By Samantha Ip
In the recent decision of South Capitol Bridgebuilders v Lexington Insurance Company, No. 21-cv-1436, 2023 US Dist. LEXIS 176573 (D.D.C. Sep 29, 2023) (“South Capital”), the United States District Court for the District of Columbia created history by conducting the first detailed examination of the LEG 3 exclusion in the context of determining coverage for a loss during the course of construction under a builders risk policy. In so doing, the court created some hullabaloo in finding that voids, or “honeycombs” in concrete resulting from a contractor’s negligence could be considered “damage” under a property policy.
Insurance professionals may ask, what about the requirement that there be resulting physical alteration of covered property in order to qualify as “damage”?
To answer that question, I will first provide a brief history of LEG exclusions in builders risk policies, summarizing some key Canadian decisions on what constitutes “damage” in property policies. I will then discuss the South Capital decision which deals with both of these topics.
History of LEG Exclusions
Our Supreme Court of Canada has determined that the purpose of builders risk policies, also known as course of construction policies, is to provide construction projects with stability by granting insurance coverage that reduces the need for litigation, recognizing the complexity of construction projects which involve many construction parties.[1] When issues arise on the construction site, as they inevitably do, builders risk policies provide coverage that allows the project to continue rather than to “grind to a halt” as a result of litigation.[2]
In 1996, the London Engineering Group (“LEG“), a consultative body for insurers of engineering class risks, developed a series of three exclusion clauses relating to defects, with LEG 3/06 being revised ten years later. These exclusions operate to varying degrees to exclude coverage in whole or in part for the losses arising after a defect is discovered:
LEG 1 – 96 – The “outright” defects exclusion excludes “loss or damage due to defects of material workmanship design plan or specification”.
LEG 2 – 96 – The “consequences” exclusion excludes costs that would have been incurred had the defect been rectified just before the physical damage occurred, but all other costs incurred due to the defect are covered.
LEG 3 – 06 – The “improvements” exclusion has the narrowest scope (ie. excludes the least) and excludes only the “improvements” in the rectification of the defect after the loss.
The LEG exclusions have been amended over time to have the effect of either excluding more or less from coverage.
The Ledcor Decision – Framework of Analysis
In Ledcor Construction Ltd. v Northbridge Indemnity Insurance Co., 2016 SCC 37 [Ledcor] one of the few Canadian decisions on builders risk coverage, the Supreme Court of Canada considered a window cleaning contractor’s coverage claim. The contractor scratched windows during its cleaning work. The financial impact was significant –$45,000 to re-clean the windows and $2.5 million to replace the damaged windows. Could replacing the windows be excluded as the cost of making good the contractor’s faulty work?
The policy in Ledcor did not insure “…the cost of making good faulty workmanship…unless physical damage not otherwise excluded …results, in which case the policy shall insure such resulting damage”. The insurers argued that the poor cleaning was “faulty workmanship” and that the cost of repair of the glass was “cost of making good”, and both the cost or re-doing the work, and the cost of replacing the glass, were both excluded. The insured argued that the exclusion did not apply, but if it did, then the cost of repairing the scratched windows was “resulting damage”.
Ultimately, the Supreme Court decided that the subject exclusion clause excluded from coverage only the cost of redoing the faulty work, that is, the cost of re-cleaning the windows. The damage to the windows, and therefore the cost of their replacement, was covered by the policy. In so finding, the Supreme Court of Canada provided the framework for an insured to establish coverage under a course of construction policy in this context:
- The insured must first prove that the loss satisfies the requirements of the insuring agreement under the policy;
- The burden then shifts to the insurer to show that an exclusion in the policy applies to restrict coverage; and
- Finally, should an exclusion be triggered, the insured may then show that a exception to the exclusion applies to broaden coverage. [3]
In Canada, “Damage” Requires Detrimental Physical Alteration
Whether there was “damage” was not the central issue in Ledcor. One can easily draw the connection in that decision between scratched windows and the requirement for physical “damage”. In Canada and in other jurisdictions, to prove that the loss satisfies the insuring agreement’s “damage” requirement, an insured has to prove detrimental physical alteration of the property in issue. See for example the decisions of B.C. Rail Ltd. v. American Home Assurance Co. (B.C.C.A.), [1991] B.C.J. No. 697 (“B.C. Rail”) and Sterling Crane, a division of Procor Ltd. v. Penner Bros. Utilities Ltd., [1985] B.C.J. No. 1200 (“Sterling Crane”).
