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December 21, 2009
(This article first appeared in the fall 2009 edition of Risk, Howrey’s insurance coverage newsletter.)
By Jill B. Berkeley
Howrey LLP
Construction disputes that arise out of a contractual relationship are subject to the economic loss rule. The economic loss rule also affects insurance coverage disputes arising out of construction claims. Although the Texas Supreme Court has stated that the “economic-loss rule… is not a useful tool for determining insurance coverage” (see, Lamar Homes Inc. v. Mid-Continent Casualty Co., 239 S.W.2d 236 (Tex. 2007), understanding the interrelationship between construction cases and the coverage case will help claimants and policyholders secure coverage.
In construction disputes, failure to complete the project on time or in accordance with specifications may entitle a party to contract damages, including the benefit of the bargain and consequential damages. Either direct damages, such as costs of repair and replacement, or consequential damages, such as loss of profits, may be claimed for breach of contract.
The economic loss rule, as articulated in many states, generally precludes recovering damages solely for a monetary loss on the basis of negligence or in tort. The rule is based on three principles: “(1) to maintain the fundamental distinction between tort law and contract law; (2) to protect commercial parties’ freedom to allocate economic risk by contract; and (3) to encourage the party best situated to assess the risk of economic loss, the commercial purchaser, to assume, allocate, or insure against that risk.” Daanen & Janssen, Inc. v. Cedarapids, Inc., 573 N.W.2d 842 (Wis. 1998).
Although the economic loss rule may be used as a defense in a construction claim, courts have created several exceptions to its application. Whether the exceptions apply generally will signal whether the defendant will have insurance coverage for defense, settlement or judgment. Three situations can be used to examine how exceptions to the economic loss rule will predict whether insurance coverage can be triggered.
Is There Damage to Property Beyond the Insured’s Work or Product?
In Board of Education v. A.C. and S., Inc., 546 N.E.2d 580 (Ill. 1990), the plaintiff brought a tort claim to recover the cost of removing asbestos-containing material from its buildings and making necessary repairs. The court rejected the argument that the parties suffered a claim for breach of contract only. The court concluded that installation of asbestos sufficiently contaminated the building that damage to property other than the defective product occurred. The claim was not that the asbestos failed to perform its function, i.e., insulate effectively, but that it deteriorated in a dangerous manner and was defective, toxic and harmful. The court noted the demarcation between tort recovery for physical harm and a contract action for economic losses depends on 1) the nature of the defect and 2) the manner in which the damage occurred.
Another situation in which a court ruled on economic loss involved property damage resulting from the insured’s operations. In In Re Chicago Flood, 680 N.E.2d 265 (Ill. 1997), the plaintiffs sued the City of Chicago for damages incurred when the city's freight tunnel network flooded following damage to one of the tunnels. The court held that “those plaintiffs who did not incur personal injury or property damage may not recover solely economic losses.” The court noted, however, with regard to claims for destroyed inventory that those damages did not run afoul of the economic loss rule. Plaintiffs were not seeking damages for a disappointed commercial expectation, such as loss of continuous electrical service. They were seeking damages for property loss in the form of lost perishable inventory as a result of a tortious event. The court held that these losses fall outside the definition of economic loss and were recoverable in tort.
Symmetry between the insurance concept of physical injury to property and the tort concept of damage to property other than a defect in the work of the insured under the contract is noted in USF&G v. Wilkin Insulation Co., 578 N.E.2d 926 (Ill. 1991). The plaintiffs in the underlying suits, as with the Board of Education case, sought reimbursement of costs for asbestos removal. The insurers argued that the presence of asbestos resulted only in intangible economic loss in the form of diminution of value of the buildings. The court cited its decision in Board of Education, noting that the presence of health-threatening, asbestos-containing products released over time contaminated buildings, therefore constituting physical injury to tangible property. The damage was not the result of the failure of the asbestos to perform its contractual function as an insulator. Rather, its detrimental impact was caused by a “wholly ancillary and coincidental phenomenon,” namely the diffusion of harmful fibers. Asbestos-related cost of repair and replacement was held to be more than merely economic damage.
