Will Subcontractor Default Insurance Still Have Value in the Recovering Economy?

The COVID-19 pandemic has burdened subcontractors with workforce shortages, supply chain issues, and financial difficulties. Therefore, as states lift their stay-at-home orders issued to limit the spread of COVID-19 and construction projects resume, subcontractors’ ability to complete demanding, time-sensitive projects might be impacted. Subcontractor default is already a common and costly problem for general contractors. When subcontractors fail to complete their contractual obligations, a general contractor’s profitability and reputation are greatly impacted. Effectively managing the risk of subcontractor default will be increasingly important for general contractors in the post-pandemic economy.

Subcontractor Default Insurance (“SDI”) is a non-traditional insurance product which can minimize a general contractor’s damages resulting from a subcontractor’s default. It is a two-party indemnity agreement between a general contractor and insurer. It was created as an alternative to surety bonds, with the idea that the general contractor controls the default process and remedy to help keep projects on time and within budget. Under a SDI policy, a general contractor enrolls prequalified subcontractors for either a specific project or policy term. Then, the general contractor is indemnified by the insurance company for any covered costs incurred if one of the subcontractors defaults. Typically, SDI claims stem from labor, work delay and quality issues, as well as financial-related defaults, which are not covered under general liability insurance policies.

In addition to direct costs, SDI coverage usually includes indirect expenses such as liquidated damages, acceleration of other subcontracts, increased overhead and the like. The insurer shares the risk with the general contractor through a deductible and co-pay; the general contractor absorbs some of the costs associated with a subcontractor’s default, usually up the deductible amount. SDI coverage extends to the limits of the individual policy rather than being limited to the value of the subcontract.

In order to lessen their risk, SDI carriers require general contractors to prequalify subcontractors before they can be enrolled on the policy. General contractors are in charge of this process. In order to evaluate a subcontractor both operationally and financially, subcontractors must submit the following types of information: financial statements, proof of available lines of credit, safety record, and history of claims and litigation. For subcontractors, the prequalification process is not different than that for surety bonds, except that it is executed by the general contractor instead of a professional surety underwriter.

After the COVID-19 pandemic, insurance carriers will necessarily adjust their outlook on subcontractors due to the increased risk of loss. Therefore, it will likely be more difficult for general contractors to find subcontractors able to prequalify for SDI policies and, in any event, the process will become more tedious. In addition to the aforementioned information, general contractors will probably be interested in subcontractors’ business continuity plans and specific plans to mitigate impacts like loss of employees and/or project shutdowns.

General contractors must be large and sophisticated enough to have the resources necessary to properly pre-qualify subcontractors, including assessing the financial risks of accepting subcontractors, and monitor their schedules and performance for the duration of the project. While the pre-qualification process is necessary, it is insufficient to thoroughly manage the risk. Even a subcontractor who is prequalified at the outset of a project must be managed throughout the entire course of work. A general contractor’s oversight of subcontractor performance will be even more critical in the post COVID-19 economy as subcontractors are more likely to be operationally and financially stretched thin.

In order to even qualify for SDI insurance, a general contractor typically needs minimum annual subcontractor volume in the $50-$100 million range. In fact, for SDI to be cost-effective, carriers say that annual subcontracted values must exceed $75 million. This is because SDI is expensive, usually ranging from 0.4 to 0.85 percent of total subcontract values.

Given the increased risk of subcontractor default, SDI policies will likely be even more expensive as the economy recovers from the COVID-19 pandemic. Deductibles, which are already high, are likely to increase. Currently, it is not unusual for a deductible to be in the $500,000 range. In addition to that, SDI policies have a co-pay which is paid up the retention aggregate—often three to five times the deductible. That said, SDI will still have value and provide cost savings under the right circumstances. For very large jobs, it would be worth taking on part of the financial risk of default for general contractors to accept SDI’s high deductibles because it would cost much less (now typically 50% less) than subcontractors bonding and passing along costs within their bid. Another consideration is whether the costs can be absorbed by the project. General contractors can also strategically utilize SDI to target high-risk subcontractors.

Cost will not be the only determinative factor in evaluating SDI’s value after the pandemic. It is possible insurers will write more exclusions into policies to manage their own risk associated with impacts associated with mandated shutdowns similar to what the United States recently experienced. Accordingly, subcontractor default stemming from such a shutdown (including impacts like workforce shortages and supply chain backlogs) would unlikely be covered. SDI policies also generally do not cover defaults, which result from the following: misrepresentation, fraud, defaults occurring prior to the policy period, material breach of warranty by the contractor, contracts acquired from other entities, war and losses arising from providing professional services.

