Arizona’s Revised Anti-Indemnification Statutes’ Effect on Insurance Requirements

In our last issue, we alerted you to Arizona’s revised anti-indemnification statutes (A.R.S. §§34-226 and 41-2586) regarding state and city public construction projects which became effective September 13, 2013. In this issue, we address the effect of those statutes on the use of insurance to shift risk to an insurance company.

The public policy behind the broadened scope of the statute is that an indemnitor should not be responsible for the indemnitee’s own negligence. Arkansas and other states have, while prohibiting indemnity provisions that shift risk for the indemnitee’s own negligence to the indemnitor, expressly approved such risk-shifting to an insurance company. Other states have expanded their anti-indemnity statutes to also void contract provisions that seek to transfer risk via additional insured coverage. It appears that these states find the additional insured approach of protecting oneself against one’s own negligence as equally inequitable as the indemnity approach.

The above Arizona anti-indemnity statutes allow for contractual provisions that require insurance coverage that complies with the statutes, including the designation of any person as an additional insured in a Commercial General Liability (CGL) policy. “Nothing in this section shall prohibit the requirement of insurance coverage that complies with this section, including the designation of any person as an additional insured on a general liability policy or as a designated insured on an automobile liability policy provided in connection with a construction contract or subcontract or design professional services contract or subcontract.” Clearly, contract provisions that require additional insured endorsements that provide coverage for the promisee’s own negligence are prohibited. The question remains whether Arizona’s anti-indemnification statutes prohibit any other type of “requirement of insurance coverage”.

The Insurance Services Office (ISO) recently made changes to its CGL policy forms and to its additional insured endorsements (2013 AI Forms) that became effective April 1, 2013. The changes are: (1) limiting coverage to the additional insured “only to the extent permitted by law”; (2) providing that coverage to the additional insured will not be broader than that which the named insured is required by the contract or agreement to provide; and (3) limiting the amount the insurer is required to pay out to the amount of insurance (a) required by the contract or (b) available under the applicable limits of insurance shown in the declarations, whichever is less.

The first limitation is applicable to states like Arizona that have enacted anti-indemnity statutes that extend to naming a party as an additional insured as well as limiting the extent to which an indemnitor may be required to indemnify an indemnitee from the indemnitee’s own negligence. This change acts as a “savings clause” and ensures that the endorsement does not run afoul of Arizona’s anti-indemnity statutes.

The second change applies in those instances in which the insurance coverage that the contractor is required to maintain pursuant to the construction contract is narrower in scope than what the contractor actually carries. In those circumstances, the owner, as an additional insured, is entitled and limited to what is actually required by the contract.

The third change provides that an owner would be provided insurance coverage limited to the amount required by the contract even if the CGL policy limits are greater. Under pre-2013 AI Forms, the owner would have coverage in the same amount of the CGL policy limit regardless of the contractually requirement for less insurance coverage.

We now return to the question of whether the above Arizona anti-indemnity statutes prohibit a variant of the insurance approach to risk shifting by which a party requires the second party to purchase a separate insurance policy in the name of the first party insuring the first party for its own negligence. Does a separate insurance policy that provides coverage for the first party’s own negligence conflict with the above anti-indemnity statutes’ public policy prohibiting the shifting of risk for one’s own negligence?

The above Arizona anti-indemnity statutes do not expressly prohibit a requirement that a party purchase a separate insurance policy in the name of the other party insuring that party for its own negligence. But, a requirement that the second party procure liability insurance coverage for the first party’s own negligence under a separate insurance policy appears to be flatly contrary to Arizona’s stated public policy of prohibiting additional insured endorsements that make an insurer responsible for the first party’s own negligence. In terms of Arizona’s public policy, it is difficult to see how the separate insurance policy approach is distinguishable from the prohibited additional insured endorsement approach to risk-shifting. However, the language of the above Arizona anti-indemnity statutes does not provide a clear and unambiguous answer to this question. We will probably need to wait for a court opinion to find out for sure.

Arizona Court of Appeals Gives Contractor the Edge over Certain Lenders in Mechanic’s Lien Foreclosure Lawsuit

In lien foreclosure lawsuits involving lenders and contractors, priority is everything. Where you stand in terms of priority will not necessarily determine when you get paid, but rather will determine whether you get paid.

