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You have to be pulling my LEG(3)

24 September 2020
By David Pryce & Rob Goodship

An unwelcome consequence of the London Market’s preference for including arbitration clauses in most types of commercial insurance policies, is that disputes regarding the meaning of clauses in those policies are frequently resolved in private, rather than in a public forum where the decision of a Court could assist policyholders and insurers in avoiding similar disputes in the future.

In a Construction All Risks context, insurers’ preference for arbitration clauses has had the remarkable effect that in the nearly 25 years since the London Engineering Group (“LEG”) first introduced its suite of defects exclusions, there has not been a single Court decision, anywhere in the world, on the meaning of the defects exclusion which LEG intended to be the most favourable for policyholders: LEG3.

So, if there are no reported cases on LEG3 then where can one look for guidance?  The current (2nd) edition of Paul Reed QC’s excellent book “Construction All Risks” doesn’t consider LEG3 in any detail.  Whilst we understand that the omission will be corrected in the forthcoming 3rd edition, at present Mr Reed’s book refers to LEG3 as being an equivalent of the most favourable of the “DE” defects exclusions: DE5.  That equivalence, however, is not accepted in all parts of the insurance market.

As noted in an article published by Iftikhar Ali of DWF in 2019, the absence of the word “additional” from LEG3 (as opposed to DE5, which explicitly excludes “additional costs of improvement”) has encouraged some to interpret LEG3 as excluding all costs which relate to works which have the effect of improving the original works.  If this interpretation was correct then it would produce particularly harsh results for policyholders where the contract works have suffered damage as a result of defects in design, as in one sense all remedial works carried out according to a different design must necessarily be an improvement if the remedial works are defect-free as a result.  For that reason Mr Ali (correctly in our view) reaches the view that such an interpretation, whilst consistent with a literal reading of LEG3, would be “a commercial nonsense”.  Unfortunately, in our experience, that does not always prevent insurers from running the argument, to the surprise and disappointment of any policyholder or broker who is familiar with how the market ordinarily approaches the clause.

Whilst other texts and commentaries are consistent with the guidance notes produced by the London Engineering Group itself, that LEG3 was intended by the underwriters who drafted it to provide the “the widest form of cover, for physical damage caused by defects”, none of the texts or commentaries discuss how, precisely, one should determine: (i) what constitutes an improvement for the purposes of LEG3; and (ii) what cost is thereby excluded.  This article attempts to address that gap.

What is an improvement for the purposes of LEG3?

For the purposes of this article the relevant part of LEG3 provides that:

“the cost of replacement or rectification which is hereby excluded is that cost incurred to improve the original material workmanship design plan or specification” (our emphasis).

It seems to us that for remedial works to constitute an improvement as compared with the original works:

  • The remedial works must be different in some way from the original works; and
  • That difference must be more than an equally valid way of performing the works, and must produce a tangible benefit (for instance an improved factor of safety, or a longer design life, or superior functionality – in all cases as compared with the original works as completed, as opposed to the outcome desired by the employer).

The requirement for the difference to produce a tangible benefit in order to constitute an “improvement” is important.  The fact that remedial works are different to the original works does not on its own mean that they are an improvement, even if the remedial works are more expensive.

In the context of a Construction All Risks claim, if an insurer cannot identify a tangible benefit produced by the remedial works as compared with the original works, then it will not be able to show that the remedial works are an improvement, and any difference in cost between the remedial works and the original works will be irrelevant, and should not result in a deduction under LEG3.  It is only if the insurer is able to identify a tangible benefit produced by a way in which the remedial works are different from the original works that one is required to consider what cost is thereby excluded by LEG3.

What cost is excluded?

