As is the case every session, several bills have been introduced that, in one way or another, affect contractual relationships in the construction industry and seek to adjust rights and duties between those who finance projects, own them, and build them. Responses to these proposals generally differ widely depending on what role the particular party plays in the drama, but regardless of whether one is pitching or catching, the economic effects of changes in the balance of power are significant.
Some of the bills we are monitoring this session were heard earlier this week in House Business & Industry. From the perspective of owners, these bills present some potential challenges and may raise the potential liability of owners (and others) under certain circumstances. In brief, these are some of the concerns we have gotten wind of:
HB 1963. This bill marries two statutory requirements that have been historically distinct: an owner’s responsibility to reserve 10% of either the contract value to the owner or the value of the work to pay mechanic’s liens under Chapter 53, Property Code, and a contractor’s obligation to treat construction funds paid under a construction contract (including from loan proceeds) as trust funds, the misappropriation of which is subject to criminal penalties, under Chapter 162. The bill provides that retained funds under the mechanic’s lien statute shall be treated as Chapter 162 trust funds, thus subjecting owners to potential criminal liability as well.
The bill has several problematic aspects for owners. First, it is unclear how it would affect the owner’s flexibility with respect to amount of retainage at any given time during the contract term. Specifically, if a subcontractor completes its part of the job at an early stage, can the owner use some of the retained funds to pay that subcontractor without running afoul of the misappropriation penalty? Under current law, an owner can do that because if 10% is not reserved, the subcontractor still has a lien on the owner’s property. In other words, there is another way to pay the subcontractor, and it’s up to the owner to adjust the balance between the retained amount and the amount of lien as the conditions of the job dictate. HB 1963 opens up this very common practice to potential liability, or at least it seems so to us.
A second concern has to do with the source of the retained funds. If the owner finances the contract and uses loan proceeds to fund payments to contractors, the bill converts loan proceeds to trust funds. Does this mean that the lender is now on the hook for criminal penalties if, for some reason, the owner gets into financial trouble?
Third, the bill may have unintended consequences for subcontractors. If the bill becomes law, it seems unlikely that an owner or the owner’s lender will make any payments they don’t absolutely have to until substantial completion of the project. The reason for this is that the owner’s liability will not be extinguished under the bill even after the expiration of statutory deadlines for retainage notices by subcontractors seeking to enforce a lien. Put another way, the bill appears to nullify the process (and protections) built into Chapter 53. If owners may get criminally popped for not withholding 10% at all times during the contract period, they will likely protect themselves to the maximum possible extent. That means that more of the burden of financing the project during construction will fall to the contractors themselves.
The bill also has a mandatory attorney’s fees provision to a trust beneficiary who prevails in a misappropriation action under Chapter 162. It’s unclear why this provision is necessary, given that Chapter 38, CPRC, which has operated in the commercial construction realm for a long time, already accomplishes this purpose in every breach of contract case. It’s possible that the bill is trying to reach situations in which the claimant is not in privity of contract with the trustee (i.e., a lower-tier subcontractor and a general contractor), where Chapter 38 does not apply. Even so, this provision could boomerang on subcontractors who are themselves trustees and who misapply the funds.
HB 2657. This bill is similar to those we have seen in prior sessions, in that it makes voidable a provision in a construction contract that incorporates by reference the terms and conditions of another document if the owner or general contractor does not provide a copy of the incorporated within a specified period time after the contract is executed. On its face, the bill does not seem unreasonable, but it may create serious headaches for everybody—owners, general contractors, and subcontractors—in practice. Part of the problem is who has the incorporated documents and at what point in the process. For a general contractor looking to secure subcontractors, this timing issue is significant. The GC may not have all the documents from the owner, such as loan agreements, drawings, specifications, or other details until later. In the meantime, the bill would compel the general contractor either to hold signing the contract until it had everything or just strike the reference to the missing document. Neither of these options seems ideal when liabilities may be attached.