For many years, Arizona courts have sorted out competing interests among lenders and contractors by applying not only the mechanics’ and materialmen’s lien priority statute enacted by the legislature, A.R.S. § 33-992(A), but also the common law doctrine of “equitable subrogation,” which allows certain lenders to step into the shoes of another lender’s priority. However, in Weitz Co. v. Heith, the Arizona Court of Appeals recently upended this practice and held that the lien statute alone controls how priority is to be established. Essentially, the court held that A.R.S. § 33-992(A) means exactly what it says: but for one exception applicable to the original lender who provides funding, contractors’ liens have priority over “all [other] encumbrances upon the property attaching subsequent to the time the labor was commenced.” The court held that the subsequent lenders who provided funding after construction commenced could not piggyback off the original lender’s lien priority under the doctrine of “equitable subrogation,” but instead were behind the contractor who built the project. This result, according to the Weitz court, was mandated by the lien priority statute.

In the Weitz case, First National Bank of Arizona (FNB) had provided a $44,000,000 loan to build the Summit at Copper Square, a mixed-use commercial and residential condominium project in downtown Phoenix. Weitz Co. was hired as the general contractor. Summit began selling condo units while construction was still ongoing in order to begin paying off the construction loan to FNB. Most of those individual condo purchases were financed through mortgages by other lenders. At project completion, Weitz Co. was still owed nearly $4,000,000 and filed a lien foreclosure action to secure payment. FNB had priority because it recorded its deed of trust within 10 days after labor first commenced (the statutory exception mentioned above), but Weitz Co. claimed priority over all other subsequent encumbrances pursuant to A.R.S. § 33-992(A). In response, the condo lenders argued they were equitably subrogated to FNB’s first position and therefore had priority over Weitz Co., because their condo financing ultimately went towards satisfaction of FNB’s construction loan.

The equitable subrogation doctrine had long been recognized by Arizona courts, including in mechanics’ lien foreclosure cases. These previous Arizona cases indicated that the equitable subrogation doctrine was intended to maintain fairness in these actions: contractors would normally be junior to the original lender’s deed of trust, so when a subsequent lender extinguished that first position deed of trust by providing additional funding, the contractors who built the project during the intervening period should not be catapulted to first position priority. These previous Arizona cases held that the equitable subrogation doctrine allowed the subsequent lender to step into the original lender’s shoes in terms of priority, which trumped the contractors’ intervening lien interests.

The trial court in Weitz acknowledged the doctrine of equitable subrogation but held the condo lenders could not invoke it because they did not fully discharge the FNB loan, as not all condo units had been sold. The trial court ruled in Weitz Co.’s favor accordingly and the condo lenders appealed. The Court of Appeals also held for Weitz Co., but instead of adopting (or even addressing) the trial court’s conclusion that partial equitable subrogation was not permitted, the appellate court instead held that the equitable subrogation doctrine should have no applicability whatsoever in mechanics’ lien foreclosure actions, given the unambiguous statutory requirement in A.R.S. § 33-992(A) that contractors’ liens have priority over all subsequent encumbrances. The Court of Appeals had held otherwise for nearly 40 years, but in the Weitz case, the court held that the lien priority statute enacted by the legislature was clear, and therefore controlled.[1]

Of course, the Weitz decision does not necessarily represent a seismic shift in favor of contractors at the expense of lenders, given that it is somewhat rare for any subsequent lender to pump money in an ongoing construction project. But a few changes are likely. For example, it will probably be more difficult or expensive for the lender to obtain title insurance now. Furthermore, more lenders may require more projects to be bonded in order to avoid liens altogether, or may attempt to find a way around broken priority by (for example) taking an assignment of the original loan, although this latter strategy has not been tested in court. However, pending any further appeal to the Arizona Supreme Court, or perhaps a successful lobbying effort on behalf of lenders during the next legislative session, contractors appear to have the upper hand when threatening lien foreclosure—for now.

New California Law Permits Expanded Use of Construction Managers At-Risk in Public Contracts

On October 3rd, Governor Jerry Brown signed into law Senate Bill 328 which permits counties to enter construction manager at-risk agreements for construction of projects over $1 million. Counties now join other public entities, such as the University of California and California State University systems, as public entities that may use the construction manager at-risk method for building construction projects.

