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Chinese Drywall and Homebuilders: How to Reduce Exposure and Recover Costs
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August 31, 2009
By Melissa Lesmes and David Beck
Howrey LLP
During the height of the housing boom from 2004 to 2007, approximately 309 million square feet of Chinese drywall was imported into the United States. Since that time, more than 600 lawsuits have been filed alleging that the imported drywall contains sulfur compounds which, when exposed to heat and moisture, release sulfurous acids causing a noxious smell and the corrosion of metals. This corrosion has been noted most significantly on copper components, such as wiring, refrigerator coils and the coils of air handling units. The lawsuits also allege a variety of health issues. Although the majority of the litigation is in the Southeast, reports indicate that Chinese drywall may have been used in construction across the United States.
Despite the large number of lawsuits filed, very little is known about the scope of the problem. On May 19, 2009, the Environmental Protection Agency released a report confirming that Chinese drywall does in fact contain sulfur as well as two other organic compounds that do not appear in domestically manufactured drywall. But the effects of these compounds remain largely unknown. The Florida Department of Health has stated that there are no discernible health effects associated with the drywall. At the same time, legislation was introduced in Congress that would ban the manufacture and use of drywall that contains more than 5 percent organic compounds until testing has been completed and the Consumer Product Safety Commission can set standardized requirements for the composition of the product. Testing by the CPSC is ongoing, with results and requirements expected to be set by mid- to late September. Given the absence of data and the continued uncertainty of the impact of Chinese drywall, additional claims and litigation are certain to ensue.
Liability of Homebuilders
Claims involving Chinese drywall typically are product defect claims. That is, the claims allege that the drywall was defectively manufactured as opposed to improperly installed. Accordingly, initial claims focused on the drywall manufacturers, with homebuilders getting somewhat of a pass. This trend, however, has quickly changed, and suits against homebuilders have become common. For example, in Flannigan v. Stafford Custom Homes, Inc., a case in North Carolina, the plaintiff named the homebuilder as the sole defendant, asserting breach of contract, breach of implied warranties, breach of express warranties and negligence. Homebuilders, therefore, must be prepared for the possibility of litigation and should take measures to reduce their potential exposure.
Steps to Reduce Exposure
Homebuilders that believe they have a potential Chinese drywall problem should immediately take steps to mitigate potential damages. The following are recommended:
| 1. | Put your insurance carriers on written notice. Even if you have not been brought into litigation, you should give notice to your commercial general liability carriers, both primary and excess, and any property carriers (builder’s risk insurers if your project is not yet complete). Consider notifying all carriers from the date the homes were completed through the present. Notice is significant because costs incurred to address or remediate the problem may be unrecoverable from insurance if notice has not been properly or timely given.
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| 2. | Collect information. Collect as much information as you can from drywall subcontractors, drywall suppliers or anyone involved on the project who would have been involved in the selection, purchase, supply or installation of the drywall. This information includes all contracts, purchase orders, invoices, warranties and certificates of insurance. To the extent possible, collect all applicable subcontractor and supplier insurance policies.
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| 3. | Put all potentially at-risk subcontractors or suppliers on written notice. Make certain that you notify your drywall subcontractor and/or supplier that complaints have been made concerning the use of Chinese drywall and advise your subcontractor or supplier to put his/her carriers on notice. If certificates of insurance were provided, send a copy of your notice letter directly to that carrier. If you are named as an additional insured on the subcontractor’s or supplier’s policy, send a notice letter directly to the carrier.
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| 4. | Confirm whether an architect or construction manager specified the use of or expressly approved the use of Chinese drywall. Consider placing any architect or construction manager on notice as well.
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| 5. | Inform property owners. You may want to pro-actively notify homeowners of the possible existence of Chinese drywall in their homes and consider providing them with alternatives as you work to remediate the problem.
