Recent Court Decision Reaffirms the Line Between Corporate and Personal Liability

A corporate officer who signs a promissory note on behalf of a corporation cannot be held personally responsible for the obligations of the company, according to a recent decision by the Kent County Circuit Court. In Great Lakes Floor Covering, Inc. v. James Droge Construction Company (JDCC), Laurie Droge and Jeffrey Droge as fiduciaries of the estate of James Droge, Sr., the court ruled that unless the officer signs the promissory note twice – once as an officer, and once as an individual – he cannot be held liable individually for the corporation’s obligations.

The dispute in Great Lakes arose when Great Lakes subcontracted with JDCC to perform flooring work on two projects where JDCC was the general contractor. Although Great Lakes satisfactorily performed its contractual obligations, and JDCC received full payment from the project owners, it failed to pay nearly $90,000 owed to Great Lakes. Because of the longstanding relationship between Great Lakes and JDCC, Great Lakes allowed the outstanding balance to remain unpaid for years. However, on July 1, 2009, James Droge, Sr., signed a promissory note memorializing JDCC’s obligation to pay the $90,000 to Great Lakes. JDCC made only one payment to Great Lakes on the note, and failed to make any further payments. Great Lakes then filed suit against JDCC and its principal, James Droge, Sr., as an individual, for breach of contract, violation of the Michigan Builders’ Trust Fund Act (MBTFA), account stated, and statutory conversion.

On the breach of contract claim, the court found that the promissory note signed by James Droge, Sr., on behalf of JDCC, obligated JDCC to make payments, and gave raise to an airtight claim for breach of contract against JDCC. However, the court ruled that James Droge, Sr., in his individual capacity, could not be held liable for this debt. The court cited Livonia Building Materials Co. v. Harrison Construction Co., which states that under Michigan law “an individual stockholder or officer is not liable for his corporation’s engagements unless he signs individually, and where individual responsibility is demanded, the nearly universal practice is that the officer signs twice – once as an officer and again as an individual.” Since James Droge, Sr., signed the promissory note as President of JDCC only, not as an individual, he is not personally liable for the company’s obligation to Great Lakes. The court granted summary disposition (an immediate judgment) to Great Lakes against JDCC for the breach of contract claim, and dismissed the claim against James Droge, Sr., in his individual capacity. 

One further take-away from the Great Lakes v. JDCC ruling is the court’s clear confirmation of Michigan statute of limitations periods for the various legal claims involved. The court explicitly stated that for breach of contract, MBTFA, and account stated claims, the statute of limitations period is six years. On a statutory conversion claim, the statute of limitations is three years.

“Pay If Paid” Provisions in Subcontracts Are Very Much Alive and Enforceable – So Says Michigan’s Second Highest Court

A July 2013 Michigan Court of Appeals decision upholds the enforcement of pay-if-paid provisions in subcontracts, provided the provisions have the “magic” language. In Walbridge Aldinger Company v. Angelo Iafrate Construction, Moorehead Electric Company, et al, the State of Michigan’s second highest court held that when a pay-if-paid clause explicitly indicates that a general contractor’s receipt of payment from the owner is a condition precedent to its obligation to pay the subcontractor, the provision is enforceable, and prevents the subcontractor from collecting monies owed.

Walbridge’s  subcontract with its subcontractor, Moorehead Electric, contained the following provision:

“PAYMENTS: Subcontractor acknowledges that it has considered the Owner’s solvency and Owner’s ability to perform the terms of its contract with Contractor before entering into this Subcontract. Subcontractor acknowledges that it relies on the credit and ability to pay of the Owner, and not the Contractor, for payment for work performed hereunder. Subcontractor is entering into this subcontract with the full understanding that Subcontractor is accepting the risk that the Owner may be unable to perform the terms of its contract with Contractor. Subcontractor agrees that as a condition precedent to contractor’s obligation to make any payment to Subcontractor, the Contractor must receive payment from the Owner. Upon written request by Subcontractor, Contractor will provide Subcontractor access to all information in Contractor’s possession, if any, regarding the Owner’s solvency and ability to perform the terms of Owner’s contract with Contractor.

“In the event that the Contractor does not receive all or any part of the payment from the Owner in respect of Subcontractor’s Work, whether because of a claimed defect or deficiency in the Subcontractor’s Work or for any other reason, the Contractor shall not be liable to the Subcontractor for any sums in respect thereto. In the event the Contractor shall incur any cost or expense of any nature in preparing for the prosecution of, and prosecuting any claim against the Owner, whether by means or negotiations, arbitration or legal action, arising out of the Owner’s refusal to pay the Contractor for Work done by the Subcontractor, Contractor shall be entitled to deduct such costs and expenses form the amount due Subcontractor.”

