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Issues & Legislation

CALPASC has the benefit of having the most talented business professionals in our industry as our members.  Below is a position paper that describes who we are as an organization and how we are fighting for fairness, as we educate residential and commercial specialty contractors and suppliers and advocate on their behalf in the California Legislature, Regulatory Agencies and Courts.

REDEFINING THE "TRADE PARTNER" CONCEPT: ELIMINATING INAPPROPRIATE RISK TRANSFER FROM BUILDERS TO SUBCONTRACTORS
 
For decades, residential homebuilders and trade contractors have partnered together to build millions of homes, condominium units, townhomes and apartments throughout California.  In addition to producing much-needed housing for California residents, these partnerships contribute tens of billions of dollars each year to the state’s economy and provide hundreds of thousands of jobs.  Recognizing the importance of these relationships not just to the homebuilding industry but to California’s economy generally, builders and subcontractors advocate together, through the California Building Industry Association (CBIA), to ensure that state laws allow the industry to prosper by providing quality, affordable housing.  Trade contractors separately advocate through CALPASC.

CALPASC, through its statewide organization and four chapters located throughout the state, has over 500 members.  CBIA has approximately 6,700 member companies.  A sizable percentage of CBIA’s membership is trade contractors (in fact, there are more subcontractor members of CBIA than there are builder members).  These subcontractor members, typically small businesses with few resources for lobbying efforts, stand side-by-side with homebuilders, urging the California legislature to enact legislation to address the current affordability crisis in the state’s housing market.  In fact, subcontractor representatives have testified before the state legislature in support of CBIA’s position on a number of these very issues.

Yet, within the last 10-15 years, a small number of issues – all of them centered around the pervasive increase of construction defect litigation in California – have surfaced which threaten to drive a wedge between the builder-subcontractor partnership that has brought so much prosperity to the industry and to the state.  California’s major homebuilders have responded to the increasing wave of defect litigation by clinging to a singular principle of risk transfer.  Rather than relying on the partnerships that allowed the state’s homebuilding industry to grow and thrive, the strategy homebuilders have pursued on these issues – whether through contractual indemnification provisions, litigation, or legislative advocacy – is effectively to turn their collective backs on their trade partners by shifting the risk of construction defect lawsuits almost entirely to them.  In particular, builders have transferred the risk of construction defect litigation to subcontractors in two crucial respects: (1) by saddling them with defense obligations they can neither control, afford, nor insure; and (2) by requiring subcontractors to enroll in insufficiently-funded wrap-up insurance programs and then holding the subcontractor responsible for this builder-created insurance gap.
     
As explained below, although the number of issues on which builders and subcontractors agree far outweighs the number of issues where their opinions differ, these risk transfer issues present such a significant risk to the financial solvency of the subcontractor industry that they threaten to destroy the long-standing partnering relationship between builders and subcontractors.  The seriousness of these issues, in fact, spurred the creation of CALPASC as an organization separate and distinct from CBIA.  Indeed, the risk transfer issues facing the subcontractor industry are so important that the trade contractor industry is now forced to speak with its own voice rather than relying on homebuilders to speak on their behalf.

Crushing Defense Obligations

It is a basic principle of risk transfer that risks should be borne by the party in the best position to avoid the risk at the lowest possible cost.  (See Phillips, The Commercial Culpability Scale (1982) Yale Law Journal 228, 230, 251-263.)  In construction defect litigation, however, builders (in particular, their outside litigation counsel) have relied on broad contractual indemnification and defense provisions to turn this principle on its head.  Until very recently, the contractual indemnification provision in virtually every builder’s subcontract – which subcontractors are typically told they cannot negotiate – required the subcontractor to indemnify and defend the builder for any claim that is in any way connected to that trade’s scope of work, regardless of the extent of the subcontractor’s negligence with respect to the alleged claim.  In fact, in briefing filed to the California Supreme Court in the pending case of Crawford v. Weather Shield, CBIA took the position that subcontractors should be required to pay for the builder’s defense for all claims arising out of the subcontractor’s scope of work even if the subcontractor was not negligent at all! In a separately-filed brief, major builders Standard Pacific Homes, KB Home and others specifically stated that their first thought when they are served with a construction defect lawsuit is "How is my defense going to be paid?"

Although, following the passage of AB 758 in 2005, the California Civil Code now restricts a builder’s ability to require subcontractors to indemnify or defend it for claims not caused by the subcontractor’s negligence, California law remains silent on the timing of the subcontractor’s defense obligation.  Virtually all builders operating in California have responded to AB 758 by taking the following position: so long as, at the conclusion of a lawsuit, the total amount spent by the subcontractor on indemnification (i.e., paying a settlement or judgment to homeowner plaintiffs) and defense (i.e., paying the subcontractor’s and builder’s legal fees) is proportionate to the amount of that subcontractor’s fault, a builder can require any individual subcontractor to pay in advance the defense costs for the entire lawsuit!  As a result, builders’ contracts typically include non-negotiable provisions allowing them to require full payment of all defense fees (up-front) from any particular subcontractor.  Even worse, the attorneys who handle these lawsuits for builders enforce these provisions ruthlessly, seemingly unaware of the practical business consequences for builders’ most valued subcontractors.

