June  4, 1999

Bulletin #27: The Challenges of Design/Build Contracting Part II

In the last Contract Bulletin, ZZZ Sheet Metal had embarked on an expansion of its business into design/build contracting. Its first project involved design and installation of an HVAC system for a new hotel. Having had experience in installing HVAC systems in other hotels, ZZZ did not view this undertaking as a radical change in its business. The subcontractor was mistaken.

After producing initial plans and signing a subcontract form presented by the general contractor, ZZZ found the project to be complex, difficult, and frustrating. Its lack of an engineering and design staff required ZZZ to consult with an outside mechanical engineer (who was not licensed in the state in which the hotel was being constructed). The initial design was constantly modified as the overall building plans changed. Components had to be moved and systems redesigned as floor plans and ceiling heights were altered and mechanical rooms relocated. The process for plan modifications, submittals, and approvals (and the related change orders) became increasingly chaotic as revised plans, shop drawings, and change orders flowed almost constantly among the subcontractor, the architect, and the general contractor.

There were also scheduling and work coordination problems throughout the project and the relationship between the general contractor and the various subcontractors became increasingly strained. Payment was often delayed and there were frequent disputes over subcontractor draws. ZZZ found that the project was creating both financial and administrative challenges at a level that it had not previously encountered.

When the HVAC system for Phase I of the hotel was finally installed, it was discovered that certain of its components were malfunctioning and that the system performance did not meet project specifications. As a result, ZZZ’s application for final payment on Phase I (including the ten percent retainage) was rejected. After attempting to negotiate for payment with the now antagonistic general contractor, ZZZ concluded that it had no choice but to exercise its remedies for payment under the subcontract. The subcontractor’s claims triggered counterclaims from the general contractor as to alleged design and installation defects that would more than offset the amount owing to ZZZ.

ZZZ and the general contractor proceeded to arbitration. The subcontractor attempted to make sense of its records from the project and to produce evidence that, at the very least, all of its proposed design changes had been approved by the architect and/or the general contractor. However, the subcontractor discovered numerous gaps in its documentation. It had no evidence that certain design changes had even been submitted. On other changes, there was no written evidence that they had been approved. Some changes to the work were covered by signed change orders, but many were not. Even though ZZZ pulled together everything that it had, it recognized that the absence of complete documentation would certainly not help in the arbitration case.

Each party submitted its case to the arbitration panel. The general contractor and architect portrayed ZZZ as unqualified, unprofessional, and slipshod in many aspects of its design and installation work. They emphasized the role of the unlicensed engineer and the absence of written approval of various changes, as well as alleged defects with the design. The general contractor asserted that ZZZ had failed in its capacity as the installer of an HVAC system, but much more fundamentally had failed in providing an adequate design for the system.

The arbitrator’s decision was received thirty days later. ZZZ was shocked at the outcome. The arbitrators ruled:

1. That ZZZ was liable to the general contractor for $2,500,000 in damages. The figures were based primarily upon testimony presented by the general contractor as to the costs for redesign and remediation of the system to meet project specifications.

2. That ZZZ’s subcontract required it to render design and engineering services and that ZZZ had breached the subcontract in delegating design and engineering responsibility to an engineer not licensed in the state. The arbitrators noted language in the subcontract stating that “all design work shall be performed by a properly licensed design professional.”

3. That this breach of the subcontract was a direct cause of the design inadequacies of the HVAC system. The arbitrators further noted that state law prohibited payment of design or engineering fees to persons or entities not licensed to perform such services in that state.

4. That, as a result, ZZZ had forfeited its right to collect any sums attributable to design or engineering work and was further liable for all design damages.

5. That the subcontractor’s defense based upon the contractor’s and architect’s review and approval of the initial design and subsequent changes was not persuasive, since ZZZ had assumed full design responsibility for the system. The arbitrators also noted that ZZZ could not establish, by written documentation, that its plan revisions had been submitted or approved.

6. That ZZZ was entitled to some payment for its final work on Phase I and approved change orders, but that the amount owed to ZZZ was far exceeded by the liabilities of ZZZ to the general contractor. Therefore, a substantial net award of damages was made to the general contractor and ZZZ was determined not to be entitled to any further payment for its work. The retainage and the balance of its contract payments were to be forfeited.

Reeling from the arbitrators’ decision, the subcontractor immediately contacted its insurance agent to verify the existence of coverage as to the damage award. The insurance company reviewed its file and informed the subcontractor that its insurance policy (which was the standard form ZZZ had procured on its prior projects) specifically excluded coverage for design-related liability. There was no insurance coverage.

After flirting with bankruptcy and lengthy negotiations with the general contractor, ZZZ reached a settlement. It performed a substantial amount of remedial work on the hotel system without further payment and agreed to pay the general contractor 50 cents on the dollar on its arbitration award, with the payments to be made over a five-year period. It would be at least that long before the subcontractor’s business was back to where it had been when ZZZ management had decided to embark on the design/build venture.

Having design/build expertise will clearly be a benefit for HVAC subcontractors in the future. The process and the risks can be managed, but the subcontractor must recognize that assuming significant design responsibility is a major step. The following are some ground rules that should be kept in mind in approaching any design/build project:

1. Contract Documents. The form of contract becomes all the more important in a design/build context. Just as a one-sided construction subcontract can make the subcontractor responsible for elements that it did not consider within the scope of its work, a one-sided design/build contract can make the subcontractor liable for design issues over which it had little or no control.

2. Project Specifications. A complete understanding of what is required of the system to be designed and installed is extremely important. The project plans and air-handling specifications have to be very well defined and fully understood. The subcontractor should obtain clarification on any elements of the project or system that appear unclear before submitting a bid.

3. Design Services. The subcontractor must secure the services of properly licensed and qualified design and engineering professionals. The licensing requirements vary from state to state, but it is typically a requirement that the architect or engineer signing any plans be licensed in the state in which the project is being constructed.

4. Project Involvement. Working effectively on a design/build basis requires that the subcontractor become much more involved with what is occurring on the overall project. The subcontractor also has to be “fast on its feet,” since it may be required to adapt its proposed design to other changes in the project.

5. Recordkeeping. It is essential that the subcontractor maintain accurate and complete records as to plans and specifications, design changes, submittals, approvals, and change orders. If a design change is implemented and the subcontractor cannot demonstrate that the change was submitted to and approved by the contractor and/or the project architect, the subcontractor faces the risk that it could be deemed to have implemented an unauthorized change.

6. Insurance. The subcontractor must review its insurance to determine what additional coverage is required for its design work. The cost of insurance for design liability should also be built into the pricing of the subcontract.

A well-managed design/build project can provide many benefits for the owner, general contractor, and primary subcontractors. It encourages “value engineering” and gives greater flexibility and control to the major parties on a project. However, whether or not a design/build project proves to be an opportunity or a nightmare will depend largely on how the subcontractor adapts to the additional requirements and challenges that come with design/build work.


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