Articles Posted in Contract Law

 

[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.

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[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.

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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.

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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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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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BJ Thompson Associates, Inc. leased an office from Jubilee Investment Corp. The lease included the following language:

Guaranty of Performance In consideration of the making of the above Lease by LANDLORD with TENANT at the request of the undersigned Guarantor, and in reliance by LANDLORD on this guaranty the Guarantor hereby guarantees as its own debt, the payment of the rent and all other sums of money to be paid by TENANT, and the performance by TENANT of all the terms, conditions, covenants, and agreements of the Lease, and the undersigned promises to pay all LANDLORD’S costs, expenses, and reasonable attorney’s fees (whether for negotiations, trial, appellate or other legal services), incurred by LANDLORD in enforcing this guaranty, and LANDLORD shall not be required to first proceed against TENANT before enforcing this guaranty. In addition, the Guarantor further agrees to pay cash the present cash value of the rent and other payments stipulated in this Lease upon demand by LANDLORD following TENANT being adjudged bankrupt or insolvent, or if a receiver or trustee in bankruptcy shall be appointed, or if TENANT makes an assignment for the benefit of creditors.

Even though the above language referred to “the undersigned Guarantor,” the lease had no signature block for a guarantor. It had signature blocks for only the landlord and tenant. The signature block looked like this

BJ Thompson Associates, Inc.

By: ____________________
Date: __________________

followed by the address for BJ Thompson Associates, Inc. and the word “TENANT.” It was signed by BJ Thompson, the sole shareholder and president of BJ Thompson Associates, Inc.

The original term of the lease was for one year, but the tenant held over for a number of years. (In essence, the lease was automatically renewed for successive one-year terms.) Eventually, however, the tenant moved out three months into the year and stopped paying rent. The landlord sued both BJ Thompson Associates, Inc. for rent for the remaining nine months, and it also sued BJ Thompson personally on the theory that he had personally guaranteed his company’s obligations under the lease. The trial court dismissed the complaint against BJ Thompson personally because he had signed the lease only on behalf of his company as tenant and not on his own behalf as guarantor. In an unpublished opinion, the Court of Appeals agreed.

A guaranty is a promise by one person to pay the obligations of another person. When landlords sign leases with small businesses, it is common for them to require the lease to be personally guaranteed by the business owners, and the same thing occurs with other types of contracts as well. A guaranty is simply a particular type of contract, and it is governed by the same rules that apply to the interpretation and enforcement of other contracts. However, a guaranty is also one of several types of contracts subject to the statute of frauds, which says that, in order for a contract to be enforced, the contract must be in writing and must be signed by the party against whom it is being enforced.

In this case, the lease included language obligating “the undersigned Guarantor,” but it did not identify BJ Thompson as the guarantor, and, although BJ Thompson signed on behalf of his company, the tenant, nothing in the lease identified his as the guarantor and nothing in the signature blocks indicated that he was signing in any capacity other than as the agent of his company.
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Suppose that eight years ago, you hired a construction contractor to build an addition to your house in Indiana. Shortly after the construction was finished, you noticed that the roof shingles on the addition weren’t quite the same color as those on the rest of the house. You checked the bundle of extra shingles that the contractor left behind and compared the information on the label with the specification in the contract. Sure enough, the contractor used the wrong shingles. Not only were they the wrong color, but they were also a lower quality than the contract specifications required. Even so, you were busy at the time and never got around to calling the contractor to get him to correct the mistake. Now you have a potential buyer for the house who is threatening to back out of the deal unless you replace the shingles. You call the contractor and demand that he correct his mistake. He refuses, saying it is too late for you to complain about the problem, that you should have called him as soon as you noticed it. Are you out of luck or not?

Statutes of Limitations

The key to answering the question is to determine the applicable statute of limitations. A person who has the right to sue someone for breach of contract (or, for that matter, the right to sue for other reasons) cannot wait forever to do it. How long the person can wait is determined by the statute of limitations that applies to the particular type of claim. In Indiana, there are two different statutes that might apply to the situation described above:

Which one applies?

It has been more than six years, but less than ten, since the addition to your house was finished and you noticed the problem with the shingles. Which statute applies?

