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By Michael C. Loulakis and Lauren P. McLaughlin

One of the many challenges faced by all parties in the construction industry in drafting their contracts is the issue of dispute resolution. All else being equal, most general contractors and general engineering consultants strongly prefer arbitration over litigation relative to their disputes with owners. Many of arbitration’s advantages, such as speed of resolution and the use of industry-experienced arbitrators, are highly desired by any party seeking money from its contracting counterparty. However, if your company or firm is defending a claim — and may be the one paying — the litigation process is typically the preferred route, as it is expected to take a longer time and cost more money for the party pursuing its claim.

But what happens to disputes between subcontractors and general contractors in which the owner might have some involvement or financial responsibility? If the prime contractor arbitrates the issue with the owner but must litigate the issue with the subcontractor, the prime contractor could face inconsistent results. And what happens if there is an issue with the subcontractor for which the prime contractor would like to arbitrate with the subcontractor, regardless of whether the owner is involved?

Many prime contractors have developed subcontracts that attempt to balance all these points. For example, some subcontract clauses give prime contractors the sole right to decide when and if to arbitrate. Some subcontracts explicitly narrow the type of disputes that a subcontractor can raise in arbitration. While the use of creative dispute clauses can certainly work, they sometimes create litigation over the very issue the parties have or have not agreed to arbitrate about. This month’s case, SR Construction Inc. v. Peek Brothers Construction Inc., is a prime example of this.

The case

The project involved a medical center in Reno, Nevada, owned by Sparks Family Medical Center Inc., an affiliate of United Health Services of Delaware. UHS entered into a cost-plus with a guaranteed maximum price agreement with SR. This contract was based on standard forms created by the American Institute of Architects, including the AIA Document A201–2017, General Conditions of the Contract for Construction. After executing the prime contract with UHS, SR awarded a $3.1 million work order to Peek to complete the project’s core and shell civil work. The work order was issued under a master subcontract agreement, or MSA, between SR and Peek.

The dispute between SR and Peek concerned $140,000 in additional costs for the building pad. Peek alleged that it bid the project assuming it would mass-grade the building pad to a few feet below the required elevation, dig the building footings and plumbing trenches, and then use the excavation spoils from the footings and trenches to backfill and grade the pad to the proper subgrade elevation. However, Peek apparently deviated from this plan after an SR employee directed Peek to import soil to elevate the pad before digging the footings and trenches. This enabled the pad to be elevated earlier than if the original sequence had been followed.

While SR rejected Peek’s change order request, it passed Peek’s claim for this work to UHS. UHS rejected the change orders and directed SR to initiate dispute resolution with Peek. Before SR could do so, Peek sued SR in a Nevada district court. SR filed a demand for arbitration with the American Arbitration Association, in which it named UHS and Peek as defendants. SR simultaneously moved to compel arbitration in district court.

SR’s motion to compel was based on the MSA’s arbitration provision, which stated that there would be no arbitration between SR and Peek unless the prime contract had an arbitration requirement, and a dispute between SR and Peek involved issues of fact or law that SR was required to arbitrate under the terms of the prime contract. The prime contract’s arbitration provision mandated arbitration for any unresolved claims, with the term “claim” being quite broad, and including any “disputes and matters in question between” UHS and SR arising out of or relating to the contract. SR argued that Peek’s $140,000 claim fit precisely within the scope of the MSA’s arbitration agreement.

The district court denied SR’s motion to compel arbitration. It held that the prime contract required arbitration only of disputes between UHS and SR and that Peek’s dispute with SR was not arbitrable under the MSA because it did not involve UHS. SR appealed this decision to the Nevada Supreme Court.

The appeal

The Nevada Supreme Court began its analysis by looking to prior Nevada case precedent holding that: “There is a strong presumption in favor of arbitrating a dispute where a valid and enforceable arbitration agreement exists between the parties” and that “Nevada courts resolve all doubts concerning the arbitrability of the subject matter of a dispute in favor of arbitration.” It found that the AIA arbitration clause was broad, as it encompassed all disputes related to or arising out of the underlying agreement. As a result, “even matters tangential to the subject agreement will be arbitrable under a broad provision.”

Peek tried to argue that the MSA’s arbitration clause was narrow because the clause stated that a dispute is not arbitrable “unless two prerequisites are satisfied.” The court rejected this position, because one of those prerequisites was whether the dispute “involves issues of fact or law which [SR] is required to arbitrate under the terms of the prime contract.” As noted, the court found that the prime contract’s arbitration clause was broad and expansive. This had the ultimate effect of making the MSA arbitration clause broad.

Contrary to what the lower court found, the Nevada Supreme Court concluded that the MSA clause did not limit its application to disputes relating to issues involving only SR and Peek. As a result, the court found it irrelevant that UHS was not a defendant in Peek’s lawsuit and that Peek was not a party to the prime contract’s arbitration agreement. “Under the MSA provision’s plain language, if SR would have to arbitrate an issue of fact or law under the prime contract with UHS, then in turn, SR and Peek must arbitrate that same issue.”

Separately, the Nevada Supreme Court was impacted by the nature of Peek’s claim under the cost-plus guaranteed maximum price prime contract. Under the prime contract, UHS was only to compensate SR for “costs necessarily incurred by [SR] in the proper performance of the Work.”

Peek argued that SR’s mismanagement caused its additional costs by unnecessarily directing Peek to import additional material to elevate the building pad’s subgrade. “Peek’s allegation amounts to a ‘claim’ about whether its costs were reasonably incurred, which involves issues of fact and law that SR would have to arbitrate with UHS when seeking reimbursement for those costs under the prime contract.”

Finally, the court was influenced by the fact that the AIA prime contract included a consolidation-of-arbitration provision in matters involving common legal and factual issues. Specifically, SR could include subcontractors in its arbitration with UHS if SR determined that the subcontractor was relevant to the disputed matter. The MSA also had a consolidation clause, which provided that “the same arbitrator(s) utilized to resolve the dispute between any Owner and Contractor shall be utilized to resolve the dispute under [the MSA] provision.”

The court found many common questions of law and fact between the Peek-SR dispute and the SR-UHS dispute. Among the questions noted in the opinion were: Who was at fault for importing the additional material? Did UHS direct SR to work faster, thus prompting SR’s alleged request of Peek? Was importing additional material reasonable in view of the larger project timeline?

The court found that because it was likely that the Peek-SR dispute would involve the same witnesses and evidence as in the SR-UHS dispute, it had the power to order arbitration because of the mutual consolidation-of-arbitration provisions in the underlying contracts.

The analysis

While this case focused on Nevada law, it provides the same type of analysis that would be involved in other states — given the strong federal and state support for enforcing arbitration agreements. Arbitration agreements are consensual, and it is up to the parties to clearly state when they do not want to arbitrate. Stated differently, courts routinely enforce arbitration clauses and compel parties to arbitrate, particularly with clauses like those found in AIA contracts, which are broad and intended to cover any dispute.

Finally, remember that this case involved a $140,000 dispute. The legal fees to get to this point alone must have been substantial, and the arbitration process has not even begun. It serves as a reminder that parties should have tight, understandable language around the disputes clause that says what they want so that substantial money and time are not spent on just getting to the dispute forum.

Michael C. Loulakis (mloulakis@cp-strategies.com) is the president and CEO of Capital Project Strategies LLC in Reston, Virginia. Lauren P. McLaughlin ([email protected]) is a partner of Smith, Currie & Hancock LLP in Tysons, Virginia.

This article first appeared in the September/October 2022 issue of Civil Engineering as “Make Sure You Understand the Scope of Your Agreement to Arbitrate.”