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Spring 2006

In This Issue: Still an Arbitration Call: CriticalPath U.S. Supreme Rules That Arbitrators, Not , Should Decide the Validity of an Message from the Editor-in-Chief… Allegedly Void or ‘Illegal’ —Page 2 New beginnings… Dealing with Disaster: Lessons from Katrina and Other Natural This is a time for new beginnings. Spring is arriving, trees are Catastrophes—Page 3 blooming, a new baseball season is about to begin, and many Can You Sue the One Who Really parts of the world where our offices are located are shrugging off Screwed Up Your Project? It May the cold for, it is hoped, more than the next six months or so. Depend on Where You Try to Sue We are also beginning a new cycle of issues of The Critical Path, Them—Page 7 following our last Summary Issue. Needless to say, the Have You (And Your Property) developments affecting the industry did not Crossed the FIN-ish Line? FIN 47 slumber. There have been significant rulings from the U.S. – Big or Small Company, This Supreme Court on enforcement of arbitration provisions; from Interpretation Applies to YOU— the state and federal courts on matters involving bad faith claims Page 10 against and the ever-important economic loss doctrine; Bad Faith: A Fresh Look at and from the Financial Standards Accounting Board on the Continuing Debate Over requirements for reporting future anticipated remediation costs in Whether Sureties Should Be buildings. These all can be viewed as new beginnings as we now Considered ‘Insurers’ for Purposes of Bad Faith – adjust and accommodate these rulings in connection with future Part I—Page 12 business endeavors. New beginnings as well are being experienced by the many people, businesses and governments as As BUILT… Look Out Below…And Above! they continue to recover from the dramatic events of 2005. We Recent Pennsylvania Case touch on all of these topics in this issue. Also, in this edition of Emphasizes Importance of “As-Built,” we address the importance of knowing the latest legal Knowing Your Forum When developments when stepping into a new territory or . Crafting and Relying on Pay- In the months to come, we will continue to monitor the new When-Paid Defenses—Page 15 beginnings of other developments impacting your current and

NEW YORK future construction projects. We look forward to reporting them LONDON LOS ANGELES to you in upcoming issues. PARIS SAN FRANCISCO Edward B. Gentilcore WASHINGTON, D.C. Pittsburgh Office PHILADELPHIA PITTSBURGH OAKLAND MUNICH PRINCETON NORTHERN VA WILMINGTON NEWARK MIDLANDS, U.K. CENTURY CITY RICHMOND reedsmith.com Still an Arbitration Call: U.S. Supreme Court Rules That Arbitrators, Not Courts, Should Decide the Validity of an Allegedly Void or ‘Illegal’ Contract

In an important arbitration deci- turn was reversed by the Florida sion affecting a wide variety of Supreme Court, which reasoned businesses, the U.S. Supreme that enforcing an arbitration agree- Court held that a challenge to the ment in a contract challenged as The Buckeye decision validity of a contract containing unlawful would violate state public stands in contrast to state an arbitration provision is to be policy and state contract . decided by the arbitrator, not the court decisions over the The U.S. Supreme Court disagreed, court, as long as the challenge is holding that “regardless of whether past decade, which directed to the contract as a whole a challenge is brought in federal or decisions have attempted and not specifically toward the state court, a challenge to the arbitration provision. Buckeye to weaken the strong validity of the contract as a whole, Check Cashing, Inc. v. Cardegna, presumption in favor of and not specifically to the arbitra- 126 S.Ct. 1204 (Feb. 21, 2006). tion clause, must go to the arbitra- arbitration created by the Reinforcing the arbitration doc- tor.” Id. at 1210. In so holding, FAA. The Supreme Court trine of separability, the court the court reaffirmed three princi- ruled that the allegation that a emphasized that the ples established in its prior deci- contract is “illegal” or otherwise agreement to arbitrate sions in Prima Paint Corp. v. Flood void under applicable state law stands or falls on its own & Conkin Mfg. Co., 388 U.S. 395 does not invalidate the agreement (1967) and Southland Corp. v. merits; a broad allegation to arbitrate. Keating, 465 U.S. 1 (1984). First, that a contract as a whole Buckeye involved a putative class as a matter of substantive federal is void as a matter of state action filed in Florida state court by law, an arbitration provision is an contract law or state public individuals who had entered into agreement to arbitrate that is sepa- policy does not invalidate “payday advance” loan transactions rate from the remainder of the an otherwise enforceable which allow customers to receive contract. Second, unless the chal- immediate cash in exchange for a lenge is to the arbitration clause and applicable agreement post-dated check. Each plaintiff itself, the issue of the validity of to arbitrate. signed a contract that set forth the the contract is considered by the charges and fees, and con- arbitration in the first instance. tained a broad arbitration provision. Third, the Federal Arbitration Act Plaintiffs alleged that Buckeye (“FAA”) is applicable in all cases, charged usurious interest rates and regardless of whether brought in violated various Florida consumer federal or state courts (provided, protection and state lending , of course, the necessary interstate rendering the criminal commerce predicate is satisfied). and therefore void ab initio. The The Buckeye decision stands in court denied Buckeye’s motion contrast to state court decisions to compel arbitration, holding that over the past decade, which deci- the court – rather than the arbitra- sions have attempted to weaken tor – should decide whether the the strong presumption in favor contract, including the arbitration of arbitration created by the FAA. clause, is illegal and void. The state The Supreme Court emphasized appellate court reversed, but it in

2 The Critical Path

that the agreement to arbitrate alleged principal; and whether the within federal circuits and state stands or falls on its own merits; a signor lacked mental capacity to courts will be the validity of class broad allegation that a contract as assent. Id. at 1208, n1. arbitration waivers, remote forum a whole is void as a matter of state selection provisions, and other In sum, Buckeye sends a strong contract law or state public policy direct challenges to the enforce- and important message to federal does not invalidate an otherwise ability of agreements to arbitrate. and state courts reaffirming the enforceable and applicable agree- separability of arbitration provi- Albert Bates Jr. ment to arbitrate. Further, the sions and the supremacy of the Pittsburgh Office court made clear in a footnote that FAA over contrary state law. it was not addressing the issue of Given the holding in Buckeye, the Editor’s Note: who decides whether an agreement next frontier for those seeking to Albert Bates Jr. is a “was ever concluded” between the avoid the arbitration process will Partner in the parties. The court specifically be challenging whether the arbitra- Construction declined to address court-of- Industry Group at tion agreement itself is uncon- decisions holding that a Reed Smith, and scionable under applicable state court, not an arbitrator, should serves as the Leader contract law. Until further direc- decide whether the obligor ever of the Reed Smith tion from the Supreme Court, the signed the contract; whether the Arbitration Team. likely divisive issues among and signor lacked authority to bind the

