Insurance Law

Construction Defects and the Space Between: Gap and Overlap In the Combined Coverage of Performance Bonds and CGL Policies for Construction Defects

By Thomas Rush and David A. Attisani

Among other harbingers of a gradually convalescing economy, construction activity is on the rise, and is projected to remain on that trajectory throughout 2014. As a consequence of such growth, there will also be an increase in construction-related loss and an inevitable uptick in construction litigation. Although few of its consequences are certain, both surety bonds and CGL cover will likely be implicated simultaneously by many of the same claims.

Potential loss scenarios abound. Consider, for example, this common fact pattern:

State decides to build a new Convention Center. An architect and design company issue preliminary plans, and State solicits bids from general contractors. State selects Contractor to be the general contractor, and requires Contractor to procure performance and payment surety bonds. Contractor also obtains commercial general liability ("CGL") cover. Contractor later builds the Convention Center and receives payment for its work. Six years later, State discovers significant leaks in the roof, due to latent defects in the roofing material used by Contractor and defective work performed by the Contractor's roofing subcontractor. State sues Contractor and its surety for the costs of repairing the roof, damages to other portions of the Convention Center and its contents caused by the leaks, as well as its costs associated with the conventions and other events it was forced to cancel during repairs. In an attempt to bring deeper pockets to the table, State also sues Contractor for negligence, seeking to trigger Contractor's CGL cover. Contractor, in turn, tenders the claim to its CGL carrier.

Under this scenario, the surety's obligations may not be triggered at all. Even if the surety's obligations were triggered, the surety might not be required to pay if the Contractor remains a financially viable company, and there is no default. Any obligation of the CGL carrier to defend or indemnify will, of course, depend on the facts of the case and State's law. Consider, however, Contractor's near-term default risk, as portended by the more generic, market-wide comments of a major broker:

[There is] pent up demand, particularly for infrastructure projects where needed improvements are being delayed, but eventually will need to be addressed. A rapid up-turn in the economy will create a potential increase in default risk as contractors will need to shift from a slower cash flow environment to an accelerated need for cash to expand backlog.

Assume that the broker's prognostication comes to fruition in the case of Contractor, and that Contractor becomes insolvent. In that event, the multi-million dollar question is "who pays" for the damage and loss occasioned by the referenced construction defect - the surety, the CGL carrier, both, or neither? Notwithstanding the seemingly expansive coverage provided by each product, it is possible that neither the surety nor the CGL carrier will cover the subject loss. This article addresses the array of risks that may reside in the "space between" a performance bond and CGL cover in these circumstances.

I. Background

A. Surety Bonds

Surety bonds are used by the construction industry to shift the risk of contractor default and non-payment for labor and materials by the contractor from the owner of a project to the surety. There are two principal types of construction bonds: performance and payment. At the most rudimentary level of analysis, the scope of a surety's obligations is determined by the specific terms of its bond. Payment bonds protect subcontractors and suppliers who provide labor and materials to a project, in the event the contractor fails to pay them. Performance bonds typically protect the project owner from a contractor's failure, inability or refusal to complete the work required by the construction contract. This article focuses on a surety's obligations under its performance bond.

Performance bonds represent an optional feature of a private construction project. In material contrast, performance bonds are required by federal or state statutes in the context of most government construction projects. For example, the Miller Act requires that a contractor working on a federal project obtain a performance bond. See 40 U.S.C. § 3131(b)(1), [enhanced version available to subscribers]. In addition, many states have enacted "little Miller Acts," which require contractors to obtain performance and payment bonds to support their state construction project contract obligations.

B. Commercial General Liability Insurance

Owners and contractors also generally obtain CGL cover, in order to protect themselves against unexpected loss and liability arising from their construction activities. Common CGL wording provides that the insurer will pay those sums that the insured becomes "legally obligated to pay" as damages because of "bodily injury" or "property damage" caused by an "occurrence." CGL wordings also obligate the insurer to defend its insured against any suit seeking such damages. An "occurrence" is commonly defined as an "accident, including continuous or repeated exposure to substantially the same general harmful conditions." CGL policies do not define "accident," or the specific attributes of an "accident" in the construction context, thereby leaving more precise definition to the courts, which have issued diverse pronouncements. See infra Part II.A.2.i.

In addition, CGL coverage grants are limited by various exclusions, some of which may apply, in certain circumstances, to construction defect claims. In fact, it is generally acknowledged that CGL policies do not cover insureds for risks assumed in the normal course of business. E.g., Roger C. Henderson, Insurance Protection for Products Liability and Completed Operations: What Every Lawyer Should Know, 50 Neb. L. Rev. 415, 441 (1971). This principle derives primarily from the content of "business risk" exclusions embedded in the CGL policy form. See infra Part II.A.2.ii.

For example, Exclusion (j)(6) to the standard (ISO) form CGL policy precludes coverage for property damage to "[t]hat particular part of any property that must be restored, repaired or replaced because 'your work' was incorrectly performed on it." An exception to this exclusion reinstates cover for "property damage" included in the "products-completed operations hazard." Generally speaking, the "products-completed operations hazard" refers to damage arising from the insured's work occurring after that work is "complete." Reading the exception and the exclusion together, Exclusion j(6) precludes coverage for property damage arising out of the policyholder's continuing operations.

