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It may come as a surprise to some practitioners that the vast majority of condominium projects are struck by construction defect litigation. Everyone gets sued: developers, contractors, subcontractors and design professionals (collectively known as the development team). However, since there appear to be significant profits to be made in condominium development, especially in the last few years, many clients cannot resist developing in the risky arena of condominium projects. Accordingly, these clients often ask: “Why all the construction defect litigation in condominium projects?” and “Can we develop condominiums and still be protected?” Let’s work through these questions. Why all the litigation? There are three main reasons for the plethora of condominium construction defect litigation across the country. First, most courts view condominium construction defect litigation the same as products liability litigation wherein they utilize theories of strict liability. In other words, condominium units are looked at in the same light as manufactured products such as soft drink cans. Simply prove the soft drink can exploded, and one wins the products liability suit. No need to prove whose negligence caused the can to explode. If strict liability was not the applicable burden of proof in products liability cases, then plaintiffs would face the more difficult burden of proving that the soft drink can explosion was caused by the negligence of the can designer, the can manufacturer, the carbonation supplier, the syrup mixer, the distributor or the vendor. Likewise with condominium construction defect litigation. Prove construction defects exist, and one wins under theories of strict liability. Plaintiffs do not have to prove whose negligence caused the design errors, failing materials, poor installation or sales misrepresentations in a condominium construction defect suit. This easy-to-prove strict liability burden of proof makes condominium construction defect litigation almost as easy as shooting fish in a barrel. The second reason for the propensity of condominium construction defect litigation is that many condominium homeowners previously enjoyed the relative peace and quiet of detached single-family residences. After selling their quiet homes and investing their sales proceeds and hard-earned cash into an expensive new condominium, purchasers are often disappointed. Condominium owners are often irritated to hear the footsteps, voices and toilet flushes of their neighbors. Furthermore, condominium owners expect their new condominium to be perfect, so when the tile cracks, the doors stick or the windows leak, condominium purchasers become angry. Coupled with the possibility of a sizable judgment, a group of disappointed condominium homeowners can be quickly whipped into a litigation frenzy against the development team by construction defect litigators. Finally, plaintiff construction defect litigators usually assert condominium defect cases on a contingent-fee basis, which makes it easy for homeowners to join in the condominium defect suit. Experts are hired by the construction defect litigators to completely tear apart one condominium unit and find every possible latent construction defect. Such experts will then opine that similar construction defects exist in every other unit throughout the condominium project, resulting in a large construction defect claim when hundreds of condominium units are involved. Accordingly, the possibility of big awards on a contingent-fee basis can attract numerous homeowners to the condominium litigation suit. Still a booming market With ever-increasing demands for urban housing and the apparent strong returns available to condominium development teams, an explosion in new condominium projects is under way in many cities across the country. According to the National Association of Realtors (NAR), the number of condominium units sold nationally between 2002 and the end of 2005 has increased 30%, with the median price climbing by 58%. See the NAR statistics from 2002 through November 2005 at www.realtor.org/Research.nsf/files/REL0511TS.pdf/$FILE/REL0511TS.pdf and monthly updates at www.realtor.org/Research.nsf/Pages/EHS-data. However, many lenders are starting to tighten their lending parameters in anticipation of a possible slowdown in the condominium market. Conversely, demand still appears to be outpacing supply in many real estate markets throughout the country. Condominiums still meet the strong demand from older homeowners who are downsizing or younger homebuyers who cannot afford a stand-alone single-family residence. Strategies to consider In order to minimize the devastating impacts of construction defect litigation, the development team needs to employ conservative risk-management strategies. One key risk-management strategy is to purchase adequate insurance. Unfortunately, many insurance carriers are unwilling to insure condominium projects because of the high risk of construction defect litigation. With fewer carriers in the marketplace, insurance premiums for condominium projects continue to increase. Also, many subcontractors and design professionals often cannot find condominium insurance, thereby limiting the number of subcontractors and designers that are able to bid on condominium projects. As detailed below, one solution to the lack of insurance on condominium projects is to provide owner controlled insurance programs, contractor controlled insurance programs or other “wrap” insurance products. A second risk-management tool is to hire a third-party inspection company that reviews the entire design and construction process from start to finish. The independent inspection company carefully reviews and identifies potential construction defect problems and requires the development team to redesign, repair or replace any potential construction defect items. The third-party inspection company then reinspects the redesigned, repaired or replaced work and provides a written and photographic record of the corrections. Having a third-party inspection company on-site throughout each design and construction phase shows the lenders and insurers that the development team has a vested interest in constructing the condominium project without defects from the start, which theoretically should lower lending requirements and insurance premiums. The use of third-party inspectors also informs the construction defect litigation bar that they are going to be up for a well-prepared fight if they target a third-party inspected condominium project. The hope is that such construction defect litigators will see the project as less likely