These contractual provisions violate the legislative intent, if not the express terms, of AB 758, which mandated a public policy to limit a subcontractor’s obligation in a construction defect lawsuit to defending and indemnifying a builder only for claims caused by that subcontractor’s negligence.  This kind of risk transfer does not reflect a partnering relationship between builders and subcontractors; rather, it reflects the absence of partnering, as the builder is simply seeking to transfer the risk of defending a lawsuit to its trade contractors.  Further, such risk transfer serves only to increase the costs of construction defect litigation to all parties.  In almost every defect lawsuit, the builder’s attorney runs the show for the defense side, in effect acting as a surrogate for the plaintiff by trying to pin as much fault as possible on the subcontractors in an effort to get them to contribute as much money as possible to settle the case (thus reducing the amount the builder must pay).  As the builder often blames the subcontractor for defective construction, the subcontractor cannot fulfill its defense obligation through use of the same attorney defending the subcontractor’s work – an obvious conflict of interest exists.  Thus, in every case, the subcontractor pays for two attorneys – one for itself, and one to defend the builder.  Given the litigation position typically taken by the builder, the subcontractor, in virtually all cases, funds litigation against itself!

CBIA defended this system in the brief it filed in the Crawford case by asserting that the risk of defect lawsuits “should lie with the subcontractors who performed the work, [and] not the builder who simply contracted to get the work done.”  This position rejects any notion of partnering.  It ignores the practical reality of construction projects, increases the costs of defect litigation, and jeopardizes the financial solvency of subcontractors.  Subcontractors do not control the work sequence that creates the circumstances under which defects occur, nor do they enforce fast-track schedules.  Subcontractors do not design buildings or approve value engineering corner-cutting. They cannot ensure their work will properly fit with the work performed by later-finishing subcontractors, much less that their work will not be damaged or destroyed by a later-finishing subcontractor in a hurry.

Builders, by contrast, are responsible for “sequencing, inspecting, and coordinating projects and otherwise bringing the entire job together, so they cannot rationally evade all responsibility for worker injury and defect claims.”  (Comment, From the Bottom of the Food Chain Looking Up: Subcontractors Are Finding That Additional Insured Endorsements Are Giving Them More Than They Bargained For (2004) 23 St. Louis U. Pub. L.Rev. 697, 730 (Comment).) The builder is “the party with the most authority and power” and “is in the best position to prevent and to avoid mistakes.” (Ibid.)  The builder is the only player in residential construction who knows how the whole puzzle of a residence must be put together.  In fact, a builder’s Class “B” contractor’s license requires it to provide direct supervision and control over a project, including supervising construction, making technical and administrative decisions, and checking jobs for proper workmanship.  (See Bus. & Prof. Code, § 7057, subd. (a) [requiring that a general contractor either build the project itself or supervise the work of subcontractors]; Cal. Code Regs., tit. 16, §§ 823, subd. (b) [requiring “direct supervision and control” over construction job sites].) The builder alone has the power to stop construction, order changes to the work, and inspect the job as it progresses.

As defense costs greatly exceed indemnity payments in defect cases (by as much as 9:1), requiring subcontractors to advance a builder’s defense costs is an overwhelming obligation that presents a real likelihood of bankrupting subcontractors.  Subcontractors’ ability to insure this broad type of defense obligation is virtually non-existent in today’s insurance market.  Builders, by contrast, typically do have insurance to cover these risks; indeed, in the current climate, the risk of defending a defect lawsuit is transferred to the party least able to avoid it and for whom the cost of avoidance is highest.

Accordingly, the initial defense obligation in defect lawsuits should be borne by the party best able to avoid it at the lowest cost: the builder.  Builders are “the manufacturers of the finished product or residence, as well as the marketer (distributor) of the finished product.”  (Heppler v. J.M. Peters Co. (1999) 73 Cal.App.4th 1265, 1279.)  The builder of mass produced homes, who enjoys the profits from the ultimate sale of these homes, is in the best financial position (both in terms of preventing and controlling risk, and in terms of insurance coverage) to defend claims.  Holding the builder responsible in the first instance (at least until each subcontractor’s liability is determined) “‘places the liability for defects in construction where the responsibility and spoils [i.e., profits from home sales] lay.’” (Ibid.) 

Collapsing Wrap-Up Insurance

As noted above, the broad-form indemnity agreements relied on by builders and, especially, their outside counsel, not only caused sufficient financial distress to the subcontractor industry to spark the passage of AB 758 in 2005, but it also created an insurance crisis for subcontractors operating in the residential market.  In response to this crisis, the majority of builders, and virtually all major builders, have turned to wrap-up insurance.  In a wrap-up program, a builder purchases a single insurance policy (or a series of primary and excess policies) that insures claims against the builder and the various specified subcontractors on the project or projects covered by the policy.
 
