(Not) the new LEG clauses.
Let me start by making something clear. The clauses referred to below are NOT the new LEG clauses.
Whilst I have made no secret of my view that the LEG committee does need to amend LEG3 (and, perhaps, should have done so before now), and that the decisions in SCB and Archer have provided a golden opportunity to overhaul not just the LEG clauses, but the DE clauses too, I have no involvement in the decision about whether the LEG committee will, in fact, produce new versions of the LEG clauses or, if they do decide to do so, in determining what those clauses will look like. As a result, what is set out below represents nothing more than my own suggestions about how the existing LEG clauses could be amended in order to preserve what I believe to be the general market understanding of their meaning, whilst being expressed in clear language that would be easily understood not only by those who specialise in CAR / Builder’s Risk, but also by those who have no involvement in this particularly fascinating area of insurance.
I have been asked, not unreasonably, whether it is misleading of me even to refer to my own draft clauses by reference to the official LEG clauses. However, after careful consideration I have maintained the view that I originally took instinctively, that it is appropriate for me to do so, for two reasons.
The first is that my proposed clauses are not intended to alter the meaning of the existing clauses but, rather, to express what I regard as the meaning of the existing clauses in a clear way. Whilst I am happy to be challenged about my understanding of the meaning of the existing clauses, it would make no sense for me not to explicitly link my drafts to the current clauses, because my re-drafts of each clause only make sense when considered in the context of the original. I don’t consider it to be my place, as a lawyer, to be suggesting that the intention of the existing clauses should be changed in order to provide more (or less) cover. That is for underwriters and brokers to decide.
The second reason is that, although the LEG clauses are officially maintained by the London Engineering Group (i.e. “LEG”), the existing clauses have become, in my view, public property as a result of their popularity, and by their wide usage across the world. For better or for worse, the scope of cover provided by Builder’s Risk policies in every insurance market needs to be considered in the context of the defects exclusions produced by the LEG committee, whether an official LEG clause is used, or whether a different form of defects exclusion is used (whether from the DE suite, or bespoke clauses).
That being the case, it seems to me that anyone with a serious interest in the health of the Builder’s Risk market has the right to contribute to the debate about what the market-leading suite of defects exclusions (which is what the LEG clauses are) should look like in the next generation of Builder’s Risk policies. I don’t claim to have any unique insight into that debate, or to be writing the last word on the subject, but I do hope that what I say can be a useful contribution to what should be a market-wide conversation about these important clauses.
What would be worse even than the unsatisfactory position that we are in today (where SCB and Archer have raised considerable uncertainty about the meaning of the clauses, and arguably called into question whether their meaning can reliably be ascertained at all), would be for insurers to fragment and begin to provide a multiplicity of their own defects exclusions. These clauses have layers of meaning, and there is beauty in their individual and collective complexity. But if we move away from standard defects exclusions, then beautiful complexity may give rise to unfathomable chaos in which brokers, policyholders and, if we’re honest, even the Builder’s Risk underwriters themselves, will have little chance of achieving a clear common understanding of the cover that their policies are providing. In that situation it would only be the lawyers who would be the only winners, and no-one wants that.
So, what is the problem with the existing clauses?
Firstly, they are overly long and convoluted. There are numerous phrases (most notably, but not only, the words in brackets in the 2006 version of LEG3) which I understand to have been introduced “for the avoidance of doubt”, but which have had precisely the opposite effect. Rather than bringing clarity to the meaning of the clauses, these superfluous phrases have instead obscured that meaning.
Secondly, the word “defect” is used to describe two quite different things in different contexts. Sometimes the word defect is intended to describe the condition of the insured property. At other times it appears to be intended to refer to a mistake (whether a mistake concerning design, or workmanship, etc).
Thirdly, the clauses have encouraged some users to take the view that they treat “damage” on the one hand, and a “defect” on the other, as binary concepts, so that one should be concerned with the question of whether insured property is damaged OR defective. However, that is plainly not right. As I remember being explained to me when I began to work with Builder’s Risk policies, when you refer to “damage” you are concerned with a happening, whereas when you refer to a “defect” you are concerned with a condition.
Knowing that insured property is in a condition that the owner would preferred it not to be in, today (so that it can therefore be described as being defective, today), tells you nothing at all about whether the insured property underwent an adverse change in physical condition which impaired the value or usefulness of the property. If it did undergo that change (i.e. it suffered damage in order to reach its defective state or, to put it another way, it become “damaged”), then that would trigger the insuring clause of a Builder’s Risk policy. If, on the other hand, the insured property was simply built badly, it should never trigger the insuring clause of a Builder’s Risk policy.
