Swartz Campbell - Who Pays The Tab for Faulty Construction: The Pennsylvania Experience

Who Pays The Tab for Faulty Construction: The Pennsylvania Experience
William Salzer

This article seeks to examine recent developments of Pennsylvania appellate case law on the subject of insurance coverage for property damage liability under a standard Commercial General Liability (CGL) insurance policy. Pennsylvania courts have staked clear boundaries between uninsured economic business risks of policyholders and insurable liability/casualty risks subject to CGL policy coverages. An understanding of the demarcation line crafted by the Pennsylvania courts between insured and uninsured liability under the CGL policy is essential to fully represent the policyholder or the insurer's interest.

The CGL policy provides the insured with liability insurance protection through the provision of paid defense counsel and for indemnification of covered damages awarded for occurrences within the terms of coverage (sometimes referred to as the "coverage grant") and not otherwise excluded from coverage. The CGL provides that the insurer company "shall pay those sums which the insured is legally obligated to pay as damages because of "property damage" liability to which this insurance applies." The insurance applies only to "property damage" which occurs during the policy period and is the result of an "occurrence."

An "occurrence" is defined as "an accident, including continuous or repeated exposure to the same general harmful conditions." As such, to come within the coverage grant, a lawsuit against the insured must be based on the existence of: (1) property damage manifested during the pendency of the term of the insurance policy; (2) caused by an "occurrence"; and (3) not subject to the exclusions to coverage.

The key policy exclusions (often referred to as the "business risk" exclusions) provide that the insurance coverage does not apply to "property damage":

2.k. To "your product," arising out of it or any part of it;

2.l. To "your work" arising out of it and any part of it and included in the "products/completed operations hazard".

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.

2.m. "property damage" to "impaired property" or property not physically injured arising out of:

(1) a defect, deficiency, inadequacy or dangerous condition in "your product" or "your work"; or

(2) a delay or failure by you or anyone on your behalf to perform a contract or agreement in accordance with its terms.

This exclusion does not apply to the loss of use of other property arising out of sudden and accidental physical injury to "your product" or "your work" after it has been put to its intended use.

The term "impaired property" is defined by the policy to mean "tangible property" other than "your product" or "your work" that cannot be used or is less useful because:

a. It incorporates "your product" or "your work" that is known or thought to be defective, deficient, inadequate or dangerous; or

b. You have failed to fulfill the terms of a contract or agreement;

If such property can be restored to use by:

a. The repair, replacement, adjustment or removal of "your product" or "your work"; or

b. Your fulfilling the terms of the contract or agreement.

Although the operational layers of the CGL policy are highly structured through its coverage grant, policy definitions and exclusions, courts have often blended these elements to the point of forming a common law of insurance coverage under the CGL policy and, in particular, in the courts' treatment of the business risk coverage quandary. As discussed in several Pennsylvania decisions, Pennsylvania courts are reluctant to find coverage under the CGL for liability which stems from the insured's failure to satisfactorily fulfill, (by misfeasance or non-feasance), a contractual undertaking where the insured's actions result in property damage to a third party. See e.g., Redevelopment Authority of Cambria Cty. v. International Ins. Co., 454 Pa. Super. 374, 685 A.2d 581 (1996) (en banc), alloc. denied, 548 Pa. 649, 695 A.2d 787 (1987).
In Redevelopment Authority, a public agency entered into a maintenance agreement with a township and water system operator whereby the Authority was to allocate funds to water projects within the township. When the community's water was not upgraded in compliance with environmental standards, the township commenced suit against the Authority for breach of the maintenance agreement. The plaintiff alleged that the insured Authority was negligent in its performance of services required by the contract and that it was thereby unjustly enriched.

The Superior Court held in Redevelopment Authority that allegations that the insured carelessly and unskillfully performed obligations under its service agreement amounted to a breach of contract and was not an "occurrence" or accident for purposes of triggering the policy's defense obligation. In this regard, it did not matter that the plaintiff had separately averred claims of negligence against the insured. 685 A.2d at 590. What mattered was that the insured's services, alleged to have been negligently and inadequately performed, were undertaken pursuant to a contract and that the losses ensuing from poor performance could not fairly be construed as an accident or "occurrence." Where the insured's negligent performance arises out of a contractual undertaking, the insured's liability for negligence, if any, is collateral to the contractual undertaking and does not trigger coverage. Id. at 590.4

Building on Redevelopment Authority is the 1998 decision of Snyder Heating Co. v. Pennsylvania Manufacturers Association Ins. Co., 715 A.2d 483 (Pa. Super. 1998) wherein the Pennsylvania Superior Court, sitting en banc, more broadly established the principle that an "occurrence" cannot be triggered by allegations that an insured failed to or inadequately performed a contractual undertaking. In Snyder Heating, the insured sought coverage for claims brought against it by a school district as a result of the insured's failure to provide adequate services under a boiler maintenance and service agreement. The trial court concluded that under the completed operations coverages of the CGL policy, the insurer was obligated to pay for the school district's damages which resulted from the insured's work. The complaint suggested the possibility of physical damage to the school's boilers as result of the poor maintenance.

