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American Bar Association

Forum on the Construction Industry

What Emergency Relief is Available to a Defaulted Construction Contractor Who Seeks to Challenge the Propriety of the Award of the Completion Contract Without Competitive Bidding?

Eileen M. Diepenbrock, Esq.

Chris A. McCandless, Esq.

400 Capitol Mall, Suite 1800

Sacramento, CA 95814

www.diepenbrock.com

April 24-26, 2008

La Quinta Resort and Club—Palm Springs, California

I. INTRODUCTION

During the course of a contractor’s business, not many letters are as significant as the one that notifies the contractor it is terminated from a public works construction project.

Dear Contractor:

Please be advised that, effective immediately, the City hereby terminates Contractor for default. Contractor’s employees, contractors and agents will be permitted onsite only after reasonable notice, under escorted security, and only as necessary to pick up and take out equipment and/or other possessions that are not necessary for the completion of the work. Otherwise, Contractor’s officers, employees, agents, and contractors are not permitted at the jobsite without prior written authorization from the City.

Sincerely,

City Manager

Upon receipt of such a letter, the relationship between the owner and contractor that once began with aspirations of a successful, on-time, on-budget, and profitable project, becomes virtually irreparable, and both sides must begin to implement strategies for completing the project and mitigating damages.

A default termination is recognized as a drastic remedy for an owner, and should only be imposed for good reasons.[1] Regardless of whether a termination for default is based upon the contractor’s failure to perform in a timely manner, the most common reason for a default termination, or whether the contractor is terminated for other reasons, such as violating material contract terms, the significance and effect of such a default cannot be understated.[2] A default termination can stigmatize a contractor and potentially affect its ability to secure future contracts. Indeed, the existence of a known default on a prior public contract may be grounds for a public entity to find the contractor to be non-responsible. Most significantly, however, a defaulted contractor likely will be held liable to the public entity for the excess costs of project completion.[3] Naturally, the public entity will want to complete its project as quickly as possible, while the defaulting contractor may wish to challenge the termination and/or challenge the manner in which the public entity chooses to complete the project in order to avoid the potential for damages. Thus, once a default termination occurs, the table is set for immediate litigation between the parties.

This article considers the emergency relief that may be available to a defaulted contractor to prevent a public entity from immediately moving forward with completion of a project using a different contractor without invoking a competitive bidding process. Whether a public entity can move forward without competitive bidding usually depends upon the nature and propriety of the termination, the terms of the contract itself, and the public entity’s legal authority to contract. For example, if the termination for default was not proper in the first instance, a subsequent procurement likely would be improper as well. As such, a defaulted contractor would want to remedy the wrong as quickly as possible. Thus, immediately challenging the award of a completion contract to another contractor may be one way to have the propriety of the default termination heard at an early stage in any litigation.

In addition to discussing some of the merits of these issues, this article first addresses the procedural remedies available in a federal court, as well as to an arbitrator, that might be used by a defaulted contractor to attempt to block a further contract procurement by a local public entity to complete the project. While a defaulted contractor may choose to simply litigate the propriety of a termination, without obtaining some emergency relief at the outset, a final determination on the merits may come long after project completion. Thus, in order to mitigate potential damages and downstream risk, a defaulted contractor should consider the various remedies and grounds upon which emergency relief might be available.

II. WHAT EMERGENCY REMEDIES ARE AVAILABLE IN FEDERAL COURT TO ENJOIN OR COMPEL LOCAL STATE ENTITY ACTION?

For purposes of this article, it is assumed that the public entity is a local one, a city, and that the parties will resort to federal court based on diversity jurisdiction.[4] Thus, once a defaulted contractor decides to seek emergency relief, counsel must determine how to proceed in federal court and what standards and law will be applied.

In an appropriate circumstance, a federal court may have authority to grant equitable relief requiring action by a local government entity. Historically, a federal court has enjoyed the power to direct local government body action when necessary.[5] Emergency relief in federal court typically is in the form of an injunction, temporary or permanent, but might also include or be referred to as a writ of mandamus.[6] The most common form of emergency relief available in federal court, as in other courts, is the temporary restraining order (“TRO”). A TRO is a form of injunctive relief issued to preserve the status quo pending the hearing on the application for a preliminary injunction.