So, what am I intending to achieve in my proposed re-drafts of the clauses? As set out above I am not intending to suggest any alteration of the cover which I believe is intended by the existing clauses. Rather, my only intention is to express, in as clear language as possible, my understanding of the meaning of the existing clauses.
With that in mind, my re-drafts have largely retained the existing language of the current LEG clauses, and primarily removed the words which in my view serve to obscure the meaning of the existing clauses. The exception to that approach is in my proposed amendment to LEG1, where in order to avoid using the word “defect” to refer to a mistake, I have instead introduced that word into the clause even though it doesn’t appear anywhere in the existing suite of exclusions. However, in my view, the natural and ordinary meaning of the word “mistake” accurately reflects the meaning of the (in my view) misleading word that it replaces in the original clause.
A final point in relation to the clauses. As I explained in my article on the SCB decision, the urgent need to amend LEG3 (and, by extension, the other LEG clauses) presents an opportunity to move away from the current unhelpful position where we have two separate suites of defects exclusions (LEG, and DE).
Each suite can be broken down in three categories: clauses that are concerned with causation (LEG1 and DE1); clauses that are concerned with improvements (LEG3 and DE5); and clauses that are concerned with the condition of the insured property before damage occurred (DE2-4, and LEG2). Of those three categories, the clauses relating to two of them are materially the same in each suite, despite differences in drafting (i.e. LEG1 and DE1 do the same thing, as do LEG3 and DE5 - there may be technical arguments that they operate slightly differently, but those technical arguments should not, in my view, be taken seriously).
The only difference between the two suites is in the intermediate clauses which are concerned with the condition of the property before the damage occurred. In that regard LEG2 operates materially differently from DE2-4. That is due to the different origin of the two suites: the DE clauses were intended to be general Builder’s Risk clauses, whereas the LEG clauses were introduced specifically to cater for engineering risks (i.e. EAR as opposed to CAR). Unfortunately, the DE clauses have not been as successfully exported as the LEG clauses (perhaps because there are more of the DE clauses and so they are perceived as being more difficult to understand), with the result that in some important markets, including the US, the LEG clauses are used as standard for civils projects, whereas the DE clauses would be more appropriate for projects of that type.
So, rather than simply amending the LEG clauses, it seems to me to be much more sensible to introduce a single suite of clauses which are based on the existing LEG clauses, but which re-brand LEG2 in the way it was intended (i.e. as applying to EAR) and amending DE3 as a civils alternative to LEG2.
And with that rather long introduction, and with thanks for the patience of anyone who has taken the time to read this far rather than jumping straight to the draft clauses themselves, here are my suggestions for a new single suite of defects exclusions, modelled on the current LEG clauses, but with an amended version of DE3 introduced as an alternative to LEG2 (and branded LEG2 (CAR)).
Original clauses | My draft clauses |
LEG1
“The Insurer(s) shall not be liable for Loss or Damage due to defects of material workmanship design plan or specification.” |
LEG1
The Insurer shall not be liable for the cost of fixing any damage caused by mistakes of any kind. |
LEG2
“The Insurer(s) shall not be liable in respect of: All costs rendered necessary by defects of material workmanship design plan or specification and should damage 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 which would have been incurred if replacement or rectification of the said portion of the Insured Property had been put in hand immediately prior to the said damage. 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 or material workmanship design plan of specification”. |
LEG2 (EAR)
Should damage occur to any portion of the Insured Property which was in a defective condition before the damage occurred the Insurer shall not be liable for the cost that would have been incurred to fix the defects in that portion of the Insured Property immediately before the damage occurred.
|
DE3
“This policy excludes loss of or damage to and the cost necessary to replace repair or rectify: i. Property insured which is in a defective condition due to a defect in design plan specification materials or workmanship of such property insured or any part thereof; ii. Property insured lost or damaged to enable the replacement repair or rectification of Property insured excluded by (i) above. Exclusion (i) above shall not apply to other Property insured which is free of the defective condition but is damaged in consequence thereof.” |
LEG2 (CAR)
The Insurer shall not be liable for the cost incurred to fix any portion of the Insured Property which was in a defective condition immediately before the damage occurred.
|
LEG 3/06
“The Insurer(s) shall not be liable in respect of: 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 the 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.” |
LEG 3
The insurer shall not be liable for the cost incurred to improve the original material workmanship design plan or specification.
|
I would love to hear from anyone who either agrees or disagrees with what I’ve set out above. The market would benefit from a debate on this important issue, and we have an opportunity to create a better situation than the one in which we find ourselves today. Please feel free to email me either at david.pryce@fenchurchlaw.co.uk, or at david.pryce@fenchurchlaw.com.sg.
