INDIANA BUSINESS LAW BLOG

Mechanics’ Liens: Part 2. Reallocating credit risk in construction projects

October 5, 2014 | Michael R. Smith

[Note: This one of a series of six posts regarding mechanics’ liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

In part 1 of this series, we discussed a hypothetical situation with a company that hired an ad agency, with the ad agency subcontracting some work to a production company and purchasing advertising time on a television station. The production company bore the ad agency’s credit risk because its contract was with the ad agency, and when the ad agency went out of business the production company faced the possibility of not being paid. In contrast, the television station did not bear the ad agency’s credit risk because its contract with directly with the ad agency’s client. The ad agency’s client faced the possibility of having to pay for the television air time twice – once to the ad agency and a second time directly to the television station when the ad agency failed to pay for the air time on the client’s behalf.

Now let’s look at the credit risks associated with a construction project in which the owner of a construction project hires a general contractor to complete the entire project on a time-and-materials basis, which means that the price paid by the owner is equal to the amount the general contractor pays for the labor (i.e., the “time”) and materials required to do the construction, plus a markup to cover overhead and profit. The general contractor does some of the work with its own employees and subcontracts some of the work, including the installation of the electrical wiring, to another contractor.

Mechanics’ Liens: Part 1. The basics of credit risk and subcontracting

October 2, 2014 | Michael R. Smith

[Note: This one of a series of six posts regarding mechanics’ liens:

Part 1. The basics of credit risk and subcontracting.

Part 2. Reallocating risk in construction projects.

Part 3. Acquiring a lien.

Part 4. Enforcing a lien.

Part 5. Personal liability notices.

Part 6. No-lien agreements.]

This starts a short series of blog articles discussing mechanics’ liens and their cousins, notices of personal liability, concepts that arise in the context of construction contracts and similar agreements. To understand what’s special about construction contracts, you need to understand a bit about how contract law, subcontracting, and credit risk work in other settings. So let’s review the basics.

Imagine your company signs an advertising agency agreement, hiring the ad agency to create a television advertising campaign for your business. The ad agency comes up with the ideas for the commercials, hires a production company to produce them, and purchases advertising time on your behalf from local television stations. The contract to produce the commercial is between the ad agency and the production company, but the contract with the television station is between the television station and your company, signed by the ad agency as your company’s agent, as it is authorized to do by the ad agency agreement.

Account Stated

August 27, 2014 | Michael R. Smith

On December 12, 2008, Layne and Anita Dellamuth bought flooring materials and installation services from Carpets Unlimited. The Dellamuths made a downpayment that left a balance of a little more than $23,000. Carpets Unlimited subcontracted the installation services to Jared Keeton, who performed that work later the same month, but apparently not to the liking of the Dellamuths because a dispute arose between them and Keeton about the quality of the installation. In addition, the Dellamuths objected to additional charges that Keeton added to the amount owed. In February 2009 Carpets Unlimited corrected the work at no additional cost to the Dellamuths.

By August 2011 the Dellamuths still had not paid Carpets Unlimited the remaining $23,000. Carpets Unlimited sent the Dellamuths a letter and invoice, demanding payment, by certified mail, which the Dellamuths signed for on August 27. Another letter and invoice, sent on June 26, 2012, was returned unclaimed. In August the same year, Carpets Unlimited sued the Dellamuths, and the trial court granted Carpets Unlimited’s motion for summary judgment. The Dellamuths appealed, and today the Indiana Court of Appeals affirmed the trial court’s decision.

Small Businesses Not Included in Proposed Reporting Requirement for Government Contractors

August 19, 2014 | Michael R. Smith

The Department of Labor’s Office of Federal Contract Compliance Programs (“OFCCP”) has issued a notice of proposed rulemaking that would require certain government contractors to submit an Equal Pay Report to the government as a supplement to the Employer Information Report (EEO-1) that is already required.