Certainly your construction contract called for the payment of money, but don’t most contracts do that? Is every contract that requires payment of money subject to the six-year statute of limitations, regardless of the rest of the contract? If so, that leaves the ten-year statute of limitations to cover only those contracts that do not involve the payment of money at all. On the other hand, maybe the idea is that the six-year statute of limitation covers contracts that do not involve anything other than the payment of money.

Surprisingly, there are very few published Indiana court decisions that address the question of which written contracts are covered by the six-year statute of limitations and which are covered by the ten-year statute, even though those statutes originated in 1881. However, the Indiana Supreme Court addressed the question with respect to an earlier version of the statutes in 1923.

The Ten-Year Limitation

The case was Yarlott v Brown, 192 Ind. 648, 138 N.E. 17 (1923), and the question was the statute of limitations on a mortgage. (At the time, the two statutes of limitation on written contracts were 10 years and 20 years, rather than 6 years and 10 years. Yarlott involved a lawsuit that was brought more than ten years, but less than 20 years, after the loan was supposed to be repaid.) Even though people commonly refer to the loans they take out to buy their homes as “mortgages,” in reality the mortgage is actually a document that reflects the lender’s right to foreclose on the property if the loan is not repaid; the obligation to pay the loan itself is set out in another document, called a note. However, in Yarlott, even though the mortgage was accompanied by a note, the mortgage contained not only the right of the lender to foreclose; it also repeated the obligation to repay the loan. It was clear that the statute of limitations on the note itself — a written contract for the payment of money — expired after ten years. But what about the mortgage? If it had not mentioned the repayment of the loan, it would have been subject to the longer statute of limitations. Did the fact that it repeated the obligation to repay the loan move it to the shorter limitation, the one that applied to “promissory notes, bills of exchange, and other contracts for the payment of money”?

The Indiana Supreme Court said no, the 20-year statute of limitations applied to the mortgage, despite the fact that it also provided for the payment of money. The Court reasoned that

. . . a mortgage differs in essential particulars from a promissory note, bill of exchange, or other written contract for the payment of money of the same kind as notes and bills. On the other hand, many actions which may be brought on such a mortgage bear a close resemblance to actions for the collection of judgments of courts of record, which are liens on real estate, or to actions for the recovery of possession of real estate. A familiar rule of statutory construction is that, where words of specific and limited signification in a statute are followed by general words of more comprehensive import, the general words shall be construed to embrace only such things as are of like kind or class with those designated by the specific words, unless a contrary intention is clearly expressed in the statute.

The underlining in the above quotation is ours, not the court’s, but those words are the key to understanding the decision. The shorter statute of limitations applies to written contracts that are similar to promissory notes and bills of exchange.

Now what about your construction contract? Even though it involves the payment of money, a construction contract is very different from a promissory note or bill of exchange. Doesn’t that mean that the applicable statute of limitations is ten years and that you still have the right to expect the contractor to pay for the cost of replacing your shingles? Well, maybe not.

Or is it the six-year limitation?

In 1991, the Indiana Court of Appeals stated that a teacher’s contract — which is also very different from a promissory note or bill of exchange — was a contract for the payment of money and therefore subject to the statute of limitations of six years, not ten. Aigner v Cass School Tp, 577 N.E.2d 983 (Ind. App. 1991). The decision did not even mention Yarlotte v. Brown or the possibility that the period of limitations might be ten years instead of six, maybe because the lawsuit regarding the teacher’s contract was brought within two years, so it was not barred regardless of which statute of limitations applied.

So where does that leave your claim against your former contractor? If a teacher’s contract is subject to a six-year statute of limitations, isn’t your construction contract also subject to a six-year limitation? It certainly seems so. But if you sue the contractor, you may be able to persuade the court that the Court of Appeals discussion of the statute of limitations governing the teacher’s contract was simply wrong because it was inconsistent with the precedent set by the Indiana Supreme Court in Yarlott v. Brown. Alternatively, you might argue that, because the contract in Aigner was valid under either statute of limitations, the court’s mention of the six-year statute of limitation is dictum and therefore not binding precedent.   Unfortunately, you might have to go all the way to the Indiana Supreme Court to get a favorable decision on either rationale.

