THE SECOND HARBOUR TUNNEL. A case study illustrating recent issues in construction insurance

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1 THE SECOND HARBOUR TUNNEL A case study illustrating recent issues in construction insurance Andrea Martignoni, Partner Malcolm Stephens, Senior Associate Allens Arthur Robinson Insurance Forum: Wednesday 7 February 2007 ymss A v Page 1

2 1. The hypothetical 1.1 The project On 1 June 2015 practical completion is achieved on a second tunnel under Sydney Harbour (the Second Harbour Tunnel). The parties involved in the project include: Consortium JV (Consortium), the owner/operator of the tunnel; Tunnel Construction Limited (TCL), which entered into a contract with Consortium to design and construct the tunnel; and Hydro Pty Limited (Hydro), which entered into a sub-contract with TCL to design a system for waterproofing the tunnel. 1.2 The water incident Under its contract with Consortium, TCL warrants that the tunnel will be "Waterproof" (a defined term) for 100 years from the date of practical completion. During the defects liability period, an expert instructed by the Consortium concludes that the tunnel will in fact only be "Waterproof" for between 50 and 70 years. Consortium directs TCL to remedy this defect. The cost of remedial work to ensure waterproofing for 100 years is agreed by Consortium and TCL to be $57 million. 1.3 The injury An employee of Hydro is injured during an inspection of leaks in the Second Harbour Tunnel. The employee brings common law claims against TCL and Hydro. These claims are successful and the employee obtains judgment against TCL for $600k (60% of $1m, being its share of responsibility multiplied by common law damages) and against Hydro for $320k (40% of $800k, being its share of responsibility for modified common law damages). TCL claims indemnity from Hydro for TCL's liability to the injured employee. This claim is based on a clause in the contract between TCL and Hydro which provides that Hydro shall indemnify TCL for any claims by an employee of Hydro against TCL in relation to the construction of the Second Harbour Tunnel. 1.4 The insurance issues: remedial work TCL claims indemnity from Fide, the insurer under a project specific professional indemnity policy (the Policy), for the cost of the remedial work. The Policy has a retention of $5m and a limit of cover of $50m (in excess of the retention). Fide relies on the following grounds to deny indemnity. An exclusion for liability arising out of construction work. An exclusion for contractual liabilities. An obligation to rectify a defect identified during the defects liability period is not a civil liability for the purposes of the Policy ymss A v Page 2

3 1.5 The retention The contract between TCL and Hydro provides that if: (i) (ii) (iii) Hydro breaches its obligations to TCL; TCL is consequently liable to Consortium; and that liability is covered by the policy with Fide, then the liability of Hydro is limited to the retention under that policy ($5 million). Fide asserts that, if it is held to be liable to TCL, then it should be entitled by way of subrogation to that payment of $5 million. 1.6 The insurance issues: personal injury Hydro claims indemnity from its workers compensation insurer, WCI, for both: its direct liability to its injured employee; and its liability to indemnify TCL for TCL's liability to the injured employee of Hydro. WCI admits indemnity for the claim by the employee. WCI denies indemnity for the claim of TCL against Hydro, however, on the basis that a workers' compensation policy does not cover claims under a contractual indemnity. We consider below each of the grounds in dispute between Fide, WCI and their insureds. In addition, we briefly consider at the end of this paper the different results that might have flowed if Consortium, TCL and Hydro had engaged in "alliance contracting". 2. Exclusion for liability arising out of construction work 2.1 The issues between the parties The Policy excludes claims "arising out of construction work". Fide asserts that it is entitled to rely on this exclusion because: the failure of the tunnel to meet the waterproofing requirement was due to both negligent design and negligent construction work; or, in the alternative, even if the construction work was not negligent, but carried out in accordance with instructions by Hydro, the construction work was nevertheless inadequate to provide the required waterproofing, entitling Fide to rely on this exclusion. TCL denies that a cause of liability was negligent construction work. It further asserts that, for the purposes of the Policy, a liability does not arise out of construction work if any defects in the construction were due solely to the implementation of a negligent design. 2.2 What will the court decide? Whether or not the construction work was negligent is, of course, a question of fact. The court will resolve this question after considering voluminous reports prepared by experts instructed by each of Consortium and TCL. ymss A v Page 3

