Policyholders Must Be Vigilant for Construction Defect Exclusions, Including For Impaired Property to Combat Insurance Companies’ Drastic Measures (and Big Money)

by Nossaman LLP

Building InspectionContinuing the most recent trend in coverage litigation, insurance companies are increasingly engaging “Big Law” firms to develop legal arguments for narrower interpretation of their policies when troublesome claims threaten the bottom line.  A prime example can be found in a recent lawsuit, Regional Steel Corp. v. Liberty Surplus Insurance Corp., in which Sheppard Mullin scored another big victory for its client Liberty insurance.  This was a construction defect case, where a subcontractor installed seismic tie hooks in conformance with shop drawings, but the building inspector later found them to be inadequate and ordered them to be removed and replaced.  The Court bought Liberty’s argument that the only thing that was at issue was removal and replacement of the defective product (seismic hooks not in conformity with building code)—even though the builder had to break walls, concrete, etc. to reach the defective hooks to replace them.  But there was a further exclusion for “impaired property,” which seems to fit the bill for this loss, barring coverage for property that cannot be used because it incorporated the insured’s “defective product.”  Thus, despite the insured’s best efforts to argue for other damage to tangible property (including presenting evidence that walls and floors were not level and sustained cracks and other damage, and that replacing the seismic hooks delayed completion of the project) , the Court found no coverage.  The subcontractor’s insurer, Liberty, convinced the Court there was no potentially covered property damage, including loss of use. The Court rejected the reasoning of other cases including Armstrong where the defective component made part of the building was inherently harmful (such as the asbestos in Armstrong, 45 Cal App 4th 1 (1996) or lead contamination in another case, Elger,  972 F 2d 805 (7th Cir. 1992) or contaminated almonds, Shade Foods, 78 Cal App 4th 847 (2000)).

One recommendation for our construction industry clients is to make sure “impaired property” exclusions are removed by endorsement on any Commercial General Liability policies they purchase (especially ones like this which was converted to a Wrap!).  What a great Wrap this one turned out to be—covers no defective construction damages, period.  Quite the profit center for an insurance company.

It is important to realize that the Regional Steel case is not an anomaly.  Courts are increasingly leaning into the arguments advocated by high-level, “big law” advocates.  Indeed these cases do involve billions in potential profits both in securing legal interpretations that narrow the scope of coverage in existing policies to eliminate the obligation to pay those troublesome claims, and, at the same time, creating markets for new forms of insurance designed to fill the “gap” created by these court opinions.  Good business plan.

The fundamental takeaway for commercial clients is to consult with your insurance lawyers early and often:  at the time you are contemplating purchasing or renewing insurance (to avoid expansive exclusions or prohibitively narrow conditions) and whenever a claim threatens and materializes (to ensure prompt timely reporting and making the appropriate record to optimize available insurance to address the risk of loss).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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