On March 10, 2011, following a four-week criminal trial, a federal jury found Zohrab B. Marashlian, the former President of Perini Corporation’s Civil Division (“Perini”), guilty of fraud and conspiracy to launder money. Two days later he took his own life. What led to this sad and unfortunate outcome? Based on information obtained from the U.S. District Court’s file in United States v. Zohrab Marashlian, Docket No. CR-08-900, I will attempt to answer this question.

Personal History:

Mr. Marashlian was President of Perini’s Civil Division from 1997 to 2007. He was born in Aleppo, Syria in 1944 to an Annenian family. He earned his civil engineering degree from the American University of Beirut, Lebanon, and immigrated to the United States in 1971. He later earned an MBA from Columbia University. Shortly after arriving in America, he was employed by Perini as an office engineer, and through hard work and ambition rose to President. Zohrab Marashlian was responsible for constructing and rehabilitating many high profile projects including highways, bridges, subways, tunnels, and waste water treatment facilities. By all accounts, he was a wellrespected executive, and a friend to many in the heavy construction industry.

The Criminal Charges:

The criminal charges against Mr. Marashlian arose out of representations, made to government contracting agencies on certain federally-funded projects, that Perini would use disadvantaged business enterprises (“DBEs”)¹ to perform certain percentages of work, as required under the public contracts awarded to and performed by Perini. Instead of having the DBE subcontractors perform the specified work, however, the jury found that Zohrab knowingly used the DBE subcontractors as “fronts” for non-DBE companies, which actually performed the work set aside for the DBE companies.

The Indictment against Mr. Marashlian, which included numerous counts of mail fraud, wire fraud and money laundering, stated in pertinent part as follows:

The defendants Zohrab B. Marashlian and … others devised a scheme to defraud government contractirig agencies … by falsely representing in proposals and other documents submitted by Perini to those agencies for public works contracts … that DBE subcontractors would perform commercially useful functions in satisfaction of the DBE requirements of those public works contracts.

Contrary to the representations made by Perini, when Perini was awarded the public works contracts, Marashlian … and others did not have the DBE subcontractors perform commercially useful functions on the public works contracts. Instead Marashlian . . . and others used non-DBE subcontractors to perform work on the public works contracts that should have been performed by the DBE subcontractors.

It was part of the scheme to defraud that the defendants Zohrab B. Marashlian … and others caused non-DBE subcontractors to list their employees and supervisors on the payrolls of the DBE subcontractors, and order supplies and materials through the DBE subcontractors, to create the appearance that the DBE subcontractors were performing commercially useful functions on the public works contracts. Marashlian …further caused Perini to falsely certify to [public contracting agencies] that the DBE subcontractors performed DBE subcontract work on the public works contracts when, in truth and fact, as Marashlian … well knew and believed, the DBE subcontract work on the public works contracts was performed by non-DBE subcontractors (¬∂¬∂ 13-15 of the Indictment, filed December 18, 2008).

According to the government, Marashlian’s false representations induced, aided and abetted the award of more than $284 million in public contracts to Perini² During the performance of these contracts, Zohrab and others took steps to maintain the illusion that the DBE subcontractors were actually performing the work, by arranging financing and laundering payments through the “front” companies. The progress payments from the public contracting agencies to Perini were deemed by the government to be financial transactions, with proceeds from a specified unlawful activity (i.e., money laundering), because, but for the fraud committed by Mr. Marashlian, Perini would not have been awarded the contract, and would not have received the progress payments. The tainted monies were then paid out, to the supervisors, workers and/or non-DBE subcontractors actually performing the work after a fee for processing the payments was deducted by the DBE (i.e., the DBE subcontractors received a fee or markup ranging from 3% to 5% of their costs). As a result of these frauds, the prosecution pointed out, Mr. Marashlian individually benefitted from the receipt of substantial payments, in the form of increased corporate salary and bonuses, totaling $14 million from 1994 through 2007. There was, however, no indication in the court papers that Mr. Marashlian personally received kickbacks from the DBE or non-DBE subcontractors or their principals.

The “Commercially Useful Function” Requirement:

In order to receive Federal highway funds, New York was required to have a DBE Program meeting Federal requirements and has done so by adopting them under 17 NYCRR35.3.

Under the relevant DBE Programs established by New York State and City agencies (the ”NY-DBE Programs”), general contractors are permitted to count toward the attainment of their DBE percentage goals only funds paid to DBE companies that perform a “commercially useful function” in the performance of a contract. Under such NY-DBE Programs, and the associated federal regulations, a DBE company performs a “commercially useful function” when it: (a) is responsible for the execution of a distinct element of the work of a contract; (b) carries out its responsibilities by actually performing, managing and supervising the work involved; and (c) furnishes all supervision, labor, tools, equipment, materials and supplies necessary to perform that distinct element of the contract work. Pursuant to federal regulations, a DBE does not perform a “commercially useful function,” if its role is limited to that of an extra participant in a transaction, contract, or project, through which funds are merely passed in order to obtain the appearance ofDBE participation in a contract.

