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Bulletin

Supreme Court of Canada Considers Builder’s Risk Policy “Faulty Workmanship” Exclusion Clause

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Construction and Insurance Bulletin

The recent Supreme Court of Canada decision of Ledcor Construction Ltd. v. Northbridge Indemnity Insurance Co. (PDF), 2016 SCC 37 considered two issues important to the construction and insurance industries: (i) the standard of appellate review for trial decisions involving the interpretation of standard form insurance contracts; and (ii) the application of "faulty workmanship" exclusion clauses in builder's risk policies. 

The Supreme Court ruled as follows:

  1. in most cases, the standard of appellate review for trial decisions involving standard form insurance contracts will be "correctness" (i.e., whether the trial judge was correct); and
  2. faulty workmanship exclusion clauses in builder's risk policies ought to be narrowly construed to exclude only the cost of re-doing the faulty work itself--not the cost of remedying the property damage caused by the faulty work. 

This is an important decision impacting both the construction and insurance industries.Contractors and other parties involved in construction projects may be provided greater insurance coverage for property damage caused by faulty work, depending on the policy wording. Conversely, insurance companies face greater exposure to claims for property damage from faulty work. It can be expected that Canadian insurers will revise their builder's risk policies to more narrowly define and restrict coverage for property damage caused by faulty workmanship.

Facts and Background

Prior to completion of a commercial tower project in Edmonton, Alberta, a contractor was hired by the building owner to do the final exterior cleaning of the tower's windows. The window cleaning contractor used improper tools and scratched the windows, which had to be replaced at a cost of $2.5 million. Insurance claims were made by the owner and the project's general contractor, Ledcor Construction, under the project's builder's risk policy for indemnity for the cost of replacing the damaged windows. The insurer Northbridge denied the claim for coverage on the basis that property damage caused by faulty workmanship was excluded under the policy. Ledcor and the owner sued for coverage.

The Alberta Court of Queen's Bench ruled that the cost of replacing the windows was covered under the policy on the basis that the cost of replacing the scratched windows was "resultant damage" from faulty work and thus covered under the policy language. The Alberta Court of Appeal, applying a standard of correctness, reversed the trial judge and held that the cost of replacing the windows was NOT covered because the damage to the windows was directly connected to the excluded faulty workmanship. Under the Court of Appeal's analysis, only "collateral" property damage (i.e., property damage not directly connected to the faulty workmanship) was covered under the policy language. Ledcor appealed to the Supreme Court of Canada.

The Supreme Court's Decision

An eight judge majority of the Supreme Court overturned the decision on the Alberta Court of Appeal and reinstated the trial court's finding that the cost of replacing the windows was covered under the builder's risk policy. Mr. Justice Wagner, writing for the majority, rejected the "connectedness" test applied by the Court of Appeal and instead applied a broad principled approach to interpreting builder's risk policies. In extensive reasons, the SCC majority also confirmed the Court of Appeal's judgment that correctness was the appropriate standard of review for decisions involving the interpretation of standard form insurance contracts. One judge, Mr. Justice Cromwell, dissented on the standard of review question holding that the standard of review for insurance contracts ought to be the same as other contracts, namely the standard of palpable and overriding error, per the SCC's decision in Sattva Capital Corp. v. Creston Moly Corp., 2014 SCC 53.

The SCC's key findings and reasoning are summarized as follows:

