Texas Supreme Court Allows General Contractor to Compel Arbitration Against Developer Despite Asserting Counterclaims and Participating in Discovery

In a recent decision involving a dispute over a construction project, the Texas Supreme Court held that the developer had to arbitrate its claims against the general contractor, even though the general contractor filed counterclaims and responded to discovery requests. G.T. Leach, LLC v. Sapphire V.P., LP, 2015 Tex. LEXIS 273 (Tex. 2015).

Sapphire V.P., LP (“Developer”) contracted with G.T. Leach, LLC (“General Contractor”) for the development of luxury condominiums (the “Project”) on South Padre Island. In July 2008, Hurricane Dolly tore through the island causing significant damage to the Project. Developer filed suit against its insurance brokers, alleging claims for negligence and breach of contract. Developer alleged that, eight days before the hurricane hit, the brokers allowed a builder’s risk insurance policy to expire and be replaced by a permanent insurance policy, even though construction of the Project had not yet been completed. More than two years later, the brokers designated several other responsible third parties. These parties included the project general contractor, General Contractor, two subcontractors, and an engineering contractor. Developer amended its petition to name these parties and defendants, also alleging their negligence and contractual breaches resulted in construction defects that caused the Project to sustain water damage that resulting in uncovered losses.

After pursuing pretrial motions and participating in discovery, General Contractor moved to compel arbitration and stay the litigation. General Contractor relied on an arbitration agreement in its general contract with Developer. The brokers, subcontractors, and engineer (collectively, the “Other Defendants”) also moved to compel arbitration, relying on the general contract (even though they never signed that contract) and their own subcontracts with General Contractor.

The trial court denied all of the motions. The defendants pursued an interlocutory appeal, the court of appeals affirmed, and defendants subsequently petitioned the Supreme Court for review.

The Texas Supreme Court took up several issues. First, the Court analyzed whether General Contractor could compel arbitration. Specifically, the Court examined whether General Contractor had waived its right to compel arbitration by participating in pretrial proceedings and discovery. In Texas, a party may waive its right to enforce an arbitration agreement implicitly, though conduct inconsistent with an intent to enforce the right. See Perry Homes v. Cull, 258 S.W.3d 580, 590-91, 594 (Tex. 2008); Moayedi v. Interstate 35/Chisam Rd., LP, 438 S.W. 3d 1, 6 (Tex. 2014). A party asserting implied waiver as a defense to arbitration has the burden to prove that the other party “substantially invoke the judicial process,” which is conduct inconsistent with a claimed right to compel arbitration, and the inconsistent conduct caused the non movant detriment or prejudice. Perry Homes, 258 S.W. 3d at 593-94. Whether a party has “substantially invoked the judicial process depends on the totality of the circumstances.” Id. at 589-90. Relevant factors include: (1) how long the party waited to move to compel arbitration; (2) how much discovery it conducted before moving to compel arbitration; and (3) whether the party asserted affirmative claims for relief in court. Id. at 590-91. “Merely taking part in litigation” was not enough to rise to the level of substantially invoking the judicial process.

Here, General Contractor’s counterclaims were compulsory and purely defensive in nature–that is, “use it or lose it” type claims. Moreover, General Contractor never sought judgments on the merits of the case. General Contractor sought to transfer venue, but venue challenges do not relate to the merits of the case. See Richmont Holdings v. Superior Recharge Sys., LLC, 2014 Tex. LEXIS 1211 (Tex. 2014). In addition, General Contractor filed motions for continuance, to quash depositions, and to designate responsible third parties (a procedure available to tort defendants in Texas that does not involve adding any parties). The Court found these actions were defensive rather than offensive in nature. A party’s litigation conduct aimed at defending itself and minimizing its litigation expenses, rather than taking advantage of the judicial form, does not amount to substantial invocation of the judicial process. Finally, Developer complained of an excessive delay in seeking arbitration. However, General Contractor moved to compel arbitration three months after it had been joined. The Court found that three months, while lengthy, was not an unreasonable delay amounting to waiver.

