Expert Commentary

Sore Knees: Recent Case Law Ignoring the Subcontractor Exception

Recent court rulings considering and applying standard ISO CGL policies span the full gamut of construction defect claims. Despite similar fact patterns, the courts' decisions are so divergent that they are impossible to reconcile. By overemphasizing the definition of "occurrence" over the property damage exclusions that serve to limit the business risk doctrine, the intent of the drafters and the rules of insurance policy interpretation have been ignored.

Construction Defect Coverage
November 2004

The last column in this series discussed two recent cases that upheld coverage under commercial general liability (CGL) insurance policies for insured general contractors for property damage arising out of the defective work of their subcontractors. The means of upholding that coverage was the subcontractor exception to exclusion (l), the "your work exclusion," which preserves coverage for the named insured for property damage arising out of the work of subcontractors.1 The subcontractor exception, together with the terms of other property damage exclusions, circumscribes and limits the "business risk doctrine" under the CGL policy as applied to construction contractors. That same column also lamented the elimination of the coverage for subcontractors' defective work by the promulgation by Insurance Services Office, Inc. (ISO), of an endorsement deleting the exception from the your work exclusion.2

Part of the impetus for the promulgation of the limiting endorsement appears to be cases such as American Family Mut. Ins. Co. v American Girl, Inc., 673 NW2d 65 (Wis 2004), and Wanzek Construction v Employers Ins. of Wausau, 679 NW2d 322 (Minn 2004). Both of those cases recently applied the intent behind the subcontractor exception to uphold coverage for insured general contractors for property damage arising out of the defective work of their subcontractors.3 These types of cases, though adhering to the plain language of the exception to the exclusion, have assumed increasing importance due to the escalation of construction defect litigation, particularly subdivisionwide lawsuits, West Coast style. Completed operations coverage for subcontractor defects has taken center stage to provide coverage for settlements in these cases, and it is little wonder that there has been an effort by insurers to scale back—if not to eliminate—the coverage.

Cases from the Other Side

Despite the standardized language of the CGL policy, including the subcontractor exception, other courts have nevertheless failed to apply it. Two recent cases, in effect, sidestep the coverage preserved through the subcontractor exception by applying the definition of "occurrence" to deny coverage for claims involving the defective work of subcontractors. Both cases were decided shortly after American Girl and Wanzek Construction, and both of them call into question the need to take further steps such as endorsing the CGL policy to eliminate the subcontractor exception as a means to reduce the coverage available for defective workmanship. For if property damage arising out of defective work cannot constitute an occurrence, by definition, there is no need to reach and apply the exclusions in the policy. Of course, the fact that ISO saw a need for the promulgation of an endorsement to eliminate the subcontractor exception may indicate that the insurance industry does not truly believe that defective workmanship cannot per se satisfy the definition of "occurrence" so that the policy exclusions can be ignored. This is truncated reading of the CGL policy, in effect, "cuts it off at the knees."

L-J v Bituminous

One of these recent cases is L-J, Inc. v Bituminous Fire & Marine Ins. Co., 2004 WL 1775571 (SC April 21, 2004). In that case, L-J, the insured site development contractor, faced claims against it arising out of an inadequately compacted road base, which resulted in the deterioration of pavement in a subdivision several years after completion. All of the defective site compaction work was performed for L-J by subcontractors. As a result, the developers sued L-J for breach of contract, breach of warranty, and negligence. L-J was insured from 1989 through 1996 by various insurance companies, three of whom contributed to a $750,000 settlement. Bituminous refused to participate in the settlement, and the other three insurers and L-J filed a declaratory judgment action seeking contribution from Bituminous for the settlement amount, coupled with indemnification for all defense costs. The trial court upheld coverage, and was affirmed by the South Carolina Court of Appeals in L-J, Inc. v Bituminous Fire & Marine Ins. Co., 567 SE2d 489 (SC App 2002).

Before the court of appeals, Bituminous argued that faulty workmanship can never constitute an occurrence under a CGL policy. The court rejected this argument, and in a footnote acknowledged the proposition that an automatic denial of coverage, on the basis that defective work cannot be an occurrence constitutes a "rehash" of the business risk doctrine, and depends entirely on the court ignoring the terms of the CGL policy. Rather, the court of appeals held that while faulty workmanship, standing alone, may not constitute an accident, when the damage due to the faulty site compaction extended beyond the cost of repairing the compaction, there was an accident which was neither expected nor intended from the standpoint of the insured.

Here there was damage beyond the faulty site compaction because the failure to properly compact the roadbed led to the failure of the road surfaces. All of this work was part of the insured's work under its contract. Finally, the court of appeals went on to uphold coverage and to apply the "subcontractor exception" to the your work exclusion. Therefore, even though the entire road construction project fell within the definition of "your [L-J's] work" within the your work exclusion, the subcontractor exception preserved coverage where the damage to L-J's work arose out of the work of a subcontractor. In other words, the court of appeals applied the plain and unambiguous language of the policy in its 2002 opinion.

