Tag Archives: construction defects

Arbitration Decision Can Make Condominium Developers More Insurable

Effective Underwriting Requires Review of CC&R's
Every insurer that insures developers of condominium projects in California for their liability for claims of construction defects should carefully review the decision of the California Supreme Court in Pinnacle Museum Tower v. Pinnacle Market Development, No. S186149 (Cal. 08/16/2012). The holding of the California Supreme Court should be kept in mind during the underwriting process before agreeing to insure the developer against the risk of loss by claims of construction defects. The prudent insurer might insist that an effective arbitration agreement be included in the covenants, conditions and restrictions (“CC&R's”) before selling any units to a buyer.

The Supreme Court resolved a dispute between an owners association and the original developer over an arbitration agreement made part of the CC&R's  before the owners association came into existence. The association filed a construction defect action against a condominium developer, seeking recovery for damage to its property and damage to the separate interests of the condominium owners who compose its membership. In response, the developer filed a motion to compel arbitration, based on a clause in the recorded declaration of CC&R's that provided that the association and the individual owners agreed to resolve any construction dispute with the developer through binding arbitration in accordance with the Federal Arbitration Act (“FAA”).

Factual And Procedural Background
Pinnacle Market Development (US), LLC, and others (collectively Pinnacle) developed a mixed use residential and commercial common interest community in San Diego known as the Pinnacle Museum Tower Condominium (the Project). Pinnacle, as the owner and developer of the Project property, drafted and recorded a “Declaration of Restrictions” to govern its use and operation (the Project CC&R's). The Project CC&R's contain a number of easements, restrictions and covenants.

The individual owners bought condominium units in the Project pursuant to a standard purchase agreement. The Association filed the instant action against Pinnacle, alleging that construction defects caused damage to the Project. As the sole plaintiff, the Association seeks recovery not only for damage to its own property, but also for damage to the interests held by its individual members.

Pinnacle filed a motion to compel arbitration, contending the FAA mandates enforcement of article XVIII's arbitration provisions. The trial court determined that the FAA is applicable and that article XVIII embodies an agreement to arbitrate between Pinnacle and the Association. Nonetheless, the court invalidated the agreement upon finding it marked by slight substantive unconscionability and a high degree of procedural unconscionability.

Discussion
To ensure that arbitration agreements are enforced according to their terms, the FAA preempts state laws which require a judicial forum for the resolution of claims which the contracting parties agreed to resolve by arbitration. The FAA also precludes a court from construing an arbitration agreement in a manner different from that in which it otherwise construes nonarbitration agreements under state law. Nor may a court rely on the uniqueness of an agreement to arbitrate as a basis for a state-law holding that enforcement would be unconscionable, for this would enable the court to effect what the state legislature cannot.

The party seeking arbitration bears the burden of proving the existence of an arbitration agreement, and the party opposing arbitration bears the burden of proving any defense, such as unconscionability.

Settled principles of condominium law establish that an owners association, like its constituent members, must act in conformity with the terms of a recorded declaration.

That a developer and condominium owners may bind an association to an arbitration covenant via a recorded declaration is not unreasonable; indeed, such a result appears particularly important because (1) the Davis-Stirling Act confers standing upon an association to prosecute claims for construction damage in its own name without joining the individual condominium owners and (2) as between an association and its members, it is the members who pay the assessments that cover the expenses of resolving construction disputes. Given these circumstances, an association should not be allowed to frustrate the expectations of the owners (and the developer) by shunning their choice of a speedy and relatively inexpensive means of dispute resolution. Likewise, condominium owners should not be permitted to thwart the expectations of a developer by using an owners association as a shell to avoid an arbitration covenant in a duly recorded declaration.

In sum, even though the Association did not bargain with Pinnacle over the terms of the Project CC&R's or participate in their drafting, it is settled under the statutory and decisional law pertaining to common interest developments that the covenants and terms in the recorded declaration, including those in article XVIII, reflect written promises and agreements that are subject to enforcement against the Association.

The Doctrine of Unconscionability
As indicated, procedural unconscionability requires oppression or surprise. Here, the trial court found no evidence of surprise. Nonetheless, the court perceived a high degree of procedural unconscionability, because the Project CC&R's were drafted and recorded by Pinnacle before any unit was purchased and before the Association was formed. Noting the Association had no opportunity to participate in the drafting of the recorded declaration, the court determined it was oppressive.

By providing for Pinnacle's capacity to record a declaration that, when accepted by the first purchaser binds all others who accept deeds to its condominium properties, the Act ensures that the terms reflected in the declaration — i.e., the covenants, conditions, and restrictions governing the development's character and operation — will be respected in accordance with the expectations of all property owners and enforced unless proven unreasonable. Far from evidencing substantive unconscionability, the consent provision reflects a restrictive term that the Legislature, for policy reasons, has determined is reasonably and properly included in a recorded declaration.

Conclusion
Article XVIII of the Project CC&R's is consistent with the provisions of the Davis-Stirling Act and is not procedurally or substantively unconscionable. Its terms requiring binding arbitration of construction disputes are therefore enforceable.

