r e s u l t s f i r s t s m n e w s l e t t e r Volume XXI, Issue 1, sprIng 2013

Co-Editors | CharlEs F. KEnny, PartnEr and MiChaEl s. ZiChErMan, PartnEr

Many performance bonds have anti-assignment language

limiting who can recover from the surety in the event of

a principal’s default. Courts regularly uphold these anti-

assignment provisions.1 However, a new case may provide

some relief and allow assignments.

adam P. handfinger, Partner and brian a. shue, associate

M. Rapoport. Mr. Rapoport will lead the expanded practice group from the firm’s New York and Washington, D.C., offices, as well as from the newly established firm location in the Philadelphia area.

The expansion of the firm’s Public-Private Partnership practice is a result of increasing demand for public-private partnership solutions throughout the United States. A growing number of the firm’s clients are seeking public-private partnership opportunities in both civil and social infrastructure projects and P&A has found it essential to offer strategic business-capture planning as clients continue to launch new public-private partnership initiatives.

The value that P&A can provide is unique because of the firm’s understanding of the culture and business model of today’s contractors, coupled with its top

PECKar & abraMson EXPands PUbliC-PriVatE PartnErshiP PraCtiCEWElCoMEs nEW PartnEr FranK M. raPoPort

assiGninG PErForManCE bond ClaiMs . . . MaybE

Peckar & Abramson is pleased to an-nounce the expansion of its Public-Private Partnership practice, with the addition of senior partner and practice leader Frank

Frank M. rapoport

continued on page 12

adam P. handfinger

brian a. shue

Smith-Boughan, to provide mechanical services in connection with the construction of an ethanol facility on GOE’s property in Lima, Ohio (the Construction Contract).

Ohio Farmers Insurance Company (the Surety) and Smith-Boughan executed a performance bond for the benefit of GOE, designated therein as the owner (the Bond).

Var ious disputes arose and GOE ultimately terminated Smith Boughan. Subsequently, Smith-Boughan filed suit against GOE for breach and wrongful termination of the Construction Contract and GOE asserted a counterclaim for breach of contract. Thereafter, GOE executed a liquidation plan (the

Plan) and all of GOE's remaining assets, including its claims against Smith-Boughan and the Surety, were transferred to a liquidating trust. Pursuant to a settlement agreement, all of GOE’s and the liquidating trust's "rights, title and interest" in the claims against Smith-Boughan and the Surety were "deemed to have [been] assigned to the Assignee," identified as PEA Lit, LLC (PEA).

The Surety challenged the assignment of GOE’s claim against the Bond to PEA, arguing that the following language in the Bond precluded assignments: “No right of action shall accrue on this Bond to any person or entity other than the owner or its heirs, executors, administrators or successors.” Note that this language, or something similar, is typically seen in standard performance bond forms, such as the AIA Document A312 – 2010 Performance Bond. Section 9 of the AIA A312 form states as follows:

continued on page 2

In GOE Lima, LLC v. Ohio Farmers Ins. C o. 2 , the owner, GOE, re-tained the contrac tor,

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The Surety shall not be liable to the Owner or others for obligations of the Contractor that are unrelated to the Construction Contract, and the Balance of the Contract Price shall not be reduced or set off on account of any such unrelated obligations. No right of action shall accrue on this Bond to any person or entity other than the Owner or its heirs, executors, administrators, successors and assigns.

The court analyzed the long-standing common law tradition that all contract rights may be assigned unless one of the following three conditions exists: (1) there is clear contractual language prohibiting assignment; (2) an assignment would materially change the duty of the obligor, materially increase the insurer’s burden or risk under the contract, materially impair the insurer’s chance of securing a return on performance, or materially reduce the contract’s value; or (3) the assignment is

forbidden by statute or by public policy. Pilkington North America, Inc. v. Travelers Casualty & Surety Co. In this case, the court noted the validity of contractual provisions prohibiting assignment of any interest under an insurance policy and the important role of such a provision:

Risk characteristics of the insured determine whether the insurer will provide coverage and at what rate. An assignment could alter drastically the insurer’s exposure depending on the nature of the new insured. “No assignment” clauses protect against any such unforeseen increase in risk.

However, the court stated “insurance policies are generally construed such that assignment of an interest is valid after the occurrence of the loss insured against, and the assignment is then regarded as a transfer of the chose in action, even in the face of an anti-assignment provision.” Because the

duty to indemnify implicated losses for property damage and bodily injury that were fixed at the time of the occurrence, the court found no reason to deviate from this standard rule, and held that the duty to indemnify was unaffected by the anti-assignment provision since the covered loss had already occurred.