On the other hand, the decision in Aigner has been around more than 20 years, and it has not been overturned yet. Indiana courts may continue to follow Aigner for most written contracts, narrowly applying Yarlott to those that, even though they involve the payment of money, “bear a close resemblance to actions for the collection of judgments of courts of record, which are liens on real estate, or to actions for the recovery of possession of real estate.” All we can say is that anyone with a claim for breach of a written contract that involves any payment of money is far better off to file the lawsuit within six years; to wait longer is, at best, risky.

We invite others who may be able to shed light on this question to send us a message using the contact form on this page.
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Consider these two relatively recent cases, one from Massachusetts and one from Indiana, both involving allegations of breach of contract through the use of social media:

  • A vice president of a recruiting firm leaves her job and goes to work for another recruiting firm. She has a covenant not to compete with her first employer that prohibits her from providing recruiting services within a specified list of “fields of placement” and within a specified geographic area. She updates her LinkedIn profile to reflect the new job. A message goes out to her list of over 500 contacts, including a number of her former employer’s customers. Her former employer sues, alleging (among other things) that her LinkedIn update violated the covenant not to compete.
  • The agreement between an IT contractor and one of its subcontractors prohibits the subcontractor from soliciting or inducing the contractor’s employees to leave their jobs. The subcontractor posts a job opening on LinkedIn where it could be viewed by anyone who had joined a particular public group. One of the contractor’s employees sees the job posting, contacts the president of the subcontractor, and expresses an interest in the job. At a later meeting, the employee tells the subcontractor his compensation requirements and what he is looking for in a job. The subcontractor makes an offer of employment, and it is accepted. The contractor sues the subcontractor for breach of the covenant not to solicit its employees.

Indiana has a relatively little known statute, the Home Improvement Contracts statute located in Title 24, Article 25, Chapter 11 of the Indiana Code, that protects the customers of home improvement contractors by establishing certain minimum contract requirements. Home improvement contractors are well advised to ensure that their contracts comply with the statute because those who violate it may find themselves on the receiving end of a lawsuit under companion Chapter 0.5 (Deceptive Consumer Sales) filed either by their customers or by the Indiana Attorney General. This article describes only some of the statutory requirements, and home improvement contractors who want to make sure they comply should seek legal advice.

Applicability

The Home Improvement Contacts statute applies to contracts between a consumer and a “home improvement supplier” for any alteration, repair, replacement, reconstruction, or other modification to residential property, whether the consumer owns, leases, or rents the residence, but only if the contract is for more than $150. The statute defines “home improvement supplier” as someone who engages in or solicits home improvement contracts, even if that person does not actually do the work. For example, if a homeowner buys installed carpet from a carpet store, the contract to install the carpet is covered by the Home Improvement Contracts statute even if the store owner doesn’t actually perform the installation but instead subcontracts the work to someone else.

Contract Requirements

Not surprisingly, home improvement contracts must be in writing. Although the Home Improvement Contracts statute does not include an express requirement for a written contract, and although the definition of “home improvement contract” includes oral agreements, as a practical matter it is impossible for an oral contract to comply with the statute.

Section 10(a) of the Home Improvement Contracts statute includes a laundry list of requirements. For example, the contract must include the name of the consumer and address of the home; the name, address, and telephone number of the contractor; the date the contract was presented to the consumer; a reasonably detailed description of the work; if specifications are not included in the description, then a statement that specifications will be provided separately and are subject to consumer approval; approximate start and end dates for the work; a statement of contingencies that may seriously alter the completion date; and the contract price.

The requirement that the contract contain specifications (or a statement that specifications will be supplied later for approval by the consumer) deserves a little more attention. The statute defines specifications as “the plans, detailed drawings, lists of materials, or other methods customarily used in the home improvement industry as a whole to describe with particularity the work, workmanship, materials, and quality of materials for each home improvement.” Note that a specification must describe the work, workmanship, materials, and quality of materials with particularity.

Consider, for example, a contract to paint the exterior of a home. Does it comply with the requirement for a contract to contain specifications if the only description of the work is, “Paint all exterior siding and window frames with gray exterior latex paint”? Does that describe the work “with particularity”? Probably not. For example, it does not specify the number of coats of paint, obviously a significant consideration. Moreover, the specification of “exterior latex paint” is probably inadequate in light of the range of quality and prices of exterior latex paint available on the market, and “gray” is probably not specific enough either, given that paint stores carry a wide spectrum of colors that can reasonably be called gray.

