All is Not Lost

With the release of its much-anticipated decision in C. N. Rail v. Royal and SunAlliance, the Supreme Court of Canada has attempted to clarify the scope of the “faulty design” exclusion to all-risks property cover. In a close 4-3 decision, the Supreme Court reversed the Ontario Court of Appeal; in doing so, it found in favour of coverage for C. N. Rail under an all-risks policy issued by a consortium of leading Canadian property insurers.

The loss that initiated the litigation occurred in the fall of 1993. At that time, a Lovat tunnel boring machine (TBM), designed to tunnel underneath the St. Clair River, suffered a serious failure when dirt entered its cutting head, threatening the TBM’s main bearing. The repair was costly and the damage delayed the project by 226 days. When C. N. Rail claimed the loss under its all-risks policy, the property insurers relied on the policy’s “faulty design” exclusion. The resultant legal saga lasted more than 15 years.

However, our story necessarily begins further back in time, because the basis for excluding “faulty design” from all-risks property cover has its roots in the very concept of insurance itself.

As a basic rule, insurance policies cover only fortuitous events, since the premium an insurer would need to charge to cover intentional acts would exceed the value of the loss after necessary charges to cover the insurer’s overhead, marketing and administration costs are considered. In theory, loss or damage to property that is poorly designed is not fortuitous: the eventual loss or destruction of such property by internal derangement is inevitable. The question is not “if” the property will fail, but rather “when.”A crane featuring a boom that is insufficiently designed to accommodate expected loads will certainly and inevitably fail due to its internal flaw. On the other hand, the collapse of the same boom occasioned by external forces such as earthquake, typhoon or windstorm is not a “certainty,” and can therefore validly be the subject of insurance coverage.

In order to entrench this concept within the four corners of the policy, drafters have historically used exclusionary terms that include “faulty design,” “faulty workmanship,” “inherent vice” and “latent defect.”

ORIGINS OF “FAULTY DESIGN”

Ironically, the modern interpretation of the “faulty design” exclusion in Canada actually begins half way around the world; its origin can be traced to the High Court of Australia’s 1969 decision in Queensland Government Railways and Electric Power Transmission Pty. Ltd. v. Manufacturers Mutual Insurance Ltd. The case involved the collapse of piers that proved inadequate to withstand unanticipated levels of floodwater. The insurer denied the subsequent claim on the basis of “faulty design.” Consistent with existing authority, the lower court held that “faulty design” required some element of blameworthiness on the part of the designer. But the High Court of Australia disagreed, finding instead that “faulty design” was broader than “negligent design.” Since the design of the piers failed to account for all known risks, the design was “faulty,” the High Court ruled, even though the designers met the appropriate professional standard of care.

The Queensland principle was first considered in a meaningful way in Canada by the Alberta Court of Appeal in Willowbrook Homes (1964) Ltd. v. Simcoe & Erie General Insurance Co. [1980]. Willowbrook involved the collapse of a concrete block wall during a severe, but not unexpected, windstorm. The Alberta Court of Appeal accepted as a fact that the bracing was under-designed by half. Since the bracing did not take into account the known forces that would be applied by wind, the loss was the result of “faulty design.”

Other similar decisions followed. The Ontario Court of Appeal upheld the “faulty design” exclusion in the 1984 case of Collavino Inc. v. Employers Mutual Liability Insurance Co. ofWisconsin (1984), in which a construction trestle collapsed because it was not designed to withstand the forces of the spring breakup of ice. In 1991, in B. C. Rail Ltd. v. American Home Assurance Co., a denial of coverage on the basis of “error in design” was upheld when a section of railroad track collapsed due to an inappropriate design assumption involving the consistency of the track’s underlying soils. In Triple Five Corp. v. Simcoe & Erie Group, the Alberta Court of Appeal held in 1997 that: (1) “mechanical breakdown” and “latent defect” subsume loss by faulty design, and (2) the collapse of a roller coaster in the West Edmonton Mall was excluded from coverage because the roller coaster’s track was incorrectly designed to be too “wide” in certain corners.

REASONABLY FORESEEABLE RISKS

The next question for the courts was whether a design must account for all foreseeable risks of failure or only reasonably foreseeable risks. The acceptance of the lower standard would require proof of negligence on the part of the designer. This issue was addressed in 1995 in Foundation Company of Canada Limited v. American Home Assurance Company.

Foundation Company involved the collapse of a bridge due to a “blow-in” caused by a rare and unforeseeable pocket of gas. A claim for the loss was denied on the basis of “faulty design.” The court confirmed the law did not require proof of design negligence to establish “faulty design.” Nonetheless, the court found, the design must be compared to some standard; the court chose the standard of “foreseeable” risks, a standard that requires a designer to consider all potential known risks. Since the gas pocket that felled the bridge could not have been foreseen, the design of the bridge was sound, and the exclusion did not apply.

