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To Err Is Human: Is Faulty Work an Insured Occurrence?

Peter Ustinov is credited with saying, “Intelligent mistakes are the worst because so much thought has gone into them.” By that measure, the mistakes courts make may be the worst of all. Stare decisis (let the decision stand) works an insidious influence on intelligent judicial mistakes as the error replicates and expands, doing greater harm as time passes.

Occasionally, though, a court recognizes a mistake and fixes it. Recently, the North Dakota Supreme Court corrected a decision made in 2006 in analyzing insurance coverage for faulty construction. In that same year, the Pennsylvania Supreme Court made exactly the same decision but has not yet fixed the error.

The North Dakota Supreme Court’s initial mistake occurred in the case ACUITY v. Burd & Smith Constr., 2006 ND 187, 721 N.W.2d 33 (2006). Burd & Smith contracted to replace the roof on an apartment building and allegedly failed to take precautions during construction to protect the building during a rainstorm. The owner sued Burd & Smith, which in turn sought coverage from its insurer. The ensuing coverage suit eventually reached the state’s Supreme Court. The question was whether the contractor’s commercial general liability (CGL) policy covered the damage to the building. CGL policies provide insurance for “property damage” (defined as “physical injury to tangible property”) caused by an “occurrence” (defined as “an accident, including continuous or repeated exposure to conditions, that causes property damage during the policy period neither expected nor intended from the standpoint of the insured”).

In holding — correctly — that “property damage caused by faulty workmanship is a covered occurrence to the extent the faulty workmanship causes bodily injury or property damage to property other than the insured’s work product,” the North Dakota Supreme Court drew an unfortunate distinction between faulty workmanship that damages the insured’s work or product and faulty workmanship that damages a third party’s work or property.

In a common scenario, a general contractor constructs an apartment building and hires a mason to build a brick façade. The subcontractor negligently mixes the concrete to secure the bricks and, after the building is complete, cracks appear in the substandard concrete. During rainstorms, water seeps into these cracks and soaks the insulation, corrodes the metal studs inside the walls, damages the drywall and spawns mold. Thus far, however, the damage has occurred only to the building itself. The building is the “work” of the general contractor and its subcontractors. It is, in the language courts use, “the insured’s own work.”

As the brick work deteriorates, bricks fall onto cars parked next to the building. The faulty workmanship has now damaged third-party property. It is this distinction between “the insured’s own work” and “third party property” that tripped up the North Dakota Supreme Court in Burd & Smith, as it has with other courts. Some courts, including the Burd & Smith court, have held that a CGL policy covers a contractor for damage to a third party’s property caused by faulty construction, but that damage to the building itself (i.e., to “the insured’s own work)” can never be a covered “occurrence.” This is a species of Peter Ustinov’s intelligent mistake. The North Dakota Supreme Court’s April 5, 2013 opinion, which corrected the Burd & Smith decision, contains one of the best recent judicial explanations why faulty workmanship is, in fact, a covered “occurrence” under CGL policies.

In K&L Homes, Inc. v. American Family Mut. Ins. Co., 2013 WL 1364704 (Apr. 5, 2013, N.D. Sup. Ct.), K&L constructed a single-family house and used a subcontractor to pour the foundation and footings. The homeowners claimed that improper footings and inadequately compacted soil caused shifting and cracking and alleged breach of contract and breach of warranty. K&L sought coverage from its CGL carrier.

When the case reached the state’s Supreme Court, the majority undertook a careful review of CGL policy language and the special rules of interpretation that apply to insurance policies. The court noted that the initial grant of coverage is for “property damage” caused by an “occurrence,” defined broadly to mean an “accident.” The policy — as there is in essentially all standard-form CGL policies — included an exclusion for property damage arising out of the general contractor’s own work and an exception to that exclusion for the faulty work of a subcontractor. The subcontractor exception says, “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 question whether a contractor’s faulty workmanship can constitute a covered “occurrence” has been the subject of considerable litigation. The K&L court correctly observed that, “Currently, the majority of state supreme courts who have decided the issue of whether inadvertent faulty workmanship is an accidental ‘occurrence’ potentially covered under the CGL policy have decided that it can be an ‘occurrence.’” It cited Supreme Court decisions from 14 states.

