The 800 Pound Gorilla in the Contract: the Indemnity Provisions

One of the most frequent inquiries I receive from contractors and subcontractors alike is what does this indemnity provision really mean, and is there any way to reduce my exposure?

Generally, “indemnity” is the obligation resting on one party to make good a loss or damage another party has incurred, which obligation may be expressly provided for by contract, implied from a contract not specifically mentioning indemnity, or may arise from the equities of particular circumstances.  In California, indemnity is defined at Civil Code § 2772:  “Indemnity is a contract by which one engages to save another from a legal consequence of the conduct of one of the parties, or some other person.”  The party being required to provide the indemnity is called the “indemnitor.”  The person receiving the benefit of the indemnity is the “indemnitee.” 

In the construction arena, indemnity is a contractual provision that shifts the risk.  By way of example, an insurance policy is nothing more than an indemnification contract (shifting the risk) subject to the specific terms, conditions and exclusions contained within the policy agreement.  The same goes here:  the indemnity provision in your construction prime contract or subcontract seeks to shift the risk subject to the specific terms, conditions and exclusions contained within the agreement.  Lawyers typically refer to the contractual indemnity provisions contained in your average construction contract as being of one of three different types:  Type I, Type II or Type III (…original, I know).

A Type I provision requires indemnification for the indemnitee’s damages from tort liability, including the active or passive negligence of the indemnitee (in other words, what he/she did or didn’t do), and strict liability.  To be enforced in a court of law, a Type I agreement must be explicit, clear and unequivocal.  A case famous (or infamous) in legal circles known as Continental Heller ’97 declared a finding of fault or even a causal connection between the indemnitee’s conduct and the harm is not required to enforce the terms of a Type I agreement.  The court opined the parties are at “great freedom of action in allocating risk,” and the parties were “expected to review, understand and bargain over their indemnity agreement.”  Under a Type I agreement, the only exceptions to an obligation to indemnify is if the indemnitee is solely responsible for the harm, or committed a willful wrongful act.  In other words, if you are the subcontractor in a contract with a general contractor with a Type I agreement, you must pay the general contractor (and usually the owner) for all damages and claims, regardless of whether the general contractor (or owner) contributed to causing the damage to a substantial degree, and regardless of the minimal nature of your contribution to the harm. 

A Type II provision is less onerous than a Type I from the subcontractor’s perspective, and requires indemnification for the passive, but not active liability of the indemnitee.  In other words, as the subcontractor in a contract with a general contractor with a Type II agreement, you must pay the general contractor (and usually the owner) for all damages and claims caused by an omission (failure to act) of the general contractor (or owner), but not for the active negligence of the general contractor (or owner).

A Type III provision is the least onerous indemnity obligation from the subcontractor’s perspective.  A Type III provision requires indemnification only for the liabilities caused by the indemnitor, not the liabilities caused by anyone else.  In other words, as the subcontractor in a contract with a general contractor with a Type III agreement, you are required only to pay the general contractor (and usually the owner) for damages and claims caused by your own conduct.

The basic components of indemnification include (i) the obligation to hold the indemnitee harmless, defend and indemnify the indemnitee, and waive subrogation claims; (ii) the length of the obligation, generally during construction and after completion; (iii) provide an additional insured endorsement, noting the indemnity provision may require indemnity regardless of the limits of insurance coverage.  In fact, most standard ISO CGL policies exclude coverage for liability assumed in a contract.

Clear as mud?  Here are some questions you can ask yourself when reading the indemnity provision in your contract:

1.         How broad is the indemnification provision in the subcontract - e.g., does it require you (the subcontractor) to indemnify under all conditions except when the general contractor is solely negligent?

2.         Does the indemnity clause match that included in the contract between the prime contractor and the owner?

3.         Does your (subcontractor's) insurance provide coverage for contractual liabilities, including indemnification obligations assumed under subcontract indemnification clauses?

It is critical to first understand the obligations being imposed upon you (the indemnitor), so that you are in the best position to try to negotiate the terms of that provision with the proposed indemnitee.  Questions?  Call me to discuss the particulars of your situation.

Nothing in this blog is intended to create an attorney-client relationship.  This article is intended to provide a general overview of the current status of the law for informational purposes only, and is not intended to constitute, or serve as a substitute for, a professional legal consultation.  Laws change every day; please consult an attorney regarding the current status of the law, and how the law affects your specific circumstances. Thank you.

Prompt Payment Penalty Statutes: What is a bona fide dispute anyway?

