South Capitol Bridgebuilders v. Lexington Insurance Company [29.09.23]: is this really a case of LEG3 wording issues?

There is much debate in the London insurance market regarding Judge Royce’s decision in the US District Court for the District of Columbia (the Court) and the stated views on the application of LEG3 (London Engineering Group).

The outspoken criticism of the standard clause may have ramifications in other cases involving LEG3, given that LEG clauses (or their derivatives) are used in most global major engineering and construction projects.

The facts

The case concerned the construction of the Frederick Douglass Memorial Bridge in Washington. The contractors, South Capital Bridgebuilders (SCB), purchased a completed risk of the value builder policy from Lexington Insurance Company (Lexington) to insure them against damage to insured property.

During the works, the abutments and the two piers for the bridge were constructed in situ by repeatedly pouring concrete using formwork. To ensure even placement, workers vibrated the concrete for even distribution. However, due to faulty workmanship when the concrete vibrated, structural deformations (known as “honeycomb” and “hollowing”) were observed when the formwork was removed. The honeycomb/cavities were apparently several feet long, deep and visible to the eye.

SCB replaced significant portions of the bridge’s support structures and sought reimbursement from Lexington, which denied coverage. SCB then issued proceedings. The court held that the honeycombing/cavities constituted damage that triggered the primary insurance clause of the policy.

Politics

The court found the policy very poorly drafted and took issue with Lexington’s arguments regarding the effect and enforceability of its terms.

The LEG3 clause in question reads as follows:

“All expenses made necessary by defects in material workmanship, design, plan or specification and in the event of damage (which for the purposes of this exclusion includes any patently injurious change in the physical condition of the Property Insured) occurring to any part of Insured Property containing any of the defects mentioned, the cost of replacement or correction, which are hereby excluded, are those costs incurred to improve the original design plan or material workmanship specification.

For the purposes of this policy, and not only of this exclusion, it is understood and agreed that any part of the Insured Property shall not be deemed damaged solely by reason of the presence of any defect in material workmanship, design, plan or specification.

All other policy terms and conditions remain the same.”

The policy insures against “all risks of direct physical loss or damage to the insured property.” The court noted that there is no separate definition of damages.

There was an exception for damages “caused by” defective or defective workmanship or materials covered for consequential damages and, separately, an exception for defective or defective design, plan or specification, under similar conditions.

There was also approval for a LEG3 clause but, somewhat oddly, it was marked as an extension and only sought to override the exclusion for defective design etc., not for defective workmanship.

It’s a shame

Of concern are the court’s views (and apparent lack of distinction) as to what constitutes a defect and what constitutes policy damage.

To trigger the policy, SCB had to prove that there was a breakdown in the works. With no definition of damage in the policy, the Court instead relied on Black’s Law Dictionary. This defines damage as “loss or injury to person or property” and rather imprecisely as “any ill effect on anything”.

Using this definition, the Court found without hesitation that the inadequate vibration of the SCB caused a reduction in the load-bearing capacity of the bridge and its supporting structures. This reduces the structural integrity of the bridge, which is a “bad effect” on the bridge and its supporting structures.

When the 208B Research Study Group produced the London Insurance Institute’s Building Insurance report, they noted: “The terms ‘loss’, ‘damage’ and ‘property’ are rarely defined in the policy and are therefore intended to be of everyday meaning”.

However, the court seemed troubled by the lack of definition and resorted to legal jargon. It raises the question that even if a standard London market definition of damage was used, such as “physical loss, physical destruction or physical damage to tangible property”, would the court have determined that the policy was triggered by defective workmanship? From the comments made in the judgment, the answer is yes.

Intuitively, in evaluating the cases relied upon by Lexington and rejecting their relevance on the grounds that none involved a similar construction project or a similar insurance policy, the Court relied on case law to the effect that, unlike policies for builders’ risk, commercial general liability policies “… are not intended to pay the cost of repair and replacement of the insured’s defective work and products.”

Although the Court repeatedly stated that the “damage” was the reduced load-bearing capacity of the bridge, this appears to be damage likely to occur in the future. It did not cause damage at the stage of pouring the concrete. Assuming that the piers and abutments will be constructed before the arches and bridge deck, no weight loading is necessary at the stage of the works when the failure vibration is undertaken. If that is true, the Court’s finding addresses potential future damages, a situation that can be argued to be at the insured’s risk.

Furthermore, when discussing damage as used in the context of LEG3 (Colin Edelman KC’s 2006 addition of “which for the purposes of this exception includes any patently injurious change in the physical condition of the property insured”), the Court held that “ In addition ” to causing diminished structural integrity “of the bridge and its components,” in terms of only the honeycombing and voiding “… it was beyond doubt apparent or apparent that there was a detrimental change in condition.”

