“The property loss from Chinese drywall could exceed every U.S. hurricane except Katrina and Andrew”. 

The complaints received by the Consumer Products Safety Commission show that the impact of Chinese drywall will be widespread.  Between 2004-2006, an estimated 500 million pounds of tainted drywall came into the United States.  It is quite possible that the tainted drywall is now in more than 100,000 homes.  The tainted drywall supplies have affected all but 12 states, with the greatest problems occurring in Florida, Louisiana, Mississippi, Alabama, and Virginia. 

“Based on $80 per square foot (the lowest cost from the verdicts made public) in 100,000 homes with an average of 2,200 square feet per house, the loss would be $18 billion in property damage”. 

The damaging health effects of having to live with the drywall have not been discussed, but the potential for property damage/claims alone are catastrophic. 

Source:  http://www.iiaba.net/IAMag/NewsViews/052010.html

The Connecticut Superior Court ruled that the business risk exclusion is applicable to deny coverage.  This exclusion, which is Exclusion L under the ISO General Liability form reads “Property damage to “your work” arising out of it or any part of it and included in the “products-completed operations” hazard.

The purpose of this exclusion is to give the contractors incentive to be careful while performing operations.  In this case, the court reasoned that the entire home was being directly worked upon.

Source:  http://www.insurancejournal.com/news/east/2010/01/21/106738.htm

The building industry is constantly experimenting with new building products and techniques in an effort to reduce costs, become more efficient, and to add value. Sometimes these products don’t stand the test of time as unforeseen problems may arise that result in construction defects. Examples include EIFS or synthetic stucco, Masonite siding, Georgia Pacific siding, polybutylene plumbing, and more recently, Chinese drywall.

The full weight of the construction defect crisis began to be felt by the insurance industry about ten years ago. Regionally, in the Southeast, the first wave of large-scale lawsuits arose over EIFS. The insurance industry fully funded a plaintiff attorney’s “gravy train” in this area since most of the costs were covered by General Liability insurance policies of manufacturers, distributors, builders, and installers. The EIFS epidemic, with its readily available funding source (General Liability carriers), seemed to fuel the spread of construction defect claims of all different types.

As a result, two trends emerged. The first was that most insurance carriers left the market and refused to write General Liability insurance for builders since they reasoned they couldn’t make a profit at any premium level. The second was that those few that remained in the market decided that they did not want to be a funding source for the next wave of construction defect lawsuits. In response, the insurance industry adopted an array of exclusionary endorsement forms from which carriers could pick and choose to limit their risk.

To follow is a listing and brief commentary of commonly found exclusions that can severely impact coverage for builders. In addition, solutions are provided where applicable.

Synthetic Stucco (EIFS) Exclusion: If you’re a builder and you install or repair EIFS, you need to buy a special General Liability policy from the high-risk marketplace to cover this type of work.

Soil Movement Exclusion: Expansive soils have been a problem in some parts of the country and have been a major source of construction defect lawsuits. Its possible to pick up coverage for this exposure through the use of certain home owner’s warranty products such as HBW 2-10.

Fungus, Mold, And Mildew Exclusion: This exclusion was added almost immediately to most General Liability policies when toxic mold lawsuits began to first appear. This strategy proved to be effective in cutting off what many feared to be the next “gravy train” of construction defect litigation. Most versions of this exclusion only eliminate coverage for the “property damage” portion of the lawsuit but leave coverage in place for “bodily injury”. If you’re concerned about this exclusion, you can purchase a special Mold And Pollution Liability policy from the high risk insurance market. The minimum premiums start out in the $2,500 to $5,000 range and prices increase according to your sales.

Absolute Pollution Exclusion: This is a powerful exclusion that can have consequences beyond what you normally think of as pollution. This is exemplified in the recently emerging Chinese drywall crisis where its alleged that drywall from certain plants in China release noxious fumes that cause corrosion of metal in a home, a foul smelling odor, and health problems. The insurance carriers plan on denying these claims by using the Absolute Pollution Exclusion. Pollution is broadly defined under this exclusion as any solid, liquid, or gaseous contaminant or irritant. Once again, if you are concerned about this exposure, you can buy a special Pollution Liability policy through the high risk marketplace.