David Pryce is a Senior Partner at Fenchurch Law.
Webinar - Archer v Ace and what it means for the CAR/Builders Risk market
Agenda
In June our Senior Partner, David Pryce, discussed the significance of the South Capitol Bridgebuilders (“SCB”) decision with David Goodman, the attorney who successfully represented the policyholder in the landmark Builder’s Risk case, which was decided under the Law of Illinois. In this follow up session, David will be speaking with Jeremiah Welch of Saxe Doernberger & Vita, the attorney who successfully represented the policyholder in the subsequent case of Archer Western v Ace. In Archer a second US Court, this time in the Southern District of Florida, again grappled with the questions of what constitutes damage for the purposes of triggering a Builder’s Risk policy, and what the proper meaning of the LEG3 defects exclusion is: both questions which have wider significance for the Builder’s Risk markets in the US and the UK. The discussion will also touch on the question of whether concrete gives rise to particular difficulties when determining whether damage has occurred and, if so, what can be done to address those difficulties. The session will include the opportunity for attendees to put questions to Jeremiah and David in relation to each of the issues discussed.
Senior Partner, David Pryce is joined by Jeremiah M. Welch from Saxe Doernberger & Vita, P.C.
Webinar - The world’s first LEG3 court decision & what it means for the CAR market
Agenda
A Court in the USA has delivered the world’s first legal decision on the most generous of the three London Engineering Group (LEG) clauses related to defect exclusions, LEG3, in the case of South Capitol Bridgebuilders v Lexington Insurance Company. The fact that the Construction All Risks (CAR) market (otherwise known as the Builders’ Risk market) has been waiting for a LEG3 decision for this long means that SCB v Lexington was always going to receive a lot of attention. However, the unrestrained and intemperate language used by the Judge means that there is a risk that the decision will create more heat than light, and has the potential to lead to a reaction by CAR insurers which could negatively affect the interests of policyholders. This case study therefore attempts to take a step back from the eye-catching language used by the Judge in SCB, and to discuss what the future for LEG3 might look like.
Senior Partner, David Pryce is joined by David B. Goodman from Goodman Law Group | Chicago, the firm that represented South Capitol Bridgebuilders.
Archer v Ace (or, The Demise Of LEG3?)
Introduction
In the London Market there is, by and large, a common understanding about how LEG3 and the other defects exclusions operate, and what they are intended to do. That doesn’t mean that disagreements don’t arise about how a particular defects exclusion might apply to a particular set of facts, but those disagreements tend to be relatively rare, and the London Market tends to deal with what we call Construction All Risks claims (or what would be known in the US as Builders’ Risk claims), quite well on the whole.
As a result, those using the defects exclusions in the London Market, whether that is insurers, brokers, or the more sophisticated policyholders, tend to overlook the fact that several of the clauses, in both the LEG and DE suites of exclusions, are actually very difficult to understand for those who come to the clauses with the (surely reasonable) aspiration of wanting to determine the meaning of the clauses from the words that they contain.
Towards the end of last year I wrote about the potential impact of the first Court decision anywhere in the world which considered the meaning of the defects exclusion which (along with DE5, which is much less commonly used outside the UK) is intended to preserve the most generous coverage for damage to works under construction, LEG3, in the case of South Capitol Bridgebuilders v Lexington. That case was decided by a Court in the District of Columbia, but applied the Law of Illinois. Now, like buses, a second decision has been handed down in the US which considers LEG3, this time applying the Law of Florida, in the case Archer Western - De Moya Joint Venture v Ace American Insurance Co.
The decision in SCB sounded alarm bells for the Builder’s Risk community in the US, and presumably also for the LEG Committee, who are responsible for the LEG defects exclusion clauses. It raised at least two questions of significance: what constitutes damage for the purpose of triggering a Builder’s Risk policy; and what is the meaning of the LEG3 clause? Its answers to those questions were striking: property that from an English law perspective would have certainly been regarded as merely being in a defective condition was held by the Court in SCB to have suffered damage. With regard to the meaning of LEG3, the Court in SCB appeared to be unable to form a view, and held that the clause was ambiguous: “egregiously so”.
The big question for those who, like me, have an interest in the health of the Builder’s Risk market, was whether SCB would come to be regarded as an outlier decision, or one that would have a meaningful impact? Archer v Ace suggests the latter.
