James D. Hollyday | Pepper Hamilton LLP | April 2017
One of the principal points of contention between insurers and insureds is whether defective construction work is, or can be, an occurrence, thereby triggering coverage.
The New Jersey Supreme Court has joined a growing number of jurisdictions holding that commercial general liability (CGL) insurance policies may provide insurance coverage to insured general contractors when property damage is the result of defective work performed on the general contractor’s behalf by a subcontractor. Cypress Point Condo. Ass’n v. Adria Towers, L.L.C., 226 N.J. 403, 143 A.3d 273 (N.J. 2016). To put the holding in Cypress Point in perspective, some background will be helpful.
Standard ISO CGL Forms
Since 1971, the Insurance Services Office, Inc. (ISO) has published standard forms of insurance policies. ISO is an organization of insurance companies that provides, among other things, policy-writing services to its member insurers for various lines of insurance, including CGL insurance. The CGL policy form was published by ISO in 1973 and revised in 1986, 1988, 1993, 1998, 2001, 2004, 2007 and 2013. The most significant changes occurred between the 1973 form and the 1986 form. For this reason, all of the revisions in and after 1986 are generally referred to as the 1986 form or the “post-1986” form. When evaluating insurance coverage for defective construction, it is important to be cognizant of the evolution of the ISO forms because cases decided under the 1973 form generally will not be applicable to cases arising under the 1986 form.
The ISO CGL policy form contains a broad “insuring agreement” that, in the first instance, grants coverage. See, for example, ISO CGL Policy Form (CG 00 01 12 07) (December 2007):
SECTION 1 – COVERAGES
COVERAGE A BODILY INJURY AND PROPERTY
1. Insuring Agreement
a. We will pay those sums that the insured becomes
legally obligated to pay as damages because
of “bodily injury” or “property damage”
to which this insurance applies. [emphasis added]
* * *
b. This insurance applies to “bodily injury” and
“property damage” only if:
(1) The “bodily injury” or “property damage” is
caused by an “occurrence” that takes place
in the “coverage territory”; [emphasis added]
* * *
The insuring agreements in the 1973 form and the 1986 form are substantially similar. Both provide 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.” It should be noted that there is nothing on the face of the insuring agreement that limits the insurer’s obligation to pay to sums that the insured is legally obligated to pay for claims sounding in tort (as opposed to claims sounding in contract).
The insuring agreement is followed by a number of exclusions that operate to limit the otherwise broad coverage granted by the insuring agreement. Some of the exclusions are subject to exceptions (which are stated in the exclusion itself). It is well-established that an exception to an exclusion does not create coverage, however. See Auto-Owners Ins. Co. v. Home Pride Cos., 684 N.W.2d 571, 575-76 (Neb. 2004) (holding that an exception to an exclusion does not provide insurance coverage and that an exception to an exclusion is irrelevant until two conditions are met: (1) there is an initial grant of coverage and (2) the exclusion to which the exception applies operates to preclude coverage).
What Triggers Coverage (an Occurrence)
The definitions of “occurrence” in the 1973 form and the 1986 form are similar but not identical. The 1973 form defines occurrence as “as an accident . . . which results in . . . property damage neither expected nor intended from the standpoint of the insured,” while the 1986 form defines occurrence as “an accident,” including “continuous or repeated exposure to substantially the same general conditions.” In both policy forms, the bodily injury or property damages cannot have been expected or intended by the insured. In the 1973 form, this is part of the definition itself. In the post-1986 form, the exclusion of expected or intended injury is made part of Exclusion (a), but the result is the same.
