Standard LEG exclusion clauses in builders' risk policies

As is common for construction contracts in Ontario, builders' risk policy insurance agreements frequently use standard form contracts. The Supreme Court of Canada has recognized the purpose of these policies as providing broad coverage for construction projects, which are "singularly susceptible to accidents and errors."^[1]

A feature of some of these "all-risk" policies are common exclusion clauses developed by the London Engineering Group ("LEG"), a consultative body for insurers of engineering class risks.

LEG exclusion clauses

LEG has developed three insurance-industry model exclusion clauses: LEG 1, LEG 2 and LEG 3.^[2]

1. LEG 1/96 — This "outright defects exclusion" clause excludes coverage for all loss or damage due to defects of workmanship, materials or design.
2. LEG 2/96 — This "consequences defects exclusion" clause excludes the before-loss cost of remedying any defective workmanship, materials or design.
3. LEG 3/06 — This "improvement defects exclusion" is the narrowest model exclusion clause, only excluding any costs incurred for improvements to the original design, material or workmanship.

There is relatively little Canadian case law interpreting these clauses. The Supreme Court of British Columbia and the British Columbia Court of Appeal did so in Acciona Infrastructure Canada Inc. v Allianz Global Risks US Insurance Co.^[3] These decisions concerned the interpretation of a LEG 2 exclusion clause. The BC Court of Appeal upheld the trial court decision, and the Supreme Court of Canada subsequently remanded the case to the Court of Appeal to be reconsidered for disposition in accordance with it holding in Ledcor.^[4]

The Ledcor analysis

In Ledcor, the Supreme Court of Canada provides a framework for courts to interpret the scope of coverage for insurance policies subject to exclusion clauses, with the onus of proof shifting between the insurer and the insured.

1. First, the insured must establish that the damage or loss falls within the general scope of coverage of the policy.
2. Second, the insurer may prove that an exclusion clause applies to limit the insured's claim.
3. If an insurer succeeds in proving an exclusion, the insured may then prove that an exception to the exclusion applies.^[5]

The Court further advised in Ledcor that where there is ambiguity in the language of the insurance policy, it must be resolved following the general principles of contractual interpretation to best represent the parties' reasonable expectations.^[6] Because builders' risk policies are standard form contracts, consideration of their purpose is "crucial in determining the parties' reasonable expectations" of the exclusion clauses.^[7]

The Court in Ledcor affirmed its earlier finding that "the purpose of builders' risk policies is stability by granting coverage that reduces the need for private law litigation",^[8] particularly recognizing the complexity of modern construction projects involving many contractors and workers.^[9] These policies allow projects to continue, rather than "grind to a halt" for litigation between contractors over liability for negligence.^[10] Damage caused by negligence and carelessness is the most common source of loss on large-scale construction projects, and the Court found indemnification against such loss is the expectation with which contractors purchase builders' risk policies.^[11]

The standard-form nature of builders' risk policies also factored into the Court's findings on the standard of review in Ledcor. The Court acknowledged that the interpretation of standard-form contracts has precedential value, with broad application of an interpretive decision, impacting the interests of many third parties. As such, absent a meaningful factual matrix relevant to the interpretation issue before the court, the standard of review on appeal in these cases is correctness.^[12]

Acciona decisions

The insured contractor in the Acciona case claimed against its insurers for approximately $15 million to repair concrete slab floors. The concrete slabs had "over-deflected", bending and cracking, as a result of faulty workmanship. While the floors met standard safety requirements, they did not meet the requirements of the project, an eight-story hospital that required the floors to meet a standard of surface functionality for its sensitive wheeled equipment. Accordingly, the contractor was required to undertake significant repairs to meet the project requirements.

The builders' risk policy at issue in Acciona included the LEG-2 exclusion clause, which provided the insurer would not be liable for:

all costs rendered necessary by defects of material workmanship, design, plan, or specification, and should damage occur to any portion of the Insured Property containing any of the said defects the cost of replacement or rectification which is hereby excluded is that cost which would have been incurred if replacement or rectification of the Insured Property had been put in hand immediately prior to the said damage.

For the purpose of this policy and not merely this exclusion it is understood and agreed that any portion of the Insured Property shall not be regarded as damaged solely by virtue of the existence of any defect of material workmanship, design, plan or specification.^[13]

The trial judge found that the faulty workmanship of the concrete slab floors was within the scope of the LEG-2 exclusion clause in the contractor's builders' risk policy, however this exclusion was limited to the cost of remedying the defect immediately before any consequential or resulting damage occurred.^[14] The clause did not exclude damage resulting from faulty workmanship. This interpretation of the LEG-2 exclusion results in insurer liability for the cost of repairing the damage, with a deduction for the cost of remedying the defect crystalized at the point in time before the damage occurred.

The Court found that the "damage" was the concrete slabs over-deflecting and cracking, and the LEG-2 clause only excluded the cost of rectifying the defects before the damage occurred. There was no evidence before the court on the quantum of costs to rectify the defective workmanship before the over-deflection and cracking of the floors occurred, though the court found that they would have been minimal.^[15] Accordingly, the exclusion clause resulted in no deduction from the cost of repair.

The Court of Appeal upheld the trial judge's decision, although it did so after finding the issues raised questions of mixed fact and law, requiring a finding of palpable and overriding error in order to interfere with the trial decision.^[16] As discussed above, Ledcor held that the standard of review is correctness, absent a meaningful factual matrix requiring a deferential standard. The Supreme Court of Canada subsequently disposed of the insurer's appeal of Acciona by remanding to the Court of Appeal for disposition in accordance with Ledcor, requiring a reconsideration of the trial judge's decisions on a correctness standard. However, this reconsideration has not followed, and the proper interpretation of LEG-2 clauses remains unsettled.

Conclusion

The past five years have not seen an influx of litigants testing the law in this area, or any relevant development. The absence of litigation in this area may indicate that the Supreme Court of Canada was successful in its objective identified in Ledcor: reducing private law litigation in complex construction projects.

Although the trial judge in Acciona did not have the benefit of the three-step framework later to be established in Ledcor, it is difficult to see how doing so would have led to a different result. The Acciona decisions are largely in accordance with Ledcor: their interpretation of the exclusion clause provides that builders' risk policies containing LEG-2 clauses provide coverage for damage otherwise covered resulting from faulty workmanship or negligence of an individual contractor, which is consistent with the purpose of the policy as found by the Supreme Court of Canada in Ledcor.

Legal approaches to this issue have additional complexity beyond those introduced by the factual background of any agreement or dispute. Please reach out to one of our professionals to discuss your unique circumstances.

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