The GOE Lima court applied a similar rationale with respect to assignment of rights under a surety bond. The court ruled that “[t]he policies supporting contractual freedom to limit assignment do not apply when the obligee is assigning only a cause of action and does not itself owe performance of any duties.” The court determined that a right of action against a surety bond is assignable where the construction contract has been terminated and the obligee has taken all steps required for a duty to arise in the surety to perform under the terms of the Bond. The court found in the instant case that the assignment to PEA occurred after GOE terminated the Construction Contract and after GOE complied with all conditions precedent to the Surety’s duty to perform under the Bond. Thus, GOE’s right of action against the Surety had already accrued at the time of the assignment to PEA, and the court allowed GOE to assign its rights against the Bond to PEA, even in the face of an otherwise enforceable anti-assignment clause.

It is not yet clear what impact this decision will have on the ability of assignees to pursue claims against performance bond sureties or whether other courts will adopt this rationale. However, it may send a signal to sureties that the standard language they typically insert in their performance bonds may not be sufficient to preclude certain assignments, and could result in performance bond sureties revising the language of their bonds to address this specific issue. n

assiGninG PErForManCE bond ClaiMs . . . MaybE

continued from page 1

1 See, e.g. Citibank v. Grupo Cupey, Inc., 382 F. 3d 29 (1st Cir. 2004)

2 2012 Bankr. LEXIS 1172 (N.D. Ohio Mar. 19, 2012)

3 861 N.E.2d 121, 128 (Ohio 2006)

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lori ann lange, Partner

FHWA imposes a Buy America domestic preference on all steel and iron products used on projects funded in whole or in part with FHWA funding, including manufactured products that are predominantly made of steel or iron. FHWA’s Memorandum clarifies that FHWA considers a manufactured product to be predominantly made of steel or iron if the product consists of at least 90 percent steel or iron content when it is delivered to the job site for installation.

buy american v. buy america

There are two separate domestic preference procurement programs that apply to FHWA. The first program is the Buy American Act program, which implements the Buy American Act.2 The Buy American Act establishes a national preference for the federal government’s procurement of domestic supplies (known as “end products”) and domestic construction materials. Under the Buy American Act, the federal government must purchase, for public use, end products and construction materials that are made or produced in the United States, unless an exception applies. The Buy American Act applies to direct procurements made by FHWA, i.e., government contracts entered into between FHWA and the contractor for goods, services or construction.

The second program is the Buy America program. This program applies to FHWA’s federal-aid highway program. As a condition to receiving federal assistance, FHWA grantees must agree to comply with FHWA’s Buy America requirements.

In 2012, Congress enacted the Moving Ahead for Progress in the 21st Century Act (MAP-21).3 MAP-21 funds surface transportation programs for fiscal years 2013 and 2014. Section 1518 of MAP-21 provides that FHWA’s Buy America requirements apply to all contracts eligible for FHWA Title 23 assistance within the scope of a finding, determination or decision under the National Environmental Policy Act (NEPA)4, regardless of funding source, if at least one contract within the scope of the same NEPA document is funded with Title 23 funding.5 As of October 1, 2012, if one contract within the scope of a NEPA document is awarded using

On December 21, 2012, the Federal Highway Administration’s (FHWA) Associate

Administrator for Infrastructure sent a Memorandum to the FHWA Division offices

clarifying the application of the Buy America requirements to manufactured products

used on federal-aid highway contracts.1

federal-aid funding, then the Buy America requirements apply to all contracts within the scope of the NEPA document, regardless of the source of funding.6 In other words, if Title 23 federal funds are used for any activity within the scope of a NEPA decision, the Buy America requirements apply to the entire project. Thus, MAP-21 has the potential to significantly expand Buy America coverage to construction contracts that are not even funded with federal-aid money.

FhWa’s buy america requirements

Section 165 of the Surface Transportation Assistance Act of 1982 (STAA) contains the basic Buy America statute applicable to federal-aid highway construction projects.7 Section 165(a) states in pertinent part:

Notwithstanding any other provision of law, the Secretary of Transportation shall not obligate any funds authorized to be appropriated to carry out the Surface Transportation Assistance Act of 1982 (96 Stat. 2097) or this title and administered by the Department of Transportation, unless steel, iron, and manufactured products used in such project are produced in the United States.8

Under the STAA, the Buy America domestic preference applies to steel and iron products that are to be permanently incorporated into the project. The Buy America requirements do not apply to steel and iron products that are used on a temporary basis for the construction work, such as sheet piling, scaffolding and falsework.9 The Buy America requirements also do not apply to materials that remain in place at the contractor’s convenience.10

