Departments — May/June 2007

Weighing the Risks For Contractors Who Build Condos

Contractors that do multifamily work must examine their risks from all sides before committing to build a condominium projects

Anthony Whitley ATTORNEY AT LAW Anthony Whitley is an attorney at the Dallas office of Ford Nassen & Baldwin PC, a law firm recognized throughout Texas and nationally for representing all participants in the construction industry.  He assists clients on public and private projects, including condominiums, with contract negotiations, defending against and pursuing bond and lien claims, and litigation/arbitration. Ford Nassen & Baldwin PC is also an active member of the QUOIN and Austin AGC chapters. Website: www.fordnassen.com

What was once a positive and upbeat prediction of progress and prosperity in the condominium construction industry has recently changed to predictions of doom and gloom. The reality is that many condominium projects spawn litigation involving everyone who had anything to do with the planning, development, construction and sales of condominium units.

But does this mean that contractors should avoid condominium projects altogether? Not necessarily. Contractors are experienced at identifying risks or else they would not survive in any market. Contractors just need to identify and control risks related to condominium construction to put them in the best position for success.

As with most projects, a contractor on a condominium project faces risks in its contract with a developer (initial owner of the project), in contracts with subcontractors, in conforming the construction to the design and obtaining adequate insurance coverage. However, these risks are amplified on a condominium project, especially when the developer is ultimately replaced by hundreds of residents.

Risks Associated With Multiple Residents

From a risk-management perspective, there are two fundamental differences between condominium and commercial projects. The first difference is that, once the units are sold, the developer is out of the picture, and ownership becomes vested in the residents. Because condominiums typically are sold before completion, residents may make decisions based on renderings and statements found in brochures. When a few residents become dissatisfied, the real estate agent, developer, designer, contractor and subcontractors all can become entwined in a cumbersome and costly lawsuit.

Contractors are disadvantaged on these projects because they are not party to the agreements with the residents. Promises made to residents may exceed the contractor’s obligations to the developer, but otherwise may be based on the same design. A contractor should try to include these concerns in its negotiations with the developer, ensuring that the developer limits warranties and other obligations to the residents to the same extent limited by the contractor in its agreement with the developer.

As the project closes out, the contractor should assist the developer in providing residents with warranty and maintenance information. This can be accomplished by giving each resident a warranty book outlining exactly what the limited warranty covers as well as the maintenance responsibilities of the residents. Most importantly, each resident should sign off on these documents.

If problems arise, assign them to a warranty response team for that project to document and address. The more quickly the contractor can respond, the less likely the issue will become contentious. If it does become an issue for litigation, the contractor would have already created a paper trail with its warranty book and responses to claims.

Risks Associated With Developers

The second fundamental difference between condominium and commercial projects is the nature of the developer. Like any other party to a contract, condominium developers wish to put themselves in a position where they have little long-term liability to the residents and contractors. Developers of condominium projects typically create “single-purpose” entities without assets, other than the project itself, to shield itself from liability. Such a developer can theoretically walk away from liability without fully paying a contractor and/or leaving contractors in the cross-hairs of disgruntled residents.

A contractor should assess and manage the risks associated with condominium developers during contract negotiations, during construction and especially after construction. Before executing an agreement, the contractor should research the corporate structure of the developer and the litigation history of affiliated companies and principals. If necessary and if you have enough leverage, request guarantees from the developer’s affiliated companies.

Before and during construction, contractors should verify availability of funding. If not satisfied, try to obtain a tri-party or set-aside agreement with the lender, where the lender commits funds to pay for construction and the contractor draws funds directly from the account.

Finally, the contractor should take a page out of the developer’s playbook and consider using a project-specific, limited-liability entity or corporation. This should be done after obtaining appropriate tax advice.

Risks Associated With Design

Even if a contractor properly mitigates the risks of multiple residents and a “single-purpose” developer, a faulty design can spell disaster. The architect is often a critical factor in the success or failure of any project, especially a condominium.  

Before a contractor signs an agreement with a developer, it should first determine whether the architect has experience in condo design, whether the architect has experience in the locale and climate of the project (what works well in the cold, dry climate of Colorado is likely unsuitable for the warm, wet climate of Florida) and whether the plans are complete.

The contractor also should request that the architect identify the contractor as a third-party beneficiary of the developer-architect agreement and that the architect guarantee the adequacy of the design. If the developer and/or architect refuses, the contractor should insist on limiting its responsibility for and exposure to the design, as it would on any project.

Finally, if the contractor is involved in a design-build arrangement, it should make sure that its liability for the design is limited to that which is recoverable from the design professional and/or the design insurers.

Risks Associated With Insurance

Some insurance carriers restrict residential construction coverage in general liability policies or exclude it entirely, creating the risk that the contractor is underinsured or lacks coverage. A contractor should check with its insurance broker to ensure there are no such exclusions or limitations in its general liability policy. Likewise, and just as important, the contractor should diligently ensure that the policies of its subcontractors have no similar exclusions.

As insurance becomes more difficult to obtain for these projects, developers and contractors may consider coverage through the use of owner-controlled or contractor-controlled insurance programs. The contractor should discuss with the developer and its insurance brokers whether these programs are available for the project and whether such programs would be cost-effective.

Risks Associated With Subs

As with any project, a contractor should pass on whatever risk it incurs in its agreement with the developer directly to the subcontractor ultimately in control of that particular risk. However, be wary of subcontractors who may attempt to assume liability for which they do not have adequate insurance coverage.

Any indemnity provision negotiated with the subcontractor is worthless if the subcontractor is undercapitalized and underinsured. The contractor should be specific in its subcontracts, not only as to the types and amounts of coverage required, and confirm that the subcontractor’s insurance includes the contractor as an additional insured and actually provides the coverage. Further, require subcontractors doing large or more risky scopes of work to provide bonds, being careful to ensure the bonds cover warranty and indemnity obligations.

In dealing with product manufacturers and suppliers, the contractor should try to require manufacturers to certify the applicability of the goods to the intended use, such as water tightness of windows in coastal areas. Request that the manufacturer certify that the goods not only meet the project specifications but also the local code requirements.