If a final rule is adopted as proposed, the Equal Pay Report will require companies to report the number of workers within each EEO-1 job category, the total W-2 wages of all workers in each job category, and the number of hours worked by all workers in each job category, all broken down by race, ethnicity, and sex. Only aggregate information will be reported; no information regarding individual wages will be required. In addition, the reports will not include any information on worker qualifications or experience that might help explain any differences among the groups within a job category.

Small Businesses Excluded

Small businesses — those with fewer than 100 employees — are excluded from the new reporting requirements. In addition the new reporting requirements apply only to companies that hold a contract, subcontract, or purchase order with the Federal government that, including modifications, covers a period of more than 30 days and is worth at least $50,000.

LLC Veil Piercing: Required Corporate Formalities, revisited

August 11, 2014 | Michael R. Smith

One of the factors for determining when the owners of an LLC (or a corporation) may be held liable for the obligations of the business is whether the required corporate formalites have been observed. A while back, we posted an article about the required corporate formalities for Indiana limited liability companies. One of them is that each Indiana LLC must maintain certain records and must make them available to members for inspection and copying. Notably, that requirement is not a default provision that can be reduced or eliminated by the operating agreement.

Last week the LLC Law Monitor blog by Doug Batey of Stoel Rives commented on a Massacusetts case, Kosanovich v. 80 Worcester Street Associates, LLC, No. 201201 CV 001748, 2014 WL 2565959 (Mass. App. Div. May 28, 2014), that imposed liability on the sole member of a Massachusetts limited liability company primarily because of the LLC’s failure to maintain records. Doug described the case (correctly, in my view) as “an outlier decision on veil-piercing” for piercing the veil based on so little.

Copyright Conundrum: A monkey’s selfie

August 8, 2014 | Michael R. Smith

Okay, this article in the Washington Post is just too good not to mention.

As reported in 2011 by the Guardian, British photographer David Slater spent three days in an Indonesian national park following and photographing crested black macaques, a type of monkey. At some point, he set up his camera on a tripod and left it unattended for a few minutes. When he returned, he found that the macaques had taken the camera and were taking pictures with it, apparently intrigued by the sound of the shutter. As it turns out, they took some pretty good pictures, including some of themselves. That’s right – monkey selfies.

At least one of the pictures was posted on Wikimedia Commons. As Wikimedia has now disclosed, it received from Mr. Slater a “take-down notice” under the Digital Millenium Copyright Act (or DMCA). The take-down provisions of DMCA are intended to deal with some of the unique intellectual property issues created by the internet, including the issue of an online service provider (or “OSP,” such as Wikimedia) being liable for copyright infringement when infringing material is posted on the OSP’s web site. If the owner of copyrighted material (text, a photograph or other image, video or audio recording, etc.) discovers his material has been posted online, the copyright owner can send a notice to the OSP demanding that it be taken down. If the OSP complies, it will not be liable for infringement. However, the OSP is also required to notify the person who posted the material that it has been taken down, and that person has the opportunity to challenge the allegation of infringement.

LLCs and Apparent Authority II

July 28, 2014 | Michael R. Smith

Last week I posted an article about apparent authority of a member or manager of an Indiana limited liability companies to bind the LLC, usually by signing a contract on behalf of the company, including a discussion of a 2013 decision of the Indiana Court of Appeals, Cain Family Farms vs. Shrader Real Estate & Auction, addressing the common law doctrine of apparent authority and the provisions of the Indiana Business Flexibility Act that bestow apparent authority on members and managers. Under the facts presented by the record, the court held that apparent authority existed and, in particular, “Whether we consider the question of apparent authority under the common law or the
Indiana Business Flexibility Act, the outcome is the same.”

As discussed in last week’s Indiana Business Law Blog post, one can imagine situations in which the statute would establish apparent authority but the common law analysis would not, and vice versa. It seems clear that a member or manager has authority to bind a limited liability company if the Indiana Business Flexibility Act says so, even if the member or manager would not have apparent authority under the common law analysis. But what if it’s the other way around? Will an Indiana court enforce a contract signed by a member or manager on behalf of the LLC if the member or manager would have apparent authority under the common law but not under the Indiana Business Flexibility Act? Although the Cain Family Farm decision does directly address that question, the Court of Appeals appears to treat the two bases of apparent authority as independently viable, implying that Indiana courts will recognize the apparent authority of a member or manager under the common law even if apparent authority does not exist under the Indiana Business Flexibility Act.

