The past year, 2007, saw the issuance of a number of significant court opinions from key states as to the issue of whether damage attributable to defective construction is covered under the commercial general liability (CGL) insurance policy. Those opinions centered around whether damage to a construction project meets the definitions of "occurrence" and "property damage" in the policy.
These cases resulted from a questionable interpretation of the CGL policy that denies claims involving defective work on the theory that the performance of defective work that breaches the insured's contract is foreseeable and outside the coverage grant of the CGL policy. The major purpose of this argument has been to avoid the coverage preserved for defective work claims under the carefully drafted property damage exclusions by rewriting longstanding law on occurrence and property damage. In 2007 these efforts met with little success, particularly as to the efforts to avoid the coverage preserved under the subcontractor exception to exclusion (l), the "your work" exclusion.
This column will summarize those developments that culminated in very recent opinions rendered in late December, and which have already carried into 2008.1
Notable 2007 Opinions
Following are the important holdings of the year, in chronological order.
The year 2007 started with an opinion from the Tennessee Supreme Court in March rejecting the "defective work is not an occurrence" argument in Travelers Indem. Co. of Am. v. Moore & Assocs., Inc., 216 S.W.3d 302 (Tenn. 2007). There, the court rejected the insurer's argument that defective work installed pursuant to a contract is foreseeable and not an occurrence. Rather, the court found the alleged water penetration from faulty window installation by the named insured's subcontractor was unexpected and unforeseen, and thus, an "accident" and an "occurrence" within the meaning of the CGL policy. Even though the water penetration could be the natural consequence of improperly installed windows, the foreseeability of damages could not be determined under an assumption that the windows would be installed improperly. Therefore, the insured could not have foreseen the water penetration if the windows had been properly installed.
In August 2007, an eagerly awaited opinion from the Supreme Court of Texas was rendered on the defective construction as occurrence and property damage issues. The court did not disappoint the construction industry in Lamar Homes, Inc. v. Mid-Continent Cas. Co., 239 S.W.3d 236 (Tex. 2007). The court answered three certified questions from the U.S. Court of Appeals for the Fifth Circuit, holding that the existence of an occurrence depends on whether the property damage is unexpected or unintended from the standpoint of the insured, and not whether the ultimate remedy is in contract or tort. In addition, the economic loss rule is a liability defense, not a test for insurance coverage. Moreover, where a defect causes physical injury to tangible property, it is not mere economic loss, but property damage as defined in the CGL policy.
Having resoundingly rejected the occurrence and property damage arguments of the insurer, the court went on to address the applicability of exclusions in the policy. The court traced the expanded coverage provided under the CGL policy for certain business risks, recognizing the effect of the broad form property damage (BFPD) endorsement which culminated in the insertion of the subcontractor exception into exclusion (l), the "your work" exclusion, in 1986. By incorporating the subcontractor exception into the "your work" exclusion, the insurance industry specifically contemplated coverage for property damage caused by a subcontractor's defective performance. In construing the subcontractor exception to the "your work" exclusion, the court rejected the notion that the subcontractor exception creates coverage, finding rather that it reinstates coverage that would otherwise be excluded under that exclusion.
The result in Lamar Homes v. Mid-Continent was followed in Arizona less than a month later in September 2007, when the Arizona Supreme Court denied review of the court of appeals opinion in Lennar Corp. v. Auto-Owners Ins. Co., 151 P.3d 538 (Ariz. App. 2007). In that case, the court held that damage to homes caused by defective site preparation by the insured homebuilder's subcontractors constituted an occurrence, and that the CGL policy covers the natural consequences of negligent construction. The court then applied the subcontractor exception to exclusion (l), the "your work" exclusion, to uphold coverage for the damage to homes caused by the defective site preparation of the builder's subcontractors.