Federal Rules of Civil Procedure, Rule 65, governs the issuance of injunctions in federal courts. Rule 65 includes the requisite contents and scope of a federal court TRO, as well as other requirements. According to Rule 65, a TRO is available in federal court with or without notice to the adverse party.[7] In order to obtain a TRO, the moving party must show “specific facts” in an affidavit or verified complaint clearly demonstrating “that immediate and irreparable injury, loss, or damage will result” to the movant before the adverse party can be heard in opposition.[8] Additionally, whether or not a federal court will issue a temporary injunction typically involves, in some form or another, consideration of (1) the likelihood of success on the merits of the movant’s claim, (2) a balancing of the potential hardships to the parties resulting from issuance or non-issuance of the injunction, and (3) the public interest.[9]

In a diversity action, federal courts typically look to the substantive state law to determine the rights of the parties.[10] It has been held that the right upon which a cause of action is based is state created, and that Rule 65(a) contemplates a federal standard governing the procedure for preliminary injunctions in federal court.[11] There is a split of authority, however, as to how Rule 65 applies in a diversity action, and whether or not a federal court must apply state law related to the right to an injunction, or whether federal remedial law applies as a matter of procedure. For instance, some cases hold the right to obtain an injunction in federal court is a matter of substantive law, with the availability of injunctive relief itself being “substantive,” while the procedure for obtaining an injunction in federal court is governed by Rule 65.[12] Thus, following the Erie doctrine[13]: “[t]he general equitable powers of federal courts should not enable a party suing in diversity to obtain an injunction if state law clearly rejects the availability of that remedy.”[14] Under this rationale, for example, a federal court sitting in diversity will not grant injunctive relief where a state statute prohibits such relief in a particular contract dispute.[15]

Some cases hold, however, that a federal court may issue an injunction based on a state substantive right, even where a state court could not grant the same remedy.[16] The Supreme Court’s interpretation on this issue has not been entirely consistent and has not provided a dispositive answer.[17] Nonetheless, the Supreme Court has proclaimed that “[s]tate law cannot define the remedies which a federal court must give simply because a federal court in diversity jurisdiction is available as an alternative tribunal to the State’s courts.”[18] While not dispositive, such language certainly suggests the availability of injunctive relief in federal court even where such a remedy might not be available in state court.

In evaluating whether injunctive relief is available in federal court, then, one inevitably must look to the substantive state rights at issue and, in the process, determine whether state law prohibits injunctive relief altogether. Thus, if state law either allows, or at least does not prohibit, injunctive relief to challenge awards of public contracts, injunctive relief would be available to challenge a completion or reprocurement contract made without competitive bidding. As discussed below, however, the inquiry does not end there. In looking to the substantive rights, the most critical analysis is the likelihood of success on the merits of the party’s claim – in this case, the likelihood of success on the merits of a contractor’s challenge to a local state agency action.

III. WHAT EMERGENCY REMEDIES ARE AVAILABLE TO AN ARBITRATOR TO ENJOIN OR COMPEL LOCAL STATE ENTITY ACTION?

In evaluating whether an arbitrator similarly may issue emergency injunctive relief to enjoin or compel local state entity action, one must consider the arbitration clause itself, which will define the arbitrator’s scope of authority. Absent an indication that the parties did not intend to limit an arbitrator’s power to issue injunctive relief, an arbitrator likely enjoys such power. Where “a contract contains an arbitration clause, there is a presumption of arbitrability.”[19] Under the Federal Arbitration Act,[20] “any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration . . . .”[21] Nothing in the Federal Arbitration Act itself purports to limit an arbitrator’s power to issue injunctive relief.