Prior Completed Operations Exclusion: The standard General Liability policy form normally picks up coverage for building operations completed prior to the start of the policy term as long as the covered “property damage” or “bodily injury” occurs during the policy term. However, with the addition of the Prior Completed Operations Exclusion, coverage for prior completed operations is eliminated. This presents a problem because the General Liability forms from the prior years don’t pick up this coverage to the extent that the “property damage” or “bodily injury” occurs after the expiration of the prior policy terms. Some versions of this endorsement limit its scope to “property damage” only. You may want to attempt to negotiate the elimination of this endorsement if it appears on your policy.

Products / Completed Operations Exclusion: This exclusion has perhaps the most devastating impact of any of the construction defect exclusions. Quite simply, this exclusion eliminates coverage for all “bodily injury” and “property damage” that occurs after the home has been sold. In my opinion, this exclusion is unacceptable for a builder under any circumstances resulting in the need to find a new insurance carrier.

Property Damage To Your Work Exclusion: This exclusion is not a stand alone exclusion like the rest that have been mentioned. Instead, it is part of the regular General Liability policy form and appears as exclusion L. This exclusion eliminates coverage for “property damage” to your “work” arising out of it…. However, there is an important exception where coverage is given back if the damaged work was performed on your behalf by a subcontractor. This exception is what historically gave builders (that were general contractors) broad coverage under their own General Liability policy for construction defect claims.

Exclusion: Damage To Your Work Performed By Subcontractors On Your Behalf (CG2294): Around 2004, most carriers began adding this exclusion to builder’s General Liability policies to eliminate the favorable coverage exception that was granted to builders (that were general contractors) under the Property Damage To Your Work Exclusion listed above. The presence of CG2294 eliminates coverage for construction defect claims. If CG2294 appears on your policy, there are two viable solutions. First, ask if your carrier has a “buyback” of the lost coverage for an additional premium charge. Second, search for a carrier that has a less severe version of this exclusion that only eliminates coverage for “property damage” to the faulty work itself but not to resulting “property damage” to the non-faulty work.

Unfavorable Case Law 

In order to have a favorable claim outcome, builders not only have to avoid the above mentioned exclusions, but also must not fall victim to unfavorable case law. Nationally, a number of courts have ruled that a contractor’s General Liability policy does not cover “property damage” to either faulty work or resulting non-faulty work under the theory that such damages don’t constitute an “occurrence”. The South Carolina Supreme Court ruled similarly in the road contractor case of L-J vs Bituminous. However, the South Carolina Supreme Court recently clarified its ruling for builders in the Auto Owners vs Newman rehearing. In this case, the court ruled that “property damage” to non-faulty work is an “occurrence” and thus subject to coverage (unless otherwise excluded). This is a mostly favorable ruling for builders in South Carolina but is still an overall coverage reduction to the extent that coverage is precluded for property damage to the faulty work itself.

Risk Management

Builders must employ aggressive risk management techniques to protect against out of pocked losses due to policy exclusions and unfavorable case law. Examples of such techniques include contractual transfer of risks to subcontractors (ex: hold harmless / indemnification provision and insurance requirements), the use of home owner warranties, thorough documentation of construction files, and being proactive in dispute resolution.

 The case involved a builder, Trinity, that constructed a house in 1999 that resulted in construction defect problems (moisture intrusion) arising from the installation of EIFS. Auto Owners Insurance Company sought a declaratory action to determine its rights and obligations. They argued the theory that negligent construction is not an “occurrence” and thus not covered under the General Liability policy form. They reasoned that the subcontractor’s defective installation of stucco did not cause an “accident” contributing an “occurrence” subject to coverage under the policy.

 On this issue, the SC Supreme court rehashed prior case law under L-J and High Country and used the following reasoning to reject Auto Owner’s argument and to strike the “no occurrence” claim denial in SC  (at least for resulting property damage beyond the defective work itself) :

“The L-J court went on to explain …. a CGL policy may provide coverage where faulty workmanship causes third party bodily injury or damage to other property besides the defective work product.”

 “…. the High Country court found that the complaint was not simply a claim for faulty workmanship seeking damages to repair the defective siding itself, but rather, was a claim for negligent construction resulting in damage to other property.”