Writing for the majority, Justice Baxter stated the following:

Even when strict privity of contract is lacking, the Davis-Stirling Act ensures that the covenants, conditions, and restrictions of a recorded declaration — which manifest the intent and expectations of the developer and those who take title to property in a community interest development — will be honored and enforced unless proven unreasonable. Here, the expectation of all concerned is that construction disputes involving the developer must be resolved by the expeditious and judicially favored method of binding arbitration.

We hold that article XVIII's covenant to arbitrate is not unconscionable and is properly enforced against the Association. Accordingly, we reverse the judgment of the Court of Appeal and remand the matter for further proceedings consistent with the views herein.

Justice Kennard, in dissent, stated that the evidence lacked a showing that the owners association's consented to an arbitration provision in the CC&R's drafted and recorded by the developer before the association's independent existence. In compelling arbitration, which offers no right to a jury, the majority deprives the owners association of its constitutional right to have its construction defect dispute decided by a jury. In the words of our state Constitution: “Trial by jury is an inviolate right and shall be secured to all …” (Cal. Const., art. I, § 16.)

Although this case never mentioned the word insurance, it is an important decision for insurers and may, if properly underwritten, make it possible to insure condominium developers for lower premium because they can effectively avoid litigation and trial and compel the resolution of construction defects by binding arbitration. Since arbitration is usually less expensive and much quicker than litigation and since arbitration does not put the parties at the risk of confusing a jury of 12 who know nothing about construction or construction defects, an actuary can more accurately calculate the potential losses and charge a competitive and fair premium to the developer.

Deny Defense And Lose The Right To Belatedly Control Defense

An Insurer Should Never Deny A Defense Unless Absolutely Certain There Is No Potential For Coverage

The District Court, Northern District of California, granted a motion for summary judgment in favor of KB Home in part against the Travelers in Kaufman & Broad Monterey Bay, et v. Travelers Property Casualty, No. : 5:10-CV-2856 EJD (N.D.Cal. 07/18/2012)

Background
Travelers issued commercial general liability policies to Norcraft Companies, L.P., (“Norcraft”) a cabinet installer. The Norcraft policies provide coverage for “property damage” arising out of an occurrence that takes place in the coverage territory and that occurs during the policy period.

Subcontract And Aldrich Action
On or about January 22, 2003, and February 5, 2003, KB Home and Norcraft entered into subcontracts to furnish, deliver and install cabinets at certain homes within two housing developments in Monterey, California. The subcontracts required Norcraft to name KB Home as an additional insured under its commercial general liability policies.

On October 21, 2008, a number of homeowners commenced a lawsuit in Monterey County Superior Court against KB Home, Aldrich, et al. v. KB Home, et al. (“Aldrich Action”). The homeowners alleged a number of construction defects, including “cabinet and wood trim” defects, that resulted in damage to the homes and their component parts.

KB Home filed a cross-complaint against various parties, including Norcraft, alleging among other things that Norcraft is contractually required to defend and indemnify KB Home with regard to the Aldrich action.

Travelers’ Acceptance, Withdrawal, And This Action
On April 1, 2009, Glaspy & Glaspy, counsel for KB Home, tendered the defense and indemnity of KB Home as additional insureds under the Norcraft policies in the Aldrich action. This initial tender included copies of the original Complaint, First Amended Complaint, KB Home’s Cross-Complaint, a Stipulation and Order of Reference to the Special Master, the Subcontract and additional insured documentation.

On April 6, 2009, Patricia E. Dlugokenski (“Dlugokenski”), a senior technical specialist for Travelers, acknowledged receipt of the tenders and requested additional information, including: a statement of claims or documentation related to the alleged defects and deficiencies, expert investigation reports into defects or damages, current pleadings and any Case Management Order or Pre-Trial Order documents, and the location of any document depository.

On April 6, 2009, in response, KB Home provided an updated Homeowner matrix, the amended complaint, and the dismissal of one of the plaintiffs’ homes. KB also informed Travelers that the Pre-Trial Order had not yet been filed and there was no defect list but that KB Home would forward the defect list as soon as it is received. On July 6, 2009, Dlugokenski noted in the internal Claims Notes that “it is likely some, although minor damages resulted from [cabinet] installation. Damages to the walls or pulling away from the walls could be attributed to installation.” (Emphasis added) Also on July 6, 2009, Dlugokenski issued a letter accepting KB Home’s tender as additional insureds under the Norcraft policies.

The letter also requested information that would assist Travelers in its evaluation of the demand for payment of defense expenses, such as contact information for all carriers who have been provided a tender of defense, their responses, the amounts they have paid, the percentage they agreed to pay, a litigation budget, and an additional insured matrix showing the carriers tendered as well as their responses.

On October 20, 2009, Dlugokenski sent an email to KB Homes’ counsel requesting “documentation of damage caused by our named insured (defect report, etc.)” KB Home’s counsel informed Travelers that no defect list was available to date.