Dealing with Disaster: Lessons from Katrina and Other Natural Catastrophes

Hurricane Katrina and four other strength and a storm surge that munity—the elevation and area powerful hurricanes led the list may have been nearly 40 feet high covered by flood waters that have of natural disasters in the United in some areas. Buildings were a 1 percent chance of being States last year, with federal major wiped away, leaving only founda- equaled or exceeded in any given disaster declarations issued for six tions, and large casino barges were year. This area has become known states. In addition, 37 other major lifted hundreds of feet inland. In as the “100-year flood plain,” but disaster declarations were issued, New Orleans, most of the damage that term is a misnomer, because a number becoming far too typical was caused by flooding after canal such a flood actually could happen in recent years. The date April 18, walls failed and levees were top- more frequently than once every 2006 is the centennial of the great pled. The question of whether the hundred years. The flood maps 1906 Earthquake and Fire in San hundreds of thousands of build- also identify coastal areas that are Francisco, a disaster predicted to ings damaged or destroyed by subject to high velocity wave reoccur. These tragic events raise Katrina can be rebuilt still looms action from storms or earthquakes. issues regarding preparedness and large, though Katrina occurred See, generally, 42 U.S.C. §§ 4001 et response, both of which are impor- more than six months ago. seq. and 44 Code of Federal tant for the construction industry. Parts 59-78. The requirements of the National Rebuilding after Flood Insurance Program Federal law requires the purchase Floods and Hurricanes (“NFIP”) control many aspects of flood insurance for a structure of reconstruction after Katrina. in the 100-year flood plain if it Hurricane Katrina brought two Under the NFIP, the Federal secures a mortgage made by a fed- kinds of devastation to New Emergency Management Agency erally regulated lending institution Orleans and the Gulf Coast. (“FEMA”) maps areas subject to or if federal loans or grants were Coastal areas were hit by high flooding. The maps locate the used to acquire, build or improve winds just below Category 4 “Base Flood Elevation” in a com- continued on page 4

3 “Dealing with Disaster” – continued from page 3

the building. For flood insurance In Gulfport, Miss., the number of to be available, however, each local structures within the 100-year jurisdiction must impose building flood plain doubled. New flood and land-use controls for new con- maps had not been released for struction or “substantial” improve- New Orleans as of this writing, but ment or repair of structures in the many residents will undoubtedly 100-year flood plain, “substantial” face the need to elevate their meaning improvement or repair homes and businesses. costs exceeding half of the previ- The threat from hurricanes has led ous fair-market value of the struc- Federal law requires the some to suggest that parts of New ture. The federal regulations have purchase of flood insurance Orleans and areas along the Gulf detailed requirements for the local for a structure in the Coast should not be rebuilt; but regulations. Among the most that suggestion has caused some 100-year flood plain if it notable are those that forbid con- of the greatest controversy in struction in certain parts of the secures a mortgage made New Orleans. The Association flood plain to permit movement of by a federally regulated of State Floodplain Managers flood water, require buildings be lending institution or if (www.floods.org) advocates an elevated throughout the 100-year approach that would limit uses in federal loans or grants flood plain, and impose special flood plains and suggests relocat- were used to acquire, build controls in coastal areas subject to ing homes and businesses out of hurricanes. Elevation of structures or improve the building. areas subject to repetitive flooding. can be done by raising the level For flood insurance to be Of course, such zoning is subject of the site with fill, or building a to constitutional restrictions on available, however, each higher building so that the lowest takings. However, while restrictive local jurisdiction must inhabited floor is above the level flood plain zoning was recently of the 100-year flood plain. impose building and upheld against a takings challenge Communities can also remove land-use controls for in Gove v. Zoning Board of Appeals areas from the flood plain by new construction or of Chatham, 931 N.E. 2d 865 building levees and other flood (Mass. 2005), it will undoubtedly “substantial” improvement control structures that prevent continue to be the subject of floodwaters from reaching the area or repair of structures in future litigation. the 100-year flood plain, in question. By way of example, “substantial” meaning such structures were built in the Rebuilding after Earthquakes St. Louis area after the 1993 Frequent California earthquakes, improvement or repair Mississippi and Missouri River particularly the 1989 earthquake costs exceeding half of the floods. near San Francisco and the 1994 previous fair-market value As applied to the Gulf Coast and earthquake near Los Angeles, have of the structure. New Orleans, the NFIP rules have led to increasingly strict zoning caused some confusion and fears and building standards. In gener- of economic hardship. Many areas al, these standards apply to new face the need to elevate single-fam- construction and substantial ily homes and other structures. In reconstruction, but some buildings Mississippi, FEMA has prepared must be retrofitted. new flood maps for the entire Gulf California statutes prohibit new Coast, subjecting additional areas construction on active earthquake to the requirements of the NFIP.

