Raising the roof: what's hot in construction defect litigation.

• Author: Maus, Kathleen J.

THE PERIOD spanning from the mid1990's to the crash of the real estate market in 2007 saw an unprecedented explosion of new construction throughout the United States, particularly in the Sun Belt. As with any boom, the frenzy of ever-increasing real estate prices tempted many of the players involved to cut corners and increase profits. Thus, the term "value engineering" took on a new meaning in the construction field. The basic tenet of "value engineering" is to increase the ratio of function to cost. This can be done either by increasing functionality or decreasing cost. The fast buck artists chose the latter with obvious consequences.

Unfortunately for the purchasers of "value engineered" projects, the reduction of cost generally resulted in a decrease in function. However, the decreased function generally did not make itself evident until years after the developer had packed up and left town. Just like Sylvester McMonkey McBean in Dr. Seuss's The Sneetches, "... when every last cent of their money was spent, [t]he fix-it-up Chappie packed up. And he went." (1) Years after construction was completed, owners of properties, riddled with defects, sued the developer, builder and/or subcontractor(s) to recover the cost of repairing the defective construction.

Ever eager to share the misery, the sued entities then turned to their general liability insurers, claiming the defective construction was an "accident" and therefore covered under their general liability policies. Not since asbestos litigation has any one coverage issue spawned so much litigation. As of the date of this article, only seven states have escaped addressing whether defective construction meets the definition of an "accident" and therefore constitutes a covered "occurrence" within the meaning of the I.S.O. general liability policy in use since 1986. (2) This article explores the various approaches courts have taken on the issue. It then presents other issues that are beginning to be addressed by courts who have found defective construction to be an "occurrence." In addition, state legislatures in at least four states have addressed the issue, spurred by decisions purportedly unfavorable to insureds in those jurisdictions.

1. Is Defective Construction an "Occurrence?"

   The broad form general liability policy widely in use since the 1960's grants the following coverage:

   We will pay those sums that the insured becomes legally obligated to pay as damages because of "bodily injury" or "property damage" to which this insurance applies .... b. This insurance applies to "bodily injury" and "property damage" only if:

   (1) The "bodily injury" or "property damage" is caused by an "occurrence" that takes place in the "coverage territory"; and

   (2) The "bodily injury" or "property damage" occurs during the policy period. (3)

   From this language, it is clear that in order to trigger the coverage agreement in the first instance, there must be "property damage ... caused by an 'occurrence.'" What then is an "occurrence?" The I.S.O. policy defines an "occurrence" as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions." (4) Enter the fortuity principle--that which is accidental is necessarily fortuitous. The policy is obviously intended only to cover fortuitous events--those which are foreseeable, but not within the insured's control. Arguably, if the resultant defect was "accidental" then the loss was an "occurrence."

   Other courts have reached the same result looking instead to policy exclusions to justify their decisions. Comprehensive General Liability ("CGL") policies contain a number of exclusions, which might apply to bar coverage even where the court finds the defective construction to be an occurrence. The I.S.O. broad form general liability policy currently in use contains three exclusions, generally referred to collectively as the "business risk exclusions," as follows:

   This insurance does not apply to:

   10. Damage to Property

       "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.

       Paragraph (6) of this exclusion does not apply to "property damage" included in the "products-completed operations hazard".

   11. Damage to Your Product

       "Property damage" to "your product" arising out of it or any part of it.

   12. Damage to Your Work

       "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 damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.

       The policy then defines the "products-completed operations hazard" as:

       all "bodily injury" and "property damage" occurring away from 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. However, "your work" will be deemed completed at the earliest of the following times:

       (a) When all of the work called for in your contract has been completed.

       (b) When all of the work to be done at the job site has been completed if your contract calls for work at more than one job site.

       (c) When that part of the work done at a job site has been put to its intended use by any person or organization other than another contractor or subcontractor working on the same project.

       Work that may need service, maintenance, correction, repair or replacement, but which is otherwise complete, will be treated as completed. (5)

       A state-by-state review of the decisions on this subject reveals a broad spectrum of interpretations spanning the gap from those which find that defective construction is never an "occurrence" (therefore, regardless of the extent of damage beyond the insured's own work product, the claim is not covered), to those which find not only that defective construction is an "occurrence" but that the business risk exclusions are ambiguous and do not bar coverage for repair and replacement of the insured's own work product. Those positions define the extremes, while the overwhelming majority of decisions within the two extremes may be harmonized into a distinct set of broad principles.

       The true majority rule as to construction defects is that claims of defective construction, standing alone, do not meet the element of fortuity necessary to constitute an accident and are therefore not covered. However, where the work in question was performed by the insured's subcontractor, the damage is either considered "accidental from the standpoint of the insured" or fits within the subcontractor exception to the "your work" exclusions. Similarly, to the extent the insured's defective work results in damage to other property not the subject of the insured's work, that damage is also generally covered. Leading decisions of each state are summarized in Appendix I following this article.

       1. Defective Construction is Never an "Occurrence"

          The Supreme Court of New Jersey first recognized the requirement of a fortuity analysis as a bedrock principle of insurance law in 1979 in what was and remains a landmark case, Weedo v. Stone-E-Brick. (6) Weedo involved a contractor who installed stucco on the side of its customer's house. The stucco later cracked and peeled. The homeowners sued the contractor, Stone-E-Brick, for the cost of removing and replacing the defective stucco. The New Jersey Supreme Court was thus faced with the question of whether defective construction, standing alone, constitutes an "occurrence." The court held that it did not.

          The Weedo court distinguished between the kinds of risks faced by a typical contractor, namely: 1) the risk that his work will not meet the customer's expectation, thereby exposing him to liability in contract; and 2) the risk that some mistake on his part may result in bodily injury or property damage to a third party. In this regard, the court noted:

          While it may be true that the same neglectful craftsmanship can be the cause of both a business expense of repair and a loss represented by damage to persons and property, the two consequences are vastly different in relation to sharing the cost of such risks as a matter of insurance underwriting. (7) Quoting Dean Roger Henderson, who espoused the principle in the Nebraska Law Review, the court noted:

          The risk intended to be insured is the possibility that the goods, products or work of the insured, once relinquished or completed, will cause bodily injury or damage to property other than to the product or completed work itself, and for which the insured may be found liable. The insured, as a source of goods or services, may be liable as a matter of contract law to make good on products or work which is defective or otherwise unsuitable because it is lacking in some capacity. This may even extend to an obligation to completely replace or rebuild the deficient product or work. This liability, however, is not what the coverages in question are designed to protect against. The coverage is for tort liability for physical damages to others and not for contractual liability of the insured for economic loss because the product or completed work is not that for which the damaged person bargained. An illustration of this fundamental point may serve to mark the boundaries between "business risks" and occurrences giving rise to insurable liability. When a craftsman applies stucco to an exterior wall of a home in a faulty manner and discoloration, peeling and chipping result, the poorly-performed work will perforce have to be replaced or repaired by the tradesman or by a surety. On the other hand, should...