During a recent conference, I was reminded of the idea that risk management in construction can be thought of as a three-legged stool. The first leg involves risk management, where a construction professional creates and manages an effective quality assurance/quality control program to minimize the risk of design and construction defects. The second leg involves risk transfer, where a construction professional includes defense and indemnification clauses in its contracts to shift the risk to the party, typically a subcontractor, which is in the best position to avoid the risk during construction. The third leg involves insurance, where the construction professional insures against the risk of construction defects either through a wrap insurance program or its own annual renewable commercial general liability insurance policies and additional insurance coverage on its subcontractors’ policies.
In rare instances, the traditional risk management stool may not be enough to effectively protect the construction professional from risking its own assets in the construction process. In 2007, Colorado became an anti-indemnity state, meaning that the extent of defense or indemnity that a builder can get from any given subcontractor is limited to the extent of that subcontractor’s own negligence. This change limited the effectiveness of the second leg of the risk management stool. Also, as discussed in previous articles, there are inherent pitfalls with newer insurance policies, which may limit or exclude coverage for various construction defect risks, such as the risk of building on expansive soils. These limitations and exclusions obviously limit the effectiveness of the third leg of the risk management stool.
These limitations on the effectiveness of the risk management stool become perilous in Colorado given the Hoang v. Arbess decision from the Colorado Court of Appeals. The decision held that homeowners can hold a builder’s corporate officers personally liable for construction defects if they are directly involved in the tortious conduct. Specifically, if they were involved with approving of, directing, actively participating in or cooperating in the negligent conduct of the corporation. In the Hoang case, Mr. Arbess was found personally liable because of his decision to use slab-on-grade basement floors instead of the structural floors recommended by the geotechnical engineer. He was also held personally liable because he “approved of, directed, actively participated in, or cooperated in the negligent conduct. For example, plaintiffs presented evidence that the defendant was personally involved in each step of the construction, chose the individual home sites, oversaw the subcontractors, set policies and procedures for the subcontractors to follow, and visited the construction sites at least once a week.”
Given the ever-increasing limitations on the effectiveness of the traditional risk management stool in Colorado and the potential for personal liability, I have begun advising builders to investigate whether to add an offshore asset protection trust as the fourth leg of the stool. While there are legal and tax implications and complications in setting up an effective trust, it may be a worthwhile endeavor in specific circumstances, particularly with closely held businesses, where the owners are involved in the process, have significant assets to be protected, and who do not want their life’s savings to be at risk in a construction defect case.
I would encourage anyone who is concerned about risking his or her legacy by engaging in home building to seek out advice from attorneys and accountants who specialize in this form of asset protection to see if it may be a viable fourth leg in their risk management stool.