Construction Defect. A Complex, Emerging Problem. Copyright 2001 CNA Financial Corporation

Transcription

1 Construction Defect A Complex, Emerging Problem AR CO FL GA TX

2 April, 2001 Homeowners, builders, subcontractors, state and local governments, and insurance companies face a growing problem in construction defect litigation and its consequences reduced housing values, a chilling effect on construction of multi-unit housing, shortages of affordable housing and the breakdown of important segments of the construction insurance marketplace. CNA, the leading provider of insurance to the construction industry, believes it is essential that all parties to the debate understand the dynamic and complex issues posed by construction defect. CNA was one of the first companies to recognize and address the problem of construction defect litigation. We have been a leader in identifying construction defect loss trends, studying the causes of construction defect losses, and taking early steps to mitigate liability. Over the past few years, CNA has: Led the effort to establish joint defense agreements. Moved to a flat fee defense arrangement in an effort to achieve greater efficiency and cost savings. Utilized knowledgeable staff counsel, as well as other experienced construction defect attorneys, to provide the highest quality representation to CNA policyholders. Increased the use of staff experts to conduct preliminary reviews of outside experts. Developed innovative coverage. Spearheaded a coalition in California to bring parties together to develop creative solutions, including development of a legislative agenda focused around a first-party warranty program. As an underwriting company dedicated to solving customer problems through superior knowledge of their risks, CNA is uniquely qualified to understand construction defect loss drivers. We have undertaken a major analysis of how other states may be affected by construction defect litigation in order to educate and provide options to prevent a crisis similar to the one in California. This white paper provides summary results of the analysis and identifies cost-effective, fair solutions to benefit homeowners and the construction industry. CNA is committed to the construction market and looks forward to working closely with insurance agents, builders, subcontractors, homeowners, public policymakers and other constituencies to implement long-term solutions to the construction defect problem. Page 1 of 16

3 Construction Defect A Complex, Emerging Problem BACKGROUND The occurrence of defects in newly constructed residential property is not a recent phenomenon. In the past, major defects in home construction occurred infrequently and were generally identified shortly after construction. When defects were discovered, a builder typically remedied the problem in accordance with the terms of the contract with the homeowner. As a result, insurers generally found that predicting potential liability from faulty construction or the use of defective materials was a relatively straightforward process. Courts traditionally upheld the Commercial General Liability (CGL) insurance policy language when disputes arose limiting recovery to damages for bodily injury or property damage resulting from faulty work or materials. Coverage was not afforded under the CGL policy for correcting the defect itself or the builder s failure to perform under the construction contract. This distinction enabled insurers to establish pricing and underwriting standards based upon relatively predictable outcomes. Commencing in California, several changes have taken place that have had a significant impact on construction defect claims: A) The economics of home construction shifted dramatically. Until the early 1980s, most developers built a few homes at a time, paying attention to every detail of the construction process. This practice allowed them to identify and resolve a construction problem early in the construction process. Demand for multi-family dwellings constructed en mass created shortages of labor, materials and expertise. Residential building quality deteriorated. Errors in design, faulty materials and poor construction were no longer limited to a single house the problems were replicated in each unit of multifamily tracts. As homeowners discovered defects in construction, they began filing claims for damages with the insurers of the contractors or subcontractors. Ultimately, this led to an explosion of litigation, primarily in California. Lawyers in a handful of other states are now poised to concentrate their efforts on construction defect litigation. B) As more construction defect lawsuits were filed, the traditional lines of distinction between contract and tort law have blurred. In California, the courts expanded the scope of the CGL policy, established a strict liability standard for construction defect lawsuits, found coverage that had not been available previously, and initiated changes in the process of dispute resolution. It can be anticipated that many of the legal challenges faced in California will ultimately manifest themselves, to varying degrees, in other states. Page 1 of 10

