Termination, Warranty Claims and Back Charges

For this week’s Guest Post Friday here at Musings, we welcome Jim Fullerton. Jim is the President of the law firm of Fullerton & Knowles, P.C., which has attorneys licensed in Virginia, Maryland, Pennsylvania, and the District of Columbia, is a Martindale Hubbell Peer Rated Lawyer AV® Preeminent. The firm represents owners, lenders, design professionals, suppliers, subcontractors, general contractors and other members of the real estate and construction industries, filing mechanic’s liens, surety bond and other construction claims across all of the states in the Mid Atlantic region. He also represents creditors in bankruptcy issues nationwide, particularly defense of bankruptcy preference claims; advises owners and lenders in real estate lending and acquisition transactions; on all real estate and construction law issues; contract formation and disputes.

The firm’s Construction Law Survival Manual is well known and widely used by participants in the construction process. The 550 page manual provides valuable information about construction contract litigation, mechanic’s liens, payment bond claims, bankruptcy and credit management and contains over 30 commonly used contract forms. All of this information and recent construction law issues are constantly updated on the firm’s website.

Rightful Termination

If the contractor has been rightfully terminated, the contractor has no claim against the owner for damages. Under a properly drafted contract, the terminated contractor may be liable for the costs of completion after termination and other damages.

Wrongful Termination

By terminating a contractor, the owner runs a considerable risk that the termination will be found “wrongful.” This is a primary reason why owners want to provide contractors an opportunity to cure any default. An owner who has wrongfully terminated can be liable for requisitions and retention that should have been paid, expenses for idle labor and unused materials, and lost profit for labor and material actually supplied on the project. An owner that has wrongfully terminated a contract may not be able to recover for the costs of completing or correcting work and may be liable for lost profit on the terminated portion of the contract.

Another possible penalty to the owner for wrongful termination is that the contractor can sue the owner for unjust enrichment. If the owner has received a benefit from the contractor’s services and refuses to pay for that benefit, then he has been unjustly enriched by the value of those services. The contractor may sue to recover the value of his services (quantum meruit) and the value of the materials he provided (quantum valebat). The value of the contractor’s work may be greater than the contract price if the bid was low.

Both the owner and the contractor should make every effort to document the progress of the work upon termination, whether the termination is rightful or wrongful. Photographs are the easiest and most important part of this, along with a scheduling analysis. The contractor and owner should also create detailed estimates of the cost to complete the work, and each may want to hire an independent expert to view the project at an early stage. This can be very important for each side in the event of litigation.

Termination for Convenience

The termination for convenience clause is the owner’s best weapon against a claim for wrongful termination. This clause was originally created by federal agencies and appeared only in government contracts. It has become more popular, however, in private contracts.

Termination for convenience means exactly that: The owner can terminate a contractor for any reason when it is in the owner’s best interest. Most clauses state that the contractor will be entitled to compensation for work done prior to termination together with earned profit. Most contracts also state that if any termination for default turns out to be wrongful, then it will automatically be deemed a termination for convenience. If this happens, the owner may be financially responsible for work completed and earned profit but will not be liable for other consequential damages or unearned profit.

There are limits to the right to terminate for convenience, primarily the implied duty to exercise the right of termination in good faith and in accordance with fair dealing. This is true even for public owners, but probably even more true for private owners. For example, an owner cannot terminate a contractor just because the owner is able to get a better price elsewhere.

Warranty Claims

If there is no written contract defining the warranties in a construction contract, the common law (court case law) would imply a warranty that the work should be done in a reasonably good and workmanlike manner.

The AIA Document A107-1997 warranty provision speaks in terms of a one year obligation. However, it is a mistake for a contractor to believe that they only have a one year obligation to correct defective work. The “statute of limitations” for breach of a written contract is five (5) years in Virginia and three (3) years in Maryland. The statute of limitations is the maximum period of time to file a lawsuit for breach of contract. If an owner can prove that labor or material was defective and was a breach of the contract at the time it was installed, the owner would have this five or three year period of time to file suit for the costs of corrective work.

Parties to a private contract can agree to shorten the statute of limitations for a breach of the contract. However, a one year warranty provision like the one above does not shorten the statute of limitations. It would be necessary to specifically state that the “statute of limitations will be one year.” In fact, there is a good chance that the one year warranty provision lengthens by one year the time to file suit. A breach of the warranty provision could occur if a contractor failed to correct work one year after completion and then the owner would have the five or three year statute of limitations time period after that to file suit.

The difference between a breach of contract claim and a breach of warranty claim is not clear in a labor and material contract. It would seem that any breach of warranty would be a breach of contract. Perhaps a breach of warranty is a type of “no fault” claim. The contractor agrees for one year to correct any work “not in accordance with the requirements of the Contract Documents.” Perhaps an owner does not need to prove that the nonconforming work was the fault of the contractor for this one year period, but must prove a breach of the contract by the contractor after one year.

