There has been much debate in the London insurance market about the decision of Judge Royce in the US District Court of Columbia (the Court) and the stated views on the application of LEG3 (London Engineering Group).
The forthright criticism of the standard clause may have repercussions in other cases involving LEG3, bearing in mind the LEG clauses (or derivatives thereof) are used in most global major engineering and construction projects.
The case concerns the construction of the Frederick Douglas Memorial Bridge in Washington DC. The contractors, South Capital Bridgebuilders (SCB), procured a “completed value builder’s risk” policy from Lexington Insurance Company (Lexington) to insure them against damage to insured property.
During the course of the works, the abutments and two piers for the bridge were constructed in situ by multiple concrete pours utilising formwork. To ensure even placement, workers vibrated the concrete for uniform distribution. However, due to defective workmanship in the vibration of the concrete, structural deformities (known as “honeycombing” and “voiding”) were observed when the formwork was removed. The honeycombing/voids were apparently several feet long, deep and visible to the eye.
SCB replaced significant portions of the bridge’s supportive structures and sought reimbursement from Lexington who denied coverage. SCB then issued proceedings. The court held that the honeycombing/voids constituted damage which triggered the main insuring clause of the policy.
The Court considered the policy was very poorly drafted and they took issue with Lexington’s arguments in relation to the effect and application of its terms.
The LEG3 clause in question read as follows:
“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 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.
All other terms and conditions of the policy remain the same.”
The policy insured against “all risks of direct physical loss of or damage to insured property.” The Court noted there was no separate definition of damage.
There was an exclusion for damage “caused by” faulty or defective workmanship or materials with cover for ensuing damage and, separately, an exclusion for faulty or defective design, plan or specification, on similar terms.
There was also an endorsement for a LEG3 clause but, somewhat bizarrely, it was noted as an extension, and it only sought to override the exclusion for defective design etc, not for defective workmanship.
Of concern is the Court's views (and apparent lack of distinction) on what is a defect and what is damage under the policy.
In order to trigger the policy, SCB needed to demonstrate there had been damage to the works. Without a definition of damage in the policy, the Court instead relied on Black’s Legal Dictionary. This defined damage as “loss or injury to person or property” and quite imprecisely as “any bad effect on something.”
Utilising this definition, the Court had no hesitation in finding that SCB’s inadequate vibration caused a decrease in the weightbearing capacity of the bridge and its support structures. This decreased structural integrity of the bridge, being a “bad effect” on the bridge and its support structures.
When the Research Study Group 208B produced the Insurance Institute of London, “Construction Insurance” report, they noted, “The terms ‘loss’, ‘damage’ and ‘property’ are seldom defined in the policy and are therefore intended to have their everyday meaning”.
The Court, however, were seemingly perturbed by the lack of a definition and resorted to a legal dictionary. It begs the question that even if a standard London market damage definition had been used, such as “physical loss, physical destruction or physical damage to material property”, would the Court have determined that the policy had been triggered by the defective workmanship? From comments made in the judgment, the answer is yes.
It is intuitive that when assessing the cases that Lexington relied on, and dismissing their relevance on the basis none involved a similar construction project or similar insurance policy, the Court referenced case law to the effect that, unlike Builders Risk polices, Commercial General Liability policies “… are not intended to pay the costs of repairing and replacing the insured's defective work and products”.
Whilst the Court repeatedly stated that the “damage” was the decreased weightbearing capacity of the bridge, this appears to be damage likely to occur in the future. This is supported by page 12 of the judgment which states “(the abutment) could support the dead load of the structure, but it had been damaged to the point it could not support the live load of the next stages of construction.”
It follows that the decreased weightbearing capacity did not cause damage at the stage of the concrete pour. Presuming the piers and abutments would be constructed before the arches and bridge deck, no weightbearing was required at the stage of the works when the defective vibration was undertaken. If that is correct, the Court’s finding concerns potential future damage, a situation one might argue was at the insured’s risk.
Further, when discussing damage used in the LEG3 context, (Colin Edelman KC’s 2006 addition of “which for the purposes of this exclusion shall include any patent detrimental change in the physical condition of the Insured Property”), the Court held that “In addition” to causing a decreased structural integrity “of the bridge and its parts”, with respect to just the honeycombing and voiding “…it was undoubtedly obvious or apparent that there was a detrimental change in condition.”
