Developers of mixed-use projects can reduce the likelihood of costly construction defect litigation by anticipating risk and allocating responsibility at the time of contract. Unfortunately, developers often assume that the standard industry forms provide sufficient protection.
These forms, however, rely heavily on good faith for resolution of issues in the future. There are certain approaches developers can take to protect them, prevent construction defects and resolve issues arising from them.
Determine project function and likely defects prior to contract
The developer’s contracts with contractors and designers are best structured after the developer has arrived at a clear “big picture” understanding of how the project will function. Gaining this understanding includes consideration of regulations, financing, insurance and marketing plans specific to the development. It would behoove the developer to conduct a “what if” analysis to determine the defects most likely to result from failures in the design or construction.
Knowing how the project will function and what defects are most likely to arise places the developer in the best position to craft project-specific core objectives for negotiation of the contract.
These core objectives related to defects should include:
A clear allocation of responsibility and accountability for preventing critical defects.
A determination of comprehensive insurance and bonding requirements based on an assessment of which risks can and should be covered.
A clear statement of how disputes will be triggered and resolved during and after completion of the project.
Resolution of disputes deserves particular attention given the implications of technical issues and the possible need to involve numerous categories of potentially responsible parties. The solution will differ from project to project.
Beware of the economic loss rule
Developers sued for construction defects invariably look to the designers and contractors for indemnification. If the designer or contractor is not held financially responsible however, the developer may remain on the hook even if subcontractors are truly at fault. Subcontractors can be immune from liability for construction defects under a principle known as the “economic loss rule,” which provides that a party whose claim is based upon a financial loss caused by construction defects is only entitled to recover under contract theories against those with whom it has a direct agreement. To the extent the economic loss rule applies, it prevents the developer from suing the responsible subcontractor, unless the subcontract provides otherwise.
Developers concerned about the economic loss rule typically require in the prime contract that each subcontract include text specifically indemnifying the developer from suits for construction defects caused by the subcontractor, and names the developer as an “intended third-party beneficiary” of the subcontract with the right to directly sue the subcontractor.
Require indemnification and defense
Developers typically do not cause construction defects, and assume the insurance furnished by the designer or contractor should be the primary source of payment for all related costs, including defense costs. Yet, under the standard industry form indemnity, the primary responsible party does not provide for defense. To address this gap, developers can explicitly require a defense obligation in addition to indemnity.
Nip the issue of warranty claims in the bud
There is the potential for confusion and discord in efficiently responding to warranty claims, given there will likely be multiple parties potentially responsible for the design and construction. Developers concerned with this concept should negotiate contract provisions for a “warranty response contractor” to ensure warranty/defect claims from third-parties are responded to and accommodated promptly, with allocation of responsibility being addressed later.
If the developer envisions the project to be above average in quality of design or construction — which is normally the case in upper-end developments where quality of construction administration is considered important to minimizing defects — the contract should memorialize that expectation. Otherwise, the enforceable measure of performance could be the minimum standard, which may make it more difficult for the developer to prove a breach of the standard of care and increase the likelihood of defects due to lower performance standards. To avoid disputes, the contract should reflect any understanding that performance will exceed minimum standards.
Contractual language dealing with any or all of these concepts is only as effective as the effort given to integrate them with the other contract provisions, as well as the core objectives, so that the entire contract clearly addresses the parties’ expectations for the specific project.