The Court then examined whether Developer proved it suffered unfair prejudice as a result of General Contractor’s litigation conduct. In this context, detriment or prejudice referred to an “inherent unfairness caused by a party’s attempt to have it both ways by switching between litigation and arbitration to its own advantage.” In re Citigroup Global Mkts., Inc., 258 S.W.3d 623, 635 (Tex. 2008). Here, General Contractor did not serve a single request for production, interrogatory, or deposition notice, therefore not giving it any more of an advantage that it otherwise would have obtained by switching back and forth. In summary, the Court held that General Contractor did not implicitly waive its right to compel arbitration.

The Court analyzed several other interesting issues in the case, including whether the issue of whether the General Contractor’s claims were timely under the language of the arbitration provision had to be resolved by arbitration (it did), and whether subcontractors and other parties who had not signed the arbitration agreement could compel arbitration (a complex issue, but they could not in this case).

Thanks to Ian Fullington at Griffith Davison & Shurtleff, P.C. for his assistance with preparing this post.

Join Us for a Breakfast Presentation on Updates to the Model Jury Instructions for Construction Litigation at the Forum's Annual Meeting

Please join Divisions 10 and 12 and the Construction Litigation Committee of the ABA Section of Litigation for a breakfast presentation on "Updates to the Model Jury Instructions for Construction Litigation: Charging to a Successful Verdict" at the Forum on Construction Law's Annual Meeting on Saturday, April 18, 2015, at 8:00 a.m. 

Join us to hear from Melissa Beutler, Vice President and General Counsel of Big-D Construction, Forum Division 10 Steering Committee Green Building Chair and ABA Section of Litigation Construction Litigation Committee Member. She is the lead editor of the soon-to-be-published Second Edition of the ABA Section of Litigation Construction Litigation Committee's book on model jury instructions for construction litigation. The First Edition quickly became a go-to resource for many construction litigators when it was originally released. Melissa will discuss key updates to the model instructions, and explain the book's use as a resource on jury instructions as well as a way to gain quick insight on the elements of key legal issues faced in the construction industry.

Join Divisions 1, 10, and 12 for cocktails at the Annual Meeting

Please remember to register for the 2015 Annual Meeting of the ABA Forum on Construction Law from April 16-18 in Boca Raton, Florida.

If you're planning to attend, Divisions 1, 10, and 12 are having cocktails on Thursday night at The Blue at the Boca Raton Resort. 

Please contact Emily Anderson to RSVP for this event. Space is limited. If you'd like to make reservations for a sit-down meal, you can do so online here.

Misuse of Construction Trust Funds May Prevent a Contractor From Discharging Its Liability in Bankruptcy

In a recent bankruptcy case in Texas, the court rejected a contractor’s attempt to discharge its liability for violation of a construction trust-fund statute. Tag Invs., Ltd. v. Monaco (In re Monaco), 514 B.R. 477, 2014 Bankr. LEXIS 3276 (Bankr. W.D. Tex. 2014). The trust-fund violation established that the contractor had breached its fiduciary duties to the trust beneficiaries with either actual knowledge of wrongdoing or reckless disregard to the risk that the conduct would violate the contractor’s duties. This was sufficient to reject a discharge under § 523(a)(4) of the Bankruptcy Code.

In many states, funds paid by an owner to a contractor to pay for subcontractors’ work are considered statutory “trust funds.” See, e.g., Tex. Prop. Code §§ 162.001, et seq. The contractor is deemed to be a “trustee” with certain fiduciary duties to the “beneficiaries” of the trust funds, including the subcontractors. Violation of the statute occurs when the contractor intentionally or knowingly does not apply the funds in the manner required under the statute. This can lead to civil liability and, depending on the statute, potential criminal prosecution. Such liability applies not only to the contractor, but to any officers, directors, or agents who control or direct the trust funds.

If such violations occur, the contractor may attempt to discharge its liability to the owner for the misapplied payments through bankruptcy proceedings. If the subcontractors have perfected liens against the owner’s property, the owner faces the risk of paying twice for the subcontractors’ work without any possibility of collecting reimbursement from the contractor.  

To reduce this risk, the owner has the option to challenge the discharge of the debtor’s liability. Section 523 of the Bankruptcy Code prohibits discharge of a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” 11 U.S.C. 523(a)(4). If successful, the owner may then seek to recover the misapplied funds from the debtor (which could be the contractor, its officers, its directors, and/or its agents).