4 C) As more information has become available concerning the dynamics of construction defect claims, insurers are able to develop a much better understanding of the underlying factors likely to give rise to construction defect problems and potential claims. Factors include Rapid housing growth, Shortage of labor, Poor soil conditions, Presence of water intrusion, A litigious environment with an active trial bar, A political and judicial climate supportive of tort system expansion. Contract and insurance law has not been clear-cut with the expansion of the CGL policy and the inclusion of additional insured coverage for contractors under the subcontractors policies. The CGL policy was changed in 1986 to provide business risk coverage that was formerly excluded from the policy. Through the CGL policy, faulty workmanship coverage was provided to contractors for work performed on their behalf. In addition, the additional insured coverage endorsement was interpreted to provide products and completed operations coverage, although never intended. The Insurance Service Office clarified the original intent of this endorsement with the 1997 version of the CG2010. DEMOGRAPHIC AND ECONOMIC FACTORS Construction of tract housing, large housing developments, and multiple family dwellings such as condominiums and townhouses, has grown rapidly during the last 20 years. This housing boom and the economic expansion led to an increase in the demand for skilled construction labor that could not be met. The financial opportunities presented by a mass production environment, coupled with time demands, can tempt some builders to cut corners. Opting for shortterm financial rewards rather than high quality, less responsible builders may skip important loss control techniques and other quality testing procedures. They may also hire workers without adequate training and knowledge of proper building techniques and standards, and may retain contractors and subcontractors whose business life expectancy is limited. These dynamics increase the likelihood that a defect may occur in multiple dwellings, and increase the possibility that one or more of the parties involved in the construction project will no longer be accountable once the defect is discovered. A number of environmental factors often contribute to the occurrence of defects. Specifically, poor soil conditions have tended to be a widespread problem in California, Colorado and Texas. Water intrusion (moisture) continues to be a potential construction problem in Georgia and California. These two primary environmental loss drivers of construction Page 2 of 10

5 defect claims cause special building design and construction challenges that can cause extensive damage if not handled properly. Because of an increasing number of construction defect claims in Colorado, Arizona, Nevada and Texas, insurers anticipate the number of claims to grow in other states that share these environmental factors. A vast majority of builders, including their contractors and subcontractors, strive to produce high quality residential construction that meets the expectations of home buyers. However, in our litigious society, even they may be named in construction defect litigation where every party that had any role in the construction process is included. It is not surprising that the builders who are most successful in defending construction defect claims are those who employ an aggressive quality control program and offer meaningful warranties to homeowners. Such builders often go the extra mile to resolve problems that arise after warranties have expired, focusing on customer satisfaction every step of the way. The combination of demographic and economic factors not only increases the likelihood that defects will appear in a number of homes but, in many cases, the damages are latent and may not manifest themselves until years after the builder s one or two-year warranty expires. As a result, groups of homeowners may face costly repairs in their housing developments with limited remedies available. Homeowner Response: Association board directors, recognizing their fiduciary responsibilities to the homeowners, may feel compelled to initiate action to protect themselves from potential liability. The opportunity to represent multiple homeowners through their associations often presents an attractive economic opportunity to some plaintiffs attorneys. Not only does this minimize the costs to individual owners, but it also enhances the damages alleged. If an association cannot promptly resolve a problem with a builder, a lawsuit is often filed as a placeholder while the development is inspected. This is to ensure that certain statutory requirements such as the statutes of repose and limitations are satisfied. Ultimately, the investigation may reveal a number of routine maintenance issues that are not related to the construction defect problem. Nevertheless, such problems are frequently made a part of the lawsuit. Once filed, a lawsuit sets in motion an adversarial relationship between the parties homeowners, builders, contractors and subcontractors. Each party assumes a litigation posture, making it extremely difficult if not impossible to secure prompt, cost-effective repairs or other solutions to the problem. Page 3 of 10