In 1991, the FHWA Buy America requirements were expanded to cover coatings applied to steel and iron.11 A coating is any process that protects or enhances the value of a material or product to which it is applied.12 Coatings include epoxy coating, galvanizing and painting. All coatings must be applied in the United States. The coating material itself, however, is not subject to the Buy America requirements and may be a foreign product.13

FhWa issUEs nEW GUidanCE on its bUy aMEriCa rEQUirEMEnts For ManUFaCtUrEd ProdUCts

lori annlange

buy america Waivers

Section 165 contains a provision authorizing FHWA to waive the application of the Buy America requirements where:

• Application would be inconsistent with the public interest;

• The materials and products are not produced in the United States in sufficient and reasonably available quantities and of a satisfactory quality; or

• Inclusion of domestic material will increase the cost of the overall project contract by more than 25 percent.14

The exception to the Buy America requirement for a 25 percent cost increase applies only when the state or local government contracting agency elects to include alternate bid provisions for foreign and domestic steel and iron materials.15 Any procedure for obtaining alternate bids must be acceptable to the FHWA Division Administrator. In addition, the procedure must include contract provisions that: (1) require all bidders to submit a bid based on furnishing domestic steel and iron materials; and (2) clearly state that the contract will be awarded to the bidder that submits the lowest total bid based on furnishing domestic steel and iron materials, unless such total bid exceeds the lowest total bid based on furnishing foreign steel and iron materials by more than 25 percent.16

State and local government contracting agencies may request a waiver of the Buy America provisions for specific projects and/or specific materials or products in specific locations. Alternatively, FHWA can issue a nationwide waiver. For example, in 1994, FHWA issued a nationwide waiver for specific ferryboat parts.17 In 1995, FHWA issued a nationwide waiver for pig iron, reduced/processed/pelletized iron ore and raw alloys, due to a lack of an adequate domestic supply.18

Minimal Use Exception

There also is a minimal use exception to the Buy America requirement. FHWA permits the minimal use of foreign steel and iron materials on construction projects. To qualify as minimal, the cost of the foreign materials cannot exceed one-tenth of one percent (0.1%) of the total contract cost, or $2,500, whichever is greater.19 For purposes of this exception, the cost is the value of the steel and iron materials as they are delivered to the project.20

In a 1989 Memorandum, FHWA provided guidance on how the minimal value is to be calculated when domestic steel has been shipped to a foreign country to facilitate one or more manufacturing processes and/or a product has been fabricated with foreign steel components, as well as other components.21 By way of example, FHWA explained that, if steel billets produced in the United States are sent out of the United States for a subsequent manufacturing process and then brought back into the United States, the full

value of the steel as it reenters the United States (including the original billet cost) is considered to be foreign. In other words, the steel billets lose their domestic status by undergoing a manufacturing process outside of the United States. If foreign steel components are combined with other components into a composite product, the foreign steel content of the composite product is the value of the foreign steel components plus the pro rata value of the fabrication and assembly labor and overhead used in combining the foreign steel and other components into the finished composite product.

application of the buy america requirement to Manufactured Products

Section 165 makes no distinction between manufactured products in general and manufactured products containing steel or iron. In 1983, however, FHWA issued a public interest waiver waiving the Buy America requirements for all manufactured products except steel and iron manufactured products.22 Manufactured products that do not include any steel or iron components are exempt from FHWA’s Buy America requirements. Steel and iron manufactured products themselves still must comply with the Buy America requirements.

In 1997, FHWA issued a Memorandum clarifying that FHWA considers a man ufactured product to be any item that must undergo one or more manufacturing processes before it can be used in a highway project.23 A manufactured product can be a stand-alone product (such as rebar and structural steel) or a component within a more complex manufactured product (such as steel wire mesh or steel reinforcing components of a precast reinforced concrete pipe).