In order to participate in the NY-DBE Programs, a minority and/or female owned company has to be certified as a DBE by the NYSDOT or the City of New York. “DBE certification” means that a general contractor can receive credit toward the attainment of its DBE percentage goals, by subcontracting work to the certified DBE company. However, the DBE company still has to perform a “commercially useful function” in order for the general contractor to receive credit; and, as you might guess, the general contractor is responsible for making sure that the DBE subcontractor performs a “commercially useful function.”

Furthermore, pursuant to New York law and federal regulations, a DBE subcontractor is prohibited from subcontracting work it is awarded in connection with its DBE status.

The Criminal Conduct:

This is where Mr. Marashlian made a serious mistake that mushroomed into criminal conduct. The prosecuting attorneys claimed, that for over a decade, Mr. Marashlian, and others working under him, repeatedly met with specialty subcontractors, and told them that in order to be awarded work by Perini, they had to bill their work through a DBE company’s name so that Perini could receive “DBE credit”. According to government witnesses, sometimes Mr. Marashlian would dictate which DBE the subcontractors should use as a “front,” and sometimes he did not care what DBE was used, as long as Perini could claim the subcontract work for DBE credit. Whether or not Mr. Marashlian was simply trying to shift the headache of complying with the DBE program away from Perini to Perini’s subcontractors, the jury was convinced that he committed fraud, by directing or causing the specialty subcontractors to transfer their management and workers to the books of DBE companies, and having those DBE companies pass on fraudulent invoices to Perini.

Recommendation:

Any person or company, when selecting a DBE subcontractor to perform a certain scope of work on a public contract, should avoid doing business with DBE subcontractors on a ”time and material” or “cost plus” basis, unless the DBE can demonstrate a history of performing the subcontract work and managing its own work, including supervising, hiring and firing of employees, and the performance of all administrative functions.

Doing business with certified DBE subcontractors that have nothing more than an office and a handful of clerical employees to run a payroll, purchase materials and pay project related invoices is clearly not enough to meet DBE requirements, and will likely draw the scrutiny of government investigators. Everyone in the heavy construction industry should recognize by now that a DBE subcontractor does not perform a “commercially useful function,” if its role is limited to that of an extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance ofDBE performance of work on a project. The u.s. Attorney clearly stated in a memorandum filed in the subj ect case that

DBE companies who agree to act as a ”hilling” or ”payroll” service for a fee, generally cease to operate as legitimate contracting companies. The DBE company that acts as a “front” for a legitimate subcontractor or the subcontractors’ employees have the effect of gutting the DBE, reducing or eliminating the need for most employees from the DBE and preventing the company from developing contract experience and increasing in size – all goals ofDBE programs.

If you can’t find a capable DBE subcontractor to meet the contract’s DBE requirements, disclose that fact to the public contracting agency at the outset, and request a reduction of the DBE goals set by the agency. Where the public agency determines that “good faith efforts” have been made by the general contractor, and competent DBE subcontractors are not available, the agency should waive compliance with the DBE goal. For example, according to the government’s court papers, during the time frame involved in Mr. Marashlian’s case, State agencies often reduced DBE “goals” by up to 50% or more, at the request of general contractors, who had attempted, unsuccessfully, to comply.

Shifting the Risk of Doing Business with DBE Subcontractors back to the Government:

The time may have also come for contractors to decline taking on the risk associated with these government set-asides. Besides the mistakes made by Mr. Marashlian and Perini, a number of other well-known and reputable heavy construction contractors have reached multimillion dollar civil settlements for doing business with DBE companies that failed to perform a “commercially useful function”. In competitively-bid construction contracts, why should a contractor be asked to take on the added risk of having to find competent DBE subcontractors, and then hope that such companies are capable of fully performing their scope of work on schedule, and in accordance with plans and specifications? In order to level the playing field among all general contractors bidding the work, perhaps the United States Department of Transportation (i.e., the federal agency responsible for issuing the regulations governing the DBE Program) should make the local governmental agency responsible for selecting one or more competent DBE subcontractors to perform a defined scope of work as separate prime contractors, and then have the government agree to assume the risk that the DBE prime contractor may fail to perform. The government could select the appropriate DBE contractors through a separate request for proposal (“RFP”) or competitive bidding process, and define the scope of work to be performed by the DBE companies in the main prime contract. This type of arrangement would enable the general contractor to focus on what it does best – – managing, scheduling and constructing the Project, without the worry of trying to increase the participation of competent DBE’s in federally-funded public construction contracts. Although this could cause some of the problems that are commonly associated with “Wicks Law” projects in New York, it would eliminate the risk, now faced by general contractors, of being criminally prosecuted for intentionally or unintentionally crossing over the line in order to meet the requirements of the Federal DBE Program.

Hopefully, every executive in the construction industry wi11leam a lesson from the above story, and pass that lesson on to younger members of our industry in order to prevent a similar occurrence in the future.

