The multi-billion dollar question: when damages resulting from an insured’s work are an insured “property damage” under a CGL policy?

THE MULTI-BILLION DOLLAR QUESTION: WHEN DAMAGES RESULTING FROM AN INSURED’S WORK ARE AN INSURED “PROPERTY DAMAGE” UNDER A CGL POLICY?

One line of recurring situations in contract indemnification case addresses whether construction defects meet the CGL policy’s requirement of an “occurrence” involving an “accident.” A separate recurring situation focuses on whether the costs associated with the insured’s defective work constitute “property damage.”

The short answer to the second question is that: it depends on the jurisdiction and on the facts of the case and who is your expert fact finder or who is your lawyer.

Here are some recent cases shedding some light into this issue:

Regional Steel Corp. v. Liberty Surplus Ins. Corp., 226 Cal.App.4th 1377 (June 13, 2014).

JSM Florentine, LLC (JSM Florentine) is the owner of an apartment building, the Florentine Apartments, under construction in North Hollywood in 2004 (Florentine Project). The Florentine Project complex consists of 14 stories, including retail space on the ground floor, four floors of parking, and 180 residential units on the upper floors. JSM was the general contractor on the project. Regional Steel was a subcontractor engaged pursuant to a June 4, 2004 subcontract to provide reinforcing steel to the Florentine Project’s columns, walls, and floors. Webcor Construction LP (Webcor) was engaged to supply and pour concrete to encase Regional’s rebar skeleton.

From May through September 2004, Regional prepared and submitted shop drawings that used both 90 degree and 135 degree seismic tie hooks in shear walls. JSM and the structural engineer for the project, Babayan & Associates (Babayan), approved the drawings. In October 2004, Regional began construction on the project, using both the 90 degree and 135 degree seismic hooks as approved in the shop drawings. Webcor poured concrete encasing the rebar and tie hooks.

In January 2005, a City building inspector issued a correction notice requiring the exclusive use of 135 degree hooks. In April 2005, JSM became aware of the problem and informed Regional that it needed to use 135 degree hooks. On May 3, 2005, JSM stopped the pouring of concrete pending resolution of the hook issue. Regional Steel immediately began to fabricate 135 degree hooks. In June 2005, the City notified JSM that garage levels one through three, and some on level four, had defective tie hooks and required repair. JSM refused to pay Regional’s invoices and withheld $545,000.

The court held that under the facts of this case, a contractor’s defective work, as well as the “rip and tear” cost of accessing and repairing that work, are not property damage. Regional Steel Corp. v. Liberty Surplus Ins. Corp., 226 Cal.App.4th 1377 (June 13, 2014). The appellate court cited F&H Construction v ITT Harford Ins. Co, (2004) 118 Cal.App.4th 364, for its conclusion that “the basic purpose of liability policies, … ‘are not designed to provide contractors and developers with coverage against claims their work is inferior or defective. The risk of replacing and repairing defective materials or poor workmanship has generally been considered a commercial risk which is not passed on to the liability insurer.” Id., at 1392.

The Regional Steel court characterized as inapposite cases that “involved contamination by hazardous materials that were incorporated into a whole, and did not involve the incorporation of defective workmanship in to a construction project.” Id., at 1393. The court held that the allegations that Regional Steel “failed to install the proper tie hooks, and its failure to do so necessitated demolition and repair of the affected areas [were] squarely within the rule of F&H Construction that this type of repair work is not covered under a CGL policy.” Id.

Regional Steel provides useful support for an insurer’s argument that its insuring clause does not extend coverage to the cost of correcting the insured’s defective work. The first line of cases followed the rule that coverage for the cost of removing and replacing the defective work or material of the insured is not covered, and that such cost is an economic loss, not physical injury to the property. According to the Court, the risk of replacing and repairing defective materials or poor workmanship has generally been considered a commercial risk which is not passed on to the liability insurer.

Insurers’ arguments that such damages do not constitute an “occurrence” have been rejected in a number of states and criticized by some commentators as not sufficiently grounded in the language of the policy. Since the mid-1970s ISO CGL forms, first within the Broad Form Property Endorsement and then within the policy itself, provide subcontractor exceptions to the normal “your work” exclusion. This argument has been advanced in support of the contention that interpreting the policy as a whole requires coverage for defects caused by others with whom the insured contracts. Similar issues will exist with respect to an insured general contractor and defects caused by subcontractors.