to be subject to an extensive list of construction defects and, consequently, will look elsewhere for easier, uninspected condominium targets. Providing warranties A third risk-management technique is to provide a written or unwritten warranty to each condominium buyer for the entire statute of limitations period, which can be as long as 10 years in some states. Providing a written warranty to each homeowner not only provides the owner with a great marketing tool when selling each condominium unit, but also gives a potential buyer a strong alternative to running into the arms of a construction defect litigator when construction defects arise. Unwritten warranties, or repair programs, may also effectively catch construction defects in their infancy before they fester and attract construction defect litigators. Finally, in addition to warranties, many developers attempt to have purchasers agree to mediation or arbitration in written informed consent documents. Mediation or arbitration often leads to an award that does not include punitive damages or other runaway jury verdicts. However, to be binding, such waivers of jury trials must be drafted in accordance with local statutory law and case law. An improperly drafted mediation or arbitration clause may even create more legal bills, as the development team tries to enforce such faulty provisions. Wrap insurance One of the solutions that has arisen to fill the insurance void for condominium projects is commonly known as “wrap” insurance, wherein the owner or general contractor purchases a project-specific policy to cover the development team, including the general contractor, subcontractors and sometimes even the design professionals. However, design professionals are typically only covered for bodily injury and property damage in such wrap insurance programs. When provided by the owner, wrap insurance is often called an owner controlled insurance program (OCIP) while wrap insurance when provided by the contractors is often called a contractor controlled insurance program (CCIP). OCIPs and CCIPs for commercial projects typically include workers’ compensation and commercial general liability coverage, whereas in condominium projects, wraps generally only include general liability coverage and only sometimes include workers’ compensation and limited design professional’s errors or omissions. While often more expensive, OCIPs and CCIPs have several advantages over the situation in which each member of the development team purchases his or her own insurance. First, by lumping all the insurance together in one project-specific policy, the development team often increases its purchasing power for expanded lines of coverage. A knowledgeable insurance broker can utilize the pooled insurance funds to buy coverage that the individual development team members may not be able to obtain. Second, by placing all of the workers’ compensation coverage under one project-specific policy with no prior loss history, the premiums may be lower than if purchased individually by each member of the development team. Third, by maintaining one policy, the owner and contractor make sure that the policy is not cancelled or materially modified, as opposed to gathering and tracking renewal certificates and endorsements every year from the entire development team to assure that all the policies remain in force. All members are covered Fourth, when a development team uses OCIPs or CCIPs, one insurance company covers all members of the team. With one carrier, claims should be more efficiently managed and settled. In other words, the same carrier for all the parties should not fight with itself when claims arise. In addition, utilizing one carrier puts the owner and all of its subcontractors on one team, creating a unified defense. Fifth, some insurance policies are “self-depleted,” meaning each dollar spent defending a claim reduces the policy amount. Therefore, if the defense cost in a construction defect suit is $1 million and the amount of coverage is $1 million, then there will be no money left to satisfy any judgments or settlements. OCIPs and CCIPs typically have higher policy limits to absorb self-depletion. Under a wrap policy, it is sometimes recommended that the defense cost be included inside the deductible or self insured retention (SIR) and outside the general liability policy limits, to prevent the limits from being eroded. However, this strategy ends up providing an element of self insurance for the defense costs that may be significant. Finally, the added buying power of OCIPs and CCIPs may allow for the purchasing of policies that are not self-depleting. Coverage for necessary time Sixth, by maintaining one project-specific policy, the owner or the contractor can assure that the OCIP or CCIP is renewed for the entire length of the applicable statute of limitations or statute of repose period for construction defects. If an OCIP or CCIP is not utilized on a large project, perhaps as many as 100 smaller insurance policies will need to be monitored to assure that they remain in force for the entire statute of limitations period. This is often an impossible burden on the development team, which may lead to the purchase of “tail” coverage that is expensive and difficult to obtain. Many additional topics should be explored before an owner or contractor elects to utilize an OCIP or CCIP, such as the overall insurance costs; the cost to administer an OCIP or CCIP; the uncovered risks for off-site work, which is typically not covered in OCIPs or CCIPs; and the use of “credits” to capture the amounts that individual development team members would have spent but for the existence of the OCIP or CCIP. Finally, many carriers and brokers may offer to return a portion of the premiums to the owner or contractor if claims are held below a certain threshold for the project. Owners and contractors should contact their construction attorneys and insurance brokers to request a detailed cost/benefit analysis before making any decision in the complex but often rewarding world of wrap insurance. Bryan C. Jackson ([email protected]) is the chairman of the construction transactional group at Allen Matkins Leck Gamble & Mallory, resident in its Los Angeles office, and an adjunct professor at the University of Southern California’s Master of Real Estate Development program. He is a past chair of the Los Angeles County Bar Association Real Property Section and a member of the American College of Real Estate Lawyers. Kevin Edwards, OCIP coordinator at Lockton Insurance, provided assistance in preparing this article by lending his wrap insurance expertise.

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