Defective Work as an Occurrence
One of the principal points of contention between insurers and insureds is whether defective construction work is, or can be, an occurrence, thereby triggering coverage. Some courts hold, as a matter of law, that defective construction cannot be an occurrence because the performance of construction work is a volitional act, intentionally performed by the insured. See Kvaerner Metals Div. of Kvaerner U.S., Inc. v. Commercial Union Ins. Co., 908 A.2d 888 (Pa. 2006). The insurance policy at issue in Kvaerner contained a broad form property damage endorsement (Endorsement 16) that provided that the “your work” exclusion “does not apply if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.” Nonetheless, the Kvaerner court held that:
the definition of “accident” required to establish an “occurrence” under the policies cannot be satisfied by claims based on faulty workmanship. Such [faulty workmanship] claims simply do not present the degree of fortuity contemplated by the ordinary definition of “accident” or its common judicial construction in this context. To hold otherwise would be to convert a policy of insurance into a performance bond. We are unwilling to do so, especially since such protections are already readily available for the protection of contractors. 908 A.2d at 899.
Exclusions Generally (and Exceptions to Exclusions)
As noted above, exclusions limit the otherwise broad grant of insurance coverage contained in the insuring agreement. Exclusions, however, are subject to certain exceptions that, in effect, restore the coverage that would have been eliminated by the exclusion.
We begin by examining several of the exclusions under the 1973 form. Exclusion (k) of the 1973 form provided that “this insurance does not apply . . . (k) to property damage to (1) property owned or occupied by or rented to the insured, (2) property used by the insured, or (3) property in the care, custody, or control of the insured or as to which the insured is for any purpose exercising physical control . . . .” [emphasis added]. Thus, Exclusion (k) effectively, by its terms, precluded coverage for damage to property being worked on by a contractor.
In addition, Exclusion (o) in the 1973 form also excluded coverage for “property damage to work performed by or on behalf of the named insured arising out of the work or any portion thereof, or out of materials, parts, or equipment furnished in connection therewith.” [emphasis added].
Therefore, in practical effect, under the 1973 form, there was no coverage for property damage to property in the care, custody or control of the insured and no coverage for damage to the work arising out of the work, regardless of whether the work was performed directly by the named insured or performed on behalf of the named insured by a subcontractor.
Broad Form Property Damage Liability Coverage
In 1976, the ISO issued an endorsement known as the Broad Form Comprehensive General Liability Endorsement. Part VI of the endorsement provided for Broad Form Property Damage Liability (Including Completed Operations) (the BFPD Endorsement). The BFPD Endorsement replaced Exclusion (k) and Exclusion (o) with new language. Specifically, the damage to property Exclusion (k) was limited to damage to “that particular part” of any property on which operations were being performed by, or on behalf of, the named insured. Thus, with the BFPD Endorsement in place (for the payment of an additional premium), it was only the property damage to “that particular part” of the property that had defective work performed on it that was excluded from coverage. Property damage to other property was, by operation of the BFPD Endorsement, now covered. Similarly, with respect to Exclusion (o), the BFPD Endorsement deleted the phrase “or on behalf of [the named insured],” thereby providing coverage for damage to work performed by subcontractors of the named insured.
A number of cases construed the 1973 ISO form with the BFPD Endorsement to provide coverage when the defective work was performed by subcontractors. In 1988, the leading case to construe the “work performed” exclusion in light of a BFPD Endorsement was decided by the U.S. Court of Appeals for the Ninth Circuit. Fireguard Sprinkler Sys., Inc. v. Scottsdale Ins. Co., 864 F.2d 648 (9th Cir. 1988) (applying Oregon law). Fireguard entered into a contract to upgrade a fire protection system at a sawmill in Washington state and hired a subcontractor to design and construct a water tank (including site preparation). After the project was completed and accepted by the owner, a landslide destroyed the tank and other parts of the project, and the owner sued Fireguard. The court held that the modified “work performed” exclusion did not exclude coverage under Fireguard’s general liability insurance because the damages arose out of work performed by a subcontractor. The court reached this conclusion, in part, on the basis of an insurance industry publication known as a “Fire, Casualty and Surety Bulletin,” published by the National Underwriters Association in 1982, that explained the intent of the BFPD Endorsement as follows:
[A]n insured has coverage for his completed work when the damage arises out of work performed by someone other than the named insured, such as a subcontractor. And the insured has coverage for damage to the work of others that arises from the named insured’s work. The usual Completed Operations coverage (no Broad Form Property Damage endorsement attached) flatly excludes property damage to work performed by or on behalf of the named insured arising out of the work. Under the usual coverage, then the insured has no insurance whatsoever, for damage to a subcontractor’s work or for damage to his work resulting from a subcontractor’s work. Therein lies the advantage of Broad Form Property Damage coverage including Completed Operations. Consequently, if an insured does not anticipate using subcontractors, the value of purchasing Broad Form Property Damage Coverage with Completed Operations is questionable, in view of the additional premium required for it. 864 F.2d at 652.