Since I posted the article last week, I’ve corresponded with my friend John Cunningham, a New Hampshire attorney, a recognized expert on LLCs, a blogger, and co-author of Drafting Limited Liability Company Operating Agreements, my go-to reference for LLC law and operating agreements. I asked John about the question, and he pointed me to the official commentary of the Revised Uniform Limited Liability Company Act, which discusses why the RULLCA leaves the issue of apparent authority of members to the common law. See RULLCA Section 301.

After reflecting on my correspondence with John and reading the commentary to the RULLCA, I’ve come to believe that the path on which the Court of Appeals appears to have placed Indiana law is a good one. Note that question of apparent authority is irrelevant if the member or manager has actual authority to bind the company, and it cannot be used by another party to avoid a contract with a limited liability company over the LLCs objection. (If nothing else, the LLC can always ratify the contract.) The question arises only when an LLC tries to avoid a contract signed by a member or manager in the absence of actual authority, and the question is, who suffers the consequences — the LLC or the other party? Although the Indiana Business Flexibility Act creates some areas of relative certainty (which I believe is superior to the intentional silence of the RULLCA), it also denies apparent authority under some circumstances in which the other party to the contract reasonably believes, based on the conduct of the LLC, that the member or manager is acting within his or her authority.

In my personal view, it is better public policy to err on the side of enforcing contracts in those situations by maintaining the common law doctrine as a viable basis for apparent authority, independent of the statutory basis. First, the LLC is in the best position to control the actions of its members or managers, and the operating agreement can provide a remedy when one of them misbehaves. Second, the LLC is also in the best position to control its own actions and to avoid conduct that cloaks its representatives with apparent authority when they lack actual authority. Third, to fail to enforce a contract that the other party entered into in good faith, based on a reasonable belief that the member or manager had authority to bind the company (or to require prospective counterparties to consult the public record before signing a contract with a limited liability company) could cause others to be overly cautious, even leery, of doing business with LLCs.

Whether Indiana courts agree with this analysis remains to be seen.
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LLCs and Apparent Authority

July 24, 2014 | Michael R. Smith

Whether a particular person has the authority to execute a contract on behalf of another person or entity is a standard question of agency law. If the principal has expressly or impliedly authorized an agent to execute contracts on behalf of the principal, the agent is said to have actual authority. However, a person who does not have actual authority can nonetheless bind the principal if that person has apparent authority.

Common Law Standard for Apparent Authority

The common law analysis of apparent authority is well established. An agent has apparent authority when a third person reasonably believes, based on the conduct of the principal, that the agent has authority. The reason for the belief need not be an actual statement by the prinicipal but can be (and usually is) found in the circumstances in which the prinicipal places the agent, but it is essential that the third party’s belief is based on the conduct of the principal; the statements or actions of the agent cannot create apparent authority. Moreover, if the third person knows that the agent has no actual authority, apparent authority does not exist.

Apparent Authority under the Indiana Business Flexibility Act

The Indiana Business Flexibility Act (Article 23-18 of the Indiana Code) contains different rules for the authority of members and managers of limited liability companies, and the rules are slightly different for LLCs formed on or before June 30, 1999 (Section 23-18-3-1), and LLCs formed after that date (Section 23-18-3-1.1).

If the LLC’s articles of organization do not provide for managers (i.e., a member-managed LLC), each member is an agent of the LLC for the purpose of the LLC’s business and affairs. Accordingly, the act of any member for those purposes, including the execution of a contract, binds the LLC, subject to the following exceptions:

The member does not have actual authority and the person with whom the member is dealing knows that the member does not have actual authority.
The act is not apparently for the purpose of carrying on the LLC’s business and affairs in the usual manner, unless the member has been granted actual authority by the operating agreement or by unanimous consent of the members.
For LLCs formed after June 30, 1999, the articles of organization provide that the member does not have the authority to bind the company.