For steel and iron products, all of the manufacturing processes, including the application of coatings, must occur in the United States.24 Manufacturing is any process that modifies the chemical content, physical shape or size, or final finish of a product.25 It includes rolling, extruding, machining, bending, grinding, drilling and coating.26

FHWA has stated that manufacturing begins with the initial melting and mixing, and continues through the bending and coating stages.27 The manufacturing process for steel or iron materials is complete, and a steel or iron product or component is produced, when all grinding, drilling and finishing of the steel or iron material have been accomplished.28 If a domestic steel or iron product is taken out of the United States for any manufacturing process, it becomes foreign steel or iron and no longer qualifies as domestic.29

The Buy America requirements apply to any steel or iron component of a manufactured product regardless of the overall composition of the manufactured product if the man ufactured product is

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predominantly made of steel or iron. In other words, FHWA’s Buy America requirements apply to steel and iron components of a predominantly steel or iron product. Steel and iron components of a predominantly steel or iron product must be manufactured in the United States unless the value of all foreign steel or iron is less than the minimal use threshold for the project.

the december 21, 2012 FhWa Memorandum

FHWA’s manufactured products waiver has resulted in much confusion, especially with regard to whether a product is predominantly made of steel or iron. As a result, on December 21, 2012, FHWA issued a Memorandum seeking to clarify the application of the waiver. The Memorandum states that, in order for a manufactured product to be subject to the Buy America requirements, the product must be manufactured predominantly of steel or iron. FHWA deems a product to be manufactured predominantly of steel or iron when the product consists of at least 90 percent steel or iron content when delivered to the job site for installation.30

FHWA identified the following products as examples of products subject to the Buy America requirements:

• Steel or iron products used in pavements, bridges, tunnels or other structures, which include, but are not limited to: fabricated structural steel, reinforcing steel, piling, high-strength bolts, anchor bolts, dowel bars, permanently incorporated sheet piling, bridge bearings, cable wire/strand, pre-stressing/post-tensioning wire, motor/machinery brakes and other equipment for movable structures;

• Guardrail, guardrail posts, end sections, terminals and cable guardrail;

• Steel fencing materials and fence posts;

• Steel or iron pipe, conduit, grates, manhole covers and risers;

• Mast arms, poles, standards, trusses and supporting structural members for signs, luminaires or traffic control systems; and

• Steel or iron components of precast concrete products, such as reinforcing steel, wire mesh and pre-stressing or post-tensioning strands or cables.

FHWA stated that miscellaneous steel or iron components, subcomponents and hardware necessary to encase, assemble and construct the components listed above (as well as manufactured products that are not predominantly steel or iron) are not subject to the Buy America requirements. Examples of these miscellaneous items include cabinets, covers, shelves, clamps, fittings, sleeves, washers, bolts, nuts, screws, tie wire, spacers, chairs, lifting hooks, faucets and door hinges.

Conclusion

Contractors and subcontractors per forming work on construction projects that are funded in whole or in part with FHWA federal-aid funds must ensure that all but a minimal amount of the steel and iron that are permanently incorporated into the project is domestic steel and iron. For manufactured products, the contractor or subcontractor needs to determine whether the manufactured product is predominantly (90 percent or more) made of steel or iron. If the manufactured product is predominantly made of steel or iron, then the contractor or subcontractor must supply a domestic product. To qualify as domestic, all of the manufacturing processes for the steel or iron, including the application of coatings, must be performed in the United States. n

1 December 21, 2012 Memorandum on Clarification of Manufactured Products under Buy America, HIPA-30. The Memorandum is available at http://www.fhwa.dot.gov/construction/contracts/121221.cfm.

2 41 U.S.C. §§ 8301-8305. 3 P.L. 112-141, 126 Stat. 574. 4 42 U.S.C. §§ 4321, et seq. NEPA requires that all federal agencies prepare detailed

environmental impact statements assessing the environmental impact of, and alternatives to, major federal actions significantly affecting the environment.

5 23 U.S.C. § 313(g). 6 As of the date of this article, FHWA has not yet issued proposed regulations implementing MAP-21. 7 23 U.S.C. § 313. 8 Cement initially was included in the list of items subject to Buy America requirements but

subsequently was removed in 1984 by Public Law 98-229, 98 Stat. 56. 9 FHWA’s Contract Administration Core Curriculum Participant’s Manual and Reference Guide

2006, § II.B.1. The manual is available at http://www.fhwa.dot.gov/programadmin/contracts/core02.cfm.

10 Id. 11 Section 1041(a) of the 1991 Intermodal Surface Transportation Efficiency Act, Pub. L. 102-

240, 105 Stat. 1914. See also, 23 C.F.R. § 635.410(b)(1). 12 FHWA’s Buy America Q & A for Federal-aid Program, Q&A No.14. The Q&As are available at

http://www.fhwa.dot.gov/construction/contracts/buyam_qa.cfm. 13 Id. 14 23 U.S.C. § 313(b). 15 23 C.F.R. § 635.410(b)(3). 16 Id. 17 59 Fed. Reg. 6,080 (Feb. 9, 1994). The waiver covers marine diesel engines, electrical

switchboards and switchgear, electric motors, pumps, ventilation fans, boilers, electrical

controls and electronic equipment. 18 60 Fed. Reg. 15,478 (Mar. 24, 1995). The waiver permits the use of foreign pig iron and

reduced/processed/pelletized iron ore to be incorporated into domestic steel and iron products. It also permits foreign source raw alloys to be incorporated into domestic steel and iron products.