Other jurisdictions followed Fireguard in interpreting the 1973 form with the BFPD Endorsement. See M. Mooney Corp. v. USF&G, 136 N.H. 463, 618 A.2d 793 (N.H. 1992) (construing the 1973 form, where, as a result of subcontractor’s faulty work, fire occurred in one condominium, costs to repair all condominiums and resulting loss of use were covered under general contractor’s insurance); McKellar Dev. of Nevada, Inc. v. N. Ins. Co., 837 P.2d 858 (Nev. 1992) (damage to apartment buildings that were “falling apart” as a result of improper soil compaction performed by a subcontractor was covered under general contractor’s liability insurance with BFPD Endorsement).
That is the way things stood from 1976 until 1986, when the ISO issued a revised standard CGL policy. Starting in 1986 and continuing to the present, the standard policy has included the Broad Form Property Damage coverage as part of the completed operations hazard. Exclusion (l) in the current form provides as follows:
This insurance does not apply to:
l. “Property damage” to “your work” arising out of it or any part of it and included in the “products-completed operations hazard.”
This exclusion does not apply if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor. [emphasis added].
Note that, by its express terms, in the 1986 form, the “your work” exclusion will not apply to claims arising from work performed by subcontractors.
In light of this background, we turn now to the Cypress Point decision.
The Cypress Point Decision
The case arose from the construction of Cypress Point, a luxury condominium complex in Hoboken, New Jersey. The project developer also served as the general contractor and hired subcontractors to perform most of the work. The developer as general contractor obtained a total of seven CGL policies modeled after the 1986 ISO policy form — four policies covering a four-year period and three covering a subsequent three-year period. After completion of the complex, residents began experiencing problems, such as roof leaks and water infiltration around windows in units and common areas.
The condominium association brought an action against the developer and several subcontractors, alleging faulty workmanship during construction and claiming various consequential damages. The association alleged that the subcontractors’ faulty workmanship during construction — including, but not limited to, defectively built or installed roofs, gutters, brick facades, EIFS (exterior insulation and finish system), windows, doors and sealants — caused consequential damage to steel supports; exterior and interior sheathing, sheetrock and insulation; the common areas; interior structures; and residential units. The complaint asserted claims of negligence, breach of express warranties, breach of implied warranties, negligent misrepresentation, and breach of contract.
The complaint was eventually amended to include a claim by the association seeking a determination (a declaratory judgment) as to whether the association’s claims against the developer were covered by the developer’s CGL policies. The insurers moved for summary judgment, arguing that they were not liable because the subcontractors’ faulty workmanship did not constitute an “occurrence” that caused “property damage” under the policies. The trial court granted summary judgment because the damages arose entirely from faulty work performed by, or on behalf of, the developer.