In B.C. Rail, the Court of Appeal rejected the argument that non-physical loss or loss of use of a failed rail line, due to excluded faulty design, could be considered “resulting damage”. That court held that resulting damage had to be physical damage, and it was irrelevant that the word “physical” was not used in the resulting damage clause.
The court in Sterling Crane reached a similar conclusion. In Sterling Crane, the B.C. Court of Appeal upheld the lower court’s decision in finding that the “physical loss of or damage to” wording did not support loss of use or other non-physical loss as damage. Damage meant physical damage, regardless of the inclusion of the word “of” after “physical loss”.
In the more recent decision of Acciona Infrastructure Canada Inc. v. Allianz Global Risks US Insurance Company, 2015 BCCA 347, the B.C. Court of appeal considered coverage claim on a builders risk policy that contained a LEG2 exclusion. In Acciona, concrete slabs over deflected and cracked. The slabs did not meet the hospital project’s functionality requirements for wheeled equipment. The contractor was required to fix the defect at a cost of about $15 million. The Court of Appeal determined this loss satisfied the builders risk policy’s insuring agreement because there had been physical damage to the concrete slab itself. Both the trial court and the Court of Appeal applied the traditional test to determine “physical damage”, which they each found required a detrimental physical alteration of the property in question. That detrimental physical alteration involved the bending of the embedded rebar past its flexure yield point, which resulted in permanent deformity.
The trial decision of MDS Inc. v. Factory Mutual Insurance Company, 2020 ONSC 1924 (“MDS”) during the pandemic temporarily put in question whether in Canada, the test for what may constitute “damage” could be relaxed to include loss of use. That decision involved loss of use of a nuclear reactor due to corrosion. The policy contained a corrosion exclusion with a resulting damage exception. The insurer relied on the corrosion exclusion to argue there was no coverage under the policy. The insured took the position that the corrosion exclusion did not apply, and argued that even if the exclusion did apply, the loss of use of the reactor was resulting “damage” based on the loss of use. The insured made this argument on the basis that loss of use could qualify as “damage”, so it did not matter that there was no “physical damage” other than the excluded corrosion.
The trial judge in MDS agreed with the insured and found that loss of use can constitute “damage” at least for the purposes of an exception to an exclusion. The trial decision in MDS sent a temporary shockwave through the insurance industry, with many insureds purporting to rely on MDS to support a claim for COVID-19 related business interruption coverage under property policies.
The Ontario Court of Appeal overturned the trial judge’s decision and held that “damage” requires a clear physical alteration of the property, thus restoring the requisite element of detrimental physical alteration to the concept of “damage” in property policies in Canada. The Court of Appeal found that the reactor shutdown, and the associated complete loss of use, did not constitute “damage” within the meaning of that policy.[4]
In Canada, the limited case law on the issue stands for the principle that for an insured to trigger coverage under a standard form builders risk policy, they must prove there is detrimental physical alteration, post-construction, rather than in the initial defective condition of the property. In the broader context of property policies, the traditional requirement for physical loss or damage has been and remains the requirement for detrimental physical alteration. There are exceptions in both Canada and the U.S. to this general rule. For example:
- In Jessy’s Pizza v Economical Mutual Insurance Co, 2008 NSSM 390, the Court determined that an oil spill which caused a business to close due to an overpowering smell constituted physical damage. The Court in that case found that the fumes in the business physically damaged the contents of the business such that its continued operation was untenable.
