It happens frequently enough: An engineering or construction firm has a Commercial General Liability policy that covers claims of damage for work that it has completed. At the same time, the policy excludes damage “arising from the provision or failure to provide professional services.” Where is the line between providing competent construction work and providing “professional services?” The California Court of Appeal has provided the correct answer.
Typically, a commercial construction project is an enterprise of astonishing complexity that requires expertise and experience as well as hard, dirt-under-the-fingernails, labor. No one is — or ever really should be — surprised that things can, and sometimes do, go wrong in the complicated process of building a skyscraper, a bridge, a tunnel, or a dam. But does it matter, for purposes of a contractor’s liability insurance coverage, whether the things that “went wrong” on a construction project were the result of applying the contractor’s specialized knowledge and expertise, as opposed to the way the contractor or its subcontractors physically put the structure together? Is it even possible to divorce one from the other?
The answer to the first question is, “Yes, it often matters very much.” The answer to the second question is, “Yes, it is.” On Thursday, March 13, 2014, the California Court of Appeal issued a decision that does a really terrific job of explaining how coverage applies when the question is whether the things that went wrong resulted from actual construction work, on the one hand, or from professional services, on the other. Before discussing the decision, however, we need to set the table. Here is the “Insurance 101″ explanation of how liability coverage is structured for most engineers and construction contractors.
The CGL policy provides litigation insurance. The law imposes several distinct duties on a CGL carrier whenever a claim is made against its insured. The first is a duty to investigate the claim promptly and in good faith, to determine if the claim is potentially covered under the policy. The second is to hire a lawyer to provide a defense to the policyholder if there is any possibility that any claim made against the policyholder might be covered. The third is to pay any settlement or judgment covered by the policy up to the limits of liability.
Most construction contractors’ CGL policies, and some engineering firms’ policies (more on that momentarily), contain what is called “Products-Completed Operations Hazard” (or PCOH) coverage. The standard PCOH provision says that the insurance company will pay for bodily injury or property damage arising from the insured’s “work” or the insured’s “products” as long as: (1) the injury or damage occurs away from premises owned or rented by the insured; (2) the products are no longer in the insured’s physical possession; and (3) the work as been completed. The intent of this coverage is to provide protection to the contractor for a broad range of liabilities for alleged faulty workmanship after the construction project has been completed and handed over to the owner. [Note: For many years now, contractors and carriers have been fighting over whether a claim of "faulty workmanship" can ever be considered "accidental" such as to trigger CGL coverage as an initial matter. A significant majority of state Supreme Courts have ruled in favor of contractors on that question. See, e.g., the blog posts here, here, and here.]
When PCOH coverage and a Professional Services exclusion appear in the same policy, it poses an interpretive problem that has bedeviled many courts and led them into error.
Insurance companies usually couple PCOH coverage in a contractor’s CGL policy with a broad “Professional Services” exclusion. The idea here is that there is separate Errors & Omissions coverage on the market to cover claims akin to professional “malpractice,” and that the CGL policy is designed to cover accidents arising from ordinary negligence. A few moments’ thought about this will reveal a potential conceptual overlap between what might constitute the “ordinary” negligence of someone with a specialized area of expertise and the “professional” negligence of that same specially skilled person.
The standard-form Professional Services exclusion says that the policy does not cover bodily injury or property damage “due to or arising from the rendering or the failure to render professional services.” This includes “engineering, drafting, surveying or architectural services, including preparing, approving, or failing to prepare or approve maps, drawings, opinions, reports, surveys, change orders, designs or specifications.” It is easy to see how such an exclusion in a policy issued to an engineering firm, or even a design-build firm, might drive the policyholder to purchase an E&O policy, which will provide coverage for liabilities arising from professional services.
Mischief can arise, though, when a CGL policy contains both PCOH coverage and a Professional Services exclusion. This is especially true when an engineering firm’s policy contains PCOH coverage. Yet, the number of reported cases that involve engineering firms facing coverage questions arising from these two policy provisions suggests that such policies are out there in significant numbers. And they pose an interpretive problem that has bedeviled many courts and led them into error. The California Court of Appeal, however, teaches us how the two provisions can exist side-by-side without either thwarting the coverage to which the policyholder is entitled or writing the exclusion completely out of the policy. The case is Northern County Engineers, Inc., et al. v. State Farm General Insurance Company. (Get a copy here.)
Gary Akerstrom is an engineer and businessman and the 90% owner of Northern County Engineers, or NCE. Lolonis Winery in Mendocino County hired NCE in 1974 to design a dam on its property, to divert the waters of two tributaries on its property for the winery’s use. Lolonis then sat on those plans for twenty years, eventually getting them approved for construction by the State of California in 1994. Actual construction of the dam began in 1998. Lolonis retained both NCE and Northern Counties Development, Inc., a construction firm owned by Gary Akerstrom’s sons, to build the dam in accordance with the plans that NCE had drawn up in 1974. Lolonis also retained both firms to build an access road, a “spillway,” and a sediment basin to catch and retain the sediment from water run-off around the site of the dam. NCE and NCD completed the dam and associated components in November 1999. Things went south pretty soon thereafter.
In 2000, the State began investigating complaints that the dam was causing sediment to accumulate in downstream waterways and that it was causing erosion in the surrounding area. The State eventually brought suit against Lolonis to fix the problems. Lolonis, in turn, sued NCE and NCD in 2004 for negligent construction of the dam, breach of contract, and breach of warranty. It is worth noting here that the Lolonis claims fell squarely and unmistakably within the PCOH coverage of NCE’s 1999-2000 policy. The complaint alleged that NCE had participated in the “construction” of the dam, access road, spill-way, and sediment basin. NCE’s work on the project was completed at the time the claims were made. Among the claims were that NCE, itself, had built the sediment basin and that the failure of the basin to perform as intended had resulted in the downstream sediment damage alleged by the State.