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| 6. | Respond to complaints/concerns. Retain a consultant through an attorney to inspect the property and, if necessary, conduct testing. The inspection should include determining if an odor is present, inspecting air handling units to determine if copper piping has blackened, and inspecting electrical outlet wiring or other exposed wiring to determine if blackening has occurred. To the extent possible, you should conduct a visual inspection of any exposed drywall to see if you can ascertain a manufacturer. Many drywall manufacturers stamp their name or a manufacturing code on the back of the drywall. Note that it has been alleged that some U.S. drywall manufacturers may have purchased Chinese drywall. While this allegation has yet to be proven, in the event it appears you may have a problem (because of the presence of an odor or blackening of metals) but the drywall is U.S.-stamped, additional testing may be required. Laboratory testing may be necessary depending on the results of the initial inspection.
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| 7. | Define a protocol to respond to Chinese drywall problems. If an initial investigation indicates the presence of Chinese drywall, you must carefully consider a response. Individual test results, costs and concerns about injury to reputation all will be factors in determining an appropriate remedial response. The fact remains, however, that the drywall should be removed from the home. Therefore, with input from your independent consultant and insurance carriers, you should consider defining a protocol for repair that includes relocation of residents and removal and re-installation of drywall. Taking affirmative steps to remediate the problem will provide several benefits. These include proof of an attempt to mitigate damages (which will prove useful in subsequent claims against insurers, installers and suppliers), the fulfillment of warranty obligations (which will limit future claims), the potential for obtaining liability waivers and positive press.
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Other Risks
Engaging in remediation efforts, however, carries its own set of risks. Although no standard protocol currently exists for the remediation of Chinese drywall, several federal agencies, including the CPSC and the Center for Disease Control, are engaged in testing and collaboration in an effort to provide a coordinated public response. To date, these agencies have not disclosed what measures such a protocol might include. Nonetheless, several federal and even local regulations may already apply. For example, the Occupational Safety Health Act may require certain protections be put in place for workers removing Chinese drywall. Similarly, compliance with environmental laws may be required for its proper disposal. So, before any remediation effort is undertaken, it will be necessary to consult with a knowledgeable attorney and to understand controlling laws and regulations.
Recovering Your Costs
One of the biggest questions for homebuilders is: How do we pay for the remediation? Homebuilders faced with Chinese drywall claims can seek recovery by pursuing all available insurance; seeking recovery from subcontractors, installers and suppliers; and seeking recovery from manufacturers.
Insurance Coverage
How successful a homebuilder will be in quickly recovering repair costs, among other costs, from insurance carriers will depend in part on the law of the jurisdiction in which the insurance policy is construed. Insurers in some jurisdictions are relying on their policies’ pollution exclusion in refusing to extend coverage for losses incurred as a result of Chinese drywall. The pollution exclusion, contained in most commercial general liability policies, typically provides that bodily injury or property damage caused by the “discharge, dispersal, seepage, migration, release or escape” of a “pollutant” is not covered. The term “pollutant” is generally defined as “any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals, and waste.”
The primary issue in obtaining coverage in the face of such an exclusion is whether the alleged contaminant constitutes a “pollutant” as contemplated by the policy. The answer to this inquiry has little to do with the actual language of the policy and much more to do with geography.
Insurance companies contend that the pollution exclusion should apply to all forms of pollutants, whether they are traditional environmental pollutants, such as the long-term discharge of hazardous waste, or more localized claims of chemical exposure, such as lead paint, asbestos, pesticides and other fumes. Many jurisdictions – including Florida, Virginia, Georgia, Pennsylvania and Texas – have agreed. The recent case of Nautilus Insurance Co. v. Country Oaks, 2009 WL 1067587 (5th Cir. Apr. 22, 2009) is illustrative. Applying Texas law, the Fifth Circuit found that plaintiff’s exposure to carbon monoxide from a furnace within her apartment, which caused difficulties with her pregnancy and the ultimate health of her baby, constituted the “discharge, dispersal, seepage, migration, release, or escape” of a pollutant and thus was explicitly excluded by the policy.