  • where the question arises from the interpretation of a standard form insurance contact and: (i) involves a question of law; (ii) is of general application; and (iii) does not involve the consideration of the underlying facts of the case, then the standard of review for trial decisions answering such a question is correctness;
  • there is no specific discrete test for the interpretation of faulty workmanship exclusion clauses. Rather, courts are to apply the broad principles respecting the interpretation of insurance policies set out by the SCC in Progressive Homes v. Lombard General Insurance Co of Canada [2010] 2 SCR 245, namely:
    • if the language of the policy is unambiguous, effect should be given to that clear language, reading the contract as a whole;
    • where the policy's language is ambiguous, general rules of contractual interpretation should first be applied to try to resolve the ambiguity as follows:
      • the interpretation should be consistent with the reasonable expectation of the parties, as long as that expectation is supported by the language of the policy;
      • the interpretation should not give rise to results that are unrealistic or that the parties would not have contemplated in the commercial circumstances in which the policy was contracted; and
      • the interpretation should be consistent with interpretations of similar policies;
    • if (and only if) ambiguity remains after the application of these principles of contractual interpretation, the contra proferentem rule may be applied to construe the policy against the insurer with coverage provisions interpreted broadly and exclusion provisions interpreted narrowly.
  • applying the Progressive Homes analysis to the Northbridge builder's risk policy, the Supreme Court concluded:
    • the faulty workmanship exclusion clause (and the resultant damage exception to this exclusion) in the Northbridge policy was ambiguous;
    • the purpose of a builder's "all-risk" policy is to provide insurance coverage for property damage caused by contractors and others during the course of construction. It is reasonable for insureds under such policies to expect that coverage will be available in the event of an accident or damage on the construction site arising out of a party's negligent acts, which are the most common source of loss in construction projects. An interpretation of the exclusion clause which denied coverage for property damage resulting from a contractor's faulty workmanship just because it related to that part of the project on which the contractor was working would undermine the purpose of the policy;
    • an interpretation of the faulty workmanship exclusion which did not exclude coverage for property damage caused by faulty workmanship would not turn the builder's risk policy into a warranty or some other type of unrealistic and uncontemplated coverage; and
    • limiting the faulty workmanship exclusion clause to exclude only to the cost of redoing the faulty work was consistent with previous cases, although the SCC acknowledged that the existing case law on this question was not unanimous and highly fact specific;
  • accordingly, the Supreme Court ruled that the subject exclusion clause did NOT exclude coverage for property damage caused by faulty workmanship of contractors. As a result, the cost of replacing the scratched windows was covered under the Northbridge policy.

Commentary

The Supreme Court's decision in Ledcor Construction v. Northbridge Indemnity Insurance is important for both the construction industry and the insurance industry. The judgment is largely helpful to contractors and owners in that its broad and purposeful analysis increases the likelihood of insurers (and courts) finding coverage for property damage caused by faulty workmanship. The Ledcor decision significantly narrows the scope and application of faulty workmanship exclusion clauses typically found in builders risk policies to the cost of remedying faulty workmanship alone and may reverse the recent direction of insurers and some courts to refuse coverage for property damage related to excluded faulty workmanship. 

While the Ledcor decision provides a helpful discussion of the purpose and application of builder's risk insurance which may aid in the future interpretation of such policies, the case unfortunately does not set out any clear analysis or test for determining whether the claimed loss is properly characterized as the cost of "making good faulty workmanship" (excluded) or "resultant damage" arising from faulty work (covered) as the Alberta Court of Appeal attempted to do. As acknowledged by the Supreme Court, it can often be difficult to distinguish between the cost of remedying faulty work and the cost of repairing property damage caused by faulty work as exemplified by the inconsistent decisions on this issue by Canadian courts. As a result, it is unlikely that the Ledcor decision will resolve with finality the common dispute between insurers and insureds as to whether a claimed construction project loss is properly characterized as the cost of making good faulty workmanship or cost of repairing resultant property damage. 

From a larger insurance industry perspective, it can be expected that the insurance industry will revise the standard form builder's risk policy in response to this decision to better define and narrow the scope of coverage for property damage caused by faulty workmanship. 

Finally, the Supreme Court's application of the standard of correctness to appeals involving the interpretation of insurance contracts brings some clarity and consistency to Canadian appellate law in that it creates a clear exception to the rule in Sattva Capital Corp. holding the standard of review in contract cases to be palpable and overriding error. The effect of Ledcor is that there is now a wider scope of appeals for insurance coverage disputes. This application of the standard of correctness may lead to more lower court judgments on insurance disputes being appealed.

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