A commercial general liability (CGL) policy is regarded as providing a rather broad array of coverage to protect the insured from risks associated with bodily injury and property damage. But the mere labeling of a policy as a CGL policy does not guarantee a standard level of coverage, especially if the policy is endorsed to limit the standard coverage.
An endorsement of this type that is of particular concern to the construction industry is the "breach of contract exclusion." It broadly denies coverage for claims involving the insured's breach of contract. It is not difficult to determine the devastating effect that such an exclusion can have on claims against an insured contractor for construction defects since those types of claims invariably have their genesis in the construction contract.
Backdrop to the Endorsement
The exclusion was developed as some insurers' next move in the chess game involving coverage for defective work under a CGL policy. Courts began to embrace the underwriting intent behind the policy to determine that, in many instances, defective workmanship constituted an "occurrence" of "property damage" under the policy definitions. Those courts rejected the notion that damages awarded for breach of contract were foreseeable under contract law and, thus, could not constitute an accident or occurrence. They also rejected the idea that damage to the subject matter of the construction contract was merely an economic loss, and based on the economic loss rule, a cause of action for negligence was barred.
Construction insureds declared a King's X as to those arguments with the advent of cases from numerous states upholding unexpected and unintended property damage as an "occurrence" under a standard CGL policy.1 Many of these courts reached the common-sense conclusion that if property damage arising from defective construction did not constitute an occurrence, then the property damage exclusions tailored to construction risks served no purpose.
In particular, the presence of the subcontractor exception, excepting property damage arising from a subcontractor's work from the "your work exclusion," was regarded as a centerpiece of the occurrence analysis. The exception would be rendered "mere surplusage" if defective workmanship was not an "occurrence" from the outset. In that regard, the case of particular note is Lamar Homes, Inc. v. Mid-Continent Cas. Co., 242 S.W.3d 1 (Tex. 2007). There, the Texas Supreme Court emphasized the subcontractor exception to the "your work exclusion" and reasoned that there would be no need for such an exception for property damage arising out of a subcontractor's work if property damage associated with defective construction was never covered in the first place.
Therefore, the court determined that the policy provided coverage for many construction defect claims. In its opinion, the court stated that a standard Insurance Services Office, Inc. (ISO), endorsement, Exclusion—Damage to Work Performed by Subcontractors on Your Behalf (CG 22 94 10 01), already existed for insurers to delete the subcontractor exception from the your work exclusion, effectively precluding coverage for property damage to a contractor's work, regardless of whether the work was performed by the insured's subcontractor.
Similarly, the Florida Supreme Court, in U.S. Fire Ins. Co. v. J.S.U.B., Inc., 979 So.2d 871 (Fla. 2007), also cited to the ISO endorsement eliminating the subcontractor exception as a means to limit coverage, but the court went on to state that if the insurer desired to eliminate coverage for breach of contract arising out of a subcontractor's work, it could have endorsed the policy with a breach of contract exclusionary endorsement.
Apparently, some insurers took the hint seriously, but of course, some insurers seem to require little incentive to attach coverage-reducing endorsements to the back of their policies. Unfortunately for construction insureds, one of the most effective endorsements of that type is the breach of contract endorsement. As a result, breach of contract endorsements, as well as litigation over them, have become more prevalent due to their negative effect upon coverage for claims for defective construction, which invariably involve an allegation of breach of contract.
Advent of the Breach of Contract Endorsement
While breach of contract endorsements were attached to some CGL policies issued to contractors and subcontractors prior to the landmark occurrence cases set out above, they nevertheless became more popular after those cases due to the growing weakness of the "defective work is not an occurrence" policy defense.2One case discussing such an exclusion is B. Hall Contracting, Inc. v. Evanston Ins. Co., 447 F. Supp. 2d 634 (N.D. Tex. 2006), involving a fire at a construction site resulting from defective work performed by the insured contractor. Allegations of breach of contract and negligence were made against the contractor, and the court had little problem applying the following exclusion to the breach of contract claims.
This insurance does not apply to claims for breach of contract, whether express or oral, nor claims for breach of an implied in fact contract, whether "bodily injury," "property damage," "advertising injury," "personal injury," or an "occurrence" or damages of any type is alleged; this exclusion also applies to any additional insureds under this policy.
