INSURANCE COVERAGE ISSUES IN CONSTRUCTION DEFECT CLAIMS

By

DAREN S. McNALLY

©2001 Connell Foley LLP
  1. DUTY-TO-DEFEND CONSTRUCTION DEFECT CLAIMS

Generally, an insurer must defend an insured whenever allegations in an underlying complaint assert a cause of action that is potentially covered under the policy. In New Jersey, however, the issue is somewhat more complicated. Over thirty years ago, the New Jersey Supreme in Burd v. Sussex, 56 N.J. 383 (1970), created a unique exception to the general rules governing duty to defend law. In Burd, the Court held that an insurer should not be permitted to control the defense of its insured in the following two circumstances:

    1. Where the trial of the underlying action will leave the questions of coverage unresolved, or

    2. Where the case may be so defended by a carrier as to prejudice the insured thereafter on the issue of coverage.

56 N.J. at 389. The fundamental principle underlying the Burd rule is to avoid the potential conflict that might arise if an insurer were to control the defense in either of the above scenarios. This rule, however, does not eliminate an insurer’s defense obligation. Rather, an insurer’s obligation after Burd becomes an obligation to reimburse for defense costs to the extent that the defense is later determined to be attributable to covered claims. Hartford Accident & Indemnity Co. v. Aetna Life & Casualty Insurance Co., 98 N.J. 18, 29 (1984).

A. Application of Burd to Construction Defect Cases

The Burd rule has been applied to construction defect cases. For example, in Grand Cove II Condominium Association v. Ginsberg, 291 N.J. Super. 58 (App. Div. 1996), the insured-developers sued their insurers for a defense of various design and construction defect claims brought against them by a condominium association. The underlying complaint against the developers asserted covered and uncovered claims. In addition, the trial of the association’s claims would not have been resolved the coverage issues between the developers and their insurers. As a result, the Appellate Division in Grand Cove II applied the rule in Burd to find that the insurers had no immediate duty to defend. Rather, the court held that the insurers’ duty to defend would be "converted to a duty to reimburse pending the outcome of the coverage litigation." Id. at 1132. Thus, pursuant to Grand Cove II, there may be no immediate duty to defend construction defect claims, even where certain counts may potentially be covered under the policy.

B. Burd Under Attack

While Burd has survived in New Jersey for the past three decades, the decision has recently come under attack. Importantly, the New Jersey Supreme Court took the extraordinary step of accepting interlocutory appeal in two of the leading Appellate Division cases that recently applied Burd. See Trustees of Princeton University v. Aetna Casualty & Surety Co., 293 N.J. Super. 296 (App. Div. 1996), leave to appeal granted, 147 N.J. 547 (1997); and Rutgers v. Liberty Mutual Insurance Co., 277 N.J. Super. 571 (App. Div. 1994), leave to appeal granted, 140 N.J. 274, appeal dismissed, 143 N.J. 314 (1995). Many believe that the New Jersey Supreme Court did not want to review these cases simply to reaffirm the application of the Burd doctrine to claims faced by New Jersey policyholders. The Court, however, did not get the opportunity to address the Burd issue in either Trustees of Princeton or Rutgers because the insurer in both situations settled the cases once leave to appeal the duty to defend issue was granted. Accordingly, the uncertainty about how the New Jersey Supreme Court would decide the application of Burd to modern coverage cases remains.

II. CGL COVERAGE FOR CONSTRUCTION CLAIMS

There are a number of coverage issues related to construction defect claims under a CGL policy. One of the most significant issues relate to whether a particular claim constitutes an "occurrence." After determining whether a claim involves an "occurrence," the question of whether there is "property damage" is critical in the construction defect context. These CGL coverage issues are discussed below.

