Builders’ Risk Insurance – The Supreme Court Clarifies the Rules of Interpretation

January 3, 2017 | Nathalie Durocher, Mary Delli Quadri, Stephanie Massé

In a very recent judgment, the Supreme Court of Canada recalled and clarified the rules of interpretation applicable to builders’ risk insurance policies.

Facts

The owner of Station Lands Ltd. (Station) retained the services of the general contractor Ledcor Construction Limited (Ledcor) with respect to the construction of an office tower in Edmonton. During construction, the tower windows were dirtied with paint specks, dirt and concrete splatter. Station hired Bristol Cleaning (Bristol) to clean the windows. However, Bristol used improper tools and methods in carrying out its cleaning work, scratching the tower windows, which consequently had to be replaced. The replacement cost of the windows was estimated at $2.5 million.

Station and Ledcor (the Insureds) claimed the cost of replacing the windows against a builders’ risk insurance policy (the Policy) issued by their insurers. According to the Insureds, the consequences of the faulty work – in this case, the damage to the windows – were covered as “resulting physical damage.” The Insurers argued that the Policy did not cover the cost of re-cleaning the windows and the cost of their replacement. Therefore, they denied coverage on the basis of an exclusion contained in the Policy for the “cost of making good faulty workmanship,” which reads as follows:

4(A) Exclusions

This policy section does not ensure:

(…)

(b) The cost of making good faulty workmanship, construction materials or design unless physical damage not otherwise excluded by this policy results, in which event this policy shall insure such resulting damage.[1]

Lower Courts

The Court of Queen’s Bench of Alberta agreed with the Insureds. The judge found the exclusion clause was ambiguous because it allowed for interpretations by the Insureds and Insurers that were equally plausible. Considering that ambiguity persisted, the judge applied the rule of contra proferentem against the Insurers.

The Court of Appeal of Alberta reversed that decision and held that the damage to the windows was excluded from coverage. According to the Court of Appeal, the trial judge had improperly applied the rule of contra proferentem because the exclusion clause was not ambiguous. The Court devised a new test of “physical or systemic connectedness.” Based on this test, the Court concluded the damage to the windows was excluded from coverage.

The Supreme Court of Canada

In a majority decision written by the Honourable Richard Wagner, the Supreme Court reversed the Court of Appeal ruling, restored the order of the trial judge and concluded the damage to the windows and the cost of their replacement were both covered under the terms of the Policy.

In its decision, the Supreme Court examined two questions: (1) the standard of review applied by the Court of Appeal; and (2) the interpretation of the exclusion clause.

1) The correctness standard of review

The Supreme Court ruled on the standard of appellate review applicable to the interpretation of an insurance contract. The Court characterized the Policy as a standard form contract whose interpretation must be recognized as an exception to the principle established in the judgment Sattva Capital Corp. v. Creston Moly Corp.[2] The Court concluded that where the appeal involves the interpretation of a standard form contract, the interpretation at issue is of precedential value, and there is no meaningful factual matrix that is specific to the particular parties to assist the interpretation process, the interpretation is better characterized as a question of law subject to the correctness standard of review.

2) The exclusion clause

The Supreme Court rejected the new test of “physical or systemic connectedness” established by the Court of Appeal, which it deemed unnecessary. The Court reiterated the principles of interpretation with respect to insurance policies that were established by its ruling in Progressive Homes.[3] These principles can be summarized as follows:

  1. where the language of the insurance policy is unambiguous, effect should be given to that clear language, reading the contract as a whole;
  2. where the policy’s language is ambiguous, general rules of contract construction must be employed to resolve that ambiguity, namely, that the interpretation should be consistent with the reasonable expectations of the parties; and
  3. only if ambiguity still remains after the above principles are applied can the contra proferentem rule be employed to construe the policy against the insurer.

The Court saw no reason to depart from the generally accepted order of interpretation in analyzing the Policy and the exclusion clause. The Court concluded that the language of the exclusion clause was ambiguous because it did not clearly point to one interpretation of “cost of making good faulty workmanship” over the other. Consequently, the Court referred to the general rules of contract interpretation.

The Court then analyzed the parties’ reasonable expectations to determine the meaning of the exclusion clause. The Honourable Justice Richard Wagner stated as follows with respect to the purpose of builders’ risk policies:

This Court stated in Commonwealth Construction Co. v. Imperial Oil Ltd., [1978] 1 S.C.R. 317, that the purpose of builders’ risk policies is to provide certainty and stability by granting coverage that reduces the need for private law litigation. The Court also recognized the complexity of industrial life and large-scale construction projects that involve many different individual contractors:

…its function is to provide to the owner the promise that the contractors will have the funds to rebuild in case of loss and to the contractors the protection against the crippling cost of starting afresh in such an event, the whole without resort to litigation in case of negligence by anyone connected with the construction.

The Court concluded that an interpretation of the exclusion clause that precludes from coverage any and all damage resulting from a contractor’s faulty workmanship would undermine the purpose behind builders’ risk policies and would deprive the Insureds of the coverage for which they contracted.

In short, the Supreme Court concurred with the Insureds’ position on the meaning of the exclusion clause because it better reflected the purpose of broad coverage underlying builders’ risk policies and the commercial reality associated with construction projects. However, the Court noted that such an interpretation did not have the effect of transforming a builders’ risk policy into a construction warranty since the cost of redoing the faulty or inadequate work was not covered under the Policy.

The Court also stated that if it were to determine that the general rules of contractual interpretation would not clarify the ambiguous exclusion clause, then it would have reached the same conclusion on the basis of the contra proferentem rule.

Therefore, the Court ruled that the replacement cost of the tower windows represented physical damage resulting from the faulty work done by Bristol, which was covered under the Policy.

Conclusion

In addition to applying the rule of interpretation developed in Progressive Homes, this decision stands out from a significant jurisprudential trend in both common law and civil law with respect to the interpretation of the exception to the exclusion applicable to the faulty workmanship in the builders’ risk insurance.

The exception to the exclusion “faulty workmanship,” “faulty design” and “faulty materials,” until the Ledcor decision, had been rather narrowly interpreted in common law case law,[4] as well as in Quebec law,[5] because the courts held that a construction project had to be viewed “as one unit incapable of being segmented for insurance purposes.”

Prior to Ledcor, the interpretation generally given by the courts in faulty design cases made it impossible to indemnify the insured under the exception to the exclusion “resulting damage” unless: (1) the project or the construction could be functionally segmented into distinct or separate units; and (2) the functional distinction or separation was only applicable to third parties and not the insured (this matter was further discussed in Progressive Homes), which had the effect of limiting the coverage beyond the original intent of the builders’ risk insurance.

In summary, the Ledcor judgment has broadened the interpretation of the exception to the exclusion applicable to the faulty workmanship in the builders’ risk insurance while respecting the original intent of the builders’ risk insurance in accordance with the Supreme Court decision in the Commonwealth case and the rules of interpretation developed in Progressive Homes.

As a Builders’ Risk policy often covers most other persons involved in a construction project, including architects and engineers, this decision is of particular importance for professional indemnity underwriters.

[1] Ledcor Construction Ltd. v. Northbridge Indemnity Insurance Co., 2016 SCC 37 (CanLII), par. 10

[2] Sattva Capital Corp. v. Creston Moly Corp, 2014 SCC 53, [2014] 2 S.C.R. 633

[3] Progressive Homes Ltd. v. Lombard General Insurance Co. of Canada, 2010 SCC 33, [2010] 2 S.C.R. 245

[4] Ledcor Construction, op.cit., at para. 68

[5] Commonwealth Construction, op.cit., at para. 329

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