2006 legal outlook: navigating complex issues: mold asbestos, indemnity clauses and construction defect claims will vex apartment owners in 2006. While next year's legal outlook is complicated, it is navigable with the right foresight and tools.

In 2005, the apartment industry had a booming year due to low interest rates and record numbers of condominium conversions. But, by the same token, there were downsides. Natural disasters affecting a substantial number of owners, managers and developers had to be confronted. And, changes in laws have affected the way those in the apartment industry do business. By analyzing this past year, it is possible to chart potential legal hot points for the coming year.

NATURAL DISASTERS

National and regional apartment professionals alike were affected in some manner by a natural disaster this past year. Whether a flood, hurricane, earthquake or other event, the challenges to the apartment industry are myriad. However, natural disasters present an opportunity to reassess a company's risk management strategy from top to bottom.

Insurance. When assessing insurance coverage, certain questions must be asked: Has the company adequately insured for the appropriate loss from a first-party stance? What about from a third-party viewpoint? While most companies have dealt with the former, many never anticipate claims from residents when natural disasters strike. Therefore, many did not have insurance or were under-insured for the claims on 100- to 200-unit communities that easily ran into $1 million or more. While it may be difficult to prove negligence when a natural disaster strikes, that difficulty does not prevent the filing of lawsuits.

Loss of Revenue. What about business interruption insurance or the loss of revenue when a building under development must halt work because of an impending natural disaster? Discuss with an insurance broker the potential risks each region presents. Don't always assume that a broker has done his or her job--discuss risks in advance. To avoid leaving the decision of potential coverage to a court, make sure that the policy explicitly covers the loss.

Lease Issues. Furthermore, has the company done advance work in risk limitations within the lease agreements with residents? Has it anticipated potential of acts of God? This past year shows that if a hurricane hits. residents could not only lose their homes, but all of their personal belongings. If they do not have renters insurance, and do not have recourse, an apartment company and its insurance may be their only avenue of recovery. Lease agreements are as good a place as any to anticipate those events and use them to contractually limit potential liability.

Public Relations. Lastly, and perhaps most importantly, is the company prepared from a public relations standpoint? Does it have a plan in place should the worst happen at one of its communities? The last thing property owners want is to have one of their communities on the six o'clock news because of a fire, with residents swing that the owner or manager has done nothing to help.

Now is the time to put procedures in place in an operations manual that allow for top to bottom control should a disaster arise, including how to deal with residents, media and government agencies.

Consequently, much like other aspects of management, it is clear that awareness and preparedness can prevent excessive losses for owners and managers of apartment communities. Further, explicit language in insurance policies can avoid huge headaches and expenses.

ENVIRONMENTAL MATTERS

The past year has witnessed the emergence of two relatively new trends in the apartment industry: a rise in mold claims filed as prospective class actions and fungal growth claims as add-on claims to construction defect lawsuits. The emergence of new asbestos litigation appears on the forefront, as well.

Class-Action Mold Claims. Apartment owners and managers will confront a variety of potential environmental claims, and because of the warranty of habitability (depending on the jurisdictions) the apartment company becomes the guarantor for ensuring that the apartment is free from conditions that might harm residents.

The singular mold claim appears to be a slowing trend. The science simply makes it difficult to achieve a substantial victory by an individual plaintiff. Studies--such as those by the National Academy of Sciences--have made the far-flung claims of truly severe injuries difficult to maintain and even more difficult to prove.

However, those still attempting to profit from mold claims have found a new venue: the class-action claim. Class actions are notably difficult to maintain as mass personal injury claims. Not every person is susceptible to respiratory symptoms caused by mold growth, so the class-action requirement that all members of the class be similarly situated and possess similar injuries may not be satisfied.

As an example, courts have stated that mass tort actions for personal injury most often are not appropriate for class-action certification. However, the filing of the "class" gives the plaintiffs' counsel the ability to conduct a mass mailing to all potentially affected residents. The ethical rules of the California Bar normally limit direct solicitation of potential plaintiffs in person or by mail unless there is a prior relationship established. Thus, it is merely a means to aggregate claims even if the tactic does not result in achieving class certification. The relatively limited potential recovery that is inhibiting to the one- or two-plaintiff mold claim suddenly, by the multiplicity of a 50- or 60-plaintiff claim, becomes advantageous to the plaintiffs' counsel.