6 Builder Response: In response to the growing number of construction defect lawsuits, builders have taken various precautions. Many have enhanced their quality control and warranty programs to ensure satisfied customers and thereby avoid the likelihood of being embroiled in litigation. Some have opted to shift responsibility by requiring that subcontractors name them as additional insureds on insurance policies. Others have established limited partnerships or corporations for specific projects, allowing them to cash out of the company once the project is completed. Some even operate without insurance. As a result, subcontractors and their insurers often find themselves defending claims that far exceed the exposure initially anticipated. This is especially true when subcontractors are unable to refuse providing additional insured coverage to the builder. Subcontractors are often inhibited in their ability to raise issues regarding project quality, work sequencing, and overall project management. The subcontractor may be tagged with poor performance for the work of another party in construction defect cases. By including the builder as an additional insured, the subcontractor may be forced to defend claims that are far in excess of the risk anticipated by them or their insurers. If the subcontractor s insurance company pays out claim dollars as a result, the subcontractor may face higher insurance rates or fewer insurance options at policy renewal. INSURANCE CONTRACT AND THE LEGAL ENVIRONMENT Individual states have different standards of liability for construction defect claims because construction law generally is predicated on individual state statutes and judicial decisions. For example, some state courts have interpreted the language as well as the coverage of the CGL policy differently. Whether a state s political climate supports or opposes expansion of tort liability can also have an impact on the outcome of legislative and judicial deliberations. Interpretation of the Insurance Contract: Interpretation of the CGL policy has shifted in some jurisdictions and now provides causes of action and coverage that previously had not been anticipated. For example, in the past when there was a leaky roof in a new home, the builder and subcontractor had to repair the roof under the performance requirements of the contract, while seeking coverage from their insurance carrier for subsequent damage that resulted from the leaky roof. As a result of court decisions expanding liability in certain jurisdictions, a homeowner with a leaky roof now may be entitled to bring a tort action against the builder for the repair of the leaky roof and the resultant damages. Because insurers had not contemplated coverage for repair of the roof when establishing the price to charge for the CGL insurance policy, they incur losses far in excess of those originally anticipated when the policy was issued. Page 4 of 10

7 Given the latent nature of many construction defects, this has resulted in years of continued claims and losses. Although California courts have expanded liability well beyond the standards imposed in any other state, it is unclear whether other state courts will follow the example. To date, most courts have applied traditional contract law governing construction defect liability. The Nevada Supreme Court recently developed a cohesive legal position that reaffirmed traditional standards of liability. In other states, such as Colorado and Georgia, it is too early to tell whether the courts will extend tort liability and expand the application of other laws to construction defect cases. This is especially true in Georgia where recent legislation established a different liability accrual standard for homes with synthetic stucco (EIFS). This is likely to lead to litigation over its applicability. Statutes of Limitation and Repose: Every state has a statute of repose and statute of limitations that are intended to balance the rights of plaintiffs and defendants facing legal liability. Plaintiffs need adequate time to discover defects and file a claim; defendants should not be held responsible for every problem that arises, particularly long after the useful life of materials and construction has expired. Defendants also require some degree of certainty that no further claims will be filed after a certain date. Time limits for these statutes are established by legislative act and vary from state to state. Because judicial decisions have extended the statute of limitations by holding that the time limitations begin to run from the date of discovery versus the actual date that construction was completed it is not unusual for cases to be filed after the statute of limitations has expired. This creates further uncertainty for builders, subcontractors and insurers, particularly when several insurers provided coverage during the intervening years and there is a dispute about when the damage may have occurred. Coverage is thereby triggered under multiple policies. The statute of repose is intended to apply for filing a lawsuit for particular types of latent claims, yet in some states the date is as long as 15 years. Given this lengthy period, builders, subcontractors and their insurance carriers find exposure extremely difficult to anticipate. The ability to properly price for potential claims that might arise a decade after construction under this scenario has proven almost impossible. Additional Insured Endorsement: Many builders insist that subcontractors include them as an additional insured on the subcontractors insurance policies. The existence of the additional insured endorsement, coupled with the expansive nature of construction defect litigation, can embroil subcontractors and their insurers in litigation even if the subcontractor played a minor role in the Page 5 of 10