On November 5, 2009, Tom Frazier (“Frazier”), Travelers’ unit manager conducted a review of KB Home’s tenders and found that they lacked documentation of damage or liability arising out of Norcraft’s work. On December 1, 2009, KB Home contacted Travelers about its outstanding balance and requested payment. On December 10, 2009, Dlugokenski responded with a single-sentence email stating, “We will be withdrawing our acceptance.” On February 9, 2010, Hartford Casualty Company (“The Hartford”), another insurance company, accepted KB Home’s tenders of defense and issued a payment of $30,000 for KB Home’s defense in the Aldrich action. The Hartford made no further payments.

On March 9, 2010, Dlugokenski sent a letter to KB Home advising that Travelers was withdrawing from KB Home’s defense.

On May 27, 2010, KB Home filed this action against Travelers. On July 8, 2010, Fred Adelman, counsel for the Aldrich plaintiffs, signed a letter stating that “[t]he plaintiffs in this action are pursuing recovery for damages arising out of the cabinets.”

On August 4, 2010, KB Home provided the Aldrich plaintiffs’ preliminary defect list regarding cabinets, entitled “Aldrich, et al. v. KB Home, et al., Preliminary Defect List.” On December 17, 2010, based on the August 4, 2010 defect list, Travelers sent a letter to KB Homes in which it agreed to participate in the defense of KB Homes as an additional insured from August 4, 2010 forward and that it was appointing Christian Lucia of Seller Hazard Manning Ficenac & Lucia (“Sellar Hazard”) to represent KB Home in the Aldrich action. Travelers added that if KB Home wished to continue to retain Glaspy & Glaspy to provide it with a defense it could do so, but at its own expense.

On January 4, 2011, KB Home sent a letter to Travelers stating that Travelers has forfeited any right to control KB Home’s defense because it breached its duty to defend KB Home. KB Home also stated that Sellar Hazard had “a clear conflict of interest and is currently representing a subcontractor directly adverse to KB Home in a pending construction defect lawsuit and that under no circumstances will KB Home waive the conflict.

On January 28, 2011, Travelers issued payment of $73,654.54 to KB Home as payment for its one-half share of KB Home’s defense fees and costs in the Aldrich action pursuant to its equal shares allocation with The Hartford. On July 19, 2011, Norcraft and the Aldrich plaintiffs reached a settlement in the Aldrich action by the terms of which plaintiffs agreed to an issue release related to all cabinet issues, in exchange for the lump sum payment of $30,000. Travelers claims that, as of August 25, 2011, it had paid in excess of $187,418 in the defense of KB Home in the Aldrich action, which it claims is the amount of all outstanding invoices presented.

On August 26, 2011, KB Home filed its Motion for Partial Summary Judgment. Also on August 26, 2011, Travelers filed is Motion for Summary Judgment or, in the Alternative, Partial Summary Judgment. On September 16, 2011, Travelers filed counterclaims against KB Homes for reimbursement, unjust enrichment, breach of contract, and declaratory relief.

Discussion
KB Home sought partial summary judgment that:

  1. Traveler’s duty to provide KB Home a defense was triggered from the date of tender, April 1, 2009;
  2. Travelers breached its duty to provide KB Home a defense; and,
  3. Belated payment of the costs of the defense in the Aldrich action did not cure Traveler’s breach of its duty to defend KB Home.

Travelers sought summary judgment in its favor on KB Home’s breach of contract claim because:

  1. KB Home breached its duty to cooperate by refusing to accept Travelers’ appointed counsel;
  2. KB Home cannot prove a duty was owed when Travelers denied coverage because Travelers’ duty to defend had not been triggered;
  3. KB Home has not presented any evidence of resulting damages. Travelers also sought summary judgment in its favor on KB Home’s breach of covenant of good faith and fair dealing because:
    1. Travelers never withheld benefits due under the policy;
    2. Any delay in paying benefits was based on a genuine dispute regarding coverage; and,
    3. Travelers conducted a reasonable investigation of KB Home’s tender.

The District Court considered both motions and ruled against Travelers and in favor of KB Home in most parts of its motion. It reasoned about the various issues:

Breach Of Contract
For an insurer, the existence of a duty to defend turns not upon the ultimate adjudication of coverage under its policy of insurance, but upon those facts known by the insurer at the inception of a third party lawsuit. Hence, the duty may exist even where coverage is in doubt and ultimately does not develop. The defense duty is a continuing one, arising on tender of defense and lasting until the underlying lawsuit is concluded or until it has been shown that there is no potential for coverage.

The Norcraft policies provide coverage for “property damage.” The Norcraft polices do not cover property damage to Norcraft’s work arising out of it or any part of it.

Travelers argued that the complaint does not allege that other property was damaged as a result of the cabinets. Specifically, Travelers argues that the Aldrich complaint only alleges the existence of cabinet and wood trim defects at the homes and that the cabinets were installed so as to interfere with the cabinets’ useful life.