 “In our view, these findings establish that there was ‘property damage’  beyond that of the defective work product itself, and that therefore, the homeowner’s claim is not merely a claim for faulty workmanship typically excluded under a CGL policy.”

 “Furthermore, although the subcontractor’s negligent application of the stucco does not on its own constitute an ‘occurrence’ , we find that the continuous moisture intrusion into the home was  ‘an unexpected happening or event’ not intended by Trinity – in other words, an ‘accident’ …”

 “To interpret  ‘occurrence’  as narrowly as Auto Owners……..would render both the  ‘your work’  exclusion and the subcontractor’s exception to the  ‘your work’  exclusion in the policy meaningless.” 

“Accordingly, we hold that the subcontractor’s negligence resulted in an ‘occurrence’ falling within the CGL policy’s initial grant of coverage for the resulting ‘property damage’ to the home’s framing and exterior sheathing.” 

 Declad / Reclad Of Stucco

 However, the SC Supreme Court reversed its earlier ruling and denied coverage for “…. the replacing and repairing of the defective stucco itself as an incidental cost to repairing the damage to the other property. The court cited the exclusion barring coverage for “….any loss, cost, or expense…for the repair, replacement, adjustment, removal or disposal of…’your product’; …’your work’; or …’impaired property’; if such product , work or property is withdrawn …from use… because of a known or suspected defect, deficiency, inadequacy or dangerous condition in it.”  In citing this exclusion, the court reasoned that its application is consistent with the court’s acknowledgement that “a claim solely for economic losses resulting from faulty workmanship is part of an insured’s contractual liability which a CGL policy is not intended to cover.”

 In My Opinion 

Even though this is a partially positive ruling for builders that use subs, the Supreme Court is faulty in its own analysis and should have ruled that the standard CGL policy form covers property damage to the faulty work itself in addition to resulting damage to the non faulty work. Such a ruling to cover the faulty work itself would have upheld the true intent of the General Liability policy form as evidenced by the “subcontractor exception” to the “damage to your work” exclusion. Even the most basic insurance courses (Certified Insurance Counselor) taught to insurance agents will illustrate this concept with on point examples about how it is the intent of the policy for coverage to extend to the faulty work itself.

As concerns its ruling on the denial of coverage for the EIFS declad / reclad, a number of carriers in South Carolina probably wish that this ruling had occurred years earlier before they paid out tens of millions in dollars of claims for this exposure.  Also, it appears that the court may have misapplied the “Recall Of Products, Work, Or Impaired Property” exclusion that was cited as the sole reason for denying the declad / reclad of the stucco. According to Scott Turner in Insurance Coverage Of Construction Disputes, this exclusion is limited to recalls of products or work for preventative purposes and does not apply to claims involving actual property damage to the product or work that has already failed.

 The carriers that write General Liability policies for builders will not like the overall tone of this decision; however, all they have to do to escape liability for construction defect is to use “Exclusion: Damage To Your Work Performed By Subcontractors On Your Behalf (CG2294)”. As a matter of fact, most carriers that write General Liability for builders have used this exclusion or a similar version since 2004. Therefore, the  partially favorable supreme court ruling will mean little for the average builder.

 Source: John Sadler 

Decision

“We know that some of the builders are estimating that a minimum remediation will cost at least $75,000 per home with an approximate square footage of 2,000. The cost will go up from there based on square footage and the adequacy of the remediation being suggest.”

“Some observers see this base estimate as extremely conservative, and do not rule out the possibility that a figure twice as big may emerge over time. This possibility cannot be dismissed entirely given the fact that this estimate simply includes materials, fittings and certain items in the home. It does not include health care costs and other expenses incurred by the people living in the homes.”

Source: US Senators Call For Chinese Drywall Probe, Peter J Bown, http://www.atimes.com/atimes/China_Business/KF24Cb01.html

This article was written by my friend, attorney John McCants, who specializes in defending contractors on behalf of their General Liability insurance carrier as well as in bankruptcy law.

