Construction Projects and the Apportionment of Liability

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1 Construction Projects and the Apportionment of Liability Insurance & Reinsurance Forum Wednesday 8 July 2009 Andrew Byrne, Senior Associate Allens Arthur Robinson Level 28 Deutsche Bank Place Corner Hunter and Phillip Streets Sydney NSW 2000 Australia Tel Fax Copyright Allens Arthur Robinson, Australia 2009 Page 1

2 CONSTRUCTION PROJECTS AND THE APPORTIONMENT OF LIABILITY INSURANCE AND REINSURANCE FORUM, 8 JULY 2009 This purpose of this paper is to provide a brief overview of legal principles governing the apportionment of liability in the context of construction projects insurance. 1 The paper is provided in conjunction with a presentation made by the author at Allens Arthur Robinson's Insurance & Reinsurance Forum on 8 July 2009, and is intended to compliment the subject matter of that presentation. The relationships of insurers, insureds and co-insureds can give rise to significant difficulties in managing risks associated with construction projects. The reason is that construction projects typically involve various independent parties bound together by complex contractual relationships. Pursuant to these contracts, it is common for certain parties to indemnify others in respect of particular risks. Furthermore, losses and liabilities are often caused by more than one party and covered by more than one insurance policy. In section 1 of this paper, we consider the principles of subrogation and contribution and how they apply in circumstances where an insured is indemnified by another party in respect of a loss. In section 2, we consider whether an insurer can exercise rights of subrogation against co-insureds. In section 3, we consider how rights of subrogation may be limited by parties. 1. Subrogation, contribution and contractual indemnities The following analysis is concerned with whether an insurer is entitled to exercise by way of subrogation the rights of its insured (say, a contractor on a construction projection) against another party (say, a subcontractor) pursuant to a contractual indemnity provided by the subcontractor to the contractor, or whether the insurer may only seek contribution from the subcontractor. The analysis applies equally to other parties to a construction project including, for instances, a principal or an operator which has suffered a loss or provided a contractual indemnity. 1.1 Principles of subrogation and contribution If a contractor suffers a loss as a result of the negligence of a subcontractor, it is well established that the contractor's insurer would be entitled to be subrogated to the contractor's right of action against the subcontractor. That action would be brought in the name of the contractor and would depend on the rights of the contractor against the subcontractor. The doctrine of subrogation relies upon the notion that the subcontractor is unable to escape liability by arguing that the contractor, having had its loss covered by its insurer, 1 This paper is derived from and updates the following papers produced by Malcolm Stephens of Allens Arthur Robinson: "Apportionment of Liability Between Insurers and Contractors", dated 17 May 2004; and "The Interaction Between Project Contracts and Insurance Policies", dated 26 November Page 2

3 has no longer suffered a loss. 2 Were it not for the doctrine of subrogation, the subcontractor would be entitled to assert that any liability to the contractor must be reduced to the extent that the contractor has already been compensated for its loss by its insurer. By contrast, the doctrine of contribution applies where parties are under "co-ordinate liabilities" to make good the "one loss". A common example of co-ordinate liabilities is where two insurers are liable to indemnify the same loss. In those circumstances, the insured party is entitled, in the absence of a contractual limitation, to recover its full loss from either of the insurers, and the insurer against which the loss is recovered has a right of contribution against the other insurer. Two important differences between contribution and subrogation are that: contribution gives a party which is liable for a loss a direct right against another party liable for the loss, whereas subrogation only entitles a party (typically, the insurer) to stand in the shoes of the entity which it has indemnified; and claiming contribution results in the liability being shared, whereas claiming subrogation results in a full recovery to the party exercising the subrogated rights. 1.2 Subrogation or contribution? A contentious issue in the context of construction projects is whether, where an indemnity is provided by one party to another r(in our example, by the subcontractor to the contractor) in respect of a loss, the contractor's insurer is entitled to bring a subrogated action against the subcontractor in the name of the contractor, or whether the insurer only has a right of contribution from the subcontractor. The two leading cases on this issue are Caledonia North Sea Limited v British Telecommunications plc (Scotland) & ors [2002] UKHL 4 (often referred to as the Elf judgment) and the judgment of the Full Court of the Supreme Court of Western Australia in Speno Rail Maintenance Australia Pty Limited v Hamersley Iron Pty Limited (2000) 23 WAR 291, each discussed below. The Elf judgment This case was concerned with an explosion on an oil rig. Although the litigation involved many different claims, one cause of the explosion was negligence by the operators of the rig and, as a result, injured workers had a right to be compensated by the operators. The operators were indemnified by their insurers, and also had a right to be indemnified by the contractors which employed the injured workers. The insurers of the operators brought subrogated claims against the contractors seeking to recover under the contractual indemnities. The contractors argued that the insurers were not entitled to do so, and were only entitled to bring claims for contribution. The essence of their reasoning was that the operators' insurers and the contractors were both liable under contractual indemnities (the insurer, under the indemnity provided in the operators' insurance policy; the contractor, under the indemnity provided in its contract with the operators) and the liabilities of the insurer and the contractors were therefore "co-ordinate". 2 Bee v Jensen (No 2) [2008] Lloyd's Rep IR 221 at 234 (CA). Page 3

