August 28, 2015

When Contract Forms Cause Unintended Consequences

Inclusion of unrevised Standard AIA contract forms in your construction agreements can cause serious unintended consequences. A case decided by the Indiana Supreme Court, Bd. of Comm’rs. Cty of Jefferson v. Teton Corp., 30 N.E. 3rd 711 (Ind. Sup. Ct. 2015), demonstrates why.

Insurance and Subrogation of Claims: Jefferson County v. Teton Corp.

The Jefferson County case dealt with sections of the General Conditions concerning the interplay of insurance and subrogation of claims. Specifically, Section 11.3.1 requires a project owner to purchase property insurance “in the amount of the initial Contract Sum” “for the entire work.” Section requires the insurance to be an “all-risk policy form” insuring against “fire and extended coverage and physical loss and damage …”

Section 11.3.7 requires the owner and contractor to “waive all rights against each other … for damages caused by fire or other perils to the extent covered by property insurance procured under this Paragraph 11.3 or other property insurance applicable to the work …”

Rather than purchasing separate business risk coverage for the project, the owner, Jefferson County, relied on its existing property insurance to meet its Paragraph 11.3 obligations such that its general property insurance covered all damage caused by the covered claims, whether part of the contractor’s work or not. Later, the owner claimed that during courthouse roof repairs, a contractor had negligently caused a fire that damaged much of the courthouse that was beyond the contractor’s scope of work. The owner’s insurer paid the entire loss and sued the contractor to pursue its rights of subrogation, contending that when all of Paragraph 11.3 was read together it had to mean the waiver was limited to damages to the project’s scope of work.

Measuring Waiver of Subrogation Scope: Coverage or Property Damaged?

The trial court granted summary judgment in favor of the contractors. The Indiana Supreme Court agreed with the trial court and the intermediate Court of Appeals that the plain language of the waiver contained in Section 11.3.7 meant that if any property insurance covered the claim at issue it was waived. Thus the scope of waiver of subrogation must be based on the extent and source of coverage, not the nature of the property damaged. The court noted that “future parties that incorporate the AIA contract into their construction agreements are certainly free to restrict the scope of the subrogation waiver to work-related damages alone. But the parties did not adopt such restriction here, so the waiver’s plain meaning applies to bar Jefferson County’s claim.”

The Court’s decision resolved a split in authority within Indiana’s own intermediate Court of Appeal that mirrored a similar split in states around the country. A little more than one year earlier, in Allen County Public Library v. Shambaugh & Son, L.P., 997 N.E.2d 48 (Ind. Ct. App. 2014), on rehearing, 2 N.E.3d 132 (Ind. Ct. App. 2014), a different Court of Appeals panel had ruled the other way, holding an owner waived damages under section 11.3.7 only to the extent covered by property insurance on the project work itself. In light of Jefferson County, this earlier decision, now overruled, demonstrates even more clearly the potential trap for the unwary when the AIA forms are incorporated unrevised.

Overruled: Allen County Public Library v. Shambaugh & Son

In Allen County Public Library, rather than utilizing its existing property insurance to meet its obligations under Paragraph 11.3, the library, as is common in the industry,  purchased an “all risk” builders risk policy for the entire $52 million value of its expansion project. The policy’s extended coverages included coverage of pollution cleanup costs — but limited to just $5,000, which the owner and its broker contended was also common. As a matter of public policy, Indiana, like many other states, has found in the construction industry a “studied attempt” to shift the risk of loss during construction to insurance in order to avoid piecemeal litigation. Moreover, if a participant is contractually required to provide insurance for a given risk, the participant assumes the risk that the amount of insurance provided is adequate. Any underinsured amount of loss is deemed waived.

In its action for damages the library claimed that, due to a contractor’s negligence, a diesel fuel line in the project’s basement had been punctured, causing over 3,000 gallons of fuel to be discharged into the underlying and surrounding soils and groundwater. It claimed as damages about $500,000 of cleanup costs and a right to recover its attorney fees. The contractor and others obtained summary judgment on the grounds that, since the library had provided insurance for the cleanup, any damages beyond $5,000 had been waived under section 11.3.7. On appeal, the Court applied the “extent of the work” rule and reversed, sending the case back for further findings on what property the fuel had damaged. The library also contended that since it was not required by Paragraph 11.3 to provide pollution cleanup coverage, the state’s policy putting the risk of the amount of coverage on the provider did not apply.

Jefferson County changes this result. Now, since the library provided any property insurance applicable to the work covering any part of the claimed damages, any damage, whether to the work or not is waived under section 11.3.7. The library would be relegated to its $5,000 insurance proceeds and would likely be looking for someone else to sue.

Review contract forms carefully and verify that sections on insurance and claims subrogation won’t leave you in such a messy place should damage occur during construction.

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