The second line of cases has held that incorporation of a defective part into a whole construction project may constitute property damage within the meaning of a CGL policy. In this regard, the Court looked at Armstrong World Industries, Inc. v. Aetna Casualty & Surety Co. (1996) 45 Cal.App.4th 1, where the California Supreme Court held that there was property damage under a CGL policy based on the incorporation of asbestos tiles and insulation into a building because the potentially hazardous material was physically linked to the building. The Court here noted thatArmstrong, as well as other cases following its ruling, all generally involved contamination by hazardous defective materials or products that were incorporated into a whole. This contamination resulted in property damage to the property as a whole, not just to the defective product itself.

The Court noted that even in Armstrong, the Supreme Court acknowledged the general rule that there was no “property damage” and thus no coverage for replacement of a defective part installed by the insured, but that because of the hazards allegedly caused by the defective asbestos tiles and insulation, that rule was not applicable. The Court of Appeal held that the Armstrong line of cases was not applicable here, since the allegedly defective rebar ties did not contaminate any other portion of the project or the project itself. Consequently, there was no property damage.

An insurer had no duty to defend or indemnify a general contractor or subcontractor in a suit alleging construction defects, a New York appellate court ruled.

Applying New Jersey law, the court determined that the construction defects did not constitute an “occurrence.” However, the insurer was not entitled to recoup the defense costs it had paid on the insureds’ behalf in the underlying action.

In National Union Fire Insurance Co. of Pittsburgh, PA v. Turner Construction Co., 986 N.Y.S.2d 74 (N.Y. App. Div. 2014), Turner was the general contractor for a high rise office building constructed in New Jersey for owner GSJC. Turner subcontracted with Permasteelisa for the building’s exterior curtain wall which consisted of granite and glass with an attached network of decorative pipe rails.

A segment of the pipe rails fell from the building onto the street. GSJC determined that a significant percentage of the pipe rail connections to the curtain wall did not conform to specifications or were defective. GSJC sued Turner and Permasteelisa in New Jersey state court for breach of contract, breach of warranty, and negligence, seeking damages for the damage to the curtain wall and the danger of additional pipe rail falling in the future. National Union, which had issued an OCIP policy for the project, defended Turner and Permasteelisa under a reservation of rights and then filed a declaratory judgment action in New York state court. The New York trial court entered judgment for National Union. On appeal, the intermediate court of appeals affirmed. As to choice of law, the court stated that

it is undisputed that the law of New Jersey governs this action, which turns on insurance policy interpretation, and that New Jersey and New York law are consistent as to the issues in dispute here.

The court then held that, under both New York and New Jersey law, faulty workmanship which results in damage to the insured’s work only, regardless of whether any of the faulty work was performed by the insured’s subcontractor, does not constitute an “occurrence.” The court rejected the argument that National Union’s expansion of the definition of “occurrence” beyond an

“accident,” to also include an “event or happening,” dictated a different result:

[T]he addition of “happening” or “event” to the definition of “occurrence” does not change the fact that fortuity is still an essential consideration under New Jersey and New York law when determining whether there is coverage under such a policy, and a claim for faulty workmanship simply does not involve fortuity.

In this case, the policy provided that “[t]his policy is primary coverage and the insurance carrier agrees not to take action or recourse against any insured for loss paid or expenses incurred because of any claims made against this policy.” National Union asserted that this provision only precluded it from seeking to recoup the cost of defending against covered claims. However, nothing in the language differentiated between covered and uncovered claims. Rather, the provision applied to “any claims,” without reference to whether those claims were ultimately found to be covered by the policy. Accordingly, the policy unambiguously precluded the reimbursement of defense costs.

METROPOLITAN’S NOTES: MAKE SURE YOU TRULY UNDERSTAND WHAT IS COVERED AND WHAT IS NOT COVERED UNDER YOUR CGL POLICY. PERHAPS PREPARE A CONTRACT CONTAINING UNAMBIGUOUS LANGUAGE REGARDING WHAT YOUR INSURANCE EXPECTATIONS ARE, IN ADDITION TO THE ISO FORMS OR OTHER FORMS USED BY THE INSURER TO AVOID PROTRACTED LITIGATION ON COVERAGE ISSUES.

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