In California, the payment of contractors and subcontractors is governed by "prompt payment statutes,” which impose sanctions on the non-paying party for failure to timely pay.  These statutes are littered throughout the Code:  for example, progress payments by general contractors to their subcontractors on private and most public works of improvement are governed by Business & Professions Code § 7108.5; retention payments to subcontractors on public works are governed by Public Contracts Code § 7107, and Civil Code § 3260 for private works. These sanctions range from a 1.5% to 2% per month penalty on the wrongfully withheld balance in lieu of interest, the 2% penalty plus interest, or statutory interest alone, and in some cases attorney fees and costs.

Although there are subtle differences amongst the payment obligations imposed by these statutes, generally, payment must be released to subcontractors within a specified time following receipt by the contractor, except when there is a dispute, or when the parties have agreed in writing to a different payment plan.  If there is a "good faith dispute over all or any portion of the amount due on a progress payment," the general contractor may withhold up to 150 percent of the disputed amount. (Bus. & Prof. Code § 7108.5(c).) On a public work, "if a bona fide dispute exists between the subcontractor and the original contractor," then the latter may withhold from retention up to 150 percent of the estimated value of the disputed amount.  (Pub. Cont. Code § 7107(e).)  On a private project, if "a bona fide dispute exists between a subcontractor and the original contractor, the original contractor may withhold from that subcontractor with whom the dispute exists its portion of the retention proceeds . . . [not to] exceed 150 percent of the estimated value of the disputed amount." (Civ. Code § 3260(e).)

So, what constitutes a bona fide, or good faith, dispute?

Alpha Mechanical, Heating & Air Conditioning, Inc. v. Travelers Casualty & Surety Company of America (2005) 133 Cal.App.4th 1319, was the first court decision to expressly examine the merits of a good faith dispute on a private work of improvement, analyzing Bus. & Prof. Code § 7108.5 and Civ. Code § 3260.  Therein, the court observed "the phrase 'good faith' does have a distinct meaning and purpose in the law," and "suggests a moral quality; its absence is equated with dishonesty, deceit or unfaithfulness to duty," or "that state of mind denoting honesty of purpose, freedom from intention to defraud, and, generally speaking, means being faithful to one's duty or obligation."  (Alpha Mechanical, supra, 133 Cal.App.4^th at 1339.) 

Alpha Mechanical involved a common dispute over work performed under a subcontract:   the general contractor alleged it did not make final payment to its subcontractor because the sub failed to correct defective work and damaged the work of other trades, requiring repairs the general would have to pay for if the subcontractor did not make the repairs. The court of appeals found no evidence in the record suggesting the general contractor "lack[ed] good faith in its belief that the dispute over the damage caused by Alpha justified withholding the remaining sums due it." (Id., at 1340.)  Therefore, the general was not liable for prompt payment penalties.

In a more recent case, Martin Brothers Construction, Inc. v. Thompson Pacific Construction, Inc. (2009) 179 Cal.App.4th 1401, a dispute arose on a public work over changes the subcontractor contended were outside its scope of work and for which additional compensation was owed.  The general contractor withheld the subcontractor’s retention (over which there was no argument as to the amount owed) due to the dispute over changes.  The subcontractor sought penalties under Public Contract Code § 7107 for the general contractor’s failure to release its retention. The court of appeal in Martin Brothers held the reference in the statute to "dispute" meant any dispute, so long as the dispute was bona fide.  In other words, even though there was no dispute over the amount of retention owed under the subcontract, the general contractor was justified withholding retention while the change order dispute was pending.  The ruling was somewhat surprising to the legal community, because it allowed the general contractor to withhold undisputed sums due to a dispute over whether additional sums were owed.

                                

As you can see from these two examples, whether a dispute is bona fide or in good faith could be interpreted broadly to suggest that nearly any dispute, provided it was genuinely asserted, enabled a general contractor to withhold amounts owed a subcontractor.

 
But just recently, the good faith dispute exception in Section 7108.5 of the Business & Professions Code (which the court observed was similar to Sections 7107 and 10262.5 of the Public Contract Code and Section 3260 of the Civil Code) was narrowed by a different court of appeal.  In the published portion of the opinion in FEI Enterprises, Inc. v. Yoon (2d Dist. 2011) B209862, the court criticized Alpha Mechanical’s “unwarranted and unwise” imposition of a subjective standard, which converted the express language of the statute from a stated "good faith dispute" into a "good faith belief" standard.  Unless the factual circumstances dictate otherwise, the FEI Enterprises court held an objective, "reasonable person" standard should be used to determine whether a payment from a contractor to a subcontractor is subject to a "good faith dispute."