On this basis, the policy would appear to be nothing more than a form of construction guarantee.
The Court uses some pejorative language in their assessment of LEG3 (“internally inconsistent and bordering incomprehensible”) and states that they will “untangle the tortured language of the Extension”. In reality, the Court only looked at the definition of damage and the intention behind the exclusionary language in the LEG clause for the costs incurred to improve.
There is no analysis on the LEG3 requirement for the defect and damage to be in the same “portion”, nor what comparison is intended by the wording of the exclusion, to assess what is an improvement. The improvement excluded requires a comparison with “the original material workmanship etc.” There appears to have been no consideration as to what is meant by “original”.
LEG3 was referenced as an extension to the policy in that it offered a broader cover than the clauses it was meant to replace. Therefore, it “fundamentally extends what SCB is entitled to recover”.
The Court also noted that LEG3 provides a definition for “damage” specific to LEG3 and a limitation on “damage” applicable throughout the policy, as set out in the rider to LEG3. In terms of damage, the Court noted that the “patent detrimental change” requirement is only for the purposes of the exclusion. The Court found that, in any event, the reduction in the weightbearing capacity of the bridge, as well as the honeycombing, was a fundamental change.
However, the Court determined that the rider did not exclude defects “caused by” workmanship but only defects “solely by virtue of the existence” of the workmanship. This, they decided, equated to defects of material workmanship “in and of themselves”. As SCB were also claiming for decreased structural integrity, this was not a claim “solely” for defective workmanship.
There is confusion here as the Court also stated that the honeycombing and voids (workmanship errors) were a detrimental change and therefore damage.
There is also confusion in relation to application of the exclusion of the replacement or rectification costs to improve the original workmanship. SCB suggested the improvement exclusion meant “making it better than originally planned”, with which the Court concurred. The Court further explained that if SCB decided to “replace the defective concrete with solid gold, or otherwise upgrade it”, they could not seek the cost of the enhancement.
However, this analogy is not a reference to workmanship repairs but to an enhancement of materials. SCB were not seeking to argue that the concrete was defective, such that it needed replacing with gold or any other material. The issue related to the workmanship of the concrete. An incorrect analogy is being used to try and explain the improvement.
In holding that SCB’s and Lexington’s ideas of improvement were both reasonable interpretations of the clause, it was determined that there is an ambiguity and, as such, under Illinois law, it is construed against Lexington.
In fact, it is possible, on the wording of LEG3, to look at the exclusion of the improvement in a number of ways, being either:
(a) An exclusion of the whole of the cost of those works which constitute improvements, or
(b) Those costs expended to bring the defective property to its designed (original) condition, or
(c) The extra over costs of improvements upon the original intention of the works.
Under the principles of English and Welsh law, this decision, even without a precise definition of damage in the policy, is difficult to understand. The claim proceeded on the basis of a defect that was built into the works. In England and Wales, this claim would not trigger cover. It begs the question, under what circumstances would the Court have determined that the workmanship was merely a defect and not damage?
On the basis of the decision when writing business in North America, underwriters may have to define and distinguish defect and damage. This could be wording in the policy definitions along the lines of:
“For the purposes of this policy:
Defect means the quality of the item built into the works or constructed that makes the works less valuable or less fit for purpose than is intended.
Damage means a fortuitous physical loss or physical alteration to the works that is adverse and impairs the value or usefulness of the property and that is different from and incrementally greater than the Defect.”
Obviously, any change in the definition of damage and defect in the insuring clause will need to be reflected in the LEG clauses.
For policies where the jurisdiction is English and Welsh, due to the plethora of case law on what constitutes a defect/damage, arguably there is no need for a definition of damage, as per the 208B study. If however, insurers wished to clarify the position, they could utilise a derivative of the definition above.
Whilst this decision, and the phraseology used by the Court, will be seen as a slight on those who drafted the LEG clauses, it is interesting to note that, despite the original intention of the clauses to be used in engineering risks, seemingly due to insurers and brokers understanding of the intention of the LEG clauses, they are now utilised extensively in CAR policies for major projects around the world.
Whilst this may have been the first court decision on LEG3, numerous arbitrations have highlighted issues with the LEG wordings and this decision merely emphasises that clauses, initially drafted 27 years ago (with the LEG3 amendment in 2006) and used beyond their original intention, now require a review.