Another exclusion often encountered in the context of construction defects is Exclusion (l) - "Damage to Your Work" - which is commonly known as the "your work exclusion." Exclusion (l) precludes coverage for "'property damage' to 'your work' arising out of it or any part of it and included in the 'products-completed operations hazard.'" In other words, unlike Exclusion j(6), Exclusion (l) bars coverage for damage to the insured's work after the insured's work is complete. A "subcontractor" exception to the exclusion reinstates cover, "if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor."

Other "business risk" exclusions that may be implicated by construction defect claims include: Exclusion (k), which precludes coverage for damage to the policyholder's own products; Exclusion (m), which eliminates coverage for certain economic damages to property rendered less valuable by the policyholder's work; and Exclusion (n), which bars cover for damages incurred by the policyholder for the withdrawal or recall of the policyholder's product or work from the market because of a known or suspected defect.

Finally, CGL policies may include any number of endorsements which alter the scope of coverage provided by the form. For example, a products-completed operations endorsement ("PCOH") may either extend or eliminate coverage for damages falling within the PCOH. As the illustration suggests, such amendments can dramatically expand or limit an insurer's liability for construction defect claims. Endorsements, however, must be read in conjunction with the policy exclusions. For example, even if an endorsement extends coverage for damages falling within the PCOH, if Exclusion l does not contain a subcontractor exception, coverage may not exist for damages falling within the PCOH.

C. So What's The Difference?

As noted above, a performance bond is not an insurance policy, and vice versa. To the contrary, the protections afforded by performance bonds and CGL policies - and their asserted purposes and essential raison d'etre - differ materially, even though both are likely to be implicated in any sizeable project. In the idiom of one court:

[T]he insurer indemnifies the insured only for resulting "property damage" arising after the project is completed. In contrast, a performance bond is broader than a CGL policy in that it guarantees "the completion of a construction contract upon the default of the general contractor." Therefore, a "variety of deficiencies that do not constitute 'property damage' may be covered by a performance bond, and not all deficiencies cause additional property damage."

Lennar Corp. v. Great Am. Ins. Co., 200 S.W.3d 651, 673-74 (Tex. App. 14th Dist. 2006) (internal citations omitted), [enhanced version available to subscribers]. The difference is, however, arguably less a pristine question of degree - as the Court's comments may intimate - and more a question of kind and application. A CGL carrier, for example, has a duty to defend the insured contractor against suits seeking damages emanating from property damage. In material contrast, a surety, after conducting an independent investigation of a claim and determining that its bonded contractor has valid contract defenses, has the right to tender its defense to the solvent contractor and demand to be held harmless, in the event that the surety is sued for performance under the relevant bond.

There are other important differences that defy simple, linear measurement according to the quantum of protection afforded. A performance bond is issued for the protection of the owner of a project, whereas insurance cover protects the contractor (i.e., the policyholder). A performance bond is a tripartite contract among principal (the contractor and primary obligor), obligee (the owner of the construction project), and surety (the secondary obligor) - it is a product designed to protect the owner against the risk of the contractor's failure to perform its contractual obligations. Insurance contracts, on the other hand, are binary agreements between the insurer and the policyholder (the contractor or subcontractor), which are designed to protect the contractor, in the event of an accidental loss unknown at policy inception.

Moreover, unlike CGL insurers, a surety does not expect to incur some number and quantum of losses for purposes of its underwriting and pricing. Because sureties guarantee the performance of qualified contractors, they do not expect to incur loss and they do not price their product to accommodate reserves in the event that loss occurs. Instead, a bond is underwritten based on what amounts to a prequalification by the surety of the particular contractors predicted financial capacity, technical expertise and ability to perform its contracts. Unlike sureties, insurers calculate premiums across a range or cluster of live policies, using loss experience data and actuarial methods, to create a pool of reserves available to address the inevitability of loss.

Finally, sureties arguably have a broader array of defenses at their disposal when a claim is made against the bond. A surety may assert any of the rights and defenses available to the contractor, as well as those rights and defenses uniquely available to the surety under its performance bond. The surety will also shift loss to the contractor through its right to indemnification to the extent the contractor is financially capable of exonerating or reimbursing the surety. By contrast, the insurer's rights and defenses are generally limited by its contract - i.e., those described by the four corners of its policy wording. It typically cannot shift its costs to the insured contractor - simply put, the insurer cannot seek indemnification from its own policyholder. customers may click here to read the complete commentary.

Tom Rush is Assistant Vice President and Senior Counsel at Hanover Insurance Company. David Attisani is chair of the Insurance and Reinsurance Group at Choate Hall & Stewart LLP in Boston. The views expressed in this article do not necessarily reflect the views of Choate, The Hanover Insurance Group, or any of their clients or business partners. The authors would like to thank Jessica Foster Pizzutelli, a former Choate lawyer, who contributed materially to this article.

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