Bituminous appealed that result to the South Carolina Supreme Court, and more than 2 years later, that court did a rapid about-face, reversing the court of appeals, and in the process, forsaking the policy language and intent. The supreme court held that, inexplicably, even though it determined that there were numerous acts of negligence on the part of L-J, no occurrence had taken place. The court stated as follows:

  • While the alligator cracking may have constituted property damage, we find that no "occurrence" took place as defined by the CGL contract. According to the deposition testimony, the only "occurrences" were various negligent acts by the Contractor during road design, preparation, and construction that led to the premature deterioration of the roads. Those negligent acts included: (1) A failure to prepare the subgrade by both failing to remove the tree stumps and failing to remove or compact the white clay in the subgrade; (2) An improperly designed drainage system; (3) A thin road course, ill-prepared to handle heavy wheel loads; and (4) an improperly designed curve edge detail. We find that all of these contributing factors are examples of faulty workmanship causing damage to the roadway system only, which does not fall within the contractual definition of "occurrence" under Bituminous's CGL policy. [Emphasis in original.]

The Bituminous policy contained the standard definition of "occurrence" as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions." Thus, while the South Carolina Supreme Court recognized the negligent conduct of L-J, it determined that that negligent conduct did not constitute an occurrence simply because the property damage arising from it was to L-J's work under its contract. The court's holding is not supported by the language of the definition itself which contains no requirement of third-party property damage to constitute an occurrence.4 The court's holding fails to take into account the fact that the property damage exclusions, including the your work exclusion, differentiate between covered and noncovered property damage.

In addition, the South Carolina Supreme Court supported its holding by quoting from Henderson, Insurance Protection for Products Liability and Completed Operations-What Every Lawyer Should Know, 50 NEBRASKA LAW REVIEW 415 (1971), a frequently cited law review article. That article is cited for the proposition that coverage under CGL policies applies tort liability for physical damage to others and not for contractual liability of the insured for economic loss because its product or completed work was not that for which the damaged person bargained. However, the Henderson law review article addressed the 1966 revisions to the CGL policy, revisions that did not include the subcontractor exception which was subsequently added by the broad form property damage endorsement and which was made a standard provision in the 1986 policy form, the form that was before the L-J court.

Finally, the court illustrated its ruling with the following hypothetical:

  • We agree that the CGL policy may provide coverage in cases where faulty workmanship causes bodily injury or property damage to another. For instance, if a bicyclist rode through Dunes West [the development], caught his front wheel in an alligator crack, and suffered an injury, the damages resulting from his successful negligence cause of action would likely be covered under a CGL policy. In our view, this example represents the type of insurable loss contemplated by a CGL policy definition of "occurrence" because it was an accident causing bodily injury and property damage to another, rather than damage to the road itself.

The hypothetical begs the question since it involves bodily injury, and bodily injury is not subject to property damage exclusions that apply to defective work claims. As such, it does little to advance the analysis and in the process, misdirects the focus from the property damage exclusions where coverage for property damage is parsed out under the CGL policy form, to the definition of "occurrence" that makes no differentiation between property damage to the named insured's own work and the property of third parties.

Because of its reliance on the definition of "occurrence," the South Carolina Supreme Court declined to address whether the damage fell within the subcontractor exception to the your work exclusion. Nevertheless, the court corrected the court of appeals for the proposition that the subcontractor exception restored coverage as contrary to existing law, "which states that 'an exclusion does not provide coverage.'"

Other courts have reached a contrary result. For example, in American Family Mut. Ins. Co. v American Girl, Inc., the Wisconsin Supreme Court held that the subcontractor exception does not create coverage where none existed before since the coverage is within the insuring agreement's initial grant of coverage. That coverage would be excluded by the your work exclusion except that the subcontractor exception applies, operating to restore the otherwise excluded coverage.

The court of appeals' opinion in L-J was issued in April of 2002, and the supreme court opinion was not handed down until well over 2 years later in August of 2004. In the interim, other courts have relied on the L-J analysis, one of the most recent being Auto-Owners Ins. Co. v Home Pride Cos., Inc., 684 NW2d 571 (Neb 2004). That opinion was issued by the Nebraska Supreme Court on August 6, 2004, only 3 days before the L-J court of appeals opinion on which it placed heavy reliance was reversed by the South Carolina Supreme Court.

In upholding coverage for an insured roofer for property damage to roof structures in a building damaged by its faulty installation of shingles, the Nebraska Supreme Court relied on the lower L-J opinion for the proposition that while faulty workmanship, standing alone, does not constitute an accident and cannot, therefore, be an occurrence, faulty workmanship that causes an accident is covered under a standard CGL policy. The South Carolina Supreme Court's recent departure from this proposition understandably caused a firestorm within the state of South Carolina. A petition for review is currently before the South Carolina Supreme Court, with amicus curiae support from several construction industry and legal groups.