4 The Critical Path

faults. Building codes impose The answer varies with local ordi- In October 2005, the Centers for structural design standards on new nances. Some cities have adopted Disease Control and Prevention buildings and substantial improve- regulations permitting reconstruc- (“CDC”) published a report titled, ment of existing buildings, and are tion of non-conforming uses, even “Mold: Prevention Strategies and intended to prevent the collapse of if the building had been complete- Possible Health Effects in the a building in an earthquake, pro- ly destroyed. In New Orleans, Aftermath of Hurricanes Katrina tecting inside the building. buildings with legal, non-conform- and Rita,” available on the CDC The definition of “substantial ing uses destroyed in whole or in Web site (www.bt.cdc.gov/disas- improvement” varies among cities. part by natural disasters may be ters/mold/report/). After noting Hospitals and public safety build- restored as long as there is no linking “several adverse ings face a higher standard; they increase in the floor area or vol- health outcomes” to “materials must be designed to be used for ume over that which existed contaminated with fungal growth,” their intended function after the before the damage. Other exam- the report stated, “[t]here are no earthquake. Existing facilities ples include emergency orders criteria for using either the con- must be rebuilt or replaced, adopted by Oakland, Calif., after centration or type of mold in although the time within which its 1991 fires, which destroyed buildings to make informed deci- the reconstruction must be done 3,000 homes, and an ordinance sions.” It went on to recommend has been extended. The cost of adopted by Santa Monica, Calif., that exposure to mold should be rebuilding hospitals was recently after the 1994 Northridge earth- limited by using personal protec- estimated to be $60 billion. quake. Other cities permit recon- tive gear or by cleaning homes Finally, California law requires struction in the event of partial and buildings, especially heating, cities located within seismically destruction of a non-conforming ventilating and air conditioning active areas to develop a plan for structure, but not if the non-con- systems. The National Institute retrofitting brick and other unrein- forming building has been totally for Occupational Health and forced masonry (“URM”) build- destroyed. The standard is often Safety (part of the CDC) ings. About half of the affected whether the cost to repair exceeds published “NIOSH Interim cites have adopted mandatory a certain percentage of the value of Recommendations for the strengthening requirements, and the structure, sometimes 50 per- Cleaning and Remediation of perhaps two-thirds of the state’s cent. Along the Mississippi Gulf Flood-Contaminated HVAC affected URM buildings have been Coast, the issue has been sub- Systems: A Guide for Building retrofitted. In summary, stricter sumed by the comprehensive plan- Owners and Managers,” which seismic standards apply now and ning effort now underway. The is available on its Web site will apply in reconstruction after lesson is to check local land use (www.cdc.gov/niosh/topics/flood/ the next earthquake. regulations before planning any Cleaning-Flood-HVAC.html). reconstruction activities. Rebuilding Non-Conforming Uses The mere cleaning of buildings is Dealing With Mold not a practical alternative in parts Most cities have buildings contain- of New Orleans, because homes ing uses that do not conform to The flooding caused by Hurricanes and businesses were flooded for current zoning, often because they Katrina and Rita left thousands of weeks. Instead, buildings must were constructed before the zoning buildings subject to mold infesta- have flood-damaged materials was adopted. New Orleans and tion, leading to much public (such as drywall) removed, often the Gulf Coast are no exception. discussion about dealing with gutting the lower portion of the The question that arises is, after mold. Although exposure to mold buildings down to the studs and being damaged in a natural disas- is associated with various adverse structural components, creating ter, can these non-conforming effects on human health, there are millions of cubic yards of moldy buildings be reconstructed? no federal or state standards for debris. Fortunately, moldy debris indoor mold exposures.

continued on page 6

5 “Dealing with Disaster” – continued from page 5

may be sent to an ordinary landfill, Editor’s Note: and the Louisiana Department of Timothy N. Brown, Environmental Quality’s in the Real “Hurricane Katrina Debris Group, focus- In New Orleans, buildings Management Plan” does not treat es his practice on with legal, non-conforming construction and demolition debris real estate and infested with mold as a hazardous . uses destroyed in whole or waste. He has substantial in part by natural disasters experience in advising clients regard- may be restored as long Concluding Thoughts ing environmental and hazardous materials issues in connection with In addition to the sometimes tragic as there is no increase in property sales, acquisitions, develop- the floor area or volume human consequences that follow ment, loans and . Tim also has these natural catastrophes, there over that which existed an extensive background in the pur- is the physical aftermath which chase or sale of office buildings, before the damage. requires months and years of industrial properties, retail properties, Other examples include efforts to overcome the havoc hotels, agricultural properties, land for emergency orders adopted reached in moments sometimes development, and multi-family resi- not longer than days, hours, or dential projects. In land use and by Oakland, Calif., after occasionally even minutes. development matters, he has prepared its 1991 fires, which However, before undertaking any applications and appeared before local destroyed 3,000 homes, efforts of rebuilding, it is essential agencies, obtaining subdivision to determine whether that rebuild- approval, and handling condominium and an ordinance adopted conversion, review and analysis of ing can occur and, if it can, the by Santa Monica, Calif., environmental impact reports, inverse new standards to which the new after the 1994 Northridge condemnation issues, analysis of structures must now adhere. initiatives and referenda regarding earthquake. Other cities Timothy N. Brown* land-use matters, revision of zoning permit reconstruction in the San Francisco Office regulations, and general plans and event of partial destruction development agreements. of a non-conforming *The author would like to acknowl- edge Krista Kim for assisting in the structure, but not if the preparation of this article. non-conforming building has been totally destroyed.

6 The Critical Path

Can You Sue the One Who Really Screwed Up Your Project? It May Depend on Where You Try to Sue Them

Most of the players in major what state is going to be the forum noted that a number of lower state construction projects pretty much for the . The reason this is courts in North Carolina had assume that, except for minor important is because the law is not refused to apply the economic loss local differences, the laws they uniform from state to state regard- rule in the context of a construc- need to worry about are predomi- ing the ability of a contractor or a tion project and had in earlier nately uniform from state to state. project owner to maintain a suit cases allowed direct suits by In one important context, how- for economic losses against a party contractors against design profes- ever, this is not the case. The with whom it had no direct con- sionals based on negligent design following situation, based on an tractual relationship. Two recent or negligent contract administra- actual case in which the author cases illustrate the point. tion. The federal concluded was involved, illustrates the point that although the North Carolina In Ellis-Don Construction, Inc. v. (the names have been changed to Supreme Court had not passed HKS, Inc., 353 F.Supp.2d 603 protect the semi-innocent). on the issue, he was obligated to (M.D.N.C. 2004), a general con- follow the consistent rulings of Ajax Electric Co. signs on to do tractor sued several design firms the lower North Carolina courts, the electrical work for XYZ Prime on a North Carolina hospital permitting direct suits by parties Contractor for the construction of project, alleging that the designers harmed by the negligence of others a major hospital in another state. were negligent in the design of the on a construction project, even in Unfortunately, Ajax discovers after hospital and in their administra- the absence of direct contractual it begins work that the electrical tion of the prime contract, causing privity between the parties. The design provided by the architect’s the contractor to incur substantial designers’ motion to dismiss the consulting electrical engineer, Al extra costs to complete the project. suit was therefore denied. Einstein, is seriously flawed and in The contractor’s contract was with many instances requires equip- the owner, who had a separate A few months later, the Ohio ment that is no longer manufac- contract with the designers, i.e., Supreme Court reached the tured. Ajax attempts to solve the there was no direct contractual opposite result. In Corporex problem by submitting proposed relationship between the contractor Development & Construction equipment that it believes is equal and the designers. The designers Management, Inc. v. Shook, Inc., 835 to what was specified, but Einstein sought to have the suit dismissed N.E.2d 701 (Ohio 2005), a project repeatedly rejects the submittals as on the grounds that, under the owner attempted to sue a concrete not meeting his specification. The “economic loss rule,” the contrac- subcontractor for defective work issues are resolved after months of tor could not maintain a direct suit on the project. The owner claimed wrangling, but by that time Ajax against them. that it suffered economic losses as has suffered severe delays and dis- a result of the subcontractor’s The federal court noted that the ruption to its work and is required negligence. In a split decision, a economic loss rule originally arose to accelerate in order to complete majority of the of the Ohio in the context of the job within the contractually Supreme Court found that the eco- cases. This legal rule basically required time, losing millions of nomic loss rule barred the owner’s provides that a party suffering a dollars in the process. suit. The court noted that the law purely economic loss (i.e., one not of negligence is designed to pro- Ajax, believing that Einstein was involving physical injury to tect against the breach of a duty negligent in creating his design, or property) as a result of the neg- imposed by law, as opposed to the consults with its attorney about ligent design or manufacture of a breach of a duty imposed by con- filing a suit against Einstein for the product, cannot sue the designer tract. The court reasoned that the economic misery he has caused. or manufacturer with whom the parties to a construction project The first important question that plaintiff had no contract, on a neg- the attorney may need to ask is ligence theory. The federal court continued on page 8