8 construction process. Some builders also demand specific contractual language in their agreements with subcontractors requiring the subcontractor to indemnify and hold the builder harmless from any losses. Passing on the costs of liability to subcontractors not only limits the builder s incentive to avoid defective construction; it also creates additional liability for the subcontractor. Public policy in a number of states prohibits making a party responsible for another s sole negligence. As a practical matter, however, litigating as to whether the other party solely caused the negligence is extremely costly and timeconsuming. In construction defect cases where virtually every contractor and subcontractor involved is named in the lawsuit, it is particularly difficult to prove the sole negligence of a single party. The difficulty of anticipating liability is exacerbated in construction defect cases when virtually every builder and subcontractor is named as a party to the litigation in some jurisdictions. For example, generally a subcontractor with responsibility for installing kitchen cabinets would have no exposure for a subsequent construction defect claim relating to a structural issue. In construction defect litigation all parties, including the cabinet subcontractor, may be named in the lawsuit. While the subcontractor ultimately may bear no liability for damages, insurers are required to assume defense costs for the cabinet subcontractor and, potentially, the costs of defending the builder as a result of the additional insured contractual agreement. Active Trial Bar: The presence of an aggressive plaintiffs bar also increases the likelihood of growth in construction defect litigation because the opportunity to represent multiple parties in a single suit makes this type of litigation especially attractive. By aggregating the individual plaintiffs into a larger suit, each plaintiff s risk factor is lowered because of the ability to share litigation expenses. Because the costs are low, some homeowners may be willing to pursue inflated or questionable claims, or to challenge the underpinnings of the law, in an effort to secure monetary recovery. Although financial risks to plaintiffs decrease, defendants risks increase in actions with multiple plaintiffs. Unlike plaintiffs who are able to share the costs of litigation, defendants and their insurers usually have different defense postures. They usually require each defendant to incur the considerable costs associated with legal fees and expert witnesses. According to a report on mass tort litigation issued by the Federal Civil Rules Advisory Committee and Working Group on Mass Torts, in an effort to avoid this exposure, defendants may elect to settle cases earlier and faster, and pay a higher Page 6 of 10

9 settlement in order to rid themselves of company-threatening liability. The Federal Civil Rules Advisory Committee indicated that aggregated plaintiffs acquire power that is much greater than if they had filed suits individually. The size of the lawsuit is reported to enhance the plaintiffs substantive rights in part because it presents the defendant with an all-or-nothing risk. Fear of the litigation lottery may weaken the defendants resolve to try construction defect cases to conclusion and result in greater proclivity toward settlement. As news of monetary settlements spreads, other homeowners and their attorneys can be motivated to file similar suits. Once attorneys prosper in one state, they are likely to move into adjacent states to pursue similar litigation. In fact, law firms from California have established construction defect practice satellite offices in Nevada, Arizona and Colorado. As word of construction defect litigation spreads, particularly in those states with rapid population growth, local attorneys also will begin to develop construction defect practices. Expansion of these cases to states other than California seems inevitable, given the ease with which information about construction defect litigation can be accessed via the Internet and elsewhere. And as never before possible, the Internet makes it possible for potential plaintiffs and their attorneys to obtain wide-ranging information on construction defect litigation, including: questions and answers about how to file a construction defect lawsuit; explanations of construction defect law in various states; descriptions of what constitutes a construction defect; free analysis of the statute of limitations and how to satisfy requirements; information on how to recover against a bankrupt builder; offers to provide in-house seminars on construction defects; tips on how to recover from insurance companies; and the amounts of past construction defect recoveries. Such information can provide valuable assistance to homeowners with legitimate construction defect claims. Trial attorneys attempting to stimulate additional construction defect litigation may also use it. Not surprisingly, much of the information is designed to encourage homeowners to consult a construction defect attorney. In fact, on one Web site homeowners are advised to retain an attorney rather than pursue an amicable resolution with the builder, even if the builder has offered to make repairs to the property. Page 7 of 10

