TSI v. Superior Court (Geocon TSI Seismic Tenant Space, Inc.) (2007) 149 Cal. App. 4th 159

The California Supreme Court recently denied a request to depublish this significant decision issued by the California Court of Appeal several months ago. In short, this case held that even though an engineer was protected against a developer's claims by virtue of a limitation of liability (LOL) clause, it could not use the clause to justify a disproportionately small payment made in the context of a "good faith" settlement. Thus, the engineer was obligated to remain in the litigation despite the existence of an enforceable LOL provision.

The underlying case involved a construction defect action in which a geotechnical engineer (Geocon) contracted with a developer (Sunbow) to provide geotechnical engineering services on a parcel of real property being developed as an apartment complex. Geocon's contract with Sunbow included a limitation of liability clause purporting to limit Geocon's liability to the developer, and to all other parties, for claims arising out of Geocon's work to $50,000, and further provided that the developer would indemnify and hold harmless Geocon against any liability in excess of that amount. The developer entered into a separate contract with the general contractor (TSI) to construct the improvements.

After problems arose from expansive soils, the developer filed suit against Geocon and other parties, a number of which (including the contractor) in turn cross-complained against Geocon. By agreement of the parties, the enforceability of Geocon's limitation of liability clause was decided by a judicial referee who concluded that Geocon did not commit gross negligence in connection with the performance of its work. Thereafter, the developer and Geocon reached a settlement for $50,000 (including a waiver by Geocon of its attorneys' fees), and Geocon moved for a "good faith" settlement determination which the contractor and other parties opposed. The trial court granted the motion and a writ of mandate was taken to the appellate court.

The court of appeal reversed, finding that the trial court had abused its discretion since the evidence indicated that Geocon's potential liability approached $3.5 million. And that while the LOL clause might well protect the geotechnical engineer from the owner's direct claims in excess of $50,000, it would not shield Geocon from the other parties' indemnity claims. The court of appeal reasoned that if the good faith settlement motion were to be granted, the developer would have been able to pursue the full amount of its claims against the other parties without any reduction in the amounts found to be the fault of Geocon. In the court's words, "the only one limited in their ability to collect against Geocon by virtue of the limitation of liability clause is Sunbow. [The other parties'] claims for indemnity are unaffected by that clause and therefore their rights must still be considered."

The TSI v. Geocon opinion is significant on a number of different fronts:

1. While generally reaffirming the validity of LOL clauses in California, it specifically holds that an LOL clause may not be used against non-parties to the agreement in determining the validity of a "good faith" settlement motion.
   
   
2. This is the first reported decision in California to discuss the operation of an LOL clause in regard to third-party indemnification claims, and the opinion seems to suggest that an A/E can validly require an owner/developer to indemnify it against third party claims in excess of the amount stated in the LOL. Indeed, this is the very premise of the court's conclusion that the proposed good faith settlement was unfair in the first place.
   
   
3. Even though Geocon's good faith settlement motion was defeated and Geocon would remain in the case, it would appear that its total exposure would be capped at $50,000 since the developer would be required to indemnify it for any amounts awarded in excess of this sum. In fact, it appears that the parties stipulated to this very mechanism before the appeal was decided. One would therefore expect the developer to assume Geocon's defense or at least advance arguments in Geocon's favor following the settlement since the developer would presumably be exposed for any amounts attributed to Geocon over and above the $50,000 amount.
   
   
4. On account of the foregoing, it would be prudent for A/E contracts to include an indemnity provision within their LOL clauses. For reference, the clause in question in this case read as follows: "Developer agrees to limit Engineer's liability to Developer and to all other parties for claims arising out of Engineer's performance of the services described in the Agreement. The aggregate liability of Engineer will not exceed $50,000 for negligent professional acts, errors, omissions, including attorney's fees and costs which may be awarded to the prevailing party, and Developer agrees to indemnify and hold harmless Engineer from and against all liability in excess of the monetary limit established above."
   
   
5. A portion of the court's opinion (footnote 3) suggests that Geocon and the contractor are "joint tortfeasors," the consequence of which is that the contractor would have a right of indemnification against the engineer. The court seemed to base this conclusion not on any duty that Geocon and the contractor might owe to each other but rather the fact that both owed a duty to the plaintiff/developer. This conclusion (which appears to somewhat contradict an earlier decision by a separate division of the 4th district court appeal in BFGC Architects vs. Forcum/Mackey Construction) potentially exposes A/E professionals to more expansive liability for economic damages, especially where the contractor defendants are uninsured, under-insured or otherwise insolvent.
   