If the LLC’s articles of organizations provide for managers, a member acting solely in the capacity of a member is not an agent of the LLC and does not have authority to bind the LLC, except to the extent provided by the articles of organization. Instead, each manager is an agent of the company and has authority to bind the LLC, subject to the following exceptions:

The manager does not have actual authority and the person with whom the manager is dealing knows that the manager does not have actual authority.
The act is not apparently for the purpose of carrying on the LLC’s business and affairs in the usual manner, unless the manager has been granted actual authority by the operating agreement or by unanimous consent of the members..
For LLCs formed after June 30, 1999, the articles of organization provide that the manager does not have the authority to bind the company.

Although Sections 3-1 and 3-1.1 of the Indiana Business Flexibility Act speak only of authority and agency, not of apparent authority and apparent agency, it seems clear that those sections deal with apparent authority and that actual authority of managers and members is addressed elsewhere, in Section 23-18-4-1. Indeed, the only Indiana decision to address Section 3-1.1, Cain Family Farm, L.P. vs. Schrader Real Estate & Auction Company, describes that section as a source of apparent authority and not actual authority.

Comparison of Common Law and Statutory Bases for Apparent Authority

The following table summarizes the main differences between the common law basis of apparent authority and the statutory basis.

Common law analysis of apparent authority	Apparent authority of members and managers under Indiana Business Flexibility Act
Applies to any agent of the company.	Applies only to members or managers.
Apparent authority created by conduct of the company.	Apparent authority created by the articles of organization; no other conduct necessary.
The person with whom the member or manager is dealing must have a reasonable belief that the member or manager has authority based on the company’s conduct.	As long as the person with whom the member or manager is dealing does not have actual knowledge that the member or manager lacks authority, that person’s subjective belief is irrelevant.
No exception for acts outside the usual course of business	No authority for acts outside the apparent usual way the company does business, unless the authority is granted by the operating agreement or by unanimous consent of the members.

When we’re dealing with managers of an LLC or with members in a member-managed LLC, the statute confers authority more broadly than the common law because no other conduct on the part of the LLC is necessary. However, the statutory exceptions are also broader because the common law contains no exception for acts outside the usual way the LLC does business. In addition, the statute denies authority to members of a manager-managed LLC (except to the extent the articles of organization confer authority) but the common law analysis treats the members of a manager-managed LLC no differently than any other agent. In other words, it is possible for a manager or member to have apparent authority under the statute but not under the common law, and vice versa. What happens then?

One possibility is that the statute is now the exclusive source of apparent authority for members and managers of LLCs. That would not appear to cause any problems when the statute confers apparent authority more broadly than the common law standard, but what about situations that fall into one of the broader statutory exceptions, for example when the member of a manager-managed LLC takes an action that a third party would reasonably believe, based on the conduct of the LLC, the member was authorized to take? Does the statute abrogate the common law in that situation?

It appears that it does not. In the Cain Family Farms decision mentioned above, the Court of Appeals considered the apparent authority of a member to bind a member-managed LLC. In doing so, the Court of Appeals analyzed the member’s authority under both the common law and the Indiana Business Flexibility Act. Perhaps because the Court found that apparent authority existed under both analyses, it did not expressly decide which one would control in the event of a conflict. Nonetheless, the implication seems to be that both sources of apparent authority remain viable and that the LLC will be bound by the actions of a member or manager if either the common law or the Indiana Business Flexibilty Act impute that authority to the member or manager.

[For more discussion of this topic, see LLCs and Apparent Authority II.)
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Covenant or Condition? Why does it matter?

July 21, 2014 | Michael R. Smith

I remember a story told by a business owner who had been involved in the negotiation of a very complicated contract, with both sides represented by high-priced lawyers. In one particularly brutal negotiating session, the lawyers argued at length about a particular provision, with one side saying it should be a warranty and the other side saying it should be a covenant. At long last, they reached some sort of agreement, and everyone took a break for dinner. The business owner related that, as he rode down the elevator with his lawyer, he asked, “What’s the difference between a covenant and a warranty?” The answer: “Not much.” And that is not too far from the truth. But it would be a very different story if the question had been, “What is the difference between a covenant and a condition?”

