Glorifying Form Over Substance: "Legally Obligated" in the CGL Insuring
Agreement
August 2001
Insurers may deny claims where a contractor,
absent the filing of a lawsuit, repairs property damage caused by an obvious
accident. Pat Wielinski discusses the scenarios, issues, case law, and provides
practical pointers for avoiding this situation.
by Patrick
J. Wielinski
Cokinos, Bosien &
Young
Construction defect claims often raise many insurance coverage issues between
the parties, not the least of which is the existence of an occurrence or property
damage under the policy. However, what if there has been a clear accident resulting
in unexcluded property damage to a project? Even under these circumstances,
claims go denied under commonly recurring scenarios. The purpose of this article
is to discuss one of those scenarios: where a contractor, absent the filing
of a lawsuit, repairs property damage caused by an obvious accident. It is this
type of claim that often is denied or is hotly contested by many commercial
general liability (CGL) insurers.
The Scenarios
Consider a frequently encountered scenario. The insured general contractor
is renovating a building. While hoisting a new HVAC unit to the top of the building,
the crane topples, causing $1 million in damage to parts of the building that
are not the insured's work. The insured fails to repair the damage to the rest
of the building despite a provision in the contract requiring the insured to
protect adjoining property, so the owner sues. The insured contractor tenders
the defense of the owner's lawsuit to its CGL insurer. Not surprisingly, a judgment
is entered for $1 million in damages plus attorney fees, costs, and interest,
and the insurer pays the judgment. Nothing earth-shattering here.
Consider a second scenario involving similar facts. After the crane accident,
the insured repairs the damage, incurring $1 million in extra costs, since,
under the terms of the contract, the contractor is required to protect adjoining
property from damage. The contractor notifies its CGL insurer of the accident,
but much to its disappointment, receives a letter in response that costs incurred
in repairing damage to the project are not covered, "However, should the Owner
file a lawsuit against you, please notify us at once." The contractor keeps
its CGL insurer advised of the progress and cost of the repairs, but the insurer
maintains its position denying coverage.
In substance, there appears to be little difference between the above scenarios.
In the first scenario, the contractor defaulted on its obligations to repair
adjoining property and the owner recovered the $1 million in repair costs from
the contractor, plus attorney fees, costs, and interest. In the second scenario,
the contractor fulfilled its contractual obligation and incurred the $1 million
in repair costs itself, thus obviating the necessity for the lawsuit by the
owner. In essence, it "did the right thing." In the process, it saved attorney
fees, costs, and interest, and most likely, its reputation. In both scenarios,
there was a classic "occurrence," i.e., a crane accident that resulted in property
damage to the building. This is a prime example of a CGL claim.
The Issue
The second scenario is the far more common method of conducting business
in the construction industry. Moreover, all variables for coverage under CGL
policies were held constant in both scenarios: an occurrence of covered property
damage for which no exclusion applies. Why, then, do some insurers treat those
scenarios differently under identical policies? The answer lies in divergent
interpretations of the insuring agreement of the CGL policy, which states that:
We will pay those sums that the insured becomes legally obligated to pay as damages
because of "bodily injury" or "property damage" to which this insurance
applies.
Specifically, some insurers take the position that in order to be "legally
obligated" for purposes of coverage under a CGL policy, there must be a legally
binding judgment entered against the insured. Of course, since most cases are
settled on behalf of insureds by their CGL insurers, this requirement often
requires, at a minimum, that a lawsuit asserting liability be filed against
the insured.
Obviously, this causes a quandary for the contractor faced with an occurrence
of property damage that it is obligated to repair under its contract. By proceeding
with repairs, in order to mitigate damages for all concerned, and to avoid a
breach of contract, the insured contractor runs the risk of its CGL insurer
taking the position that absent a lawsuit, the contractor is not entitled to
coverage under its CGL policy. The contractor runs this risk even where the
insurer is promptly notified and kept apprised of the cost and progress of repairs.
This glorification of form over substance is not warranted under the terms of
the insuring agreement and is clearly contrary to best construction practices,
where any delay in repairing damage, let alone litigation between the parties,
only prevents timely completion of the project.