Limitation strategies can inhibit, if not prevent, these claims. With the advent of larger claims, the determination to limit the potential of these claims increases. Apartment owners and managers must be ready and well documented to avoid becoming targets and then, in turn, fight the claim if they do.

Construction Defect Mold Claims. Similarly, in the construction defect arena, the issue of fungal growth has become an asset to plaintiffs and a detriment to developers. The ordinary construction defect lawsuit suddenly becomes attractive if the plaintiff can put a personal injury spin on it to boost the potential recovery. In light of the increasing trend toward condominium conversions, the previous owners, managers and developers of condo-converted apartment communities could potentially become targets of lawsuits.

Asbestos. Finally, the issue of asbestos is still alive. Claimants have found new avenues of potential recovery through insurance policies with premises liability. Thus, this is a new "non-product" claim that is separate from those based in asbestos as a product, which potentially provides for third-party liability. The vigilant apartment owner will be ready to confront these issues in older communities when they arise.

Protecting Against Liability. Clearly, the environmental risks involved in managing and owning apartment communities are entrenched in both the communities' construction and maintenance. A mold addendum to the lease can inform residents of the potential for fungal growth and impose a duty on residents to inform management of any potential mold. Further, early detection of fungal growth should be handled promptly, including cleaning, testing and remediation, if necessary. Leaving the problem to solve itself will only result in larger problems in the future.

Regarding construction defect risks and protections, owners and managers will only be at risk if they were responsible for the design, development or building of either the property itself or any subsequent improvements to the property. Owners and managers who took no part in any of these processes should have fairly limited liability for construction defects.

However, there have been attempts to legally name real property as a product, thereby making the owner or manager liable for purposes of product liability, absent and apart from being involved in the development of a project. While this has occurred with houses, it is relatively untested in the apartment and condominium arena. This is certainly an unnerving consideration for apartment owners who believe themselves protected from liability because they did not do any work to a building. Disclaiming this type of liability will rest on risk limitation strategies, founded in indemnity and insurance issues.

INDEMNITY CLAUSES

California experienced significant turmoil in the indemnity arena this past year because of legislative changes. Property contractors and developers are confronted with a major change in how they limit their potential liability.

Gov. Arnold Schwarzenegger (R) signed into law this past year California Civil Code [section] 2782, which states that all Type I Indemnity Agreements entered into after Jan. 1, 2006, are void and unenforceable.

The amendment states, "For all construction contracts, entered into after Jan. 1, 2006, for residential construction ... all ... agreements ... that purport to indemnify, including the cost to defend, the builder ... by a subcontractor against liability for claims of construction defects are unenforceable to the extent the claims arise out of, pertain to, or relate to the negligence of the builder or the builder's other agents, other servants, or other independent contractors ... or for defects in designs furnished by those persons.... This section shall not be waived or modified by contractual agreement, act or omission of the parties." (See 2005 Cal ALS 394.)

What does this mean for owners and managers of apartment communities? Although this amendment is California-specific, this type of legislation should concern all who contract for development of properties because it has the potential to become a trend and be enacted in other states. In essence, this legislation means that all claims for construction defect against owners, managers, builders, general contractors and subcontractors will be evaluated on a contributory negligence basis. In other words, if the managers or owners played any role in the building, design and development of the subject property, managers and owners cannot simply pass the buck on to general contractors and subcontractors for negligent design or construction. On the contrary, liability for any claims made by residents will be divided among the responsible parties accordingly.

Further, this amendment will substantially transform the substance of indemnification clauses of management, construction and subcontractor contracts. As stated in the plain language, this new amendment may not be waived or modified by contractual agreement. However, there is no limitation on continuing to obtain Type 1 indemnity for non-defect claims, such as death or bodily injury, and contract-related claims that are not defect related. Moreover, while this harms the developer, by its language it may not harm the general contractor in contracts with the subcontractors.

What are the collateral effects of this amendment? The insurance arena will also feel the effects of this type of legislation. Prior to this amendment, insurers of subcontractors and general contractors bore the burden of the majority of construction defect litigation. With this new legislation, however, insurers of managers and owners will also be forced to shoulder some of the load if these same managers or owners had a part in the development, design or construction of the community. Such increased exposure will likely result in higher premiums and may result in restructuring of managers and owners' insurance policies.