¹ A DBE is a small, for-profit business concern that is at least 51 % owned and controlled by socially and economically disadvantaged individuals. The firm must be operational, independent and operate in a selfsufficient manner. The owners must meet the federal definition of “socially and economically disadvantaged” (Women, minorities, or individuals who can document their disadvantage; all must also demonstrate that their adjusted personal net worth is no more than $1.32 million). Owners must possess the power and expertise to control the daily operations and management of the firm, and be able to establish at least 51 % ownership through real and substantial investments of capital. If anyone of these conditions is not met, the company does not qualify as a DBE. (49 C.F.R. 26)

² On October 30, 2009, Perini Corporation entered a civil settlement with the government in connection with the contract frauds outlined in the indictment. Perini paid $9.75 million in settlement, to the government to avoid any actions against Perini Corporation, including actions for false claims against Perini. These monies eliminated any profit from the four contracts referenced in the Indictment. Perini also agreed with the USDOT to take steps to insure compliance with the DBE program on future public works contracts.

INTRODUCTION

A comprehensive investigation of subsurface conditions before the design and construction of a project is generally considered a worthwhile investment that will, for the most part, eliminate surprises and costly change orders to the construction contract. Sometimes, however, even the most comprehensive investigation does not eliminate all surprises during performance of the construction contract and the Owner, Engineer and Architect must decide how to allocate the risk for such unanticipated subsurface conditions. If the risk is shifted to the Contractor, one would reasonably expect that the Contractor would add a contingency to its bid price in order to cover the risk of such unforeseen conditions. By adding a differing site conditions clause to the construction contract, however, the Owner can accept the risk and agree to issue the contractor a change order in the event of such unforeseen conditions. Set forth below is a discussion of how to manage these risks through the construction contract documents and of the pitfalls to avoid in preparing such contract documents, which normally include soil boring logs and a geotechnical report.

Key Contract Clauses and Related Court Decisions

1. Differing Site Conditions, Changed Conditions and Concealed or Unknown Conditions

The terms “differing site conditions”, “changed conditions”, and “concealed or unknown conditions” are perhaps best defined by the Federal Acquisition Regulations as follows:

(1) subsurface, latent or physical conditions at the site materially different from those indicated in the Contract; or
(2) unknown physical conditions at the site of an unusual nature, differing materially from those ordinarily encountered and generally recognized as inherent in work of the character provided for in the Contract (48 CFR Section 52.243.5).

In Other Words . . .
+ Type I = Bid documents differ significantly from the actual site conditions

+ Type II = Bid documents show nothing, but site conditions are significantly different than what would normally be expected

New York law allows a contractor to prevail on a differing site condition claim, but the contractor is first required to prove six elements:

(1) the contract documents must have affirmatively indicated the subsurface conditions; (2) plaintiff must have acted as a reasonably prudent contractor in interpreting the contract documents; (3) plaintiff must have reasonably relied on the indications of subsurface conditions in the contract; (4) the subsurface conditions actually encountered must have differed materially from those indicated in the contract; (5) the actual subsurface conditions encountered must have been reasonably unforeseeable; (6) and plaintiff’s claimed damages‚Ķmust have been solely attributable to such materially different subsurface conditions.

Fruin-Colnon Corp. v. Niagara Frontier Transp. Authority, 180 A.D.2d 222, 226, 585 N.Y.S.2d 248 (4th Dept. 1992). “[T]o the extent [that] the conditions described in the contract materialize, the contractor bears the risk, while the government assumes the risks for conditions [that] the contract documents fail to disclose.” Id. at 227.

2. Shifting the Risk to the Contractor by use of Disclaimer and Exculpatory Clauses

As a defense against differing site condition claims, Owner’s have successfully enforced disclaimer and exculpatory clauses in the bidding documents. Typically, a disclaimer or exculpatory clause states that the conditions depicted on the bidding documents are not to be treated as a representation of the actual conditions and the information is not to be substituted for the personal investigation to be performed by the contractor prior to bidding on the documents. A. S. Wilkstrom, Inc. v. State, 52 A.D.2d 658, 381 N.Y.S.2d 1010 (3d Dept. 1976).

Several types of Contract Clauses attempt to limit the Contractor’s right to make or prevent such claims. Disclaimer and exculpatory clauses are used by Owners to shift the risk for “differing site conditions:, “changed conditions” or “concealed or unknown conditions” to the Contractor.

Disclaimer clauses, for example, are used to avoid responsibility for incorrect or incomplete information which may be contained in the Contract Drawings and Specifications. Such clauses generally require the Contractor to investigate the site and determine the risks associated with the job, state that the Owner does not warrant the information it provides, and state that the information is provided for estimating purposes only. For example, the New York State Department of Transportation has previously used a clause which disclaims the accuracy of stated conditions and quantities. It reads as follows:

SPECIAL NOTE – Unclassified Excavation:
The excavation table appearing on this sheet was prepared by the State from the best information available. The Contractor’s attention is called to the fact that conditions and quantities, as shown on the table are estimated and not actual, and in any event they are not to be determined or considered by the Contractor as a warranty or a representation by the Superintendent of actual field conditions or quantities.