A. Occurrence

Liability coverage for construction defect claims will exist only where there is an "occurrence" during the policy period. Under a CGL policy, an "occurrence" is usually defined as "an accident, including continuous or repeated exposure to substantially the same general conditions." The nature of the alleged property damage will often dictate whether a particular construction defect claim arises out of an "occurrence." When property damage arises out of the insured’s defective workmanship, there may be no occurrence and, thus, no coverage. See Solcor Equipment Leasing v. Pennsylvania Manufactures’ Association Insurance Co., 606 A.2d 522 (Pa. Sup. Ct. 1992) (holding that there can be no "occurrence" where insured "was negligent and nothing more"); Monticello Insurance Co. v. Wil-Freds Co., 277 Ill.App.3d 697 (1996) (construction defects which are the "natural and ordinary consequences of the improper construction techniques of the insured and its subcontractors do not constitute an ‘occurrence’ within the definition of the CGL policy"). On the other hand, when the damage was neither expected nor intended, there will likely be an occurrence under the policy. See High Country Associates v. New Hampshire Insurance Corp., 648 A.2d 474 (N.H. 1994) (damage that was "unexpected and unintended from the standpoint of the insured and was caused by continuing exposure…fits within the definition of ‘occurrence’ in the policy"); Federal Mutual Insurance Co. v. Grapevine Excavation, Inc., 187 F.3d 720 (5th Cir. 1999) (construction defect claims that are unexpected or unintended constitute an "occurrence" that trigger coverage). The determination of whether there is an "occurrence" under the policy, therefore, will depend upon the nature of the underlying construction defect claim and the type of property damage alleged.

    1. Property Damage

A key element in any coverage analysis is whether a construction defect claim seeks "property damage" within the meaning of a CGL policy. CGL policies generally define "property damage" as "[p]hysical injury to tangible property." This definition distinguishes between actual injury to tangible property and losses to intangible property damage, such as economic losses.

    1. Damage Caused by Faulty Workmanship

Courts have held that construction defect claims that are "limited to remedying faulty workmanship or material do not constitute ‘injury to…tangible property.’" Blaylock and Brown Construction, Inc. v. AIU Insurance Co., 796 S.W.2d 146 (Tenn. Ct.App. 1990); see also Golden Eagle Insurance Co. v. Travelers Insurance Co., 103 F.3d 750 (9th Cir. 1996). However, where a claim of faulty workmanship causes damage to other parts of a project, the derivative damage will be considered covered "property damage." Maryland Casualty Co. v. Reeder, 270 Cal.Rptr. 719 (Ct. App. 1990). While these derivative property damage claims may be covered, there will still be no coverage for derivative intangible economic losses, such as lost wages and damage to reputation. Aetna Casualty and Surety Co. v. First Sec. Bank, 662 F. Supp. 1126 (D. Mont. 1987).

2. Damage Caused by Products

In addition to damage caused by faulty workmanship, property damage can also arise from the incorporation of defective products into tangible property. In these cases, there is a diminution of value to the property in which the insured’s product was incorporated. As a result, the defective product often needs to be removed and replaced by dismantling the affected property, resulting in tangible property damage. See, e.g., Yakima Cement Products Co. v. Great American Insurance Co., 608 P.2d 254 (Wash. 1980). Other courts have held, however, that diminution in property value can never be covered property damage, reasoning that "the nature of the repair cannot create coverage where none exists." New Hampshire Insurance Co. v. Vieira, 930 F.2d 696 (9th Cir. 1991).

III. CGL POLICY EXCLUSIONS

There a several exclusions in a CGL policy that operate to bar coverage for various construction defect claims. Many of these exclusions relate to the faulty or defective workmanship of the insured.

A. Contractual Liability Exclusion

Subcontractors in construction projects routinely agree to provide contractual protections to contractors and others. These contractual liabilities include a warranty or guarantee to conduct work in a workmanlike manner, indemnity obligations, as well as an agreement to procure insurance. CGL policies often exclude coverage for certain of these contract claims. In particular, the "insured contract" exclusion bars damages caused by "the assumption of liability in a contract or agreement…[except for] a contract of agreement that is an ‘insured contract.’" In other words, the CGL policy will only cover "insured contracts," which are defined as:

* * *

That part of any other contract or agreement pertaining to your business (including an indemnification of a municipality) under which you assume the tort liability of another party to pay for "bodily injury" or "property damage" to a third person or organization. Tort liability means a liability that would be imposed by law in the absence of an contract or agreement.

This definition of an "insured contract," therefore, only provides coverage for an agreement to indemnify for one’s tort liability. See Aetna Casualty & Surety Co. v. Lumbermens Mutual Casualty Co., 527 N.Y.S.2d 143 (App. Div. 1988). The definition, however, does not provide insurance for a breach of warranty or contract claims. See The Rivers v. Richard Schwartz/Neil Weber, Inc., 459 N.W. 2d 166 (Minn. Ct. App. 1990). Thus, other than with respect to an indemnity provision, the "insured contract" exclusion bars coverage for most contractual liabilities.