The Uniform Commercial Code, a part of most state codes, defines a breach of warranty in the sale of construction materials, although those UCC warranties can be modified by a purchase order or other contract to warranties similar to those in a labor and material contract.

Back Charge Damages

As discussed above, the owner runs a considerable risk in terminating a contractor. If the owner breaches the contract by “wrongfully” terminating a contractor, the owner has committed the “first breach” and may not be able to enforce the contract against the contractor to get costs of completion or correction. Wrongful termination most often occurs by an owner who simply does not read the contract provisions and fails to follow the termination procedure.

When a subcontractor fails to keep his agreement, the measure of damages will normally be the amount necessary to put the non-breaching party in as good a position as if the contract had been performed. The non-breaching party must prove their damages with reasonable certainty, but not with mathematical certainty. The non-breaching party is required only to enable the court to make an intelligent and probable estimate of the damages sustained.

The contract will often dictate or modify the costs that can be charged against the defaulting subcontractor. Owners and general contractors are also often guilty of not reading these contract provisions and seeking unallowable back charges. If a contract says only that the breaching contractor will “be responsible for all of the costs” of the defect, then “costs” do include profit on the corrective work and may not include overhead either. Similarly, there is much argument whether in house supervisors and laborers are a cost at all, whether their regular hourly rate would be a “cost,” or only their direct payroll. An owner or general contractor can solve these problems with contract terms stating that a defaulting subcontractor is responsible for all out of pockets costs, supervisors and laborers at their regular hourly rates, plus twenty per cent (20%) overhead and profit.

An owner or general contractor will have the “burden of proof” to prove their damages against a defaulting subcontractor. If they fail to put on sufficient proof, they will lose in a court of law, even if it is clear that the subcontractor did default. Of course, the burden of proof is really only relevant in a court trial. In negotiations, a debtor owner or general contractor has a tremendous advantage against a creditor subcontractor or supplier. The debtor has possession of all the labor and material and possession of all the money. The creditor is often forced to make considerable accommodation in negotiating the exact amount of back charges, because of this leverage.

Direct and Consequential Damages

The types of damage incurred in a contract action include “direct” and “indirect” damages. Direct damages are those which arise “naturally” or “ordinarily” from a breach of contract. They are damages that can be expected to result from a breach in the ordinary course of human experience. “Indirect” damages, also called “consequential” damages arise from the intervention of “special circumstances” not ordinarily predictable.

If damages are direct, they are compensable. If damages are consequential, they are compensable only if it is determined that the special circumstances were within the “contemplation” of both contracting parties or were “predictable.” Whether damages are direct or consequential is a question of law. Whether special circumstances were within the contemplation of the parties is a question of fact.

It is often difficult to determine whether damages are direct or consequential. Court case law is sometimes conflicting and confusing. Commonly identified examples of consequential damage, however, would be lost profits or lost opportunities to pursue other business, where no contract yet exists. It is possible to waive the right to consequential damages in a contract.

Cost or Value Measure of Damages

There are sometimes arguments whether the proper measure of damages for defective construction is the cost to rectify the work or the reduction in value of the building with the defects. If some imbedded construction material did not comply with the contract, the cost to rectify the work can be huge compared to the minor reduction in value of the building because of the nonconforming work. The owner is entitled to the cost of correction, unless that cost “is grossly and unfairly out of proportion to the good to be attained.” When that is true, the measure is the difference in value.

These two methods of determining monetary damages in breach of construction contract cases are called the “cost rule” which is the cost of correcting the defects in the construction and making it conform to the terms of the contract and the “value rule” which is “the difference between the value of the structure properly completed according to the contract and the value of the defective structure. The cost of correction or completion rather than loss in property value is normally the proper basis for measuring the damages, especially where correction or completion would not involve unreasonable destruction of work done by the contractor and the cost would not be grossly disproportionate to the results to be obtained.

As always, Jim and I welcome your comments below. Please subscribe to keep up with this and other Guest Post Fridays at Construction Law Musings.

Print Friendly
Send to Kindle
One Response to Termination, Warranty Claims and Back Charges
  1. […] Termination, Warranty Claims and Back Charges […]

Leave a Reply

Wanting to leave an <em>phasis on your comment?

CommentLuv badge

About Musings

I am a construction lawyer in Richmond, Virginia, a LEED AP, and have been nominated by my peers to Virginia's Legal Elite in Construction Law on multiple occasions. I provide advice and assistance with mechanic's liens, contract review and consulting, occupational safety issues (VOSH and OSHA), and risk management for construction professionals.

Please join the conversation!

More About Musings
Creative Commons License