The importance of the distinction between a covenant and a condition was driven home by a 2010 decision from the Ninth Circuit Court of Appeals. The decision received a great deal of attention at the time, and I used it as an assignment in the law school class I was teaching on contract drafting. Even though the decision has been thoroughly discussed from every angle, it still serves as a useful reminder to lawyers not to be careless with license agreements and to pay particularly close attention when drafting conditions.

The case was MDY Industries v. Blizzard Entertainment, and it dealt with a license agreement for the popular online role-playing game, World of Warcraft, or WoW. The license agreement prohibited the licensee from using bots to simulate people playing WoW. There was no question that the licensee had violated that term of the agreement. The question was whether the provision was a covenant or a condition.

A covenant is a promise by a party to a contract to do something or not to do something. If the promise is broken, the breaching party is liable to the other party for monetary damages — usually the amount of money required to put the non-breaching party in the same situation it would have occupied if the covenant had not been broken.

In contrast, a condition is a fact that must exist (or not exist) before another substantive provision of a contract takes effect. In the context of a license agreement, the other substantive provision is the license itself. If the conditions to a license are not satisfied, the license is void. And if the license is void, the breaching party will probably be liable for infringement of the underlying intellectual property — in this case, the copyright to the software.

So the question before the Ninth Circuit was whether the crucial contract provision was a promise by the licensee not to use bots or a condition on the grant of the license itself. If the former, the licensee would be liable for monetary damages, which would amount to relatively little. However, if the prohibition on using bots was a condition to the license, the licensee would be liable for copyright infringement, including statutory damages that could greatly exceed the damages owed for breach of contract.

In analyzing the provision, the Ninth Circuit noted that the folowing language was under a heading, “Limitations on Your Use of the Service.”

You agree that you will not . . . create or use cheats, bots, “mods,” and/or hacks, or any other third-party software designed to modify the World of Warcraft experience . . .

First the court disregarded the heading, using the common rule of contract interpretation that headings are for convenience only and are not part of the actual language of the contract. Once that was done, the court noted that there was nothing else about the language to connect the prohibition on bots to the scope of the license or the effectiveness of the grant of the license. Instead, the provision was written merely as an ordinary agreement, or a promise. If the copyright owner’s real intent when the license agreement was drafted was to restrict the scope of the license, it could easily have done so by designating the prohibition as a condition to the license. The resolution of the case, or at least part of the case, turned on that subtle, technical drafting issue.

So if you are ever in a contract negotiation and your lawyer is arguing with the other side that a provision should be a covenant instead of a warranty, or vice versa, you might want to take a break and, outside the negotiating room, ask your lawyer if it is really worth the time to argue about it. However, if your lawyer is arguing with the other lawyer about a covenant versus a condition, you can be fairly certain it really is worth the time.
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Anticipatory Breach and Mitigation of Damages revisited: The Indiana Supreme Court Clears the Minefield

July 17, 2014 | Michael R. Smith

Last year we wrote about a decision of the Indiana Court of Appeals, Fisher v. Heyman, that addressed the amount of damages owed to the seller of a condominium after the buyers refused to go through with the sale unless the seller corrected a minor electrical problem. See “Anticipatory Breach and Damage Mitigation: A Minefield for Real Estate Sellers?” Today the Indiana Supreme Court overruled the decision of the Court of Appeals.

The case began with a purchase agreement for a condo between Gayle Fisher, the seller, and Michael and Noel Heyman, the buyers. The purchase agreement permitted the buyers to have the condo inspected and to terminate the agreement if the inspection revealed major defects. The inspection report showed that some electical outlets and lights did not work. The Heymans informed Fisher that they would terminate the contract unless Fisher corrected the problem by a specified date. Fisher did not meet the deadline, and the Heymans refused to go through with the purchase. However, shortly after the deadline passed, Fisher had an electrician repair the problems, for which the electrician charged her $117. By then, however, the Heymans had found another property and refused to purchase Fisher’s condo. Fisher put the condo back on the market, but the best offer she received was $75,000 less than the price that the Heymans had agreed to pay. In the meantime, she incurred additional expenses that raised her damages to over $90,000.