To determine whether or not SDI is a worthy investment, a general contractor must separately evaluate each project, and carefully weigh the cost, potential savings and risk involved.

For more information on the efficacy of subcontractor default insurance in a recovering economy or other construction law topics, please contact Nicole Lentini and Becky Juhl.

Using the Prevention Doctrine

The following scenario happens regularly in the construction industry. A contractor on a project reaches out to a subcontractor to perform work. Excited about the prospect of performing the work, the subcontractor signs a contract and puts it nose to the grindstone. After dutifully completing the work the subcontractor turns to the contractor and asks to be paid. But, the contractor refuses saying that there is a provision in the subcontract that says the contractor is only obligated to pay the subcontractor if the contractor receives payment from the owner. So the contractor has completed the work, but has no money to show for it.

One potential remedy for a subcontractor in this situation is the use of the prevention doctrine. “Under the prevention doctrine, ‘if a promisor prevents or hinders fulfillment of a condition to his performance, the condition may be waived or excused.’” Cox v. SNAP, Inc., 859 F.3d 304, 308 (4th Cir. 2017) (quoting Moore Bros. Co. v. Brown & Root, Inc., 207 F.3d 7171, 725 (4th Cir. 2000)). “Put simply, ‘where a party to a contract is the cause of the failure of the performance of the obligation due him or her, that party cannot in any way take advantage of that failure.’” Haddon Hous Assocs v. United States, 711 F.3d 1330, 1338 (Fed. Cir. 2013) (quoting Restatement (Second) of Contracts § 245; Williston, § 39:4).

So let’s add to the scenario above that the contractor failed to request payment from the owner for the subcontractor’s work. The contractor’s failure to request payment could be deemed a violation of the prevention doctrine, which would bar the contractor from being able to raising the contract terms as a defense. Alternatively, let’s say that the contractor had committed significant errors on the project and that as a result, the owner was withholding funds. Here too, the subcontractor could contend that the contractor’s mistakes on the project, which led to the owner withholding payment, should excuse contract terms that would otherwise bar payment. Basically, the contractor should not be allowed to benefit from its mistakes and failures to not pay an innocent party.

While the prevention doctrine is not a sure-fire solution to a problem with a contractor who won’t pay, it is a useful tool that we should be ready to use when the situation warrants.

Illinois Supreme Court Limits Reach of Implied Warranty Claims Against Contractors

In a recent decision, the Illinois Supreme Court held that a purchaser of a newly constructed home could not assert a claim for breach of the implied warranty of habitability against a subcontractor where the subcontractor had no contractual relationship with the purchaser. Sienna Court Condo. Ass’n v. Champion Aluminum Corp., 2018 IL 122022, ¶ 1. The decision overruled Minton v. The Richards Group of Chicago, which held that a purchaser who “has no recourse to the builder-vendor and has sustained loss due to the faulty and latent defect in their new home caused by the subcontractor” could assert a claim of a breach of the warranty of habitability against the subcontractor. 116 Ill. App. 3d 852, 855 (1983).

In Sienna Court Condo. Ass’n, the plaintiff alleged that the condo building had several latent defects which made individual units and common areas unfit for habitation. 2008 IL 122022 at ¶ 3. The Court rejected the plaintiff’s argument that privity should not be a factor in determining whether a claim for a breach of the warranty of habitability can be asserted. Id. at ¶ 19. The Court also rejected the plaintiff’s argument that claims for a breach warranty of habitability should not be governed by contract law but should instead be governed by tort law analogous to application of strict liability. Id.

The Court reasoned that the economic loss rule, as articulated in Moorman Manufacturing Co. v. National Tank Co., 91 Ill. 2d 69, 91 (1982), refuted the plaintiff’s argument that the implied warranty of habitability should be covered by tort law. 2008 IL 122022 at ¶ 20. Under the economic loss rule, a plaintiff “cannot recover for solely economic loss under the tort theories of strict liability, negligence, and innocent misrepresentation.” National Tank Co., 91 Ill. 2d at 91. The Court explained that the rule prevented plaintiffs from turning a contractual claim into a tort claim. 2008 IL 122022 at ¶ 21. The Court further noted that contractual privity is required for a claim of economic loss, and an economic loss claim is not limited to strict liability claims. Id. Because the plaintiff’s claim was solely for an economic loss, it was a contractual claim in nature; therefore, the Court concluded that “the implied warranty of habitability cannot be characterized as a tort.” Id. at ¶ 22.