Travelers’ reading of paragraph 17, however, appears to consider only the final sentence of the allegation which list the defects, including cabinet and wood trim defects, to which the rest of the paragraph makes reference. The immediately preceding sentence states that the “defects … have resulted in damage to the homes and their component parts. Thus, the complaint alleges that cabinet and wood trim defects caused damage to the homes and their component parts, which potentially includes parts of the homes other than the cabinets.

The District Court concluded that as a result of the Aldrich complaint tendered on April 1, 2009, Travelers was required to defend KB Home unless and until Travelers could demonstrate, by reference to undisputed facts, that the claim cannot be covered. KB Home’s motion for partial summary judgment that Travelers owed it a duty to defend as of April 1, 2009 was granted.

Travelers failed to present evidence showing a genuine issue of fact regarding whether, at the time of its March 9, 2010 withdrawal, there was no potential for a covered liability.

To be excused from its duty to defend by KB Home’s alleged breach of the duty to cooperate, Travelers must show prejudice that resulted from KB Home’s withholding these documents. Travelers has not identified any related prejudice, much less provided evidence upon which a reasonable jury could find prejudice. KB Home, however, has pointed to evidence that Travelers was not prejudiced by these documents because, even if these documents had been produced earlier, Travelers would have acted no differently.

Travelers’ expert, Gene Irizarry, declared that “even though KB [Home] did not provide the Lot Files to Travelers, had it done so, no duty to defend would have been triggered.” This evidence indicates that, with or without the documents, Travelers still would have determined that it did not have a duty to defend. Thus, assuming that KB Home withheld these documents, Travelers has not raised a genuine issue of fact regarding whether Travelers was excused from its duty to defend as a result.

The undisputed facts demonstrate that Travelers breached its duty to provide KB Home with a complete and immediate defense of the Aldrich action when it withdrew from KB Home’s defense on March 9, 2010. Therefore the District Court granted KB Home’s motion and denied Travelers’ motion.

Whether Travelers Cured Its Breach By Its Belated Payment
KB Home also moved for summary judgment that Travelers’ belated acceptance of its duty to defend does not cure its prior breaches. In opposition, Travelers argued that KB Home has not provided any evidence of damages. KB Home sought judgment that Travelers’ failure to take up KB Home’s defense when its duty was triggered is not cured because Travelers did so after KB Home filed this action.

A belated offer to pay the costs of defense may mitigate damages but will not cure the initial breach of duty. KB Home’s motion for summary judgment that Travelers did not cure its breach by its belated payment for KB Home’s defense was, therefore, granted by the District Court.

“The insurer’s right to control the insured’s defense extends to the right to select legal counsel.” Travelers Property Cas. Co. of America v. Centex Homes, No. 11-3638-SC, 2012 WL 1657121, at *4 (N.D. Cal. May 10, 2012). However, “[w]hen an insurer wrongfully refuses to defend, the insured is relieved of his or her obligation to allow the insurer to manage the litigation and may proceed in whatever manner is deemed appropriate.” Eigner v. Worthington, 57 Cal. App. 12 4th 188, 196 (1997).

Here, the Aldrich action was tendered to Travelers on April 1, 2009 and triggered Travelers’ duty to defend. On March 9, 2010, Travelers declined to participate in the Aldrich defense. Travelers, however, agreed to defend KB Home on December 17, 2010, after KB Home had provided Travelers with a defect list from the Aldrich plaintiffs on August 4, 2010 and after KB Home filed this lawsuit.

Duty To Defend Arose Immediately Upon Tender
Since Travelers’ duty to defend arose immediately upon the April 1, 2009 tender, Travelers’ withdrawal and delay in providing KB Home with a defense divested it of the right to control KB Home’s defense. Thus, Travelers failed to demonstrate that the undisputed evidence shows KB Home’s rejection of Travelers’ chosen counsel was a breach of the cooperation clause.

During the time the insurer had rejected the tender of the defense, the insured arranged and paid for its own defense. The belated tender did not fully remedy the harm caused by the insurer’s refusal to defend by later paying the insured’s attorney fees, though this belated decision unquestionably mitigated its damages.

Breach Of Duty To Investigate
An unreasonable failure to investigate amounting to such unfair dealing may be found when an insurer fails to consider, or seek to discover, evidence relevant to the issues of liability and damages. Based on KB Home’s initial tender, on July 6, 2009, Travelers’ Claim Notes document Traveler’s decision to accept KB Home’s defense because of a likelihood of covered damages.

An insurer’s early closure of an investigation and unwillingness to reconsider a denial when presented with evidence of factual errors will fortify a finding of bad faith. KB Home, therefore, presented evidence sufficient to create a genuine issue of fact regarding whether Travelers acted in bad faith in refusing to defend KB Home.

Conclusion
For the reasons discussed above, the District Court ordered as follows:

  1. KB Home’s motion for partial summary judgment that Traveler’s duty to provide KB Home a defense was triggered from the date of tender, April 1, 2009;
  2. Travelers breached its duty to provide KB Home a defense; and
  3. belated payment of the costs of the defense in the Aldrich action did not cure Traveler’s breach of its duty to defend KB Home.