4 If the court were to decide that the construction work was not negligent, it still may hold that the exclusion applies by analogy with the reasoning of Einstein J in the Third Runway Case 1 and of the Full Court of the Supreme Court of Western Australia in Speno 2. In the former case, Einstein J held that the construction work was negligent and applied the exclusion. He further held, however, that: in order to rely on the exclusion, the insurer did not need to prove that the construction work was negligent; and the exclusion would apply even if the construction work conformed with the plans and specifications for that work. In Speno, the court considered an extension of a cover under a policy for "liability arising out of the performance by [Speno] of any contract [for Hamersley]". An employee of Speno was injured by the negligence of employees of Hamersley. The court held that Hamersley was entitled to indemnity under this clause, even though there was no negligence or default by Speno or any of its employees. The fact that an employee of Speno was injured whilst performing work under a contract for Hamersley sufficed to attract cover. For a more detailed discussion of these cases, see the attached paper on the Third Runway Case. 3. Contractually assumed liabilities 3.1 The issues The Policy excluded claims: For any legal liability assumed by the Insured under a contract, but only when such liability would not have been imposed upon the Insured pursuant to the law of tort. Fide purported to rely on this exclusion to deny the claim by TCL. It asserted that there was no professional negligence by TCL, and that any liability to the Consortium arose only because of the breach of a contractual warranty that the tunnel would be Waterproof for 100 years. 3.2 Breach of contractual warranty The liability of TCL to Consortium is quite clearly a legal liability assumed by TCL under its contract with Consortium. The application of the first part of this exclusion is therefore clear. The more difficult question, however, is whether the proviso (but only when such liability would not have been imposed upon the Insured pursuant to the law of tort) to the exclusion applies. 1 Baulderstone Hornibrook Engineering Pty Ltd v Gordian Runoff Ltd [2006] NSWSC Speno Rail Maintenance Australia Pty Ltd v Hamersley Iron Pty Ltd (2000) 23 WAR 291 ymss A v Page 4

5 3.3 Would a liability have been imposed upon the insured pursuant to the law of tort? This proviso to the exclusion requires consideration of 2 separate issues. Was TCL negligent? If Hydro, but not TCL was negligent, does the proviso apply in respect of a claim by TCL? The first issue is of course a question of fact. Does the proviso apply to a claim by TCL if only Hydro were negligent? If Hydro (but not TCL) is found to have been negligent, then the exclusion would appear to apply (and the proviso not apply) to any claim by TCL, as TCL would not have been liable to Consortium pursuant to the law of tort. There may, however, be an argument available to TCL under Special Extension 1 of the Policy, which provides that: The coverage provided by this Policy is extended to indemnify the Insured, subject to the Policy's terms and conditions, against their liability for claims.arising out of any act, error or omission in the conduct of Professional Activities and Duties committed by specialist designers or consultants acting on the Insured's behalf pursuant to any contract for service and for whom the Insured are responsible. This clause, which is commonly found in professional indemnity policies, would appear to be intended to apply where: (d) the insured assumes design obligations under a contract; the insured subcontracts those design obligations; the subcontractor performs those design obligations negligently; and the insured is in breach of its own contractual design obligations as a result of the negligence of its subcontractor. With a few minor exceptions, a company will not be liable in tort for negligence of designers or consultants who are not employees of that company such a liability will only arise in contract. The intended operation of this extension, therefore, is inconsistent with the exclusion for contractually assumed liabilities. The alternatives for a court, therefore, are: to give precedence to the exclusion, which would deprive the Special Extension of almost all its operation; or to give precedence to the Special Extension, which would still allow the exclusion to operate where a contractual liability arises in the absence of negligence by the insured or its specialist designers or consultants. We are not aware of any court decision resolving this conflict. As discussed in section 3.1 of the attached paper, the issue was briefly raised, but not resolved, by Einstein J in the Third Runway Case. 3 3 Baulderstone Hornibrook Engineering Pty Ltd v Gordian Runoff Ltd [2006] NSWSC 223 ymss A v Page 5

