Builders Risk Litigation Newsflash: LEG-3 Court Decision

Lack of Direct Physical Damage

The builders risk insuring agreement provided coverage for "direct physical loss or damage to insured property." The insurer contended that, in order to sustain direct physical loss of or damage, the insured property must be in an initial satisfactory state and then changed by some external event into an unsatisfactory state. The Contractor noticed that the affected abutments and piers were defective upon removing the formwork. These defective components were never placed into use or incorporated into nondefective components of the bridge and never caused damage to any other property. Therefore, the insurer concluded that no other part of the bridge incurred direct physical loss or damage as a result of the defects.

LEG-3 Defect Extension Endorsement Precludes Coverage

The LEG-3 Defect Extension endorsement replaced Exclusion C. in the builders risk policy. Exclusion C. read: "Fault, defect, error, deficiency or omission in design, plan or specification, unless direct physical loss or damage by an insured peril ensues and then this policy will cover for ensuing loss or damage only." It should be noted that the LEG-3 Defect Extension did not replace Exclusion B. in the builders risk policy: "Faulty or defective workmanship or materials, unless direct physical loss or damage by an insured peril ensues and then this policy will cover for such ensuing loss or damage only."

The LEG-3 Defect Extension in the builders risk policy is as follows. This is the same exclusion as the LEG-3/06 exclusion above, except commas were added throughout.

All costs rendered necessary by defects of material workmanship, design, plan, or specification and should damage (which for the purposes of this exclusion shall include any patent detrimental change in the physical condition of the Insured Property) occur to any portion of the Insured Property containing any of the said defects, the cost of replacement or rectification which is hereby excluded is that cost incurred to improve the original material workmanship design plan or specification.

For the purpose of this policy and not merely this exclusion, it is understood and agreed that any portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship, design, plan, or specification.

The insurer contended that the LEG-3 Defect Extension did not apply to the claim for two major reasons.

First, the last paragraph of the LEG-3 Defect Extension stated that insured property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship, design, plan, or specification. The insurer reasoned: "Thus, the requirement of the Policy's Insuring Agreement, has not been met" and "the abutments and V-piers were simply defective construction."

Second, the insurer concluded that "the LEG-3 Extension makes clear that should damage … occur to any portion of the Insured Property containing any of the defects, the excluded cost is the cost incurred to improve the original material workmanship design plan or specification. The defective abutments and V-piers were never incorporated into any other portion of the bridge. Accordingly, all costs associated with rectifying these defects were merely for the purpose of bringing the defective components in conformity with the contract required."

The Damage Alleged by Contractor Was Unambiguously within the Scope of Coverage

The builders risk policy at issue insured against "all risks of direct physical loss of or damage to insured property." The abutments and piers were "insured property" under the policy. "Damage" was not defined in the policy. As a result, the court considered dictionary definitions, including Black's Law Dictionary: "loss or injury to person or property" or "any bad effect on something." The court concluded that the decreased weight-bearing capacity of the bridge was surely an injury or, at the very least, a bad effect on the bridge and its support structures.

The court contrasted Exclusion B. in the "Perils Excluded" section of the builders risk policy with the LEG-3 Defect Extension. It concluded that Exclusion B. implies that "faulty or defective workmanship" can cause "loss, damage, or expense" because the lead into Part B—Exclusions is very broad. ("This policy shall not pay for loss, damage or expense caused directly or indirectly by any of the following.") As respects the LEG-3 Defect Extension, the court concluded that "caused by" language in the builders risk policy language differs from the "solely by virtue of the existence" language in the LEG-3 Defect Extension. The LEG-3 Defect Extension does not suggest that property cannot be damaged if there were defects in material workmanship somewhere in the causation chain. However, defects in material workmanship in and of themselves are insufficient to constitute damage. In this case, the Contractor did not seek reimbursement solely for its defective workmanship.

Lastly, the court considered the "parties' intent" and "overall purpose of the contract" (builders risk policy) in assessing the meaning of "damage." The builders risk policy is "all risk" in nature. One risk inherent to a job like this one is damage from errors of workmanship. The insurer was aware that it was agreeing to insure issues that arose during construction of the bridge.

Insurer's Case Law Fails To Establish That the Damage Alleged by the Contractor Was Not Covered

The insurer argued that the insured property must be altered—not merely defectively constructed—to constitute physical loss or damage. No property was altered because the honeycombed concrete components were defective from the moment they were made. Further, the insurer argued that incorporation of defective components into a larger project does not constitute damage under Illinois law.

The court disagreed with the insurer because (1) a change that resulted in a reduction in the weight-bearing capacity of a bridge was an "alteration" to that bridge, and (2) the authorities the insurer cited were inapposite.

Insurer Fails To Demonstrate That an Exclusion Applies

The court found the LEG-3 Defect Extension to be ambiguous. It had this to say: "The LEG-3 Extension is ambiguous—egregiously so. To understand this, one need only attempt to read it. Lexington managed to squeeze in a run-on sentence, an undefined term, several mispunctuations, and a scrivener's error…. The Extension is internally inconsistent and bordering incomprehensible. SCB's [Contractor's] statement that the Extension is 'convoluted' is an understatement." In support of this, the court noted the following.

• The parties disagree on the nature of the title of the "LEG-3 Defect Extension." The insurer argued it was an exclusion. The Contractor considered it to be a broadening of coverage. The court said they were both correct.
• The LEG-3 Defect Extension replaced builders risk policy Exclusion C. However, the Contractor correctly pointed out that the LEG-3 Defect Extension addressed the subject matter of both Exclusion B and Exclusion C. As such, the court determined that the insurer made a scrivener's error and that the parties intended for LEG-3 to replace both Exclusions B and C.
• The parties had competing arguments on what constitutes "damage" within the LEG-3 Defect Extension. The court determined that "damage" in the LEG-3 Defect Extension encompassed the Contractor's claim: honeycombing resulted in a reduction in the weight-bearing capacity of the bridge. This qualified as a detrimental change in the insured property, and the damage was "patent" in nature. The honeycombing was certainly visible to an onlooker.
• The insurer argued that any repairs were "improvements" and excluded by the LEG-3 Defect Extension endorsement. The Contractor's interpretation of "improvement" was "making it better than originally planned." The court determined that to improve something "means to make a thing better than it would have been if it were not for defective work."

The court ruled that the LEG-3 Defect Extension was subject to more than one reasonable interpretation and was, therefore, ambiguous. The Contractor's reading was more plausible. Under Illinois law, the court must construe the LEG-3 Defect Extension against the drafter (the insurer) and in favor of coverage. The court held the insurer liable for breaching its builders risk policy.