7 “Can You Sue” – continued from page 7

enter into detailed contracts allo- S.E.2d 724 (Va. 1987). In Blake, cating the risk of nonperformance, the for the con- and held that liability in such cases struction of a state office building should be governed solely by the attempted to sue the project archi- terms of the parties’ contracts tect for economic damages allegedly rather than by the of resulting from delays caused by the negligence. Because the subcon- architect’s defective design. The tractor’s contract was only with architect’s contract was not, how- the prime contractor, and not the ever, with the contractor but rather owner, the trial court’s dismissal with the owner. The Virginia of the owner’s claim was upheld. Supreme Court ruled that the contractor could not bring a direct Virginia is aligned with In reaching this conclusion, the action for negligence against the majority refused to follow a line the majority opinion in architect because the damages of Ohio cases that permitted the the Ohio case, since it is sought were purely economic losses recipients of the opinions of as opposed to losses occasioned by now well established that accountants to maintain suits personal injury or physical damage Virginia law does not against the accountants for negli- to property. permit a person to gence, even in the absence of a prosecute a damages direct contractual relationship In the later case of Sensenbrenner v. between the plaintiffs and the Rust, Orling & Neale, 374 S.E.2d action for negligent accountants. In the accountant 55 (Va. 1988), the Supreme Court construction or design cases, the courts had ruled that held that a purchaser of property if that person did not such suits were permitted if the could not recover damages for the contract directly with the accountants should have reason- cost to repair a defective indoor ably foreseen that the plaintiffs swimming pool against the sub- party that was negligent. would rely on their opinions. contractor who built the pool and Several of the justices in the the architect who contracted with Corporex case dissented, and the general contractor to design would have followed the rule in the pool. Although leakage from the accountant cases, because the the defective pool had damaged concrete subcontractor should other parts of the property, the have known that the owner would court found that the primary loss be harmed economically if the complained of was the cost to subcontractor’s work was negli- repair the pool. In reaching its gently performed. conclusion that this loss was an “economic loss,” the court relied Virginia is aligned with the majority on products liability principles opinion in the Ohio case, since it is applicable to manufactured goods, now well established that Virginia which provide that an injury to the law does not permit a person to defective product itself caused by prosecute a damages action for neg- the defect in the product is an ligent construction or design if that economic loss. In support of its person did not contract directly ruling, the court stated: with the party that was negligent. The first case to address this issue The plaintiffs here allege was Blake Constr. Co. v. Alley, 353 nothing more than disap-

8 The Critical Path

pointed economic expecta- The practical result of the econom- , it really does tions. They contracted with a ic loss rule as applied in Ohio and make a difference where you or builder for the purchase of a Virginia is that, absent a special your project are located when you package. The package includ- statutory or contractual provision, want to sue that person or entity ed land, design services, and a party seeking to recover damages who really screwed up the project. construction of a dwelling. for defective construction work S. Miles Dumville The package also included a must sue the party with whom it Richmond Office foundation for the dwelling, contracted rather than a more a pool, and a pool enclosure. remote party who may be primari- Editor’s Note: The package is alleged to ly at fault for the defective work. S. Miles Dumville, have been defective—one or On the other hand, in North head of the firm’s more of its component parts Carolina and a number of other litigation practice was sufficiently substandard states, a suit can be brought direct- in the Richmond as to cause damage to other ly against the party primarily office, has more parts. The effect of the failure responsible for the loss, even in than 25 years of of the substandard parts to the absence of a direct contractual experience in the meet the bargained-for level relationship. state and federal courts throughout of quality was to cause a Virginia and in other , The ability or inability to sue a at both the trial and appellate level. diminution in the value of remote party in the chain of con- Miles, who had been a partner at the whole, measured by the tractual relationships can have a Hazel & Thomas, P.C. since 1987, cost of repair. This is a purely significant practical effect in cases joined Reed Smith when the two firms economic loss, for which the in which the party with whom the combined in 1999. He represents law of contracts provides the injured party contracted has business entities in sole remedy. Recovery in become insolvent or is otherwise proceedings, including litigation in all is available only when there federal and state courts and before not susceptible to being sued. In is a breach of a duty “to take administrative agencies, primarily on such cases, if a remote party can- care for the safety of the per- financial, commercial and construc- not be sued because of the applica- son or property of another.” tion contracting disputes. Miles also tion of the economic loss rule, the has experience in representing trade Sensenbrenner, 374 S.E.2d at 58. injured party may, as a practical associations and business clients matter, be left without a means of before the Virginia General Assembly. recovery. Thus, in the world of

9 Have You (And Your Property) Crossed the FIN-ish Line? FIN 47 – Big or Small Company, This Interpretation Applies to YOU