Prior to the passage of this law, counties were stuck with the traditional design-bid-build delivery method and the “lowest responsible bidder” system. The purpose behind the traditional model and the competitive bidding process is to enhance competition and prevent corruption and undue influence. Although laudable, these goals can be overshadowed by problems created by the traditional project delivery model. Contractors on traditional design-bid-build projects have no design involvement and, consequently, have less familiarity with the design and relatively little time to assemble a team of subcontractors to efficiently and effectively construct the project in accordance with the design goals. In addition, the traditional low bid approach can often lead to lower quality work and more risk to the county if the low bidder attempts to make up for its low bid by submitting numerous change orders, which could lead to increased claims, and time and money spent by the county resolving the claims.

In contrast, the construction manager at-risk delivery method minimizes some risks inherent in the lowest responsible bidder approach. The county is permitted to award the contract to a construction manager who is responsible for delivering the project within the agreed upon price, and since the construction manager is often already involved during the design phase, this should reduce the number of change orders on the project. Thus, the profitability of the construction manager is connected to the success of the project. The construction manager contract can be awarded to either the lowest responsible bidder or the bidder that provides the best value, which takes into account many factors other than price, such as the experience, financial strength and safety record of the construction manager. Thus, this approach provides the county with more control and options when choosing contractors.

The construction manager at-risk approach combines elements of the design-bid-build and design-build methods. Under this approach, the construction manager is usually involved prior to the construction phase to provide pre-construction services that can often alleviate problems earlier in the process. The construction manager then continues to oversee the work (similar to a general contractor) through the completion of the project. The continuity of expertise and a full understanding of the concerns expressed at the design stage can reduce risks and promote efficiency on a project.

By enacting this bill and expanding the role of the construction manager at-risk in California public works projects, California joins the growing trend of states that now seem to favor this alternative delivery method to the traditional design-bid-build method. We expect to see further expansion of the construction manager at-risk project delivery method in the years to come.

Unintended Third-Party Beneficiaries Created Through Flow Down Clauses in Subcontracts

Construction work done under an agreement between a general contractor and a subcontractor clearly has the property owner—the ultimate recipient of the construction work—in mind. It is somewhat counterintuitive, then, that the general rule in contract law is that the property owner is not an intended beneficiary of subcontracts between general contractors and subcontractors working on the project. Nevertheless, this is the rule followed by the majority of courts and supported by influential legal commentators. It is a rule well-settled in precedent and well-founded on policy. However, you may wish to consult with a knowledgeable construction attorney in your state to confirm that your state follows the general rule.

Attorneys relying on this well-settled rule while drafting construction subcontracts may be surprised to discover that a commonly used provision, a flow down clause, can muddy this legal analysis and create third-party beneficiary status in a property owner. This article reviews the black letter law governing property owners’ third-party beneficiary status in construction subcontracts and then examines the flow down clause and a recent Utah case that calls this rule into question when the subcontract or subconsultant agreement contains a flow down clause.

The general rule is that a party does not become a third-party beneficiary of a contract absent manifestation of the promisor and promisee’s intent to provide a direct benefit to the third party. This general rule can be difficult to apply, but its application is quite clear in situations where a property owner and a general contractor have entered into a prime contract and the general contractor then enters into agreements with subcontractors. In such circumstances, the rule is that, although the property owner is the ultimate beneficiary of the completed construction, the owner is merely an incidental beneficiary of construction subcontracts.

This majority rule is well established and seems fairly easy to apply: “the owner has no right against the subcontractor, in the absence of clear words to the contrary. The owner is [not an intended, direct beneficiary]; the benefit that he receives from performance must be regarded as merely incidental.” The general rule’s appropriateness is particularly obvious when the subcontract contains what can be called a “non-beneficiary clause”—a provision expressly stating that the subcontract is not intended to benefit any third parties. Non-beneficiary clauses are common in a wide variety of contracts, and because they clearly eviscerate the intent requirement for third-party beneficiary status, courts have treated them as determinative in destroying outside parties’ claims to third-party beneficiary status.

Despite the general rule, however, and even despite the inclusion of a non-beneficiary clause, another common subcontract provision, the flow down clause, can muddy the third-party beneficiary analysis to the point that the owner may become a direct, intended beneficiary of the subcontract. For example, flow down clauses, which extend to the engineering firm the architect’s obligations to the owner under the prime agreement, are common in subconsultant agreements and may inadvertently grant third-party beneficiary status in such subconsultant agreements to property owners.