In K&L, the court recognized a key historical point that many other courts have missed: Since it was first introduced in 1940 as a means to protect insureds against business losses, the standard CGL policy has undergone numerous changes that have expanded the insuring agreement and narrowed the exclusions. There was, for instance, no coverage at all in the early versions of the CGL for “property damage to work performed by or on behalf of the named insured.” In 1976, however, the CGL form was changed to eliminate this exclusion for “work performed on behalf of the insured.” In 1986, coverage was expanded further to include the subcontractor’s exception, which now, as described above, provided coverage for damage to the contractor’s own work (i.e., to the building itself) arising from the faulty workmanship of a subcontractor.

The K&L court, quoting Appleman on Insurance, described the decision to include the subcontractor’s exception to the faulty-workmanship exclusion:

The insurance and policyholder communities agreed the CGL policy should provide coverage for defective construction claims so long as the allegedly defective work had been performed by a subcontractor rather than the policyholder itself. This resulted both because of the demands of the policyholder community (which wanted this sort of coverage) and the view of insurers that the CGL was a more attractive product that could be better sold if it contained this coverage.

The K&L court understood the exclusion for damage arising from the contractor’s own work (now narrowed by the subcontractor’s exception) is antithetical to a finding that the “occurrence” definition precludes coverage for all faulty workmanship. It found there would be no need for an exclusion of property damage arising from faulty workmanship if faulty workmanship was always precluded by the initial coverage grant.

It also found, “There is nothing in the definition of ‘occurrence’ that supports that faulty workmanship that damages the property of a third party is a covered ‘occurrence,’ but faulty workmanship that damages the work or property of the insured contractor is not an ‘occurrence.’” After such a careful analysis, the K&L court’s holding followed, “We conclude that when a general contractor becomes liable for damage to work performed by a subcontractor — or for damage to the general contractor’s own work arising out of a subcontractor’s work — the subcontractor exception preserves coverage that the ‘your-work’ exclusion would otherwise negate.” To this extent, it overruled its prior decision in Burd & Smith.

The Pennsylvania Supreme Court’s decision in Kvaerner Metals v. Commercial Union Ins. Co., 589 Pa. 317, 908 A.2d 888 (2006). Kvaerner, like K&L, involved claims by an owner against a contractor for breach of contract and breach of warranty. Kvaerner Metals contracted with Bethlehem Steel to build a coke oven battery. After the work was complete, the owner complained that the battery was not built as specified. Kvaerner blamed the defects on the masonry work of a subcontractor. Kvaerner sought coverage from its CGL carrier, which denied the claim. The Pennsylvania Supreme Court affirmed the trial court’s grant of summary judgment in favor of the carrier.

The court consulted a dictionary for the definition of the term “accident.” It found, “The key term in the ordinary definition of ‘accident’ is ‘unexpected.’ This implies a degree of fortuity that is not present in a claim for faulty workmanship.” In a footnote, however, the court remarkably acknowledged the contrary: “[T]he situation is rare indeed in which a contractor intends that the work product suffer injury.”

The court provided only one justification for analyzing the term “accident” in this odd way: “To hold otherwise would be to convert a policy for insurance into a performance bond.” Performance bonds, however, do not protect a contractor against liability for faulty workmanship. The owner, not the contractor, is the insured on a performance bond. A performance bond is not liability coverage; it merely protects the owner against the risk of not receiving a quality building completed on time.

The Kvaerner decision also relied on early decisions of courts in New Hampshire and South Carolina for the proposition that faulty workmanship can never be a covered “occurrence.” The Supreme Courts of both of those states later held precisely the opposite — that faulty workmanship that causes damage to both third-party property and to the contractors’ own work can constitute a covered occurrence.