    1. Faulty Workmanship Exclusion

More recent general liability policies contain at least two exclusions that relate to the insured’s faulty workmanship. These exclusions are commonly referred to as exclusions j(5) and j(6) in the post-1986 ISO policy forms, which bar coverage for property damage to:

* * *

(5) 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; or

(6) That particular part of any property that must be restored, repaired or replaced because "your work" was incorrectly performed on it.

While excluding different types of defective workmanship claims, both exclusion j(5) and j(6) have the common goal of seeking to bar coverage for losses arising out of the insured’s work.

    1. Exclusion j(5)

      2. Exclusion j(5) bars coverage for property damage that is caused during the period that the insured is performing the work. In addition, the exclusion, by its terms, only relates to "that particular part" of the property on which the work is being performed. Thus, for example, if an insured is working on a roof of a condominium complex and causes damage to that roof, the property damage to the roof will be excluded under j(5). However, if the insured was not working on the roof at the time of the damage, or if the damage occurs to a different part of the property, such as the siding, exclusion j(5) will not operate to bar coverage. See, e.g., Economy Lumber Co. v. Insurance Company of North America, 204 Cal.Rptr. 135 (Ct.App. 1984).

    2. Exclusion j(6)

Exclusion j(6) is very much like j(5) because it also bars coverage for "that particular part" of property damage that is caused by faulty workmanship. The two exclusions differ in several important respects. Most significantly, exclusion j(5) applies to work in progress and requires that the insured be working at the time of the damage; whereas exclusion j(6) only applies to repairs that must be made after the work is performed. It should be noted, however, that while exclusion j(6) has a later time element, most versions contain a specific exemption for property damage within the completed operations hazard. See American Insurance Co. v. M&R Construction Corp., No. A-6316-96T1 (N.J. App. Div. 1999) (upholding similar exclusion to construction defect claims).

These two exclusions seek to bar coverage for faulty workmanship that becomes manifest during a period during which the insured should be able to notice any problems. The insured presumably does not have the same opportunity to notice its faulty workmanship when the damage is caused by hidden defects. The later situation will usually find coverage, despite the above exclusions.

    1. Your Work Exclusion

      2. Another exclusion found in a CGL policy that is designed to bar claims for faulty workmanship is the "your work" exclusion. The "your work" exclusion bars coverage for "property damage to ‘your work’ arising out of it or any part of it and included within the products-completed operations hazard." This exclusion, however, does not apply to work that was performed "on your behalf by a subcontractor." Thus, if a general contractor is sued because of damage caused by a subcontractor, this "your work" exclusion would not bar coverage. See, e.g., National Union Fire Insurance Co. v. Structural Systems Technology, Inc., 964 F.2d 759 (8th Cir. 1992); see also Prudential-LMI Commercial Insurance Co. v. Reliance Insurance Co., 27 Cal.Rptr.2d 841 (Ct. App. 1994). Other courts, however, have found that the exclusion is inapplicable where the subcontractor was under the control of the insured. See, e.g., Bor-Son Building Corp. v. Employers Commercial Insurance Co., 323 N.W.2d 58 (Minn. 1982); Lassiter Construction Co. v. American States Insurance Co., 699 So.2d 768 (Fla.App. 4th Dist. 1997). In either event, the "your work" exclusion will generally operate to bar coverage for construction defect claims that arise out of an insured’s faulty workmanship. See Weedo v. Stone-E-Brick, Inc., 81 N.J. 233 (1979) (holding that liability insurance policies are not intended to provide coverage when the insured’s "competed work is not that for which the damaged person bargained"); American Insurance Co. v. M&R Construction Corp., No. A-6316-96T1 (N.J. App. Div. 1999) (following Weedo); Lords Landing Village Condominium Council of Unit Owners v. Continental Insurance Co., 191 F.3d 448 (4th Cir. 1999) ("CGL policies are not intended to be surety bonds").

