Chinese Drywall: Cracks in Coverage Claims?

Although not in the national news as much lately, Chinese drywall continues to disrupt the lives and finances of thousands of homeowners and other users of the product. In the courts, homeowners are fighting to obtain jurisdiction over the drywall’s foreign manufacturers and some large builders that incorporated Chinese drywall into new homes have filed for bankruptcy. Not surprisingly, homeowners are looking to suppliers, and insurers, as sources from which to recoup their cost to repair the damage caused by the sulphur gases released from the Chinese drywall.

Despite the number of lawsuits filed, there have been few rulings on whether Chinese drywall claims are covered by insurance policies. There have been no decisions addressing such coverage under CGL policies, but, in early 2010, conflicting opinions were issued by courts in Louisiana and Virginia dealing with coverage of Chinese drywall claims under homeowner policies, with the Louisiana court holding that there was coverage and the Virginia court finding that coverage was excluded.

Then, on Dec. 16, 2010, the federal court in Louisiana handling the multi-district litigation for Chinese drywall issued its decision on whether such claims were covered under homeowner policies. In reaching its decision, the MDL Court considered the Virginia and Louisiana decisions, but neither slavishly followed either nor split the difference between them. Instead, agreeing with portions of each decision, the MDL Court found that some of the homeowner policy exclusions were applicable to Chinese drywall claims, but others were not.

The Finger and Travco Opinions

On March 22, 2010, in Finger v. Audubon Insurance Co., a Louisiana state district court was asked to decide whether several exclusions in a homeowner’s insurance policy applied to the homeowner’s Chinese drywall claims. The court held that:

The “Pollution or Contamination” exclusion did not apply because under the Louisiana Supreme Court’s ruling in Doerr v. Mobil Oil Corp., the gases released by Chinese drywall did not qualify as a “pollutant” and the exclusion was never intended to apply to a homeowner’s claim for substandard building materials.

The “Gradual or Sudden Loss” exclusion also did not apply. Although it excluded, in pertinent part, loss caused either by “rust or other corrosion” or an inherent vice or latent defect, the court held that the phrase “rust or other corrosion” did not apply since the rust and corrosion at issue did not cause the damage, but was itself the damage. With regard to inherent vice and latent defect, the court determined that these exclusions applied to losses caused by a vice or defect in the property that causes the property to damage itself from within and the Chinese drywall was not damaging itself from within; rather, the drywall performed all expected functions of drywall while at the same time releasing gases which damaged surrounding property.

Similarly, the “Faulty, Inadequate or Defective Planning” exclusion did not apply because the defect in the drywall did not prevent it from performing the purposes of drywall.

Several months later, on June 3, 2010, a Virginia federal court held in Travco Insurance Co. v. Ward that under Virginia law, a homeowner’s Chinese drywall claims were subject to several exclusions in a homeowner’s policy. The court first determined that the homeowner had suffered a “direct physical loss” within the meaning of the coverage provision of the policy, finding that the phrase “direct physical loss” did not require physical damage to the property and included loss of use of the property, both of which were satisfied by the damage caused by the drywall off-gassing.

However, rejecting the contrary conclusions in Finger, the court found that the homeowner’s Chinese drywall claims were excluded by:

• The Pollution exclusion.The court noted that Virginia interprets Pollution exclusions more broadly than Louisiana and concluded that the gases released by Chinese drywall fall within the exclusion.
• The Faulty Materials and Corrosion exclusion. The court rejected the reasoning of Finger in holding that the corrosion exclusion under the “Gradual or Sudden Loss” exclusion and the “Faulty, Inadequate or Defective Planning” exclusion did not apply to Chinese drywall claims on the basis that its reasoning was against the weight of authority.
• The Latent Defect exclusion.The court found “an inherent contradiction” in the homeowner arguing that since the Chinese drywall was not destroying itself, there was no latent defect within the meaning of the exclusion, but, at the same time, claiming that his property suffered a direct physical loss. The court concluded that the drywall was integral to the homeowner’s residence and the residence was being damaged by a defect within itself; therefore, the Latent Defect exclusion applied. However, the court held that the Latent Defect exclusion did not apply to the homeowner’s damaged air conditioner and garage door since the drywall was not integral to either.