10 Page 8 of 10 The Litigation Process: Construction defect cases often have dozens of parties with a number of distinct adverse positions. This can mean that multiple representation may be necessary to avoid conflicts of interest. As a result, each time a deposition is taken, or pleadings, correspondence, or discovery documents are provided to the other parties, there could be more than 50 attorneys who must be served. This is time consuming and extremely costly. Trying to arrange multiple schedules to accommodate all involved parties also inhibits resolving these cases expeditiously. Even when the cases are resolved, closing them can be a complex process. In some cases it can take up to a year to complete a fully-executed settlement agreement. In a judicial system already clogged by a criminal and civil cases, the courtroom does not appear to be the most efficient forum for handling construction defect cases. To address this problem, legislators and court administrators have attempted to devise better ways of resolving or managing construction defect litigation. In California, a special process was implemented to move cases along. This originally seemed like a potential costeffective tool, but it has not resulted in significant savings. In Colorado, construction defect attorneys attempted to implement a similar program, but were rebuffed by local lawyers. As construction defect claims occur in other jurisdictions, first-party mechanisms appear to be a far more effective way to manage construction defect cases. SOLUTIONS Despite the many problems that have been outlined here, there are a number of solutions to be pursued: ensuring quality construction; establishing public policy educational programs, including judicial education; developing legislative approaches; and clarifying insurance coverage. Construction Excellence: Builders are responsible for ensuring that their work product conforms to applicable codes and standards. Each builder should have an effective quality control program that includes elements of responsibility: formality through a written program; job site controls; trade contract controls for subcontractors; workmanship controls through appropriate hiring and training protocols; and appropriate usage of construction materials. Safety measures are infused into the culture of good contracting firms. The same level of focus and energy needs to be devoted to infusing a culture of quality into those same firms. Contractors can also establish customerfocused warranty programs to resolve problems before they reach litigation. Warranty programs can be developed that include alternative dispute resolution mechanisms that are understood up front at closing with homeowners. Judicial Education and Amicus Briefs: The complexity of construction defect cases makes it important for judges to understand the dimensions of these cases. The plaintiffs bar has recognized this need and initiated a number of efforts to

11 ` educate judges through training sessions and educational seminars. Educational initiatives that inform local judges about the broader issues and defenses presented in construction defect cases are just as important to defendants and their insurers. To ensure credibility, these initiatives must be appropriately structured, utilizing objective, respected professionals as educators. Filing amicus briefs represents another avenue for insurers and the construction industry to educate jurists about construction defect law. Actual parties to litigation may represent the facts and law at issue effectively, but the future impact on others who are not parties to the litigation may not be obvious. Amicus briefs allow others, whose interests may be affected by the outcome of the litigation, to inform judges of the ramifications of their decisions beyond the specific facts of the case at hand. Public Policy Education: Another alternative is the creation of coalitions in selected states to inform the public about the nature of the construction defect problem, emphasizing steps that can be taken to prevent and manage construction defect claims. Because the problem affects a wide variety of constituencies, an opportunity exists to build a coalition beyond builders, subcontractors, and insurers. Potential partners include homeowner associations, architects, engineers, lenders, realtors, environmentalists, and land use planners. Legislation: Although most construction defect laws have evolved through judicial decisions, rather than changes in statutory law, several legislative proposals have been enacted to address this issue. Some states have adopted warranty statutes that are intended to serve as an exclusive remedy for homeowners with construction defect claims. States have also considered legislation that would impose requirements on homeowner associations prior to initiating litigation and established procedural guidelines to promote settlement. Future legislative options include revising the statute of repose in states with very long time limitations, adopting strict statewide building codes, and/or requiring builders to include strong risk management programs, including proper employee training. In order to establish sufficient support for legislative action, it is important to ensure that diverse constituencies are represented. PRECIS Construction defect and its resulting impact to homeowners, builders, subcontractors and insurance companies did not occur overnight. Nor will it be resolved overnight. However, it is important that all potentially impacted and involved parties begin to create awareness by educating the public to the dangers inherent in seemingly innocent consumer protection legislation and case law. Page 9 of 10

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