Similarly, in Firemen’s Insurance Co. v. Kline & Son Cement Repair, Inc., 474 F.Supp.2d 779 (E.D. Va. 2007), the U.S. District Court, in applying Virginia law, found that the pollution exclusion applied to bar coverage for personal injuries to an employee caused by the application of a protective sealant to the concrete floors of the warehouse in which the employee worked. The court explained that “[n]owhere in the Policy is there any reference to the word ‘environment,’ ‘environmental,’ ‘industrial,’ or any other limiting language suggesting the pollution exclusion is not equally applicable to both ‘traditional’ and indoor pollution scenarios.” See also, Reed v. Auto-Owners Insurance Co., 667 S.E.2d 90 (Ga. 2008) [holding that carbon monoxide released into an apartment was a pollutant as defined and excluded by the policy].
Other jurisdictions, such as Louisiana, Alabama, New Jersey, Illinois, California, New York and Michigan, define the scope of the exclusion more narrowly to apply “only to those injuries caused by traditional environmental pollution.” See, e.g., Doerr v. Mobil Oil Corp., 774 So.2d 119 (La. 2000) [“it is appropriate to construe a pollution exclusion clause in light of its general purpose, which is to exclude coverage for environmental pollution, and under such interpretation, the clause will not be applied to all contact with substances that may be classified as pollutants.”]
In Meridian Mutual Insurance Co. v. Kellman, 197 F.3d 1178 (6th Cir. 1999), a case with similar facts to Firemen’s Insurance Co., the Sixth Circuit, applying Michigan law, found that fumes from a floor sealant were not a “discharge, dispersal, seepage, migration, release or escape” under the pollution exclusion when those fumes caused injury to a school employee working in the room directly below where the sealant was applied. Adopting this same logic, the New York Court of Appeals held that the pollution exclusion did not apply to the release of paint fumes in the normal course of a contractor’s business, explaining that the use of the terms “discharge” and “dispersal” “does not clearly and unequivocally exclude a… claim arising from indoor exposure to [the painting contractor’s] tools of its trade.” Belt Painting Corp. v. TIG Insurance Co., 795 N.E.2d 15 (N.Y. 2003). See also, Nav-Its, Inc. v. Selective Insurance Co. of America, 869 A.2d 929 (N.J. 2005) [holding that the pollution exclusion is limited to traditional environmental pollution claims]; Porterfield v. Audubon Indemnity Co., 856 So.2d 789 (Ala. 2002) [holding that personal injuries caused by exposure to lead paint were not barred from coverage by the pollution exclusion]. In these jurisdictions, it is well-settled that the pollution exclusion does not, nor was it intended to, apply to claims affecting indoor air such as the allegations pertaining to Chinese drywall.
Accordingly, whether a homebuilder will be easily working with carriers to remedy these problems or fighting to obtain coverage for repairs may in large measure depend on jurisdiction. Therefore, it makes sense for homebuilders to consider all possible jurisdictional issues before pursuing coverage. In other words, consider where the policy was purchased, in what state is the insured located, in what state is the insurance broker located and in what state is the insurance company primarily based. Carefully review the policy for a provision that might define what jurisdiction’s laws will be applied. Simply because the affected home is in a jurisdiction such as Florida or Texas does not automatically mean that that state’s law will apply or that the pollution exclusion will bar coverage. Indeed, while carriers in these jurisdictions are relying on the pollution exclusion to deny coverage, there has been no reported decision to date confirming its application in the Chinese drywall context.
Nonetheless, regardless of which state’s law will apply, homebuilders should, in every instance, immediately notify their insurance carrier of any complaints and potential claims and should always seek coverage. With such a clear split among jurisdictions as to the appropriate scope of the pollution exclusion, a good faith argument, based on distinguishable facts or a change in the law, always can be made.