   
6. Finally, although not addressed by the court, there is an open issue as to whether the indemnity provision in question, which the court of appeal impliedly endorsed, could be challenged under California Civil Code section 2782 (a) which provides in pertinent part:

   provisions, clauses, covenants, or agreements contained in, collateral to, or affecting any construction contract and that purport to indemnify the promisee against liability for damages for death or bodily injury to persons, injury to property, or any other loss, damage or expense arising from the sole negligence or willful misconduct of the promisee or the promisee's agents, servants, or independent contractors who are directly responsible to the promisee, or for defects in design furnished by those persons, are against public policy and are void and unenforceable; provided, however, that this section shall not affect the validity of any insurance contract, workers' compensation, or agreement issued by an admitted insurer as defined by the Insurance Code.

   This issue was not raised in the appeal, but to the extent that the engineer's indemnity agreement purported to obligate the owner to indemnify it for defects in design, one could make the argument that the clause is void as against public policy.

We will continue monitoring this important line of cases and report any significant developments in subsequent publications.

On January 1, 2008, a very important provision will go into effect -- Article 4.5 of the California Professional Engineers Act ("CPEA"), California Business and Professions ("B&P") Code ("B&P") §§ 6700-6799, states in § 6770(a)(a) that an engineer shall report to the Professional Engineers & Land Surveys ("PELS") Board of the California Department of Consumer Affairs, in writing, within 90 days of:

Any civil action judgment, settlement, arbitration award, or administrative action resulting in a judgment, settlement, or arbitration award against the licensee in any action alleging fraud, deceit, misrepresentation, breach or violation of contract, negligence, incompetence, or recklessness by the licensee in the practice of professional engineering if the amount or value of the judgment, settlement, or arbitration award is fifty thousand dollars ($50,000) or greater.

For background purposes, this provision became law on January 1, 2005 by Senate Bill ("SB") 1549 (Chapter 691, Statutes of 2004) by then Senator Liz Figueroa of Fremont. However, it did not receive funding until the latest 2006-2007 Legislative Session. Specifically, the Legislature finally made the appropriation from the PELS Fund for the 2006-2007 fiscal year in the annual Budget Act, thus granting hiring authority to the PELS Board to provide sufficient staffing to enforce the provisions of SB 1549 and to fully enact the CPEA.

The CPEA also requires the engineer to sign the report and set forth the facts that constitute the reportable event. If the reportable event involves the action of an administrative agency or court, the report shall set forth the title of the matter, court or agency name, docket number, and the date the reportable event occurred. The engineer shall promptly respond to oral or written inquiries from the PELS Board concerning the reportable events, including inquiries made by the PELS Board in conjunction with license renewal. Failure of an engineer to report to the PELS Board within 90 days of knowledge of the event shall be grounds for disciplinary action.

Likewise, B&P Code § 6770.2(a) and (b) requires that any insurer providing professional liability insurance to the engineer, or any state or local government agency, which self insures the engineer, must report to the PELS Board within 30 days of payment of all or any portion of any civil action judgment, settlement, or arbitration award of $50,000 or greater (1) the name of the engineer, (2) the amount of value of the judgment, settlement or arbitration award, (3) the amount paid, and (4) the identity of the payee.

B&P Code § 6770.3 applies the foregoing provisions to a sole proprietorship, partnership, firm, corporation, or state or local government agency in which the engineer is or was an owner, partner, member, officer, or employee, and is or was the engineer in responsible charge of that portion of the project that was the subject of the civil judgment, settlement, or arbitration award. B&P Code § 6770.4 provides that an engineer will not be considered to have violated a confidential settlement or other agreement by reporting the required information to the PELS Board.

Lamar Homes, Inc. v. Mid-Continent Casualty Co.

There has been a controversy raging between insureds and insurance carriers in Texas as to whether CGL policies cover property damage (as distinguished from personal injury) resulting from defective construction. Several insureds have recently challenged denials of coverage by CGL carriers in the courts. However, there has been a split of authority among courts in different states and even among courts within the same state on this issue.

On August 31st, the Texas Supreme Court decided what may be the most important decision affecting CGL coverage in Texas in the last eighty years. In a 6-3 decision, the Texas Supreme Court definitively and affirmatively answered the question of whether a defense obligation to a general contractor exists under a CGL policy for construction defect/defective workmanship claims in Lamar Homes, Inc. v. Mid-Continent Casualty Company, No.05-0832 (Tex. August 31, 2007) [Supreme Court Case No. 05-0832]. The Texas Supreme Court has decided that Texas will follow those courts that have found coverage under CGL policies for damage to a contractor's own work product as a result of defective construction. Additionally, the Texas Supreme Court held that the carrier's decision to deny a defense obligation subjected it to liability under Article 21.55 of the Texas Insurance Code (recodified as sections 542.051-.061 of the Texas Insurance Code), a statutory "bad faith" provision that allows the contractor to recover its attorney's fees and an 18% penalty on any sums expended in the underlying matter.