- The court in Western Fire Ins Co v First Presbyterian Church, 437 P.2d 52 (Supreme Court of Colorado 1968) (QL) found that the infiltration and saturation of gasoline vapours, combined with a government declaration of uninhabitability, amounted to a “direct physical loss” triggering cover.
- The court in P. Murphy Inc v Laurentian Casualty Co of Canada, 1992 CanLII 14095 (PEI SC) determined that gasoline vapours in the air in a neighbouring premises which caused the insured premises to be unsafe for occupation constituted damage to property. A fire inspector ordered the insured’s premises to be evacuated. Notably, there was no actual explosion or fire. The dangerous vapours had nevertheless infiltrated the premises causing an evacuation. The Court concluded the word “damage” was synonymous with “injury”. The presence of gasoline fumes in the air constituted damage or injury to the extent they rendered the building unsafe for occupation.[5]
The South Capital Decision
In what was the first judicial consideration of the LEG3 exclusion, the Court in South Capital was critical of the exclusion’s wording, and also determined that voids in concrete can constitute “damage” under a builders risk policy.
In South Capital, the insured contractor was hired to build the Frederick Douglas Memorial Bridge in Washington DC. During construction, the insured’s poor vibration of concrete caused malformations known as “honeycombing” and “voiding,” in the concrete harming the bridge’s structural integrity. The insured contractor was required to replace significant portions of the bridge’s supportive structural components. The insured contractor sought coverage under a builders risk policy, including indemnity for related costs. The insurer denied coverage for two primary reasons: (1) There was no “direct physical damage”; and (2) the policy’s LEG3 exclusion excluded the loss.
The particular LEG3 exclusion in this case read:
This policy shall not pay for loss, damage or expense caused directly or indirectly by any of the following.
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 Insuring Agreement Was Satisfied – Damage Found
The Court determined that the claimed damage, which was essentially voids or “honeycombs” in concrete, was within the scope of coverage. In the subject policy, “damage” was not defined. As courts often do in the context of terms not specifically defined in the policy, the court considered the plain, ordinary, and popular meaning of the term, as well as the parties’ intent and overall purpose of the contract. The Court relied on Black’s Legal Dictionary which defined damage as “loss or injury to person or property” and “any bad effect on something.” Utilising this definition, the Court found the inadequate vibration caused a decrease in the weightbearing capacity of the bridge and its support structures. The Court reasoned that a “decreased weightbearing capacity is surely an injury, or at the very least a bad effect, on the bridge and its supporting structures.”
The Court stated that “damage” included the costs of fixing the concrete “flaws” that weakened the bridge. The court emphasized that the insured purchased an all-risk policy, and “[o]ne such risk, inherent in any complex construction project, is damage from errors in workmanship.”
The LEG3 Exclusion was Ambiguous and Interpreted against the Insurer
After the insured established coverage under the policy, the burden then shifted to the insurer to demonstrate that an exclusion applied. The insurer was not successful in arguing that the LEG 3 exclusion defined “damage” in a way that conclusively excluded defects caused by material workmanship. The insurer directed the court to the final paragraph of the provision, which stated 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.” That argument did not persuade the court:
But “caused by” and “solely by virtue of the existence” are not the same. The Extension does not suggest that property cannot be “damaged” if there were defects in material workmanship somewhere in the causal chain. Instead, it indicates that defects of material workmanship in and of themselves are insufficient to constitute damage.
With respect to the insurer’s reliance on the LEG 3 exclusion, the Court found the exclusion to be ambiguous:
The LEG 3 Extension is ambiguous—egregiously so. To understand this, one need only attempt to read it. In just three sentences, [the insurer] managed to squeeze in a run-on sentence, an undefined term, several mispunctuations, and a scrivener’s error…The Extension is internally inconsistent and bordering on incomprehensible. [The insured’s] statement that the Extension is “convoluted” is an understatement.
