Do You Smell Something?

Thousands of homeowners are smelling a rotten egg odor emanating from their walls. Just the result of a teenager’s prank gone awry?

No, it’s no prank. It’s 600 million pounds of drywall imported from China after the 2004–2005 hurricane seasons. Homeowners claim that Chinese drywall emits noxious sulfur odors, which are especially pungent when exposed to the heat and humidity common to the southern regions of the United States.

Florida is home to almost half of the estimated 100,000 homes constructed with Chinese drywall; although, complaints have emerged in more than two dozen other states, including Louisiana, Alabama, Mississippi, and Texas, to name a few. Hundreds of these suits have been transferred and consolidated to a federal court in Louisiana. Homeowners report that defective drywall has damaged electrical components, corroded wiring and caused major home appliances to fail, resulting in costly repairs and major headaches. Many have also experienced breathing problems, nausea, headaches and sore throats, allegedly from prolonged exposure to the odors. A number of homeowner lawsuits name the drywall manufacturers and some domestic builders as defendants.

Litigation on coverage for defective drywall claims is in its early stages, and both homeowners and commercial general liability (CGL) policies are being considered in the courts. Does the damage caused by the alleged defects in the drywall constitute an “occurrence”? If so, do pollution or “your work” exclusions apply? Get ready for debate, and potentially a debacle, as insurers and insureds duke it out in the courts.

Occurrences and Your Work
Courts widely accept that a CGL policy does not warranty the quality of construction. Instead, it insures against the risk of an accident or occurrence. They have often defined an accident as anything that happens that is unexpected, unusual and fortuitous. Clarifying “occurrence” is a stickier wicket.

A majority of decisions have found that damage confined to the contractor’s product and due to nonconforming performance is not an occurrence that triggers coverage. This is because the damage flowed naturally from deficient workmanship and, therefore, is not fortuitous. Notwithstanding, a minority has held that those same damages do qualify as an occurrence because the contractor intended to perform adequately and never expected harm to occur, even if the damage flowed from the deficient workmanship.

Some courts have interpreted an occurrence to be based upon the specific, resulting property damage at issue. For example, if the property damage resulting from defective workmanship goes beyond the builder’s work product, such as to other portions of the property, an insured’s argument for coverage may be bolstered.

The question of qualifying defective drywall as an occurrence often arises simultaneously with consideration of the “your work” exclusion. A typical faulty workmanship exclusion could contain the following or similar language: “We do not pay for loss caused by or resulting from faulty or inadequate… design… workmanship, construction or materials used in construction.”

Tell It to the Judge
When it comes to insurance coverage, courts generally agree that an insurer bears the burden of proof when it relies upon an exclusion as a basis to deny coverage. The analysis focuses on whether the policy language is “clear and unambiguous,” with ambiguities construed narrowly and reasonable inferences drawn in favor of the policyholder.

Faulty workmanship or pollution exclusions are interpreted in accordance with the laws of the jurisdiction where the claim is being presented. Chinese drywall claims will be no different. Claims adjusters, working with counsel, should become familiar with the legal precedents of the respective venue because seemingly identical exclusions in insurance policies could produce vastly different legal precedents in neighboring jurisdictions.

A recent federal court, considering the occurrence requirement and the your-work exclusion in a CGL policy, added a new twist to the typical coverage issues. In Houseman Construction Co. v. Cincinnati Casualty Co., a contractor and a number of subcontractors performed construction at a grocery store, which suffered from a sinking floor several years later. In deciding whether there had been an occurrence within the meaning of the builder’s CGL policy, the court held that the your-work exclusion in the builder’s policy did not preclude coverage against various third party claims. The court was influenced by the policy’s exception to the your-work exclusion for damage caused by a subcontractor’s work. The court found the subcontractor exception to be ambiguous and, therefore, found against the insurer. The court reasoned that the exception expressed the insurer’s intent to cover some damage, at least where it was caused by the poor workmanship of a subcontractor.

Defective drywall claims will surely raise many of these referenced issues, including installation by various builders and subcontractors, the defective state of the drywall when it was received by the builders, and the resulting damages not being limited to the drywall, all of which will impact a CGL insurer’s obligation to defend and indemnify builders and subcontractors. Further, the Houseman decision illustrates that the specific policy exclusions will be closely scrutinized since exclusions dealing with work performed by subcontractors could impact a CGL insurer’s obligations. These arguments will depend upon the specific policy language and exclusions as well as applicable state law.