In the underlying coverage case in Lamar Homes, a homebuilder (Lamar) sought a declaration of rights under a commercial general liability ("CGL") policy after two homebuyers sued Lamar for foundation defects. Lamar forwarded the lawsuit to its insurer, Mid-Continent Casualty Company, seeking a defense and indemnification under its CGL policy. Mid-Continent refused to defend, prompting Lamar to seek a declaration of its rights. Lamar also sought recovery under article 21.55 of the Texas Insurance Code.

On cross motions, the federal district court granted summary judgment for Mid-Continent, concluding it had no duty to defend Lamar for construction errors that harmed only Lamar's own product. The court reasoned that the purpose of a CGL policy is "to protect the insured from liability resulting from property damage (or bodily injury) caused by the insured's product, but not for the replacement or repair of that product."

On appeal, the Fifth Circuit certified the following three questions for the Texas Supreme Court to answer:

1. When a homebuyer sues his general contractor for construction defects and alleges only damage to or loss of use of the home itself, do such allegations allege an "accident" or "occurrence" sufficient to trigger the duty to defend or indemnify under a CGL policy?
   
   
2. When a homebuyer sues his general contractor for construction defects and alleges only damage to or loss of use of the home itself, do such allegations allege "property damage" sufficient to trigger the duty to defend or indemnify under a CGL policy?
   
   
3. If the answers to certified questions 1 and 2 are answered in the affirmative, does former Article 21.55 of the Texas Insurance Code (recodified as sections 542.051-.061 of the Texas Insurance Code) apply to a CGL insurer's breach of the duty to defend?

On August 31, 2007, the Texas Supreme Court issued its opinion in Lamar Homes, concluding as follows:

We conclude that allegations of unintended construction defects may constitute an "accident" or "occurrence" under the CGL policy and that allegations of damage to or loss of use of the home itself may also constitute "property damage" sufficient to trigger the duty to defend under a CGL policy. Accordingly, as to the duty to defend, we answer the first two questions, yes. We do not reach the duty to indemnify, however, as that duty is not triggered by allegations but rather by proof at trial. We further conclude that former article 21.55 (recodified as sections 542.051-.061 of the Texas Insurance Code) does apply to an insurer's breach of the duty to defend and accordingly answer the third question, yes.

These answers addressed the split of authority among Texas appellate courts and Texas federal district courts as to whether "shoddy workmanship" could constitute an "occurrence" and whether damage to the home would be "property damage." In so doing, the Texas Supreme Court has greatly expanded the duty to defend under Texas law in construction defect cases.

The decision to allow the breach of the duty to defend to trigger a violation of Article 21.55 has implications far beyond construction defect cases. In any case in which a defense has been denied, the insured may not only be allowed to recover any amounts spent in defending the underlying matter (defense costs and settlements or judgments paid), but may also be able to recover its attorney's fees in the coverage case AND a statutory penalty of 18% on all sums expended in the underlying matter.

Vincent Loduca, Jr v.George Polyzos (2007) 153 Cal. App. 4th 334

The California Court of Appeal in the third appellate district recently affirmed the award of almost $200,000 in attorney fees pursuant to a "prevailing party" attorneys' fees provision in a contract. What makes this case interesting is the fact that the property owner, who was awarded his attorneys' fees, was not in contract with the subcontractor who was ordered to pay the fees. The Court based its award on a contract between the general contractor and subcontractor and found that the owner was an intended third party beneficiary to that contract.

In 1989, Vincent Loduca, the project owner, retained MCM Builders to act as the general contractor to build his custom home. MCM, in turn, hired subcontractor QMC to manufacture and install custom cabinetry in the new home. The subcontract between MCM and QMC included a clause which stated that the prevailing party in any litigation arising out of the subcontract would be awarded its attorneys' fees.

Although QMC was directly in contract with MCM, Loduca paid for some of the subcontractor's services directly. In addition, toward the end of the project, Loduca and QMC entered into a separate agreement, where QMC agreed to deliver certain remaining components and Loduca agreed to pay $10,000 on delivery. When Loduca received the cabinets he noticed numerous problems with them and asked his bank to stop payment on the check sent to QMC. QMC then removed all of the cabinetry from the home without the owner's permission and litigation ensued. QMC filed a complaint against Loduca for recovery of unpaid amounts and Loduca filed a cross complaint for breach of contract, among other things.

