The Scope of Additional Insured Coverage and Duties of an Indemnifying Subcontractor in Construction Project

While the South Carolina Construction Defect Blog focuses legal issues impacting CD litigation, we would not be providing “full treatment” to the topic if we did not, once and a while, discuss case law with subject matter outside the realm of defective construction as these discussions directly affect construction defect litigation.

Additional insured policy endorsements are a powerful weapon, in theory. The concept known as an “additional insured” refers to a person or organization that enjoys the benefits of being insured under an insurance policy, in addition to whoever originally purchased the insurance policy. Typical language within insurance policies seeks to limit the subject matter that can be “additionally insured.” Standard policy language providing for additional insured treatment states something similar to the following: “any person or organization whom you (the named insured) are required to add as an additional insured on this policy under a written contract … that person is only an additional insured with respect to liability arising out of ‘your work’ for that additional insured.” The limits of this coverage is still being tested, defined, and applied within the contract law(s) of individual states.
In New York, the Court of Appeals ruled that a subcontractor had a duty to defend and indemnify an upstream contractor based upon the language of the additional insured endorsement, which provided coverage to the superior contractor for claims “arising out of” the operations of a subcontractor. The court rationalized that the additional insured coverage need not be restricted to actions or omissions limited to the scope of the subcontract duties as the only requirement is that “there be some causal relationship between the injury and the risk for which coverage is provided.”
The scope of coverage “is not on the precise cause of the accident but the general nature of the operation in the course of which the injury was sustained.”
Although this site attempts to address South Carolina precedent, trends, and other events which might impact the construction and insurance industries in South Carolina only, our blog tracks cases in other jurisdictions these are indicative of how the courts in Columbia might treat a similar factual scenario. The impact of the decision is potentially significant in that insurers will have an obligation to provide coverage for additional insured(s) for activities that do not necessarily involve negligence on the part of their named insured, and where there may be negligence on the part of the additional insured. There need only be a logical connection between the work being performed by the named insured and the accident giving rise to a personal injury claim. The potential negligence of the additional insured, even if it contributes to the injury, will not serve as a basis for disclaiming coverage to the additional insured.

Homeowner’s Insurance Does Not Cover Defective Construction

The Sixth Circuit Court of Appeals ruled that an insurer was not obligated to pay for water damages to a condominium building because the insurance policy specifically excluded coverage for damages caused or resulting from building construction and design defects. TMW Enterprises, Inc. v. Federal Ins. Co., No. 09-1542, (6th Cir. Aug, 25, 2010). Substandard construction on an exterior wall allowed the water intrusion which resulted in damages of $4 million.

“In no case will we entertain any loss or claim that occurred or was in progress prior to the policy period inceptiondate or after the policy period expiry date shown on the Declarations.” This, and other similar language is common in policies as it implies that defective construction occurs prior to completion. While this language is in the insuring agreement, the clause discussed in the TMW case was a specific exclusion which related to substandard construction.

Economic Loss Rule Applicable to Residential Construction Only as Court overrules recent Colleton Prep decision

In Sapp & Smith v. Ford Motor Company, Opinion 26754 (S.C. December 21, 2009), South Carolina’s Supreme Court once again ruled that the economic loss rule only applies to residential construction.

“The economic loss rule is a creation of the modern law of products liability. Under the rule, there is no tort liability for a product defect if the damage suffered by the plaintiff is only to the product itself. Kennedy v. Columbia Lumber & Mfg. Co., 299 S.C. 335, 341, 384 S.E.2d 730, 734 (1989). In other words, tort liability only lies where there is damage done to other property or personal injury. Id.”

In South Carolina, the “the economic loss rule does not preclude a homebuyer from recovering in tort against the developer or builder where the builder violates an applicable building code, deviates from industry standards, or constructs a house that he knows or should know will pose a serious risk of physical harm.” Kennedy v. Columbia Lumber & Mfg. Co., 299 S.C. 335, 341, 384 S.E.2d 730 (1989). This notion was extended to commercial construction in Colleton Preparatory Academy, Inc. v. Hoover Universal Inc., 379 S.C. 181, 666 S.E.2d 247 (2008).