The Court dismissed all of Moorehead’s arguments. The Court said the language of the subcontract (receipt of payment being a condition precedent) clearly and explicitly shifted the risk that the owner would not pay to the subcontractor. The Court also rejected the idea that the pay-if-paid provision was not enforceable because Walbridge fraudulently induced Moorehead to enter into the agreement by misrepresenting the project owner’s identity. The Court pointed to the contract’s specific language that “upon written request by the Subcontractor, Contractor will provide Subcontractor access to all information in Contractor’s possession regarding the Owner’s solvency and ability to perform the terms of Owner’s contract with Contractor.” Since Moorehead had at its disposal the means to establish the true identity of the owner and its solvency, there was no fraud. Moorehead’s claims were dismissed on a motion, without the necessity of a trial.

The take-away from this case is that subcontractors that sign pay-if-paid subcontracts containing the explicit “condition precedent” language must know that courts will enforce them, even though they may appear onerous, unfair, and unreasonable.

When contracting with generals contractors, there are ways subcontractors can negotiate to reduce their risk, in spite of the enforceability of pay-if-paid provisions. You may also consider using this same provision in your subcontracts. If you are interested or need additional information, please feel free to contact me.

Contractors on Public Projects Should Seek to Limit Indemnity With Their Bonding Company to Minimize Personal Liability

It is well known that on public projects, contractors must obtain performance and payment bonds, which protect owners from contractors who fail to complete a job or fail to pay subcontractors and suppliers. It is common practice for bonding companies to require the owner of a contracting company to sign an indemnity agreement that would hold the owner personally liable to the bonding company against losses paid out on the bond in addition to holding the contracting company liable. This adds an extra layer of protection for the bonding companies to collect in the event of a default.

Bonding companies will often require both a husband and wife to also sign the indemnity agreement, even when only one of them individually owns the contracting company. Married couples should think very carefully before agreeing to sign such an indemnity agreement. Both husband and wife signing the indemnity agreement puts all of the couple’s joint assets, including their home, at risk in the event of a default on the project.

Where there is a valid, signed indemnity clause, the courts will enforce it against the parties who signed, as illustrated by a recent decision by the U.S. District Court for the Eastern District of Michigan. In Hartford Fire Insurance Company v. ABC Paving Company, Thomas Morrison, and Donna Morrison,  the court held that where there is a valid, enforceable indemnity agreement, the signing parties are contractually obligated to indemnify the bonding company for all losses it incurred as a result of issuing the bonds.

In Hartford, the bonding company required both the owner-husband and his wife to sign an agreement to personally reimburse Hartford for all claims paid out on the bond. When the project went south, Hartford had to pay out on the performance bond, and sued to enforce the indemnity agreement. The court found ABC Paving and the owner-husband liable. However, there was a factual dispute over whether the wife’s signature had been forged – an  issue for the jury to decide.

The controversy in Hartford reminds us to be extremely cautious about signing such an indemnity agreement. If the jury finds that the signature on the agreement is the wife’s, then all of the couple’s personal assets will be at risk. If the signature is deemed to be a forgery, then the couple’s joint assets will be much better protected.

Contractors should think carefully before signing such an indemnity agreement. If possible, negotiate with the bonding company so that only the construction company’s owner will sign the agreement, not the spouse. Also, consider placing a limitation on the amount that the owner will be personally liable. For example, the indemnity clause might limit the owner’s personal liability to $100,000. Many public construction projects cost millions – to hundreds of millions – of dollars. An indemnity clause that limits a contractor’s personal liability will still serve as incentive to complete the project as required, while also protecting some of his or her personal assets.

Michigan Builder’s Trust Fund Act Provides Subcontractors and Suppliers with Powerful Collection Remedy

One of the main advantages for contractors and subcontractors that operate under a corporation or limited liability company is that their business entities generally protect the owners and officers from being held personally liable for the acts of the business entity. However, these protections are not absolute. Under the Michigan Builders Trust Fund Act (MBTFA), if a contractor company fails to use the payments received from an owner to pay subs or suppliers, the company’s individual owners and officers can be held personally liable for the money owed. This also applies to a subcontractor who receives money from a contractor and fails to pay its subs or suppliers. The MBFTA provides a powerful remedy for subs and suppliers to collect monies owed on private construction projects, even where the contractor or subcontractor has gone out of business, into bankruptcy, or is otherwise not collectable. Violation of the MBFTA may also result in a criminal prosecution. The MBTFA does not apply to public (governmental) projects.