The buyers argued that they believed the electrical problem was a major defect that allowed them to back out of the deal. However, the trial court and the Court of Appeals disagreed with the buyers, holding that the demand for repairs was an anticipatory breach, a concept we discussed in our previous blog post. The Supreme Court decision changes nothing about that aspect of the Court of Appeals decision. Both the Court of Appeals and the Supreme Court held that trial court did not err by finding that the electrical problems were not a “major defect” and that the buyers breached the purchase agreement by making a demand that they were not entitled to make. The difference between the two opinions is how to analyze the seller’s duty to mitigate damages.

When one party breaches a contract, the other party is entitled to damages sufficient to put the non-breaching party in the same position it would have occupied had the contract been performed. However, the non-breaching party must use reasonable efforts to mitigate the damages. This case illustrates the concept nicely. The original purchase price was $315,000. Sometime later, Fisher received, but rejected, an offer of $240,000. Ultimately, she sold the condo for $180,000. The trial court found (and the Supreme Court affirmed) that Fisher acted unreasonably when she rejected the offer of $240,000. Accordingly, the most she could recover was the difference between $315,000 and $240,000, not the difference between $315,000 and $180,000. The question, however, is whether the doctrine of mitigation of damages required Fisher to comply with the Heymans’ demand to have the electrical problem fixed. If so, she would be able to recover only $117, the amount it cost her to fix the electrical problems. Last year, the Court of Appeals said yes.

Today, the Supreme Court said no, agreeing with Judge Cale Bradford of the Court of Appeals. In his dissenting opinion, Judge Bradford reasoned that the doctrine of mitigation of damages does not require the non-breaching party to accede to a demand that creates a breach. The Supreme Court agreed with that reasoning and elaborated that, just as a non-breaching party may not put itself in a better position than it would have been had the contract been performed as agreed, neither can the breaching party. Here, the buyers agreed to pay $315,000 for a condo that had minor electrical problems (if tripped ground fault interrupters and burnt out light bulbs can be considered “problems”), and the seller was not obligated to sell them a condo with no electrical problems for the same price. Result: The Heymans owed Fisher not $117, but more than $90,000.

Setting aside the legal arguments, the Supreme Court decision avoids some very practical, real-world issues that would have been posed by the Court of Appeals decision. Had that decision stood, the law in Indiana would have allowed a party to a contract to continue to make additional demands on the other side, confident that the worst thing that could happen is that it would be required to pay the incremental cost of the demand. Conversely, the party on the receiving end of those demands would be forced to choose between acceding to them or being satisfied with the incremental cost of the demand, regardless of the magnitude of its actual damages.

A simple example: Imagine a musician who agrees to perform at a concert for $20,000. The organizer of the concert has already incurred another $30,000 in expenses and sold $100,000 worth of tickets. At the last minute, the musician refuses to go on stage unless he is paid an additional $10,000. The organizer would be forced to choose between paying the additional $10,000 or suffering a loss of $80,000, while being able to recover no more than $10,000. Surely that is not how mitigation of damages is supposed to work.

[Note: In discussing the example of the last paragraph, this post originally mentioned a loss of $130,000 rather than $80,000, but that’s not the way damages are calculated. The organizer’s damages would be the cost of refunding the price of the tickets ($100,000) less the $20,000 that the organizer originally promised the musician. The $30,000 in expenses would have been incurred even if the concert proceeded, giving the organizer a profit of $50,000. If the musician breached, the organizer would have to refund the price of the tickets, leaving the organizer with a $30,000 loss. To put the organizer in the same position it would have occupied had the contract not been breached — i.e., with a $50,000 profit — the musician would owe the organizer $80,000.]
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