However, the court did not apply the exclusion to bar coverage for the negligence claims and went on to consider other exclusions in the policy as to those allegations. A similar case is Essex Ins. Co. v. Patrick, 2006 WL 3779812 (W.D. Tex. Oct. 16, 2006), where the court applied an identical breach of contract exclusionary endorsement in the same manner, that is, to bar claims involving breach of contract, but not other claims such as negligence.
The Broad Endorsement
Unfortunately, not all "breach of contract" endorsements are limited in scope to breach of contract claims, so the moniker "breach of contract" exclusion is something of a misnomer. Consider the following broadly worded endorsement.
This insurance policy does not apply, nor do we have a duty to defend any claim or "suit" for "bodily injury," "property damage," or "personal and advertising injury" arising directly or indirectly out of the following:
Breach of express or implied contract;
Breach of express or implied warranty;
Fraud or misrepresentation regarding the formation, terms, or performance of a contract; or
Libel, slander, or defamation arising out of or within the contractual relationship.
The trigger of this exclusion is not a breach of contract claim alleged against the insured. Rather, it is much broader, encompassing "property damage" (and, even more obtusely, "bodily injury") "arising directly or indirectly" from the breach of contract or other related causes of action. Pushing the interpretation envelope, Mt. Hawley, the insurance company that regularly attaches the endorsement to its policies, routinely contends that the endorsement not only eliminates coverage for allegations of breach of contract but also related claims for negligence arising out of the same defective construction.
The endorsement has been the subject of considerable litigation. In one of the earliest reported cases to interpret the endorsement, the exclusion did not survive the common-sense scrutiny of the court. In Mt. Hawley Ins. Co. v. Aguilar, 2008 WL 11342656 (C.D. Cal. Feb. 29, 2008), Mt. Hawley thought the exclusionary endorsement should be broadly applied because it was directed at property damage "arising directly or indirectly" out of breach of contract. However, the court rejected that argument, finding Mt. Hawley's broad interpretation was unreasonable and, instead, took a practical approach given the nature of the construction industry.
The court held that, since a subcontractor almost always enters into an oral or written contract when performing work on a construction project, the court was "hard-pressed to identify a scenario in which an insured-subcontractor would be entitled to coverage" under the policy. Therefore, the court refused to allow the breach of contract exclusion to be relied on to defeat all coverage for construction defect claims, thoroughly rejecting the untoward restriction on coverage asserted by Mt. Hawley.
Unfortunately, common sense does not always carry the day in the face of the express terms of an insurance policy, even a policy endorsed to eliminate some of the most critical coverage for an entire industry such as construction. For example, in Scottsdale Ins. Co. v. Mt. Hawley Ins. Co., 2011 WL 9169946 (S.D. Tex. June 15, 2011), the court applied a very broad interpretation of the exclusion. There, in an apparent attempt to plead into coverage, the underlying plaintiff had removed all of its breach of contract claims and proceeded under a negligence theory against the insured subcontractor.
However, the court held that the broadly worded exclusion did not limit its application to breach of contract claims. In the court's view, allegations of negligent performance of contracted-for work were sufficient to trigger the breach of contract exclusion and preclude coverage for the lawsuit.
In cases such as Aguilar and Scottsdale, the insureds were subcontractors to which the subcontractor exception was not available. Thus, the question still remained as to whether Mt. Hawley's breach of contract exclusion effectively overrode the subcontractor exception and eliminated coverage for all property damage to an insured general contractor's project arising out of defective construction by its subcontractors.
That question was addressed in a recent pair of cases out of the Southern and Western Districts of Texas. In those cases, two separate construction defect claims were made against the same general contractor, Huser Construction. Both claims involved defectively performed work by subcontractors, one as to defects in a municipal sports complex and one as to defects in an apartment project. Both claims went to suit and, in terms of CGL coverage, presented textbook scenarios for the application of the subcontractor exception to the your work exclusion so as to preserve coverage for the insured general contractor.
Mt. Hawley, after little (if any) investigation, denied defense and indemnity as to the construction defect suits based on its breach of contract endorsement attached to four consecutive CGL policies and four consecutive excess policies issued to Huser. Further, again without any substantive investigation or discovery, Mt. Hawley filed a motion for summary judgment in both cases based solely on the applicability of the breach of contract exclusion in its policies.
