Form is Substance: The Business Exclusion Provisions of a Subcontractor’s CGL Policy May Limit a General Contractor’s Ability to Recover Costs to Repair Subcontractor’s Defective Work

A Laurie & Brennan article featured in the Construction Law Corner, Summer, 2016 eNewsletter.

by Sierra Sterling

Courts throughout the country have wrestled with the question of whether allegedly defective construction is an occurrence under a commercial general liability policy.   The Georgia Court of Appeals jumped into the fray late last year in a rather unique case. In particular, the court examined an issue of first impression in Georgia: which party’s scope of work — the contractor’s or the subcontractor’s — should be considered when determining whether a business risk exclusion in a subcontractor’s CGL policy applies to a general contractor’s claim for first party coverage as an “additional insured” under its subcontractor’s CGL policy. This case is significant for general contractors seeking to recover costs for repair work they undertake when a subcontractor’s performance is inadequate or unacceptable. General contractors seeking to avoid uncertainty and potentially high litigation costs should discuss with their attorneys whether, in light of the terms of the CGL policies at issue, it makes more sense to file a first-party claim against an insurance company as an additional insured or as a judgment creditor against its debtor’s (the subcontractor’s) insurer. These issues are discussed more fully below.

In Auto Owners Ins. Co. v. Gay Const. Co., 774 S.E.2d 798 (Ga. Ct. App. 2015) a general contractor — Gay Construction Company (GCC) — served as the general contractor for a project to reconstruct a swimming pool and associated buildings for the Piedmont Park Conservancy. Part of the project required GCC to build a terrace. GCC hired a subcontractor, Dai-Cole, to install a waterproofing membrane and drainage mat to prevent leaks from the terrace to the restrooms and buildings below the terrace. However, shortly after the certificate of occupancy was issued, Piedmont Park officials complained of water leaking into the space below the terrace. GCC investigated and determined that the waterproofing membrane had been improperly applied. GCC unsuccessfully attempted to have Dai-Cole repair its faulty work. Instead, GCC had to undertake the work itself, at the cost of $126,000. After performing repairs, GCC sought to recover its expenses under Dai-Cole’s CGL policy.

Dai-Cole, as required by its contract, had obtained a CGL policy from Auto Owners Insurance Company (Auto Owners). The CGL policy contained several key definitions that would play a significant role in the court’s decision. GCC filed a claim with Auto Owners as an “additional insured.” The additional insured provision of Dai-Cole’s CGL policy stated:

[a] person or organization is an Additional Insured only with respect to liability arising out of “your work” for the Additional Insured by or for you: (1) if required in a written contract or agreement; or (2) if required by an oral contract or agreement only if a Certificate of Insurance was issued prior to the loss indicating the person or organization was an Additional Insured (emphasis added).

The court assumed, for the purposes of this case, that GCC qualified as an additional insured under Dai-Cole’s policy. However, the court’s inquiry did not end with whether GCC was an additional insured. Like most CGL policies, Dai-Cole’s CGL policy contained numerous “business risk exclusions.” The case turned on whether the business risk exclusions applied to GCC’s claim. To answer this question, the appellate court needed to determine whose scope of work — GCC’s or Dai-Cole’s — should apply in light of the language of the policy exclusions. The business risk exclusions are couched in terms of work performed. Thus, the scope of work is critical.

The trial court determined that GCC’s claim did not fall under the policy’s business risk exclusions. This determination stemmed from the trial court’s opinion that the business risk exclusions encompassed only the subcontractor’s (Dai-Cole) scope of work. Auto Owners argued instead that the business risk exclusions should instead apply to all the work charged to the general contractor (GCC). This issue was taken up on appeal, and the appellate court agreed with Auto Owners. The court explained that since there was no claim for damage to nondefective property outside of GCC’s or Dai-Cole’s scope of work, the business risk exclusions barred GCC’s claim. In so holding, the court clarified whose scope of work is considered when interpreting a CGL policy. This is summarized in the table below:

The court justified its holding by explaining the purpose of business risk exclusions and CGL policies. A CGL policy is not, the court emphasized, intended to serve as a warranty or guarantee of work. The business risk exclusions contained in standard CGL policies are designed to exclude from coverage defective or faulty workmanship by the insured that causes damage to the construction project itself. Since GCC’s claim was simply for faulty workmanship — the precise type of claim the business risk exclusions are intended to exclude — the claim was barred. To decide otherwise would be fundamentally unfair, according to the court. Since GCC’s scope of work was broader than Dai-Cole’s, and in fact encompassed Dai-Cole’s work, it must be subject to the same exclusions. If Dai-Cole had performed the repairs instead of GCC, any claim Dai-Cole made would be excluded under the business risk exclusion. GCC, as the general contractor, is not entitled to more protection than its subcontractor.

The upshot of this case is that general contractors must be circumspect when deciding the most effective way to recover costs associated with repairing its subcontractors’ defective work. The court suggests, in a bart note, that its analysis may have differed if GCC had filed a claim as a judgment creditor against Dai-Cole’s insurer rather than filing a first-party claim as an additional insured against the insurance company. In a 2009 case, Hathaway Dev. Co., Inc. v. American Empire Surplus Lines Ins. Co., 686 S.E.2d 855 (Ga. Ct. App. 2009), the Georgia Court of Appeals held that a general contractor may recover a judgment from the insurer that issued the subcontractor’s CGL policy. General contractors seeking to recover costs and their attorneys should consider this distinction when preparing a claim.

It does not appear that Illinois courts have addressed this specific issue, although Illinois courts have consistently interpreted the business risk exclusions in CGL policies to mean that work that arises from defective work is not covered by the policy. For example, in Auto-Owners Ins. Co. v. Chorak & Sons, Inc., 2008 WL 3286986 (N.D. Ill. Aug. 8, 2008), the U.S. District Court in the Northern District of Illinois explained that “CGL policies are intended to protect the insured from liability for injury or damage to the persons or property of others; they are not intended to pay the costs associated with repairing or replacing the insured’s defective work and products.” Similarly, the Appellate Court of Illinois has stated that business risk exclusions in CGL policies “are not intended to provide protection against the insured’s own faulty workmanship or product, which are normal risks associated with the conduct of the insured’s business.” The Court went on to state that “liability insurance should not become a warranty or be converted into a performance bond.”

In light of the recent case from Georgia and Illinois courts’ consistent emphasis on the purpose of business risk exclusions in CGL policies, it is prudent to consider the possibility that a general contractor cannot recover as an additional insured for the faulty workmanship of its subcontractor, even if the general contractor performs the repairs. In attempting to do so, a general contractor is effectively stepping into the shoes of the named insured for purposes of recover from the CGL insurer. If business risk exclusions eliminate coverage for faulty workmanship, it is unlikely that a general contractor in any jurisdiction can recover under its subcontractors’ CGL policy.

In sum, the nature of a general contractor’s claim is important. Attempting to recover under a subcontractor’s CGL policy could lead to increased legal costs, and ultimately, a denial of coverage. All parties involved in construction projects should be aware of the limits on claims and have a discussion with their attorneys regarding the best way to recover costs of repair in the event that work is defective. The Georgia case –like many cases in Illinois– simply shines some light on a slightly more complex variation of a typical CGL insurance claim for defective work.