California has held for at least a decade that in order for there to be insurance coverage under a standard Comprehensive General Liability for a claim arising out of a construction project, including a duty to defend by the insurer, there must be damage to other property, not solely to the property on which the insured worked. (See F&H Construction v. ITT Hartford Ins. Co. (2004) 118 Cal.App.4th 364.) The recent decision of Regional Steel Corporation v. Liberty Surplus Insurance Corporation (May 16, 2014, No. BC464209) __ Cal.App.2d. __ [2014 WL 2643242] (Regional Steel), in the California Court of Appeal highlights a not uncommon problem in construction actions, and several ramifications for owner/general contractors (GCs) to consider at project inception to alleviate and mitigate these issues are outlined below.

The facts of this dispute are not unfamiliar, and could be substituted for many projects by changing the name, location, and nature. Here, the owner/GC of a 14-story mixed-use apartment project hired a subcontractor to erect the steel and another subcontractor to pour concrete. The owner also retained Quality Assurance, presumably, to do just that. As a part of the construction process, the steel subcontractor (Regional) submitted shop drawings during a four-month period. The owner/GC and the owner’s engineer approved the drawings, which identified two types of seismic hooks. Four months after the last shop drawing approval, the City issued a correction notice requiring the exclusive use of only one type of hook. The owner became aware of the problem four months after the correction notice, and thereafter stopped further concrete pours until the hook issue was resolved. The City then notified the owner/GC that the first three levels and part of the fourth level of the building had defective hooks and required repairs. The owner/GC withheld $545,000 of Regional’s progress payments as a result. Not surprisingly litigation followed, including a claim against Regional for the defective hooks, the engineer for approving the shop drawings, the concrete subcontractor for not catching Regional’s error, and Quality Assurance for, well, not providing quality assurance. The owner/GC alleged that it was damaged because completion of the project was delayed, resulting in loss of use, loss of rental income, and other damages. Thereafter, the owner/GC filed a first amended cross-complaint adding claims based upon theories of negligence and negligent interference with economic advantage, and asserted claims against the parties’ performance bonds.

After Regional tendered the claims against it to its insurer (Liberty), the insurer investigated the claims, analyzed the allegations, and determined that there were no covered claims. Regional apparently agreed, as it didn’t challenge the denial, but over a year later re-tendered the claim alleging that there were resulting damages to the owner from the installation of the defective hooks. The problem, in part, was that the owner in its claims, and the discovery in the underlying action, didn’t bear out the new resulting damages claims, e.g., out-of-level floors and cracking concrete due to the hooks. In the interim, the underlying parties settled the lawsuit, without Liberty, and described many of the damages to be “damage to … tangible property” in the release. Thereafter, Liberty denied the tender, and Regional sued.

On Liberty’s motion for summary judgment, the trial court ruled that it owed no duty to defend and no duty to indemnify where Regional could show no coverage, including among other items, damage to property other than the insured’s own work. The appellate court affirmed the trial court’s decision after a thorough analysis of the apparently conflicting decisions of Armstrong World Industries, Inc. v. Aetna Casualty & Surety Co. (1996) 45 Cal.App.4th 1 (Armstrong), and Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc. (2000) 78 Cal.App.4th 847 (Shade), which found coverage for claims against prior decisions finding no coverage. The court clarified: “[h]ere, however, Armstrong and Shade are inapposite because they involved contamination by hazardous materials that were incorporated into a whole, and did not involve the incorporation of defective workmanship in to a construction project. California cases consistently hold that coverage does not exist where the only property ‘damage’ is the defective construction, and damage to other property has not occurred. Under that thesis, there is no coverage for Regional’s use of defective tie hooks.”  Regional Steel, supra, 2014 WL 2643242, at p. *8.

The court further held that the prior decisions following this distinction “are consistent with the basic purpose of liability policies, which, as explained by the court in Maryland Casualty Co. v. Reeder (1990) 221 Cal.App.3d 961, ‘are not designed to provide contractors and developers with coverage against claims their work is inferior or defective. [Citation.] The risk of replacing and repairing defective materials or poor workmanship has generally been considered a commercial risk which is not passed on to the liability insurer. [Citations.]…’”  Id. at p. *7. The court also summarily addressed the nature of the policy, a “wrap” by endorsement, and several common policy exclusions, finding that there was no coverage basis by which Regional was otherwise owed a defense or indemnity based upon the evidence.

While the outcome of the coverage case is not unexpected given the facts, the case also highlights several areas of project risk management for the perceptive owner and GC:

1. The importance of good project contract documents: while the parties to the lawsuit reflect the common “shotgun” theory of litigation, the brief description of the underlying facts begs the question of who – if anyone – was responsible (other than the steel subcontractor) for the failure to catch the use of defective hooks, and why it took four floors and the City to identify the error (and the owner four months after the City issued a correction notice to stop further concrete work)?

    

2. The importance of good “hands on” project risk management: again, why didn’t anyone catch the hook error until the fourth floor had been built? Paper management is one thing, active and effective quality control is another. Even if the “catch” wasn’t in the shop drawing phase, there were plenty of potential “eyes” that could have caught the error on the first floor and saved substantial time and money. I’m sure everyone is grateful the “catch” wasn’t delayed until the 13th floor, but were there qualified personnel randomly verifying basic work?

    

3. The importance of understanding what insurance covers: understandably the steel subcontractor would have preferred insurance coverage to bond coverage (under which the surety has extensive indemnity rights against the subcontractor), but for the owner, had it not secured a bond (hopefully the bond provided coverage and the bond requirements were followed), it would likely be looking at a collection issue, even if it had a solid liability case against the steel subcontractor.

    

4. The importance of bonds: while the case does not discuss the resolution of the bond issue, not having a performance bond would have meant that the owner would have had to look to the assets of the steel subcontractor itself (and any other liable parties) given that liability insurance was not an option for recovery. While bonds add to the cost of a project, so does insurance, and they cover very different risks.

    

5. Considering coverage in claims: the steel subcontractor’s counsel was apparently diligently seeking evidence and the ability to secure coverage for their client, but how much of the underlying facts would or could have borne out a defense or some indemnity is always a factor to be considered when the claim first arises – is there an ability to muster additional evidence prior to the settlement and not simply use conclusive language in the release?