There have been several recent noteworthy decisions from courts examining insurance coverage for, and liability issues impacting, architects, engineers and other design professionals. These cases have dealt with, among other things:

• the scope and application of the "professional services" exclusion in commercial general liability policies;
• the duty of care owed to future homeowners;
• criminal liability for circumventing state and local codes;
• application of the "first cost" doctrine for calculating damages;
• the "completed and accepted doctrine;" and
• allocation between covered and non-covered claims.

We provide brief summaries of these cases below.

North Counties Engineering, Inc. et al. v. State Farm General Insurance Co. (California): Engineering firm's "ordinary labor" was not the performance of "professional services" within meaning of GL exclusion.

In March 2014, the California Court of Appeals ruled that the professional liability exclusion in a general liability policy precludes coverage for true "engineering services" at a project, but it does not preclude coverage for ordinary construction labor at the site. This case is significant because it provides A&E insurers an option to argue that at least some part of the insured's work at a site may fall under GL coverage instead.

The engineering firm, North Counties Engineering, Inc. ("NCE"), entered into a contract with a California winery to design and construct a dam in 1974. Construction began over twenty years later, with completion in 1999. In 2004, after neighborhood complaints and a State investigation regarding erosion in surrounding waterways and excess sediment downstream, the State of California sued the winery owner. The owner then filed a cross-complaint against its engineer, NCE, alleging failure to construct the dam in a good and professional manner. Shortly thereafter, the winery filed its own action against NCE alleging, in part, that the property damage was caused by NCE's negligent construction of the dam.

State Farm issued a "Business Liability" policy to NCE, which included a "professional services" exclusion. State Farm denied coverage to NCE and refused to defend based, in relevant part, on the "professional services" exclusion. NCE filed suit seeking a declaration of coverage. State Farm argued that the "professional services" exclusion precluded coverage, as NCE is an engineering firm, and engineering is one of several "professional services" expressly named in the exclusion. The trial court granted a directed verdict in favor of State Farm, finding no duty to defend because all work performed by NCE was professional in nature, including its construction of the dam.

However, on appeal, the Court of Appeals reversed the trial court, finding that the exclusion is inapplicable when the evidence showed that the engineering firm performed ordinary labor and construction work in connection with building the dam and was being sued for negligent construction. The Court of Appeals determined that NCE's manual labor and construction did not fall within the policy's definition of "professional services," because the definition did not include "construction," "labor," and the like allegations against NCE in causing the property damage.

Wisznia Company, Inc. v. General Star Indemnity Co. (Louisiana): Professional services exclusion in GL policy precludes all claims from insured's work at the project.

On July 16, 2014 the Fifth Circuit (applying Louisiana law) reached the opposite conclusion of the case above and held that the professional services exclusion in a general liability policy excluded all services rendered by the architecture firm in connection with the project because all services were "professional" in nature, and even the allegations of negligence existed only in the context of professional negligence.

Wisznia Co. ("Wisznia"), an architecture firm, entered into a design contract with a Louisiana municipality for the design of a performing arts center. The municipality sued Wisznia, alleging breach of contractual warranty, negligence, and lack of professional skill when the center experienced problems during and after construction. After Wisznia's commercial general liability insurer, General Star, denied coverage for the claim, Wisznia sought a declaration regarding the insurer's duty to defend. The district court determined that, based on the professional services exclusion, General Star owed no duty to defend.

On appeal, Wisznia argued that the exclusion should not preclude the duty to defend because the underlying lawsuit included allegations of simple negligence that fall outside of a "professional service." The Fifth Circuit disagreed and ruled that, even when liberally construing the underlying lawsuit's allegations in favor of the insured, coverage was precluded by the professional services exclusion, because all of the allegations concerned Wisznia's design and planning of the construction project. The exclusion applies where, as in Wisznia, every factual allegation pertained to the rendering of professional services and did not allege a breach of a general duty of care or give rise to a simple non-professional negligence claim.

Beacon Residential Community Association v. Skidmore, Ownings & Merrill, LLP et al. (California): Architect designing condominiums now owes duty to future residents.

In a matter of first impression, the California Supreme Court held in July 2014 that a principal architect designing residential buildings owes a duty of care to future homeowners, with whom there is no contractual relationship, even when the architect does not actually build the project or exercise ultimate control over construction. As follows, design professionals' liability in California is now expanded to a wider spectrum of claims.

Skidmore, Owings & Merrill LLP ("Skidmore") and HKS, Inc. ("HKS") contracted with The Beacon in San Francisco to provide architectural services for the construction of 595 residential condominiums. The homeowners association brought a construction design defect action against the two architectural firms, the developer, and others, alleging that negligent architectural design made the residences unsafe and uninhabitable during high temperatures. The architects argued that they could owe no duty of care to residents with whom they did not contract and who were not even residents at the building until long after the professional services contract was completed.