With respect to the State’s production of soil boring logs along with plans, specifications and other bid documents, which are used by a prospective Contractor in preparing its bid, the State has also used the following clause effectively:

This information is intended for State design purposes only, and is made available to bidders only that they may have access to identical subsurface information available to the State. It is presented in good faith, but is not intended as a substitute for the personal investigations, interpretations or judgments of the Contractor.

Another form of disclaimer requires the Contractor to investigate the site and to determine the risks associated with the job. In Article III of the State’s Standard form contract there is a requirement that the Contractor examine the Contract Documents and the site of the proposed Work which reads as follows:

ARTICLE 3. EXAMINATION OF DOCUMENTS AND SITE.
Contractor agrees that before making his proposal he carefully examined the Contract Documents, together with the site of the proposed Work, as well as its surrounding territory, it is fully informed regarding all of the conditions affecting the work to be done and labor and materials to be furnished for the completion of this contract, including the existence of poles, wires, pipes and other facilities and structures of municipal and other public service corporations on, over or under the site, and that this information was secured by personal investigation and research and not from the estimates or records of the department, and that he will make no claim against the State by reason of estimates, tests or representations of any officer or agent of the State.2

Despite a disclaimer clause, the State may still be liable “if said conditions are not as represented and (1) inspection would have been unavailing to reveal the incorrectness of the representations or (2) the representations were made in bad faith.” A. S. Wilkstrom, Inc., 52 A.D.2d 658, 381 N.Y.S.2d 1010 (3d Dept. 1976).

The State and for that matter any Owner should disclose all information it has regarding subsoil conditions from either tests it has performed or prior knowledge of the conditions, but if the disclosed information was the same as the undisclosed information and the bid would not have differed otherwise, the State or the Owner is not liable. Id. By signing an agreement which stated that the documents make no representation regarding existing sub-surface conditions, character and extent of the soil data or other subsurface conditions to be encountered during the work and no guarantee as to their accuracy, the contractor waived the right to hold the architect liable unless the architect withheld information which would have affected the amount of the bid. Wrecking Corp. of America v. Memorial Hospital for Cancer and Allied Diseases, 63 A.D.2d 615, 405 N.Y.S.2d 83 (1st Dept. 1978).

In Wrecking Corporation of America, the agreement between the parties clearly imposed upon the excavation subcontractor the responsibility and risk of subsurface conditions. One part of the Contract provided that “no representation is made by the General Contractor, Owner, Architect or Engineer in any Contract Document regarding the existing subsurface conditions”, and in another part of the contract it further provided that “the Owner, Architect and Consulting Engineers make no representations regarding the character and extent of the soil data or other subsurface conditions to be encountered during the Work and no guaranty as to their accuracy or interpretation is made or intended”. Based on these Contract provisions, the excavation subcontractor’s complaint that subsurface conditions encountered differed materially from those represented in the design drawings furnished by the Contractor and the Owner was dismissed. The Court found that plaintiff clearly assumed full and complete responsibility for all excavation and construction costs relating to the foundation, including total responsibility for subsurface conditions. Also with respect to the excavation subcontractor’s claim that the Owner withheld relevant information and failed to determine subsurface conditions in a reasonable manner it was found that there was no showing that the as-built drawings, which plaintiff claimed were not supplied to it at the time of bid, were actually in existence, let alone that they were in the Owner’s possession or control and were withheld by it. The usefulness of the as-built drawings was also seriously questioned in the depositions of the parties.

In Depot Const. Corp. v. State of New York, the State included a disclaimer in the bidding documents stating that the information provided was for “design purposes only” and was “not intended as a substitute for personal investigations, interpretations or judgment of the Contractor.” Depot Const. Corp. v. State of New York, 19 N.Y.2d 109, 114, 224 N.E.2d 866 (N.Y. 1967). The State was not liable for fraudulent misrepresentation when it provided to the contractor the boring data results, as well as any other information it had on the subsoil conditions. Id. “No reasonable bidder could have assigned to the borings a more significant role of specificity; or could have expected them to represent more than a small number of samplings over a large area.” Id. Therefore, the State, by providing all the information it had on underground conditions and using a disclaimer in the bidding documents, successfully transferred the risk of differing site conditions to the contractor.

On the other hand, the reasonableness of the contractor’s reliance on the bidding documents may depend on the timing requirements for the bid. For example, the State was liable for fraudulent misrepresentation when after ten years of investigation, the bidding documents indicated that the “boulders‚Ķwere the least predominant” in the soil, when in reality, the contractor found “nested boulders” which were “so large and numerous and so close together as not to allow room for pile insertions.” Conduit and Foundation Corp. v. State of New York, 74 A.D.2d 684, 685, 425 N.Y.S.2d 874, 877 (3d Dept. 1980). The court found it was reasonable for the contractor to depend on the bidding documents as an accurate representation of the subsoil conditions since the State had investigated the area for over ten years, the contractor only had one month to prepare its bid, and did not have sufficient time to conduct its own subsoil inspections. Id.

