Lowering Defect Lawsuit Risks

OP RESIDENTIALBy Blair Lichtenfels and Jonathan Pray   

Multifamily housing construction has been booming across the country, evidence of what has been dubbed the “back-to-downtown movement.” Much of the construction has been at the top end of the residential market, particularly in the luxury apartment sector. Despite this, in pockets of the country, condominium construction is at near all-time lows, in part due to legal frameworks that make it easy for HOAs to bring expensive construction defect suits against developers and contractors. Developers and contractors are natural (and sometimes easy) targets for HOA boards, who all too often view a construction defect lawsuit as a no-lose proposition. Once filed, construction defect lawsuits can last years, and the costs of defending them can be staggering — and in the meantime unit owners are frequently unable to sell their units.

Some state and local governments are trying to pass measures intended to reduce these risks. By way of example, Colorado recently enacted legislation requiring HOAs to go through stricter processes and follow tougher voting requirements before bringing construction defect claims against developers, contractors and designers. This measure (and similar legislation around the country) is a step in the right direction, but certainly not a panacea. The current state of uncertainty means that contractors and developers often need to find their own tools to mitigate the risks associated with condo projects.

So what can contractors and developers do to reduce the odds of being named in a construction defect lawsuit?

  • Design Peer Review: Successful developers are having the architectural and engineering drawings for their project reviewed by a second (or third) set of eyes. This process, often called “peer review,” gives an independent architect and/or engineer the chance to review the plans for errors or room for improvement.
  • Construction Inspections: Another technique that is increasing in popularity is to rigorously inspect the subcontractors’ work and create extensive photographic and video documentation of the construction techniques being employed on-site. These photos could be key evidence in a defect lawsuit down the road.
  • Arbitration: Many developers and contractors believe that arbitration is a better forum than litigation for the resolution of construction defect claims. More specifically, developers and contractors frequently conclude that having a claim decided by an arbitrator with expertise in construction (rather than a jury) is more likely to lead to a fair result. On this basis, HOA declarations and other governing documents frequently include mandatory arbitration provisions that require unit owners to give up their right to have a construction defect claim heard in court. That said, courts have struggled to balance the competing interests of developers, contractors, and unit purchasers—and they have sometimes found mandatory arbitration provisions to be unenforceable.

Keep in mind that, in addition to constituting best practices, many of these same strategies will be required by the insurance carriers underwriting the project.

That’s a Wrap

Speaking of insurance, perhaps the most important component of any defect mitigation strategy is the use of an owner-controlled insurance program (OCIP) or a contractor-controlled insurance program (CCIP), both of which are often referred to as “wraps.” Traditionally, the general contractor and its subcontractors have been required to purchase their own liability insurance. The result can be a maze of insurance policies with varying limits, coverages and exclusions. Worse, when there is a claim, each carrier is incentivized to point the finger at other parties. Under a wrap, by contrast, a single package of liability insurance policies provides coverage to all of the parties that enroll and perform work on the project. A wrap can provide significant advantages to owners and contractors, including:

  • Control: With a wrap, the parties gain control over what is included in the insurance program for the project and how much insurance is available to respond to claims.
  • Longevity: If structured correctly, a wrap should also provide coverage for the entire statute of repose, so contractors and developers don’t have to worry about whether subs will have insurance after the project is complete.
  • Cost Savings: Rather than paying for insurance costs that are imbedded in bids, by purchasing a single policy, the parties can potentially negotiate less expensive coverage and higher limits.

Not all wraps are created equal, however, and it is critical to understand what is and is not included in a particular program. Common coverage exclusions can weaken the coverage provided by a wrap, and it’s important to work with a skilled risk management team that can help you shape the right wrap for your project.

There may not be a silver bullet for avoiding litigation on condominium projects, but developers that work to mitigate risks – and maximize insurance coverage – can be successful even in the current environment.

Jonathan Pray, shareholder at Brownstein Hyatt Farber Schreck, is an experienced litigator specializing in real estate and construction disputes and a shrewd transactional attorney who demonstrates a skillful hand at risk mitigation. He has represented clients in all aspects of the development and construction industries, including commercial and residential developers and landlords, public agencies, design and engineering firms, contractors, subcontractors, suppliers, lenders, sureties and municipalities. 

Blair Lichtenfels, shareholder at Brownstein Hyatt Farber Schreck, is a real estate attorney with a business perspective who advises prominent developers and equity investors in connection with redevelopment, urban infill, brownfields, mixed use and transit-oriented developments. Her expertise encompasses entitlement review, securing required land use approvals, acquisition and disposition, planned community development and formation, providing community outreach advice and advising on public-private partnerships for complex commercial projects including industrial parks, office buildings, apartments, hotels, retail and mixed-use projects across the country.

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