The judgment in Archer concerns an application for summary judgment by the insurer which was denied, and so the issues in the case will continue towards a substantive trial in due course. However, the judgment runs to some 66 pages, and so the issues were considered in some detail. I am not going to try to cover all of the detail but, as with my article on SCB, am going to focus instead of what the most important elements might mean for the Builder’s Risk market.
The facts
Again, I’ll start with a very brief description of the facts, which up to a point may create a sense of Deja Vu for those familiar with the SCB decision. Once more we have a Builder’s Risk claim relating to inadequate concrete in a bridge under construction. We have a disagreement about whether the works under construction were damaged (so as to trigger the Builder’s Risk policy), or whether the works were merely defective (which would not trigger the policy). We have a policy that contains a LEG3 defects exclusion. And we have disagreements about what LEG3 means, and about how one might establish what constitutes the “improvements” with which LEG3 is concerned.
In Archer the policyholder was a design and build contractor for the snappily titled “I-395/SR 836 Reconstruction / Rehabilitation Project” in Miami, Florida, which included the construction of a “signature bridge”. The design of the bridge involved batches of concrete, the production of which included the addition of “fly ash” from a pressurised fly ash silo, which had a mechanical system which was intended to allow specified amounts of fly ash to be added to the concrete batches. At some point between August and November 2020 the pressure relief valve of the silo failed, so that certain batches were “adulterated by an excessive amount of fly ash”.
I am not my firm’s expert on concrete (the “I ❤️ concrete” mug on my colleague Joanna Grant’s desk probably tells you who is) but, as the Court explained in Archer, although cement and concrete are terms that are often used interchangeably, they aren’t the same. Rather, cement is one of the ingredients of concrete, with the other common ingredients of concrete being fly ash, water, and aggregates. So, the presence of fly ash in concrete is not a problem in and of itself. In fact, in one sense, the more fly ash there is in the concrete, the better, as long as using additional amounts of fly ash does not come at the expense of the amount of cement used. High proportions of both fly ash and cement “generally increases the overall compressive strength of the concrete”. The problem comes when, as in Archer, additional amounts of fly ash are used at the expense of the amount of cement used. Then the compressive strength of the concrete is impaired.
When the policyholder became aware that some of the concrete had inadequate compressive strength, it submitted a claim for indemnity for the cost of repairing the concrete. The insurer denied coverage “reasoning the concrete constituted a defective material due to to the excess fly ash, and `because of this defect the material was never in a satisfactory state and therefore was not damaged’”.
Based on the above, the Court was required to address the following questions:
- Did the insured property suffer damage?
- Is LEG3 ambiguous?
In approaching those questions, the Court applied the test for summary judgment under the Law of Florida, which is that “summary judgment is appropriate where there is ‘no genuine issue as to any material fact’, and the moving party is ‘entitled to judgment as a matter of law’” (per Federal Rule of Civil Procedure 56), and that “when deciding whether summary judgment is appropriate, the court views all facts and resolves all doubts in favour of the non-moving party”.
It also applied the test for ambiguity under the Law of Florida, which is that “a policy is ambiguous only when ‘its terms make the contract susceptible to different reasonable interpretations, one resulting in coverage and one resulting in exclusion’”, and that “if there is an ambiguity, then it is construed against the insurer and in favour of coverage”.
As I did in my SCB article, I’ll explain what the Court held in relation to each issue, and add some comments of my own.
Did the insured property suffer damage?
As with SCB, the policy in Archer didn’t define the term “damage”. However, rather than just going to the dictionary, as the judge had done in SCB, the judge in Archer held that the test for damage had been determined by previous cases, and that it “requires a tangible alteration to the covered property”. That test is largely consistent with the test under English law, which requires a change in the physical condition of the insured property, which impairs the value or the usefulness of that property.
On the facts, and based on the high bar required to give summary requirement, the judge was “not prepared to accept the insurer’s argument that damage to the cement did not involve a physical alteration” and so that issue will remain to be determined at trial.
From an English law perspective, the issue is an interesting one, and the correct answer is not obvious. The correct answer will, in my view, turn on what is considered to be the relevant property: the concrete, or the cement?
If I was representing the policyholder, I would be arguing that the relevant property is the cement, and that the cement has become damaged by being overlaid with excessive quantities of fly ash. We know, from cases such as Hunter v Canary Wharf and R v Henderson, that the deposit onto insured property of excessive quantities of benign substances is capable of constituting damage, where the excessive quantities of those substances cost more money to remove than if ordinary quantities of those substances were present. On that basis, I would argue that the cement has undergone an adverse change in physical condition, that impairs both its value and its usefulness by coming into contact with excessive amounts of fly ash: the policyholder started out with cement which had a particular value, and as a result of the change in physical condition that occurred when the fly ash was added, it no longer retains that value.