The Court also rejected the plaintiff’s argument that warranty of habitability should be governed by tort law because it involves a duty imposed by the courts. Id. at ¶ 23. It reasoned that “an implied term in a contract is no less contractual in nature simply because it is implied by the courts . . . .” Id. The Court noted that the warranty of habitability can be waived under Illinois law, but individuals are not able to waive duties imposed upon them by the courts. Id. If the warranty of habitability was a tort claim, it would “raise[] significant practical problems, particularly for subcontractors” given that they “depend upon contract law and contracts with the general contractor to protect and define their risks and economic expectations.” Id. at ¶ 24. Because a subcontractor’s fees, costs, and liability are controlled by his contracts, turning an implied warranty of habitability claim into a tort would make those contracts pointless. Id.

The Court’s decision to overrule Minton rested on three primary reasons: (1) Minton failed to discuss why the economic loss rule did not apply; (2) Minton did not address what effect its holding would have on the contractual relationships of subcontractors and general contractors; and (3) there is “no authority for the idea that a tort duty comes into and out of existence depending on whether another entity is bankrupt.” Id. at ¶ 25. In light of the opinion, a home purchaser’s remedy where there is economic loss is now limited to those parties with whom it has a direct contractual relationship.

Illinois Court Clarifies Law Governing Claims for Breach of Implied Warranty of Habitability against Design Professionals, Suppliers, and Subcontractors When Builder or Seller is Insolvent

The Illinois Appellate Court for the First District issued Sienna Court Condominium Ass’n v. Champion Aluminum Corp., clarifying the prior decision Minton v. The Richards Group of Chicago concerning the availability of certain defendants to claims for breaches of implied warranty of habitability. 2017 IL App (1st) 143364 (citing 116 Ill. App. 3d 852 (1983)). The First District considered three consolidated appeals brought by a condominium association seeking damages for defects in the design and construction of a condominium building. 2017 IL App (1st) 143364. Two of the Sienna Court appeals addressed the viability of claims for breach of the implied warranty of habitability against defendants that were not the builder or the seller. Id. at ¶ 48. The First District ruled that a property owner may not assert a claim of breach of implied warranty against design professionals and material suppliers who did not perform construction work. Id. at ¶¶ 66, 69. However, a property owner may assert a claim against a subcontractor of an insolvent developer or general contractor.  Id. at ¶ 81.

The plaintiff, relying upon the First District’s opinion in Minton, asserted that modern Illinois common law is in derogation of the principle that a breach of implied warranty of habitability claim may only to be asserted against a builder or seller. Id. at ¶ 19. The plaintiff argued that the class of defendants liable for breach of implied warranty of habitability was previously expanded by the First District in Minton. Id. (citing 116 Ill. App. 3d 852 (1983)). In Minton, the First District permitted a property owner to proceed against a subcontractor under an implied warranty of habitability theory because the property owner had no other recourse where the builder was insolvent and the defect was caused by the subcontractor. 116 Ill. App. 3d at 855. The Minton court reasoned that the “purpose of the warranty is to protect purchasers” and “an innocent purchaser” without recourse against the “builder-vendor” should be able to look to the subcontractor that performed inadequately. Id. at 854-55.

The plaintiff in Sienna argued that Minton should be applied to permit claims against design professionals and material suppliers where the property owner has no other recourse. 2017 IL App (1st) 143364, ¶ 19. The First District rejected the plaintiff’s arguments and refused to expand the class of defendants subject to a breach of implied warranty of habitability claim. Id. at ¶¶ 68-69. The Court stated that Illinois common law clearly provides that design professionals and suppliers are not subject to claims for implied warranty of habitability where they did not partake in construction. Id. (citing Bd. of Managers of Park Point at Wheeling Condo. Ass’n v. Park Point at Wheeling, LLC, 2015 IL App (1st ) 123452). The First District refused to use the narrow holding in Minton, which provided for a claim against subcontractors, to negate the holding in Park Point that any entity or person that does not take part in construction, including design professionals and material suppliers, cannot be defendants to a property owner’s breach of implied warranty of habitability claim. Id. at ¶¶ 64-69.

Despite finding that subcontractors may be suitable defendants under Minton, the First District clarified the focus for determining when subcontracts are suitable defendants to a claim  for breach of implied warranty of habitability. Id. (citing Minton, 116 Ill. App. 3d 852; 1324 W. Pratt Condo. Ass’n v. Platt Constr. Group, Inc., 2013 IL App (1st) 130744). The court states that the claim in this instance is permissible not because the property owner did not have an alternate method of recourse, but because the builder or seller was insolvent. Id. As a result, in Sienna Court, the availability of recovery from insurers and an escrow fund did not preclude the breach of implied warranty of habitability claim against the subcontractor. Id. at ¶¶ 80-81.

By issuing the Sienna Court opinion, the First District has made clear that it will not deviate from the set limitations on who is an appropriate defendant to a claim for breach of implied warranty of habitability.