Travelers’ has been found to breach its duty to defend in two cases in California because of its failure to thoroughly investigate upon tender of defense and that, when it had second thoughts and agreed to defend, found it had lost its right to control the defense.

If, as in KB Homes, there is a small potential for coverage, a defense should be provided promptly subject to a reservation of rights. Withdrawing that defense when there is no additional investigation or new facts is not within the custom and practice of Commercial General Liability insurers in California and most of the country.

Travelers then added insult to the injury caused by its withdrawal of defense by coming back and offering to defend with control of counsel and the defense and ignoring the conflict of interest between it, its chosen counsel, and the additional insured. In addition, had it done a thorough investigation, it could have accelerated the settlement negotiations and resolved the Aldrich case for less than the amount of defense costs.

Construction Defects: A Primer For Construction Financial Managers

The construction industry's reputation has been tarnished by poor quality performance. Construction defects decrease the satisfaction of property owners and erode the confidence of the financiers, buyers, and end users of construction projects.

Total construction costs are increased by lost productivity, and higher rework and insurance costs. Defective construction undermines the reputations of affected contractors and threatens their profitability.

Until recently, Construction Financial Managers outside the homebuilding sector may not have heard of or thought much about construction defects. However, these defects are now an industry-wide issue.

Likewise, while formerly concentrated in the western states, construction defects are now a national concern to all Construction Financial Managers involved in either general contracting or the specialty trades within commercial building.

With a rise in reported construction defects, companies — now more than ever — need to improve quality during the construction life cycle.

This article discusses the basics of construction defects, and presents the barriers to and indicators of quality construction — in addition to the risk management consequences of poor quality performance.

The Origins of Construction Defects

Construction defects occur at the intersection of construction operations, real estate transactions, contract law, and business insurance.

A construction defect is a component of construction that is not built according to plan, specification, or in conformance to established construction codes and industry standards of care.

To be considered a construction defect in the eyes of the legal and judicial systems, physical damage to tangible property or bodily injury must result from the alleged defective construction.1 Construction defects can also include the loss of use of the “impaired property” — property that is not physically damaged, but is rendered unusable due to defective construction work.

Unfortunately, in our litigious judicial system, reality does not always match theory. Sometimes, “alleged” construction defects are pursued because attorneys think there's a good chance of winning a verdict or receiving a settlement. This can also happen when a group of people, such as a homeowners association, is “unified” for the purpose of class-action litigation.

In the U.S., the general legal doctrine that governs the sale of property is caveat emptor, or “let the buyer beware.” In order to receive legal protection, buyers have a general duty to inspect their prospective purchases before taking possession. The legal system recognizes the inherent limitations of such inspections, and therefore distinguishes between two types of defects: patent vs. latent.

There is a fundamental and legal difference between patent defects found during the course of construction and latent defects that manifest later.

Patent defects are regarded as conditions that can clearly be observed or detected in a reasonably thorough inspection prior to the sale or transfer of the property from the seller to the buyer. In contrast, latent defects are faulty conditions in a property that could not have been discovered during a reasonably thorough inspection.

Types of Construction Defects

The types and causes of construction defects vary and are influenced by many factors, which are commonly categorized into the following eight types:

  1. Improper design;
  2. Poor workmanship that leads to poor finishing quality;
  3. Improper means or methods of installation or fastening;
  4. Improper materials;
  5. Defective material or poor material performance;
  6. Missing or inadequate protection from weather or environmental conditions;
  7. Water intrusion/infiltration and moisture; and
  8. Soil subsidence or settlement.

These types of construction defects result from one or more common causal factors. Researchers at the University of Florida reviewed the common causes and types of building occupancies most often implicated in construction defects.

This study revealed that 45% of all construction defect claims occurred in multifamily housing.2 (A large percentage of which presumably relates to condominiums, given the potential for class-action litigation by homeowners associations.)

Another major study found that “…84% of claims are associated with moisture-related defects in building envelope systems (69%) and building mechanical systems (15%).”3

Causes of Construction Defects

The most common causes of construction defects are: 1) the nature of the construction industry itself, and 2) climate, weather, and environmental factors. Let's look at how scheduling pressures and sequencing issues are driven by both causes, and review their potential negative impact on construction quality.

Scheduling Pressures
Contractors face increasing demands for shorter schedules and faster project completion. The potential adverse effects of these types of pressures include cost overruns and nonconformance to specifications, as well as other quality issues.

As these increased schedule pressures contribute to compromised quality performance, the number of construction defects increases. The rework necessary to rectify these quality issues also adversely impacts productivity — and jeopardizes the project's overall profitability, as well as the profitability of all parties involved.

Sequencing Issues
A problem related to scheduling pressures is the improper sequencing of material delivery and/or subcontractor trades. Construction projects require precise coordination of various suppliers and subcontractors. Conditions are ripe for latent construction defects when weather-sensitive materials, such as drywall boards, are delivered to a jobsite before the building has been enclosed and is weather-tight.