Therefore, it appears that the Court not only considered the reduction of potential future load as damage, but also the defectively vibrated concrete embedded in the works.

On this basis, the policy appears to be nothing more than a form of construction warranty.

LEG3

The court used some pejorative language in its assessment of LEG3 (“internally inconsistent and bordering on the incomprehensible”) and stated that they would “unravel the tortured language of the extension”. In fact, the Court only considered the definition of damage and the intent behind the exclusionary language in the LEG clause for amelioration of costs incurred.

There is no analysis of LEG3’s requirement that the defect and the damage be in the same “part”, nor what comparison is intended by the wording of the exclusion to assess what is an improvement. Excluded improvement requires a comparison with “the manufacture of the original material, etc.” There seems to be no consideration of what is meant by “original”.

LEG3 was listed as an extension of the policy. The court also noted that LEG3 was an extension in that it offered wider coverage than the clauses it was supposed to replace. It therefore “fundamentally expands what SCB is entitled to recover”.

The court also noted that LEG3 provides a definition of “damage” specific to LEG3 and a limitation of “damage” applicable throughout the policy, as set out in the LEG3 addendum. With respect to damages, the Court noted that the requirement of a “change injurious to the patent” is only for purposes of exclusion. The court found that, in any event, the reduction in the bearing capacity of the bridge, as well as the honeycomb, was a fundamental change.

The rider at the end of LEG3 (also present in clauses DE 2-5 and LEG2 and which the judge noted applied to the policy as a whole) was intended to make it clear that cover was not provided only for the presence of defects.

However, the court held that the rider did not exclude defects “caused by” the workmanship, only defects “solely due to the existence” of the workmanship. This, they decided, amounted to defects in material workmanship “in and of themselves.” Because SCB also claimed diminished structural integrity, this was not a claim “solely” for defective workmanship.

There is confusion here as the Court also stated that honeycomb and voids (flaws in workmanship) are a deleterious alteration and therefore damage.

There is also confusion regarding the application of the replacement or adjustment cost exclusion to improve the original workmanship. The SCB suggested that the exclusion of improvement meant “becoming better than originally intended”, with which the Court agreed. 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 improvement.

However, this analogy is not a reference to repairing the workmanship, but to improving the materials. SCB did not want to claim that the concrete was defective so that it needed to be replaced with gold or some other material. The question is related to the production of the concrete. An incorrect analogy is used to try to explain the improvement.

Assuming that SCB’s and Lexington’s ideas of improvement were reasonable interpretations of the clause, it was found to be ambiguous and, as such, under Illinois law, it was construed against Lexington.

In fact, it is possible, according to the wording of LEG3, to consider the exclusion of improvement in several ways, such as:

(a) Excluding the whole value of such works which constitute improvements, or

(b) Those costs incurred in bringing the defective property back to its designed (original) condition, or

(c) An additional amount over and above the cost of improvements to the original purpose of the works.

Review

Under the principles of English and Welsh law, this decision, even without a precise definition of damages in the policy, is difficult to understand. The claim was made on the basis of a defect which had been built into the works. In England and Wales this claim would not trigger cover. The question arises under what circumstances would the Court decide that the workmanship is merely a defect and not a fault?

Based on the decision when writing business in North America, insurers may need to define and distinguish between defect and damage. This can be worded in policy definitions as follows:

“For the purposes of this policy:

Defect means the quality of the element built into the work or constructed which makes the work less valuable or less fit for purpose than intended.

Damage means an accidental physical loss or physical alteration of the Works which is adverse and reduces the value or utility of the property and which is different from and progressively greater than the Defect.’

Obviously, any change in the definition of damage and defect in the insurance clause will need to be reflected in the LEG clauses.

For policies where the jurisdiction is English and Welsh, due to the abundance of case law on what constitutes a defect/damage, there is probably no need for a definition of damage, according to Survey 208B. However, if insurers wish to clarify the position, they could use a derivative of the above definition.

Although this decision and the phraseology used by the Court will be seen as a slight to those who drafted the LEG clauses, it is interesting to note that despite the original intention of the clauses to be used on engineering risks, it appears that due to insurers and brokers understand the intent of LEG clauses, they are now widely used in CAR policies for major projects worldwide.

Comment

Although this may be the first court decision on LEG3, numerous arbitrations have highlighted problems with the wording of the LEG and this decision simply highlights that clauses originally drafted 27 years ago (with the amendment of LEG3 in 2006) and used outside of their original intent , now requires review.

Leave a Comment

Your email address will not be published. Required fields are marked *