Financial Accounting Standards sites and power plants that obvi- Board (FASB) Interpretation No. 47 ously needed to undergo some kind (FIN 47) took effect December of environmental cleanup in the 2005. This interpretation forces future. However, a closer reading public companies to recognize of FIN 47 and certain papers filed In the past, companies contingent (that is, not known or with and by the Securities have been uncertain about fixed) compliance, cleanup or dis- Exchange Commission (“SEC”) what triggers reporting posal costs associated with facili- warn that there is no exemption for obligations when the ties or equipment being taken out any company, large or small: if your of service, sold, mothballed or company owns an asset with a condi- specifics of an asset’s being retired. The rule change is tional environmental liability (any retirement are unknown part of a broader regulatory trend piece of property, building, lot, ware- (that is, “conditional”). toward requiring greater disclosure house, etc), you are subject to FIN FIN 47 reduces the wiggle of environmental liabilities. The 47. Many companies have heeded provisions of Sarbanes-Oxley the warning in a big way: Ford room by requiring asset applicable to financial reporting Motor Company took a $251 mil- owners to report the can be summed up in four words: lion hit in both its fourth quarter fair value of the asset- Just tell the truth (or face criminal and annual after- profit to retirement obligations as penalties). When FIN 47 is comply with FIN 47 (see http:// viewed in conjunction with the www.corporate-ir.net/ireye/ soon as such liabilities are personal criminal liability provi- ir_site.zhtml?ticker=F&script=412 incurred—i.e., when the sions of Sarbanes-Oxley, directors &layout=-6&item_id=806910) in a owner acquires, builds, and officers of any corporation year that Ford could have used a develops or operates the should sit up and take notice. boost in earnings. asset in the course of FIN 47 effectively requires compa- What is a conditional asset retire- business. As such, even nies to go out and identify all of ment obligation? In simple terms, their conditional asset-retirement it is any legal obligation associated if you cannot reasonably obligations on an asset-by-asset with the asset, even if the cost estimate what it will cost to basis. Also, FIN 47 clarifies that must not be paid right now. The retire that obligation in the owners must quantify and report best example under FIN 47 is future, you need to report it the financial liabilities they repre- asbestos remediation expenses: now and explain the sent as soon as they arise – that is, many structures contain asbestos, when the asset owner acquires, but it is in good condition and uncertainty. builds, develops or operates the removal is not currently required. asset in the course of business. Accounting before FIN 47 would The net effect is that companies likely not have reported this as a will report more liabilities than liability. However, eventual deteri- they did previously and report oration or sale or demolition of the them sooner. property will cause the asbestos removal expense to come home to Initially, most companies took the roost. FIN 47 requires a valuation view that FIN 47 only directly of such expense as of December affected owners of chemical-storage

10 The Critical Path

2005. The asbestos example can Houston-based waste-disposal Securities Litigation or a full-blown easily be broadened to any cost company US Liquids Inc., alleging SEC investigation, the risk is there. which might hit at sale or demoli- the company misled shareholders How FIN 47 and related regula- tion of the property, such as about material environmental lia- tions will affect companies removal of underground storage bilities by failing to adequately depends largely on how they previ- tanks, lead-based paint removal, quantify and report the financial ously have recognized contingent PCB issues, and mercury disposal environmental liabilities in a case obligations. For companies that costs. In addition, under FIN 47, where the company pled guilty in already take pains to recognize the companies are now expected to November 2002 to federal charges fair value of their conditional report detailed valuations of proba- that its Detroit facility dumped asset-retirement liabilities on an ble compliance obligations under toxic waste into the city sewer sys- asset by asset basis, FIN 47’s any federal or state environmental tem in August 1999. The plaintiffs impact will be minimal. But for law or . are seeking unspecified damages, others, complying with FIN 47 fees and costs, as well as rescission could (and should) have momen- In the past, companies have been of common stock arrangements tous implications. uncertain about what triggers and other relief. See also, Collmer reporting obligations when the Jennifer A. Smokelin v. US Liquids, Inc., 268 F.Supp.2d specifics of an asset’s retirement Pittsburgh Office 718 (S.D. Tex. 2003). If that were are unknown (that is, “condition- not unsettling enough, in February al”). FIN 47 reduces the wiggle Editor’s Note: 2004, the U.S. Court of Appeals room by requiring asset owners to Jennifer Smokelin, for the Fifth Circuit upheld the report the fair value of the asset- Counsel in the environmental exclusion in the retirement obligations as soon as Pittsburgh office, company’s D&O insurance poli- represents clients in such liabilities are incurred—i.e., cy—leaving directors and officers a broad range of when the owner acquires, builds, on the hook for penalties and environmental develops or operates the asset in damages. National Union Fire issues, including the course of business. As such, Ins. Co. of Pittsburgh, PA v. US environmental civil enforcement and even if you cannot reasonably esti- Liquids, Inc. 88 Fed.Appx. 725 litigation matters concerning mate what it will cost to retire that Superfund, RCRA, and the Clean (C.A.5 (Tex.), 2004). obligation in the future, you need Water Act, as well as various state law to report it now and explain the In addition to shareholder suits, equivalents. In addition to litigation, uncertainty. companies must satisfy the SEC Jennifer’s practice includes environ- with regard to compliance with mental counseling and due diligence, Additionally, FIN 47 clarifies FASB FIN 47. Recently, the SEC has including brownfield development. 143’s definition of “conditional been issuing comment letters Her environmental counseling experi- asset retirement obligation” to ence encompasses compliance issues, requesting that companies re-do mean legal obligations, the timing corrective action and permitting. their financial statements or make or methods of settlement of which changes in the future. In other may be uncertain. This definition, words, the SEC is pushing compa- in effect, requires companies to nies to estimate costs more com- fully recognize liabilities even if pletely, and to disaggregate their their value is currently unknown. discussion of environmental liabili- Risks for failing to comply with ties, so shareholders can get a FIN 47 include not just potential fuller picture of the issues (and SEC investigations but also poten- liabilities) in play. tial shareholder suits. In at least Although most examples of under- one case, In Re: US Liquids reporting under FIN 47 will likely Securities Litigation, 2002 U.S. involve less dramatic circum- Dist. LEXIS 26713 (S.D. Tex. stances than In Re: US Liquids 2002), shareholders are suing

11 Surety Bad Faith: A Fresh Look at the Continuing Debate Over Whether Sureties Should Be Considered ‘Insurers’ for Purposes of Insurance Bad Faith Statutes – Part I