Related Issue
Before examining the "legal obligation as judgment" position, it is helpful
to review an issue related to the "legal obligation" requirement. That issue
involves the viewpoint that the CGL policy provides coverage for only tort damages
and not damages arising out of breach of contract.1 Very briefly, the genesis for this point of view developed in a line of California
cases which has been, for all intents and purposes, laid to rest by the California Supreme Court in Vandenberg v Superior Court,
12 Cal 4th 815, 88 Cal Rptr 2d 366, 982 P2d 229 (1999). There, even though the
insured was sued for breach of contract pursuant to a lease obligating it to
clean up contaminated premises, the court nevertheless held that for purposes
of CGL coverage, the distinction between breach of contract and tort damages
was rejected. Rather, the focus should be on whether there has been an occurrence
resulting in property damage, regardless of the cause of action pled. This case
is of obvious importance to the construction industry where most occurrences
of property damage on a job site involve a breach of contract.2
Back to the Construction Contract
While Vandenberg appeared to lay many of these
issues to rest, the issue for many contractors still remains wide open: that
is, whether contractually mandated costs to repair property damage caused by
an occurrence are covered under a CGL policy. Simplistically viewed, a contractor's
contractual obligations are clearly "legal obligations," once the false contract
versus tort distinction debunked by Vandenberg is abandoned. Nevertheless, for most contractors, a suit awarding those repair
costs as damages will never be filed. As such, the insuring agreement of the
CGL policy does not appear to match up very well with the realities of the construction
business.
Perhaps because searching for such realities in court cases is a debatable
pursuit, very few courts have effectively dealt with these issues. Those that
have seem to have reached inconclusive results. Nevertheless, since CGL policies
are heavily litigated contracts, the task of examining and reconciling court
cases interpreting their standard language is hard to avoid.
With that in mind, the first case to address this issue is San Diego Housing Comm'n v Industrial Indemnity Co.,
68 Cal App 4th 526, 80 Cal Rptr 2d 393 (1998). In that case, the Housing Commission
incurred repair costs at a low-income housing project in response to tenant
complaints. It sought coverage for those costs as an additional insured on the
general contractor's CGL policy, contending that it had contractual and statutory
duties to tenants and the Department of Housing and Urban Development (HUD)
to maintain the premises. In turn, those duties rendered the Housing Commission
"legally obligated to pay damages." The court reviewed the potential exposure
of the Housing Commission and stated as follows:
First, did Housing become legally obligated to pay these repairs costs,
due to potential adverse orders which could have been issued in any suits
filed by the tenants, HUD, or the Authority against the Commission? The
answer is clearly no, because neither the tenants nor HUD sued Housing,
nor did the Authority sue its sister agency, the Commission, for failure
to make needed repairs. Here, while Housing incurred expenses to repair
the property, the statutory and contractual duties on which it relies are
not enough to implicate this liability policy, even if they constitute separately
owed public obligations. Those duties do not of their own force create insurance
coverage. They did not create "damages" paid out by Housing . . . [Citations
omitted.]
The court found it troubling that the Housing Commission's potential liability
for damage to the tenants or HUD was never formalized by means of suit, let
alone a claim. Under those circumstances, the court found that there was no
legal obligation on the part of the Housing Commission to a third party. Any
obligation of the Housing Commission appears to have been particularly ephemeral
since it was never clearly articulated to the court and was based on a statute
exposing a public entity, under a mandatory duty to protect against a particular
kind of injury, to liability for failure to discharge that duty. It was also
based on the tenant leases, although the provisions of the leases were not discussed.
Therefore, the duties of the Housing Commission, whether statutory or contractual,
were at best vaguely articulated in the opinion, which contributed to the court's
ultimate decision to deny coverage. Had the contractual duties involved in San
Diego Housing been more clear and concrete, perhaps the result may have been
different.
A case involving more substantive contractual obligations is Continental Casualty Co. v Major Constructors,
2000 Tex App LEXIS 4800 (Tex App—Houston 2000). In that case, Major, the insured,
was the prime contractor on a construction project during which one of its subcontractors
accidentally caused water damage to a building at the Johnson Space Center.
Major requested Continental, its CGL insurer, to reimburse NASA for the damages.
Continental refused, maintaining that pursuant to the CGL policy it was only
required to pay sums that Major became legally obligated to pay as damages.
Even though no one claimed that Major was at fault for the damage, Major contended
it was nevertheless "legally obligated to pay" NASA for the damage pursuant
to its contract which specifically required Major to repair damage to the premises.
When NASA instituted collection procedures pursuant to the Federal Acquisition
Regulations, Continental contended that the insured's legal obligation could
only be established by judgment. This position ignored the fact that the liability
of a government contractor is usually determined administratively and not by
judgment.