    2. Insured Product Exclusion

      3. In addition to the "your work" exclusion, recent CGL policies also contain an exclusion for damage to the insured’s product. This "insured product" exclusion bars coverage for property damage "to ‘your product’ arising out of it or any portion of it." Thus, this exclusion bars coverage for damage to an insured’s products or personal property brought onto a job site. These is, however, a split of authority about whether an entire building complex can be considered an insured’s product for purposes of this exclusion. Compare Wm C. Vick Construction Co. v. Pennsylvania National Mutual Cas. Insurance Co., 52 F. Supp. 2d 569 (E.D. N.C. 1999) (a building project is considered the insured’s product); Schwidt v. Underwriters at Lloyd’s of London, 914 P.2d 119 (Wash. Ct. App. 1996) (medical building constructed by contractor-insured within "insured products" exclusion); The Rivers v. Richard Schwartz/Neil Weber, Inc., 459 N.W. 2d 166 (Minn. Ct. App. 1990) (condominium project within the "insured products" exclusion in the general contractor’s liability policy), with Mid-United Contractors, Inc. v. Providence Lloyds Insurance Co., 754 S.W.2d 824 (Tex. App. 1988) (holding that a building is not a product for purposes of "insured product" exclusion); Maryland Casualty Co. v. Reeder, 270 Cal.Rptr. 719 (Ct. App. 1990) (insured products exclusion inapplicable to suit by condominium unit owners). In any event, the "insured products" exclusion is an important part of the CGL policy that should be closely examined in the relevant context.

       

       

    3. Impaired Property Exclusion

      4. The "impaired property" exclusion also operates in concert with the faulty workmanship and "your work" exclusions to bar business risks of the insured. This exclusion is intended to apply where there is no actual physical injury to property, but where property is impaired because of a defect, deficiency, inadequacy or dangerous condition in "your product" or "your work." In other words, the "impaired property" exclusion bars coverage for economic losses arising from damage to another’s property caused by the incorporation of an insured’s faulty workmanship or materials into a larger product. In addition, the exclusion specifically provides that the impaired property must be capable of being restored by the repair or replacement of the insured’s work or product before it will operate to bar coverage. The exclusion will not apply, however, to any loss arising out of a "sudden and accidental" injury to "your work" or "your product" after it has been put to its intended use. The "impaired property" exclusion, therefore, is narrowly limited to economic losses caused by the insured’s failure to comply with its workmanship obligations, so long as the damaged property can be repaired. See Newark Insurance Co. v. Acupac Packaging, Inc., No. A-006043-97T3 (N.J. App. Div. 2000) (holding that impaired property exclusion does not bar coverage if damage caused by defect cannot be repaired); but see Harris Specialty Chemicals, Inc. v. United States Fire Insurance Co., No. 3:98-cv-351-J-20B (M.D. Fla. 2000) (finding that water sealant applied to building siding was "incorporated" into work and, because it could be repaired, triggered the "impaired property" exclusion).

    4. Absolute Pollution Exclusion

In addition to the above exclusions, the "absolute pollution" exclusion may also apply to bar certain construction defect claims. In particular, there has been a significant increase in "sick building" claims arising from improper design and construction defects. These claims seek recovery for exposure to toxins, such as mold, concrete and wall sealant and carbon monoxide. Courts are split on the issue of whether the absolute pollution exclusion bars these types of claims. The recent trend, however, seems to be moving away from excluding coverage under the absolute pollution exclusion for these "sick building" claims. See, e.g., Byrd v. Blumenreich, 317 N.J. Super. 496 (App. Div. 1999) (finding absolute pollution exclusion ambiguous in residential lead paint claims); Stoney Run Co. v. Prudential-LMI Insurance Co., 47 F.3d 34 (2d Cir. 1995) (absolute pollution exclusion did not apply to carbon monoxide in apartment building); Meridan Mutual Insurance Co. v. Kellman, 197 F.2d 1178 (6th Cir. 2000) (exclusion does not bar exposure claims where contractor used drywall sealant); see also Keggi v. Northbrook Property and Casualty Insurance Co., 13 P.3d 785 (Ariz. Ct. App. 2000) (bacteria is not a pollutant for purposes of absolute pollution exclusion). Nevertheless, given the recent and dramatic increase in "sick building" claims, this issue must be considered in any such situation.

IV. COMPLETED OPERATIONS COVERAGE

The completed operations provision in a CGL policy is intended to provide liability coverage for accidents that occur away from the insured’s premises after the insured has completed the work. The CGL policy generally defines "completed operations" as:

a. "Products-completed operations hazard" includes all "bodily injury" and "property damage" occurring away from the premises you own or rent and arising out of "your product" or "your work" except:

    1. Products that are still in your physical possession; or

    2. Work that has not yet been completed or abandoned.

    1. "Your work" will be deemed completed at the earliest of the following times:

    1. When all of the work called for in your contract has been completed;

    2. When all the work to be done at the site has been completed if you contract calls for work at more than one site; or

    3. When that part of the work done at a job site has been put to its intended use by any persons or organizations other than another contractor or subcontractor working on the same project.