19 23 C.F.R. § 635.410(b)(4). 20 Id. 21 July 6, 1989 Memorandum on Buy America Requirements, HHO-32. The memorandum is

available at: http://www.fhwa.dot.gov/programadmin/contracts/070689.cfm. 22 48 Fed. Reg. 53,099 (Nov. 25, 1983). In its final rule implementing Section 165, FHWA noted

that its previous Buy America regulation did not cover manufactured products and that Congress had not specifically directed a policy change in the STAA. FHWA also noted that Congress’ primary concern in enacting Section 165 was to protect the domestic steel industry.

23 December 22, 1997, Memorandum on Buy America Policy Response, HNG-22. The memorandum is available at http://www.fhwa.dot.gov/programadmin/contracts/122297.cfm.

24 23 C.F.R. § 635.410(b)(1). 25 FHWA’s Contract Administration Core Curriculum Participant’s Manual and Reference Guide

2006, § II.B.1. 26 Id. 27 Quick Facts about “Buy America” Requirements for Federal-aid Highway Construction,

available at http://www.fhwa.dot.gov/programadmin/contracts/b-amquck.cfm.28 Buy America Application to Federal-aid Highway Construction Projects (July 9, 2002),

available at http://www.fhwa.dot.gov/programadmin/contracts/buyamgen.cfm. 29 FHWA’s Buy America Q and A for Federal-aid Program, Q&A No. 46. However, the domestic

steel and iron products may be shipped overseas strictly for physical assembly without impacting their domestic status.

30 The job site includes the sites where any precast concrete products are manufactured.

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todd n. bressler, Partner and alex r. baghdassarian, Partner

thE ChanGinG landsCaPE oF ContraCtUal indEMnity:

CaliFornia is thE latEst JUrisdiCtion to liMit indEMnity obliGations

todd n. bressler

alex r. baghdassarian

Contractual indemnity can take many forms, but the enforceability of such provisions varies widely, depending on the scope of the indemnity obligation and the state in which it is being enforced. To understand whether a particular indemnity clause is enforceable, one first must understand the different types of indemnity provisions and how they may be classified in that jurisdiction. For example, some agreements provide a comparative fault or negligence scheme to trigger a party’s indemnity obligations, while others may simply require an indemnitor to agree to indemnify an indemnitee for all losses, regardless of fault. In this respect, some jurisdictions generally distinguish indemnity clauses based on whether the provision offers coverage to the indemnitee for both passive and active negligence (Type I), for passive negligence only (Type II), or if it bars indemnity in the case of any negligence on the part of the indemnitee (Type III).

In California, historically, construction contracts that required a party to indemnify another for construction defects or damages to persons or property resulting from the indemnitee’s sole negligence or willful misconduct were void and unenforceable as against public policy. Parties were allowed to include an express provision allowing indemnification in the event of active negligence; however, if the parties included a “general” indemnity clause within their contract, requiring the

indemnitee to be held harmless from any cause (without reference to any degree of the indemnitee’s negligence), an indemnitee was not allowed to derive the benefit of such a broad provision if it was deemed to have been actively negligent.1

So how does one distinguish between active and passive negligence? Consider the following examples, in which a contractor has an agreement with a subcontractor for site preparation work:

• Active Negligence – The contractor’s foreman directs the subcontractor’s excavator operator to dig bollard holes in a certain location and then informs the subcontractor’s superintendent that he, the contractor’s foreman, will take care of covering the holes. A site inspector then trips and falls into one of the uncovered bollard holes. The contractor’s negligence is considered active because it arises from its failure to perform a duty that it had specifically undertaken by informing the subcontractor where to dig the holes and telling the subcontractor that the contractor’s own crew would cover the holes.

• Passive Negligence – In contrast, the contractor provides the subcontractor’s superintendent with a set of drawings that designate the placement of the bollard holes, but the subcontractor’s excavator operator digs the holes along a line that is five feet to the east of what is shown in the drawings. Before the subcontractor has an opportunity

to cover the holes, the site inspector trips and falls into one of the holes. The subcontractor’s negligence in digging the holes in the wrong location would constitute active negligence, whereas the contractor’s negligence would be deemed passive, since it is attributable only to its failure to notice the improperly placed and uncovered holes.