For example, if a load of drywall is exposed to moisture from humidity, dew, or rain, then the likelihood of mildew or mold increases. Likewise, if the various subcontractor trades are not properly sequenced, then additional punch list items or rework can result.

Exhibit 1 below summarizes quality management barriers and lists the factors that contribute to construction defects at the industry, company, and project levels.

Exhibit 1: Barriers of Implementing Quality Management in the Construction Industry

Industry Factors Company Factors Project Factors
Traditional split between design, engineering, and construction functions Type of company: GC vs. Specialty Trade contractor Multiple parties involved in construction (subcontractors, sub-tiers, and suppliers)
No uniform definition for quality or quality management Percentage of lump sum (hard bid) vs. negotiated work Design factors, especially the building envelope
Increasing number of fast-track projects Typical project delivery method used: Design/Bid/Build vs. Design/Build Tight scheduling and sequencing of trades and tasks
Historically thin profit margins that shift priorities away from quality Owner selection process and percentage of work for repeat owners Jobsite geotechnical factors: water table, drainage, and soil type
Conflicting definitions of what constitutes rework Commitment to a zero defects and management accountability culture No overall assigned responsibility for quality management at the project level
Long tail before latent construction defects manifest as completed operations claims Historical performance with liability insurance, especially completed operations claims for latent construction defects Third-party design review completed and course of construction conformance inspections scheduled
Contractual risk transfer of liability through indemnification and additional insured contract requirements Insurance program structure: deductible vs. guaranteed cost program, limits purchased, and premiums paid Weather (especially wind-driven rain) and climate factors (including differential thermal vapor transfer due to temperature, humidity, air flow, and ventilation)
Lack of uniform quality management metrics to establish performance baselines or benchmark comparisons Quality control and quality assurance staffing, programs, policies, procedures, and protocols Lack of uniform methods to measure or monitor quality performance during the course of construction
Lack of systematic method for allocating uninsured indirect costs of poor quality Failure to develop job costing method to capture and chargeback indirect costs of poor quality Indirect costs not captured and charged-back to project in job costing

The Role of Insurance

Risk Financing
Insurance is a financial risk transfer method that may help resolve construction disputes or litigation that involves alleged defective construction. Insurance pays on behalf of an individual or business when two conditions are met:

  1. It is proven that one party is liable for causing or contributing to the construction defect; and
  2. It is determined that the party has a legal duty to correct or otherwise remedy the defective conditions.

Commercial General Liability Coverage
Specifically, Commercial General Liability Insurance is purchased to cover payments for bodily injury and property damage sustained by third parties arising out of business operations. These damage claims are known as third-party liability claims.4

Construction-related Commercial General Liability property damage losses are further divided into losses that occur during two different timeframes: the course of construction and completed operations.

Course of Construction
The course of construction involves construction operations from the inception of building activity until a certificate of occupancy (CO) is issued for the facility.

Completed Operations
The completed operations aspect of Commercial General Liability coverage responds to allegations of construction defects. The completed operations component provides coverage from the time a certificate of occupancy is issued through coverage termination.

The increased severity and volatility of losses in construction insurance primarily stems from losses with a “long tail” — the length of insurance coverage extending beyond the term of the policy.

It's common for the coverage period to extend between 3-10 years (often to match the length of the statute of repose and/or statute of limitation). During the extended coverage period, latent conditions often manifest as insurance claims with associated monetary losses. In construction insurance, the long tail results from alleged and actual construction defects.

Completed Operations vs. Products-Related Coverage
While coverage for completed operations and products are included in the same limit of the policy, there is a distinction between the two types of coverage.

A general rule of thumb: Once a product is incorporated into real property, it loses its characteristic as a product and is considered a “completed operation.”

For example, a contractor that is also a supplier of ready-mix concrete has a “products liability” exposure until the time the concrete is incorporated into the building. At that point, it becomes a “completed operation,” and is subject to all of the provisions of that coverage part — including the potential to respond to construction defect claims.

Statute Of Repose vs. Statute Of Limitation
Generally, companies involved in construction seek to purchase completed operations insurance to correspond with either the legal statute of repose or statute of limitation. Both the statutes of repose and limitation restrict the total time period contractors are subject to liability.

What's the difference? The statute of repose is a specific legal limitation or length of time following the completion of the project in order to provide the owner or occupants an opportunity to discover if defects or non-conformance to specifications need to be rectified by the contractor. The statute of limitation bars legal action after a specified length of time following the discovery of a deficiency.

These statutes are state-specific and are used to adjudicate alleged construction defect cases in state court systems. After the expiration of the statute of repose, buyers have no standing to bring legal suit against the property seller.

The statutes of repose range from a low of four years in Tennessee to a high of 15 years in Iowa.5 The most common length of statutes of repose is either seven or ten years.

