California Supreme Court speaks on Unanticipated Conditions: Owner’s Problem or Contractor’s Risk?

Contractors bidding a fixed price or guaranteed maximum price contract necessarily must make assumptions about job conditions that will affect their bid price. Usually the contractor can obtain information from the owner (plans and specs) or on its own (job walk). 

However, some conditions cannot easily be observed before actual construction starts. These conditions literally may be below the surface, like the large slabs in the picture, which certainly would make excavation more expensive. Unanticipated conditions also may lurk above the surface, such as behind walls in modernization projects.

Inevitably, contractors encounter during performance conditions which weren’t easily observable prior to construction but substantially increase the cost of performance. In this all too common situation, who bears the increased cost? Does the owner have to compensate the contractor? Or does the contractor have to absorb the cost? The  very recent California Supreme Court decision in L.A. Unified Sch. Dist. v. Great American Ins. helps answer this important question.

L.A. Unified Sch. Dist. v. Great American Ins. – Facts

L.A. Unified Sch. Dist. v. Great American Ins. involved a contractor who took over for a defaulted contractor part way through the construction of an elementary school.  The school district had prepared correction lists, also called pre-punch lists, concerning deficiencies in the defaulted contractor’s work. One pre-punch list called for repairing and cleaning portions of the exterior stucco. However, when the takeover contractor removed some of the plaster surfacing, it discovered it could make acceptable repairs only by removing and replacing the entire exterior surface plus portions of an underlying material. 

Obviously, removing and replacing the entire exterior surface plus part of the underlying material is far more expensive than just repairing and cleaning the exterior stucco. The contractor unsurprisingly contended it was entitled to be compensated by the school district for this additional expense. The school district, equally unsurprisingly, contended that the contractor assumed the risk of this unanticipated condition and had to absorb the additional expense. In particular, the school district relied on language in the pre-punch list which stated that the contractor awarded the job would be responsible for unlisted defects in existing work: ‘Corrections or comments made in regard to the pre-punch list during this review do not relieve the Contractor from compliance with the requirements of the drawings and specifications. This review is only for General Conformance with the design concept of this project and general compliance with the information given in the Contract Documents. . . .’

L.A. Unified Sch. Dist. v. Great American Ins. – Issue

Prior cases were divided on this issue. On the pro-owner end of the continuum, some cases held that the contractor must show the public entity affirmatively misrepresented or intentionally concealed material facts that rendered the furnished information misleading. In other words, fraud, which is notoriously difficult to prove. On the pro-contractor end of the continuum, other cases held that the contractor need only show that the public entity knew material facts concerning the project that would affect the contractor’s bid or performance and failed to disclose those facts to the contractor. These cases put little burden on the contractor to do its own due diligence. And there were cases in between. The California Supreme Court took this case to resolve these conflicting decisions. 

L.A. Unified Sch. Dist. v. Great American Ins. – Ruling

So who had to pay for the increased cost of performance? The California Supreme Court didn’t decide that. Instead, it established the following ground rules for deciding the question:

“[A] contractor on a public works contract may be entitled to relief for a public entity’s nondisclosure in the following limited circumstances: (1) the contractor submitted its bid or undertook to perform without material information that affected performance costs; (2) the public entity was in possession of the information and was aware the contractor had no knowledge of, nor any reason to obtain, such information; (3) any contract specifications or other information furnished by the public entity to the contractor misled the contractor or did not put it on notice to inquire; and (4) the public entity failed to provide the relevant information.” 

Relevant factors include:

“[P]ositive warranties or disclaimers made by either party, the information provided by the plans and specifications and related documents, the difficulty of detecting the condition in question, any time constraints the public entity imposed on proposed bidders, and any unwarranted assumptions made by the contractor.”

The California Supreme Court concluded:

“The public entity may not be held liable for failing to disclose information a reasonable contractor in like circumstances would or should have discovered on its own, but may be found liable when the totality of the circumstances is such that the public entity knows, or has reason to know, a responsible contractor acting diligently would be unlikely to discover the condition that materially increased the cost of performance.”

The contractor won the battle of the ground rules, since the contractor does not have to prove fraud, which is very difficult. However, the contractor does need to show its own due diligence in checking job conditions before entering into the contract.

Does the ruling apply beyond Public Entity vs. General Contractor?

Very likely yes. Courts don’t rule on hypothetical situations, so the case doesn’t say whether its ruling also would apply to private projects. But my opinion is that the decision likely would apply to private projects as well. 

Do subcontractors need to care about this case? Well, if the general contractor can’t pass the increased cost of performance of, say, electrical work on to the owner, then the general contractor likely will take the position that the electrical subcontractor should absorb this cost. So subcontractors should not rely on the general contractor’s due diligence, but instead also do their own.  

Lessons for the Contractor

While the contractor need not shoulder the difficult burden of providing fraud, the contractor nevertheless will need to show that a reasonable inspection could not have disclosed the unanticipated condition. As a practical matter, the more cursory the inspection, the less sympathetic the judge. 

However, it isn’t enough for the contractor to conduct a thorough inspection. If litigation occurs, the contractor will have to prove that it conducted a thorough inspection. Again, as a practical matter, judges and juries are more likely to believe the contractor’s assertion that it was thorough if the contractor also was thorough in documenting its inspection effort. 

The contractor’s documentation should include not just what the contractor checked, but also who checked what. Years may pass between the inspection and the realization that the inspection has become an issue. Memories fade. Who did what can be important in identifying witnesses and then refreshing their memories. 

After over three decades in construction litigation, I realize this advice may be greeted with the eye rolling that contractors often exhibit when receiving advice from their attorneys that they don’t view as practical. A contractor understandably may not want to put a lot of time, effort and expense in documenting pre-contract inspections, particularly when it doesn’t then know if it will even get the job. 

My response is that the life, or at least expense, you save may be your own. Unanticipated conditions can cost a lot of money.
We really would appreciate your feedback. Praise, kudos and compliments are always nice to hear. But constructive suggestions for improvement are particularly appreciated. There’s always room for improvement, and your suggestions can make this newsletter better, and more useful to you. Thanks. Jeff

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