In recent years, much has been the potential ramifications flowing suretyship contracts and insurance written about the expansion in from a bad faith determination. contracts and the risks covered. the number of asserted For the “obligee” (or the party to As will be explored more fully in against insurers on extra-contrac- whom the bonds were furnished to Part II of this Article, the courts tual claims of “bad faith” conduct. provide protection against default) adopting this latter line of logic While such bad faith actions seeking to recover from a perform- tend to preclude obligees from against insurance companies have ance or payment bond surety, bad asserting claims against sureties. become relatively commonplace,1 faith claims present attractive whether they are proper against remedies and/or negotiating lever- The Decisions Permitting Bad sureties issuing payment or per- age generally not available under Faith Actions Against Sureties: formance bonds has been a subject traditional , such as The Inclusion of Sureties as a of considerable debate among the the threat of punitive damages and Type of “Insurer” courts. The September 2000 the possible recovery of attorney’s The position of the state courts edition of The Critical Path first fees and costs. By contrast, for the first considering the subject of reported on the conflicting case surety companies, the very threat potential surety liability under law on this issue within the limit- of such extra-contractual damages state insurance codes in the 1980s ed context of the Pennsylvania has caused them to mount vigor- and early 1990s tended to equate courts.2 The Critical Path attempt- ous defenses against the recover- surety companies with insurance ed to sort through the develop- ability of these damages. companies and/or emphasize ments in the conflicting the unequal financial resources The Great Divide: Should Sureties in that jurisdiction, and suggested possessed by a surety company Be Treated Like Insurers? a consensus appeared to be devel- compared to the resources of an oping in Pennsylvania adverse to The case law involving obligee obligee/claimant. Indeed, under permitting such bad faith claims bad faith claims generally divides many of the state insurance to be asserted against sureties. into two camps of legal analysis. statutes, surety companies are This two-part article provides an According to the first view, bad often defined as “insurers.” These updated look at this contentious faith claims should be permitted decisions generally permitted area of the law for sureties and against sureties because sureties obligee bad faith claims to be for the contractors and owners are treated the same as insurers for pursued against payment or per- 5 who rely on surety bonds. purposes of state insurance law formance bond sureties. statutes. Under this view, the While claims by the bonded In Dodge v. Fidelity & Deposit threat of bad faith damages is nec- principal/contractor against the Company,6 for example, the essary to redress the potential eco- surety based on alleged improper Arizona Supreme Court permitted nomic imbalance in power that is claims-handling or settlement homeowners who were the oblig- perceived to exist between the practices by the surety may be ees on a performance bond issued surety companies and the obligees the subject of potential bad faith in connection with the construc- asserting claims under the per- claims,3 the issue of whether tion of a residence to maintain an formance or payment bonds. A sureties are subject to tort liability action for bad faith against the second, and opposing, view in the for bad faith claims by obligees surety for the surety’s alleged case law, which will be explored in whose performance or payment refusal to investigate their claim more detail in our next issue of bond claims have been denied because sureties were considered The Critical Path, law argues that remains the subject that has gener- to be insurers under Arizona’s any attempt to equate sureties with ated the most confusion and the statutory scheme. Thus, the court insurers is erroneous because of most scholarly attention.4 This expressly held “a surety has a duty the inherent differences between attention is hardly surprising given to act in good faith in responding

12 The Critical Path

to its obligee’s claims that the prin- er to permit a school district to against sureties that fail to exercise cipal has defaulted.”7 In reaching assert a bad faith claim against a a proper degree of care.”15 this conclusion, the court deter- performance bond surety based on However, the authors did not stop mined that sureties are treated the the reasoning that “[a] special rela- there, but went on to predict that same as insurers under Arizona’s tionship exists between a commer- “the tide appears to be turning as insurance statutes; that permitting cial surety and an obligee that is more states address this issue and a surety to withhold performance nearly identical to that involving hold that sureties should not be of its obligations without reason an insurer and an insured.”12 In liable for common law bad faith.”16 would defeat the purpose for support of this conclusion, the Part II of this Article, forthcoming which “surety insurance” is court observed that, when an in our next issue of The Critical intended; and that imposing tort obligee requests that a principal Path, will explore how the surety damages on a surety who in bad obtain a surety bond, it is essen- companies responded to the initial faith refuses to pay a valid claim tially insuring itself from the volley of bad faith case law by would deter such conduct.8 The potentially catastrophic losses emphasizing the inherent differ- Alaska Supreme Court in Loyal that would result in the principal ences between suretyship contracts Order of Moose, Lodge 1392 v. defaulted on its contractual obliga- and insurance contracts and the International Fidelity Ins. Co.,9 tions.13 Thus, although acknowl- risks covered. Also to be dis- found the Dodge decision to be edging certain differences between cussed is how the sureties have persuasive , and likewise suretyship contracts and insurance been successful in convincing held that an implied covenant of contracts, the court nonetheless courts in key jurisdictions, such good faith and fair dealing exists determined there was a sufficient as California, Texas and between a surety and its obligees parallel in the underlying interests Pennsylvania, to reconsider the on payment and performance to be protected so that imposing notion of whether sureties should bonds, and permitted a bad faith bad faith liability was appropriate. be treated the same as liability claim against the surety. Utilizing Four years later in 2001, and after insurers for state bad faith law similar rationales, a number of performing a nationwide survey purposes. Finally, Part II of this other state and federal courts simi- of the case law on both sides of Article will provide some guidance larly concluded that state insur- the issue, the Superior Court for owners and contractors unsure ance codes permitted bad faith of Delaware agreed with the of how to respond to this changing claims to be asserted against Transamerica court’s assessment landscape regarding bad faith case sureties for bad faith refusal to pay of the issues and likewise held law. out claims under performance sureties should be subject to bad James M. Doerfler and/or performance bonds.10 faith claims under Delaware law in Pittsburgh Office International Fidelity Insurance Although many of the initial deci- Company v. Delmarva Systems sions permitting such bad faith Editor’s Note: Corporation.14 claims were rendered in the 1980s James M. Doerfler, an associate in the and early 1990s, these decisions Coming in Part II: The Sureties have been joined by a number of Pittsburgh office, Strike Back joined Reed Smith more recent court opinions that When the American in 1998 following adhere to this line of reasoning, experience in the and add a response to the criti- Association’s Tort and Insurance Practice Group published its local construction cisms or contrary approaches industry with a commercial electrical Second Edition of The Law of taken by other courts that attempt- contractor. During his tenure in the ed to draw a distinction between Suretyship treatise in 2000, it construction industry, he served as suretyship contracts and insurance included a chapter on “Extra- project manager, estimator and corpo- contracts. For example, in 1997, Contractual Damages.” At the rate secretary, and his responsibilities the Colorado Supreme Court in conclusion of that chapter, the included overseeing numerous com- Transamerica Premier Insurance authors noted that “[a] majority of mercial construction projects. Jim Company v. Brighton School District the states recognize a common law now focuses his practice on general 11 for bad faith 27J, determined that it was prop- continued on page 14