Over the past several years, due to public policy concerns and also as a result of lobbying efforts by insurers and other construction industry organizations, several jurisdictions have implemented legislation that severely limits a party’s right to be contractually indemnified by another when an injury arises due to the party’s own active negligence, gross negligence or willful misconduct. This group of states includes Florida, Massachusetts, Michigan, Minnesota, New Mexico, New York, Rhode Island, Utah and Washington.2 In 2006, Oklahoma enacted legislation that prohibited a party to a construction agreement from being indemnified for any injury “which arises out of the negligence or fault of the indemnitee.”3 Colorado and Georgia likewise enacted changes prohibiting construction contracts from providing broad-form indemnity coverage in 2007.4 As of 2012, Washington and California became the latest states to join the trend limiting broad-form indemnity provisions, with California’s legislation, SB474, prohibiting the use of contractual indemnity as a means to shift the burden of defending claims onto subcontractors

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for an owner/developer ’s, contractor ’s or construction manager’s own active negligence, both in public and private work projects.

the requirements of sb474

For all construction contracts entered into in California after January 1, 2013, the provisions of Cal. Civ. Code Section 2782 and 2782.05(a) state that contract clauses purporting to require a subcontractor to indemnify a contractor, construction manager or other subcontractor for that person’s own active negligence or willful misconduct are void. Basically, this codifies California’s case law and makes it clear that “general” or “broad-form” contractual indemnity provisions, which fail to limit the indemnitor’s obligations

to instances of only passive negligence, are unenforceable in California. Moreover, the statute does not distinguish between personal injuries and economic losses—for purposes of indemnification, any active negligence would apparently result in a limitation or loss of one’s indemnity rights. The reasons given for the enactment of the statutes by the supporters of the new legislation are that the changes would (1) require parties to undertake responsibility to defend claims resulting from their own negligent acts; (2) lessen the financial burden (and insurance burden) on subcontractors that may not have the same resources available to larger contractors and owner/developers, and (3) promote safety and efficiency in the course of a project by requiring an equitable apportionment of liability for one’s own actions.

The statutes also make it clear that a subcontractor’s indemnity obligations do not arise until after written notice by the contractor or construction manager to the subcontractor, which specifically explains how the claim pertains to the subcontractor’s scope of work and allocates the defense obligations among the parties. The indemnitee must apportion liability on a reasonable basis as soon as it is informed of the claim, so that a subcontractor is not required to take on a greater share of defense costs and obligations than its proportionate share of liability. Of most significant is the right provided to subcontractors in Sections 2782(e)(1) and 2782.05(e)(1) to appoint defense counsel and control the defense of the action, assuming they have accepted a tender of defense and indemnity. If, however, the subcontractor fails to respond to the

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tender of claim (90 days for residential projects; 30 days for commercial projects), it loses its right to control the defense of the action. Finally, Section 2782.05(a) also states that it does not affect the ability of an insurer to assert its right of subrogation to seek reimbursement from contractors or subcontractors that are liable for the damages at issue.

Although public and private owners, as well as contractors and construction managers, can no longer shift the burden of indemnity and defense for their own active negligence onto lower-tier subcontractors, the parties are otherwise free to contract for specific obligations and protections that are not contrary to the terms of the statute.

Specifically:

• Parties can require the purchase of additional insurance;

• Parties can agree on the timing and immediacy of indemnity and defense obligations, subject to the statutory requirements pertaining to notice, allocation and the opportunity for a subcontractor to retain counsel of its choosing and control the defense of the claim, and, in the event the subcontractor fails to perform such obligation, it may be liable to the contractor and construction manager for compensatory damages and reasonable attorneys’ fees;

• Parties can contract for additional obligations with regard to passive negligence of the owner/developer or contractor; and

• Parties may be able to reallocate the

apportionment of defense costs as additional facts are developed.