Sudden and Unforeseen Damage
In Moorman Manufacturing Co. v. National Tank Co., 435 N.E.2d 443 (Ill. 1982), the plaintiff brought a products liability suit alleging that a defect in a grain-storage tank had caused it to crack. The Illinois Supreme Court held that solely economic losses are not recoverable in tort actions for products liability. There are three exceptions to the Moorman economic loss rule. The one typically at issue in construction cases is whether the claimant’s property damage was caused by a sudden, calamitous or dangerous occurrence. The “sudden and accidental” exception to the Moorman doctrine was the lynchpin to the insured’s recovery for the repairs to a building that collapsed.
Similarly, in American Family Mutual Insurance Co. v. American Girl, Inc., 655 N.W.2d 127 (Wis. 2004), the court held that there was coverage when a building was constructed on loose soil because of negligent advice by a soil engineering subcontractor. The sinking, buckling and cracking of the building resulted in property damage caused by an occurrence within the meaning of the CGL policies’ general grant of coverage. In so holding, the Wisconsin court found that the economic loss doctrine did not preclude coverage.
Damage to Other Property as Determined by the Integrated Systems or the Disappointed Expectations Test
If construction claims are based on damage to “other property” or a combination of economic loss and damage to “other property,” the economic loss doctrine is not a bar. See, Wausau Tile, Inc. v. County Concrete Corp., 593 N.W.2d 445 (Wis. 1999) [economic loss doctrine does not preclude plaintiffs’ claims that allege economic loss in combination with non-economic loss].
A recent case addressed the economic loss issue squarely in the context of a design-build contract. IRI/Quad v. American Engineering Testing, Inc., 2009 Wis.App 62, 2009 Wisc. App. LEXIS 272 (2009). Quad Graphics operated a warehouse for the storage of magazines. It contracted with Leavitt to design and build a delivery system. One month after the system was put into operation, it collapsed and completely destroyed the system, the inventory and several adjacent buildings. The court determined, based on both the integrated systems and disappointed expectations test, that the owner sustained damage beyond the builder’s product. See also, Foremost Farms USA Co-op v. Performance Process, Inc., 726 N.W.2d 289 (Wis. 2006).
On the coverage side, the incorporation doctrine can be used as a sword to assert coverage when a defective product is incorporated into a larger structure, thereby rendering the larger structure damaged or unusable. The prevailing view is that incorporation of a defective component into a larger structure does not constitute property damage unless or until the defective component causes physical injury to tangible property in some other part of the system. F&H Construction v. ITT Hartford, 12 Cal.Rptr. 896 (Cal. App 2004). The incorporation doctrine must be distinguished from cases in which the defective product merely rendered the whole structure “less valuable.” See, Yakima Cement Products Co. v. Great American Insurance Co., 608 P.2d 254 (Wash. 1980); Travelers Insurance Co. v. Eljer Manufacturing Co., 757 N.E.2d 481 (Ill. 2001).
The key to coverage in construction cases in which the insurer claims that the incorporation doctrine does not apply because damage to the insured’s product is excluded lies in the definition of “your product.” In all post-1986 ISO form policies, “your product” is defined to mean goods or products other than real property. Because most jurisdictions find that buildings are real property, the insurers’ argument against coverage should fail.
Conclusion
Insurance coverage will depend on the nature of the defect and the manner of occurrence. If some of the damages claimed by the plaintiff survive the economic loss rule, then insurance coverage typically will follow. Finding that a sudden and accidental catastrophic occurred or that some of the damages relate to property other than that performed supports a finding that property damage, loss of use or consequential damages will be covered.
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For more information about the issues covered in this report, please contact Jill Berkeley in our Chicago office at 312.846.5675 or at BerkeleyJ@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.
©2009 Howrey LLP
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