Once one has a taken a view not just on how the remedial works are different from the original works, but also in what way that difference relates to a tangible benefit (i.e. what is the “improvement”), one can then try to identify the cost that relates to that improvement.  Pausing there, it is of course entirely possible that there may be no “cost” of improvement, because a policyholder may find a different way of approaching the remedial works which, although producing a tangible benefit as compared with the original works, is nevertheless cheaper than the original works.  In that situation whilst there is an “improvement”, there would be no “cost incurred to improve”, but rather a saving.

Any other interpretation would be precisely the “commercial nonsense” referred to by Mr Ali, and we doubt that there is a single CAR underwriter who, when writing a risk, would want to encourage their policyholder to carry out remedial works more expensively than a cheaper and better alternative if one was available.

Assuming, then, that remedial works are both an improvement, and are more expensive than the original works, it seems to us that the “cost incurred to improve” can then be identified in one of the two following ways.

Item by item comparisons

Depending on the facts, it may be possible to identify excluded costs on an item by item basis.  For instance, there will be occasions when:

  • Some elements of the remedial works are different to the original works, but produce no tangible benefit (“Differences”);
  • Some elements of the remedial works are exactly the same as the original works; and
  • Some elements of the remedial works are different to the original works, and do produce a tangible benefit (“Improvements”).

In that situation, the Differences may occasionally be cheaper than the comparable items of the original works.  However, there wouldn’t be any justification, in our view, for offsetting any such savings against the cost of the Improvements if those were more expensive than comparable items of the original works.  Rather, the cost excluded by LEG3 in that situation would be the un-discounted difference in cost between the Improvements, and the comparable items of the original works.

Equally, if the Differences are more expensive than the comparable items of the original works we can see no justification for excluding the difference in cost relating to them: what is excluded by LEG3 remains the difference in cost between the Improvements, and the comparable items of the original works.

It should be obvious, we hope, that any differences in cost which relate to elements of the remedial works which are exactly the same as the original works, are unaffected by LEG3.

The approach of separating Differences and Improvements should, in our view, be applied not only to separate items of work, but where required by the facts can also be used to identify the excluded costs where individual items of work may contain both Differences and Improvements.

Items of work containing both Differences and Improvements

How this would work in practice in relation to individual items of work can be illustrated by considering a length of steel pipe which was under-specified, has suffered damage by becoming deformed under expected pressure, and has been replaced by thicker steel pipe.  In that situation:

  • There is a difference between the original works and the remedial works, in that a thicker steel pipe has been used in the remedial works; and
  • The fact that the steel pipe used in the remedial works is thicker than that used in the original works produces a tangible benefit, in that is more robust and less likely to become deformed under expected pressure (i.e. the pipework constitutes an Improvement in that it is thicker).

Suppose the thicker steel pipe used in the remedial works is more expensive for two reasons:

  • Because more steel has been used to make it thicker; and
  • Because the cost of steel has increased since the original works were carried out.

In that situation LEG3 would only exclude the cost of making the pipe thicker by using more steel, as it is only that cost which is related to the way in which the thicker steel pipe is superior to the original steel pipe.  The increased material cost is not related to the way in which the thicker steel pipe is superior to the original steel pipe, and so that difference in cost is not, in our view, excluded by LEG3.

Holistic comparisons

There will be other occasions where individual items of remedial work cannot sensibly be compared with any items of the original works (for instance, where the remedial works follow a substantially re-designed scheme).  In that situation it will be necessary to compare the overall (remedial and original) schemes with each other.

Even in that situation, however, care needs to be taken not simply to subtract the cost of the original works from the cost of the remedial works in order to identify the cost excluded by LEG3, because that would risk including Differences (i.e. which don’t relate to the way in which the remedial works improve the original works).  Rather, the cost of any Differences (e.g. fluctuations in material costs), need to be identified and disregarded.

Ordinarily the most appropriate way to do so in order to produce a reliable holistic comparison, is to compare the cost of the remedial works against not the cost of the original works, but against the cost that would have been incurred if the original works had been re-performed (in exactly the same way) following the occurrence of damage instead of the remedial works which were actually done.