However, statutes of limitation are shorter for bringing suits once damage is discovered and usually range from 1-3 years.6

Subcontractors & Contractual Risk Transfer
Contracts govern how expectations are communicated, responsibilities are assigned, and risks are allocated to facilitate successful project execution.

Generally, subcontractors are expected to assume responsibility for the work they perform (both financially and legally). One of their legal responsibilities is to purchase insurance as a means to protect the owner and all other parties.

A gap between legal and financial risk transfer can occur if subcontractors are not able to obtain the required types of insurance coverage. This gap can also occur if the required policy limits cannot be obtained or if the coverage has exclusions for particular perils or exposures that are likely to occur during the course of construction.

Quality Management In The Construction Industry

When strictly adhered to, quality management systems instituted by contractors can minimize the need for rework on construction projects.

As the amount of rework decreases, a contractor's performance increases in the areas of quality, productivity, and profitability. Unfortunately, a universal or standard definition of “quality” does not exist within the industry. Instead, many competing definitions are used, including:

  • Customer satisfaction
  • Contract requirements met
  • On-time completion
  • Conformance to specifications
  • Project completed within budget
  • No rework required within warranty period
  • Zero punch list items at project turnover
  • Continuous quality improvement

Leading Indicators
In my article on “Risk Performance Metrics” (in the September/October 2007 issue of CFMA Building Profits), lagging indicators were defined as “passive metrics of prior results without consideration of the activities that influence the results.” So, lagging indicators are retrospective and trigger reactive, tactical responses.

In contrast, leading indicators are metrics established to gauge the effect of activities designed to prevent or counter the metrics that are monitored by the lagging indicators. Accordingly, leading indicators are drivers of strategic and proactive activities consistent with continuous improvement. Exhibit 2 below presents leading indicators for project quality management for the three distinct phases of construction: pre-construction, course of construction, and post-construction.

Exhibit 2: Representative Examples of Leading Project Quality Indicators

Phase of Construction Leading Indicators or Metrics
Pre-Construction

Number of third-party expert reviews on building envelope designs and materials

Number of subcontractors with pre-approved quality programs

Number of projects with site-specific quality plans

Architect approval for changes to specified materials or design specifications

Course of Construction

Number of projects completed with zero punch list items open

Percent of documented moisture evaluations of incoming materials

Number of quality assurance inspections completed

Percent of discovered defects corrected

Percent of notifications on moisture, water intrusion, mold, or other key events

Post-Construction

Percent of completed project files with documented inspections and corrections

Percent of project turnover video training programs documented

Number of signed and certified receipt of turnover documents by owners

Scheduled follow-up inspection process with owners verifying no quality issues

Number of maintenance callbacks during warranty period

The ability to deliver a quality project safely provides a significant competitive advantage among contractors. The integration of safety with quality management enables projects to be built within budget and schedule constraints.

Safety performance is improved through the quality management discipline of “continuous improvement” that increases communication and feedback among workers and supervisors. Similarly, projects with reduced safety incidents experience improved quality, schedule, and cost performance.3

As a risk management professional, I've seen proactive construction companies take various actions to minimize the adverse effects of quality issues.

These actions are divided into the following stages or phases:

  • Awareness
  • Prevention
  • Detection and measurement
  • Mitigation
  • Documentation for defense

The 5 Ps & 5 Rs
Similar to the 6P model as described in my article on “Return to Work: The Foundation for Successful Workforce Development” (in the September/October 2008 issue of CFMA Building Profits), the 5P and 5R models are offered to help increase awareness of construction defect prevention and response. (See Exhibit 3 below)

Exhibit 3: Strategic Processes for Construction Defect Prevention

  • Vision and culture for zero defects, zero punch lists, and/or zero rework
  • Quality management organizational structure and staffing
  • Owner selection practices and risk-adjusted process for project approval
  • Prevention measures throughout the construction life cycle
  • Subcontractor prequalification and oversight process
  • Insurance and contractual risk transfer review
  • Conformance verification vs. nonconformance detection during course of construction
  • Project closeout and owner education processes
  • Warranty period and maintenance callback processes
  • Response and mitigation of known or suspected problems
  • Claim coordination and documentation for defense
  • Measurement and continuous process improvement
  • Management accountability systems that include quality measurement in personnel performance evaluations and decisions about bonuses
  • Quality awareness education and staff training

The 5 Ps are proactive steps focused on quality control and assurance that help prevent construction defects: Program, Policies, Procedures, Protocols, and Practices.

The 5 Rs are reactive steps taken in response to potential or suspected occurrences of defective construction: Report; Response/Investigate; Root Cause Analysis; Remediate, Repair, or other Recourse; and Recordkeeping.

For construction companies, there are potential consequences of not implementing effective quality management systems. One adverse consequence is unintended and undesirable exposure to risk.

As shown in Exhibit 4 below, poor quality performance impacts a company's reputation and has financial, operational, insurance, and legal consequences.