Late December saw yet another refusal to accept the no occurrence and property damage position in a high profile case in U.S. Fire Ins. Co. v. J.S.U.B., Inc., 2007 WL 4440232 (Fla. Dec. 20, 2007). There, the Florida Supreme Court reversed prior Florida case law that had been read to hold that providing CGL insurance coverage for defective work was against public policy. Rather, the court held that unexpected and unintended property damage to a number of homes arising out of the faulty site preparation by a subcontractor constituted an "occurrence" of "property damage," as defined in the insured general contractor's CGL policy. The court rejected arguments based on the purported distinction between tort and breach of contact claims for purposes of CGL coverage, also refusing to recognize the applicability of the economic loss rule to support such a distinction.
In addition, the Florida Supreme Court went on to recognize the applicability of the subcontractor exception to exclusion (l), the "your work" exclusion, by upholding coverage for the insured builder for the property damage to homes caused by inadequate site preparation performed by a subcontractor. The court also rejected the argument that to apply the exception would create coverage through an exclusion, concluding that to uphold coverage under the CGL policy would not convert it into a performance bond.
Unfortunately, on the same day, Florida clouded the issue in the companion case to U.S. Fire v. J.S.U.B., on a certified question from the Eleventh Circuit Court of Appeals, in Auto-Owners Ins. Co. v. Pozzi Window Co., 2007 WL 4440389 (Fla. Dec. 20, 2007). Consistent with its opinion in U.S. Fire v. J.S.U.B., the court found an "occurrence" arising out of the unexpected defects in the installation of windows on a custom home. Nevertheless, the court denied coverage to the insured homebuilder for damages arising out of the defective installation of the windows by a subcontractor. The damages included water intrusion into the interior of a home, as well as damage to the windows themselves, but the court held that the installation of the defective windows themselves did not involve "physical injury to tangible property."
It should be noted that the facts before the court appeared to be indistinguishable from the J.S.U.B. case in which the same court upheld coverage and applied the subcontractor exception to exclusion (l). That aspect of the case is the subject of a motion for rehearing currently pending before the Florida Supreme Court in this case.
Momentum in 2008
Cases already addressing the issue this year include the following.
The momentum gained by construction insureds has already carried into 2008, with the court's opinion in Aten v. Scottsdale Ins. Co., 2008 WL 65595 (8th Cir. Jan. 8, 2008), applying Minnesota law. Relying on O'Shaughnessy v. Smuckler Corp., 543 N.W.2d 99 (Minn. App. 1996), the Eighth Circuit Court of Appeals held that the defective construction of a home, which led to water damage to that home, was an accident, and thus an "occurrence." The court remanded the case to the trial court for a determination as to whether the defective workmanship had been performed by a subcontractor.
Even in states where the breach of contract approach has been accepted, such as South Carolina, in L-J, Inc. v. Bituminous Fire & Marine Ins. Co., 621 S.E.2d 33 (S.C. 2005), there have been signs of retrenchment. In that case, the S.C. Supreme Court held that damage to a roadway due to cracking caused by a subcontractor's work was not an occurrence since the only damage was to the road, the insured contractor's work. Despite that pronouncement, several federal district courts in South Carolina recently certified the question as to whether the S.C. Supreme Court's holding in L-J v. Bituminous applies to deny coverage for property damage caused by continuous exposure to moisture which results from faulty workmanship.
That same issue was addressed in Okatie Hotel Group, LLC v. Amerisure Ins. Co., 2006 WL 91577 (D. S.C. Jan. 13, 2006), where the court determined that L-J v. Bituminous stands for the proposition that no occurrence exists if the damage is restricted to the defective work itself. However, if the damage extends beyond the defective work to otherwise non-defective work, there is an occurrence. In Okatie, the court upheld coverage for a claim involving water intrusion damage to the interior of a hotel resulting from defective work.
