30 Jun 2009

Innovation and design risk in construction projects

by Dan Thompson, Brooke Coghlan

The Canadian Supreme Court has taken a more liberal approach which makes it more difficult for insurers to avoid liability.

Innovation has always been a key component of Australian business. A survey undertaken by the Australian Procurement and Construction Council in 2002 showed that there is a direct correlation between innovation and increased profitability. In that survey, 92 percent of the participating businesses saw themselves as innovative. Indeed, the Australian construction industry is known globally as an innovator in terms of design, construction methodology and engineering solutions.

It is imperative that in models of procurement where contractors bear the risk of both design and construction, risks associated with innovative designs and methods must be effectively identified and managed for delivery of successful project outcomes for all stakeholders.

An integral part of the successful management of such projects is the effective placement and maintenance of insurance. However, this is not always possible: not all risks can be insured. For example, most builders' risk policies specifically exclude insurers' liability in respect of loss caused by "defective or faulty design". This exclusion is sometimes relied on by insurers when innovative or new technologies fail. This is because the exclusion has often been broadly interpreted under Australian law, and this has created a grey area in insurance protection: whether a failed new design is truly "defective or faulty". In order to avoid falling victim to this grey area, project stakeholders must take additional measures to manage design risk, such as robust and comprehensive design processes and extensive quality control systems.

A recent Canadian decision may encourage the Australian courts to reconsider the "defective or faulty design" exclusion under Australian law, which could have the result of narrowing the scope of the exclusion, thus making it more difficult for insurers to rely on it to avoid liability under applicable policies of insurance.

The Australian position - 'perfection'

A design is considered defective or faulty "if it is not as adequate for the purpose as art and skill can make it" (Chalmers Leask Underwriting Agencies v Mayne Nickless Ltd (1983) 155 CLR 279). The adequacy of a design has to be judged in the context of the purpose for which it is intended to be implemented (New South Wales v AXA Insurance Australia Ltd (2002) 12 ANZ Ins Cas 61-522). A design may be "defective or faulty" despite a lack of negligence on the part of the designer.

The leading case is Manufacturers' Mutual Insurance Ltd v Queensland Government Railways (1968) 118 CLR 314 (MMI), where the High Court held that a design was faulty because it did not work, notwithstanding that the designing engineers were not negligent and that, at the time of designing, not enough was known about the problems involved and their solution to achieve a successful outcome.

This "perfection test" may therefore be described as rather draconian: if it doesn’t work, it must have been faulty. This provides insurers with a broad scope for relying on the "defective or faulty design" exclusion in builders' insurance policies, and therefore little scope for contractors to successfully claim on their insurance policies when an innovative design goes wrong, notwithstanding months or perhaps years of rigorous design review procedures.

The Canadian position - "state of the art"

A different position was adopted in the recent significant Canadian case of Canadian National Railway Co. v Royal and Sun Alliance Insurance Co. of Canada 2008 SCC 66.

During the early 1990s, the Canadian National Railway Co (CNR) designed and constructed an ambitiously conceived, customised tunnel boring machine (TBM), which subsequently failed while it was being used to construct a railway tunnel. The principal's insurance policy for the construction of this particular project covered "all risks of direct physical loss or damage... to... [a]ll real and personal property". However, the insurance policy also purported to exclude all liability of the insurer in relation to " faulty or improper design". The major issue considered by the Supreme Court of Canada was whether the principal's insurer was ultimately liable for the losses caused by the failure of the TBM.

At first instance, the trial judge concluded that the risk of failure of the TBM was not foreseeable because the insurer had failed to prove that "all foreseeable risks" had not been taken into account. It was held that the "faulty or improper design" exclusion under the insurance policy did not apply.

On appeal, the Canadian Court of Appeal overturned the original decision and effectively shifted the burden of proof back on to the principal by requiring not only that the design withstand "all foreseeable risks", but also that the design succeed in accommodating those risks - invoking a standard of perfection similar to Australian MMI decision. The Court of Appeal determined that because the TBM failed, its design was faulty. Accordingly, the "faulty or improper design" exclusion under the insurance policy should apply.

The Supreme Court of Canada took a different view. In allowing CNR's appeal the Court largely reinstated the reasoning at first instance and adopted a "state of the art" standard. It was remarked that in an innovative project there is inevitably a gap between the then current state of engineering and a state of perfect knowledge. This gap conceals risks that are not foreseeable on the basis of the state of knowledge and available information at the time. It was said that a design is not "defective or faulty" simply because it falls short of perfection in relation to all foreseeable risks.

On the facts of the case it was concluded that "all foreseeable risks" had been properly explored during the design phase. Based on the existing state of the art, it was not foreseeable that the particular risk that transpired (in this case, "excess differential deflection") was even a remote or unlikely risk in the context of the particular design. Accordingly, the Supreme Court held that the "faulty or improper design" exclusion under the insurance policy did not apply.

Is there a need for change in Australia?

We wait with interest to see whether, as a result of the CNR decision, the High Court of Australia will reconsider the Australian position in relation to the issue of "defective or faulty" design. A move in that direction may be considered appropriate given the significant technological and other industrial advancements which have occurred since the MMI decision in 1968. It is clear that innovation should be encouraged, as it benefits the whole industry in terms of cost, time and quality of product. Reaping such benefits will continue to distinguish the Australian construction industry as a world leader.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.