Our experience in a recent Utah case illustrates how flow down clauses can create third-party beneficiary issues even when the contracting parties were careful enough to include a non-beneficiary clause. The plaintiff was a property owner that contracted with an architect for the construction of a hotel. The architect, in turn, entered into a subconsultant agreement with a structural and mechanical engineering firm. The subconsultant agreement included a non-beneficiary clause. The subconsultant agreement also contained a flow down clause, however, making all terms of the prime agreement applicable to the engineers’ services. To the extent of any conflict between the terms and conditions of the subconsultant agreement and the prime agreement regarding the engineer’s scope of service or requirements of performance, the prime agreement was to govern the relationship of the architect and engineer.

Although not a direct party to the subconsultant agreement with the architect, the owner brought suit on the subconsultant agreement against the engineer, alleging a number of breaches. In response, the engineer filed a motion to dismiss. The motion was based on the general rule discussed above, which is also followed in Utah, that property owners are not intended beneficiaries of construction subcontracts. For the owner to achieve third-party beneficiary status, it had to show (1) that the flow down clause in the subconsultant agreement provided it with a separate and distinct benefit from the architect, and (2) that any apparent intention to benefit the owner was not invalidated by the subconsultant agreement’s non-beneficiary clause.

The owner argued that the engineer’s obligations under the subconsultant agreement flow down to the owner pursuant to the flow down clause. Utah case law, the owner argued, supports the proposition that when a prime contract is incorporated into a subcontract the prime contract’s terms must be interpreted as if they were the terms of the subcontract. Moreover, other precedent establishes that flow down clauses in subcontracts mean that the same rights and duties should flow equally from the owner down through the general contractor to the subcontractor, as well as flowing from the subcontractor up through the general contractor to the owner.

In addition to arguing that the subconsultant agreement did not confer a separate and distinct benefit upon the owner, the engineer claimed that any benefit that potentially existed was expressly denied by the non-beneficiary clause disclaiming any contractual relationship with, or cause of action in, third parties under the subconsultant agreement. In support of this argument, the engineer pointed to a decision by the Utah Supreme Court acknowledging that a non-beneficiary clause establishes the intent of the parties to a subcontract to not create third-party beneficiary status in the owner’s assignee.

The owner attacked the non-beneficiary clause with the arguments that (a) it was not bound by the clause since it was not a signatory to the subconsultant agreement, and (b) the clause was limited by the flow down clause. The flow down clause specifically carved out certain sections of the subconsultant agreement that could not be overridden by the prime contract. Because the non-beneficiary clause was not one of these carved out provisions, this meant it could be—and was—overridden by the terms of the prime agreement.

The owner survived the motion to dismiss, leaving resolution of the issue for further litigation in the suit. When attorneys include non-beneficiary clauses in subcontracts, or in subconsultant agreements, however, they no doubt hope to prevent third parties attempting to sue on the contract from achieving legal victories even in the earliest stages of litigation. For that reason, the revelation that in some circumstances a non-beneficiary clause in a subcontract or in a subconsultant agreement that also contains a flow down clause may be insufficient to preclude a cause of action by the property owner is a significant warning to parties negotiating subcontracts or subconsultant agreements.

If the parties don’t want the inclusion of a flow down clause to have unintended collateral consequences—including the creation of a third-party beneficiary—it is important to draft the clause to make that intention absolutely clear. Parties should be aware of the interaction between the prime agreement and the subcontract or the subconsultant agreement. In this case, the heightened duties of care imposed by the prime agreement alongside some assorted services provided by the subconsultant directly to the owner were enough to avoid a motion to dismiss.

Avoiding this problem will often be simple. It is likely that a different result would have been reached if the subconsultant agreement had simply carved out the non-beneficiary clause from the flow down clause, just as it had already done for various other subconsultant agreement provisions. This would have prevented the prime agreement from overriding the non-beneficiary clause, allowing the non-beneficiary clause to provide conclusive—or at the very least, very persuasive—evidence for the engineer that the owner was not an intended beneficiary of the subconsultant agreement. Such additional caution by parties drafting construction agreements can preserve the clarity of the general rule precluding property owners from becoming third-party beneficiaries of construction subcontracts or subconsultant agreements.

