Salt in Open Wounds: Liability for Bad Deals

Sept. 1, 2008
If a project fails, contractors may face a financial loss on the job - but could they get sued just because they took on a bad job?

On August 20, 2008, a plaintiff's law firm in New York issued a press release announcing that a class action lawsuit had been filed in federal court in Massachusetts against Perini Corp. on behalf of shareholders who had bought stock between Nov. 2, 2006, and Jan. 17, 2008. According to the complaint, Perini (and certain of its officers and directors) issued “false and misleading statements” that misrepresented and failed to disclose that one of the company's projects, a condominium high-rise in Las Vegas, was experiencing financial problems due to lack of financing, and that success of the project would be dependent on sale of condominium units. The suit claims that the projections of sales were “unrealistic and aggressive,” that the company knew that the project could be delayed or even halted, and that this one project accounted for about 20% of the company's backlog. The press release invited such shareholders to contact the firm to get in on the action.

While this lawsuit charged violations of federal securities laws, since Perini is a publicly held company, the case got me to thinking: could this happen to my clients, who are not big, publicly held companies? This lawsuit arose out of the credit scarcity that affects the entire construction industry. Many contractors are knowingly taking on projects that have more risk, not because they like gambling with their net worth, but because they want to keep their doors open and their crews busy. They know that if the project fails, they may face a financial loss on the job - but could they get sued just because they took on a bad job?

Of course they could - and they do. With the help of lawyers who specialize in this type of lawsuit, such suits are filed all the time, and increasing. One recent commentator calculated that, with the addition of the Perini lawsuit, the current tally of subprime and credit crisis-related securities lawsuits now stands at 108, of which 68 have been filed in 2008. And it doesn't take much of a stretch of the imagination to see such suits filed against companies (and their officers) that are not publicly traded.

The theory for such suits is called “breach of fiduciary duty.” The plaintiff has to allege (and ultimately prove) that he had the right to rely on management to look out for his best interests, keep him advised of all important information - such as an impending loss - and use good and cautious judgment to protect him from such losses. Management doesn't have to guarantee success, but someone with a fiduciary duty can't take the kind of risks with someone else's money that she can with her own.

Who can file such lawsuits? Anyone who can claim that he was an owner of a company that suffered financial losses at the hands of management. The group includes family members who are passive owners, or employees in employee-owned companies. It is not at all uncommon to see business owners who have spent years building a firm up, transfer stock in the firm to family members as part of their estate planning. Similarly, many business owners sell or give stock to key employees to reward them and keep them fully invested in the firm's success. I don't know how many of these business owners understand the obligations they take on in this process.

Construction is an inherently risky business. It is largely dependent on weather, and underground and unknown conditions. Construction projects often take a long time to complete, which leaves them vulnerable to escalations in price or sudden unavailability of materials. It is labor-intensive and subject to frequent personal injuries. For these and many other reasons, contractors operate on much thinner profit margins than other industries. The best thing that the industry has had going for it - until recently - has been the fact that people need roads, power plants, hospitals, offices, homes, stores and factories. Unlike Cessnas and mink coats, structures have been viewed as necessities.

When homeowners cannot get mortgages, and state tax revenue and retail spending go down, those “necessities” can suddenly become luxuries, leading contractors to have to take greater risk to get work. That risk can come from reaching out to new markets, or new types of work that the company hasn't done before, or working for customers who are strangers to them. It is not at all uncommon for a contractor to agree that part of its compensation will only be paid once the project reaches certain financial milestones. When that doesn't happen, the contractor is in the same boat in which Perini finds itself.

How does a construction company protect itself from such lawsuits? First and foremost, by using good business judgment. Second, by keeping all owners advised of what is going on, with written reports, copies of financial reports, conducting meetings where the shareholders can ask questions, and listening to their comments and concerns. It is bad enough for a contractor to have to find ways to survive the current economic slowdown. The last thing he needs is a lawsuit blaming him for its consequences.

Susan McGreevy is a partner at Stinson, Morrison, Hecker LLP, Kansas City, Mo., 816/842-4800, e-mail [email protected].

Read more on construction law by Susan McGreevy

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