However, choice-of-law provisions that designate the use of another jurisdiction’s laws will not be effective if the construction project is located in California.

recommendations: how to Cover your bases

In view of this new law, owner/developers, contractors and construction managers performing work in California should ensure that the indemnity clauses in their construction agreements do not require their lower-tier contractors to indemnify them against their own “active” negligence, and are not otherwise drafted such as to provide so-called broad-form coverage. Agreements should acknowledge that the parties’ indemnity obligations are to be interpreted and limited in light of California law, and, preferably, go so far as to expressly reference Civil Code sections 2782 and 2782.05. The parties should state that the subcontractor has a specified, but reasonable, period of time in which to respond to a tender to undertake to defend the claim—failing to do so allows the owner/developer, contractor and construction manager to select counsel and control the defense of the claim. When notified of a claim, inform the subcontractor of the allegations relating to its scope of work and, subject to a later reallocation, apportion the costs of defense on a reasonable basis with respect to the subcontractor’s potential liability and that of other defendants. Finally, one should not overlook the possibility of an OCIP, CCIP (owner- and contractor-

controlled insurance programs) or an Owner’s Protective Professional Indemnity Policy for design-build projects, with subcontractor participation, to avoid some of the pitfalls inherent in the notice and compliance requirements for indemnity of claims mandated by SB474.

In order to trigger a lower-tier contractor’s indemnity obligations, one should make sure to have internal procedures in place to comply with the written notice and allocation requirements of SB474 before facing a claim. The first step is always to directly tender the defense of any claim to your subcontractor and its insurer as an “additional insured” under specified policies. Notwithstanding this, early and creative attempts are encouraged to resolve all claims prior to engaging in litigation. Initial proactive measures to be prepared to handle claims are more critical now than prior to the enactment of SB474. Bear in mind that once a subcontractor accepts a tender of defense under SB474, within the time frame set forth in the contract, the subcontractor will, thereafter, control the defense with counsel of its choosing. As suggested above, there are creative and proactive ways to deal early on with these issues and potential obstacles, rather than waiting until one is faced with a claim. n

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1 Rossmoor Sanitation, Inc. v. Pylon, Inc., 13 Cal. 3d 622, 628-629 (1975). 2 Cal. Civ. Code §2782; Fla. Stat §725.06; Mass. Gen. Laws, Ch. 149, §29C; Mich. Comp. Laws §691.991; Minn. Stat. §§337.01 and 337.02; N. M. Stat. §56-7-1; N.Y. Stat. §5-322.1; R.I. Gen. Laws 6-34-1;

Utah Code §13-8-1 (subject to exception that permits indemnity of owner); Wash. Rev. Code §4.24.115. 3 Okla. Stat. §15-221 4 Colo. Rev. Stat §13-50.5-102 and §13-21-111.5; Ga. Code §13-8-2(b)

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Eight years after the New Jersey Supreme Court’s holding, the Appellate Division issued a decision in the matter entitled L&W Supply Corp. v. DeSilva2, which examines the Craft decision and reaches conclusions concerning its lasting impact that are sure to provoke debate.

the supreme Court’s decision in Craft

In Craft, a homeowner hired a general contractor to construct a residence. In connection with the project, the contractor purchased lumber from a supplier. The

contractor had previously purchased lumber from this supplier for other projects and had open accounts with the supplier.

During the course of the project, the homeowner made payments to the contractor, which, in turn, made payments to the lumber supplier. When the lumber supplier received payments from the contractor, it applied those payments to the balances due on all of the contractor’s open accounts with the supplier, not just toward the balance owed by the contractor for the homeowner’s specific project.

scott G. Kearns, associate

scott G. Kearns

On these facts, the New Jersey Supreme Court held that “a supplier has a duty to determine which of a contractor’s projects is the source of its payment and to allocate the payment accordingly.”3 This duty exists “regardless of a debtor’s [allocation] instruction, or lack thereof.”4 If the supplier fails in that duty, it “cannot verify the existence of a debt as required under the (Construction Lien Law) and thus no lien claim against the owner’s property can be advanced.”5

This holding, on its face, gave contractors and owners a powerful weapon in their mutual fight against overstated lien

In 2004, the Building Contractors Assoc iation of New Jersey (BCA-NJ), represented by this firm,

submitted an amicus curiae brief to the New Jersey Supreme Court in the matter entitled Craft v.

Stephenson Lumber Yard, Inc. (Craft).1 The BCA-NJ’s arguments in Craft resulted in one of the most

significant decisions to date interpreting New Jersey’s Construction Lien Law (N.J.S.A. 2A:44A-1

et. seq.) and set forth the proofs required for a supplier to establish the validity of its lien claim.

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nEW JErsEy CoUrt ClariFiEs a sUPPliEr’s dUty to alloCatE PayMEnts to sECUrE liEn riGhts

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claims. However, in practice, the lower courts have been reluctant to enforce the payment allocation requirements set forth in Craft to the detriment of many innocent building contractors.

the appellate division’s decision in L&W supply Corp.

In December 2012, the Appellate Division issued its decision in L&W. It was the first meaningful decision by the Appellate Division addressing the payment allocation requirement since Craft was decided by the New Jersey Supreme Court eight years ago.