“we overrule Colleton Prep to the extent it expands the narrow exception to the economic loss rule beyond the residential builder context”

Newman II Decision and SC Construction Defect Law

South Carolina Insurance Coverage in 2009

In the recent Supreme Court ruling on appeal of Auto Owners v. Virginia Newman, et al, (Newman II), the question was presented as to whether faulty construction that causes physical damage to tangible property (residential home) will trigger insurance coverage.  In the initial case (Newman I), assertions were made by a claimant that Trinity Construction built a defective home for Virginia Newman back in 1999.   The primary issue surrounded a subcontractor’s stucco application to the home’s exterior, and damages resulting from the application.  As an interesting side note, this was not an EIFS clad home, rather, traditional Portland cement/traditional stucco.

            The Plaintiff in the case, Ms. Newman, noticed water intrusion and subsequently retained an inspector to document the issues.  The expert (Engineer) observed that the stucco was improperly installed and the stucco, sheathing, and other components were damaged.  An arbitrator awarded Ms. Newman nearly $56,000 for her claims against Trinity.
            Auto Owners had issued a CGL policy to Trinity, and the claim was defended under a reservation of rights by the insurer.  Auto Owners filed a declaratory judgment action as South Carolina case precedent was murky, at best after the LJ-Bituminous decision in 2004.

            In its first published opinion on the matter, our court of appeals held that defective construction was an “Occurrence” as determined by rules of construction in the insuring agreement issued to Trinity.  Further, the court held that any exclusions (EIFS/Stucco etc) was construed in favor of the policyholder if the work excepted was performed by a subcontractor.  Of particular significance was that the interior damage to elements other than the cladding were covered as was the stucco removal due to the fact that the siding had to be removed in order to reach the damaged interior components.
            In September of 2009, the court withdrew and re-issued its opinion. In a bizarre twist, the opinion relies not on the subcontractor exclusion, or stucco exclusion, rather the rarely considered “Sistership” Exclusion.  In reaching this conclusion, Chief Justice Toal reversed her earlier holding that the cost to remove the stucco was covered.  The opinion seemed to further validate the concept that defective work performed by a subcontractor is an “occurrence” and, therefore, a damage which is covered.
             Newman clarified that coverage does not exist for the removal and demolition of exterior components excluded under the policy.  This is the most significant aspect of the opinion as logic would now presume that other defective construction claims will be interpreted and evaluated using the Newman case. 

            1.         Roofing Material Removal:      Not covered in situations where leaking causes a roof to be removed in order to access and correct water damaged areas beneath the roof membrane.

            2.         Windows and Doors:   Removal and replacement would, arguably, not be covered to make corrections to components such as pan flashing.  windows pulled to install flashing omitted during original construction. The biggest losers, though, may be homebuilders and commercial contractors who purchased CGL policies over the years, believing they were covered for all damages.

            3.         HVAC and Electrical: Removal and replacement of equipment would not be covered when such removal is necessary to correct issues involving floor deflection, indoor air quality, and caulking/fireproofing issues.

HISTORY AND BACKGROUND

            The September 2009 decision was actually the second opinion on the issue as well as a rehearing of Auto Owners Ins. Co. v. Newman, 2008 WL 64856 (S.C. Mar. 10, 2008) (Newman I). Newman I overturned the LJ case which is mentioned above.  The LJ opinion was doomed from its inception as it was based on a non-traditional factual pattern whereby damage to a road (Cracking) was determined to have been caused by a subcontractor’s work.  In sum, the court found no coverage due to the court’s opinion that the “Your Work” exception was applicable to the entirety of damages as the cracking was the only “damage” and that damage was the subcontractor’s work product.

            Because of the facts surrounding LJ, lawyers immediately looked for a case to overturn the opinion.  Since most construction defect cases involved houses and other commercial, horizontal structures, insurance policies were typically covering these risks, not highway construction.

            Newman I was the case that made the cut, as the SC Court of Appeals ruled in 2008 that defective stucco work performed by an insured subcontractor was covered under the general contractor’s policy.  The court found an “Occurrence” (Prong A) had caused physical damage to tangible property (Prong B) due to water intrusion causing damage to the component products and labor of other trades.  The court attempted to further clear up any confusion by listing the actual areas of the home that were damaged outside and apart from the actual stucco siding.

POLICY INTERPETATION UNDER NEWMAN I

            The court relied on the plain meaning examination of the insurance policy in question which both fail to define “accident” or “physical damage to tangible property” in the context of a trade contractor’s work damaging the work of another trade.  For example, it is not clearly defined whether a window installer’s defective placement of windows triggers coverage for damages to the interior wall and floor.   

            Significantly, the court in Newman I determined that costs associated with remedying the other property damage that resulted from an “occurrence”, the removal of such otherwise excluded work was also covered.  This issue prompted the rehearing.