John’s article reviews bankruptcy under Chapter 7 (liquidation), Chapter 11 (reorganization), and Chapter 13 (reorganization). In addition, it address the following contractor related issues:

* The impact of bankruptcy filing on a contractors General Liability policy which is considered to be an asset of the bankruptcy estate. In some cases, a General Liability policy may be the most significant asset of a bankruptcy estate if a claim is pending. As a general rule, just because such a policy may be the property of the bankruptcy estate does not preclude the payment of a claim under such a policy to the claimant.

* The impact of bankruptcy filing on a performance or surety bond in the event of default. Here is the normal chain of events: contractor enters into a contract and procures a performance or surety bond; contractor does not finish the job; bond company steps in the shoes of contractor and completes job; bond company then subrogates against contractor for reimbursement. But……. how can the bond company subrogate against the contractor that has filed for bankruptcy protection? The courts usually rule that the bonding company has priority over bankruptcy creditors.

* The impact of Chapter 11 bankruptcy filing after a home owner or project owner has entered into a construction contract. In other words, can the home owner or project owner discontinue the contract? The answer is, that it depends on several factors which are outlined in the article!

* The impact of an arbitration clause in a construction contract where the contractor has filed for bankruptcy. Courts typically rule that an arbitration clause is enforceable under such circumstances.

For more information: John L. McCants, Ellis Lawhorne & Sims, P.A., Bankruptcy Law: Fundamentals For The Construction Law Practitioner,
John Sadler

The most common contractual risk transfer tools are indemnification / hold harmless clauses, request of additional insured status, and request of waiver of subrogation.

These concepts can be difficult to understand and are further complicated by the fact that upper tier contractors frequently over reach and impose protections that are onerous and are not achievable by most lower tier subs in the current insurance market place.

I found an excellent article (see link below) that exposes the strong handed techniques by upper tier contractors. Presentation of this article to a general contractor can be persuasive in negotiations to lower some of these requirements.

I am all for contractual risk transfer to protect the legitimate needs of the general contractor; however, the contractual provisions must be fair and readily achievable in the insurance market place. If not, they result in a great deal of wasted administrative time on the part of both parties and they force the subcontractor into a breach of contract position.

Source: Insurance Journal, “Contractual Risk Transfer And Endorsements To The CGL”, June, 2009

Under the standard General Liability policy, “pollutants” are defined to mean “any solid, liquid, gaseous, or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste. Waste includes materials to be recycled, reconditioned or reclaimed.”

Some courts such as in CA may extend this definition further to follow the EPA or equivalent state definition of “pollutants”. In these states, even dirt and rocks can be pollutants once they are removed from their original location.

According to Vita and Jordan, the successful use of the pollution exclusion to deny coverage will depend on state case law to a large degree. As a result, choice-of-law issues can be important if the option is available to choose the state of defense.

Some states define “pollutants” differently than others for the purposes of such exclusion. For example, some states may define “pollutants” in their traditional sense and require the pollutants in question to involve an environmental catastrophe caused by reckless or intentional misconduct (ex: dumping of hazardous chemicals) in order for the exclusion to stand. Other states may allow the exclusion to stand where the negligent use or handling of toxic substances occurs in the ordinary course of business (ex: unintentional release of carbon monoxide by an HVAC contractor).

For More Information: See article entitled The Not-So-Great Drywall Of China by Jeffrey J. Vita and David G. Jordan

Source: Saxe Doernberger & Vita, P.C.  www.sdvlaw.com

However, due to the impact of little known policy exclusions, and evolving case law in many states, General Liability carriers may escape liability for all or a significant percentage of claims leaving builders and trade subs facing huge uninsured losses and potential bankruptcy.

From the point of view of the homeowner, these claims will not likely be covered by Homeowners Property Insurance. And, to the extent that the damages are not covered by the General Liability policies of builders, subs, and distributors, home owners will incur devastating out of pocket losses.

Per House Damage Could Be Astronomical

There is a lot at stake for all parties because the damages on a per house basis are likely to be astronomical. The lawsuit papers will allege that the fumes from the defective Chinese drywall have resulted in corrosion damages to all metal parts of the house including electrical systems, copper piping, HVAC and other metal fixtures. In addition, it will be alleged that the non metal parts of the house have been damaged by foul smelling and noxious sulfur dioxide fumes.

