May a Backcharge Always Include a Mark-Up?

By John S. Mrowiec

Consider the following scenario: A contractor or subcontractor suffers damages resulting from a subcontractor's or supplier's defective performance.

The contractor or subcontractor then "backcharges" the subcontractor's or supplier's subcontract price for those damages plus "mark-up for overhead and profit." The backcharged party then objects to the backcharge.

The battle typically involves the issue of whether the backcharged party was in breach. If so, argument then focuses on whether all the damages were caused by the backcharged party's breach or by some other cause. Lastly, the backcharged party questions the amount of damages.

Seldom, however, is there a challenge to the concept of the backcharging party's entitlement to a "mark-up."

Recently, the "mark-up" question arose in an Indiana backcharge litigation in Blakley Corp. v. EFCO Corp., 2006 Ind. App. LEXIS 1798 (Aug. 31, 2006).

A Curtain Wall Crisis

Blakley was a subcontractor for the fabrication and erection of exterior curtain wall, windows and interior storefronts for the Indiana State Museum. EFCO was the supplier of the aluminum curtain wall and window frames under a purchase order with Blakley.

According to the Blakley court opinion, the curtain wall fabrication was plagued by errors and delays. The supplier's bid was premised on supplying a standard system which the supplier admitted it included without reviewing the contract documents' deflection requirements.

Shop drawings were due from the supplier on Aug. 29, 2000. The supplier knew that its standard system would not meet the deflection requirements.

Additionally, the supplier claims to have discovered a conflict between the architectural and structural drawings at this time but did not notify the subcontractor of either issue. The supplier's initial shop drawings were incomplete and contained incorrect details so the supplier missed the deadline for submitting shop drawings. The supplier submitted its first shop drawings one month after the deadline.

Over four months after submitting its original shop drawings, the supplier submitted revised shop drawings with proposed modifications to the structural and aesthetic requirements. Eventually, the structural engineer relaxed the deflection requirements.

Until the time the deflection requirements were relaxed, the supplier still had not signed a purchase order. Once signed on April 11, 2001, the purchase order required delivery dates in May and July 2001. By May, the project was ready for curtain wall to be installed. But the supplier did not deliver.

The subcontractor then reduced the supplier's fabrication scope to expedite delivery of the remainder. The subcontractor demanded firm delivery dates.

The supplier committed to dates in July and September.

The supplier missed those dates, too, but was close in two deliveries.

Unfortunately, the entire first delivery was misfabricated. The subcontractor had to modify the misfabricated pieces to use them. Then, the supplier notified that it would not meet the revised delivery dates either.

Finally, the supplier's president promised an October 2001 delivery. Starting in mid-October, the supplier delivered over the next month.

Expenses Accrue

The subcontractor incurred additional expenses of $307,020 for fabrication, field installation, equipment and field labor costs for a compressed erection sequence in order to mitigate project schedule delays. The subcontract refused to pay the unpaid purchase order balance of $229,880, instead backcharging the supplier $383,755. The subcontractor's backcharge was comprised of $307,020 for damages and $76,755, representing a combined 25 percent mark-up for overhead and profit.

The supplier sued and the subcontractor counterclaimed. After a trial, the court ruled in favor of the subcontractor but did not award the mark-up on damages.

The subcontractor moved the trial court to correct the denial of the mark-up. The trial court declined. The supplier appealed, and the subcontractor cross-appealed.

On appeal, the supplier argued that design errors in the contract documents excused the supplier's failures. The appellate court found no basis to reverse the trial court's finding that the supplier had failed to establish that the deflection requirements were a design error. The engineer had relaxed them for the supplier's convenience.

Moreover, the Blakley appellate court noted that the trial court correctly relied on Indiana law holding that "[a] contractor has a duty to discover defects in plans or specifications, that are reasonably discoverable or patent, and then warn the contractee or architect of the defects, even if the plans and specifications are supplied by the contractee," Blakley, 2006 Ind. App. LEXIS 1798, * 16 quoting St. Paul Fire & Marine Ins. Co. v. Pearson Construction Co., 547 N.E.2d 853, 858 (Ind. Ct. App. 1989).

The supplier had not advised of any design errors until well after beginning performance. Regardless, the supplier failed to meet the delivery deadlines established after the deflection requirements were relaxed. The Blakley appellate court affirmed the trial court's judgment against the supplier.

On the subcontractor's mark-up, the Blakley appellate court declined to reweigh the evidence or the credibility of witnesses. There was expert trial testimony that the subcontractor's bid contained a 25 percent markup but the expert did not have the information about historic mark-ups nor the ability to distinguish true overhead costs versus profits, Blakley, 2006 Ind. App. LEXIS 1798, * 20-21.

The fundamental purpose of damages for breach of contract is to make the nonbreaching party whole. The Blakley appellate court noted that there was a flaw in the subcontractor's proof regarding the combined overhead and profit mark-up:

"[T]he damages awarded [subcontractor] were sufficient to cover the costs it incurred as a result of [supplier's] breach. Awarding an additional twenty-five percent would go beyond making [subcontractor] whole. We acknowledge [subcontractor's] argument that this markup included overhead costs as well as profit. The problem is that the two were not clearly defined. Had overhead costs associated with [supplier's] breach been separately established, [subcontractor] may have recovered those costs. Nevertheless, because profit and overhead were lumped together into one figure, we cannot say [subcontractor] was entitled to an amount exceeding that which makes it whole," Blakley, 2006 Ind. App. LEXIS 1798, * 22-23.

Thus, the Blakley decision holds that "mark-up" on damages will be awarded only to the extent that the backcharging party can prove the mark-up includes damages, normally uncompensated expenses actually incurred. Mark-up should not be awarded in an amount that will exceed making the backcharge claimant whole.

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.