however, on the other hand, if you are defending one of these claims it has just become more difficult, particularly with the relaxation of proving causation and apportionment of delay without schedule analysis.

Indemnification of Defendant by HOA for Attorney’s Fees and Costs in Utah Construction Defect Litigation

by Elisabeth M. McOmber

Articles of Incorporation and other governing documents for a homeowner’s association (HOA) often contain indemnification provisions for HOA board members and former board members providing that the HOA will indemnify board members that are made party to a suit. These provisions are put in place early in a development project and often contain broad terms. It pays to consider the long-term consequences that may result from these provisions should an HOA later bring a construction defect case against the original developer.

Utah trial courts have recently been granting motions for indemnification filed by developer defendants against plaintiff HOAs based on the terms of the HOA’s Articles of Incorporation or other governing documents. The cases involve breach of fiduciary duty claims by an HOA against developer defendants who were original board members of the HOA during the development of the given project. Upon prevailing at trial or via dispositive motion, defendants have asserted that, because the court has found the developer defendant not liable for breach of any fiduciary duty while a member of the HOA, the HOA must indemnify the defendant for the attorney’s fees and costs incurred in defending against the HOA’s construction defect claims. Some Utah courts have agreed. Applying traditional rules of contract construction, Utah courts have found that broad indemnification provisions are unambiguous and apply to HOA board members/developers for a suit brought against the member by the HOA where the board member/developer was determined not to be negligent or to have engaged in misconduct. The courts have accordingly held that the HOA must indemnify the board member/developer for fees and costs incurred in the lawsuit brought by the HOA. Not surprisingly, such rulings can result in a considerable award against the HOA, with one recent trial court judgment including over $300,000 in fees and costs.

In sum, while it is likely this issue will eventually be clarified by appellate court decisions, awareness of this developing issue can help guide HOAs, owners, and developers to best position themselves both prior to and in the course of construction defect litigation.

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.

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