AUTO OWNERS INSURANCE AND CLARIFICATIONS SOUGHT BY REHEARING

            AO argued that, based on L-J v. Bituminous, there was no “occurrence” within the terms of the CGL policy considered by the court in Newman. Once again, the court disagreed and upheld its prior holding that the negligent application of stucco by the subcontractor resulted in an “occurrence” of water intrusion, resulting in “property damage” that was tangible and adversely impacted the home owned by Ms. Newman.  Hence, the court ruled that this was covered.

            The court reiterated that the subcontractor’s negligent application of the stucco did not, in and of itself, constitute an “occurrence” absent tangible damage to the work or products integrated within the house by others. The Supreme Court appears to be in line with the definition of an occurrence as opined by the SC Ct. of Appeals as recently as Spring, 2009 in Auto Owners v. Rhodes.

            The South Carolina Supreme Court in Newman II also addressed the applicability of two exclusions in the CGL policy. Auto Owners argued that, even if an occurrence was present, indemnity was not appropriate if that damage was within the expected or intended damages exclusion that was discussed in a very important Texas opinion, Lamar Homes v. Mid-Continent Casualty.

            In this argument, Auto Owners contended that damages awarded to Ms. Newman which were relative to the framing and exterior sheathing of the home were not covered due to the assumption that a builder should expect moisture intrusion from defective stucco placement to result in water related damages.  The court ruled that it was not reasonable to assume a contractor intended or expected an inferior product, citing the Lamar Homes decision.  Therefore, the court rejected the argument based on the expected or intended injury exclusion, that argument being essentially a restatement of arguments rejected by the courts listed above as to the ability to foresee  property damage arising from defective workmanship.

            The “Sistership Exclusion” was effectively argued by Auto Owners in Newman II.  (Author’s Note:  Many of us that practice in the construction realm anxiously awaited the Newman II decision and had varying theories as to how the court would come to either one or two conclusions regarding the defective work of a subcontractor.  In my discussions, I never heard the sistership exclusion mentioned once.  I bashfully admit that I had not ever heard of it, much less considered it). 

            The Sistership argument is based on the following logic: 

            Even if the damage to the home constituted an occurrence of property damage to tangible property within the insuring agreement, the exclusion nullified coverage for replacement and repairing defective stucco itself as an incidental cost to repairing the damage to other property.

            The “sistership exclusion,” is an often ignored element of the standard CGL policy as it argues that there is no coverage for damages claimed for any loss, cost, or expense incurred as a result of the loss of use, withdrawal, recall, inspection, repair, replacement, adjustment, removal, or disposal of the insured’s product, work, or impaired property in the event such is withdrawn or recalled from the market or from use because of a known or suspected defect, deficiency, inadequacy, or dangerous condition in it.

            Everyone ignored this ancillary, “Plan C” argument.  Everyone but the court, that is, as it agreed with this argument.  In contractual matters, the insurance policy is to be read and applied independently of any other exclusion. Since the subcontractor exception preserved coverage for property damage that would otherwise be excluded as the named insured’s work, the court pointed to another exclusion that barred coverage for damage to the defective workmanship itself.

            There is wide speculation that the court’s reliance on this exclusion will serve to further muddy the waters.  This reasoning states that a “Product Recall” exclusion (“Sistership) should not be applicable in the analysis of property damage and coverage in residential or commercial construction.  The court’s reasoning is troublesome to both defense attorneys and those that represent owners of property in construction defect claims.   The court appears to have ignored the  primary issue on appeal, which was whether construction deficiencies causing physical damage to tangible property constitute “occurrences” and “property damage”. 

            The reliance on obscure exclusions or endorsements affecting coverage is damaging to both contractors and their insurers as both sides want some clarity.  If you build houses, you have the right to know whether or not your policy will cover your subcontractor’s work.  As an insurance company, billions of dollars rest on the same question.  Therefore, the construction industry and insurance industry should certainly agree that consistency is needed if they are going to engage in business practices which are based on some element of risk.  Had the court answered the primary issues left open by LJ and Auto Owners I, the construction industry would have a better idea as to what their policies covered and, just as importantly, the insurance industry would have a much better gauge on pricing these policies of insurance.  To be continued.