If, on the other hand, I was representing the insurer, I would be arguing that the relevant property is the concrete, and that it was in a defective condition from the moment it was created (by the mixing of the cement and the fly ash). I would argue that from that point onwards it didn’t undergo any further “tangible alteration”, meaning that the test for damage hasn’t been satisfied. We know from the Bacardi case that, in English law, the creation of a defective finished product doesn’t constitute damage. Although Tioxide tells us that damage does occur when a defective finished product undergoes a change in physical condition that constitutes a further impairment of value or usefulness, that hasn’t happened in Archer, where the concrete was under-strength as soon as it came into existence, and remained that way until discovery.
So, which material should the Court be concerning itself with, the cement or the concrete? Although, as a policyholder representative, I would like to say that the Court should be concerning itself with the cement, I don’t think that’s right. The property which needs fixing is the concrete. The claim is not for the cost of repairing the cement, but for the cost of repairing the concrete.
On the basis of the above, although the insurer wasn’t successful in obtaining summary judgment on the proposition that the insured property hadn’t suffered damage, I expect the insurer to succeed on that issue at trial.
Is LEG3 ambiguous?
As in SCB, the Court in Archer first considered whether it was ambiguous as to whether LEG3 was an extension or an exclusion. The policyholder had argued that LEG3 is “both a coverage grant and an exclusion”, and the Court held that LEG3 “generates a functional extension, or broadening, of coverage”, as compared with the narrower exclusion which LEG3 had replaced by endorsement.
That doesn’t sound right to me, and in my view that doesn’t reflect the position under English Law. Tesco v Constable makes clear that the main insuring clause of a policy can only be widened by other clauses in the policy by using the clearest terms (and ABN Amro then gave an illustration of just how clear those terms needed to be, i.e very).
The second potential ambiguity in LEG3 was what it means to “‘improve’ the original workmanship”. Here, the Court in Archer didn’t develop the arguments any further than in SCB, and simply agreed that LEG3 was ambiguous in that regard.
So, where does that leave us?
In a few short months two different Courts, applying the law of two different States, have both held that LEG3 is ambiguous. In fact that’s being somewhat diplomatic, and it’s probably more true to say that neither Court could work out what on earth LEG3 was supposed to mean. That being the case, if SCB suggested that there was an opportunity for the LEG Committee to take a fresh look at the drafting of LEG3 and the other defects exclusions, Archer suggests that it really has no option, and that it must do so as a matter of urgency.
If LEG3 is going to be amended (as, in my view, it must), then the LEG Committee also has an opportunity to overhaul the other defects exclusions.
Although the DE clauses and the LEG clauses have different origins, it is not helpful for there to be two different suites of clauses which are so similar to each other. In my view it would be much better for there to be a single suite of clauses which captures the best elements of the current clauses.
So:
- There should be a clause which is concerned with causation, and which excludes the cost of repairing any damage caused by mistakes (which would essentially be a re-drafted, simplified, version of DE1 and LEG1, which both do the same thing);
- There should then be two clauses which are concerned with the condition of the relevant property before the damage occurs. One of those clauses would exclude the cost that would have been incurred to repair any defects which were present in property that has become damaged, if those defects had been discovered immediately before the damage occurred (i.e. a re-drafted, simplified, version of LEG2). The other clause would exclude entirely the cost of fixing damage to property which was in a defective condition immediately before the damage occurred (i.e. a re-drafted, simplified, version of DE3, which one might call LEG2A in the new suite);
- The final clause would exclude only the cost of improvements (i.e. a re-drafted, simplified, version of LEG3). My SCB article proposed an amended version of LEG3, and a few months later I would still stand behind that draft.
Those clauses would be made to be bought together. So, a policy with the most limited cover would contain only LEG1. A policy with wider cover would contain both LEG1, and also either LEG2 or LEG2A (whichever is most appropriate for the type of project involved). A policy with the widest cover would contain LEG1, plus one of LEG2 or LEG2A, and also LEG3. Where a policy contains more than one of the new defects exclusions, the policyholder should be able to choose which to apply in the event of a claim, with each exclusion coming with a different deductible. LEG1 would have the lowest deductible. LEG2 or LEG2A would have a higher deductible, and LEG3 would have the highest deductible of all.
That, in my view, would represent a very healthy outcome for insurers, brokers, and policyholders alike, and constitute a positive response to the issues raised by SCB and Archer: a single suite of defects exclusions; which are simply drafted and easy to understand; and which fit together with each other, and are intended to be used in conjunction with each other.