13 “Surety Bad Faith” – continued from page 13

commercial litigation, construction to declare that “[m]ost jurisdictions 980 P.2d 407 (Cal. 1999); see also litigation and construction contract that have considered the issue have Suver v. Personal Serv. Ins. Co., 462 drafting, and insurance coverage recognized a separate cause of N.E.2d 415 (Ohio 1984) (interpret- matters related to construction action in tort for a commercial ing surety bad faith liability applied projects. surety bad faith in processing claims to financial responsibility bonds). made under a surety bond.” See 11 Transamerica Premier Ins. Co. v. 1 One commentator has identified 25 William M. Shernoff, Sanford M. Brighton Sch. Dist. 27J, 940 P.2d 348 states that permit tort recovery in Gage & Harvey R. Levine, (Colo. 1997) the insurer-insured context. “Insurance Bad Faith Litigation” 12 940 P.2d at 353-354. Bernard L. Balkin & Keith Witten, § 5.06 Bad Faith Issues Under 13 940 P.2d at 352. “Current Developments in Bad Property Insurance and Related 14 See International Fidelity Ins. Co. v. Faith Litigation Involving the Coverages (2005). Delmarva Sys. Corp., No. 99C-10- Performance and Payment Bond 6 Dodge v. Fidelity and Deposit Co., 065 WCC, 2001 WL 541469 (Del. Surety,” 28 Tort & Ins. L. J. 611, 778 P.2d 1240 (Az.1989) Super. Ct. May 9, 2001). A few 611 (1993). 7 778 P.2d at 1244. months earlier, the U.S. District 2 See James M. Doerfler, “A Trend 8 778 P.2d at 1242-1243. Court for the District of New Jersey Toward Consensus… The Status of 9 Loyal Order of Moose, Lodge 1392 v. predicted that the New Jersey Bad Faith Claims Against Sureties International Fidelity Ins. Co., 797 Supreme Court would reach a simi- Under Pennsylvania Law,” 1 The P.2d 622 (Alaska 1990) lar conclusion and permit bad faith Critical Path 11 (September 2000). 10 See, e.g., K-W Indus. v. National Sur. claims against sureties under New 3 See, e.g., United States Fidelity & Corp., 754 P.2d 502 (Mont. 1988) Jersey law. See United States ex. rel. Guaranty Co. v. Bilt-Rite Contractors, (payment bond surety could be Don Siegel Constr. Co., Inc. v. Atul Inc., Civ. No. 04-1505, 2005 US liable under the Montana Unfair Constr. Co., 85 F.Supp.2d 414 (D. Dist. Lexis 9299 (May 16, 2005) Claims Settlement Act for failure N.J. 2000). Interestingly, this pre- (contractor alleged surety breached to act fairly and in good faith in diction about how the New Jersey good faith obligations under general handling a claim); Szarkowski v. Supreme Court would rule conflict- agreement in entering Reliance Ins. Co., 404 N.W.2d 502, ed with an earlier prediction ren- into settlement); PSE Consulting v. 504-05 (N.D. 1987) (concluding dered by a federal court Frank Mercede and Sons, Inc., 838 that because suretyship was regulat- from another district that reached a A.2d 135 (Conn. 2004) (payments ed by the insurance code, a sub- different conclusion. Compare In re made by a payment bond surety contractor could sue the general Technology for Energy Corp., 123 alleged to have been made in bad contractor’s surety in tort for bad- B.R. 979 (Bankr. E.D. Tenn. 1991) faith because of insufficient investi- faith breach of the performance (predicting that New Jersey law gation of the claims). bond); Farmer’s Union Central would not allow either a tort or 4 For example, one leading construc- Exchange, Inc. v. Reliance Ins. Co., punitive damages claim for surety’s tion commentator has observed that 626 F. Supp. 583 (D.N.D. 1985) alleged bad-faith breach of obliga- “[p]erhaps the greatest confusion (subcontractor that brought suit tions under performance bond, and arising out of the inclusion of sure- against contractor’s surety to recover finding that only contractual dam- tyship in state insurance codes is under payment and performance ages were recoverable). over whether a surety should be bonds had potential cause of action 15 Thomas J. Casamassima, Mark E. treated as an “insurer” so as to war- for tort based on state insurance Aronson & Frank Marchetti, “Extra- rant subjection of sureties to insurer claims settlement practices law); Contractual Damages,” in The Law liabilities for the common law tort General Ins. Co. v. Mammoth Vista of Suretyshi of bad faith.” See Philip L. Bruner Owners’ Assn., 220 Cal. Rptr., 291 16 Id. & Patrick J. O’Connor, 4 “Bruner (Cal. App.1985) (obligee could and O’Connor on Construction bring action against surety for Law,” § 12:7 Suretyship and “bad engaging in unfair claim settlement faith” (2005). practices in violation of the Unfair 5 One leading insurance bad faith Practices Act), overruled by Cates treatise, citing a number of these Construction, Inc. v. Talbot Partners, early decisions, even goes so far as

14 The Critical Path AsBUILT… Look Out Below…And Above! Recent Pennsylvania Case Emphasizes Importance of Knowing Your Forum When Crafting and Relying on Pay-When-Paid Defenses