In evaluating an arbitrator’s scope of authority, courts generally apply ordinary state law contract principles in determining whether parties agreed to arbitrate certain disputes and the scope of an arbitrator’s powers.[22] Thus, where the arbitration provision, as interpreted by the relevant state law, can be interpreted to provide authority to issue injunctive relief, an arbitrator likely enjoys such power.[23] Consequently, courts have both upheld and rejected arbitrators’ issuances of injunctions depending upon whether the scope of the arbitration can be interpreted to preclude issuance of injunctions.[24] For example, where an arbitrator issues an injunction that purports to bind persons not in privity of contract with the parties to the arbitration, such an injunction may exceed an arbitrator’s powers.[25] In such a case, a federal court reviewing an arbitrator’s issuance of an injunction may find that the injunction is void in part and good in part and, accordingly, vacate a portion of an award and leave the remaining portion intact.[26]

Of course, the presence of an arbitration clause itself poses other practical issues for a defaulted contractor seeking to challenge the completion contract. As discussed above, such a contractor will want to move forward as swiftly as possible with the challenge. The inevitable delays associated with setting up the arbitration process, including most especially the appointment of the arbitrator, can be an unnecessary hindrance and/or obstacle. Accordingly, regardless of the presence of an arbitration clause, the defaulted contractor may want to apply for preliminary injunctive relief in federal court to stay the award of the completion contract pending the outcome of the arbitration. As discussed in the companion article by Joel B. Rosen and John M. Tedder, whether the federal court will hear such an application depends upon the particular Circuit in which the federal court sits.[27]

IV. EVALUATING THE LIKELIHOOD OF SUCCESS ON THE MERITS

Arguably the most significant factor in determining whether any preliminary injunctive relief will issue, is the evaluation of the likelihood of success on the merits of the moving party’s claim. In addition to considering whether or not injunctive relief is a permissible remedy, federal courts still must assess the merits of a request for injunctive relief in a diversity action by evaluating the substantive rights of the parties. As noted above, this involves consideration of the respective state law.[28] For instance, in Advance Tank Const. Co. v. Arab Water Works,[29] the Eleventh Circuit was required to interpret substantive provisions of the Alabama Code in order to determine whether the district court’s injunction preventing the execution of a contract between the city water board and the second lowest bidder was proper. For its decision, the court expressly relied on the Alabama Supreme Court’s interpretation of Alabama law. In the context of emergency relief challenging a reprocurement contract, the starting point is the substantive state law concerning the statutory authority and duties of the public entity with respect to contracting.

It is well settled that the general purposes of competitive bidding are to “invite competition, to guard against favoritism, improvidence, extravagance, fraud and corruption, and to secure the best work or supplies at the lowest price practicable.”[30] Therefore, as a general proposition, most public construction projects must be competitively bid at the outset.[31] As a result, where a public entity fails to follow its competitive bidding process, the terminated contractor might challenge the validity of the reprocurement itself based on the public entity’s failure to follow statutory process. Where a public entity has exceeded its authority, the resulting contract generally is considered void and can be set aside by a court,[32] thus providing substantive grounds to seek injunctive relief. In that case, an injunction can be an effective remedy to challenge a state agency’s failure to competitively bid.[33] Similarly, an injunction may be effective to prevent a state agency from moving forward with an improperly awarded contract.[34]

While there are an abundance of cases discussing various state laws and challenges to awards of initial construction contracts let without competitive bidding, there are fewer cases discussing the propriety of reprocurement following termination. Logically, though, the terminated contractor may look for guidance to the requirements for, and policies underlying, competitive bidding in the first place and argue that there should be no exception merely because it is a reprocurement.