The California Supreme Court, affirming the appellate decision, found that a duty was owed to the third-party homeowners association even in the absence of privity of contract at the time the services were performed. The Court explained that an architect owes a duty of care to third parties where the architect is the principal architect on the residential project – or is not subordinate to any other design professional in providing its professional design services. This is true despite the fact that, as the architects argued, they had no role in the residences' actual construction and made no final decisions in this regard. The California Supreme Court found that Skidmore and HKS's primary roles in the project's design, and the implementation of same during construction, bear a direct and immediate connection to the alleged injury, as they were the only entities with architectural expertise on the project. Further, the Court found that recognizing the design professionals' duty of care to future homeowners did not subject such professionals to the prospect of indeterminate liability exposure, as the architects knew all along that the finished project would eventually benefit the third parties who purchased the condominiums as residences. The Court determined that the policy of preventing future harm to those future homeowners who rely on the architects' specialized skill also supports a duty finding.

State of California v. Gerhard Becker (California): Architect's faulty design results in manslaughter charge.

Criminal negligence for design professionals may not be as far-fetched as once thought, especially if the design professionals willfully attempt to circumvent state and local codes. German architect Gerhard Becker ("Becker") was sentenced in January 2014 to one year in prison by the State of California after he pleaded no contest to involuntary manslaughter for the death of a firefighter responding to a fire at his home.

In 2011, a fire broke out in the architect's residential home that he had recently remodeled, acting as the project's architect and also supervising the construction. Among other building and fire code violations that were blatantly ignored and sidestepped by Becker, the fire was determined to have started in one of several fireplaces that he installed indoors despite a manufacturer's warning of outdoor use only. With emergency crews inside, the roof collapsed, killing one firefighter and injuring others.

After a lengthy investigation that determined he negligently installed a fireplace inside that was intended for outdoor use, Becker was charged with involuntary manslaughter, facing a maximum of four years in prison. After serving his remaining jail time, he will be deported.

The School Board of Broward County v. Pierce Goodwin Alexander & Linville (Florida): As a matter of first impression, Florida expressly recognized the "first costs" principle in calculating damages for the breach of a design contract.

A June 2014 decision by Florida's Court of Appeals recognized the "first costs" principle, holding that tort damages against a design professional should not include "first costs" in construction, or the costs of items that are required but were incorrectly omitted from the design due to the design professional's breach of contract.

A Florida school board contracted with the architectural firm Pierce Goodwin Alexander & Linville ("Pierce Goodwin") for design services related to the renovation of a high school. Pierce Goodwin disagreed with a peer review of the design plans, which opined that a third floor balcony required an emergency exit staircase in accordance with fire safety codes. Instead, Pierce Goodwin submitted the plans for bidding even without an official determination that the emergency staircase was not needed.

After construction was completed, it was determined that the design plans were not code-compliant because the staircase was in fact necessary. Pierce Goodwin had to redraft the design plans, and the school board incurred additional costs for the renovation. The school board sued Pierce Goodwin for breach of contract, breach of contractual indemnity, and breach of common law indemnity, alleging that numerous "change order items" resulted because the architect failed to provide initial design plans that were code-compliant.

A pre-trial order granted Pierce Goodwin the right to seek a damages setoff for "first costs" (sometimes referred to as "betterment"). Thus, after the jury awarded damages to the school board on the change order items for which liability was admitted, the circuit court granted remittitur reducing the award, and the school board appealed.

The Court of Appeals recognized that the school board's damages should not include costs for construction that the school board would have incurred if the initial design plans matched the final design plans. The principle of "first costs," according to the Court of Appeals, ensures that a party entitled to damages is not "placed, because of th[e] breach, in a position better than which he would have occupied had the contract been performed" as agreed. As such, the Court of Appeals agreed that the circuit court's remittitur equal to the "first costs" for each change order item on appeal was proper. The Court did not, however, assign the burden of proof regarding "first costs," as the issue was not raised on appeal.

SRC Construction Corp. of Monroe v. Atlantic City Housing Authority, et al. (New Jersey): Economic loss doctrine does not bar tort claims against architect by contractor because no contractual privity existed.

The differing applications of the economic loss doctrine have important implications for construction projects, where damages are often limited to purely economic loss. In April 2013, the United States District Court for the District of New Jersey held that the economic loss doctrine does not apply to preclude tort claims against the non-contracting architect, as explained below.

SRC Construction Corp. of Monroe ("SRC") contracted with the Atlantic City Housing Authority (the "housing authority") as the general contractor on a project to build an assisted living facility. The housing authority also entered into a contract with an architect to design the project. SRC sued the housing authority with relation to the contract, and the housing authority filed various counterclaims. SRC then brought, among other things, a negligence action against the architect (with whom it had no direct contract) related to various alleged construction delays. SRC alleged that the architect's delays caused it to incur additional costs associated with the project.