Where does that leave the California contracting community?  There are now two cases, one in each of the third[1] and fourth[2] districts, applying a subjective standard to the decision of whether a good faith dispute exists to excuse prompt payment, and one case in the second[3] district applying an objective standard to that same question.  If your dispute arises in one of these districts, your trial court will likely follow the precedent set by the appellate court in its own district. If the dispute arises elsewhere, it will be difficult to predict how a court will rule.  Therefore, applying the more conservative, objective standard is likely the most prudent course to follow when analyzing the facts of your case, and deciding your legal strategy.

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[1] The Third District of California’s Court of Appeal is located in Sacramento, and has jurisdiction over appeals arising in Alpine, Amador, Butte, Calaveras, Colusa, El Dorado, Glenn, Lassen, Modoc, Mono, Nevada, Placer, Plumas, Sacramento, San Joaquin, Shasta, Sierra, Siskiyou, Sutter, Tehama, Trinity, Yolo, and Yuba Counties.

[2] The Fourth District of California’s Court of Appeal has courts in Riverside, San Diego and Santa Ana and has jurisdiction over appeals arising in Inyo, Riverside, San Bernardino, Imperial, San Diego and Orange Counties.

[3]  The Second District of California’s Court of Appeal has courts in Los Angeles and Ventura, and has jurisdiction over appeals arising in Los Angeles, Ventura, Santa Barbara and San Luis Obispo Counties.

The Last of the Seven Deadly Sins of the Construction Industry: Do You Have an Effective Sales Process?

The Last of the Seven Deadly Sins of the Construction Industry:  Do You Have an Effective Sales Process?

Seven Avoidable Mistakes Construction Businesses Commonly Make

In this final installment, will look at whether your business has an effective sales process. 

Know your “Top Tier” customers.  Define the qualities of your “best” customer, whatever those qualities may be.  Evaluate the current and potential sales generated by this group, the cost of acquiring this customer, and the cost of losing this customer.  After you’ve done that, determine how this definition affects your profit plan.  Your lead generation can be tailored specifically to attract these “best” customers, with the sales and pricing process focusing on encouraging these customers to buy from your company.

Sell effectively to your “best” customers.  Don’t leave business on the table because you don’t know your market or your pricing position.  If you are selling a commodity with fundamental standards of quality (in which there is no uniqueness to your product, simply a price comparison), then you must distinguish yourself from the competition with your communications and responsiveness, schedule maintenance, and meeting your customer’s delivery expectations.  The true value of your product or service when it is otherwise comparable to your competition is what is measured by the customer.  You can explain your value added (sometimes known as “service value” or “between the walls” value) to your customer, which helps them understand what they should be looking for from a “top tier” contractor.

Define your “Customer Promise”, and keep it. A “Customer Promise” is your up-front documented and agreed upon statement of the customer’s expectations of your company, its products, and results, as well as what you expect of the customer, including prompt payment, open communications and assessments, etc.  The process creates a branding and control process that allows the marketplace to know who you are.  The process allows you to secure testimonial letters from your customers, in which they attest that you keep your Customer Promises.  It is one thing for you to say who you are or what you do…it is quite another altogether, and far more effective, to agree up front with your client about who and what you are, followed by a customer “report card” at the end.  Post your testimonial letters and cumulative scores on your website. 

“Hook,” don’t “Sell”.  Generally, people and businesses don’t want to be sold. They want their expectations to be fulfilled, and most often they want to buy from someone who can take away the “pain” from previous interactions with vendors.  When you are the one asking questions of the potential customer, you are in control of the relationship.  On the other hand, when you are the one answering questions, you are not in control.   This does not mean that you shouldn’t answer questions, but it’s important to ask yourself why is this customer asking the question he or she is asking.  Asking yourself why establishes your interest in the customer; it establishes control; and finally, it touches this pain component of the customer, which is their fundamental basis for decision-making.  Intellectualizing will get you little in the way of business.  Do not start “selling” the prospect.  If you need to talk about your company, do it with an initial statement explaining how you work with customers and what they can expect from you.  There are multiple methods of non-selling that work:  one is the Sandler Method, which is described in David Sandler’s book “You Can’t Teach A Kid To Ride A Bike At A Seminar.”  In the Sandler method, a general series of questions called a “Pain Funnel”, is asked:

a.       Is that a problem, or was that experience a problem in the past?

b.      Can you be more specific?

c.       Tell me more about that?

d.      How did this affect you past on a day-to-day basis?

e.       How did you try to correct this or mitigate its impact?  Did it work?  Did you give up trying?

f.        How long did you have to deal with this problem?  That long?

g.       Ball park figure, what do you think the problem cost you in dollars, time and emotional inconvenience?  That much?  Are you sure?

h.       How does that make you feel?

i.         Can you see how our company’s process may support your needs?