Illustrating this, for example, is City of Chicago v. Hanreddy,[35] where the court held that a local entity may not proceed without competitive bidding in the face of a contractor’s failures where statutory authority to so proceed was lacking. There, the contractor defaulted on its obligation to complete a sewer interceptor. The City of Chicago attempted to complete the project itself using day labor. A taxpayer challenged the method of contract completion, claiming the completion of the project could only be procured through competitive bidding. The court held that if the cost of completing a contract would exceed the statutory limit for purposes of competitive bidding, then the city was not authorized to complete the project by day labor. Rather, the court held the city must relet the project to the lowest responsible bidder pursuant to its statutory authorization.[36] The court explained:

To hold that the [competitive bidding] statute does not apply to an unfinished public improvement … would be to permit contracts for public improvements to be let to irresponsible parties, which … would open wide the door to fraud and destroy competition, and enable city officials to do indirectly what in express terms they are prohibited from doing by the statute. The object of the statute is to require the municipalities of this State to advertise for bids upon any work or other public improvement which they propose to construct, and to let the same to the lowest responsible bidder. The statute is in general terms and applies to all public improvements where the costs exceed $500, and the fact that a contract for the improvement had once been let and the work abandoned before completion, if the cost of completing the same will exceed the sum of $500, does not authorize the municipality to complete the improvement by day labor, but a contract for its completion must be let to the lowest responsible bidder after an advertisement for bids. To hold otherwise would be to nullify the statute.[37]

In a Wisconsin case, Center Drainage Dist. v. Capitol Indemnity Corp.,[38] a contractor hired to cleanout drainage ditches within the district was terminated before completion of its contract. The local district thereafter completed the work without competitive bidding and the performance bond surety sought to defend an action against it by claiming the completion contract had been illegally procured. The trial court agreed the contract had been illegally let and found in favor of the surety. On appeal, however, the court held that, even though the district failed to follow competitive bidding requirements, the defense of illegality could not be used by the surety to avoid its obligations.[39]

Even if substantive law generally would require competitive bidding of completion contracts, the owner can be expected to assert any of the exceptions that allow a public entity to proceed without competitive bidding. For example, some statutes permit the letting of a public contract in the first place by using an informal bidding process.[40] If competitive bidding was not required at the outset, absent unusual changes in the nature of the project, the exemption presumptively would apply to the reprocurement.

One exception in particular that owners may assert is that the completion contract falls within an emergency exception to competitive bidding. States generally recognize that, under “emergency” circumstances, a state agency may contract without the formal bidding process.[41] However, for that exception to apply, the need for the completion contract must fall within the definition of “emergency.” For example, while not a termination for default case, Marshall v. Pasadena Unified School District[42] is instructive because it found that a completion contract following a termination for convenience did not satisfy the emergency exception to competitive bidding and thus was an invalid contract. In that case, the Pasadena Unified School District invoked its contractual right to terminate for convenience a contract for a school modernization project and then purported to award a completion contract to another contractor under the “emergency” exception. The claimed “emergency” was that prompt completion was required for instruction/curriculum and the unfinished project was unsafe. In a subsequent legal challenge to the validity of the completion contract, the court of appeal concluded that an emergency, as defined by California law (“a sudden, unexpected occurrence that poses a clear and imminent danger, requiring immediate action to prevent or mitigate the loss or impairment of life, health, property, or essential public services”)[43] did not exist. Specifically, the purported emergency stemmed from the District’s decision to terminate the original contract for its own “convenience.” That event was not a “sudden, unexpected occurrence” posing a clear and imminent danger requiring prompt action to protect life, health, property, or essential public services.[44] Depending on the reason for the default termination – i.e., the default is not because the contractor created an imminent safety issue – a default-terminated contractor similarly should be able to challenge the use of an emergency exception for the award of a completion contract. The fact that a project must be completed by a particular time, or that a contractor is not performing, or even that the state of the project poses safety hazards, is not sufficient unless there in fact has been a “sudden, unexpected occurrence” creating the dangerous situation.