In the Monaco case, a contractor and several individual officers sought to discharge debts in bankruptcy that included claims asserted by an owner based on the debtors’ misapplication of trust funds. The contractor failed to pay several subcontractors despite receiving the funds to do so from the owner. The bankruptcy court found that the debts were not dischargeable, as the owner had shown that the debtors misapplied funds with sufficient knowledge to meet the requirements of § 523(a)(4) of the Bankruptcy Code. In particular, this finding was based on evidence that one of the officers submitted written certifications that all subcontractors and suppliers had been paid, when he knew they had not. These false certifications were intended to obtain payment from the owner and conceal the misapplication of the trust funds. Thus, the discharge was denied as to the officer who had signed the certifications. Another officer evidently was permitted a discharge because, though she likely knew the subcontractors had not been paid, she did not sign false certifications or engage in other conduct suggesting intentional violation of the trust-fund statute.

Bankruptcy proceedings can impose significant obstacles to the successful pursuit of claims against the debtors. Statutory fiduciary duties can serve as an important tool to owners seeking to overcome these obstacles.

An Invitation from Steve Lesser to Attend the 2015 Annual Meeting of the ABA Forum on Construction Law

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New Retainage Law Takes Effect in Massachusetts

The Commonwealth of Massachusetts has a new retainage law applicable to most private construction projects, which took effect on November 6, 2014.  The Retainage Law limits the ability of owners and contractors to negotiate retainage, punchlist, and substantial-completion provisions of certain private construction contracts.  It applies to any construction contract with an original contract price of not less than $3,000,000, and to which the Massachusetts mechanic’s lien law, M.G.L. Ch. 254, §§ 2 and 4, applies (i.e., contracts with prime contractors, all first- and second-tier subcontractors, and all first- and second-tier suppliers). Residential construction projects consisting of four or fewer units are exempt regardless of the contract value.  All construction contracts executed after the effective date are subject to the new law.

The Retainage Law limits the amount of retainage withheld from each progress payment to no more than five percent (5%) of the payment.  The law also specifically defines “substantial completion” as the stage of the project (or phase thereof, if applicable) at which work “is sufficiently complete . . . so that the project owner may occupy or utilize the work for its intended use.”  Any contract terms which conflict with this new statutory definition are void and unenforceable. 

The Retainage Law also prescribes a timeline and procedure for the release of retainage.  In general, retainage cannot be withheld for more than 90 days after substantial completion and seven additional days for each contract tier below the prime contractor.  The Retainage Law imposes a new statutory form of notice of substantial completion, which the prime contractor must submit to the owner within 14 days after achieving “substantial completion.”  The owner must accept or reject the substantial completion notice within 14 days of receipt and must send the general contractor a punchlist of deficient or incomplete items within 14 days after the owner’s acceptance. 

An owner may continue to withhold retainage, in limited amounts specified by the Retainage Law, for incomplete or incorrect work or deliverables and for certain outstanding claims.  In such event, the owner must, before the date payment is due, provide the party seeking payment with written notice describing the deficient or missing work items and deliverables, the basis of the outstanding claims, and the value attributable to each. 

The PowerPoint presentation in the link below provides more detail on the timeline and process for releasing retainage and on other aspects of the Retainage Law.  

New Massachusetts Retainage Law Powerpoint

The text of the New Retainage Law can be found here. 

Proposed legislation to change Florida's construction-defect notice statute

Sanjay Kurian recently posted an interesting article concerning proposed changes to Florida’s statute governing notice of construction defects. 

Proposed legislation to change Chapter 558

The Legislature will be considering legislation this year to change Chapter 558, Florida Statutes.  Chapter 558 is  required process for any party seeking to pursue claims for construction defects.  The original goal of Chapter 558 was to provide an opportunity to settle defect claims without litigation or arbitration, and not to create another source of dispute or litigation.  This bill is contrary to that original intent. The proposed bill would create new rights and defeats any realistic hope to amicably resolve claims as more fully explained below.  These changes, if enacted, will negatively impact all owners of construction improvements including hospitals, doctor’s offices, school buildings, condominiums, single family homes and commercial buildings.  The proposed legislation can be found here and the specific problems are noted below.

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