Similarly, the State was liable for fraudulent misrepresentation despite a disclaimer clause in the bidding documents when the State knew exactly how much work would need to be performed to obtain acceptable subsoil conditions, but intentionally specified only half of such work in the bidding documents. County Asphalt, Inc. v. State of New York, 40 A.D.2d 26, 337 N.Y.S.2d 415 (3d Dept. 1972). The fact that the contractor’s bid would have been significantly higher if it had known of the actual amount of work to be performed and that the contractor only had three weeks to prepare its bid weighed against the State, because in such conditions, it was reasonable for the contractor to rely on the bidding documents as an accurate representation of the subsoil conditions. Id. The limited amount of time to prepare the bid also meant the contractor did not have sufficient time to perform an independent subsurface exploration to determine the actual conditions. Id.

3. Misrepresentation Theory

“To rely on fraudulent misrepresentation, claimant [has] to prove that the additional work performed resulted directly from the State’s [or Owner’s] concealment or nondisclosure of material facts either known to it or within its possession.” D. A. Elia Const. Corp., v. New York State Thruway Authority, 289 A.D.2d 665, 666, 734 N.Y.S.2d 295, 297 (3d Dept. 2001). A clause in the bid documents advising bidders to conduct their own field inspections can be relied on as a defense, as long as there is no evidence that sufficiently thorough inspection could not have been made before the contractor submitted its bid. Id. Since the contractor failed to perform its own inspection, the contractor “could not reasonably rely on the bid documents for anymore than an approximation of the repair areas.” Id.

Despite a disclaimer clause, the State may still be liable “if said conditions are not as represented and (1) inspection would have been unavailing to reveal the incorrectness of the representations or (2) the representations were made in bad faith.” A. S. Wilkstrom, Inc., 52 A.D.2d 658, 381 N.Y.S.2d 1010 (3d Dept. 1976).

While disclaimers can be effective to protect an Owner from a Contractor’s claim of changed conditions, such clauses will be strictly construed against Owners. For example, in Andrew Catapano Company v. The City of New York, 116 Misc.2d 163, 165, 455 N.Y.S.2d 144 (New York, 1980) the Court determined that even where a contract disclaimed responsibility for conditions “on, about or above the site,” the Owner had not disclaimed responsibility for subsurface conditions, because of the stated language and because the changed conditions clause in the Contract specifically provided for adjustments in the event of unanticipated subsurface conditions.

Such disclaimers will also be unavailing when conditions represented by the Owner are highly inaccurate. In Warren Bros. Company v. New York State Thruway Authority, 34 A.D.2d 97, 99, 309 N.Y.S.2d 450, 452 Aff’d. 34 N.Y.S.2d 770, 358 N.Y.S.2d 139, the court stated:

In a construction contract between the State and an individual, which contains representations as to existing conditions affecting work thereunder as well as an exculpatory clause relieving the State of liability and requiring personal inspection of the contract site, liability, nevertheless, may attach to the State if said conditions are not as represented and (1) inspection would have been unavailing to reveal the incorrectness of the representations or (2) the representations were made in bad faith.

Exculpatory clauses meant to relieve an Owner of liability for the information that it provides and for damages incurred due to changed conditions, are generally valid and enforceable, even when they are intended to relieve the Owner of responsibility for its own negligence. Such Exculpatory clauses will, however, not insulate an Owner from liability where the conditions are not as represented in the Contract and inspection by the Contractor would not reveal the representations to be false Rusciano Construction Corp. v. The State of New York, 37 A.D.2d 745, 746, 232 N.Y.S.2d 21, 24 (3rd Dept., 1971). Furthermore, a Contractor is not to be foreclosed by standard exculpatory clauses which place the burden to investigate the site and discover potential problems wholly upon it, when the State or municipality is chargeable with knowledge of their existence and location (see Laura Roofing & Renovation Co., Inc., v. The Board of Education of the City of New York, 57 A.D.2d 586, 393 N.Y.S.2d 593 (2nd Dept., 1977)). Without exception, an exculpatory clause will not insulate an Owner from liability when the Owner intentionally misrepresents the conditions. Rusciano Construction Corp. v. State of New York, 37 A.D.2d 745, 323 N.Y.S.2d 21 (3rd Dept., 1971). The bottom line is that even when such disclaimer and exculpatory clauses are included in a contract, an Owner may be liable for both innocent and intentional misrepresentations. Under either theory, however, the misrepresentation must be material in order for a Contractor to recover damages. See A.S. Wilkstrom, Inc. v. State of New York, 52 A.D.2d 658, 381 N.Y.S.2d 1010 (3rd Dept., 1976).