The architect moved for summary judgment on the grounds that SRC's claims are barred by the economic loss doctrine. The district court denied the motion, finding that the doctrine does not bar SRC's negligence claim because SRC did not have a contractual relationship with the architect. Rather, the contract was between the architect and the housing authority. The district court rejected the architect's argument that the doctrine should still apply because SRC had a contract with the housing authority who had asserted a related contract claim the architect, and SRC was attempting to seek the benefit of that contractual agreement through the disguise of a tort claim against the architect. The district court found that, where there is no contractual relationship between the plaintiff and defendant in a tort action, and there can be no contract claim, the tort claim cannot possibly be a contract claim in disguise and is not barred by the economic loss doctrine.

Neiman v. Leo A. Daly Company (California): Architect not liable for third party's injury after project was "completed and accepted" by owner.

In January 2013, the California Supreme Court denied review after its Court of Appeals afforded the protections of the "completed and accepted doctrine" to an architect despite plaintiff's argument that the project was incomplete because it did not comply with the plans. Under the "completed and accepted" doctrine, when an architect completes work that is accepted by the owner, the architect's liability to third parties for injuries resulting from patent defects (apparent by reasonable inspection) is extinguished, even if the architect was negligent in performing under the contract.

The Santa Monica Community College District ("District") contracted with the Leo A. Daly Company ("LAD") to design a theater arts building for campus and to observe the construction of the building. After the project was done and the theater was opened to the public, Ellen Neiman ("Neiman") fell on the theater's stairs and filed a personal injury action against the District and LAD, alleging that LAD failed to properly mark the stairs with contrast marking stripes and failed to notify the District that the stripes were absent despite their presence in the design plans.

The trial court granted LAD's motion for summary judgment, finding that the affirmative defense of the "completed and accepted doctrine" was applicable. Affirming the trial court, the California Court of Appeals found that the alleged defect – LAD's failure to place contrast marking stripes on the stairs at the theater – was obvious and apparent to any reasonable person, and thus patent as a matter of law. Further, the project was in fact completed at the time of injury despite the District's assertion that the project was incomplete because the marking stripes specified in the plans were not installed and, therefore, LAD did not fulfill its duties under the contract. "LAD's negligence in performing the contract is irrelevant in application of the completed and accepted doctrine." Thus, the doctrine was properly applied to preclude the architect's liability to the third party.

Remodeling Dimensions, Inc. v. Integrity Mutual Insurance Company (Minnesota): The potential of offering jury interrogatories on allocation of damages in underlying action can create a burden on the insureds to do so, or risk losing later insurance coverage for indemnity.

In August 2012, the Minnesota Supreme Court held, as a matter of first impression, that when an insurer accepts a defense under a reservation of rights with respect to non-covered claims, the insurer will later have a duty to inform the insured that the insured should obtaining a written finding at arbitration or trial as to what portion of damages, if any, are for covered versus non-covered claims. This case has not been significantly discussed in subsequent reported decisions, but it does create an opportunity for insurers in construction cases to impose a clear burden on the insured to establish an allocation between covered and non-covered losses.

The insured, Remodeling Dimensions, Inc. ("RDI"), is a home remodeling contractor who received an arbitration demand from a homeowner based on its allegedly defective work under a construction contract. The arbitration demand was tendered to RDI's insurer, Integrity Mutual Insurance Company ("Integrity"), which reserved its rights to deny coverage due to its belief that the claims were not "occurrences" and were excluded under the business-risk exclusion. Approximately four months later, Integrity sent a second letter to RDI that stated, "It will be up to you and your counsel to fashion an arbitration award form that addresses the coverage issues and your respective burden."

After the arbitration hearing on three claims – a failure to inform claim and two negligent construction claims for the original house and the addition – an award in favor of the homeowner was entered. The attorney for RDI then requested a written explanation of the award, which was denied as untimely. When Integrity subsequently denied coverage, RDI paid the homeowner the amount awarded and then filed a declaratory judgment action against Integrity alleging breach of contract and seeking indemnification.

The Court of Appeals, reversing the District Court, granted Integrity's motion for summary judgment and held that Integrity had the right to challenge coverage even though no award explanation was obtained and, further, that the failure to inform claim was uncovered as a matter of law. RDI appealed.

The Supreme Court of Minnesota found that, with regard to Integrity's liability for the lack of an allocated arbitration award, when an insurer issues a reservation of rights with regard to a defense that includes both covered and uncovered claims, the insurer has a duty to advise the insured that the insured can, and should, obtain a written explanation from the underlying trier of fact as to what portions of the award are attributable to covered versus uncovered claims. When the insurer does not so advise the insured, then the burden can shift from the insured to the insurer to prove that some portion of the award is uncovered. The matter was remanded back to the district court for a determination of whether Integrity's notice to RDI was timely.

Please do not hesitate to contact us should you have questions on these A&E matters or other coverage challenges.