THE THIRD RUNWAY CASE: BAULDERSTONE HORNIBROOK ENGINEERING PTY LIMITED V GORDIAN RUNOFF LIMITED On 12 th April 2006 Einstein J delivered his judgment in Baulderstone Hornibrook Engineering Pty Ltd v Gordian Runoff Ltd 1. Baulderstone Hornibrook Engineering (BHE) had sought indemnity under a project specific professional indemnity policy (the Policy). Einstein J held that BHE was not entitled to indemnity because its liability arose out of defective construction work, which was excluded under the Policy. This paper focuses on three aspects of the judgment which may be of concern to construction companies. They are the interpretation of: clauses extending cover for liability arising out of the negligent acts of subcontractors; clauses excluding liability for claims arising out of defective workmanship; and clauses excluding liabilities assumed under contracts. 1. Background to the proceedings 1.1 Construction of the third runway In August 1992, Federal Airports Corporation, the predecessor to Sydney Airports Corporation Limited (SACL), entered into a contract with BHE for the design and construction of the third runway (or 'parallel runway') at Sydney Airport. The third runway was constructed between August 1992 and August 1994. 1.2 Loss giving rise to proceedings After construction of the third runway, it became apparent that the seawall and the millstream wall (the Walls) were losing sand. In 2002 SACL brought proceedings against BHE in respect of the loss of sand. These proceedings were settled in June 2004 on the basis that BHE would rectify the seawall and millstream wall. The estimated cost of carrying out the rectification work exceeded $60 million. 1.3 The insurance claim BHE sought indemnity for its liability to SACL under its annual professional indemnity policy with AMP and under a project specific professional indemnity policy arranged by SACL. This paper only deals with issues arising under the latter policy. BHE settled its claims against the majority of its insurers. The judgment of Einstein J concerned claims against the 2 insurers which do not settle (the Insurers): Gordian Runoff Limited (Gordian), in relation to a policy originally issued by GIO Insurance Limited, and CGU Insurance Ltd (CGU), in relation to a policy originally written by Commercial Union Assurance Company of Australia Ltd, trading as Pacific Indemnity. 1 [2006] NSWSC 223. ymss A0107587884v1 150520 6.2.2007 Page 1
The primary issue in the proceedings was the cause of the loss of sand from the Walls. The Walls were constructed with prefabricated concrete facing panels. The joints between the panels were sealed with a geotextile through with water, but not sand, could flow. Behind the concrete panels was sand backfill, which was required under the contract to be compacted to a uniform 80% density. The design of the Walls was carried out by Connell Wagner and Reinforced Earth under subcontracts with BHE. For the purposes of the judgment of Einstein J, it was not necessary to draw any distinction between the roles of Reinforced Earth and Connell Wagner, who are referred to in the judgment and in this paper as RE/CW. BHE asserted that the design by RE/CW was negligent in prescribing the use of geotextile. The insurers submitted that the design was not negligent and that the loss of sand was due to defects in the construction of the sand backfill by BHE. In particular, it was asserted that this construction was defective because: the sand was not compacted to the required density; and the sand backfill was compacted in layers of 660mm rather than layers of approximately 300mm. 2. Findings of fact and law Einstein J made the following findings. The loss of sand was caused by the construction defects alleged by the Insurers 2. RE/CW failed to provide proper instructions to BHE in relation to the compaction process and the affixing of the geotextile 3. BHE failed to take appropriate steps during the compaction of the sand backfill to ensure that this compaction did not adversely affect the geotextile 4. (d) BHE's liability to SACL did not 'arise' (within the meaning of Special Provision 2) from the failure of RE/CW to give proper instructions as to the construction process to be followed by BHE 5. (e) (f) The liability of BHE to SACL arose from the construction work of BHE, for the purposes of Exclusion 1 (p) 6. The Insurers were therefore entitled to deny indemnity. 2 Paragraph 81 3 Paragraphs 95 and 972 4 Paragraphs 1020-1022 5 Paragraph 955 6 paragraph 1024 ymss A0107587884v1 150520 6.2.2007 Page 2
3. Liability for negligence of third parties 3.1 Special Provision 2 Special Provision 2 of the Policy provided as follows. The coverage provided by this Policy is extended to indemnify the Insured, subject to the policy's terms and conditions, against their liability for claims.arising out of any act, error or omission in the conduct of Professional Activities and Duties committed by specialist designers or consultants acting on the Insured's behalf pursuant to any contract for service and for whom the Insured are responsible. This clause would appear to be intended to apply where: (d) the insured assumes design obligations under a contract; the insured subcontracts those design obligations; the subcontractor performs those design obligations negligently; and the insured is in breach of its own design obligations as a result of the negligence of its subcontractor. It is far from clear, however, that Special Provision 2, as drafted, gives effect to this intention. The first difficulty is the interaction between Special Provision 2 and exclusion 1, which excludes claims for contractually assumed liabilities. This exclusion is considered later in this paper. Einstein J did not need to consider this issue because of his finding that the liability of BHE did not in fact arise out of the design of RE/CW. A second, related issue is the meaning of the phrase 'for whom the insured are responsible'. It was submitted by the Insurers that Special Provision 2 only applied where the subcontractor's conduct