The further explained that the LEG 3 clause’s exclusion of costs incurred to “improve” the original work was also ambiguous. It was not clear from the language used whether excluded “improvements” meant true upgrades to the original work, or mere replacements of the defective components. As the court rhetorically questioned, “[a]fter all, if something broken gets fixed, hasn’t that thing been improved?”.
The court determined that the provision excluded replacement or rectification costs incurred to “improve” the original workmanship. In this context, the next issue for determination was what it meant to “improve” the original workmanship. The insured suggested it meant “making it better than originally planned and argued that the LEG 3 clause should only exclude those costs associated with true upgrades, such as replacing defective concrete with “solid gold.”
The insurer argued that the LEG 3 provision meant “simply patching or replacing defective components constitutes an improvement” and that simply patching or restoring the defects was an improvement, resulting in the loss being excluded by the LEG 3 clause.
The Court noted that the insurer’s position had “intuitive appeal,” such that “repairing or replacing a defective component can technically be considered an improvement—unless that component is replaced with something worse.” However, the court ultimately determined that “to improve means to make a thing better than it would have been if it were not for defective work.” The court held that the language distinguished the “cost incurred to improve” work from “the cost of replacement or rectification.” As such, the court stated that since the LEG 3 provision was subject to more than one reasonable interpretation, it was ambiguous requiring construction against the drafter-insurer.
Commentary on the South Capital Decision
South Capital is a clear departure from the Canadian decisions on “damage” in property policies. In Canada, the terms “loss” and “damage” are rarely defined in the policy (as was the case in MDS) and courts try and determine the everyday meaning of these terms. The approach of the court in South Capital was essentially the “defect as damage” approach which has generally not been accepted by our Canadian courts. Based on Canadian case law, the voids or “honeycombs” in the concrete caused by poor installation work would likely not be resulting “damage” in Canada – there was no physical alteration of covered property as a result of defective work.
The U.S. federal district court adopted and relied on definitions of “damage” that are unlikely to be accepted in Canada. In our jurisdiction, something more than the “bad effect” found in that case (a decrease in the weightbearing capacity of the bridge and its support structures) is required to be “damage”. It is also my view that in Canada, “damage” would not include the costs of fixing the concrete “flaws” as those flaws occurred at the time of installation (the insured’s work) and cannot be considered resulting physical alteration of covered property.
There is yet another difference between the court’s decision in South Capital and the prevailing view in Canada. The court found that the “damage” was the decreased weightbearing capacity of the bridge, as there would be an issue with the abutment and whether it could support the dead load of the structure. Further, there was concern whether it had been damaged to the point that it could not support the live load of the next stages of construction. Even if we accept that reduced weightbearing capacity could be “damage”, is that not potential “damage” in the future, rather than existing “damage” required to support a coverage claim? How can potential future “damage” support a finding of existing damage required to trigger coveage? In Canada, it would not. Based on the court’s rationale in South Capital, it is difficult to comprehend what workmanship issue would be a defect only, and not “damage”, as long as there was a “bad effect”.
The court’s comments on the LEG 3 exclusion have concerning implications for insurers who may attempt to rely on the exclusion in the future. The LEG 3 exclusion would benefit from further clarity in its wording. While this is one court’s decision, and certainly not binding in Canada, it is the first judicial commentary on the LEG 3 exclusion. This decision creates uncertainty as to how the provision may operate to exclude costs related to “improvement”, and whether it will net the effect likely intended by its drafters. Most builders risk policies have the requirement of replacement only with construction of “like kind and quality”, and most insurers and insureds have been able to come to an agreement on this issue in Canada it appears, given the lack of case law on this point.
[1] Ledcor Construction Ltd. v Northbridge Indemnity Insurance Co., 2016 SCC 37 (“Ledcor“), at paragraph 68
[2] Ledcor, at paragraph 66
[3] Ledcor, at paragraph 52
[4] MDS Inc. v Factory Mutual Insurance Company, 2021 ONCA 594 paras. 93-97
[5] D.P. Murphy at paras. 1 and 8.