Sandler’s conclusion for an effective sales process:  “Don’t sell, let the customer buy.”

I hope you’ve found this series helpful.  Next week, I’ll start addressing contract provisions you should look at closely before closing the deal.

Ideas?  Thoughts?  Questions?  Post a comment and let’s discuss!

Contractors State License Board Revokes License of Once- Prominent Sacramento Area Restaurateur and Developer

THIS PRESS RELEASE JUST OUT FROM THE CONTRACTORS STATE LICENSE BOARD:

 

Settlement requires restitution and repayment by company president

SACRAMENTO – The Contractors State License Board (CSLB) officially revoked the license of Stonegate Construction, Inc.’s license (#766777) on August 12, 2011. Stonegate Construction President and Responsible Managing Officer Abolghassen “Abe” Alizadeh signed and accepted the terms of a stipulated settlement agreement on August 5, 2011, in response to a CSLB investigation that concluded Alizadeh had diverted construction funds, and failed to pay subcontractors and materials suppliers.

As part of the agreement, Stonegate Construction’s license is revoked for at least one year. Before the license can be reinstated, or another license issued to Alizadeh, he must:

·         Pay CSLB for the cost of its investigation and enforcement ($16,386.05);

·         File a disciplinary bond valued between $15,000 and $125,000 for at least two years; and

·         Prove that restitution has been made to subcontractors, or demonstrate that these debts were resolved civilly or successfully discharged in bankruptcy.

CSLB opened its investigation in 2009 after complaints were filed by more than 20 subcontractors and materials suppliers who had not been paid. CSLB partnered with the Franchise Tax Board, Board of Equalization, Employment Development Department, and Division of Labor Standards Enforcement, to whom Alizadeh also owed millions in unpaid fees and taxes. Alizadeh was arrested in January 2011 on grand theft and other felony charges related to that part of the investigation.

“CSLB hopes this sends a clear message that there will be serious consequences for licensees who do not follow state laws,” said CSLB Registrar Steve Sands. “Mr. Alizadeh must be held accountable for these violations of state contracting and other laws before he is ever allowed to contract again.”

The Contractors State License Board operates under the umbrella of the California Department of Consumer Affairs.  More information and publications about hiring contractors are available on the CSLB website or by calling 800-321-CSLB (2752).  You can also sign up for CSLB email alerts at www.cslb.ca.gov.  CSLB licenses and regulates California's more than 300,000 contractors, and is regarded as one of the leading consumer protection agencies in the United States.  In fiscal year 2010-11, CSLB helped recover nearly $45 million in ordered restitution for consumers.

The Sixth of the Seven Deadly Sins of the Construction Industry: Ignoring Your Employees

The Sixth of the Seven Deadly Sins of the Construction Industry:  Ignoring Your Employees

Seven Avoidable Mistakes Construction Businesses Commonly Make

In the last installment of this discussion, we addressed whether you are working for a profit.  In this next to last installment of the Seven Deadly Sins, we will address one of your most important assets:  your employees, and what can happen to your business when you ignore them.

Use recruiting and retention methods that work regardless of the kind of person you can afford.  You can invoke just as many problems by hiring an expensive person who doesn’t perform, as you can by hiring someone without the experience or qualifications because recruiting the right person is too expensive.  In the long run, it is usually more efficient and cost effective to develop internal management and key personnel than it is to look for those people outside of your company. But to do that successfully, you must develop an effective process that is defined, tested, routine, and communicated to the targeted employees.  Beyond defining your training processes to the candidates, you must also define your expectations of them, what they should expect of themselves and what is in it for them. Communicating these objectives will help you retain personnel who might otherwise look for opportunities elsewhere. 