The Superior Court held that the failure to provide adequate services under the agreement could not be construed as involving tortious, accidental conduct sufficient to constitute an "occurrence"-- - even if the plaintiff separately pled negligence claims in addition to breach of contract. 715 A.2d at 487. The court noted that the important difference between contract and tort actions is that the latter lie from a breach of duties imposed by law as a matter of social policy while the former lies from a breach of duties imposed by mutual consent between particular individuals. Id. A CGL policy "involves risks that are limited in nature; they are not the equivalent of a performance bond on the part of the insurer." Id., citing Ryan Homes, Inc. v. Home Indemnity Co., 436 Pa. Super. 342, 349, 647 A.2d 939, 942 (Pa. Super. 1994). See also PHICO Ins. Co. v. Presbyterian Med. Serv., 444 Pa. Super 221, 663 A.2d 753 (1995) (allegations that insured acted negligently resulting in breach of management agreement not covered).

The Snyder Heating court stated that to require the CGL liability insurer to defend or indemnify an insured for poor or inadequate workmanship, necessitating repair and replacement expenses, would transform the insurer into a business partner of the policyholder. 715 A.2d at 488. The court premised its decision on the definition of "occurrence" and further observed that the policy's "impaired property" exclusion removed coverage for the costs of repairing defective property caused by an insured's failure to adhere to contractual warranties. The court left open, however, the notion that the "active malfunctioning" of an insured's product or service, causing property damage might meet the policy definition of an "occurrence" and further creates the unanswered inquiry of when a tort claim is collateral to contract liability.

What the Snyder Heating Court is meant by "active malfunctioning" is not crystal clear; however, it appears to denote some damage outside of the chain of normal events and not simply the cost of correcting poor workmanship. This may, in effect, revive the issue of foreseeability as a factor in determining the existence of a covered "occurrence," a concept previously rejected. While the phrase "active malfunctioning" (versus passive malfunctioning) may be difficult to apply; a far simpler approach to applying the policy term "occurrence" is to consider that, in laymen's terms, one would not ordinarily refer to the expenses of correcting poor workmanship as an accident.

These principles have been applied in the construction litigation context where the Pennsylvania Superior Court has held that a concrete contractor did not have coverage for damage claims based on slipshod construction that reduced the value of the plaintiff's homes. Solcar Equip. v. Pennsylvania Manufacturers Association Ins. Co., 606 A.2d 522 , 527 (Pa. Super. 1992). The plaintiff in Solcar alleged that the defendants improperly planned and prepared the concrete foundations and that the insured knew or should have known that the construction of the homes with the concrete improperly prepared would jeopardize the structural integrity of the homes.

The Solcar court, in strong language, expressed its view that poor workmanship resulting in the need to replace or repair the insured's work could not be view as an accident, i.e., an "occurrence":

Appellants erroneously contend that Solcar's substandard performance, which contributed to massive property damage in the Regency Hill homes makes this claim a covered one. We are not shocked that Solcar's slipshod construction work caused the homes to be of little value. However, this was not an accident or occurrence, a prerequisite under the insurance contract for reimbursement. Solcar was negligent and nothing more. The insurance contract is not a performance bond or any type of construction malpractice insurance.

606 A.2d at 527 (emphasis added).

Recently, the Pennsylvania Superior Court extended these principles to consideration of a 1993 edition of the ISO CGL policy. See Assumption of the Blessed Virgin Mary Church v. Foremost Insurance Group, 764 A.2d 1116 (Pa. Super. 2000) (unpublished opinion), app. denied, 2001 Pa. LEXIS 419 (Pa. 2001). In Assumption, the policyholder contracted with the plaintiff for the installation of a pre-engineered classroom facility which was installed by the insured through the use of subcontractors. Years after the installation, the building sustained water infiltration as a result of a defective roof and improper site grading. The building owner alleged claims of negligence and breach of contract against the policyholder based on negligent construction of the classrooms by the insured and subcontractors.

The trial court entered judgment for the insured and held that coverage was triggered at the time of the negligent construction (while the policy was in force) even though the damage did not materialize until several years later after the policy expired. The trial court also concluded that the CGL policy provided coverage for the costs of repair under the completed operations coverages of the policy.

On appeal, the Superior Court in Assumption reversed, holding that the date of the first manifestation of property damage was the appropriate trigger of coverage5 and, therefore, the expired policy could not be reached. The panel also stated that regardless of the negligence claim, poor workmanship resulting in the need for repairs does not involve a covered "occurrence." The general contractor/insured in Assumption subcontracted work on the project and, therefore, had asserted that it was entitled to coverage by virtue of the "subcontractor exception" of the workmanship exclusion contained in the 1993 ISO CGL policy6. Although not the subject of much discussion, the appellate panel did not find that the use of subcontractors transformed an economic loss claim into a covered "occurrence."