Groves v Erie Insurance Company

The second recent case relying on the occurrence requirement to bypass coverage for a general contractor for property damage arising out of subcontractors' defective work is Groves v Erie Ins. Co., 333 F Supp 2d 568 (ND W Va 2004). In that case, Bland, the insured homebuilder, sued the Groves, the parties with whom Bland had contracted to construct a home, seeking recovery of the balance owed on the contract. The Groves counterclaimed, recovering damages for the costs of completion and the cost to repair construction defects in the home. They subsequently filed suit as judgment creditors against Erie, Bland's CGL insurer, to recover the repair costs.

Faced with the coverage dispute, the court framed the issue as "whether the Policy covers property damage arising out of negligent workmanship by Bland or his subcontractors." In resolving the dispute, the court addressed the issue of whether faulty workmanship constitutes an occurrence. Initially, the court felt compelled to determine whether negligence cannot be an "occurrence."5 The court noted that although an occurrence can include a continuous or repeated exposure to the same general harmful conditions, it must nevertheless be an accident, going on to apply the following reasoning:

  • An "accident" generally means an unusual, unexpected and unforeseen event…. An accident is never present when a deliberate act is performed unless some additional unexpected, independent and unforeseen happening occurs which produces the damage…. To be an accident, both the means and the result must be unforeseen, involuntary, unexpected and unusual.

The court then determined that negligence must have been reasonably expected to produce an injury to support a cause of action on behalf of the plaintiff. In contrast, the cause and result of an accident are unforeseen, involuntary, unexpected, or unusual. Therefore, the court reached the somewhat novel conclusion that "the unambiguous definition of 'accident' does not encompass negligent acts. Accordingly, the negligent workmanship by Bland or his subcontractors is not an 'occurrence' and receives no coverage under the Policy."

Of course, in reaching this conclusion, the Groves v Erie Ins. court appears to have ignored the traditional formulation of occurrence, that is, an accident, resulting in property damage that is neither expected nor intended from the standpoint of the insured. See King v Dallas v Fire Ins. Co., 85 SW3d 185 (Tex 2002). Moreover, its formulation of "occurrence" runs counter to the notion that one of the basic purposes of a CGL policy is to provide coverage for the negligence of the insured. Only where the property damage is expected or intended should the definition of "occurrence" not be satisfied.

In addition, the Groves v Erie case contains a truncated treatment of the subcontractor exception, addressing it in a single sentence, "[T]he parties argue that whether a certain exclusion in the Policy that is inapplicable to subcontractors consequently creates coverage for subcontractors for their negligent work." However, the court never addresses that issue, even though the opinion appears to make a point of describing the property damage as having been caused by subcontractors. The failure to address the subcontractor exception is not particularly astounding in light of the court's occurrence analysis and result. In fact, it is a characteristic of many of the "defective work as no occurrence" cases that the court stops short of considering the effect of the subcontractor exception.

Tying It Together?

At first blush, the disparate results between cases such as American Girl and Wanzek, as opposed to L-J and Groves, is surprising, possibly disturbing. After all, these courts are all considering and applying CGL policies on standard forms promulgated by ISO. Such cases span the full gamut of construction defect claims, from single-family homes to subdivisionwide residential to large scale commercial office, retail, and industrial to road construction projects. Despite similar fact patterns, results are so divergent that they are impossible to reconcile, and even an explanation is difficult to achieve. However, the single thread that winds throughout many of them is the diversion of the court's attention from the policy as a whole, overemphasizing the definition of "occurrence" over the property damage exclusions that serve to limit the business risk doctrine. That failure to consider the entire policy cannot be squared with either the intent of the drafters or the rules of insurance policy interpretation applied by the courts. As such, this truncated analysis is misguided.

Nevertheless, the temptation to "tie together," especially at the end of this circuitous column, persists. If this occurrence analysis is followed, truncating the coverage and cutting the policy off at the knees, there is no need for the restrictive endorsements recently promulgated by ISO to eliminate the coverage preserved by the subcontractor exception. No defective work will constitute an occurrence, and the insuring agreement of the CGL policy will not be satisfied, eliminating the need to consider the property damage exclusions and their limitations on the business risk doctrine. Ouch, the insured's knees hurt.

1The your work exclusion states as follows: "property damage" to "your work" arising out of it or any part of it and included in the "products-completed operations hazard." This exclusion does not apply if the damage to work or the work out of which the damage arises was performed on your behalf by a subcontractor.

2See endorsement CG 22 94, discussed in "Full Circle Regression: The New ISO "Your Work" Endorsements" (January 2002).

3These cases were described in detail in "Recent Case Law Applying the Subcontractor Exception: Too Little Too Late?" (August 2004).

4See "The Myth of “Third-Party Property Damage" (May 2003).

5The policy included a standard definition of "occurrence" as "an accident, including continuous or repeated exposure to the same general, harmful conditions."

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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