caused BHE itself to breach its duty of care. This submission, if accepted, would result in Special Provision 2 having virtually no operation, as it will be extremely rare for an insured to be liable in tort for the negligent acts of third parties 7. Einstein J appeared to reject this submission of the Insurers 8. As mentioned above, however, it was not necessary for Einstein J to consider whether the result contended for by the insurers would in any case have followed from the application of Exclusion 1. A further issue in relation to clauses such as Special Provision 2 is the meaning of 'act, error or omission'. Einstein J appeared to accept the submission of CGU that if, 'act' were given its normal meaning, Special Provision 2 might apply even where the design by the subcontractor was faultless, because liability arising from defective work pursuant to a faultless design could be seen as a liability 'arising out of any act' of the subcontractor 9. The simplest response to such an argument would appear to be that the liability would not arise out of any defective design by the contractor, but would only arise out of the defective work by the insured. For example, if one were to ask the question: why is the insured 7 As a general principle, a person is only liable for negligent acts of a third party if that third party is an employee of the person or if that third party causes the person to breech a 'non-delegable' duty of care. 8 Paragraph 944 9 Paragraph 948 ymss A0107587884v1 150520 6.2.2007 Page 3
liable? the answer would be: the insured is liable because of its defective construction work. The answer would not be: the insured is liable because of the faultless design of the subcontractor. Einstein J did not however reject the argument of this basis, but instead held that 'act' should: be given parity of operation with the words 'error or omission' and that 'act' relevantly means any positive action by a specialist designer or consultant which is inconsistent with performance of the obligations imposed by the contract into which the specialist designer or consultant entered 10. The issue as to whether a liability can arise out of an act which does not breach any contractual, tortious, or other duty is also a significant issue in the construction of the exclusion for defective construction work, which is considered next. 4. Exclusion for liability arising out of construction work 4.1 Exclusion 1(p) Exclusion 1(p) excluded claims: Arising out of construction work performed involving the means, methods, techniques, sequences, procedures and use of equipment, of any nature whatsoever which were employed by the Insured's contracting staff or others in the executing of any phase of any project. 4.2 Analysis of Exclusion 1(p) This exclusion is poorly worded and difficult to construe. One suspects that it may have evolved from a simple exclusion for 'construction work by the Insured'. In some respects, the application of this exclusion in the present case was quite simple. Einstein J held that the claim by SACL against BHE arose out of defective construction work by BHE. The exclusion therefore applied and BHE was not entitled to indemnity. The judgment of Einstein J is consistent with the general rule in interpreting insurance contracts that, if a cause of a loss or liability is an excluded risk, the insurer will not be liable even if other causes of the loss or liability are covered by the policy. There were, however, a number of observations by Einstein J on the operation of this exclusion which, although consistent with authority, may cause concern to construction companies. In particular, Einstein J held that: it is not necessary for an insurer to prove that the construction work by BHE was negligent 11 ; and the exclusion would apply even if the construction conformed with the plans and specifications for the performance of the work 12. 10 Paragraph 948 11 paragraph 1018 12 paragraph 1024 ymss A0107587884v1 150520 6.2.2007 Page 4
In the context of a design and construct contract, negligent design will almost invariably be manifested in construction which conforms with that negligent design. If exclusions such as Exclusion 1(p) apply in these circumstances, it is difficult to see what cover would be provided by a professional indemnity policy. One should not perhaps give too much weight to these observations of Einstein J given his finding that a cause of the claim by SACL against BHE was poor workmanship by BHE 13. 4.3 The meaning of "arising from" As stated above in the context of Special Provision 2, it is submitted that, when applying clauses such as Exclusion 1(p), one should ask: why is the insured liable? If the insured has performed defective construction work, and is now liable for the cost of rectifying that work, then it would make sense (in the context of an insurance policy) to state that the insured is liable because of its defective construction work. If, in the alternative, an insured faultlessly performs construction work pursuant to a defective design, then it would not make sense (in the context of an insurance policy) to state that the insured is liable because of its construction work. It was not the construction work of the insured that prevented it from fulfilling its obligations, but the design pursuant to which the construction work was performed. Einstein J referred in his reasons 14 to the judgment of the Full Court of the Supreme Court of Western Australia in Speno Rail Maintenance Australia Pty Ltd v Hamersley Iron Pty Ltd 15. This decision is considered in the next section. 4.4 Speno The decision of the Full Court of the Supreme Court of Western Australia in Speno is frequently cited as support for the proposition that an insurer is entitled to bring a subrogated claim against a party providing an indemnity to its insured. Less well known, however, is the decision of the Court on the meaning of the phrase "arising out of". The relevant facts were as follows. Speno entered into a contract to perform rail grinding work for Hamersley Iron. Speno arranged a general liability policy with Zurich. The policy provided by Zurich extended cover to Hamersley for: liability arising out of the performance by [Speno] of any contract for the performance of work for [Hamersley]. (d) (e) An employee of Speno was injured by the negligence of employees of Hamersley. Although there was no suggestion of any negligence on the part of Speno, Hamersley asserted that its liability to the employee of Speno arose out of the performance by Speno of the contract for work for Hamersley. 13 paragraph 1020 14 paragraph 1003 15 (2000) 23 WAR 291 ymss A0107587884v1 150520 6.2.2007 Page 5