Exhibit 4: Risk Management Consequences of Poor Quality Performance

Consequences Primary Risk Secondary Risk
Decreased productivity due to required rework Operational Financial
Diminished profit margin (or loss) on project Financial Reputation
Delayed turnover of completed projects Operational Reputation
Loss of key clients due to dissatisfaction Reputation Financial
Possible liquidated damages from delayed completion Financial Legal
Higher deductibles, increased premiums, and/or lower limits for liability insurance Insurance Financial
Increased legal costs to defend against alleged construction defect claims Financial Insurance/Legal
Damaged partnerships between GCs and subcontractors Reputation Operational
Fewer opportunities to bid or negotiate for future work due to damaged reputation Financial Reputation
Type and size of projects limited for future work due to lowered surety bond credit line Financial Reputation
Surety bond default and company survival threatened due to decreased corporate profitability Financial Reputation

Industry Changes Since 2009: Proceed with Caution

Since this article first appeared (in the January/February 2009 issue of CFMA Building Profits), the construction industry has experienced challenges and changes that have led to the continued emergence of construction defects as a pressing industry issue. Most notably, the U.S. and global financial crises have contributed to the protracted economic recession and lingering recovery.

There have been some positive outcomes as a result of these changes, including growing awareness of supply chain risk management practices, improvements in building envelope design, the adoption of controls for moisture and water damage prevention, and other construction quality improvement methods and techniques.

However, the aftermath of these challenges includes such negative effects as the precipitous decline in the residential housing and construction markets and marked shifts between private and public construction funding and hard bid vs. negotiated work.

As always, contractors must consider the financial, operational, risk management, and insurance impacts from these and other changes to avoid increased risk.

Specifically, unique challenges occur when contractors pursue business in new states and/or with new partners (owners, subcontractors, and/or joint ventures), use new delivery methods, and involve new types of projects/occupancies and new products and/or materials, with which they have less experience and are beyond their core competencies.

Shifting Sands & Slippery Slopes
The resulting and ever-changing landscape of construction defects has been caused by such factors as:8

  • State legislation and judicial case law interpretations to the legal definitions of an occurrence, property damage, and resulting loss under CGL policies;
  • Increased contention between GCs and subcontractors on matters of contractual risk transfer;
  • The expansion of “business risk” exclusions and exclusionary insurance endorsements vs. the growing availability of construction defect coverage;
  • Unproven impacts of innovative design features, new products, and integrated technologies involved in Leadership in Energy and Environmental Design (LEED) and green construction; and
  • The emergence of e-discovery in construction litigation.

Unfortunately, the lack of aggregated industry data on alleged vs. actual construction defects increases the challenge of finding proven proactive solutions that are focused on prevention. As a result, information has been focused on reactive mitigation strategies based on lessons learned from construction defect litigation outcomes.

Moving Forward

The adoption of quality management systems can positively influence the construction industry's reputation and contractors' bottom lines.

Moreover, those companies that elect to implement quality management systems are more likely to gain a competitive advantage in the form of improved productivity and reduced rework, which leads to higher profitability.

Upfront coordination and rigorous pre-project planning can reduce schedule dynamics that disrupt the entire system of a construction project. Successful project management entails quality, risk, and safety management among owners, designers, engineers, contractors, subcontractors, and suppliers.

Ultimately, with respect to construction defects, prevention is a better strategy than mitigation, and mitigation is a better strategy than litigation.

As incidents of alleged construction defects rise, they pose a serious risk to your company's tangible and intangible assets.

It's critical for contractors to fully understand the specific state legislation and case law that governs construction defects in the jurisdictions in which their companies have completed projects or plan to perform work.

Active, ongoing collaboration with construction specialty professionals in the areas of law, insurance, surety, and accounting can help your company stay abreast of the ever-changing landscape and make informed business decisions.

Endnotes:

1 Wielinski, Patrick J. Insurance for Defective Construction, 2nd Edition, 2005. International Risk Management Institute, Inc. (IRMI). Dallas, TX.

2 Grosskopf, K.R. & Lucas, D.E. “Identifying the Causes of Moisture- Related Defect Litigation in U.S. Building Construction.” www.rics.org/site/download_feed.aspx?fileID=3158&fileExtension=PDF.

3Grosskopf, K.R., Oppenheim, P. & Brennan, T. “Preventing Defect Claims in Hot, Humid Climates.” ASHRAE Journal, July 2008, 40-52.

4 For more information on Commercial General Liability, see Wm. Cary Wright's article, “The Anatomy of a CGL Policy,” CFMA Building Profits, January/February 2009.

5 “Statute of Repose Limitations for Construction Projects.” American Insurance Association, Inc., January 7, 2007.

6Ibid.

7 Chang, A.S., & Leu, S.S. “Data Mining Model for Identifying Project Profitability Variables.” International Journal of Project Management, April 2006, Volume 24, Issue 3, 199-206.

8 “Construction defects: Managing risk, covering exposure.” Business Insurance, www.businessinsurance.com/section/NEWS070102.

© 2012 by the Construction Financial Management Association. All right reserved. This article first appeared in CFMA Building Profits. Used with permission.