Specific Requirements and Accommodations for Work Covered by Insurance

Section 10(b) of the statute deals with special issues presented by contracts to repair damage that is to be covered by an insurance policy. Several of the provisions provide alternative ways for the contract to comply with the general requirements listed in Section 10(a). For example, the requirement to include the start date can be satisfied by specifying that the repairs will begin within a specified amount of time after it is approved by the insurance company. Similarly, the contract price can be expressed by stating the amount owed by the consumer in addition to the amount of the insurance proceeds, and that includes a contract provision that the contractor will not charge the consumer any amount above the amount of the insurance proceeds. Note, however, that because of the prohibitions in Section 10.5 (discussed below), the consumer is responsible for any insurance deductible.

More importantly, Section 10(b) requires home improvement contracts for repairing exterior damage that covered by insurance to give the consumer a right to cancel the contract within three days of receiving notice from the insurance company denying coverage for some or all of the repairs. The contract must include some very specific language dealing with the right to cancel, and it also must include a form, attached to but easily removable from the contract, that the consumer can use to cancel the contract.

Prohibitions

Section 10.5 of the statute also contains some prohibitions that home improvement contractors need to know about. One has already been mentioned — contractors are prohibited from paying or rebating to the consumer any part of an insurance deductible or giving any sort of gift, allowance, or anything else of monetary value to the consumer to cover the insurance deductible, including things like referral fees and payments in exchange for the consumer allowing the contractor to place a sign in the yard.

As another example, Section 10.5(d) contains a blanket prohibition on home improvement contractors acting as public adjusters.
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In a previous post we discussed a few basic principles of confidentiality agreements (also known as non-disclosure agreements or NDAs). That post discussed the basic of these agreements and the important principles of restrictive covenants and trade secrets. Left unanswered was the critical question: How long can, or should, a confidentiality obligation last?

Reasonable Periods of Confidentiality
Now let’s get back to the question of a reasonable amount of time for confidentiality obligations to last with respect to CBI that does not meet the definition of a trade secret. As discussed above, a factor is the nature of the CBI owners legitimate business interests that are protected by the agreement. An example of a legitimate business interest of the owner is to protect the confidentiality its cost of goods sold or COGS. Disclosure of that information to competitors may give them an unfair advantage when bidding for the business of new customers. But how long does that legitimate business interest last? That depends on the nature of the goods and the nature of the industry. In some industries, costs are sufficiently stable that knowledge of a company’s COGS from five years ago enables a competitor to make an accurate estimate of the company’s COGS today, and a court might consider a confidentiality period of five years to be very reasonable. In other industries, costs change much more quickly, and a court might find that a confidentiality period of five years is unreasonable and rule that the agreement is unenforceable — unless the COGS also meets the definition of a trade secret.

Here’s where things get more complicated because the definitions of CBI in most confidentiality agreements are not identical to the definition of a trade secret. In most cases, all trade secrets are also CBI, but not all CBI qualifies as a trade secret. So what to do?

One one might consider writing a confidentiality agreement that, for CBI that qualifies as a trade secret, lasts for as long as that is true and, for all other CBI, lasts for only, say, three years. And one can certainly write a contract with precisely that provision, but it will pose a dilemma for the recipient: The recipient will probably not be able to tell the difference between CBI that qualifies as a trade secret and CBI that does not. Here are some possible ways to resolve that dilemma.

  • The recipient may decide to simply live with the dilemma and assume that all CBI must be protected essentially forever. Some recipients find that acceptable.
  • The owner of the CBI may accept a time limitation for all CBI, including CBI that qualifies as a trade secret. However, that may create other problems for the CBI owner. Note the second part of the definition of a trade secret — it must be subject to reasonable precautions to protect its secrecy. Is it a reasonable precaution to disclose information under a confidentiality agreement that permits the disclosure or use of the information after a certain period of time? Some courts say no, with the result that the information loses its status as a trade secret.
  • The confidentiality agreement may impose a limit that applies to ALL CBI, but only if, and for as long as, the CBI qualifies as a trade secret. In that case, the owner accepts the possibility that some CBI may have no protection at all because it never qualifies as a trade secret. For some owners in some situations, that is a more acceptable risk than the possibility of having its CBI lose status as a trade secret.

In short, there is no single solution that works in every case. Each situation must be negotiated individually, with the interests of both sides of the agreement taken into account.
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