6 3.4 Defects liability period The contract between Consortium and TCL imposes a contractual obligation on TCL to rectify defects identified by Consortium during the defects liability period. Fide therefore denies indemnity to TCL by asserting that: Consortium is not claiming damages from TCL, but merely giving a direction to TCL in accordance with the contract; TCL has a contractual obligation to rectify the defective work; and if TCL does not rectify the defects, then any liability to Consortium would be for damages for breach of a contractual obligation rather than damages for professional negligence. TCL raises two arguments in response to this ground for denying indemnity. (i) (ii) regardless of its obligations during the defects liability period, TCL is separately liable to Consortium for breaching its obligations to design the Second Harbour Tunnel; and Consortium has a contractual right to rectify the defective work itself and to recover the cost of doing so from TCL. We are not aware of any judicial consideration of this issue. The two competing considerations are as follows. An insured should not be able to manufacture a claim under a professional indemnity policy simply by refusing to perform its contractual obligations. For example, an insured which refused to complete a design for a project should not be entitled to recover any consequential liability from its insurer. Conversely, errors in professional design will frequently become apparent during the construction period or defects liability period. In both cases, there may be a contractual obligation either to complete a proper design (during the construction period) or perform remedial work (during the defects liability period). In both cases, the professional negligence of the insured has increased the cost of complying with this contractual liability. An insured might therefore seek to include a clause in the policy extending cover for additional costs incurred as a result of its professional negligence. Insurers, however, are likely to be wary about agreeing to such a clause, given the practical difficulty in proving what cost overruns result from professional negligence and what cost overruns result from other causes. As stated above, we are not aware of any judicial consideration of this issue even though, in our experience, it is a problem which frequently arises. ymss A v Page 6

7 4. Claim for retention 4.1 The issue It is common for agreements in the construction industry, and for commercial agreements generally, to include clauses along the following lines. A party to an agreement (the First Party) indemnifies the Second Party for losses arising from its breach of the agreement. The Second Party agrees, however, that before recovering from First Party, it will seek indemnity under any applicable insurance policy. The First Party will however be liable to indemnify the Second Party to the extent of any retention under the insurance policy. These clauses have become particularly popular given the significant retentions under many professional indemnity policies. 4.2 Development of scenario A court finds that: Fide is liable to indemnify TCL for $50 million (the limit of cover); Hydro was negligent and is liable to indemnify TCL. Pursuant to its contract with TCL, Hydro's liability is limited to $7m: the retention under the Policy of $5 million and the uninsured loss (in excess of $55m) of $2m. Fide then claims $5 million from TCL. It asserts that TCL holds the $5 million on trust for Fide because it relates to amounts for which TCL has been indemnified by Fide. TCL denies the claim by Hydro because, it asserts, the $5 million relates to the retention, for which TCL has not been indemnified. 4.3 The issues There is a general principle of insurance law that recoveries by an insured operate from the "top-down". That is: TCL retains $2m for the "uninsured" top layer (its total liability was $57m, but TCL was uninsured for losses exceeding $55m, being the retention of $5m plus the limit of cover of $50m); and the balance of $5m is held on trust for Fide. We are not aware of any case which has considered whether this usual principle can be affected by an agreement between the insured and the third party. The competing principles are as follows. From the perspective of an insurer, an insured and third party should not be able to agree, between themselves, that an amount recovered by the insured should be retained by the insured rather than recovered for the benefit of its insurer. ymss A v Page 7