(f) the Full Court upheld the argument of Hamersley and held that its liability arose out of the performance by Speno of its contract with Hamersley. The reasoning of the Full Court in this case is surprising and probably inconsistent with the intention of the parties to the insurance policy. If this reasoning is consistently applied to insurance policies then it could lead to some extraordinary results. Consider, for example, how the following exclusions could be held to apply. An exclusion in a professional indemnity policy for liability arising from dishonest conduct would apply to a negligent failure by an auditor to detect dishonesty by the director of a company. An exclusion for liability arising from a terrorist act would apply to a doctor who negligently operated on a person injured during a terrorist attack. An exclusion for liability arising from flood would apply to negligent repair of damage caused by a flood. Parties to insurance contracts should therefore be wary about using phrases such as "arising from". 5. Contractually assumed liabilities 5.1 Exclusion 1(e) Exclusion 1(e) excluded claims: for any legal liability of whatsoever nature imposed upon the Insured pursuant to the Law of Contract but only when such legal liability would not have been imposed upon the Insured pursuant to the Law of Tort. Einstein J did not consider the application of this exclusion because of his finding that Exclusion 1(p) applied 16. He did, however, refer in his judgment to the competing submissions of the parties as to the operation of this exclusion. Of particular concern are the submissions put forward by Gordian as to the operation of this exclusion. In essence, the argument of Gordian appears to have been as follows. (d) BHE would not have any liability in tort to SACL unless BHE owed SACL a duty of care. The courts will not impose a duty of case if and when detailed contractual arrangements can be seen as exclusively defining the obligations of the parties to the exclusion of any obligations in tort. The detailed contractual provisions between SACL and BHE meant that BHE owed no separate duty of care to SACL. As BHE owed no duty of care to SACL, it could not have been liable in tort to SACL and the exclusion therefore applied. 16 Paragraph 1048 ymss A0107587884v1 150520 6.2.2007 Page 6
It is unlikely that a court would accept these submissions as, if it were to do so, the professional indemnity policy would be deprived of almost any operation. It is therefore improbable that it was the intention of the parties for the exclusion to operate in this manner. Nevertheless, Gordian appears to have put detailed submissions to the court in support of its arguments as to how this exclusion should apply, so a similar argument may again be made in the future. 6. Recommendations 6.1 Cover for liability arising out of the acts of subcontractors If an insured seeks cover for liability arising out of the acts of its subcontractors, then it should ensure that the extension applies: if the insured breaches a contractual obligation to undertake professional activities; if the act of any third party, whether or not the insured is "responsible" for the third party, causes the insured to breach the contractual obligation; and notwithstanding any exclusion in the policy for contractually assumed liabilities. An insurer may in turn wish to clarify that such an extension to cover only applies in so far as the third party was itself negligent. 6.2 Exclusion for liability arising from construction work Professional Indemnity policies frequently contain an exclusion for liability arising from construction work. An insured can, however, seek to take the following steps to minimise the impact of this type of exclusion. The exclusion should be limited to negligent, or perhaps defective, construction work. The insured should seek an apportionment clause so that, in so far as negligent construction work was one of a number of causes of a liability or loss, there will still be some cover under the policy. 6.3 Exclusion for contractually assumed liabilities If an insured cannot persuade its insurer to provide cover for contractually assumed liabilities, then it should at least seek to ensure that the exclusion would not apply in so far as the insured is liable due to a failure to meet the standards of a reasonable professional in its position. An insured should also, of course, seek as far as possible to ensure a fit between its professional indemnity cover and the liabilities which it assumes under a contract. 6.4 "Arising from" There has long been a tendency for insurance policies to use broad tests of causation ("arising out of", "arising from", "in connection with" etc) rather than narrow tests of causation ("caused by"). It may be appropriate, however, for both insurers and insureds to reconsider this approach in light of the very broad interpretation given by courts to phrases ymss A0107587884v1 150520 6.2.2007 Page 7
such as "arising out of" in clause defining either the scope of cover or exclusions from cover. 7. Conclusion In some respects the judgment of Einstein J is a simple application of a difficult finding of fact. For the reasons given in this paper, however, the judgment is a reminder to construction companies of some of the obstacles that might be placed in their way when seeking indemnity from professional indemnity insurers. ymss A0107587884v1 150520 6.2.2007 Page 8