The Appellate Division reversed the trial court’s grant of summary judgment in favor of the insurers:
We hold that the unintended and unexpected consequential damages caused by the subcontractors’ defective work constitute “property damage” and an “occurrence” under the policy. We base this holding in part on the developer’s reasonable expectation that, for insurance risk purposes, the subcontractors’ faulty workmanship is to be treated differently than the work of a general contractor. We reach that conclusion by viewing the policy as a whole and distinguishing Weedo v. Stone-E-Brick, Inc., 81 N.J. 233, 405 A.2d 788 (1979), and Firemen’s Insurance Co. of Newark v. National Union Fire Insurance Co., 387 N.J. Super. 434, 904 A.2d 754 (App.Div.2006), two opinions construing ISO’s 1973 standard CGL form (the “1973 ISO form”). Cypress Point Condo. Ass’n v. Adria Towers, L.L.C., 441 N.J. Super. 369, 373, 118 A.3d 1080, 1083 (N.J. App. Div. 2015).
The Appellate Division distinguished Weedo and Fireman’s Insurance “because they (1) involved only replacement costs flowing from a business risk, rather than consequential damages caused by defective work; and (2) interpreted different language than the policy language in this appeal.” Id. at 441 N.J. Super. 369, 378, 118 A.3d 1080, 1085.
The New Jersey Supreme Court affirmed the Appellate Division and held that “the term ‘accident’ in the policies at issue encompasses unintended and unexpected harm caused by negligent conduct. That construction of the term ‘accident’ as relates to an ‘occurrence’ in a CGL policy aligns with both the commonly accepted definitions of ‘accident’ and the legal import given to the term by both this and other jurisdictions,” citing, among other cases, American Family Mut. Ins. Co. v. American Girl, Inc., 673 N.W. 2d 65, 70 (Wis. 2004) (finding an “accident” and therefore an “occurrence” when “neither the cause nor the harm was intended, anticipated or expected”). Cypress Point Condo. Ass’n, 226 N.J. 403, 427, 143 A.3d 273, 287.
Applying that definition, the court then turned to the question of whether the consequential water damage to the completed, nondefective portions of Cypress Point resulting from the subcontractors’ poor workmanship was foreseeable. The court summarized the argument of the insurers as follows:
Here, no one claims that the subcontractors intentionally performed substandard work that led to the water damage. Rather, relying on Weedo, the insurers assert that damage to an insured’s work caused by a subcontractor’s faulty workmanship is foreseeable to the insured developer because damage to any portion of the completed project is the normal, predictable risk of doing business. Thus, in the insurers’ view, a developer’s failure to ensure that a subcontractor’s work is sound results in a breach of contract, not a covered “accident” (or “occurrence”) under the terms of the policies. 226 N.J. 403, 427,143 A.3d 273, 287.
The court disagreed and held that the argument that a breach of contract cannot give rise to a covered “occurrence” is not consistent with the express policy language, citing American Family Mut. Ins. Co. v. American Girl, Inc., and U.S. Fire Ins. Co. v. J.S.U.B., Inc., 979 So.2d 971 (Fla. 2007) (rejecting CGL insurer’s “argument that a breach of contract can never result in an ‘accident,’“ because such an assertion “is not supported by the plain language of the policies”). Cypress Point Condo. Ass’n, 226 N.J. 403, 427,143 A.3d 273, 287.
The court then turned to the final two steps of its analysis “in which we examine the policies’ pertinent exclusions, and then, if applicable any exceptions to those exclusions.” Id. In concluding that consequential water damage to the competed portions of the Cypress Point project were covered losses, the court held that the subcontractor exception to the “your work” exclusion provided coverage:
The policies at issue here, like those in Weedo and Firemen‘s, contain numerous exclusions eliminating coverage for a variety of business risks including the cost of repairing damage to the contractor’s own work–the “your work” exclusion. As outlined above, the “your work” exclusion precludes coverage under the policies for ” ‘property damage’ to ‘your work’ arising out of it or any part of it.” Thus, under the second step of our three-part analysis, and viewing that exclusion in isolation, the policies would seem to eliminate coverage for the water damage to the completed sections of Cypress Point.