The MBTFA was created in 1931, and is intended to prevent contractors from diverting funds intended to pay subs or suppliers to other uses and projects. It states that monies paid by an owner to a contractor  are held “in trust” by the contractor for the benefit of subs, suppliers, and laborers. The MBTFA requires that the contractor act as “trustee,” and pay subs, suppliers, and laborers first, before using the funds for any other purpose, including the owner’s own business expenses. Good faith is not a defense; nor is the fact that the project is “under water.”

The leading court case is Livonia Building Materials v. Harrison Construction, Bell, and Penner, which was decided by the Michigan Court of Appeals in 2007. In this case, the court found the company’s individual owners and officers personally liable where the property owner paid the contractor (Harrison), but the contractor failed to pay the supplier (Livonia). Harrison went out of business, and the individual owners and officers argued that, because of the economic downturn, they were “upside down” on the project, and therefore, there was not enough money to go around.

The court rejected this argument, stating that even if the owners had acted in good faith, “the difficulties posed by a downturn in the economy or poor business acumen do not excuse non-compliance with the MBTFA’s obligations in regard to accounting practices and ordering of payment.”

Even if the company owner files personal bankruptcy, he cannot escape a MBTFA claim, since no debt is dischargeable in bankruptcy that was incurred by larceny, embezzlement, fraud, or defalcation while acting in a fiduciary capacity. In Michigan, defalcation includes a deficit resulting from a trustee’s duty to make the proper payment of money coming into his possession – such as a contractor’s failure to pay a sub or supplier once he has received payment on a project.

In summary, the MBTFA provides a powerful remedy, beyond a construction lien or payment bond, that should be considered by subcontractors, suppliers, and laborers who do not receive payment once the owner has paid the contractor or the contractor has paid the subcontractor.

New arbitration rules can save contractors significant time and money in resolving disputes

On July 1, 2013, the Revised Uniform Arbitration  Act (RUAA) will go into effect in Michigan. In the construction industry, where arbitration is often required by contract to resolve claims and disputes, the changes under the RUAA have the potential to save general contractors, subcontractors, and suppliers significant time and money when disputes arise.

Although not perfect, arbitration continues to be a preferred alternative to litigation to resolve disputes. Why? First, due to the complex nature of construction claims, it benefits the parties to have a construction law expert who possesses insightful understanding of construction practices and procedures to hear and resolve claims, rather than a judge or jury with only very general and limited knowledge of construction. Second, compared to litigation, arbitration can be completed much faster than waiting to get “your day in court.” Third, arbitration can result in significant cost savings over litigation, because there is very limited discovery. Many provisions of the new RUAA will enhance these benefits. Therefore, I recommend that your standard contract and subcontract forms be updated to take full advantage of these changes.

One provision in the RUAA that has great potential to reduce the cost and duration of disputes allows an arbitrator to permit or limit discovery. In the court system, discovery is intentionally broad and liberal, which translates into high costs and huge amounts of time spent for the parties. An arbitrator must take into account a contractual limit on discovery, while keeping in mind the goal of making the proceedings fair, expeditious, and cost effective. Therefore, parties can potentially save a great deal of time and money in resolving disputes by including terms in their arbitration clauses that limit the amount of discovery allowed, while remaining confident of a fair and equitable outcome.

Another provision that is likely to cut down on the length and cost of disputes allows arbitration proceedings to be consolidated. This provision will become especially useful in commercial situations where there are a numerous parties involved in the same controversy. For example, if a dispute arises between an owner and an architect, but also involves the general contractor, a subcontractor, and a supplier, usually all the parties have not signed the same arbitration agreement. In the past, courts have been reluctant to order consolidation in such cases, because the courts do not want to undermine the voluntary nature of arbitration. The RUAA allows a court to order consolidation of all parties to such disputes into one proceeding, so long as it does not result in prejudice to one or more of the parties. This allows all parties to resolve their disputes in a single proceeding, rather than forcing parties to navigate separate proceedings with each party. 

The RUAA continues to promote the goal that arbitration be a faster, cheaper, and better alternative to the courtroom, and aims to promote greater efficiency and predictability in arbitration proceedings. Modifying and updating standard arbitration clauses in construction contracts can save significant time and money for construction industry professionals at all levels.

Practical pointers for the 30 and 90 day certified mail bond claim notices for Michigan public projects.

The Michigan Public Works Bond Statute requires that a supplier or subcontractor that does not have a contract the the principal contractor (providing the payment bond) must give two notices by certified mail: First, written notice to the principal contractor within 30 days after the first supply of labor or material; and second, written notice to both the principal contractor and governmental body within 90 days after the last labor or material.

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