The Supreme Court has just released a decision that will directly affect insurers, engineers, Councils, and anyone else potentially exposed to defective building claims which include a mix of both watertightness and other defects.

Defective building claims often involve allegations of water ingress/leaky defects as well as various non-leaky claims such as fire and/or structural defects. Where there are mixed claims against a given defendant, that defendant’s liability insurance policy will typically exclude cover in relation to watertightness defects but, subject to the terms of the policy, may indemnify against the other non-watertightness allegations.

However, in 2021 a High Court decision created uncertainty around this commonly understood approach. In that case, the Napier City Council (the ‘Council’) faced allegations of negligence in issuing building consents, inspections, and issuing code compliance certificates in respect of a residential apartment complex. The defects included water ingress defects, as well as structural and fire defects which were unrelated to water ingress. Surprisingly, the entirety of the Council’s insurance claim in respect of its global settlement sum was declined on the basis the ‘leaky exclusion’ applied to exclude indemnity for not just the water ingress-related defects, but also the fire and structural defects. The High Court held that the Council’s entire insurance claim was ‘tainted’ by the water ingress defects such that the entirety of the claim was excluded.

The applicable clause excluded liability for Claims alleging or arising directly or indirectly out of the failure of any building to meet the Building Code in relation to leaks and water penetration (para-phrased) (the ‘Exclusion’).

The High Court’s decision was informed by the unique facts of the case, which were presented as admissible extrinsic evidence. It was held a reasonable person with the relevant background knowledge would have understood the Exclusion to have had the meaning advanced by the insurer where the commercial reality was that the insurer could not continue to make significant losses due to building defects associated with weathertightness claims. The Judge also saw the extrinsic evidence as providing support for “a mutual intention” consistent with the insurer’s approach to the Exclusion. In particular, the Court relied upon communications between the insurer and the Council in relation to a claim in 2012. The Court described how the Council had been notified in 2012 that a claim against it in negligence which included non-weathertight defects (fire and structural) would not be covered. The insurer had responded to the notification saying that the Exclusion applied to exclude the entire claim.

Accordingly, the High Court took the view that even if the insurer’s broad interpretation of the Exclusion was not the meaning known and agreed to by the Council at the time it was added in 2009, it definitely knew the meaning ascribed by the insurer following the Council’s unsuccessful 2012 claim. The High Court accepted the insurer’s argument that because there was a single Claim which included an allegation the failure of the building to meet the Building Code in relation to leaks, the Exclusion should apply to exclude the entire claim.

The Council successfully appealed. The Court of Appeal disagreed that the Exclusion applied to exclude those aspects of the claim which did not relate to water ingress. It held the claim was properly divisible, and that the wording of the Exclusion only removed cover for those aspects of a claim that are causally connected to water ingress. The Court of Appeal decision put less focus than the High Court on the admissible extrinsic evidence of a “mutual intention”, which was consistent with the insurer’s approach.

The insurer duly appealed to the Supreme Court and that decision has just now been released. The Supreme Court did not agree with the view that once it is determined the Council faced a single Claim (as defined) which includes water ingress then that is essentially the end of the inquiry as the Exclusion applies to Claims alleging water ingress. Rather, the Supreme Court agreed with the Court of Appeal’s view that the Exclusion does not apply to exclude the entire Claim. It applied to exclude only those aspects of the Claim which related to water ingress. The Supreme Court concluded there was no error in the Court of Appeal’s approach. Accordingly, the insurer’s appeal was dismissed.

Defendants in mixed-defect claims which includes water ingress can take comfort from the Supreme Court’s decision. Subject only to very clear and unique wording to the contrary, the standard ‘leaky exclusion’ within liability policies will continue to apply to exclude only that portion of a claim which relates to water ingress defects, and not defects unrelated to water ingress.