The Pennsylvania Superior Court's prior decisions in Solcar, Redevelopment Authority and Snyder Heating did not involve claims of defective workmanship attributable to subcontractors. The Ryan Homes decision was premised on a workmanship exclusion which did not contain the 1988 ISO "subcontractor exception" which has been carried through in subsequent policy editions. Ryan Homes left unanswered whether an insured general contractor had coverage for claims of defective workmanship which was attributable to the work of subcontractors, under the post-1988 and later ISO policy editions of the CGL policy.

The "subcontractor exception" is not, however, intended to provide indemnification of a general contractor for the cost of repairing or replacing defective workmanship of its subcontractor in the absence of a covered "occurrence" of "property damage." To illustrate, if a general contractor has hired a roofing contractor who negligently installs shingles which are shorn off during a windstorm, the general contractor's liability to the building owner for the costs of fixing the roof are part of the general contractor's business risk which is uninsured under the CGL policy. It does not matter that the roof work was performed by a subcontractor because the cost of fixing the damaged roof does not represent "property damage" caused by an "occurrence."

The insured's liability for the costs of correcting the shoddy workmanship of its subcontractors is not an accident but is an expected cost of operations and the expected consequence of hiring poor workers or failing to supervise their work. See e.g. Monticello Ins. Co. v. Wil-Freds Co., 277 Ill. App.3d 697, 661 N.E. 2d 451, 456 (Ill. App. 2d Dist. 1996)(construction defects which are the "natural and ordinary consequences of the improper construction techniques of the insured and its subcontractors do not constitute an "occurrence" within the definition in the CGL policy"); West American Ins. Co. v. Keno & Sons, 2000 U.S. Dist. LEXIS 2181 (Feb. 25, 2000)(applying Wil-Freds, insured's liability for negligent construction of water reservoir based on defective subcontractor work resulting in water main rupture, not an "occurrence"); Wm. Vick Construction Co. v. Pennsylvania National Mutual Ins. Co., 52 F.Supp.2d 569 (W.D.N.C. 1999)(surveying law on meaning of "occurrence" in construction defect cases), aff=d, 2000 U.S.LEXIS 8486 (4th Cir. Apr. 28, 2000); R.N. Thomson & Associates, Inc. v. Monroe Guaranty Ins. Co., 686 N.E.2d 160 (Ct. App. Ind. 1997)(economic cost to replace defective roof work by subcontractor not "property damage" caused by an "occurrence"; no need to address subcontractor exception to "your work" exclusion).

In contrast, if during the windstorm, water leaks into the property because of the missing shingles, causing damage to the interior of the building which the insured constructed, the subcontractor exception would be triggered such that the insured would have coverage for the unexpected damage to the interior - even if the damage were to components of the building constructed by the insured or other subcontractors ( i.e., "your work"). Carpenter v. Federal Insurance Co., 432 Pa. Super. 111, 637 A.2d 1008 (1994) (subcontractor's negligence in the installation of a light fixture caused a fire, destroying a building). The subcontractor exception is designed to assure the general contractor that unforseen damage caused by the negligence of its subcontractors is within the coverages of the CGL policy. Although not delineating the demarcation of insured risks in this fashion, other jurisdictions have noted that notwithstanding the presence of the "subcontractor exception," claims against an insured for defective workmanship by a subcontractor do not constitute an "occurrence." See e.g. R.N. Thomson Associates, supra.7

The third and better approach is to carefully determine whether the allegations against the insured are solely to correct the poor workmanship of the subcontractor or, instead, whether the subcontractor's work has physically damaged or impaired the use of other parts of the structure built or sold by the insured. If the latter, the insured would have coverage only for the extent of the damage caused, but not the costs of repairing the work or product which caused the damage. See e.g. Weedo v. Stone-E-Brick, Inc., 405 A.2d 788, 796 (N.J. 1979)(no coverage or payment for building flaws, only for that damage caused by construction flaw); Underwriters at Interest v. SCI Steelcon, 905 F.Supp. 435 (E.D. Mich. 1992)(roof defect resulting in leakage and damage to interior covered as well as "loss of use", but not repair costs). If, however, the physical damage caused by the negligence necessitates secondary repair work, then this would constitute covered consequential damages. This allocation between business risks and insured casualty risks assures that the insurer is not a guarantor of work performance but protects against fortuitous damage outside of the control of the insured.

Pennsylvania courts have staked out the boundaries between covered property damage under the CGL policy and uninsured business risks resulting from defective workmanship or products. Insurers and policyholders should carefully scrutinize the underlying claim for which coverage is sought to differentiate between insured consequential damages resulting from an unforseen, accidental event and liability based on the failure to provide a suitable product or work. Only an analysis of the entire policy language will correctly apportion insured risks from non-covered claims.

Curtis P. Cheyney, III and William T. Salzer, partners in Swartz Campbell LLC's Insurance Coverage Practice Group, specialize in representing insurers in all aspects of coverage litigation. Questions concerning Foremost Insurance Group v. Assumption of the Blessed Virgin Mary Church may be directed to the attention of William T. Salzer, Esquire. Information concerning Swartz Campbell LLC's Insurance Coverage Practice group may be obtained by visiting the firm's website at www.swartzcampbell.com.