Quantifying the Impact of Change Orders

By John S. Mrowiec

Contractors or subcontractors sometimes seek compensation for labor cost overruns, contending that project change has adversely affected their labor productivity on the unchanged work.

Among typical owner responses are that the claimant has demonstrated no link between the change and labor productivity on other work, the claimant has not ruled out other causes, signed change orders release that "cumulative impact" claim or the amount sought is overstated. Owners and the courts seek evidence for causation of change to reduced labor productivity.

Contractors have sought empirical support for the concept that change might adversely impact unchanged work on a particular project.

Beyond that, there seems to be no method to recognize this phenomenon, much less to quantify it, at the time of agreeing to specific change orders.

Illinois Case Illustrates Issue

This month, just such a situation arose in the bankruptcy of a general contractor in James Cape & Sons Co. v. Bowles (In re Bowles), 2004 Bankr. LEXIS 1999 (Bankr. Ct. E.D. Wis., Dec. 16, 2004).

The case is especially interesting because it shows how the result would be different depending on whether Wisconsin or Illinois law applied.

The Army Corps of Engineers awarded a contract to Bowles Construction Services Inc. under a small business enterprise set-aside. The contract involved construction of a steel revetment barrier along Lake Michigan in Chicago.

Like it had done on past projects, Bowles subcontracted most of the work to a subcontractor, James Cape & Sons Inc. The subcontractor apparently guaranteed the indemnity for the prime contractor's payment bond.

Some other facts regarding payment by the owner to a lock box are complex.

In summary, owner made payments to the prime contractor during the project and not to the lockbox. As the construction proceeded, the subcontractor eventually claimed $1,893,000. The prime contractor argued delays allegedly caused by the subcontractor justified nonpayment.

The parties mediated and then began arbitration. After the subcontractor served its demand for arbitration, the prime contractor purported to terminate the subcontract. Then, the principal of the prime contractor sold his stock to another officer of the prime contractor.

Because the project was federal, the subcontractor had no mechanics lien rights. Having guaranteed the payment bond, suing the surety would have meant the subcontractor was "chasing its tail." Thus, liability of the corporate principal was the subcontractor's only hope for payment.

The arbitrators awarded nearly $2.4 million to the subcontractor. More important, the arbitrator "pierc[ed] the corporate veil" and held the award could be pursued against the former or current owners of the prime contractor.

The former principal of the prime contractor filed for bankruptcy protection.

The subcontractor filed an adversary complaint in the bankruptcy asking the bankruptcy court to hold that the debt by the prime contractor's principal to the subcontractor was not "dischargeable" and would survive the bankruptcy.

The Bankruptcy Code excepts from dischargeability certain debts procured by fraud when the debtor had been acting in a fiduciary capacity.

In Bowles, the subcontractor argued that a prime contractor who receives construction contract payments for a subcontractor's work is, by state statute, a trustee of those funds. Thus, the subcontractor argued, a contractor's failure to pay such funds to the subcontractor after receipt from the owner is fraud in a fiduciary capacity.

Illinois, Wisconsin Laws Differ

The Bowles bankruptcy court agreed that the question of whether a debt was incurred in a fiduciary capacity was one of state law. Both the prime contractor and subcontractor were Wisconsin corporations. The project was performed in Illinois for the federal government.

The Bowles court reviewed the "construction trust fund" statutes of Wisconsin and Illinois and found them to be "significantly different" Bowles, 2004 Bank. LEXIS 1999, *19.

Wisconsin has a "theft by contractor statute", Wis. Stat. §§779.02(5) and 779.16, which "create[s] a trust fund for sums paid by an owner to a general contractor for the benefit of subcontractors and material suppliers" Bowles, 2004 Bank. LEXIS 1999, *19 citing Kraemer Bros., Inc. v. Pulaski State Bank, 138 Wis. 2d 395, 406 N.W.2d 379, 381 (1987). A knowing breach of the Wisconsin statute is grounds for holding the debt to the subcontractor nondischargeable, Chase Lumber & Fuel Co. v. Koch (In re Koch), 197 B.R. 654, 656 (Bankr. Ct. W.D.Wis. 1996).
I
llinois has a construction trust fund statute too, 770 ILCS 60/21.02. "In contract, to the fairly broad provisions" of the Wisconsin statute, the Bowles court held that the Illinois statute "provides a limited trust fund only to the extent a subcontractor has provided a waiver of mechanics lien in exchange for funds paid to a prime contractor for the subcontractor's benefit" Bowles, 2004 Bankr. LEXIS 1999, *21. There was no evidence in the record that the subcontractor had submitted any lien waivers for the unmade payments.

Therefore, if Wisconsin law applied, the debt to the subcontractor would not be dischargeable in bankruptcy. If Illinois law is applied, the debt would be dischargeable. The subcontract did not contain a choice of law provision.

Reviewing the case law, the Bowles court said that the Wisconsin statute (which is part of the Wisconsin mechanics lien statute) could not apply in Illinois nor to a federal project outside Wisconsin.

The Bowles court said Illinois law applied to the dispute and did not help the subcontractor. According to Bowles, the Illinois statute "is limited to situations in which a contractor requests or requires a waiver of mechanics lien from a subcontractor in exchange for payment or progress of payment" Bowles, 2004 Bankr. 1999 *27. Bowles also noted that the Illinois Construction Bond

Act, if it could be said to apply at all, contained no "trust fund" provisions.

The subcontractor tried other arguments as well. One is of interest.

The debtor had signed payment applications as president of the general contractor stating that to the best of his knowledge, information and belief, no improper or undisclosed amounts were being withheld from subcontractors.

The Bowles court did not view those signed applications as "ris[ing] to the level of fraud" Bowles, 2004 Bankr. LEXIS 1999, *40 citing Rotman Electrical Co. v. Cullen (In re Cullen), 145 B.R. 719, 727-28 (Bankr. Ct. D. Mass. 1992).

Under the facts, the Bowles court said the subcontractor did not justifiably rely on the false certifications. The debt owed personally by the prime contractor's former president arising from the arbitration award was dischargeable in bankruptcy.

John S. Mrowiec is a partner with Chicago-based Conway & Mrowiec, a construction and public contracts law and litigation practice. He may be reached at (312) 658-1100. For information, go to the firm's Web site at www.cmcontractors.com.