The confusion in these cases resulted in the certification by the federal courts of the issue of whether damage to other portions of a construction project due to water infiltration constitutes an occurrence of property damage under a general contractor's CGL policy. Pending the answer of the certified question by the South Carolina Supreme Court, the various federal cases have been stayed. This stay is the result of an appeal before the S.C. Supreme Court, Auto-Owners Ins. Co. v. Newman, 2002-C.P. 10-4390. Oral arguments were heard in that case in early January 2008. It is expected that the S.C. Supreme Court will issue a detailed opinion, particularly as to the issue of resulting damages and the court's favorable citation to High Ctry. Assoc. v. New Hampshire Ins. Co., 648 A.2d 474 (N.H. 1994), in the L-J case, as an example of a case upholding coverage where defective workmanship resulted in property damage.
Confusion over the citation to that case in L-J was created because the facts of High Country are substantially similar to those in the other federal cases, that is, where water infiltration causes damage to other nondefective portions of the work. Nevertheless, under the strict holding of L-J, the court there did not seem to be upholding coverage for such resulting damage. At any rate, it is expected that the court's opinion in Auto-Owners v. Newman may resolve these issues. If resolved in favor of coverage, that finding would represent a departure from the strict "breach of contract is not an occurrence" approach.
Other Pending Appeals
Other cases on the issue of defective work as occurrence and property damage are currently pending in the following states:
In Hathaway Dev. Co., Inc. v. Illinois Union Ins. Co., No. 07-00118 (N.D. Ga. Oct. 4, 2007), appeal pending, Case No. 07-15155 (11th Cir.), the district court held that because the subcontractor intended to perform work on an apartment complex, the damages arising out of that work did not constitute an accident under the insured general contractor's CGL policy and Georgia law. The case also considers the applicability of exclusions j(5) and j(6), the operations and faulty workmanship exclusions.
In St. Paul Fire & Marine Ins. Co. v. Building Const. Ent., Inc., 484 F. Supp. 2d 1004 (W.D. Mo. 2007), appeal pending, Case No. 07-2246 (8th Cir.), the district court determined that property damage caused by a subcontractor's substandard work on a governmental contract to construct the ducts on a training facility for the Army Corps of Engineers was not an "accident," and thus not an "occurrence" under the insured general contractor's CGL policy, since breaches of contract are not considered accidents or occurrences under Missouri law.
Mid-Continent Cas. Co. v. Williamsburg Condo. Ass'n, 2006 WL 2927664 (W.D. Wash. Oct. 12, 2006), appeal pending, Case No. 06-35977 (9th Cir.). In that case, the district court determined that property damage to condominiums caused by the insured builder's breach of contract or breach of warranties could not be regarded as an "occurrence," since such a breach is reasonably foreseeable.
A map as to the current status of the law in all 50 states and the District of Columbia illustrates the effect, on a national basis, of the cases discussed above, as well as prior and existing opinions on the issue of defective work as occurrence. The map, together with a matrix summarizing the cases addressing the issue of defective work as occurrence and the treatment of the property damage exclusions, is available as an update to the IRMI Online edition of Insurance for Defective Construction, Second Edition.
As can be seen, it appears that the argument that defective workmanship arising out of a breach of contract cannot be an occurrence under a CGL policy, which was somewhat successful in previous years, has been overwhelmingly rejected in 2007. Even in states where that view was adopted, such as South Carolina, the courts appear to be reconsidering it. The rejection of this argument was not extremely surprising since—based on the language of the policy itself and the notion that unexpected and unintended property damage arising out of faulty workmanship constituted an occurrence—it has been the majority rule for quite some time. In essence, the courts are simply restoring order on this aspect of construction defect coverage. As a result, construction insureds can likely expect more emphasis by insurers on the property damage exclusions as applied to these claims, and a continuation of the effort to modify those exclusions to reduce the scope of coverage available.
Many of these cases have been discussed in prior columns, but the purpose of this discussion is to provide the reader with an updated status as to the case law set out in those earlier columns. Of particular note to this analysis is Patrick J. Wielinski, "Defective Work as Occurrence" 2007: Too Close to Call," May 2007 and "Court Weighs in on Defective Work as Occurrence," September 2007.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI.
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