The Coverage Conundrum in Chinese Drywall Claims

Unless you live in Florida or Louisiana, or regularly read the Insurance Journal, you may only now being hearing about the latest mass tort craze: Chinese-Manufactured Drywall (often simply referred to as “Chinese Drywall”).

The property damage and personal injury claims arising out of the use of this product could not come at a worse time for the construction industry, and in particular the residential home construction industry, which have already been battered by the worst recession since World War II. The financial and legal ramifications arising from these claims, both inside and outside the insurance industry, may be significant.

The construction industry began using large amounts of Chinese Drywall during the residential housing construction boom of the mid-2000s, when American drywall manufacturers could not produce sufficient quantities of drywall to meet demand. The Sarasota Herald Tribune reported earlier this year that since 2006, the U.S. has imported more than 550 million pounds of drywall from China.

Since the first reports of problems surfaced in 2008, the Consumer Products Safety Commission reports that it has now received over 800 incident reports from twenty-three states and the District of Columbia. The key questions, such as what are the real problems with the material and how many homes contain the allegedly-defective material, are mostly unanswered.

The Problem
The current theory is that Chinese Drywall emits various gases when exposed to humidity over time. These gases include hydrogen sulfide and other sulfur-reducing compounds. Because hydrogen sulfide smells like rotten eggs, the presence of an odor may be a tell-tale sign that Chinese Drywall has been installed in a house. Another alleged sign is corrosion or discoloration of air conditioning coils, water pipes, and electrical wiring.

Early scientific analysis of the Chinese Drywall suggests that it contains impurities not contained in drywall manufactured in the United States, including sulfur, strontium, magnesium and iron. (Drywall is primarily made from gypsum.) However, scientists studying this issue have not reached a consensus as to what causes the Chinese Drywall to release gases.

For those homeowners who have Chinese Drywall in their homes, there is unfortunately no accepted remediation protocol. Nor is there any firm science concerning the effects on human health of short-term or long-term exposure to the gases allegedly being released although several agencies are actively researching the issue.

The Lawsuits
Whether or not the science catches up with the litigation remains to be seen. Unhappy homeowners have filed numerous lawsuits seeking to recover the costs of repairing their houses and sometimes alleging physical injury and mental anguish as well. (Only a fraction of the pending lawsuits involve commercial property claims, although that may change over time.) Those lawsuits typically target homebuilders, the drywall installers, and any vendor in the drywall supply chain from the manufacturer on down.

Many of the lawsuits filed in federal court are being consolidated into a “multi-district litigation” or “MDL” in a federal court in Louisiana. The Judge, Eldon Fallon, has expressed his intent to start trying lawsuits involving only property damage claims as soon as January 2010.

It is presently unclear whether the manufacturers will be in the courtroom if those trials start next January. Service of process on these Chinese manufacturers has been slow. However, even if the Chinese manufacturers are successfully served, no one knows whether a judgment could be successfully recovered against them should they be held liable.

If the Chinese manufacturers cannot be served or are judgment-proof (i.e., without assets to pay a judgment), then some of the remediation costs will be borne by American companies.

No one knows what those costs will be, although Lennar Homes, a large homebuilder, recently made a recent public filing, announcing that it had reserved $39,800,000 for warranty work on approximately 400 homes constructed in Florida, primarily in 2006 and 2007, that it had identified as containing Chinese Drywall. That amounts to almost $100,000 per house.

Lennar was one of the first homebuilders to try to get out in front of this issue by offering to replace the drywall in its houses in exchange for a limited release from the homeowners from future liability. Lennar has even filed its own lawsuit in a Florida state court against drywall installers, suppliers and manufacturers whom it contends are liable for the cost of the repairs it has undertaken.

The Insurance Issues
Of course, many affected homeowners may not have access to an immediate remedy because their homebuilder has closed down due to the recession or lacks the financial resources to undertake such repairs.

Those homeowners may turn first to their homeowners’ property insurance policies, but so far most property insurers are declining coverage citing numerous policy provisions, including “errors, omissions and defect” exclusions that bar coverage for loss arising out of defective construction. These denials have led to the filing of several coverage lawsuits against homeowners’ insurers in Florida.

Although the liability coverage litigation has been sparse, it is likely to explode in connection with the MDL proceeding, as plaintiffs exploit the right under Louisiana law to sue insurers for the homebuilders, drywall installers and drywall distributors directly.

Judge Fallon has ordered that the plaintiffs refrain from doing so for now, but the plaintiffs’ initial discovery includes identification of the defendants’ insurers. The coverage litigation will likely include the following issues:

• The Pollution Exclusion: The applicability of the pollution exclusion may decide the outcome in many cases. If the policyholder has a policy with an “absolute” pollution exclusion – which requires that the pollution fall within a particular category to be excluded – then policyholders may try to argue that the pollutants emitted by the Chinese Drywall fall outside of those categories. However, they may be less successful if their policy contains the so-called “total” pollution exclusion.

  Another key factor will be which state’s law applies to the claim, as Florida has traditionally interpreted the pollution exclusions broadly, but Louisiana has not.

  On a related issue, we may also see how many insurers have endorsed their policies in recent years to exclude coverage for bodily injury or property damage that began before their policy incepted, regardless of whether the injury or damage was known to the policyholder before that time.

  Prior case law involving insurance coverage claims for other defective products suggests that this issue may depend in part on the nature of the policyholder’s business – was the policyholder in question the manufacturer, the distributor, the home builder, or the drywall installer?

  This issue may also be subject to some gamesmanship, as the “number of occurrences” positions taken by the litigants in a particular instance may depend on whether that position limits coverage for the insurer or maximizes coverage for the policyholder.

  A key coverage question involving the business risk exclusions is whether the cost of removing and replacing all Chinese Drywall is covered or if it: depends on whether the drywall has caused other injury or damage, or if the removal is preventive in nature.

  The so-called “sistership” exclusion, which bars coverage for the cost of recalling or withdrawing a defective product from the market, may apply if governmental agencies recall Chinese Drywall.

  Additionally, we will see how many contractors may have lost coverage because of insurers who have endorsed their policies to remove the so-called “subcontractor exclusion” to the “Damage to Your Work” exclusion.

Experienced Plaintiffs’ Lawyers
From our initial observations, the plaintiffs’ lawyers leading this litigation are experienced, many of them having been involved in the EIFS/synthetic stucco litigation and other construction defect/mass torts. Whether or not this litigation will rise to the level of the EIFS litigation remains to be seen. We can safely predict that these claims will keep plaintiffs’ lawyers, defense lawyers and coverage counsel for both insurers and policyholders occupied for the near future.

Brian S. Martin and Rodrigo “Diego” Garcia, Jr. are partners in the Houston office of Thompson, Coe, Cousins & Irons L.L.P.