The construction defect hot potato: the interplay between the performance bond and CGL policy - a surety's perspective.

• Author: Briglia, Shannon J.
• Position: Commercial general liability

OWNERS OF PROJECTS under construction protect against unexpected loss by requiring contractors to provide certain types of insurance, including a current commercial general liability policy ("CGL"). A CGL policy protects the owner from the negligent acts of the contractor causing property damage or bodily injury during the performance of the contract and for a limited period of time thereafter. All public owners and many private owners also require the contractor to provide performance and payment bonds to protect against the risk that the contractor will fail to complete the project or fail to pay his subcontractors. These two forms of financial protection can sometimes overlap, making critical an understanding of what protection they provide and the circumstances under which each form of protection is available.

A surety called upon to complete a project also needs to have a thorough understanding of insurance coverage in place in the event that the original contractor's negligence caused property damage or bodily injury. When a newly installed roof leaks, damaging the drywall and interior finishes, a property owner's typical first reaction is to call his insurance company and make a claim for the damage. If any of these occurrences happen while a surety is completing the project following default in performance by a contractor, then the surety needs to ensure its principal gives notice of a claim under the policy.

Insurance may not be the only source of recovery for the owner where defective work performed by the bonded contractor results in damage to the building or parts of the project. If a surety bond has been required of the general contractor or subcontractor, and the damage is the result of defective work by the contractor providing the bond, recourse may also be available against the performance bond. The surety who corrects defective work as part of a completion effort should evaluate whether the costs associated with correcting the defect or addressing the damage caused by the defect can be recovered from an insurance carrier. This article discusses the inherent differences between insurance and suretyship, highlighting the distinctions that arise in claims made for defective workmanship under a CGL policy or under a surety performance bond.

1. The Construction Defect Hot-Potato

   1. Is There Overlap Between Insurance and Suretyship?

      In general, a CGL policy provides coverage for the negligence of a contractor which results in injuries to people or property belonging to someone else. It does not provide indemnity for pure breaches of contract by the insured, even those arising out of the faulty workmanship of the insured. The standard CGL form widely used throughout the construction industry, prepared by the Insurance Services Office ("ISO"), covers "property damage," including "loss of use" of property caused by an "occurrence." (1) Under this definition, defective work causes property damage to a covered property if it damages the materials involved, the property surrounding the defective work, or causes a loss of use of the property. CGL does not cover the cost of replacing or correcting the defective work itself--in the above scenario, the roof--except to the extent that the materials themselves are damaged. Most importantly, the ISO CGL limits recovery to damage caused by an "occurrence," which is typically defined as an accident. The ISO CGL policy contains several important exclusions, including an exclusion for failure by the insured to complete the construction work.

      A seminal decision summarized coverage provided by a CGL policy as follows: "[u]nder well-established case law, a CGL policy does not cover faulty workmanship, only faulty workmanship that causes damage to other property." (2) The distinction is that the CGL policy covers damage resulting from an accident caused by faulty workmanship, not damage resulting from the costs required to correct the faulty workmanship itself. Typically, a CGL policy terminates upon a specific date set forth in the policy or when the work is completed.

      In contrast, a surety performance bond ensures that if a contractor defaults, the surety is obligated to assume the duty to perform the construction work or to pay for labor and materials incorporated into the project. If, as is usually the case, the contract requires the contractor to perform his work in accordance with the plans and specifications in a good and workmanlike manner, a surety's duty under a performance bond will likely extend to correcting defective or faulty workmanship. (3) The surety's obligation to correct patent defective work will be limited to defects identified during the warranty period, while the obligation to correct latent defects is limited only by the applicable state statute of repose. (4)

   2. Confusion Over Coverage

      Occasionally, courts have expressed confusion when requested to identify the distinction between insurance and suretyship. For example, in Sanitary District of Chicago v. U.S. Fidelity & Guaranty Co., (5) a surety was held liable under its performance bond for damages to an adjacent landowner's property in tort arising out of the negligent blasting operations of the contractor. Similarly, a number of courts addressing a claim against a bond which incorporates a contract containing a broad indemnification provision have found the surety liable to provide indemnification for risks that are normally covered by insurance. (6) Most courts, however, keep the distinction straight, acknowledging the public policy benefit in preserving the performance bond from being exhausted by tort claims to the detriment of those for whom the bond is supposed to provide protection. (7) Likewise, most courts correctly conclude that the CGL is not intended to serve as a performance bond or a guaranty of goods or services. (8)

      Confusion is most likely to arise in a case where the owner has suffered damage to its property resulting from defective workmanship. The property owner may seek recovery both from his contractor and the surety. If the defective work was performed by a subcontractor, the contractor, in turn, may seek recovery from its own CGL carrier, the subcontractor, or the subcontractor's CGL carrier. In states with a direct action statute, like Wisconsin, where the owner can pursue the contractor's CGL carrier directly, the property owner may pursue initially the contractor, its CGI insurance carrier and the surety. (9)

      Often, courts faced with this situation focus on whether "faulty workmanship" is "property damage" under a standard CGL policy. (10) Under these circumstances, the decision on whether damage is classified as property damage covered under the CGL policy depends upon how the damage is pied. Where the theories of recovery are premised solely on "allegations that the subject property was never constructed properly in the first place," and the damages sought are repair costs or completion costs, then it is far more likely that the court will reject the contention that they are property damage covered under the CGL policy. (11) The Vick Construction court provided a bright line test to determine if damage qualifies as property damage:

      These requirements [the definition of property damage in the policy], in this court's opinion, infer that the property allegedly damaged has to have been undamaged or uninjured at some previous point in time. This is inconsistent with allegations that the subject property was never constructed properly in the first place. (12) Despite careful pleading designed to invoke coverage, precedent supports both sides of the question whether a contractor's defective performance is an "occurrence" triggering coverage under standard insurance CGL policies. Although cases discussing whether defective workmanship can be an "occurrence" are inconsistent, if the defective workmanship results in bodily injury, it is more likely that coverage will be found. (13) In part relying on how the allegations were framed, the Vick Construction court found that:

      "[o]ccurrence does not include the normal, expected consequences of poor workmanship. While over the years, the definition of occurrence has been broadened to include 'continuous or repeated exposure to conditions' as well as sudden catastrophes, it still connotes the idea of 'accident'...." (14) Conversely, the Kalchthaler court relied on allegations of windows leaking and causing damage to tangible property, which constitute an "accident" as defined by Webster's dictionary and, hence, an "occurrence" as defined by the policy. (15)

      The Florida Supreme Court has recently issued a series of decisions that clarify the scope of CGL coverage and provide some insight into when, or whether, CGL coverage might be available to a surety called on to remedy defective work. In United States Fire Insurance Co. v. J.S.U.B., Inc., (16) the Court squarely addressed whether the post-1986 CGL Policy form's completed operations coverage, "provides coverage when a claim is made against the contractor for damage to the completed project caused by a subcontractor's work." (17) The Court determined that the policy did provide coverage, addressing both how the coverage provided by the policy itself, and how the "your work" exclusion, including the exception for subcontractor work, apply when evaluating the scope of the coverage.

      J.S.U.B. was a real estate developer that built a series of single-family homes. After completion, the homes developed damage to their foundations, drywall and interior areas. (18) Some of these conditions also caused damage to personal property of the homeowners, such as wallpaper installed on the drywall that had cracked. (19) An investigation showed that the damage was caused by settlement, due to a subcontractor's improper soil testing and compaction. (20) The homeowners sued J.S.U.B. for damages, asserting various contract, warranty, and building code violation claims. (21) J.S.U.B...