The court also concluded that the losses otherwise not covered under the foregoing exclusions could not be claimed under the Ensuing Loss clause because the claimed losses did not occur subsequent to the initial loss and the losses were specifically excluded under the above policy exclusions.

The Louisiana MDL Decision

The MDL Court was presented with the same arguments raised in Finger and Travco, but, unlike Travco, was applying Louisiana law. Also, unlike those two cases, the MDL Court was deciding the coverage issues under nine different homeowner policies. The court noted the differences between the policies where applicable, but found that they generally did not lead to a different result.

The MDL Court’s decision is too lengthy to describe in detail, but its specific findings on the coverage issues are summarized below.

• Physical Loss: As in Travco, the MDL Court first addressed whether the damage caused by the Chinese drywall constituted a physical loss within the meaning of the coverage provisions of the various homeowner policies and concluded that there was a physical loss because the off-gassing caused a distinct and demonstrable physical alteration to the homes and resulted in the loss of their use. The court also found that the physical loss was “direct,” “sudden” and “accidental” as required by the different policies, reasoning that: (1) the word “direct” means proximate cause and the homeowners alleged that the damage to their homes was proximately caused by the Chinese drywall; (2) the word “accidental” denotes an event which is unexpected or unusual and the damage caused by the Chinese drywall qualified as such, and (3) the word “sudden” and the phrase “sudden and accidental” includes an event which is either abrupt, though expected, or unexpected and which also occurs from an unknown cause or is an unusual result of a known cause, and, again, the damage caused by Chinese drywall qualified as such.
• Latent Defect Exclusion: The MDL Court refused to follow either Finger or Travco on the applicability of the Latent Defect exclusion. The court stated that Finger commingled its analysis of the Latent Defect exclusion with the Inherent Vice exclusion, which was a separate exclusion not at issue before the MDL Court. In contrast, the MDL Court found that the Travco discussion of the Latent Defect exclusion was “thorough” and sound, but, nonetheless, determined that it could not be given much weight in light of different definitions of “Latent Defect” under Virginia and Louisiana law.

• Pollution Exclusion: In considering the Pollution exclusion, the MDL Court followed the lead of Finger in looking to the Louisiana Supreme Court’s decision in Doerr v. Mobil Oil Corp. to determine if it was applicable to Chinese drywall claims. In Doerr, the Louisiana Supreme Court held that the applicability of a pollution exclusion in any given case required consideration of whether (1) the insured was a “polluter”, (2) the injury causing substance was a “pollutant” and (3) whether there was a discharge, dispersal, seepage, migration, release or escape of a pollutant by the insured. Each consideration was a fact based conclusion which encompassed a wide variety of factors.

• Faulty Materials Exclusion: Under Louisiana law, a physical thing tainted by imperfection or impairment constitutes “faulty material.” Unlike faulty workmanship or faulty construction exclusions, the Faulty Material exclusion focuses upon the quality or character of material rather than its installation, design, construction or repair. Accordingly, the MDL Court concluded that although the Chinese drywall might perform the intended purpose of drywall, the fact that it was composed of material, specifically, elemental sulphur, that made it imperfect caused the claims for damage to fall within the Faulty Materials exclusion.

• Corrosion Exclusion: In interpreting the Corrosion exclusion, the MDL Court recognized that the critical issue was whether, under Louisiana law, the Corrosion exclusion applied when the corrosion was the damage itself rather than the cause of the damage. After reviewing relevant decisions, the MDL Court concluded that all Chinese drywall related corrosion was excluded by the Corrosion exclusion, whether the corrosion was the cause of damage or the damage itself.

• Ensuing Loss: Because the MDL Court concluded that the homeowner’s Chinese drywall claims were excluded from coverage, it next considered the “Ensuing Loss” provisions of the homeowner policies. The damages alleged to have been caused by the Chinese drywall included odors and corrosion of metal components and electric wiring. The MDL Court concluded that neither form of damage qualified as an ensuing loss because they were not sufficiently distinct in kind from the losses caused by the drywall, and, with respect to corrosion, the corrosion was specifically excluded from coverage.