Wrap-up insurance is designed to solve many of the insurance and defense problems associated with construction defect litigation; indeed, a well-designed and funded wrap-up policy ensures a sole source of funding for any lawsuit and allows for a unified defense of the builder and all of the subcontractors for any claims.  In practice, however, most wrap-up programs are neither well-designed nor well-funded, with potentially disastrous consequences for the industry and for subcontractors in particular.
 
Most wrap-up policies do not provide the amount of insurance that was typically provided on construction projects when the builder and the numerous subcontractors used their own traditional general liability policies.  It is not at all uncommon today to see large, attached housing projects (which produce construction defect lawsuits nearly 100% of the time) being built with wrap-up insurance limits of only $2 million.  One very large builder has a wrap-up insurance program with only $25 million in limits covering over 10,000 homes, an average of only $1,750 in coverage per home constructed!  For many, if not most, wrap-up programs, the question is not if the program will exhaust before it can pay all claims, but when.  A hugely important problem for the industry is what to do about the risk that wrap-up programs will prematurely exhaust.

Like with the defense obligation, builders have responded to this crisis by turning away from a partnering relationship with subcontractors and instead turning to risk transfer.  The vast majority of builders’ subcontracts on wrap-up projects include a requirement that the subcontractor indemnify, including the cost to defend, the builder for any claim not paid by the wrap-up policies.  Again, the party in the worst position to avoid and insure the risk is asked to bear it.
 
In today’s insurance market, it is virtually impossible for subcontractors to obtain insurance that will cover a project with a wrap-up program.  Thus, for any claim for which the wrap-up program is not available, a subcontractor must bear any indemnity obligation, as well as potentially the entire up-front cost of defending the lawsuit, without any insurance!  In this scenario, the builder’s argument that a subcontractor would be entitled to reimbursement of any defense costs it fronted if it turned out those costs did not arise out of the subcontractor’s negligence is virtually meaningless.  Even one or two lawsuits with this sort of obligation would bankrupt the subcontractor long before the cases resolved and any reimbursement would be paid.  This problem is more significant and will reach a crisis point more quickly than the problems associated with Type 1 indemnity that led to the passage of AB 758 because unlike that scenario, here subcontractors have no practical ability to insure the risk.
 
Even worse, subcontractors have no ability to control or prevent the risk of a wrap-up program exhausting prematurely.  Subcontractors have no say in the type or amount of wrap-up insurance that is purchased.  Trades have no influence over the quality of other subcontractors selected to perform work on the jobs covered by the wrap-up program.  As noted, subcontractors have no opportunity to control the scheduling design, or supervision of the work giving rise to potential litigation.  Yet, subcontractors are asked to front the risk of any failure by the wrap-up program to cover all claims.
 
Left with this bankruptcy-inducing obligation, subcontractors will have no choice but to pursue litigation against the builder to challenge the indemnity and defense obligation in these cases.  Now, rather than providing a single, unified defense to the homeowners’ claim, the already paltry wrap-up insurance policy will be forced to pay for the defense of dozens of subcontractors in addition to the builder.  This will only hasten the exhaustion of the wrap-up policy limits and plunge the industry further into crisis.  
 
A poorly financed wrap-up policy is therefore bad for subcontractors and builders.  It will increase, rather than decrease, litigation between the parties.  It will greatly accelerate and worsen the “bankrupt subcontractor” problem that builders often identify as a struggle in responding to construction defect lawsuits.  The solution to this problem, however, is clear:  in the context of a wrap-up program, contractual risk transfer is entirely inappropriate.  Subcontractors can always be brought into a lawsuit directly by the homeowners or by the builder under equitable indemnity principles.  To ask the subcontractor to front a builder’s defense costs without insurance, however, only exacerbates the problems that created the insurance crisis in the first place.  The only real solution to the construction defect problem is wrap-up insurance with sufficient limits and no contractual risk transfer; indeed, creating one source of insurance that actually does “wrap up” the project.

Conclusion

Like the myriad of issues on which they agree, when it comes to construction defect litigation, builders and subcontractors should be allies rather than adversaries.  Too often, however, builders employ a risk management model of shifting risk rather than sharing it with their trade partners and working together to reduce it.  Unfortunately, this decision hurts not only subcontractors but builders as well.  When builders and subcontractors fight each other rather than the plaintiffs’ attorneys in construction defect lawsuits, the plaintiffs’ attorneys win and the industry loses.  When builders purchase insufficient wrap-up policies and rely on questionable indemnity and defense provisions in their contracts to make up the difference, more litigation results and the industry loses.  The partnering relationship between builders and subcontractors should not exist only when land is being zoned for housing and homes are being built.  Builders and subcontractors should be partners throughout the warranty and litigation period as well.  Without this latter partnership, the former partnership will inevitably fail.

 

 

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