This brings us full circle to Canadian National Railway Co. v. Royal and Sun Alliance Insurance Co. of Canada. The machine that was the subject of the C. N. Rail loss was, to that point, the largest TBM ever built. It was designed with a complex sealing system intended to prevent soil from contaminating the main bearing. On Dec. 28, 1993, after two months of digging, extensive damage to the sealing system was discovered. Experts concluded that the loss was caused by the deflection of the cutterhead, a condition known as “differential deflection.” C. N.’s property insurers took the position that the design of the TBM was “faulty” and therefore the loss was excluded.

At trial, the court followed the law established in Foundation Company of Canada; is, the TBM’s designer had to accommodate all known “foreseeable” risks. The court accepted the evidence of the many engineers involved in the design and the project that the risk of excess differential deflection was impossible to anticipate. As such, and even though the design failed, it was not “faulty.”

The property insurers successfully appealed. The Ontario Court of Appeal’s reversal of the trial decision hinged on the evidence of Rick Lovat, one of the TBM’s designers. Lovat conceded he had actually anticipated differential deflection, and that he attempted to accommodate for it in the design. This being the case, the very fact of the TBM’s failure due to differential deflection confirmed a design failure in the court’s eyes. The policy was not intended to be a warranty of the TBM’s entrepreneurial design risk, the court ruled. It thus rejected C. N.’s argument that the insurers’ interpretation of the “faulty design” exclusion rendered the coverage illusory. The Appeal Court held that all-risks policies represent a fair bargain between those risks that will be covered (external assault) and those risks that won’t (internal derangement).

SUPREME COURT WEIGHS IN

The Supreme Court of Canada, in a narrow majority, restored the trial decision in reasons released on Nov. 21, 2008.The Supreme Court’s reasons focussed on the innovative nature of the design in question. Although the court agreed the design must accommodate all “foreseeable” risks, the standard for comparison should be “state-of-the-art” and not “perfect knowledge.” Property designed to meet all foreseeable risks may nonetheless fail due to some unanticipated external force. Such a design is not “faulty.” The court referenced the DeHavilland Comet and the Tacoma Narrows Bridge as examples of “state of the art” designs that nonetheless failed when confronted with unknown or unexpected conditions during use. The high court found no evidence of any specific design flaws in the TBM; as such, the insurers failed to meet their burden of proof. The court rejected the premise that a failed design must necessarily be “faulty.”

The result of the Supreme Court’s decision in C. N. Rail is no doubt disconcerting for insurers, but its practical application may be limited. Without question, it does not represent a death knell for the “faulty design” exclusion. One could make the argument that none of the prior decisions cited above, most of which upheld the “faulty design” exclusion, would be decided differently were they re-addressed post-C. N. Rail. In fact, it is arguable that the decision only narthat rows the application of the exclusion in the case of cutting-edge or first-impression designs. Accordingly, although the failure of the Lovat TBM to account for excess differential deflection or the Tacoma Narrows Bridge to account for unforeseen wind shear did not constitute “faulty design” prior to their failures, the failure of similar designs to account for the same risks in the future would be considered “faulty.”Also, granting coverage for losses related to cutting-edge and first-impressions designs is consistent with fundamental insurance tenets, since such losses are not expected or intended from the standpoint of any of the insured, the property designers or knowledgeable industry experts.

In a way, the Supreme Court’s decision in C. N. Rail reinforced what most in the industry already knew — a thorough investigation of the loss is mandatory. Since the evidence necessary to establish faulty design is fleeting, all available resources should be directed to the early adjustment of the loss and steps should be taken to preserve evidence. All the money in the world thrown at a case of this type during the litigation stage can never make up for a poor initial investigation.

The court’s decision also accentuates the importance of hiring the appropriate expert(s) and hiring them quickly. The retainer of an appropriate expert is not an area in which to scrimp or save. Depending on the complexity or rarity of the property involved, there may be only one or two experts worldwide capable of speaking in a meaningful way about the subject design(s). Tie them up, and tie them up early.

Finally, it is clear that from a litigation perspective, “faulty design” is a complex concept that will without question elude many trial judges. As such, the search for the “right answer” may necessarily require appellate intervention. It thus goes without saying that for both insurers and insureds, litigating these cases is not for the faint of heart — or weak of pocketbook.

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In a way, the Supreme Court’s decision in C. N. Rail reinforced what most in the industry already knew — a thorough investigation of the loss is mandatory. All available resources should be directed to early adjustment of the loss.

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The result of the Supreme Court’s decision in C. N. Rail is no doubt disconcerting for insurers, but its practical application may be limited. Without question, it does not represent a death knell for the “faulty design” exclusion.