Very recently, the Superior Court At issue were claims by American point, the court concluded that the of Pennsylvania, Pennsylvania’s Rock Mechanics (“AMROC”) for language set forth in the was intermediate appellate court, sums it asserted were due for work not a “pay-when-paid” provision. issued its decision in American on a construction project located Therefore, even if the court had not Rock Mechanics Inc. v. N. Abbonizio in White Marsh Township, held that the contract payment pro- Contractors, Inc., 2005 Pa. Super. Pennsylvania. Abbonizio contended visions were controlling, the Code 390 (Pa. Super. Nov. 21, 2005). that under Section 3933 of the would not have provided Abbonizio This case is significant because it Code, its obligation to pay AMROC any safe harbor for claims by is one of the first to address pay- did not mature until 14 days after its AMROC. Aside from arguably ment language contained in own receipt of payment from the being dicta (analysis or conclusions Chapter 39 of the Pennsylvania political subdivision for which it unnecessary for the disposition of Procurement Code, 62 Pa.C.S.A. undertook to perform the underly- the matter at hand), the decision §§ 101, et seq. (the “Code”), the ing project. The trial court held, of the Superior Court in American Commonwealth’s central reposi- and the appellate court affirmed the Rock is directly at odds with the tory for public contracting provi- holding, that the language of the conclusion of another panel of the sions. While the court’s ultimate contract (particularly regarding final Superior Court in the case of Joseph holding is of most importance payment) superseded the language F. Capelli & Sons, Inc. v. Keystone to public contractors in the of the Code. In particular, both Custom Homes, Inc., 815 A.2d 643 Commonwealth of Pennsylvania, courts viewed as controlling, the (Pa. Super. 2003). There, reviewing some conclusions also reached in language of the subcontract agree- nearly the identical statutory lan- this decision should be observed ment which obligated Abbonizio to guage contained in the Contractor with caution because they are at compensate AMROC final payment and Subcontractor Payment Act (73 odds with another decision from “within thirty (30) days after the P.S. § 507), the court held that this the same court as relates to private work is completed.” Accordingly, statute did, in fact, contain a “pay- contracting in Pennsylvania, and both courts concluded that AMROC when-paid” provision which, if to a nearly identical statute that was currently entitled to its money statutorily followed, provided the relates to most private contracting from Abbonizio, regardless of contractor significant protection efforts in that state. Beyond the whether the public owner had paid from claims by subcontractors for borders of the Keystone State, the Abbonizio for AMROC’s work. amounts which the contractor had decision is a warning that con- not yet received from the owner. However, the Superior Court did tracts need to be tailored to fit the Capelli, 815 A.2d at 645. not stop there. Rather, it chose to jurisdiction in which you are Ultimately, it will require future proceed with an analysis of the working and the result you seek determinations by the Pennsylvania contractor’s contention that Section to achieve, so important decisions Superior Court, or the Pennsylvania 3933 of the Code did, indeed, con- affecting your payment obligations Supreme Court, to resolve this con- tain a “pay-when-paid” provision (or those of others) are not left to flict. Nevertheless, an important and that the provision overrode the the sometimes inconsistent realm lesson currently to be learned from subcontract’s stated terms. On this of statutory interpretation. continued on page 16

15 “As Built” – continued from page 15 CONTRIBUTORS American Rock is to avoid use of Albert Bates, Jr. IV Editor’s Note: Pittsburgh, PA contractual language that creates Edward B. 412.288.7222 payment obligations greater than Gentilcore, a [email protected] those imposed by statute and/or partner in the Timothy N. Brown greater than those which you want Pittsburgh office, San Francisco, CA to follow. Particularly in a jurisdic- has a practice 415.659.5931 tion where “pay-when-paid” provi- which places heavy [email protected] sions are generally enforceable emphasis on con- James M. Doerfler (such as in Pennsylvania), contracts struction litigation. He has represent- Pittsburgh, PA ed owners, contractors, subcontractors 412.288.3280 should be drafted so as to maximize [email protected] the availability of such a , and material suppliers in matters involving a variety of construction- S. Miles Dumville and compliant provisions should be related issues including design-build, Richmond, VA utilized to avoid the scenario faced delays, extras, contract negotiation 804.344.3430 by Abbonizio in the American Rock and compliance, construction safety, [email protected] case. Further, if the parties strive to payment and mechanics’ liens. He Edward B. Gentilcore place in their agreements what they has prepared and negotiated numer- Pittsburgh, PA intend to govern their obligations ous agreements for a wide variety 412.288.4274 [email protected] and performance, and not leave to of private, public, commercial and unnecessary uncertainty important industrial projects. Ed’s concentration Jennifer A. Smokelin in construction litigation, as well as Pittsburgh, PA elements such as payment obliga- 412.288.3016 in design and construction contracts, tions, the prospects of litigation [email protected] over these issues will likely be has enabled him to serve on the reduced and all of the parties will Construction Litigation Committee The Critical Path is published and distributed of the ABA Section of Litigation, by Reed Smith for the general information of its be able to keep building for the clients, friends and newsletter recipients. The where he is currently Committee opinions expressed in The Critical Path are future! those of the individual authors and not Liaison, and he frequently contributes necessarily those of Reed Smith. The contents Edward B. Gentilcore articles on various construction- of The Critical Path are not designed or intended to be, nor should they be considered Pittsburgh Office related topics. or used as, the sole source of analyzing or resolving any legal problems. If you have, or think you may have, such a legal problem or issue related to any of the matters discussed in The Critical Path, consult legal counsel. You may contact Edward B. Gentilcore, Editor- The Critical Path Editor-in-Chief in-Chief, or any one of the in our Construction Group at the numbers listed Edward B. Gentilcore Pittsburgh 412.288.4274 [email protected] herein if you have any questions regarding these or any other construction matters. The Critical Path Regional Editors “Reed Smith” refers to Reed Smith LLP and related entities. Bernard J. Casey San Francisco 415.659.5959 [email protected] ©Reed Smith LLP, 2006. All rights reserved.

Lawrence J. Reina New York 212.549.0255 [email protected] NEW YORK @ Thomas R. Folk Falls Church 703.641.4294 tfolk reedsmith.com LONDON LOS ANGELES James A. Kosch Newark 973.621.3195 [email protected] PARIS SAN FRANCISCO Timothy J. Cornetti Pittsburgh 412.288.3169 [email protected] WASHINGTON, D.C. PHILADELPHIA Construction Group Steering Committee PITTSBURGH OAKLAND MUNICH @ S. Miles Dumville Richmond 804.344.3430 mdumville reedsmith.com PRINCETON NORTHERN VA Edward B. Gentilcore Pittsburgh 412.288.4274 [email protected] WILMINGTON NEWARK Robert A. King Pittsburgh 412.288.4128 [email protected] MIDLANDS, U.K. CENTURY CITY Joseph S. Luchini Falls Church 703.641.4274 [email protected] RICHMOND Quality Matters. reedsmith.com