4 The decision of the trial judge in favour of the contractors was overturned on appeal. On a further appeal, the House of Lords also disagreed with the trial judge and held that the liability of the contractors (pursuant to the contractual indemnities provided by them to the operators) was "primary", whereas the liability of the insurers (pursuant to the insurance held by the operators) was "secondary". The insurers were therefore entitled to bring subrogated claims against the contractors. The decision of the House of Lords is often cited as authority for the proposition that an insurer is always entitled to bring a subrogated action against a party which has given a contractual indemnity to the insured. A closer examination of the decision, however, indicates that the House of Lords based its findings on the particular facts of the case and the presumed intentions of the parties that the contractors would be "primarily liable" and the insurers would only be "secondarily liable" in respect of a loss of the type in question. There will be many factual situations where such an intention cannot be presumed and where, consequently, an insurer will not be entitled to bring a subrogated action relying on a contractual indemnity provided to its insured. The Speno case In the Speno case, which is consistent with the Elf judgment, Speno was engaged by Hamersley for rail grinding work. Pursuant to their contract, Speno indemnified Hamersley in respect of all claims arising out of the rail grinding work. Speno also obtained liability insurance covering itself and Hamersley, but the insurance did not cover any liability of Speno pursuant to the contractual indemnity provided to Hamersley. Whilst engaged in the rail grinding work, one of Speno's workers was injured as a result of negligence of Hamersley. The worker made a claim against Hamersley. Hamersley subsequently made a claim against Speno on the basis of the indemnity in their contract, and against the insurer under the policy arranged by Speno. The insurer accepted that it was obliged to indemnify Hamersley in respect of the worker's claim, and sought to recover the amount of its liability by way of a claim fro contribution against Speno on the basis of the contractual indemnity provided by Speno to Hamersley. The judgment of the Full Court of the Western Australian Supreme Court was delivered after the first appeal in the Elf litigation but before the House of Lords judgment was handed down. The Full Court determined that, on the facts in Speno, the liability of the insurer was "secondary" to, rather than "co-ordinate" with, Speno's obligation under the contractual indemnity, and contribution could therefore not be claimed. 3 3 A number of decisions related to the Speno case have recently been handed down. In Zurich Australian Insurance v MMI Insurance Pte Ltd [2007], Hamersley insurer the subject of the Speno case, Zurich, sought contribution from MMI, another insurer of Hamersley. MMI successfully argued that, if it was liable to contribute to the payment made by Zurich, it was also entitled to exercise by way of subrogation Hamersley's rights against Speno pursuant to the contractual indemnity. However, in Speno Rail Maintenance Australia Pty Ltd v MMI Insurance Pte Ltd [2009] WASCA 31, the Court of Appeal reversed the decision on the basis that MMI had not paid the full indemnity to Hamersley under its policy and, in any event, MMI's payment was not made to Hamersley in satisfaction of indemnity but as a contribution to Zurich. Page 4

5 2. Exercising rights of subrogation against co-insureds A common feature of construction project specific insurance is that many entities involved in a project are typically insured under the same policy (for example, a "Contract Works" or "Construction All Risks" policy). It is frequently the case that, where one insured party suffers loss, the damage is caused by the negligence of another party insured under the same policy. There has been much litigation as to whether an insurer, in those circumstances, has a right to bring a subrogated claim against the negligent co-insured. 2.1 Circuity and insurable interests Various early English cases indicated that an insurer was not able to bring a subrogated action against a co-insured because of "circuity". The argument in those cases was that the co-insured would in turn be indemnified by the insurer, and so the proceedings should not be allowed. In more recent decisions, however, courts have dismissed that argument on a number of bases including the basis that the defence of circuity applies only where there is a circuity of claims between parties to litigation. 4 In a subrogated action, the insurer is not a party to the litigation because it brings the subrogated claim in the name of the insured. As such, there can be no circuity in this technical legal sense. There is, however, broader support for a principle preventing subrogated claims against coinsureds on the basis of an "insurable interest" argument. In particular, in a number of cases the courts have held that each party involved in a construction project has an "insurable interest" in the entire construction project. 5 The rationale for this position has been that the interests of each party may be affected by damage to the property of another party. The consequence of giving each party an insurable interest in the entire project is that each co-insured then has a right to recover from the insurer the entire loss in respect of any property damage. Insofar as property owned by an insured entity other than the coinsured making the claim has been damaged, the co-insured will hold any proceeds from the insurance on trust for that entity. If one follows this line of reasoning, it would be theoretically possible for a negligent insured subcontractor (the negligence of which has caused loss to a co-insured contractor) to be entitled to recover from the insurer the loss, thereafter holding the proceeds on trust for the contractor. As such, it would arguably be inappropriate to allow an insurer to bring a subrogated claim against a negligent co-insured if that co-insured would itself have been entitled to recover the loss from the insurer. This reasoning, which is also sometimes referred to as "circuity", would seem to be commercially sensible although it involves a slightly artificial application of the principle of "insurable interest". It is also arguably 4 See the decisions of the English Court of Appeal and the House of Lords in Co-operative Retail Services Limited v Taylor Young Partnership [2001] LRIR 122 (Court of Appeal) and [2002] UKHL 17 (House of Lords). 5 See for example the decision of the Supreme Court of Canada in Commonwealth Construction Co Ltd v Imperial Oil [1977] 69 DLR (3d) 558. This reasoning was followed by Franklyn J in Co-operative Bulk Handling Limited v Jennings Industries Ltd (1986) 17 WAR 257 (Full Court of the Supreme Court of Western Australia). Page 5