David Pryce is the Managing Partner at Fenchurch Law
The world’s first LEG3 Court decision, and what it means for the Builders’ Risk market
Introduction
27 years after the London Engineering Group (“LEG”) introduced its suite of defects exclusions, a Court in the District of Columbia in the USA has delivered the world’s first Court decision on the most generous of the three LEG clauses, LEG3, in the case of South Capitol Bridgebuilders v Lexington Insurance Company, No. 21-cv-1436, 2023 US Dist. LEXIS 176573 (D.D.C. Sep 29, 2023). That fact that the Builders’ Risk market (or what we in the UK would call the Construction All Risks, or “CAR” market) has been waiting for a LEG3 decision for this long means that SCB v Lexington was always going to receive a lot of attention. However, the unrestrained and intemperate language used by the Judge means that there is a risk that the decision will create more heat than light, and has the potential to lead to a reaction by Builders’ Risk insurers, particularly in the US, which could negatively affect the interests of policyholders. That would be a great shame, as the availability of appropriate Builders’ Risk insurance is essential for the global construction community. This article therefore attempts to take a step back from the eye-catching language used by the Judge in SCB, and to discuss what a constructive response to the case might look like.
The facts
I’ll start with a very brief description of the facts. The policyholder, SCB, was hired to build the new Frederick Douglas Memorial Bridge, which is a stunningly designed bridge which crosses the Anacostia River in Washington DC, and which is the biggest public works project in the history of the District of Columbia. The design involves three consecutive steel arches on either side of the bridge, which are supported by concrete abutments on either side of the river, and by two v-shaped concrete piers which provide support towards the centre of the river.
The concrete was placed in each of the abutments and piers in separate pours, with workers standing within the formwork and vibrating the concrete in order to achieve even placement. Due to the vibration being carried out inadequately the concrete never achieved even placement, and when the concrete had dried and the formwork was removed, the policyholder saw that the concrete contained voids, referred to as “honeycombing”. The honeycombing diminished the concrete’s weight bearing capabilities, and meant that the concrete had to be repaired so that an even distribution of concrete, without honeycombing, could be achieved.
The policyholder had the benefit of a Builder’s Risk insurance policy issued by Lexington, which contained the 2006 version of the LEG3 defects exclusion. The policyholder submitted a claim to the insurer on the basis that the honeycombing of the concrete constituted “damage” which triggered the main insuring clause of the policy, which was not excluded by LEG3. The insurer refused indemnity on the basis that, in order for there to be damage which triggered the policy it was not sufficient for the honeycombed concrete components to have been in a defective condition from time they were made. Rather, for there to be damage, a subsequent alteration in the physical condition of the concrete components was required.
The insurer also argued that, even if the concrete was damaged, the LEG3 clause excluded coverage because the whole of the remedial works constituted an improvement, on the basis that “if something broken gets fixed, hasn’t that thing been improved?”.
Based on the above the Court (which, although it was in the District of Columbia was applying Illinois Law) was required to address the following questions:
- Did the honeycombing of the concrete components constitute damage, so as to trigger the main insuring clause of the policy?
- Is the meaning of the LEG3 clause unambiguous?
- If the meaning of the LEG3 clause is ambiguous, how should that ambiguity be resolved?
I’ll explain what the Court held in relation to each issue, and add some comments of my own, in turn.
Did the honeycombing comprise damage?
Lawyers from common law jurisdictions who work regularly with policies which are triggered by property damage, whether in relation to works under construction, completed works, or products, will be familiar with the extensive body of authority from around the world in relation to the question of what constitutes “damage”. In this respect it is common for the Courts of a variety of different jurisdictions to look to decisions in other jurisdictions to help inform that issue, not because decisions from other jurisdictions are binding, but because they can be helpful in understanding an issue which has received a significant amount of prior judicial attention.
The insurer in SCB appears to have drawn a significant amount of authority to the Court’s attention, but the Judge could not have been less interested in it (“Lexington does not bother to explain how these non-binding cases are analogous, or why the Court should consider them persuasive”). Ouch. Had the Judge taken the view that the damage authorities were persuasive then the outcome of the case would almost certainly have been different, because most common law jurisdictions clearly do regard damage as a “happening” (which requires a change in physical condition), as opposed to a “condition” (which does not require a change in physical condition). In SCB’s case, there was no change in physical condition, as the concrete components contained honeycombed voids from the outset. According to the authorities in most common law jurisdictions, and certainly in England & Wales, the honeycombing would therefore have meant that the concrete components were in a defective condition from their creation, and the lack of a subsequent change in physical condition would therefore have meant that they didn’t suffer damage.