On appeal, the court reversed the summary judgment on behalf of the insured
contractor. It remanded the case to the trial court, inviting the parties to
develop a record in order to clear up issues of material fact as to Major's
obligations under its contract with NASA. In doing so, the court appeared to
operate on the assumption that if in fact the contract obligated Major to repair
the property damage, there would be coverage under the CGL policy.
A somewhat similar case is Acceptance Ins. Co. v
S&S Telecom, Inc., 2001 WL 844749 (Tex App—San Antonio 2001). In that
case, the insured, S&S, entered into a contract with Southwestern Bell to remove
telephone equipment from a plant. During the removal, S&S employees cut through
cable trays enclosing telephone switching equipment. Metal shavings from the
cable trays fell into the switching frames, damaging them in the amount of $66,000.
Southwestern Bell demanded that S&S pay the repair costs, and S&S turned the
claim over to Acceptance, its CGL insurer, seeking coverage for the loss. Acceptance
denied the claim and S&S did not pay for the repairs. Southwestern Bell consequently
withheld $66,000 from contract payments to S&S, causing S&S to file suit against
Southwestern Bell for breach of contract. At trial, the court ruled that Southwestern
Bell did not breach the contract by withholding the repair costs due to the
negligence of S&S employees.
In denying coverage, the insurer claimed that the withholding of repair costs
by Southwestern Bell did not constitute a covered loss under the insuring agreement.
The court rejected this argument, holding that the dispositive issue was not
the fact that Southwestern Bell withheld fees from S&S and did not actually
sue S&S, but rather, the fact that it was the negligence of the insured which
caused the metal shavings to fall into the switching frames. The court focused
on the negligent actions of the insured that caused property damage, not whether
the insured had been sued, and in upholding coverage, it refused to glorify
form over substance and found a "legal obligation on the part of the insured."
Practice Pointers
While the parameters of the "legally obligated" requirement can be debated,
it is obvious that the requirement serves as a limitation on those claims an
insurer must pay. Particularly, an insurer is not obligated to pay claims that
the insured voluntarily pays, but only those for which it is legally bound.
In other words, the insured cannot expect its insurer to pay claims for which
the insured is not actually liable.
Obviously, a judgment is the ultimate means of establishing that an insured
is "legally obligated" to pay damages. In order to convince an insurer to pay
a claim short of judgment, the insured must take steps sufficient to satisfy
the insurer that a legal obligation in fact exists. In the construction context,
this requires that the insured contractor notify the CGL insurer promptly of
a loss and give it the opportunity to investigate. Moreover, it needs to cooperate
with the insurer and keep it apprised of progress and cost of repairs, giving
it the opportunity to be involved. Often, a CGL insurer will decline to do so,
but the insured should nevertheless err on the side of notification and cooperation.
In the event an insured does not do so, the claim can be severely prejudiced.
For example, in Charter Oak Fire Ins. Co. v Color Converting
Industries Co., 45 F3d 1170 (7th Cir 1995), an insured manufacturer represented
to its largest customer that a certain type of ink could be used on the customer's
packaging. The ink did not work, and the insured paid $235,000 for damaged packaging
to its customer and, after the fact, sought recovery from its insurer, Travelers.
Travelers attempted to investigate the claim, but the insured refused to turn
over the cost data to Travelers on the ground that the data was proprietary.
In light of the circumstances, the court quite understandably acknowledged that
since the cost to replace the packaging appeared high, there was a danger of
collusion between the insured and its customer.
While the Charter Oak v Color Converting opinion
represents an extreme case, the insured contractor usually should not expect
its CGL insurer to pay for repairs after the fact. In an absence of a lawsuit
seeking damages against the insured, the insured needs to persuade its insurer
that its damages are legitimate in amount, and that the other party, usually
the owner, is looking to the insured to pay them. Toward that end, it may be
necessary to encourage the owner to make a written demand against the insured
and, in extreme cases, convince the owner to file suit. Due to the stance many
CGL insurers take toward coverage for breach of contractual obligations, parties
often resort to these types of cooperative efforts.
The court cases on the "legally obligated to pay as damages" requirement
present a mixed bag of results, and none of them have adequately addressed the
issue. The insured can nevertheless improve the chance of prevailing on a claim
for contractually required repair of property damage by taking commercially
reasonable measures. Those measures include documentation and control of costs
and keeping its insurer informed as to progress. In this way, the insured can
minimize the objection to the absence of a judgment in establishing its legal
obligation to repair and pay the amount of those damages. The less palatable
alternative is for the insured contractor to sit on its hands and wait for a
disgruntled owner to sue for breach of contract and then seek coverage after
the horse is already out of the barn.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.