6 inconsistent with authorities on the meaning of "insurable interest" and may not by itself suffice to prevent a subrogated action. 2.2 Implied terms Co-insureds have also sought to resist subrogated claims by insurers on the basis of the implication of terms in a relevant insurance policy and/or the commercial contract governing the relationship between co-insureds. Insurance policy It has been suggested by English courts that a term should be implied into insurance policies preventing an insurer bringing a subrogated action against a negligent co-insured. 6 Part of the justification for implying such a term has been the reasoning set out above concerning "insurable interests". However, it would seem unlikely that the strict requirements under Australian law for the implication of terms into contracts would allow such a term to be implied into a construction project specific policy. In particular, Australian law provides that a court may imply a term into a contract for business efficacy, to make the contract workable 7 : It would not appear to be necessary to imply such a term to give a policy of this type commercial efficacy. Furthermore, construction project specific policies now typically contain express terms preventing an insurer bringing a subrogated action against a co-insured. As such, where no express term has been included in such policy, it would be unlikely that an Australian court would imply such a term where the parties to the insurance contract had, presumably intentionally, decided not to. Contract between co-insureds As noted above, an insurer bringing a subrogated claim against a negligent co-insured does so by exercising the rights of the insured indemnified by the insurer. It has been held that a term should be implied into the contract between co-insureds preventing subrogated claims where one of the co-insureds has been indemnified by the insurer for its loss. It could be argued that such a term is implicit from the agreement between the co-insureds requiring one insurance policy for the benefit of both. Even though there are better prospects of a court implying a term into a contract between insureds rather than into an insurance contract, it would still be difficult to meet the strict requirements under Australian law for implication of terms into contracts. Once again, it is not necessary to imply a term preventing subrogated claims against co-insured to give business efficacy to a contract between co-insureds. Nevertheless, the House of Lords has held that, depending on the particular contractual arrangements between co-insureds, 6 See the judgments of Colman J in Stone Vickers Ltd v Appledore Ferguson Ship Builders Ltd [1991] 2 Lloyd's Rep 288 and National Oilwell (UK) Ltd v Davy Off-Shore Ltd [1983] 2 Lloyd's Rep 582; see also Tyco Fire and Integrated Solutions (UK) Ltd v Rolls-Royce Motor Cars Ltd [2008] Lloyd's Rep IR 617 at Codelfa Construction Pty Ltd v State Rail Authority of New South Wales (1982) 149 CLR 337. Page 6

