Although they are in frequent use and well known to insurers and insureds in the construction industry, policy exclusions for “faulty or improper design” have been the focus of considerable debate in Canadian courts in recent years. The uncertainty surrounding the scope of such clauses can be attributed to the existence of two opposing lines of authority as to the burden of proof that must be met in order for the exclusion to apply. The majority position, inspired by a decision that originates from the High Court of Australia and has been frequently cited in Canada,1 was that an insurer need only show that a loss was occasioned by the design of the thing insured in order to invoke the faulty or improper design exclusion. The other line of authority required the insurer to establish negligence in connection with the design in order for the exclusion to be triggered. On November 21, 2008, in Canadian National Railway Co. v. Royal and Sun Alliance Insurance Co. of Canada,2 the Supreme Court of Canada, in a lengthy and complex ruling by a slim four-to-three majority of the Court, endorsed a new approach which lies mid-way between the two interpretations.

The property insurance policy analysed in this case had been negotiated by the Canadian National Railway Company (“CN”) with various insurers in connection with a project to construct a railway tunnel under a river in Ontario. The policy was a Builders’ Risk policy providing CN with all-risks coverage, with exclusions for the cost of making good “faulty or improper design” and for “inherent vice”. Very early on in the digging of the tunnel, it was discovered that dirt had entered some of the bearing chambers of the immense boring machine used to perform the work and the operations were halted. Major repairs had to be made to the boring machine and the tunnel was completed several months behind schedule. When CN sought indemnity under the policy for the cost of the repairs and the loss suffered as a result of the delay in the work, the insurers denied coverage based on the faulty or improper design exclusion.

In the opinion of Justice Binnie, writing for the majority of the Supreme Court, the insurers needed to show that the design of the boring machine did not meet state-of-the-art standards prevailing at the time, and had failed to discharge that burden. Thus Justice Binnie chose not to apply the principles derived from the Queensland decision referred to above, since, in his view, the design of the boring machine could not be said to be “faulty” just because it did not achieve the desired result or because it failed in conditions of foreseeable risk, in this case the deflection of the steel of the cuttinghead. Nor, in Justice Binnie’s opinion, was it enough for the design to meet only minimum industry standards. In short, the view of the majority of the Supreme Court was that the standard required to be met in order for the insured to escape the application of the faulty design exclusion was a realistic, state-ofthe- art based standard lying somewhere between a design that survived the negligence test and one that was perfect and able to withstand every possible risk.

In dissenting reasons delivered by Justice Rothstein, the minority of the Supreme Court adopted a more traditional approach and would have upheld the decision of the Ontario Court of Appeal, which applied the Queensland principles and found for the insurers.

IMPACT OF THE RULING

This is an important decision which will likely signal a change in the analysis of faulty design exclusion clauses in all contracts of insurance. While at first sight the ruling appears favourable to insureds holding policies that contain such clauses, one needs to be mindful of the specific facts that were present in this case. The boring machine designed for CN’s project was the largest of its kind in the world at the time and every precaution had been taken, by the designer and the consulting engineers who were retained to provide advice on the project, to guard against the possibility of a failure of the sort that ultimately occurred. Consequently, it was very difficult for the Court to find anything to reproach the insured for, and its diligence unquestionably influenced the conclusion arrived at by the majority justices.

Moreover, as Justice Binnie suggests in his reasons, there is nothing to prevent insurers from changing the way they formulate their exclusion clauses and broadening the scope of such clauses to exclude coverage for all claims arising from any failure in the design of the insured property. That being the case, as a result of this recent decision, insureds will, in future negotiations with insurers, want to pay particular attention to the wording of faulty design exclusions.