Canada: Builders Take Note: BCCA Upholds Interpretation Of Common Defective Workmanship Exclusion

A unanimous panel of the B.C. Court of Appeal recently upheld a 2014 B.C. Supreme Court decision which interpreted, for the first time, the "LEG 2/96" exclusion clause for defective workmanship common in some Course of Construction insurance policies.

The LEG 2/96 is one of three model defective workmanship exclusion clauses developed by the London Engineering Group, a U.K. think tank that develops policy wording for the insurance industry. By way of comparison, the LEG 1/96 contains the broadest exclusion by excluding recovery for all loss or damage due to defects of workmanship or design. The LEG 3/96 is the narrowest exclusion, as it only excludes the costs incurred to improve the original material, workmanship, or design. The LEG 2/96 falls in the middle and excludes:

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 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 of material workmanship, design, plan or specification.

Course of Construction, or "Builder's Risk," insurance policies seek to insure against certain defined risks which may occur during the construction process.

Background and Decision Below

The Plaintiffs were hired to design and build the new Patient Care Centre, an eight story reinforced concrete structure, at the Royal Jubilee Hospital in Victoria. A subcontractor was hired to design and build the concrete framework, including constructing the thin concrete slabs that comprised the flooring. During construction these slabs over-deflected, causing concave recessions in the middle of some of the slabs, as well as cracking in the slabs, support walls and columns. Although found to be structurally safe, the slabs were functionally defective as they created an uneven flooring surface which did not meet the serviceability requirement under the contract. The Plaintiff claimed indemnification from its Insurers under their Course of Construction Policy (the "Policy") for the costs of repairing the damage. The Insurers argued that all of the damage was excluded from coverage by virtue of the LEG 2/96 exclusion clause included in the Policy.

At trial, Justice Skolrood made a key finding of fact, namely that the design of the slabs was not defective. Rather, the defect was found in the faulty formwork and re-shoring procedures used during construction and the damage was the resulting over-deflection and cracking of the slabs.

Rejecting the Insurers arguments on the issue, Justice Skolrood found the over-deflection constituted damage for the purpose of the Policy, as the slabs were left in an altered physical state. Such damage was fortuitous as the slabs were not designed to deflect to the point of rendering them unfit for their intended purpose. As a result, the loss fell under the "Perils Insured" provision of the Policy and was within the scope of coverage, subject to any exclusion clauses.

This brought the analysis to the central issue in the case – whether the LEG 2/96 exclusion applied. Justice Skolrood found that, while the clause was intended to exclude the costs of the defect, the exclusion is limited to the costs that would have been incurred to remedy the defect immediately before any resulting damage occurred. Thus, the exclusion does not operate to exclude the cost of remedying the damaged property itself; rather, "the excluded costs crystallize immediately prior to the damage occurring and are thus limited to those costs that would have prevented the damage from happening."

Having found that the defect was in the defective formwork and shoring procedures, such preventative costs in this case would be the cost of implementing proper procedures, which would have been minimal. Thus, the exclusion was held not to apply to the cost of repairing the damage to the slabs themselves, and the Plaintiffs were entitled to recover $8.5 million in this regard.

Court of Appeal Ruling

The Insurers appealed the decision to the B.C. Court of Appeal, arguing that Justice Skolrood erred 1) in finding that the damage to the slabs constituted damage to property within the meaning of the Policy, and 2) in finding that the damage was not excluded by the LEG 2/96 exclusion clause.

On the first issue, the Court of Appeal upheld Justice Skolrood's finding that over-deflection, bending and cracking of the slabs constituted damage under the Policy. The uncontested evidence at trial affirmed that the slabs were not defective as designed but were damaged as a result of faulty shoring procedures. The defect was a state of affairs (faulty shoring procedures) and the damage was a result of the occurrence of the over-deflection caused by the defect. Thus, the claim did not arise from a latent defect or economic loss alone, rather, "a fortuitous event occurred when there was greater than anticipated deflection," which caused the slabs to crack. Moreover, the Court held that to accept the Insurers' argument that the slabs were not damaged because they were never in a satisfactory state to begin with would be to "deprive the contractor of any insurance coverage for unfinished work during construction, which cannot be what the parties intended" given that Course of Construction policies are generally intended to cover work in a partially finished state.

The Court of Appeal also dismissed the Insurers' second ground of appeal, finding Justice Skolrood did not err in holding that only the costs to prevent or avoid the damage, which were nil in this case, were excluded. To this end the Court relied on the reasoning in PCL Constructors Canada Inc. v. Allianz Global Risks US Insurance Company, 2014 ONSC 7480, which considered a similarly worded clause. Under such clauses, in order to prevent underperformance by the insured, a deduction is made for the costs of doing the job right the first time. Justice Skolrood's reference to the costs that would have been incurred to rectify the defective workmanship before resulting damage occurred was thus an appropriate description of the application of the clause to the circumstances of this case.

On the second issue, the Insurers also argued that to exclude from coverage only the minimal costs of preventative measures is to give insufficient weight to the commercial context in which the Policy was operating. The Court of Appeal disposed of this argument on two bases. First, it was coincidental that preventative costs were minimal in this case. Such costs could have been quite substantial in different circumstances. Second, if the parties truly intended to exclude all damage caused by faulty workmanship, they could have used language to that effect. In this regard the Court noted that the LEG 1/96 language was available to the parties. Justice Skolrood's interpretation of the LEG 2/96 clause was thus consistent with the words chosen by the parties within the context in which the policy was written.

Potential Significance

This decision confirms that the LEG 2/96 exclusion clause is restricted to denying only those costs that would have been incurred to prevent the damage from happening. Thus, even if the insurer can prove the workmanship or design is defective, in certain circumstances they may not be able to deny the entire claim.

The result in this case was factually driven. Had the defect been found in the slabs themselves, and not simply the shoring and formwork procedures, the LEG 2/96 exclusion likely would have operated to preclude recovery for the majority of the loss. Policyholders should thus be cognizant of the scope of damage when reporting claims under policies utilizing a LEG 2/96 exclusion. It is in the interests of the policyholder to characterize the defect narrowly in order to attract an interpretation of the exclusion that will exclude the least amount of costs.

This case also serves as a good reminder of basic principles of interpretation: the onus is on the insured to bring themselves within the coverage provisions of the policy, which will be construed broadly; the onus is on the underwriter to show an exclusion clause applies, which will be construed narrowly; and ambiguities will be resolved in favour of the insured.

Having been unsuccessful on appeal, the Insurers in Acciona recently filed an application for leave to appeal to the Supreme Court of Canada (36660). Leave was recently granted in Ledcor Construction Limited. v. Northbridge Indemnity Insurance Company et al(36452), a decision of the Alberta Court of Appeal considering the extent to which resulting damage will be covered by a defective workmanship exclusion clause contained in a Course of Construction policy. In finding the exclusion applied to the loss, the Court in Ledcor held that the clause excluded both the cost of redoing the work, and any damage connected to that work. While Ledcor was grappling with a clause using different wording, policyholders should stay tuned to see how Canada's highest court interprets defective workmanship clauses in the context of Course of Construction policies.

Case Information

Acciona Infrastructure Canada Inc. v. Allianz Global Risks US Insurance Company, 2015 BCCA 347

Docket: CA42166

Date of Decision: August 5, 2015

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