Effective Use of CPM Scheduling

In a relatively recent case, Metcalf Construction Co. v. U.S., 107 Fed. Cl. 786 (2012), the U.S. Court of Federal Claims once again looked to the critical path method (CPM) in determining the allocation of damages in a somewhat complicated delay claim. There is nothing remarkable about this ruling, perhaps, except that it underscores once again the utility and necessity of presenting a court or a board with an understandable, practical method of showing what went wrong with a project schedule and who was responsible for the deviations.

First, interested parties must review the contract, including the scheduling provisions and the definitions of excusable and unexcusable delay. In addition, a workable analytical framework or narrative line on the day-to-day activities of a construction project is obviously necessary to bring some sense of order to the day-to-day scheduling difficulties on any construction project. Achieving the best possible results in resolution of construction delay claims requires being able to explain (and understand) the claim and its equities in a simple, understandable form.

A basic framework for the analysis of delay construction claims exists: set out the original plan and show that it was (or was not) reasonable, compare that original plan to what actually happened on the project, identify the differences between the two, assign cause for the differences and then demonstrate the impact and cost to the project. The classic statement of that framework, which involves CPM scheduling, comes from Messrs. Wickwire, Driscoll and Hurlbut in CONSTRUCTION SCHEDULING: PREPARATION, LIABILITY AND CLAIMS, § 9.1 at 202:

The basic technique used in evaluating contract claims with CPM is to compare the as-planned CPM schedule with the as-built CPM schedule. The technique can be summarized in the following five questions:

  1. How was it planned that the project would be constructed?
  2. How did construction actually occur?
  3. What are the variances, or differences, between the plan for performance and the actual performance with respect to activities, sequences, durations, manpower and other resources?
  4. What are the causes of the differences or variances between the plan and actual performance?
  5. What are the effects of the variances in sequence, duration, manpower and so on as they relate to the cost experience both by the contractor and the owner for the project?

An older Tenth Circuit case demonstrates just how important it can be to use CPM methodology. In Morrison Knudsen Corp. v. Fireman's Fund Insurance Co., 175 F.3rd 1221 (10th Cir. 1999), the Tenth Circuit ruled that in order to be excusable, any delay complained of must extend the project's overall completion; that is, the delay must be on the critical path. In that case the Tenth Circuit stated:

A critical delay is one which may delay not just a particular activity at issue, but the overall completion date of the Work. Many activities may be performed on a project at any time without any effect on the completion of the project. A delay in such non-critical activities will not delay the project overall and cannot constitute an excusable delay. Only delays to activities on the critical path - activities with no leeway in the schedule - may give rise to excusable delay.

The Tenth Circuit then went on to state:

Courts often use CPM scheduling to resolve disputes over excusable delay claims. CPM provides a useful, well-developed nomenclature and analytical framework for expert testimony. While CPM has generated technical terminology, the legal requirement that is used to analyze is general and commonsensical: contractors must prove that a delay affected not just an isolated part of the project, but its overall completion. Courts often do not use formal CPM terminology, but simply an informal, CPM-like analysis to determine whether a contractor has met its burden of proof on that general requirement.

The Tenth Circuit expressly required the subcontractor to examine each specific delay claim, determine whether the contractor caused each delay in a manner authorized by the contract, and then determine whether each delay caused the subcontractor to incur reasonable costs which were properly allocable to the contract. The lesson from that case is that a critical path analysis is often essential to a clear, effective claims presentation and can be an absolute legal requirement.

Case law shows clearly that not just juries, but courts, boards and other fact finders, want to hear from those lawyers and witnesses who are objective and base their opinions on (and also understand) what actually happened day to day on the project. See ABA Section of Litigation, Jury Comprehension in Complex Cases 41 (1990); Neal & Company, Inc. v. U.S., 36 Cl. Ct. 600 (1996); Williams Enterprises, Inc. v. Straight Manufacturing & Welding, Inc., 728 F. Supp. 12 (D.C. Cir. 1990). Next, one of the best, if not the best, method of doing so can be through the use of the CPM technique described above.

In that regard, no matter what the measure of damages, no matter what the style of the lawyers; whether the playing field is mediation, arbitration, negotiation, bench trial, board hearing, summary proceeding or jury trial, the same factors which ultimately persuade fact finders are stated repeatedly. Courts and mediators want to hear in the simplest possible terms what are the key contract scheduling provisions and what actually happened day to day on the project (in the form set out above) from objective, credible persons who have first-hand knowledge of the project or the project documentation, who back their testimony with relevant project data, facts and records. Again, one of the best ways of doing so can be a CPM analysis.