On the other hand, never follow your “promotion plan” blindly:  do not promote someone who is great at his or her current job to a position for which he/she is not fully prepared.  You will set that employee up for failure, and in the end, you will lose money and likely your valued employee.  An employee who is performing at the top of his/her game, should not have to be promoted to receive more pay.  As discussed further below, an employee who is producing for you could make more money than the manager who manages that employee.  A manager is there to support those they manage, and to ensure company policies and the business plan are being followed.  Develop a rational business culture of communications that confront and coach (not embarrass and punish), coupled with a working pay for performance plan, and you will become a leader in recruitment and retention of valued employees.

Use Pay for Performance plans that work and sell others on your company.  A “pay for performance” plan is not Christmas bonuses, or subjective bonuses that become entitlements. Employees should never be left to question what they got, why they received it, why it is more or less than last time, if it was enough, or if it is what they deserve.  A true PFP plan establishes measurable standards attributable to the job the person performs with at least one of the measurements dealing with the link between what the employee does and company profit.  If what the employee does is not measurable directly to profit (for example, the accounting department), the timeliness and accuracy of what they do weekly and monthly is, as are evaluations monthly or quarterly by their internal customers in other departments.  Ultimately the combination of values that set the bonus score is taken as a percentage of the pool created by the percentage of the company profit (which must also be defined), the pool available to the department or profit center, and the pool available to the individual by job classification.  The PFP plan is a scorecard that shows the employee how he/she is doing periodically in measurable terms and money.  Each company plan should be unique.  Each company plan should incorporate standards that support the company goals of revenue, profit, customer branding, and internal culture. 

Include middle managers in senior management meetings.  It is always useful to include non-management staff in appropriate business meetings to introduce them to the real process of managing the company.  It gives them a sense of inclusion, an opportunity to learn, contribute and feel valued.  Of course, it is critical to hold a meeting that begins on time, has an agenda, involves participation by attendees, ends on time, and is followed up.

Listen to and respond to suggestions from the field and staff. Employees will often express concern or offer an idea, but there is often no structured response back.  The opportunity to coach the employee as to how the business needs to make decisions is lost.  Even a simple response such as, “Great idea, but we can’t afford it right now,” provides a teaching moment.  If someone has an idea that can be measured against ROI to an amount and timeline, and if the business is willing to take the risk, and the person managing the process or key to it (typically the one making the suggestion) is willing to “take the hit” within their PFP plan if it doesn’t work, then the company should seriously consider taking action on the idea.  Conversely, if an employee suggests something that is beneficial to the company and has a measurable effect on the profit of the company or sales of the company, then the employee should be rewarded within the PFP plan or in addition to it based on the measurable gain to the company.  In the end, it is always appropriate to say “no” when “no” is explained.  It is important to let your employees know you heard them:  it is the essence of good management, and keeps the employee from losing his/her emotional investment, which can be measured in lost productivity and profit/revenue loss.

Next week will be the last post in this series, and we will look at whether your business has an effective sales process.  Ideas?  Thoughts?  Questions?  Post a comment and let’s discuss!

The Fifth of the Seven Deadly Sins of the Construction Industry: Failing to Work for a Profit

The Fifth of the Seven Deadly Sins of the Construction Industry:  Failing to Work for a Profit

Seven Avoidable Mistakes Construction Businesses Commonly Make

Last week, we talked about understanding your true cost of doing business.  This installment should give you something to think about:  are you working for a profit?  Sure…that’s the goal, and we all think everyone in the company is on board with that goal.  But do you have the necessary checks and balances in place to make sure that is actually what is happening?

Complete production and job reviews regularly. Regardless of your business type, production and job review processes are critical to identifying production issues.  These include accurately evaluating work in progress and accrued costs. Such a process creates the feedback required for pricing standards and managing production schedules and related issues, and ensures better accuracy of your monthly financial statements.  Working for a profit is all about management:  identifying potential issues and mitigating them.

Respond to, and mitigate problems urgently.  It serves no purpose to have the needed information, but not mechanism to accomplish an urgent response.  Your managers must be able to understand the information in front of him or her, and respond to it immediately. The manager must be able to target when and how the problem will be solved.  All too often, the issue is not that a problem occurred, but that the problem is not resolved or mitigated quickly.  There is no perfect business. The most successful companies are those who respond to problems, maximize these problems as opportunities by implementing targeted mitigation techniques, and stop making the same mistakes over and over again.   

Observe, understand, respond, learn, and then adapt!

The next topic in this series will look at whether you are ignoring the needs of your most valuable asset, your employees.

Ideas?  Thoughts?  Questions?  Post a comment and let’s discuss!