However, the Judge in SCB not only took the opposite view, but did so in the clearest terms. Asking himself the question of “whether ‘damage’ is properly understood to include the costs of fixing the concrete flaws that weakened the bridge”, he found that “the answer is unambiguously, yes”. So, how did he reach a view that for lawyers in other jurisdictions would find so surprising?
The reason starts with the fact that “damage” was not a term that was defined in the policy issued by Lexington. That meant that under Illinois Law the way to understand the meaning of the term was not to consider any authorities, but to look instead to “plain, ordinary, and popular meaning of the term”. To determine that meaning the Judge looked at Black’s Law Dictionary (10th ed., 2014), which defined damage as “loss or injury to person or property” or “any bad effect on something”.
Applying the above definition, the Judge found that the policyholder’s inadequate vibration of the concrete “caused a decrease in the weight bearing capacity of the bridge and supporting structures”, and that “a decreased weight bearing capacity is surely an injury, or at the very least a bad effect, on the bridge and its support structures”. That analysis may be true as far as it goes, but it can only be justified on the basis that the “decreased capacity” exists in comparison with the intended capacity, and not as compared with a capacity which existed before a change in physical condition which resulted in the decrease. The problem with that approach, is that a decreased capacity as compared with an intended capacity is describing contract works which are in a defective condition, and Builders’ Risk policies are not intended to cover the cost of repairing defective but undamaged property. That is a commercial risk for builders which the Builders’ Risk insurance market isn’t, and never has been, prepared to insure.
That problem is not a small one, in practice. If it is right that, under Illinois Law, property which is in a defective condition triggers an insuring clause which requires “damage”, it gives rise to a risk that Builder’ Risk insurers in that jurisdiction (and other similar jurisdictions) will use another way to ensure that they aren’t required to pay for the cost of repairing defective but undamaged property. One way to do so would be to withdraw the availability of the more generous LEG clauses (LEG2 & LEG3), and restrict cover to LEG1, which excludes the cost of repairing any damage which is caused by mistakes of any kind. That would be a significant backward step for the Builders’ Risk market, and would be a terrible development for affected policyholders.
Fortunately, there is a simple fix, which is that if a Builders’ Risk policy is issued in a jurisdiction which, like Illinois, looks to the dictionary definition of damage if it isn’t defined by the policy, rather than to any of the damage authorities, then insurers and brokers need to ensure that their policies do include a definition of damage. I would suggest the following (other formulations are available):
“Damage means an accidental change in physical condition (whether permanent and irreversible, or transient and reversible) of insured property, which impairs either the value or the usefulness of that property”.
Is the meaning of LEG3 unambiguous?
Both policyholder and insurer argued that LEG3 was unambiguous. The policyholder argued that LEG3 unambiguously provided cover for the cost of repairing the honeycombed concrete components, and the insurer argued that LEG3 unambiguously excluded cover. The Judge disagreed with both parties, finding that “LEG3… is ambiguous, egregiously so”. Ouch (again). Is it, though?
Again, it is important to remember that the Judge was applying Illinois law to the question of ambiguity, and Illinois Law in this respect isn’t necessarily going to be the same as other jurisdictions. It certainly isn’t the same as the approach that would be taken by the English Courts, which only find that a clause is ambiguous if there are competing interpretations which the Court is unable to choose between. According to the Judge in SCB, however, under Illinois Law a clause is ambiguous if it is “subject to more than one reasonable interpretation”. That is a very low bar, and the Judge may well have been right that the low bar was met in this case. Of course, that does not mean that a Judge applying a different test, with a higher bar for ambiguity, wouldn’t have been able to make a finding about what LEG3 does actually mean. However, the SCB Judge’s (too) scathing comments about the drafting of LEG3 may have the positive effect of prompting a re-draft of the clause which addresses an issue with the clause which clearly exists in theory, but which thankfully I haven’t yet seen in practice.
The specific problem with the way in which LEG3 is drafted is that it mixes up causation on the one hand, and the condition of the relevant property, on the other. Defect exclusions should be concerned with either causation (which is the intended focus of LEG1 and DE1) or with the condition of the relevant property (which is the intended focus of DE2, DE3, and DE4), but not with both. The problem with LEG3 is that the exclusionary words which begin the clause (“all costs rendered necessary by [mistakes]…”) are concerned with causation. That part of the clause is a full exclusion for the cost of fixing mistakes of all types, whether workmanship, design, materials, specification, or plan, just as with LEG1 or DE1. There is then a write back (“should damage … occur to any portion if insured property containing any of the said defects…”) which brings back cover for the cost of fixing damage to insured property where the mistakes have been built into the works (with the end of the clause limiting the write back so that it only excludes improvement costs). The problem with that is that the write back is not expressed to extend to cover the cost of repairing damage caused by mistakes which are sustained by property which is not in a defective condition prior to the occurrence of the damage. A literal reading therefore suggests that LEG3 provides greater cover for the cost of fixing damage to defective insured property than it does for the cost of fixing damage to un-defective insured property. That was clearly not the intention of the LEG committee when drafting LEG3, and it is not how CAR insurers in the UK approach LEG3, but unfortunately it is what LEG3 actually says.
