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Design, construction firms wary of mounting liability risks associated with condo projects

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As the number of residential condominium construction and conversion projects continues to rise dramatically in San Diego and throughout Southern California, all the entities associated with these projects are becoming increasingly concerned about potential liability exposures associated with them. The entities involved typically include the developer, architect, construction companies and, in the event of a conversion, the company selling the property that is to be converted.

Notably, claims have been rising dramatically against firms associated with residential construction and, in particular, condominium projects. Most liabilities are being found through the application of implied warranties. Implied warranties apply two standards to a builder's work - habitability and workmanlike construction. The former essentially means the residence may be safely occupied while the latter imposes a quality of work standard by the contractors.

In many cases, courts have blended the two standards, consequently holding the builder responsible for more defects for a longer period of time.

According to the California Department of Real Estate, more than one in five (21 percent) defects are related to plumbing, drainage and other leaks; 19 percent to building structure; infrastructure problems account for 17 percent of defects; roof leaks and other defects account for 12 percent; and internal systems comprise 12 percent of the problems.

To address exposures, firms participating on a project are taking a number of steps to improve quality, including maintaining records, establishing and reinforcing quality standards for all aspects of projects, and providing written warranties that establish reasonable levels of responsibility for firms participating in a project and that comply with third-party standards, including "state right to repair" legislation (such as SB 800 requirements in California).

Developers are structured to accommodate the needs of the project's investors. This includes the effective management of potential liabilities associated with the project.

Typically, they are formed as Limited Liability Companies (LLCs) set up for the specific project and are normally dissolved at some point in time following the sale of the last unit. Inherent in this structure is a conflict between the responsibility the developer has to the investors in the LLC and their ongoing responsibility to the condominium owners and the association, such as those imposed by SB 800 in California.

Historically, LLCs have survived the construction period and a finite period of time following the sale of the last unit, at which time the entity has been dissolved. Once dissolved, there is limited recourse the unit owners and association have to the original entity. In the event of significant repair expense, they are compelled to look to all parties to the project to recover. This often exposes architects, construction companies and other entities affiliated with the project to litigation.

In the absence of a developer, design professionals may have personal liability because they sign and seal the documents. Most states' design professional licensing acts have provisions making design professionals who seal the drawings personally responsible for liabilities arising out of the construction documents and calculations. Contractors are also exposed to loss to the extent they are found responsible under applicable law.

Small design firms are particularly vulnerable to professional liability claims. According to Victor O. Schinnerer, an underwriting manager and Marsh affiliate that handles construction risks, seven of the top 25 claims paid by a large insurer were for small firms. In addition, more than half of all professional liability claims on condo projects are made against architects and 70 percent of such claims against design professionals are made by the owner.

Managing these risks calls for a combination of approaches. The project participants should review the marketing materials, schedule and budget to determine potential exposures. They should also be proactive in ongoing maintenance requirements that would include maintenance manuals and recommended budgets for the future owners.

It is also reasonable practice to prepare reserve studies that show the remaining useful life of common elements of the building (such as the roof, windows, walls, etc.). Share the studies with the condo associations so they can set up reserve accounts that are funded by homeowners as monthly assessments. Do this at the time the developer prepares the Condominium Declaration.

During the planning and contract phases the responsibility for each of the parties needs to be clearly and specifically stated. Particular attention needs to be paid to areas that have resulted in significant defect litigation in the past, including site work, roofing, exterior finishes and waterproofing. In addition, it is generally prudent to include alternative dispute resolution wording in those contracts.

To mitigate potential liabilities, any recommended changes to any aspect of the project should be reviewed by all project participants, including the architect and quality assurance representatives.

In the turnover stage, the association's representative (accountant, attorney, engineer, etc.) will inspect the financial records, contract documents and the building. Once completed, the development team should meet with the association's team to discuss the report, as well as the maintenance manual and budget in detail.

It is also a good idea to provide annual or semi-annual inspections. The original design team may agree to sell its services for these inspections; however, other entities may also be able to provide them. In cold climates, where freeze and thaw conditions occur, at least one inspection should be performed in the fall so repairs needed to prevent water infiltration may be made before the winter.

The insurance associated with condominium development is problematic at best. The development team should be ready to address the quality and risk management issues of interest to the insurance underwriters.

While the risks associated with condominium construction and conversions remain significant for the development team, firms that assess risks carefully and practice effective risk management will continue to benefit from the vast opportunities these projects represent.

Coughlan is vice president and San Diego Construction Practice Leader for Marsh Inc.

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