Protecting Against Liability. This amendment will be inapplicable if the manager or owner took no part in the design, manufacture, development or construction of the community. Unfortunately, this is not always the case, so it is important to analyze the most feasible way to limit liability.

It is clear that while there are ways to still use indemnity language to an apartment owner's benefit, this new situation requires appropriate solutions. Furthermore, insurance and additional insured certificates become all the more necessary and appropriate in this new era of construction contracts.

Although this amendment is clearly California-specific, as stated previously, no state is precluded from adopting similar legislation. Consequently, it is vital that each apartment manager and owner know state laws regarding the enforceability of these types of indemnification clauses. Certainly, this is a developing area, but it is clear that a majority of contracts will require alteration to keep pace with the changing nature of the law.

CONSTRUCTION DEFECT CLAIMS

The rate of condominium conversions during the past two years has been astonishing. The market appears to be shifting from a seller's and developer's market to a buyer's market. With conversion rates likely to keep increasing, the potential for litigation is likely to increase, as well.

Developers of apartments built for conversion hopefully have put all the appropriate safeguards in place via contract and insurance. Of course, the question is not whether litigation is coming, but when is it coming and who will be a target. Will developers be covered by insurance? The question is far more critical than it would at first seem.

A Commercial General Liability Policy (CGL) is the lifeline for owners and managers in many situations. In these policies, insurance depends on whether an event sparking liability is covered as an "occurrence." The question of whether an alleged construction defect can constitute an occurrence and trigger an insurer's duty to defend or indemnify in favor of the insured in the context of a CGL continues to be a subject of discussion and litigation among insurance companies and property owners.

Depending on the language of insurance policies, instances of breaches of contract are not "occurrences" and therefore not usually covered by CGLs. This means that insurers can avoid defending or indemnifying the insured if they categorize the alleged construction errors as a breach of contract, thereby failing to trigger coverage. However, if the defects are found to be "property damages" or acts of negligence, then the insurance company may be responsible for indemnifying the insured. Thus, the dispute revolves around whether or not a construction defect is a breach of contract or "property damage."

Several circuits have only begun to tackle this important issue. As an example, the U.S. Court of Appeals for the Fifth Circuit has only recently certified the question to the Texas Supreme Court of whether defects in construction qualify as an "occurrence," triggering an insurer's duty to defend and indemnify the insured. See Lamar Homes, Inc. v. Mid Continent Cas. Co., 2005 U.S. App. LEXIS 2144I (5th Cir. 2005). The insurance policy at issue in this case stated that an "occurrence" meant an accident, including continuous or repeated exposure to substantially the same general harmful conditions. Despite this seemingly clear language, the court refused to answer the question and instead certified the issue to be decided by a higher court. Such a holding appears to show that courts are hesitant to impose more responsibility on insurers.

Once again, the precise effect on managers and owners depends on whether or not those managers or owners are also the builders of the property. Should a manager or owner also be responsible for construction of the property, any damages for defects claimed by residents may come out of the owner's or manager's pockets instead of out of an insurance policy. If the manager or owner is the party seeking recompense for construction defects, he may be limited in recovery, as huge insurance policy limits may not be available.

Therefore, there is an inordinate amount of liability riding on the determination as to whether construction defects meet the "occurrence" requirement. As is the case with many indemnification issues, it is vital that every manager and owner of apartment communities inquire into what each jurisdiction has ruled on this issue. If no such conclusion has been made, it would be wise to keep a watchful eye on upcoming decisions.

2006 LEGAL ISSUES AT A GLANCE

1. Natural disasters in 2005 raised questions about future insurance coverage, loss of revenue, risk limitations within lease agreements and public relations preparedness.

2. Environmental matters at issue include class-action mold claims, construction defect mold claims and asbestos abatement.

3. Indemnity clause transformations in California represent a major change in how contractors and developers limit liability.

4. Construction defect claims brought on by an increasing number of condo conversions raise the issue of whether developers will be covered by insurance in certain lawsuits.

John C. Manly is an attorney and founding partner of Manly and McGuire, which represents apartment owners and managers. He may be reached at [e-mail].