Chinese Drywall and Insurance

Chinese Drywall is getting national press, government scrutiny and a great deal of attention from insurers that might have underwritten policies for general contractors and subcontractors who may have, unknowingly, used drywall product imported from China during 2003-2007. Hurricane Katrina has been blamed on the shortage of United States produced drywall during that time period thus, forcing distributors to reach out to at least one Chinese subsidiary of Knauf Plasterboard, a German company. (Editorial Comment: I am curious as to why they don’t call the product German Dryall, Knauf Plasterboard, or something else besides “Chinese Drywall”, as the notion that local mom and pop building suppliers had then, or had now, direct access to Chinese markets has never made sense to me.)
I first read about the allegedly deficient product at some point during the past two years, although I can’t pinpoint an exact date. At first, there were statements made that the drywall contained a putrid, sulfur-like odor. Later, I heard that it could strip paint, chrome, and all sorts of other coatings from fixtures in a home. The latest word on the street is that it makes people sick.
With permission of Jeff Casale, I would like to copy, paste, and link his latest article from Business Insurance.
Several small private insurance companies have filed pre-emptive declaratory judgment motions in Florida state courts, saying they are not obligated to cover damages caused by the tainted drywall based on exclusions in their policies. While no large commercial insurers have taken similar action so far, it’s likely more lawsuits will roll in during the next year.
“Some insurers are denying claims left and right,” said Barry I. Buchman, a partner at Washington-based law firm Gilbert L.L.P. “They are citing pollution exclusions, business risk exclusions, and construction defects and occurrence as reasons for denying coverage.”
Mr. Buchman said the insurers involved primarily are companies with a larger exposure to the situation, but added that “it shows the insurers are taking this seriously and that they are willing to dig their heels in.”
Towers Perrin, a Stamford, Conn.-based consulting firm, estimates the total economic losses from the tainted drywall could fall between $15 billion and $25 billion, costs that rival the 10 most-expensive hurricanes in recorded history, excluding Hurricane Katrina.
Towers Perrin added that, based on past construction defect experience, legal fees could represent 40% to 50% of the total claims cost, which would make a court fight rather costly for insurers. Meanwhile, the National Assn. of Home Builders estimates the cost of repairing homes with the defective drywall will be approximately $8 billion.
The problem stems from about 500 million pounds of drywall that was imported to the United States between 2004 and 2007 when the housing market peaked and the Southeast was rebuilding after Katrina. The drywall was traced back to Chinese subsidiaries of German manufacturer Knauf Plasterboard Tianjin Co. Ltd. (BI, May 11.)
Early environmental studies conducted by health officials in Florida found the gypsum wallboard used in the homes was tainted with strontium sulfide and elemental sulfur that, when exposed to high levels of humidity and heat, produce a gas strong enough to corrode copper wiring, pipes and appliances.
Additionally, homeowners have contacted state health departments complaining of dizziness, nosebleeds, difficulty breathing, and itchy or irritated skin, among other symptoms.
Federal investigators released initial results of its ongoing investigation of Chinese drywall and found no direct link between the chemicals in the drywall and the health problems homeowners reported. While they said they did find higher concentration levels of sulfur and strontium in Chinese drywall than from non-Chinese drywall, they could not determine any direct correlation.
The report, released Oct. 29, is the first of an ongoing series. The U.S. Consumer Product Safety Commission along with Environmental Protection Agency will conduct more tests during the coming months. Next month, the results of a 50-home indoor air quality study will be released as well as engineering analysis of electrical and fire safety associated with corrosion.
The CPSC has received 1,897 reports from residents with homes built with the contaminated drywall in 30 states, the District of Columbia and Puerto Rico. Nearly 70% of those reports are from Florida homeowners. The office received its first consumer complaint on Dec. 22, 2008.
Mr. Buchanan and Ron Kozlowski, Hong Kong-based Towers Perrin principal and leader of the company’s property/casualty insurance consulting practice in Southeast Asia, said how courts define pollution will be a major determining factor as to how insurers react.
In the past, Mr. Buchman said Florida courts have taken a broader view on the exclusion, which could lead to more litigation bouts.
Recently, Citizens Property Insurance Corp., a state-backed insurer of last resort in Florida, denied homeowner claims, saying it considered the drywall a pre-existing condition and that such defective materials fall under the pollution exclusion. After media coverage about the denial, Jacksonville, Fla.¬based Citizens reversed its decision and said it will renew policies for homes built with the defective drywall.
Torus Specialty Insurance Co. sees the Chinese drywall event and Chinese product importation as an emerging liability.
R. Lincoln Trimble Jr., Jersey City, N.J.-based senior vp of Torus’ U.S. excess casualty unit, said it is likely that general liability underwriters will ask a lot more questions when constructing a policy that will leave general contractors little wiggle room in the future, but will provide good coverage.