Given that damage is required to trigger the insuring clause of a Builders’ Risk policy then, as long as damage is properly defined, the cost of fixing defective but undamaged property should never trigger the insuring clause, and so does not need to be excluded. That being the case, the intention of the current LEG3 clause (which is to only exclude improvement costs) could be achieved by the following much simpler formulation:
“The insurer shall not be liable for that cost incurred to improve the original material workmanship design plan or specification”.
Wouldn’t the above formulation be much easier for policyholders to understand? Clearly yes. In my view nothing useful from the current clause would be lost, but I would be very interested to hearing from anyone who takes a different view (david.pryce@fenchurchlaw.co.uk).
Resolving the “ambiguity”
Having found that LEG3 was ambiguous, the consequence under Illinois Law was that the clause must be “construed against its drafter”, which in this case meant that the clause needed to be construed against the insurer, Lexington. That was the case notwithstanding that, of course, LEG3 is a standard clause that wasn’t in fact drafted by either of the parties in SCB, but by the LEG committee in London, and has been commonly used by parties to Builders’ Risk insurance policies across the world for more than a quarter of a century.
Outcome & final comment
Given the above, the Judge found wholly in favour of the policyholder. As a policyholder representative I can only applaud the effectiveness of the arguments made by SCB’s attorneys, but I am concerned about the potential for the outcome to have a negative effect on Builders’ Risk policyholders in the future. I hope the suggestions above can help those who, like me, want to ensure that doesn’t happen.
I’d like to finish with a final comment on a point that didn’t ultimately affect the outcome in SCB, but which touches on a point of general importance, which is the issue of how to assess improvement costs, which the Judge addressed in an interesting, and quite neat, way. What constitutes improvement costs is an issue that comes up frequently in practice, and there remains no clear guidance from the Courts on how improvement costs should be determined.
In SCB the insurer argued that fixing property which had been defective before the damage occurred must necessarily constitute an improvement. The extension of that argument is that the cost of fixing design mistakes which have resulted in damage must all constitute improvement costs. That interpretation is not only contrary to the intention of LEG3, but is also wrong as a matter of principle for the reasons explained in our previous article (“You have to be pulling my LEG(3)"). The way the Judge dealt with the point in SCB was as follows:
“The context of [LEG3] suggests that to improve means to make a thing better than it would have been if it were not for the defective work”.
That formulation, in my view, works well as far as it goes, and is a useful way to look at what constitutes improvement costs where damage has been caused by workmanship failures. However, it is less clear that it works for damage which is caused by design mistakes, which need to repaired by utilising a superior and more expensive design the second time around. It remains my view that the best way to assess improvement costs is by adopting the three-stage test outlined in our earlier article.
David Pryce is the Managing Partner at Fenchurch Law
Webinar - Damage: A Deep Dive
Agenda
This session will dig deeper into a subject touched upon briefly in David’s recent Defects Exclusions webinar. It will aim to provide a pathway through the leading authorities in relation to the various common types of damage encountered in construction projects, including physical rearrangement, overlaying of insured property with benign substances, and contamination. It will also look at the difference between development and discoverability in a damage context, and will consider the New Zealand case that arguably represents the higher water mark of damage authorities: Technology Holdings v IAG.
Speaker
Webinar - Insurance for Design Mistakes: a PI CAR Case Study
Agenda
This session focuses on the interplay/overlaps between CAR and PI policies in the context of a case study concerning a defectively designed roof which is damaged leading to various losses and claims against the policyholder. In particular, the session provides practical guidance on how the policyholder may approach claims under any CAR and PI policy in tandem including the strategic choices and implications.
Speakers
David Pryce, Managing Partner
Rob Goodship, Senior Associate
Webinar - Defects Exclusions under CAR policies
Agenda
Defects Exclusions give rise to a variety of difficult issues. This webinar will address some of those, including the overlapping concepts of inherent vice, defective condition, damage, and physical damage, as well as considering how to determine the value of what is excluded by the most commonly used clauses.
David Pryce is the Managing Partner of Fenchurch Law