In L&W, a materials supplier, L&W Supply Corporation (L&W), sold building materials to a now-bankrupt subcontractor, known as Detail Contractors, Inc. (Detail). When Detail failed to pay L&W in full for the materials, L&W filed a construction lien claim (Lien) against the project for which the materials were supplied in the sum of $127,834.89.

L&W commenced a lawsuit against the general contractor (Patock Construction Co., Inc.), the property owner and the surety, seeking to foreclose upon its construction lien claim and recover sums allegedly owed to it by Detail. During the course of the litigation, it was discovered that L&W had many open accounts with Detail (or related companies) during the relevant period. Although L&W received $217,000.00 from Detail, it credited only $103,959.45 to the project at issue. The remaining $113,040.55 was applied to pay down L&W’s other open accounts with Detail.

L&W ultimately moved for, and was granted summary judgment for the amount demanded in its construction lien claim ($127,834.89) plus prejudgment interest. The general contractor and owner appealed the decision and award.

On appeal, the general contractor and owner argued that summary judgment should not have been granted since

L&W had failed to prove that payments from Detail were properly allocated to the project from which they were derived as required under Craft. The Appellate Division reversed the trial court’s order granting summary judgment to L&W, finding that issues of material fact existed as to whether L&W had fulfilled its payment allocation obligations under Craft.

the appellate division limits a supplier’s allocation duty Under Craft

Although the Appellate Division ultimately ruled in favor of the owner and general contractor in L&W, the Appellate Division’s decision, in many respects, favors suppliers since it places significant limitations upon their allocation duties that were not previously apparent in Craft.

The holding in L&W acknowledges and claims to follow Craft insofar as it reiterates that a supplier has a duty to

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ascertain the source of the payments it receives and to allocate those payments correctly.6 However, the court interprets Craft as imposing this duty upon a supplier only “if the supplier ‘knows or should know’ the source of the payment” it received.7 Upon this questionable interpretation of Craft, the Appellate Division framed the issue on appeal as being “. . . the lengths to which a supplier must go to discharge its [Craft] duty to allocate payments accurately.”8 As to this question, it held:

In sum, we hold that, when the purchaser of mater ials has not provided specific, reliable instructions as to the allocation of its payments, or when the circumstances are such that a reasonable supplier should suspect the purchaser has not used an owner’s funds to pay for materials supplied for that owner, then the supplier must make further inquiry and attempt to ascertain the source of the payment funds so that it can allocate them to the correct accounts. A supplier that fails to fulfill this duty sacrifices its rights under the Construction Lien Law.

Does this holding mean that a supplier’s duty to determine the source of the funds it receives is only triggered if (1) it hasn’t been given specific allocation instructions by the materials purchaser, or (2) the supplier knows or has reason to suspect that payments are being misallocated by the purchaser? Also, this decision seems to suggest that the owner and general contractor are to bear the risk of a subcontractor’s incorrect direction to its supplier as to how to apply the funds received—a result that flies in the face of the purpose behind the lien fund concept that the owner and contractor should not have to pay twice for work that has been properly paid for.

Suppliers are certain to promote this interpretation of L&W. General contractors and owners, on the other hand, will argue that L&W is bad law since Craft previously held that a supplier’s allocation duty exists “regardless of a debtor’s [allocation] instruction, or lack thereof.”9

Depending upon the facts of a given case, owners and contractors will either

praise or criticize the Appellate Division’s holding in L&W. On the one hand, L&W is a long-awaited follow-up to Craft insofar as it acknowledges a supplier’s duty to allocate payments correctly. On the other hand, and perhaps more importantly, L&W places significant limitations upon a supplier’s allocation duty that many will argue were not intended by the New Jersey’s Supreme Court’s holding in Craft. n

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1 179 N.J. 56 (2004). 2 429 N.J. Super, 179 (App. Div. 2012) 3 Craft v. Stephenson Lumber Yard, Inc., 179 N.J. at 63. 4 Id. at 63, 74.

5 Id. at 77. 6 L&W Supply Corp. v. DeSilva, 429 N.J. Super at 188-90 7 Id. at 188-9 8 Id. at 188 9 Craft, 179 N.J. at 63, 74.

Co-Editors | CharlEs F. KEnny, PartnEr and MiChaEl s. ZiChErMan, PartnEr

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legal and political framework for public-private partnerships with the experience of having handled big-ticket government contracts and construction litigation. His knowledge and respect for the political issues in public-private partnership deals have led to successful collaborations with key government officials.

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