4. Owner’s Acceptance of the Risk for Changed Conditions

If the Owner decides to accept the risk for unforeseen subsurface conditions, there are many ways to address this in the construction contract. For example, AIA Document A201 – 1997 provides the following clause covering changed conditions but does not limit the location of the condition:

4.3.4 Claims for Concealed or Unknown Conditions. If conditions are encountered at the site which are (1) subsurface or otherwise concealed physical conditions which differ materially from those indicated in the Contract Documents or (2) unknown physical conditions of an unusual nature, which differ materially from those ordinarily found to exist and generally recognized as inherent in construction activities of the character provided for in the Contract Documents, then notice by the observing party shall be given to the other party promptly before conditions are disturbed and in no event later than 21 days after first observance of the conditions. The Architect will promptly investigate such conditions and, if they differ materially and cause an increase or decrease in the Contractor’s cost of, or time required for, performance of any part of the Work, will recommend an equitable adjustment in the Contract Sum or Contract Time, or both. If the Architect determines that the conditions at the site are not materially different from those indicated in the Contract Documents and that no change in the terms of the contract is justified, the Architect shall so notify the Owner and Contractor in writing, stating the reasons. Claims by either party in opposition to such determination must be made within 21 days after the Architect has given notice of the decision. If the conditions encountered are materially different, the Contract Sum and Contract Time shall be equitably adjusted, but if the Owner and Contractor cannot agree on an adjustment in the Contract Sum or Contract Time, the adjustment shall be referred to the Architect for initial determination, subject to further proceedings pursuant to Paragraph 4.4. (underlining added for emphasis)

Unless otherwise addressed in the Contract Specifications, the above Changed Conditions clause would permit the Contractor to recover additional costs associated with a subsurface condition, such as rock, which differs materially from what was indicated in the Contract Documents (e.g. soil borings, geotechnical engineering reports, or geological profiles). If the Contractor has no control over the extent of soil borings (e.g. quantity, quality and depth) taken by the Owner or other geotechnical studies performed on behalf of the Owner, it would seem fair that the risk of such changes in subsurface conditions should be carried by the Owner. The Owner, however, should be cautious in how the fair and reasonable value of the necessary extra work is determined. For example, having the Contractor insert a unit price for the removal and disposal of increased quantities of rock in its bid proposal up front may not always work in favor of the Owner as the real cost will depend on the actual quantity and character of the rock to be removed. Negotiating a fair and reasonable price for such work may be the best alternative depending on the size of the Project and the parties involved.

5. Conclusion

The geotechnical engineer and/or design consultant needs to gather all available subsurface information at the planning stage of the project and to determine with the Owner and other design consultants the scope of the preliminary geotechnical investigation. Depending on a number of factors including the size of the project, the parties must then decide how to allocate risk with respect to unforeseen conditions, etc. and to draft the appropriate provisions in the construction contract to meet their objectives.

1. A.S. Wilkstrom, Inc. v. State of New York, 52 A.D.2d 658, 381 N.Y.S.2d 1010 (3rd Dept., 1976).
2. Id.

A 1998 decision by the State of New York’s highest court underscores the importance of contractors strictly complying with the notice and reporting provisions contained in many construction contracts, no matter what type of “directive” they may have received from the Owner or its representatives.

In A.H.A. General Construction, Inc. v. New York City Housing Authority, 92 N.Y.2d 20, 677 N.Y.S. 2d 9 (June 11, 1998), the Court of Appeals of New York dealt with a common scenario on construction projects. According to the contractor, the public owner would, during the course of the project (as was the case on their previous projects), direct the contractor to perform extra work and the work would then be done with the expectation that a change order would be issued or that correspondence containing price proposals submitted by the contractor to the Owner would constitute sufficient notice and documentation of its claim. The contractor claimed that the parties would negotiate over claimed extra work and ultimately the contractor would be paid for same.

The public owner, however, had a different recollection. It denied the contractor’s contention that, with respect to work that the public owner claimed was contract work but the contractor contended was extra, the public owner permitted the contractor to use correspondence as a substitute for the documentation required by the contract. The public owner argued that by the express terms of the contract, only when both parties agreed that an item of work was extra and when prior to the performance of the work, the public owner ordered the contractor in writing to perform the work for an agreed upon sum, would the contractor’s obligation to submit daily reports be obviated.

By the end of the project, several disputes arose over whether the work performed by the contractor was extra work, or work required under the contract. On some occasions, the public owner issued the requested change order, on others it refused, and on still others, it issued change orders only to subsequently rescind them.

The contractor commenced an action against the public owner alleging claims of breach of contract and unjust enrichment and the public owner moved for summary judgment dismissing the complaint, on the grounds that the contractor had waived its right to recover for extra work by failing to comply with the notice and reporting requirements of the contract.

The contractor’s president in opposing the public owner’s motion for summary judgment, swore in his affidavit that the public owner was “being less than truthful” and was “acting in bad faith” by suggesting that no documentation existed to support the contractor’s claims for extra work. The contractor noted the vast amount of correspondence between the parties on that issue, including requests by the public owner to complete certain tasks, and the contractor’s detailed cost proposals responding to those requests. The contractor’s president further stated that certified payroll reports and daily activity reports were kept regarding all of the work but that separate records for the extra work could not be kept because it was physically impossible to do so.