NCE tendered the Lolonis complaint to its CGL carrier, State Farm, and demanded a defense. What happened next was a series of mistakes and apparent willful blindness on the part of State Farm that lasted several years.
The initial claim handler at State Farm noted in the file that the “date of loss” was 2004. Thus, the claim was assigned to the NCE 2004-2005 policy period. This is important because, in 2000, State Farm began to include a PCOH exclusion in NCE’s policy. Before that period, all of NCE’s policies had included PCOH coverage. The State Farm claim file notes that the date of loss would need to be “updated” after review of the underlying Lolonis complaint. That update never occurred, even though the Lolonis complaint clearly described, in great detail, the history of the construction project and the fact that the events giving rise to the claim took place from 1997 to 1999.
In June 2004, State Farm wrote to NCE’s counsel and advised that it had completed its investigation and had decided to deny all coverage. As it happens, the only “investigation” State Farm had actually conducted was to review the 2004 policy and compare it to the claims in the Lolonis complaint. The claim handler “conducted no interviews, made no inquiries, and requested no written statements regarding the underlying actions or the scope-of-work performed by” NCE or NCD. Despite a carrier’s obligation to conduct a good-faith investigation of every claim, this kind of perfunctory review is disturbingly common among insurance company claim handlers.
The denial letter cited a litany of exclusions, advised that the damage from the construction of the dam was not a covered “occurrence,” and listed both the PCOH exclusion and the Professional Services exclusion as applicable to the claims. The claim handler later admitted in testimony that it was a mistake to review the claim on the basis of coverage under the 2004 policy; the correct policy was the one for the 1999-2000 period. Nonetheless, two years went by following the denial, during which NCE and Akerstrom were defending themselves in the underlying Lolonis action. During that period, NCE spent over $500,000 of its own money on the defense.
In November 2006, NCE’s attorney wrote again to State Farm, providing an update and demanding an immediate defense of the Lolonis action. Various people within State Farm reviewed the letter and compared, once again, the pleadings with the 2004 policy. State Farm also referred the letter to outside coverage counsel. NCE’s counsel had conversations directly with State Farm’s claim personnel, during which he informed the carrier that the applicable policy was the one for 1999-2000, not 2004; that the 1999 policy contained PCOH coverage; and that the Lolonis complaint claimed damages arising directly from actual construction work performed by NCE. Nevertheless, four months later, relying primarily on the original coverage opinion of the initial claim handler, State Farm reiterated its complete denial.
Not content at this point to take “No” for an answer, NCE’s counsel persisted, in increasingly strident tones, to pursue coverage on the ground that the denial was based on “patently incorrect facts,” ultimately sending to State Farm’s outside counsel 3,000 pages of documents from the underlying case and a 34-page letter. Finally, in September 2007, three years and $500,000 in defense costs later, State Farm changed its position and began to defend NCE. It flatly refused, however, to reimburse NCE for any of the money that had been spent on the defense to date. That refusal led to coverage litigation between NCE and State Farm in 2008.
Following three years of discovery, the case went to trial before a jury in August 2011. After eighteen days of testimony, State Farm made a motion for a directed verdict (a motion that claims that there was no evidence presented from which a jury could reasonably conclude that NCE was entitled to a recovery). The trial judge granted the motion on the basis of the Professional Services exclusion. In a lengthy verbal opinion on the record, the trial judge viewed all of the work NCE had performed for Lolonis — including NCE’s actual hands-on construction work — through the prism of NCE’s engineering “expertise.” Accordingly, the court concluded that NCE acted primarily in the capacity of a supervising expert on the project and that the Professional Services exclusion therefore applied. NCE appealed.
If the damage occurs after the job is complete, PCOH coverage applies but the Professional Services exclusion never should.
The interesting thing about the Court of Appeal decision is the way it resolves the complications that arise from the inclusion of PCOH coverage and the Professional Services exclusion in the same policy. First, the Court of Appeal analyzed the Professional Services exclusion under a standard that the trial court had neglected: strictly and narrowly against the insurer. It is a universal rule of insurance policy interpretation that exclusions in coverage are narrowly construed against the drafter of the policy. Here, the Court of Appeal looked at the list of tasks in the definition of “professional services” and did not find either “construction” or “labor,” two tasks that appeared in the complaint against NCE.
Second — and this affords a key insight into the proper application of a Professional Services exclusion — the Court distinguished a 1989 Court of Appeal case in which a professional services exclusion was found applicable to a customer’s injury while she was having her ears pierced. The NCE Court noted that injury resulting from the faulty ear piercing “occurred while [the insured] was operating a retail cosmetics store.” In other words, the injury occurred during the act of piercing. In contrast, the damage in NCE “occurred after the appellants’ work was completed.” And there’s the rub.
PCOH coverage is defined as damage that occurs after the insured’s work is complete or after the insured’s product is no longer in the insured’s physical possession. NCE completed constructed of the dam and turned it over to Lolonis. It was only then that damage arose from the allegedly faulty construction. Thus, PCOH coverage and the Professional Services exclusion can be said to be mutually exclusive. There should, in fact, never be any overlap between what a PCOH provision covers and what a Professional Services exclusion excludes. If the injury or damage a party seeks against a contractor occurred on the job and during construction, it is then — and only then — that a Professional Services exclusion might apply. If the damage occurs after the job is complete, PCOH coverage applies but the exclusion never should.
If future courts take no other lesson away from the decision in NCE v. State Farm, it should be this one.