7 an obligation to take out insurance cover for the benefit of both parties may justify implying a term preventing claims between them in respect of insured losses Limiting rights of subrogation The final section of this paper considers how insureds, co-insureds and insurers are able to modify rights of subrogation by express terms in insurance policies or commercial contracts between coinsureds. 3.1 Waiver of subrogation clauses Firstly, an insurer may be willing to include a term in an insurance policy preventing it from bringing subrogated claims against co-insureds. For example, the contractor (in our example) may have arranged the inclusion of such term in a construction project specific policy covering it and the subcontractor with the effect that the insurer is unable to bring a subrogated claim against the subcontractor. The courts will not read down such clauses. For example, a waiver of subrogation clause which prevents an insurer bringing claims against a co-insured will be effective to prevent a subrogated action even if: the cause of the insured's liability is expressly excluded from the policy cover: GPS Power Pty Ltd v Gardiner Willis Associates Pty Ltd (Queensland Court of Appeal, 8 December 2001); the subrogated claim does not relate to the incident which gave rise to the insurer's obligation to provide indemnity to the insured: Larson-Juhl Australia LLC v JayWest International Pty Limited (2000) 11 ANZ Ins Cas (New South Wales Court of Appeal). 3.1 Agreements between co-insureds On the other hand, co-insured may seek to limit subrogated actions by including express terms in the contract governing their relationship. In this respect, the law differentiates between terms that seek to release or compromise existing rights of an insurer, and terms that seek to release or compromise future rights of an insurer. Existing rights It is reasonably well established that an insured may not release or compromise existing rights in a manner which prejudices its insurer's right to subrogation. In the leading judgment on this issue 9, Barwick CJ in State Government Insurance Office (Old) v Brisbane Stevedoring Pty Limited (1969) CLR 228 stated (at 241): It is also settled law that an insured may not release, diminish, compromise or divert the benefit of any right to which the insurer is or will be entitled to succeed and enjoy under his 8 Co-operative Retail Services Limited and ors v Taylor Young Partnership & ors [2002] UKHL 17(25 April 2002); this approach was also recently adopted by the English Court of Appeal in Tyco Fire and Integrated Solutions (UK) Ltd v Rolls- Royce Motor Cars [2008] Lloyd's Rep IR State Government Insurance Office (Old) v Brisbane Stevedoring Pty Limited (1969) CLR 228. Page 7

8 right of subrogation. On occasions an attempt by the insured to do so will be ineffective against the insurer because of the knowledge of the circumstances which the person under obligation to the insured may have. On other occasions when the insured's act has become effective as against the insurer, the insured will be liable to the insurer in damages, or possibly, on some occasions for money had and received. But such conduct on the part of the insured will not in general avoid the insurer's liability to indemnify, though in some circumstances the insurer may be entitled to set off the amount of the damages against the amount otherwise payable under the indemnity. In a subsequent New South Wales Court of Appeal decision it was stated that, insofar as the above passage suggests any such release would be "ineffective" (particularly if an insured was aware of the insurer's rights of subrogation), then it is incorrect. 10 The court suggested in that case that the correct remedy for an insurer was probably a claim in damages for breach of an implied term of the insurance contract. If the insured was aware of the insurer's rights of subrogation, there might also be available to the insurer a tortious claim for inducing a breach of contract. Future rights A further and important issue is whether parties can effectively diminish the rights of an insurer before those rights come into existence. In particular, can parties agree that, insofar as any future losses may occur, they will not be liable to each other to the extent that those losses are covered by insurance? Such clauses are now quite common. The common law on this issue is unclear, but it appears that the parties may limit the rights of an insurer by including such a term in their contract. In the Brisbane Stevedoring case (referred to above), the parties under a crane hire contract agreed to exclude any rights of contribution that might rise against each other as joint tortfeasors. Following a subsequent injury, it was held that both parties were liable in negligence for the injury. The insurer of one of the parties (the employer of the injured worker) sought to reduce its liability to the extent that it was unable to obtain contribution from the other party. The High Court held that the insurer was not entitled to reduce its liability in this manner as the agreement between the parties "precluded rights arising" which, according to the High Court, "is quite a different matter" from a release or compromise of or derogation from rights. The decision of the High Court relied, to an extent, on the particular facts of the case. There is therefore still some uncertainty at common law as to the extent to which such agreements might entitle an insurer to reduce its liability. In order to clarify this uncertainty, section 68 was introduced to the Insurance Contracts Act 1984 (Cth) 11, which provides: (1) Where a contract of general insurance includes a provision that has the effect of excluding or limiting the insurer's liability in respect of a loss by reason that the insured is a party to an agreement that excludes or limits a right of the insured to recover damages from a person other than the insurer in respect of the loss, the insurer may not rely on the provision unless the insurer clearly informed the insured 10 Sola Basic Australia Ltd v Morganite Ceramic Fibres Pty Ltd (Unreported, NSW CA, 11 May 1989, BC ) per Meagher J 11 Australian Law Reform Commission, ALRC 20, paragraph 308. Page 8

9 in writing, before the contract of insurance was entered into, of the effect of the provision. (2) The duty of disclosure does not require the insured to disclose the existence of a contract that so limits the insured's rights. However, section 68 really addresses a different issue. It provides that, where an insured has entered into such an agreement, a provision in its insurance policy limiting the insurer's liability will be ineffective unless the insurer clearly informed the insured in writing of the effect of the provision. The indirect consequence of section 68 is to make it extremely difficult for an insurer to seek to exclude or limit its liability in circumstances where an insurance policy does not contain a provision of the type contemplated by section 68. Andrew Byrne, Senior Associate Allens Arthur Robinson 8 July 2009 This document is intended to provide a general review of matters of interest to readers. The text of the document should not be relied upon as legal advice. Matters differ according to their facts and the law changes. You should seek legal advice on specific fact situations as they arise. Page 9