The lower court ruled that no matter how much correspondence existed on the issue, and how many project records existed, the contractor’s failure to strictly comply with the contract’s notice and reporting requirements(1) barred it from recovering for the extra work.

On appeal, the contractor argued that the public owner’s actions waived strict compliance with the notice and reporting provisions because of the hundreds of instances in the past where it had negotiated payment for extra work without requiring technical compliance with those provisions. This argument, coupled with the evidence that the public owner had also executed change orders acknowledging that certain work was extra work only later to rescind them, asserting that the work was actually required by the contract, was enough to sway the State of New York’s Appellate Division, First Department to find that the contractor had raised triable issues of fact as to whether the public owner had acted in bad faith or had been grossly negligent in the performance of the Contract.

The Appellate Division’s decision, however, was short lived because the New York City Housing Authority took its appeal up to New York’s Court of Appeals. The Court of Appeals reversed the Appellate Division and upheld the decision of the lower court finding that the contractor had failed to come forward with any evidence to demonstrate that the actions of the public owner had in any way prevented him from complying with the strict notice and reporting requirements contained in the contract. The Court determined that the applicable provisions of the contract required the contractor, when proceeding with disputed work, to submit contemporaneous statements and documentation of its actual damages, not proposed costs or estimates. The Court of Appeals also specifically found that the public owner’s own daily construction site reports and the contractor’s submission of certified payroll reports – neither differentiating between contract work and disputed work – did not satisfy those requirements.

The Court of Appeals’ reversal of the Appellate Division’s decision rested on its conclusion that the notice and reporting provisions of the contract were “conditions precedent” to suit or recovery for the extra work, and not “exculpatory clauses”.(2) The Court said:

That conclusion is legally significant. While an exculpatory clause will not be enforced when, “in contravention of acceptable notions of morality, the misconduct for which it would grant immunity smacks of intentional wrongdoing” (Kalisch-Jarcho, Inc. v. City of New York, 58 N.Y.2d at 385, 461 N.Y.S. 2d 746, 448 N.E. 2d 413, supra), the standard for excusing a condition precedent is different. A condition precedent is linked to the implied obligation of a party not to “do anything which will have the effect of destroying or injuring the right of the other party to receive the fruits of the contract” (Kirke La Shelle Co. v. Armstrong Co., 263 N.Y. 79, 87, 188 N.E. 163). Thus, it is a “well-settled and salutary rule that a party cannot insist upon a condition precedent, when its non-performance has been caused by himself” (Young v. Hunter, 6 N.Y. 203, 207; see also Arc Elec. Constr. Co. v. Fuller Co., 24 N.Y.2d 99, 104, 299, N.Y.S. 2d 129, 247 N.E.2d 111; 3A Corbin, Contracts 767, at 540 [1960]). Put another way, a party to a contract “cannot rely on the failure of another to perform a condition precedent where he has frustrated or prevented the occurrence of the condition” (Kooleraire Serv. & Installation Corp. v. Board of Educ., 28 N.Y.2d 101, 106, 320 N.Y.S.2d 46, 268, N.E.2d 782; see also, Armies v. Wesnofske, 255 N.Y. 156, 163, 174, N.E. 436; Patterson v. Meyerhofer, 204 N.Y. 96, 100-101, 97 N.E. 472).

Therefore, New York’s Highest Court determined that the relevant inquiry is not simply whether the Owner committed bad faith or was negligent in the performance of the contract, but whether the alleged misconduct prevented or hindered the contractor’s compliance with the notice and reporting requirements. The Court ultimately decided in the case before it that none of the actions attributed to the Owner by the contractor impeded the contractor’s ability to comply with the contract requirements as to its claims of extra work, and the contractor’s complaint was dismissed.

The moral of the this saga is that every contractor or subcontractor faced with a contract containing notice and reporting provisions covering the performance of extra work or disputed work must not only give notice to the Owner but must also strictly comply with the reporting provisions while the work is being performed (e.g. submit daily time and material records for the Owner’s signature). This must be done even if you are promised a change order, directed to proceed in writing, or in the midst of negotiating a change order. If the extra work is completed without a signed change order and without complying with the contract’s reporting provisions, the contractor will be completely at the mercy of the owner and will, in all likelihood, lose its claim no matter how clear cut the issue may be.

A.H.A. General Construction, Inc. waived its rights to approximately $1 million in claimed extras by failing to follow the express terms of the contract. Don’t let it happen to you.

1. The subject contract required that in the event the Owner determines that the work being performed is not extra work, the contractor must notify the Owner within 5 days that the work is being performed “under protest”, or else the claim for extra work is waived. Also, a contractor claiming damages resulting from an act or omission of the Owner is required to give notice within 5 days of the act or omission, and provide detailed statements and proof of damages within 30 days, or the claim would also be waived.

Under another section of the contract, a contractor performing extra work or disputed work is required to furnish daily statements to the public owner, during the performance of that work, including the names and number of workmen employed on the work; the number of hours employed; the character of the work; and the nature and quantity of any materials or equipment used.