Pollution Exclusions Muddy the Waters
Generally speaking, a traditional pollution exclusion, which is contained in most property insurance policies, contains language similar to the following: “We do not pay for loss… caused by the discharge, disposal, release or escape of any… gaseous or thermal irritant, pollutant or contaminant, including smoke, vapors, soot, and fumes….” Similarly, CGL policies typically bar coverage for bodily injury or property damage “arising out of the actual, alleged or threatened discharge, seepage, migration, release or escape of pollutants,” with “pollutants” being further defined as any “solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste.”

One argument litigants will likely make is that sulfur compounds emitted by the drywall are not pollutants because sulfur occurs naturally and most people are exposed to it daily without any harmful effects. Property owners in Fort Myers, Fla., have taken this approach in their breach of contract suit against their homeowners insurance company. They want payment for the cost of having their home stripped of the defective drywall. The Bakers, in Baker v. American Home Assurance Company, Inc., have attempted to circumvent the pollution exclusion in the policy by alleging that the fumes do not satisfy the definition of a “contaminant” because the gases are not an impurity resulting from the mixture of, or contact with, any foreign substance.

A recent decision from Fifth Circuit Court of Appeals, interpreting Texas state law, ruled that toxic levels of carbon monoxide fumes fell into the pollutant category and that the plaintiff, CGL insurer Nautilus Insurance Co., had no duty to defend or indemnify its insured in claims arising from the release of the fumes from a furnace into an apartment. The insured, County Oaks Apts. Ltd., argued that carbon monoxide, although a gas, was not a pollutant under the exclusion because carbon monoxide does not “generally” or “probably irritate,” meaning that it was a naturally occurring substance encountered by humans every day.

Rejecting this argument, the court observed that even if the release of the carbon monoxide was not “meant to occur,” Texas law has consistently focused on defining an irritant as one that simply produces an effect, regardless of whether it “generally or probably should” cause the effect. Similarly, the Supreme Court of Washington, in Quadrant Corp. v. American States Insurance Co., held that the pollution exclusion barred coverage for claims involving toluene fumes emanating from waterproofing material used in an apartment complex.

Other jurisdictions have done an about-face with the interpretation of the pollution exclusion by looking beyond the plain language of the policy and incorporating an insured’s “reasonable expectation.” For example, the New York Supreme Court has held that exposure to toxic glue fumes was covered under a CGL policy despite the absolute pollution exclusion because the insured could expect the endorsement to apply only to “traditional” environmental hazards.

Some courts tend to view the term “pollutant” as ambiguous, asserting that most substances or chemicals in existence could be classified as an irritant or contaminant. Jurisdictions like New York have also posited that the plain purpose underlying the pollution exclusion was to exclude coverage for typical “environmental pollution” and that terms like “discharge and dispersal” are unique to the types of damages resulting from the disposal of hazardous waste.

Claims personnel should be mindful that this is uncharted territory. The drywall claims are unique since they do not involve stereotypical environmental pollution claims. Further, whether there will be any consistency in judicial interpretation of the meaning of a pollutant—or the discharge and dispersal of a pollutant—remains to be seen.

Uncertain Future
One thing is certain: A variety of coverage issues will arise from Chinese drywall claims. Ongoing investigations and tests could reveal further issues and grounds for claims. Adjusters need to follow the precedents closely, and insurers may need to find specialized counsel.

The repair and replacement costs resulting from defective Chinese drywall may prove to be staggering for many builders and subcontractors. Although homeowners policies might not cover the drywall defects, CGL insurers should anticipate a possible increase in coverage litigation over their potential obligation to defend and indemnify builders and subcontractors for drywall claims.

Michael A. Hamilton is a partner and chair of the National Insurance Coverage group at Nelson, Levine, de Luca & Horst LLP, a national law firm focused on the insurance industry. Kathryn L. Fettrow is an associate in the National Insurance Coverage group. Mr. Hamilton can be reached at mhamilton@nldhlaw.com.