Insurance Coverage for Defective Construction

In another new decision addressing coverage for post-construction property damage claims against contractors, the Eighth Circuit, applying Arkansas law, has ruled that defective workmanship is not an insured, accidental occurrence if the resulting damage is confined to the subcontractor’s “work product.” Lexicon, Inc. v. ACE American Insurance Company, 2010 U.S. App. LEXIS 27016 (Amended Opinion filed February 14, 2010). However, the court also ruled that coverage does exist for resulting, consequential damage to other parts of the project. Thus, the Eighth Circuit has crafted somewhat of a compromise, recognizing, as effectively ruled earlier this year by the South Carolina Supreme Court, that in some instances, faulty workmanship can be an “accidental” occurrence if there is resulting, consequential damage to other property. See Crossman Communities of North Carolina, Inc. v. Harleysville Mut. Ins. Co., __S.E.2d. __, 2011 WL 93716 (S.C. Jan. 7, 2011).    

In Lexicon, the insured general contractor constructed a battery of storage silos to store the output of a Direct Reduced Iron plant being built in the West Indies. Months after completion, one of the silos collapsed because of faulty welding by Lexicon’s subcontractor. The collapse damaged nearby equipment and tons of direct reduced iron (DRI) that was not part of the subcontractor’s “work.” Lexicon spent millions of dollars cleaning up the site, re-erecting the silo and replacing the damaged DRI. The insurers refused to pay for any of the damages. Relying on Essex Ins. Co. v. Holder, 261 S.W.3d 456 (Ark.2008), the district court held that under Arkansas law, property damage resulting from faulty work of a subcontractor can never be an “occurrence” covered by a CGL policy.

The Eighth Circuit affirmed in part, reversed in part, and remanded for further proceedings, finding that the district court had misapplied Holder. The Lexicon court concluded that Holder stood for the proposition that “defective workmanship” that only damages the subcontractor’s work product “is not an occurrence under a CGL policy.” While the Eighth Circuit agreed that Holder justified the insurers’ decision to deny coverage for damage to the silo that collapsed (the defective “work product”), the court held that the insurers were obligated to reimburse Lexicon for all property damage to property that was part of the overall project, but not part of the actual “work product” (the silo construction) of the subcontractor.

The Eighth Circuit also rejected a popular argument by insurers that extending CGL coverage to construction defects essentially converts the policy into a performance bond. The Court noted with approval authority from the Texas Supreme Court and the Florida Supreme Court that the availability of a performance bond is irrelevant to a CGL coverage analysis and that the purpose of a performance bond is to (1) guarantee completion of a contractor upon default, (2) benefit the project owner and not necessarily the contractor, and (3) to permit indemnification by the surety against the contractor. The Court then concluded: “While a performance bond and a CGL policy may have similarities and may overlap in some events, they are different products with different language and are not the same by origin, purpose, pricing, or applications.” Lexicon, fn. 3.

There are at least three lines of authority addressing “products completed operations hazard” (PCOH) coverage for post-construction damage caused by a subcontractor’s faulty workmanship. In South Carolina, Arkansas, Iowa, Nebraska and North Dakota, accidental faulty workmanship that damages property other than the “defective” work product can be covered. Those courts appear to define the term “occurrence” by focusing on the consequences of the injury or loss, i.e., the damages it causes, rather than on the issue of whether or not the loss was caused by a negligent subcontractor, such as by the negligent welding at issue in Lexicon. In such jurisdictions, if a negligently constructed masonry wall (or storage silo) falls outward and damages other property, there is coverage, but not if the wall falls inward or collapses and only damages itself. Is the outcome any less “accidental” if only the work product itself is damaged? In Pozzi Window v. Auto-Owners Insurance Co., 984 So.2d1241 (Fla. 2008), a case handled by this firm, the Florida Supreme Court answered this question in the negative, holding that if the damage results from accidental (unintended and unexpected) negligence of a subcontractor, the PCOH coverage is triggered, even if the resulting damage is confined to the subcontractor’s work product.

While perhaps not as precise as the Pozzi Window ruling in holding that property damage to the “defective work” itself is covered, there are at least fifteen other states whose high courts have allowed PCOH coverage under a post-1986 standard form CGL policy issued to a general contractor when a subcontractor’s faulty workmanship causes property damage to the completed project. Those courts reason that faulty workmanship or improper construction can be an “accident” and thus an “occurrence” if the resulting damage occurs without the insured’s expectation or foresight. Unfortunately, in a third line of authority, the courts of several states (Pennsylvania, Kentucky and Oregon), have taken a more pro-carrier approach, holding that faulty workmanship that damages the completed project can never be an insured “occurrence” because such claims do not present the necessary level of “fortuity” contemplated by the ordinary definition of “accident.”

The recent rulings in Lexicon and Crossman Communities highlight the importance of proving that there has been an accidental “occurrence” of negligent construction work that caused some or all of the damage at issue. The Lexicon ruling, while certainly not as broad as some of the more favorable rulings upholding construction-related claims for CGL coverage, is a step in the right direction by recognizing that not all negligent, “defective” construction is outside the scope of the coverage provided by the PCOH provisions of a contractor’s policy when a subcontractor is at fault.