2. Exculpatory clauses like “no-damage-for-delay” clauses are meant to absolve or exculpate the Owner from liability for its acts or omissions.

The Construction Contracts Act (hereinafter the “Act”) went into effect on January 14, 2003. All private construction contracts entered into after January 13, 2003, whether oral or written, where the aggregate amount of the construction project is $250,000.00 or more will be subject to the Act. Public works projects and contracts for the performance of work on public works projects are exempt from the Act’s provisions. In addition, certain residential projects and projects arising out of the events of September 11, 2001 are exempt from the Act.

The intent of the legislature in passing the Act was to prevent unjust delays in payments to contractors and subcontractors, working on private construction projects. If payments are not timely made, the Act establishes remedies for the benefit of contractors and subcontractors. The bulk of the Act’s provisions are triggered only upon default and can be bypassed if the construction contract is carefully drafted. However, the right to interest payments, the right to suspend performance and the right to have New York Law cover the rights of the parties and designating New York as the forum for any and all disputes are requirements for all contracts subject to the Act. Contracts with material suppliers are excluded and may be made subject to the laws of another State or jurisdiction and/or designate another jurisdiction or State as the venue for any and all contract disputes.

In the absence of an agreement to the contrary, the Act authorizes contractors and subcontractors to invoice for interim payments on a monthly basis. The party being invoiced, whether it is the owner, contractor or subcontractor, is required to approve or disapprove the invoice within twelve (12) business days of receipt of the invoice and all contractually required documentation, including partial waivers of lien. If the owner, contractor or subcontractor disapprove of the invoice or any portion thereof, it must prepare a written statement outlining the item(s) which are not approved, the reasons why and the amount(s) being withheld. The Act recites a list of grounds a party may raise when disapproving an invoice or any portion thereof. The sum of the withholdings are limited to amounts sufficient to cure and/or correct the defects and capped by the line item amount in the schedule of values, if previously submitted. In essence, the withholdings must be reasonable and can be based on contract provisions such as the owner’s and/or contractor’s rights to liquidated damages if the contract is not performed on time. However, the Act also provides that delays by anyone other than the invoicing party and/or its subcontractors and material suppliers shall not be a basis for withholding approval and payment of an application for payment.

Unless otherwise agreed, payments are due no later than thirty (30) days from approval. In situations involving subcontractors, payment is due, from the party with which it subcontracts, within seven days of that party’s receipt of good funds. Although not discussed here, the reader is also alerted to the fact that the Act contains provisions for situations when a lender is involved in financing all or part of the contract.

A contractor or subcontractor must disclose to a subcontractor of any tier the dates when payment is expected or contractually mandated from the owner or contractor. If the contractor or subcontractor fails to furnish the required notice, then it will be concluded that the due dates or time periods adopted by the act were complied with and payment will have to be made according to these adopted dates or time periods. Additionally, upon a written request from the subcontractor and within five (5) days of the request, the owner must provide the subcontractor with written notice of making any payments to the contractor.

Notwithstanding any agreements to the contrary, if payments are made beyond the due date, the party who owes the monies must pay interest at the rate of one percent (1%) per month or at a higher rate, if previously negotiated by the parties. In addition, the contractor may suspend performance without being in breach of the contract, if a ten (10) day written notice is provided to the owner with an opportunity to cure, and the notice outlines the contractor’s intention to suspend performance because payments were not timely approved or made. The subcontractor has the same remedy available to it when approvals and payments are unreasonably withheld, however, it must provide the ten (10) day written notice with an opportunity to cure to both the owner and contractor. The subcontractor may also suspend performance if the owner forwards payment to the contractor but the contractor fails to remit the payment to the subcontractor for its approved work.

In the event contractor or subcontractor suspends performance, the time frames established for performance are extended for the length of the suspension. The costs incurred for re-mobilization, however, can only be collected if negotiated by the parties. The Act provides that the suspending party must be permitted a reasonable opportunity to remove its materials, equipment, tools and/or machinery from the job-site.

If the parties agree, the Act permits retainage to be withheld, however, the contractor cannot retain an amount which exceeds the retainage withheld by the owner. Retainage must be released within thirty (30) days final approval of the work or interest will begin to accrue from the date the retainage became due and owing. The contractor must release proportionate amounts of retainage to each subcontractor after receipt of retainage from owner.

The definitions enumerated in the Act are very far-reaching, including how the terms “Construction Contract”, “Contractor”, “Subcontractor” and “Owner” are defined. The definitions, subject to the exemptions mentioned above, were intended to encompass most, if not all, contracting entities working on private construction projects greater than or equal to $250,000.00. Nevertheless, a carefully drafted contract can circumvent a majority of the Act’s more onerous provisions. Hopefully, the legislative intent of protecting contractors and subcontractors from unscrupulous payment practices will prevail. If you would like more information on this or any other construction issue, please feel free to contact Welby, Brady & Greenblatt, LLP.

This Article is supplied for informational purposes only and is not intended to constitute legal advice. You should consult competent legal counsel depending on the specific issues of your matter.