Another problem for owners and general contractors is the sheer number of documents that may be involved. In large projects or multiple projects that proceed more or less simultaneously, an owner or GC may manage hundreds, if not thousands, of contracts. If the bill passes, the most prudent thing an owner or GC can do is to obtain an acknowledgment in writing from each subcontractor that the subcontractor has received and reviewed all the pertinent documents. This will take time and it will increase costs, in terms of both compliance and project delay, while everybody gets their ducks in a row.
Finally, there is a real question mark as to what it means to “void” a contract “provision’s applicability to the incorporated document not provided to the party.” In the first instance, that’s a legal question that will have to be litigated. A party to a contract cannot just unilaterally declare that some provision of the contract—to which the party as already agreed—is “void.” There has to be a lawsuit, and we presume that the way the bill is drafted contemplates that the lawsuit will be filed during the contract period, which means that construction will be affected in some way. If this is indeed the case, the disruption to the project could be disastrous. Keep in mind as well that construction financing depends on a lot of things going right in the project, not things going off the rails. It’s unclear to us how a dispute between contractors and owners over the voidability of part of the contract could ripple throughout the whole project, all the way to the construction lender.
In the second instance, what if the contract provision at issue has a safety implication? We suppose that if it does, the whole project could be jeopardized. And if something bad does happen, who bears the liability for that? How would an owner or contractor insure against an incident arising out of this situation? Another scenario that occurs to us would be the defensive use of the voidability provision in a dispute arising out of a construction accident. In other words, does the bill permit a contract provision to be voided retrospectively, after something bad has happened? We really can’t say one way or another, but it does appear that the bill may have pretty significant unintended consequences, particularly with regard to GCs who are stuck in the middle.
HB 2928. This bill prohibits a party from withholding payment owed under one contract to offset a claim or damages under another contract. Like HB 1963, it would criminalize (under Chapter 162) what is a pretty standard practice in the construction industry. Again, on its face this bill doesn’t seem unreasonable, but, again, the devil is in how things actually work in practice. This bill would trigger in the event somebody in the construction chain doesn’t make a required payment, for example an owner or a subcontractor who gets into a spat with another party or, God forbid, goes belly up. If the dispute is between a private owner and the GC, at least the GC can sue the owner for payment and secure it with a lien. A subcontractor default, however, would put the GC in a more difficult position under this bill. Say, for example, that a defaulting subcontractor owes the GC more than the retainage on the contract. Currently, GCs can offset that amount, if excess retainage is available on another contract with that sub. If the bill passes and the GC can’t secure payment that way, the GC might turn to subcontractor default insurance, but those policies not only have very high deductible and co-pay thresholds (running into millions of dollars), but the premiums are based on the ability to offset. If the bill takes the offset away, that insurance is likely to be completely unaffordable, if it is available at all. Project costs will, in turn, go up, which isn’t good for owners, GCs, or subcontractors.
There’s another problem in the event of a subcontractor default. If a subcontractor, for whatever reason, fails to pay a supplier, Texas law allows the supplier to recover against the GC. The GC can thus be forced to pay twice for the same thing, three times if the subcontractor assigns its receivables to get out of trouble and a third-party assignee comes back against the GC. Sometimes the only leverage a GC has to limit its liability is the threat of offset. This bill would make that a criminal offense.
HB 3977. This bill goes beyond the construction industry to pierce the exclusive remedy of workers’ compensation insurance for personal injury lawsuits by an employee against an employer alleging that the employee was injured by a sexual assault arising from the employer’s negligence. While this bill certainly has a laudable objective, we are concerned for two reasons: (1) exceptions to the exclusive remedy defeat the purpose of the comp system; and (2) making an employer responsible for a third-party criminal act is problematic in itself. This is not to say there might not be some egregious set of circumstances in which an employer may be complicit in a criminal act, but that should be left to the criminal justice system, where due process protections are hard-baked into the process of determining responsibility. Moreover, if the employer has acted intentionally or with gross negligence, the employee can sue and the exclusive remedy does not apply.
