February 19, 2009
Organization: Robert E. Frankel
Over the past decade, the construction industry has experienced significant growth, although recently it has waned due to the financial meltdown caused by subprime mortgages. Even with the recent abatement in construction, the growth of new construction over the last decade is apparent. Greater frequency of the discovery of, and ensuing litigation over, faulty or defective workmanship has followed this boom in construction and such exposure is not likely to end soon.
An improvement on real property may have any of a number of defects. Typically, the developer or builder will be sued by a purchaser for damages to repair the faulty workmanship and related damages caused thereby. In addition to recovery from other responsible parties, a developer or builder will want to consider his entitlement to insurance coverage for such claims. This article acts as a primer for the insurance recovery related to faulty workmanship.
Comprehensive or commercial general liability ("CGL") insurance contains a promise by the insurance company to defend and indemnify the policyholder for certain "property damage" claims asserted by third-parties. The following elements must exist to obtain coverage under the CGL policy.
A. Legally Obligations To Pay Damages
First, in addition to providing the policyholder with an insurance-paid defense to claims potentially covered by the policy, CGL insurance pays for, among other things, the policyholder's legal obligation to pay damages. Judgments, awards, and verdicts satisfy this requirement. Settlements and consent decrees usually also qualify. However, with respect to consensual dispositions, an issue may arise if the claimant's right to execute on it is limited. This may happen, for instance, where the settlement stipulates an amount of damages and the policyholder assigns its rights to coverage to the underlying claimant in exchange for a promise not to execute against the policyholder's assets.
B. "Property Damage"
Additionally, to obtain CGL insurance coverage, "property damage" must be in existence, and such "property damage" must be suffered by someone other than the policyholder. "Property damage" is tangible property damaged by experiencing either: (a) "physical injury or destruction;" or (b) "loss of use." With respect to construction defects, physical injury is clearly present if the construction defect causes damage to non-defective work or personal property. However, there is a split of authority as to whether the construction defect itself can constitute physical injury or destruction. However, if the defective workmanship causes the property to be unusable or uninhabitable, this distinction will be irrelevant because such loss of habitability will fit within the "loss of use" prong.
Further, CGL insurance is triggered when "property damage" is caused by an "occurrence," defined as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions." A policyholder's or third party's negligence is generally considered an "occurrence" covered by CGL insurance. Nationally, there is a split in authority as to whether construction defects constitute "occurrences." One line holds that construction defects causing unexpected and accidental "property damage" can constitute an occurrence regardless of the legal theory asserted against the contractor. Another line of authority holds that construction defect claims can never constitute "occurrences" because: (a) under the "gist of the action" doctrine, construction defect claims are breach of contract claims irrespective of whether negligence is alleged; and (b) breach of contract claims can never amount to "occurrences."
1. Trigger of Coverage
Two sub-issues flow from the "occurrence" issue. First, a question arises as to the appropriate trigger of coverage - namely, the timing of the "occurrence." This issue determines what policy or policies must respond to a claim. There are four theories of "occurrence" triggers: (a) exposure - a policy is triggered upon the first exposure to the injury-causing event; (b) manifestation -- a policy is triggered upon the first manifestation of injury; (c) injury-in-fact - a policy is triggered when the first injury takes place; and (d) continuous - all policies between the date of first exposure and the date of manifestation are triggered. Cases around the country apply different trigger theories for construction defect claims, although the most prevalent theories are: (a) manifestation; and (b) continuous.
2. Number of Occurrences
Another sub-issue is whether each instance of "property damage" would constitute one "occurrence" or multiple "occurrences." This is important for "per occurrence" deductibles and "per occurrence" indemnity limits. As an in initial matter, the vast majority of courts that have attempted to ascertain the "number of occurrences" have followed the cause test -- namely, an occurrence is determined by the cause or causes of the resulting injury. The minority approach looks at the effects, focusing upon the number of individual claims or injuries. However, either approach involves a fact-based inquiry. Not surprisingly, courts have construed nearly identical policy language and reached inconsistent results when applying the cause test to construction defects.
CGL policies contain a number of exclusions often cited by insurance companies in reservation of rights letters.
1. Alienated Premises Exclusion
First, the "alienated premises" exclusion excludes coverage for damage to property sold by the policyholder. Thus, by its terms, the exclusion will not apply to policyholders that do not transfer the property at issue, such as contracting entities. However, even for sellers of property, the exclusion has an express exception if the premises are the seller's "work" and were never "occupied, rented or held for rental by" the policyholder. Because the premises will generally be the developer's "work," the exclusion will only apply if the damaged premises were ever occupied, rented, or held for rental by the developer. An unanswered issue in the case law is coverage for damage to a model home.