However, the “your work” exclusion contains an important exception that “narrow[s] the exclusion by expressly declaring that it does not apply ‘if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor.’ ” This exception to the “your work” exclusion was not contained in the  ISO CGL form, but unquestionably applies in this case. Accordingly, the third and final step of our inquiry compels the conclusion that, because the water damage to the completed portions of Cypress Point is alleged to have arisen out of faulty workmanship performed by subcontractors, it is a covered loss. 226 N.J. 403, 429-30,143 A.3d 273, 289 (internal citations omitted).
With its decision in Cypress Point, the New Jersey Supreme Court joins a growing trend in the state and federal courts. In the next section, we review the cases in Wisconsin and Florida cited by the court in Cypress Point.
Wisconsin (American Family Mut. Ins. Co. v. American Girl, Inc., 673 N.W.2d 65 (Wis. 2004))
The Supreme Court of Wisconsin was among the first to address CGL coverage for damage caused by defective construction in accordance with the terms of the post-1986 policy form. In American Family Mut. Ins. Co. v. American Girl, Inc., 673 N.W.2d 65 (Wis. 2004), the court held that, when defective soil compaction performed by a subcontractor caused structural damage to a large warehouse facility that rendered the building unsafe and resulted in the demolition of the entire building, the contractor had coverage under its CGL policy. The court summarized the three steps in its analysis as follows:
Our procedure follows three steps. First, the court examines the facts of the insured’s claim to determine whether the policy’s insuring agreement makes an initial grant of coverage. If it is clear that the policy was not intended to cover the claim asserted, the analysis ends there. If the claim triggers the initial grant of coverage in the insuring agreement, the court next examines the various exclusions to see whether any of them preclude coverage of the present claim. Exclusions are narrowly or strictly construed against the insurer if their effect is uncertain. The court analyzes each exclusion separately; the inapplicability of one exclusion will not reinstate coverage where another exclusion has precluded it. Exclusions sometimes have exceptions; if a particular exclusion applies, the court then looks to see whether any exception to that exclusion reinstates coverage. An exception pertains only to the exclusion clause within which it appears; the applicability of an exception will not create coverage if the insuring agreement precludes it or if a separate exclusion applies. Id. at 73.
The insurer argued that, because the claims against the insured contractor arose from its contract, the economic loss doctrine precluded recovery in tort. The court held that the language of the CGL policy can provide coverage for claims sounding in breach of contract in some instances, noting that “the question here is not whether [the building owner] is confined to a contract remedy rather than a tort remedy in its claim against the contractor (we assumed for the purposes of this opinion that it is), but whether [the contractor’s] insurance policy covers the loss.” Id. at 75, n. 4. The court held that the contracting parties allocated their risks by contract, and the contractor insured against that risk when subcontractor fault gives rise to liability under the warranty, because the underlying insurance policies contained a subcontractor exception to the business risk exclusion. Id. The court acknowledged that CGL policies do not generally cover contract claims arising out of the insured’s defective work or product, “but this is by operation of the business risk exclusions, not because a loss actionable only in contract can never be an occurrence within the CGL’s initial grant of coverage.” Id. at 76.
The court held that there had been an occurrence because “no one seriously contends that the property damage to [the building] was anything but accidental (it was clearly not intentional), nor does anyone argue that it was anticipated by the parties.” Id.
The court then turned to the exclusions. The court held that Exclusion (a), which eliminates coverage for “‘property damage’ expected or intended from the standpoint of the insured,” did not apply, as there was no evidence that the extreme settlement that occurred was expected or intended. The court held that Exclusion (b), the exclusion of contractually assumed liability, applies only to the assumption of the liability of a third party, as in an indemnification or hold-harmless agreement. Id. at 81. Finally, the court evaluated the business risk exclusions and held that the contractor’s work plainly fell within the policy definition of “your work” and that under Exclusion (l) the subcontractor exception applied. After summarizing the changes to the CGL policy in 1986, the court held that:
Cases in Wisconsin and in other jurisdictions have consistently recognized that the 1986 CGL revisions restored otherwise excluded coverage for damage caused to construction projects by subcontractor negligence. In Kalchthaler [v. Keller Constr. Co., 591 N.W.2d 169 (Wis. App. 1999)], the court of appeals concluded that ‘the only reasonable reading of [the 1986 exception] is that it restores coverage for damage to completed work caused by the work of a subcontractor. 673 N.W.2d at 83.