8 From the perspective of TCL, however, the $5 million is a windfall to Fide because, had TCL and Hydro known that these recoveries would be for the benefit of Fide, they would never have included the relevant clause in the contract. In order to avoid future disputes on this issue, we recommend that insures and their insureds seek to agree expressly on the allocation of amounts received by an insured pursuant to clauses of this type. For a further discussion on subrogation and related issues whether there are multiple insureds, see the paper: "Apportionment of Liability Between Insurers and Contractors" at 5. Personal injury claim 5.1 The issue Many contracts provide for the parties to indemnify each other in respect of claims by employees of other parties. One suspects that, where negotiating these clauses, the parties intend that such liabilities should be covered by the employers' workers' compensation insurer. The New South Wales Court of Appeal has again confirmed, however, that (at least in New South Wales) employers are covered under their workers' compensation policies for such liabilities. 4 WCI is therefore entitled to deny indemnity for Hydro's liability to TCL. 5.2 The reasoning The Court of Appeal in Heyday considered the statutory form of workers compensation policy in NSW, which indemnifies an employer against: compensation that the employer becomes liable to pay under the Act due or in respect of any person who is a worker of the employer other amounts that the employer becomes liable to pay independently of the Act for injury to any such person. The Court of Appeal decided in 1995 that this clause did not provide cover to an employer who was liable under a contractual indemnity (in that case to its lessor) where the employer was not negligent. 5 The Court further held in that it made no difference if the employer was negligent and would have been liable in tort to its employee, even if it was not in fact liable. In that case, the employer was not sued by its employee, but the court found that the employer would have liable had a negligence claim been brought against it. In Heyday the Court held that it makes no difference if the employer was also found to have been liable to its employee in tort. The fact remained, in the Court's view, that the 4 Gordian Runoff Limited v Heyday Group Pty Limited [2005] NSWCA 29 5 Nigel Watts Fashion Agencies Pty Limited v GIO General Limited (1995) 8 ANZ Insurance cases Multiplex Constructions Pty Limited v Irving & Ors [2004] NSWCA 346 ymss A v Page 8

9 liability under the indemnity is not a liability for injury, even if the employer separately had such a liability. 5.3 Lessons from this decision The first important lesson from this decision is that indemnities in respect of claims by employees can have the effect of transferring liabilities from insurers (eg public liability insurers) to the parties themselves (who would not normally have insurance cover for liabilities under contractual indemnities). The second important point for parties to bear in mind is that the decision will not necessarily apply in other states. It was submitted in Multiplex 7 that the decision Nigel Watts was incorrect because it was inconsistent with the earlier High Court decision in State Government Insurance Office (Queensland) v Brisbane Stevedoring Pty Limited 8. The Court rejected that submission because, in part, Brisbane Stevedoring concerned the Queensland statutory policy which provided cover for liability "in respect of" injury. The words "in respect of" were held to be somewhat wider than "for". 6. Alliance contracting "Alliance contracting" is used to describe contractual arrangements under which the parties, to an extent, share risks and profits from a project. A common feature of such contracts is that losses arising from the fault of one party are shared between the parties. An advantage of alliance contracting is that it can minimise the time and money spent disputing the cause of losses. From an insurance perspective, a potential disadvantage of alliance contracting is that, in the absence of liability for loss being imposed on one party, there may be no insurance cover for that loss. In our present example, if TCL was not liable to the Consortium for the failure of a design to meet the contractual requirements, then TCL would not have a liability in respect of which it would seek insurance from Fide. TCL and Consortium may therefore be left sharing the remediation costs. Two possible responses to the situations are: to decide that the benefits of alliance contracting outweigh the possibility that insurance may not be available to cover certain losses; or to negotiate with insurers for a means by which losses can be recovered from insurers in the absence of an actual legal liability between the parties. 7 February Multiplex Constructions Pty Limited v Irving & Ors [2004] NSWCA (1969) 123 CLR 228 ymss A v Page 9