Some experts may claim that the drywall can be sealed, but this approach is questionable and unlikely to be accepted by home owners. Most lawsuits will likely ask for the total removal and replacement of all drywall and electrical systems as well as other building materials that may have been contaminated by the fumes.

Next, add damages for remediation or replacement to household contents for exposure to corrosive and foul smelling fumes. Top this off with the possibility of bodily injury claims due to adverse health consequences to occupants due to exposure.

Pollution Liability Exclusions

All Contractor General Liability policies include a standard exclusion for liability arising from the “actual, alleged or threatened discharge, seepage, release or escape of pollutants’,” “Pollutants” are defined as any solid, liquid, gaseous, or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals, and waste. “Based on this broad definition, the carriers will take the position that the fumes released from Chinese drywall fall under the policy definition of “pollution.”

Fortunately, the standard policy language includes an exception to the exclusion for pollution that results from the products or completed operations of an insured. In other words, the insurance carrier can’t use the pollution exclusion to deny a claim when the pollution arises after the house has been sold.

Unfortunately, many General Liability policies that are sold to contractors include a Total Pollution Exclusion that does not allow the exception that is mentioned in the above paragraph. The presence of the Total Pollution Exclusion (or similar exclusion) on a policy will allow the insurance carrier to take the position of denial of all damages and legal defense. The success of such a position will be determined by the allegations in a specific lawsuit as well as case law. The successful use of the Total Pollution exclusion, if upheld by the courts, will have a devastating impact on all defendants.

Property Damage Exclusions And Emerging Case Law

In the event that the Total Pollution Exclusion is not present on the General Liability policy or if it is not ultimately upheld by the courts, the claims adjusters will have a fallback position in their quest to deny a significant percentage of Chinese drywall claims.

As a result of the construction defect crisis, most General Liability carriers specializing in builders insurance began to insert special policy exclusions around five years ago to escape liability for construction defect claims. The most common exclusion entitled “Exclusion: Damage To Work Performed By Subcontractors On Your Behalf” (CG2294), virtually eliminates all property damage liability for damage to the builder’s faulty work itself (drywall) and resulting damage to the builder’s non faulty work (corrosion to electrical systems, copper piping, HVAC, and other metal fixtures).

Existing case law in many states has resulted in claim denials for construction defect under the theory that property damage to a builder’s work is not considered to be an “occurrence” or accident and thus the policy should not act as a warranty. Therefore, the end result in these states is the same as the application of exclusion CG2294.

However, General Liability coverage under the builder’s insurance policy will still likely apply to property damage to contents and bodily injury claims by occupants. Since most lawsuit papers are likely to allege at least some covered damages, coverage will still be triggered for the entire legal defense for all claims at the expense of the insurance carrier.

As concerns drywall subcontractors, their General Liability policies will not cover property damage to their work (drywall) but will cover resulting property damage to other parts of the house and contents. Their policy will also cover bodily injury to occupants. In addition, their policy will likely trigger a full legal defense of all claims.

Assuming that both the builder and drywall sub have General Liability insurance in force continuously from the completion of the job to the filing of the lawsuit papers, their combined policies won’t likely cover the cost to tear out and replace the drywall. Such a repair job represents a huge undertaking and will be very expensive.

US Suppliers And Chinese Manufacturers

US suppliers of Chinese drywall will undoubtedly participate in these lawsuits with both builders and drywall subs. Plans for class action lawsuits are already under way. Under a worst case scenario, some US suppliers may run out of general aggregate limits under their General Liability policies and it is unlikely that Chinese manufacturers will share in these claims due to the difficulties in enforcing judgments against foreign manufacturers.

Builders can protect themselves from future construction defect and pollution claims by implementing the following practices:

* Implement mandatory subcontractor agreements with all subs including insurance requirements for General Liability, hold harmless/indemnification provision, and a requirement for all subs to participate in arbitration proceedings.

* If the builder’s General Liability policy includes the Exclusion-Damage To Your Work Performed By Subcontractors On Your Behalf (CG2294) or a similar exclusion, find out if the insurance carrier provides a buyback for an additional premium charge.

* Ask the insurance agent if any insurance carriers are available that don’t use exclusion CG2294 or have a less severe version that covers resulting property damage to the builder’s non faulty work.

* Purchase a Pollution Liability policy.

Source: John Sadler