The completed operations hazard does not affect when or whether an "occurrence" has taken place under a contract. Nor does this provision afford retroactive coverage. Instead, the competed operations is designed to provide coverage for claims that arise after a project is complete. In order to operate this coverage, however, certain specific requirements must be met.

    1. Requirement of Off-Premises Injury

      2. The completed operations hazard provision requires that the injury must occur away from the insured’s premises. Thus, even where the work was performed on the premises, the completed operations hazard will apply if the injury occurred off-site. See Moreau v. Moran, 465 So.2d 202 (La.Ct.App. 1985); see also Pacific Indemnity Co. v. Linn, 766 F.2d 754 (3d Cir. 1985).

    2. When the Operation is Completed

In most instances, an operation is considered complete when the work is substantially finished. Thus, an operation will be complete for purposes of this coverage provision if, except for certain minor issues, the work is final. Courts will look to whether the work is ready for its "intended use," even though minor work might still be necessary, to determine whether the work is completed. See, e.g., Marinez v. Hawkeye Security Insurance Co., 576 P.2d 1017 (Colo. 1978) (work was completed on door even where minor work remained); Savanna Laundry & Mach. Co. v. Home Insurance Co., 376 S.E.2d 373 (Ga.App.Ct. 1988) (work on boiler competed even though need for further repairs).

C. Abandonment of Work

In order to determine whether particular work has been abandoned, one must look at the requirements of the contract. Where the insured has ceased work without finishing the contract, the work will be considered abandoned. See Fidelity & Casualty Co. v. Horton & Horton Custom Work, Inc., 462 S.W.2d 613 (Tex.Ct.App. 1971).

 

  1. TRIGGER OF COVERAGE

In addition to the above-referenced coverage issues, the question of the proper trigger of coverage is always relevant to construction defect claims. Courts have generally applied the "manifestation trigger" to construction defect claims. The issue, however, has been most clearly addressed in the first-party context. Recent decisions suggest that the "continuous trigger" should apply to certain third-party construction defect suits.

    1. First-Party Policies

      2. The New Jersey Appellate Division has recently upheld the application of the manifestation trigger to a first-party policy in Winding Hills Condominium Association, Inc. v. North American Specialty Insurance Co., 332 N.J. Super. 85 (App. Div. 2000). In Winding Hills, the court noted that the continuous trigger was a judicial construct that was designed to maximize available coverage for third-party claims. In the first-party context, however, there are no third-parties with which to be concerned, nor is there a threat that there might not be enough insurance coverage available to the insured. The court in Winding Hills, therefore, applied the "manifestation trigger" to the first-party policy dispute.

    2. Third-Party Policies

The court in Winding Hills also stated that, while the manifestation trigger applies to first-party construction defect claims, the continuous trigger applies in the third-party context. This view is consistent with cases that have applied the continuous trigger to progressive, indivisible injuries that span over multiple policy years. See, e.g., Owens-Illinois, Inc. v. United Insurance Co., 138 N.J. 437 (1994); see also Centennial Insurance Co. v. United States Fire Insurance Co., No. A090305 (Cal.App. 1st Dist. 2001). The issue, however, is not as settled as in the first-party context.

 

 

 

  1. SUE AND LABOR CLAUSE

Recently, a federal district court held that the "sue and labor" clause in a builders’ risk policy was not a separate insuring agreement that would provide coverage for otherwise excluded perils. See Swire Pacific Holdings, Inc. v. Zurich Insurance Co., 99-2825 (S.D. Fla. 2001). In Swire, the owner of a Florida condominium sought coverage for structural repairs to the condominium to properly comply with building codes related to hurricanes. The policy otherwise excluded such repair costs attributable to faulty design, but the insured argued that the "sue and labor" clause of the policy nevertheless afforded coverage because the repairs were made before the hurricane season to avoid further damage. The court in Swire rejected this argument, noting that the insured "cannot recover simply by attempting to characterize its work as for the purpose of preventing a collapse of the building."

 

 

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