2. Performing Operations Exclusion [Exclusion J(5)]
Exclusion J(5) excludes coverage for "property damage" to "that particular part of real property on which you or any contractors or subcontractors working directly or indirectly on your behalf are performing operations, if the ‘property damage' arises out of those operations."
(i) During Operations
Cases construing this exclusion universally hold that it is inapplicable to claims involving "property damage" arising after operations are completed and are limited to "property damage" occurring during ongoing operations.
(ii) "That Particular Part"
Moreover, there is a question as to the meaning of the phrase "[t]hat particular part of real property on which you or any contractors or subcontractors working directly or indirectly on your behalf are performing operations." A policyholder may be able to avoid application of Exclusion J(5) by arguing that the damage occurred to work that had already been completed or parts of the building that were never intended to be renovated.
3. Faulty Workmanship Exclusion [Exclusion J(6)]
Exclusion J(6) excludes coverage for "property damage" to "[t]hat particular part of any property that must be restored, repaired or replaced because ‘your work' was incorrectly performed on it."
(a) Completed Operations
Exclusion J(6) has an exception, stating that it "does not apply to ‘property damage' included in the ‘products-completed operations hazard.'" Courts have upheld the exception, holding that Exclusion J(6) does not apply to "property damage" arising away from the policyholder's premises and out of its completed operations.
(b) Damage To Defective Work Itself
The majority of courts have held that Exclusion J(6) excludes damage only to the faulty or defective work itself, and it does not operate to exclude damage to other property or to non-defective work caused by the faulty or defective work. The basis for this view is that "it" in the above-quoted passage refers to "that particular part of any property" which both: (a) must be repaired, restored or replaced; and (b) is the location on which "your work" was incorrectly performed.
4. "Your Product" Exclusion
Exclusion K or "Your Product" Exclusion also bears some mention because it is often relied upon by insurance companies in denying coverage to developers for claims related to defective construction. Exclusion K excludes coverage for "‘[p]roperty damage' to ‘your product' arising out of it or any part of it." Reliance upon Exclusion K in this context is often misplaced. CGL Policies typically define "Your Product" specifically to exclude real property. In fact, cases have specifically held that "Your Product" exclusion is inapplicable to real estate or construction work of a developer or contractor. The confusion results from some case law construing an earlier version of the CGL policy that failed to specifically exclude real property from the definition of "your product."
5. "Your Work" Exclusion
The standard form CGL insurance policy also contains the "your work" exclusion, which excludes coverage for "'property damage" to ‘your work' arising out of it or any part of it and included in the ‘products-completed operations hazard.'"
(a) "Your Work"
By definition in the policy itself, work performed by subcontractors hired by the policyholder would be included in "your work."
(b) Damages Occurring During Operations
Moreover, only if the "property damage" is included in the "products-completed operations hazard" is the "Your Work" exclusion potentially applicable. In other words, if the "property damage" occurs during operations, such exclusion is inapplicable.
(c)Damage To Others' Work
Under the express language of this exclusion, any damage to other property (i.e., others' non-defective work or personal property) would not be encompassed by this exclusion. However, by definition in the policy itself, work performed by subcontractors hired by the policyholder would be included in "your work." Hence, damage to "your" subcontractor's work would not be damage to others' work.
(d) Subcontractor Work
Nonetheless, in cases where the property damage occurs after operations are completed and therefore within the "products-completed operations hazard," analysis of the exception will be required. The "Your Work" exclusion usually has an express exception "if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor." Courts have held that such exclusion has no application to property damage to the part of "your work" performed by subcontractors. In such cases, the CGL policy does, to some extent, operate as a performance bond.
With the recent amount of new housing, construction defects litigation will likely dominate courts throughout the next decade. This article set forth the principal coverage issues building professionals will face when seeking CGL insurance coverage for such construction liabilities. Ultimately, the central theme that emerges is that a CGL insurance policy should not operate as a performance bond. Coverage is never even sought for most of the non-performance facets of a performance bond. However, if a contractor subcontracts out all of the work, the CGL policy will act as a performance bond to the extent a performance bond covers the repair of defective work of the subcontractor. However, such a result stems from the historical needs of building professionals that the insurance industry chose to address and insure through the policy form in use. In any event, the debate often can be avoided by focusing on the existence of damage to property caused by the defect.
ROBERT E. FRANKEL
5001 Raintree Circle
Parker, Colorado 80134
H: (720) 851-1508
W: (303) 723-1621
Email: [email protected]