The trial court entered judgment in favor of Loduca and awarded $65,000 in damages. At a subsequent hearing, the trial court awarded attorneys' fees to Loduca pursuant to the contract between MCM and QMC in the amount of $190,350. QMC appealed, claiming the court erred by awarding Loduca attorneys' fees because Loduca was not a party to the contract between QMC and MCM and therefore should not benefit from the attorneys' fees clause.

The court held that the homeowner was in fact "an intended third party beneficiary" who could enforce the subcontract and request attorneys' fees. A third party beneficiary, although not a party to the contract, may be entitled to enforce a contract if it proves that the contracting parties intended to benefit the third party with the contract.

In Loduca's case, the court concluded that Loduca was an intended beneficiary of the subcontract and therefore able to enforce the attorneys' fees provision for several reasons. First, the subcontract's "reference" line identified Loduca as the owner. Second, the subcontract stated the cabinetry was to be built according to plans developed for Loduca's home. Third, the contract contained a broad attorneys' fees clause which did not specify who could collect the attorneys' fees if they prevailed. The court thus applied this broad provision to extend to any court action that arose out of the contract even if was brought by a third party.

QMC argued the separate agreement between Loduca and QMC demonstrated the parties did not intend for Loduca to be able to recover attorneys' fees because this agreement did not contain an attorneys' fees provision. However, the court disagreed and held the QMC-Loduca agreement did not state that it superseded the MCM-QMC agreement but it simply changed the terms of payment and imposed additional penalties.

In addition, the court based its decision on the close relationship between the subcontractor and the property owner. Loduca made a separate agreement and paid QMC directly. The court held that the alteration by the QMC-Loduca agreement to the original contract effectively made Loduca a party to the contract, thereby entitling and burdening him with the attorneys' fees provision. The court concluded that in these circumstances, where such a close relationship exists between the contracting parties and the third party beneficiary, the contracting parties intended for the owner to have a right of enforcement of the prevailing party attorneys' fees clause.

A few lessons may be learned from this case. First, all construction participants should be acutely aware of any prevailing party attorneys' fees clauses in their contracts. These provisions can vastly increase a party's exposure and most insurance policies do not cover their contractually agreed upon transfer of risk. In order to avoid potential liability to a third party, contracts should specify the parties who can enforce the prevailing party clause. Good drafting techniques can assist in avoiding this type of third party liability. Further, all construction participants should always be aware of the established contractual relationships and their associated chains of communication. Deviating from the norms could unknowingly subject you to the terms, and obligations of a contract between others.

The attorneys at Gordon & Rees LLP are very experienced in counseling and advising on all types of construction contracts. We can assist you in tailoring your contracts to provide you with the most benefit and the least amount of risk.

• On October 12, 2007, Ellen Tagtmeier of the Houston office spoke at the Annual Council Meeting of the National Association of Insurance Women in Dallas, Texas, regarding construction defect insurance coverage litigation and the recent Texas Supreme Court Opinion in Lamar Homes, Inc. v. Mid-Continent Casualty Company.
  
  
• On November 8, 2007, Dion Cominos of the San Francisco office will be presenting a seminar with Lorman Education Services entitled "Architect and Engineer Litigation".
  
  
• On November 15, 2007, Dion Cominos of the San Francisco office will be presenting a Practice Management Seminar with Dealey Renton Associates.
  
  
• On December 8, 2007, Lisa Perrott of the San Francisco office will be presenting at the Semi-Annual Principals Meeting for Lea + Elliott. She will be discussing diminishing risk and avoiding claims.
  
  
• On February 6 and 8, 2008, Ernie Isola of the San Francisco office and Chuck Juliana of the New York office, along with Alann Ramirez with Hill International, will be presenting all-day seminars with Lorman Education Services in San Francisco and San Jose, respectively, entitled "Construction Law: From Contract to Closeout."
  
  
• On March 19, 2008, Sandy Kaplan, Ken Strong, Mark Meredith and Lisa Perrott of the San Francisco office will be presenting an all-day seminar with Lorman Education Services in San Francisco entitled "Contracts to Insurance: Tips for Getting Your Construction Project Right"
  
  
• On March 27, 2008, Bill Peters and Ernie Isola of the San Francisco office will be part of a panel presenting an all-day seminar with Lorman Education Services in San Francisco entitled "Understanding the Construction Bidding Process."