Source: http://www.lexology.com, June 23, 2014
By: Mary (“Molly”) Woodson Poag and Jeremy B. Glen, Steptoe & Johnson LLP
In Regional Steel Corporation v. Liberty Surplus Insurance Corporation, — Cal.Rptr.3d –, 2014 WL 2643242 (Cal. App. 2d Jun 16, 2014) (Regional Steel), the Court of Appeals for the Second District of California affirmed the lower court’s grant of summary judgment for the insurer, finding no duty to defend claims arising out of a subcontractor’s installation of defective steel framing in an apartment building.  The court found that the risk of repairing defective materials was a commercial risk, which was not covered under the CGL policy (the Policy) issued by Liberty Surplus Insurance Corporation (Liberty).
Regional Steel Corporation (Regional) was hired as a subcontractor to provide reinforcing steel to the columns, walls, and floors of a construction project.  Id. at *1.  After its work was underway, a city building instructor rejected Regional’s use 90 degree seismic tie hooks in the walls of the building’s garage.  Id.  To make the repairs, the general contractor, JSM Construction, Inc. (JSM), had to open up numerous locations in the concrete walls, weld reinforcements, and otherwise strengthen the inadequate installation.  Id. at *2.  JSM then refused to pay Regional’s invoices, withholding approximately $545,000.  Id. at *1.
Regional sued JSM for payment of the outstanding invoices, and JSM filed a cross-complaint against Regional and other subcontractors.  Id. at *2.  JSM alleged that it was damaged because completion of the project was delayed, resulting in loss of use, loss of rental income and other damages.  Id.  Regional tendered a claim for defense of the underlying action to Liberty.¹  Id. at *3.  Liberty declined coverage, asserting that no damage to the property was alleged and that the purely economic losses caused by the need to correct the tie hook problem did not constitute property damage within the meaning of the Policy.  Id.
Later, after further discovery, Regional again tendered its claim to Liberty, this time alleging that the construction problems included out-of-level, cracked floors.  Id.  Liberty investigated and again declined coverage, since there was no evidence that JSM was asserting claims for out-of-level floors.  Id.  The underlying action thereafter settled.  Id.  The settlement agreement purported to release Regional from all claims, including alleged responsibility for the out-of-level floors.  Id.
Regional then filed a coverage action against Liberty.  Id.  Liberty filed a motion for summary judgment.  Id.  The trial court granted the motion, finding that Liberty had no duty to defend Regional, and Regional appealed.  Id. at *3-4.
The appellate court acknowledged that the law is in conflict as to whether construction defects that are incorporated into a whole property constitute property damage under CGL policies.  Id. at *7.  It then followed the line of cases holding that the costs to repair defective work or materials are economic losses, not property damage.  Id. at *7-8.
The court described as the “prevailing view” the premise that “‘the incorporation of a defective component or product into a larger structure does not constitute property damage unless and until the defective component causes physical injury to tangible property in at least some other part of the system.’”  Id. at *7 (quoting F&H Construction v. ITT Hartford Ins. Co., 12 Cal.Rptr.3d 896 (Cal. App. 4th 2004)).  The court noted this approach is consistent with the principle that CGL policies are not designed to provide contractors with coverage against claims that their work is inferior or defective.  Id.  Rather, the risk of replacing and repairing defective materials or poor workmanship is considered “a commercial risk which is not passed on to the liability insurer.”  Id.
The Regional Steel court acknowledged that other courts have held that the installation of defective materials constitutes a physical injury to property sufficient to trigger the CGL policy protections.  Id.  However, it found the cases upon which Regional Steel relied to be “inapposite because they involved contamination by hazardous materials that were incorporated into a whole,” as opposed to the “incorporation of defective workmanship into a construction project.”  Id. at *8.  Specifically, Armstrong World Industries, Inc. v. Aetna Casualty & Surety Co., 52 Cal.Rptr.2d 690 (Cal. App. 4th 1996), involved the use of asbestos construction materials that could ultimately release dangerous asbestos fibers into the air of the entire building, and Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc., 93 Cal.Rptr.2d 364 (Cal. App. 4th 2000), involved the commingling of wooden splinters with roasted almonds that were eventually incorporated into nut clusters for a breakfast cereal.  Regional Steel, at *7-8.  The court found the rulings in those cases consistent with the view that CGL coverage is not available where “damage to other property” has not occurred.  Id. at *8 (emphasis in original).
Applying that standard, the court found no coverage for losses resulting from Regional Steel’s use of defective tie hooks.  Id.  It also found that the recitals in the settlement agreement could not transform JSM’s construction defects claim against Regional into covered property damages.  Id.
Regional Steel provides another ruling in the line of cases finding that standard CGL policies do not provide insurance for poor workmanship or the use of defective materials in a construction project, unless damage is caused to some other part of the project.  It also reconciles this approach with courts that have reached a different result in cases involving the installation of hazardous materials.  This ruling also confirms that an insurer can make a coverage decision on the basis of the allegations in the underlying complaint and, so long as the policy language clearly demonstrates that coverage does not extend to those allegations, it can decline to defend.  In addition, this ruling demonstrates that an insured cannot manufacture coverage by reciting, in a settlement agreement, facts not supported by the pleadings.