Another argument the contractor may face is that the nature of the completion contract is really just a continuation of the original construction contract rather than a new project.[45] In Shore v. Central Contra Costa Sanitary District,[46] a California court distinguished between an owner’s termination of a contractor’s right to proceed with the work versus the termination of the contract itself. Where only the right to proceed had been terminated, the court found that the owner was not required to comply with California’s competitive bidding laws because the completion contract was merely a “continuation” of the city’s existing and still legal contract with the original contractor.[47] Because the contract language allowed the owner to take over and complete the contract, the court agreed that the local entity was not letting a new and separate contract, but instead was exercising its rights under the original contract. As such, the public entity was not required to reprocure the completion of its project by following California’s statutory competitive bid requirements.[48]

The original contract language also must be considered because it may provide a public entity with sufficient grounds to proceed with completion of a contract without further competitive bidding. For instance, in Trustees of Sanitary District of Chicago v. Poe,[49] a sanitation district ordered its contractor to discontinue all work under the contract, proceeded to complete the project with its own forces using day labor, and then sued to recover the additional expense necessary to complete the unfinished work. The contract expressly provided that if the contractor should fail for any reason to complete by a specified date, then the district would have the right proceed with its own employees and by day labor.[50] The court found that similar provisions in contracts of this nature have been held valid by a number of state courts.[51] As such, the court held that the district was not required to relet the contract under the competitive bidding statute because the contract language excused this requirement.

A California court reached the same conclusion considering the following contract language:

should the contractor at any time during the progress of said works, refuse, or neglect to supply a sufficiency of materials or workmen, the owner shall have the power to provide materials and workmen (after three days’ notice in writing given) to finish the said works, and the reasonable expenses thereof shall be deducted from the amount of said contract price.[52]

Thus, where the contract expressly provided for a city’s right to proceed with the work after a contractor’s failures, the court allowed the city to proceed without competitive bidding.

Each of the foregoing cases demonstrates how the propriety of a completion contract might be challenged or defended based on contractual or statutory arguments. Independent of these requirements, a terminated contractor might also choose to invoke well recognized legal principles such as the duty to mitigate. An owner seeking to complete its project presumably will seek to recover its resulting damages from the terminated contractor and/or its surety. Once an owner has terminated a contractor, however, it is obligated to mitigate its damages.[53] Consequently, in seeking emergency relief, a terminated contractor may use a public entity’s failure to competitively bid as evidence of a failure to mitigate damages, citing an underlying purpose of competitive bidding as finding the lowest cost.[54] In contrast, of course, an owner may contend that time is of the essence in completion and the nature of the competitive bidding process may cause too significant a delay in progress.

Another potentially effective means of seeking emergency relief may be to challenge the propriety of the termination itself, rather than the reprocurement. If the termination is improper, then the contractor presumably would still enjoy the right to proceed with completion of the contract. For this strategy, one should consider the burden of proof in a termination case. As noted at the outset, a default termination is a drastic sanction.[55] In some courts, therefore, it has been held that the government has the initial burden of establishing that the contractor was in default.[56] In those cases, if a default is established, the burden then shifts to the contractor to demonstrate its default is excused.[57] Therefore, an early challenge and request for injunctive relief may be effective to flush out evidence the public entity believes supports its decision to terminate. In the absence of such evidence, a contractor’s likelihood of success on the merits increases, and thus gives way to a greater chance of obtaining emergency injunctive relief.

Apart from the availability of injunctive remedies, both the defaulted contractor and the public owner must consider the substantive rights under the law of the state governing the construction contract. As demonstrated above, the availability of emergency relief for a defaulted contractor may depend not only the merits of the termination itself, but the public entity’s authority to contract, exceptions to public bidding laws, the language of the contract itself, and the parties’ duties to mitigate damages. Each of these matters may well support or diminish a contractor’s likelihood of success on the merits of its claim, and thus, its potential for securing emergency relief.

IV. CONCLUSION

A defaulted contractor’s rationale for seeking emergency relief and immediately contesting a public owner’s decision to terminate and relet the completion of a construction project to another cannot be understated. In addition to its reputation, a defaulted contractor faces potentially grave economic consequences if the public owner is permitted to proceed unchallenged and unchecked. Similarly, a public owner that neglects to proceed with caution and legal authority after a termination for default might find itself spending far more of its own funds to complete its project than initially projected. To mitigate these uncertainties, contractor’s counsel must conduct a swift analysis of the emergency remedies available, the forum within which to seek such remedies, the procedures and standards to apply, and, ultimately, the underlying likelihood of obtaining emergency relief.