Florida (U.S. Fire Ins. Co. v. J.S.U.B., Inc., 979 So.2d 971 (Fla. 2007))
The Supreme Court of Florida has held that defective construction performed by a subcontractor can be an occurrence under a post-1986 CGL policy, regardless of whether the resulting damages is to a third party or the property of a third party or to the completed project itself. U.S. Fire Ins. Co. v. J.S.U.B., Inc., 979 So.2d 971 (Fla. 2007). There, J.S.U.B., as general contractor, contracted for the construction of several homes. After completion and delivery of the homes, damage to the foundations, drywall and other interior portions of the homes appeared. It was undisputed that the damage was caused by a subcontractor’s use of poor soil and improper compaction of the soil beneath the foundations.
The issue before the court was “whether a post-1986 standard form commercial general liability policy with products-completed operations hazard coverage, issued to a general contractor, provides coverage when a claim is made against the contractor for damage to the completed project caused by a subcontractor’s defective work.” Id. at 877. The insurer did not argue that any of the policy exclusions apply to bar coverage. Id.
U.S. Fire argued that a subcontractor’s faulty workmanship that damages the contractor’s own work can never be an “accident” because its results in foreseeable damages. In rejecting any distinction between faulty workmanship that damages the contractor’s work from faulty workmanship that damages the property of a third party, the court held that:
we fail to see how defective work that results in a claim against the contractor because of injury to a third party or damage to a third party’s property is “unforeseeable,” while the same defective work that results in a claim against the contractor because of damage to the completed project is “foreseeable.” This distinction would make the definition of “occurrence” dependent on which property was damaged. For example, applying U.S. Fire’s interpretation in this case would make the subcontractor’s improper soil compaction and testing an “occurrence” when it damages the homeowners’ personal property, such as the wallpaper, but not an “occurrence” when it damages the homeowners’ foundations and drywall. Id. at 883.
The appropriate consideration, the court held, is whether the damage was expected or intended from the point of view of the insured, not whose property was damaged. Id. at 885.
The court also rejected the insurer’s argument that a breach of contract can never result in an accident based on the plain language of the policy, citing with approval American Family Mut. Ins. Co., and held that, if U.S. Fire intended to preclude coverage based on the nature of the cause of action asserted against the insured, it was incumbent on U.S. Fire to include clear language to accomplish this result. 979 So.2d at 884.
The court summarized its holding as follows:
We conclude that faulty workmanship that is neither intended nor expected from the standpoint of the contractor can constitute an “accident” and thus an “occurrence” under a post-1986 standard form CGL policy. We further conclude that physical injury to the completed project that occurs as a result of the defective work can constitute “property damage” as defined in a CGL policy. Accordingly, we hold that a post-1986 standard form commercial general liability policy with products completed-operations hazard coverage, issued to a general contractor, provides coverage for a claim made against the contractor for damage to the completed project caused by a subcontractor’s defective work provided that there is no specific exclusion that otherwise excludes coverage. Id.
With its decision in Cypress Point, the New Jersey Supreme Court joins a growing number of state and federal courts holding that defective construction work performed by a subcontractor, on behalf of an insured contractor, is an “occurrence” and that resulting consequential damage to nondefective portions of the insured contractor’s work, including nondefective work performed by other subcontractors of the insured contractor, is “property damage” for which there is coverage under the post-1986 CGL policy form.