Recovery from Installers
Perhaps the most logical source of recovery is from the subcontractors that installed the Chinese drywall. They are the parties with whom the homebuilder may have a direct contractual relationship, allowing the homebuilder to assert claims of breach of contract and warranty, including claims for indemnification. In addition, the homebuilder can assert tort claims against these entities for negligence. The difficulty with suits against these entities in today’s market is that many are no longer in business or have been financially drained in prior litigation and remediation efforts. Therefore, it is critical to notify their insurance carriers, as soon as possible, and include them in the process. Insurance claims that accrued during the policy period, while the company was still viable, will typically survive bankruptcy.
Recovery from Suppliers and Manufacturers
Homebuilders also should seek recovery from the manufacturers and suppliers of the Chinese drywall. Lennar Corp., a nationwide homebuilder facing its own class action lawsuit for its use of Chinese drywall in the construction of numerous homes in Florida, has taken such an approach. In a case filed in Florida state court, Lennar has brought claims of product liability and negligence against the manufacturer. Lennar has alleged that the defective drywall caused damage to “other” property within the affected homes, entitling Lennar to damages in tort.
With no contractual privity between homebuilders and manufacturers, any recovery from Chinese drywall manufacturers will need to be based on theories of tort. This means that homebuilders will need to allege and prove that the drywall itself is not only defective but that it has caused damage to property other than the drywall itself. The economic loss rule “prohibits tort recovery when a product damages itself, causing economic loss, but does not cause personal injury or damage to any property other than itself.” Casa Clara Condominium Assn. v. Charley Toppino & Sons, Inc., 620 So.2d 1244 (Fla. 1993).
What constitutes “other” property within the context of a newly finished home or apartment undoubtedly will be the subject of intense dispute. Manufacturers will argue that HVAC units and other damaged property are all part of the same dwelling and thus do not constitute “other” property within the economic loss rule. However, in determining what constitutes “other” property,“ the Casa Clara court held one must look to the product purchased by the plaintiff. Therefore, in a claim brought by a homebuilder against a manufacturer, when the final product purchased was drywall, “other” property should undoubtedly include damage to HVAC units, wiring and other components within the newly constructed dwelling; all entitling homebuilders to recovery.
What is more difficult, however, is that the manufacturers at issue are Chinese companies. Suing a foreign company can be time-consuming and expensive. Service of process must be completed through the Hague Convention, which requires the use of intermediaries, and can take anywhere from two to four months. Further, establishing jurisdiction may be a problem. In order to sue a foreign company in the United States, plaintiff must demonstrate that the foreign company has specific ties to the state in which it is being sued. Simply placing a product in the stream of commerce, without more, is not enough. Asahi Metal Industry Co., Ltd. v. Superior Court, 480 U.S. 102, 112 (1987). These jurisdictional issues coupled with issues of international law will make the pursuit of and recovery from these foreign companies much more complicated.
Multidistrict Litigation
On June 15, 2009, a special panel on multidistrict litigation issued an order consolidating all Chinese drywall lawsuits currently pending in the federal courts (more than 600) in the Eastern District of Louisiana, to be heard by Judge Eldon E. Fallon. Multidistrict litigation is a federal court system procedure that allows the consolidation of cases that share common questions of fact. Such a consolidation authorizes one judge to oversee all pretrial discovery matters, hearings and motions and to get the cases ready for trial and ripe for settlement. If after all pretrial matters have been resolved there remain issues to be tried, each case is then remanded to its home district where the trials are conducted independently.
Judge Fallon, with the help of plaintiff and defense steering committees, is selecting five test cases to be tried by the end of the year. This accelerated timetable undoubtedly will encourage settlement, as the outcome of these five cases will in large measure define the results of all others.
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For more information about the issues covered in this report, please contact Melissa Lesmes in our Washington office at 202-383-7352 or at lesmesm@howrey.com, David Beck in our Washington office at 202-383-7491 or at beckd@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.
©2009 Howrey LLP
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