In the first case, Mt. Hawley Ins. Co. v. Slay Eng'g, Texas Multi-Chem, & Huser Constr. Co., Inc., 335 F. Supp. 3d 874 (W.D. Tex. 2018), Huser essentially argued that application of the breach of contract exclusion to the work of subcontractors would read the subcontractor exception out of the policy, contrary to the rule that a court must give effect to all provisions of an insurance policy when interpreting it. The Western District of Texas agreed with Huser's narrower interpretation of the exclusion, holding that to interpret the breach of contract exclusion so broadly that it encompassed all work incidentally related to the general contractor's project, regardless of whether a subcontractor performed the work, would unnecessarily leave the subcontractor exception to the your work exclusion with no meaning.
As a result, the court initially determined that Mt. Hawley had a duty to defend Huser. However, Mt. Hawley filed a motion for reconsideration, and nearly a year later, the court ultimately concluded that, even under Huser's narrower reading of the breach of contract exclusion, Mt. Hawley had no duty to defend under the particular facts of the case. Mt. Hawley Ins. Co. v. Slay Eng'g, 390 F. Supp. 3d 794 (W.D. Tex. 2019). In a subsequent opinion, the court also determined that Mt. Hawley had no duty to indemnify Huser. Mt. Hawley Ins. Co. v. Slay Eng'g, Tex. Multi-Chem, Huser Constr., LLC, 409 F. Supp. 3d 587 (W.D. Tex. 2019).
However, a few months later, without addressing the Western District's opinion in Mt. Hawley v. Slay Engineering (prior to reconsideration and still favorable to Huser), another federal court in Texas, this time the Southern District, held that Mt. Hawley owed no duty to defend Huser under the same policies in Mt. Hawley Ins. Co. v. Huser Construction Co., Inc., 2019 WL 1255756 (S.D. Tex. Mar. 19, 2019. The court held that the breach of contract exclusion limits the terms of the "your work exclusion's" subcontractor exception when property damage arises directly or indirectly out of a breach of contract. The court found the language of the breach of contract endorsement to be unambiguous, rejecting Huser's interpretation as failing to overcome the plain language of the endorsement.
Therefore, the court applied the exclusion according to its plain language, holding that Mt. Hawley did not have a duty to defend or indemnify Huser in the underlying construction defect action. Huser appealed, primarily on the strength of the conflicting initial Western District decision, but the Fifth Circuit Court of Appeals summarily affirmed the Southern District for the same reasons stated by the district court. Mt. Hawley Ins. Co. v. Huser Constr. Co., Inc., 797 Fed. Appx. 183 (5th Cir. 2020).
As set out above, the Western District reconsidered its opinion in Slay Eng'g as to Mt. Hawley's duty to indemnify in light of the Fifth Circuit's ruling and upheld the applicability of the breach of contract exclusion in that case, leaving Huser without coverage under its policies in both construction defect lawsuits.
An insurance policy is a contract, and when interpreting a contract, every court is tasked under the law to apply its terms according to the intentions of the parties to it. But a contract is a piece of paper that cannot testify as to what the parties intended. Therefore, the best evidence of the parties' intent is the words of the contract itself. If the contract, or policy, is written in plain language, a court is likely to enforce it, even if the enforcement of the contract works a hardship on one party, such as Huser. Only if the contract is ambiguous—that is, subject to two reasonable interpretations—will the court break the tie in favor of the insured.
Exclusion of coverage for breach of contract in an industry that does business through complex contracts is certainly contrary to the intent of any contractor. However, the attachment (or effect of the attachment) of a breach of contract endorsement to a CGL policy may go unnoticed until it is too late after the occurrence of a claim. More likely than not, the provision was not negotiated by both parties and was unilaterally inserted by the insurer, the other party with the superior bargaining power. Yet, if that is what the policy says, courts will enforce the plain language excluding coverage.
The simple fact is that a contractor, and certainly its broker or agent during negotiation or upon issuance, or its lawyer if given an opportunity to review the policy, should reject the attachment of such an endorsement to the policy. The entire policy must be reviewed and understood to avoid post-claim surprises.
The coverage under a CGL policy should never be taken for granted as "standard." Insurers make major revisions to limit coverage but still market the policy as a "CGL" or "commercial general liability" policy. While it may still be labeled "CGL," in reality, a policy endorsed with a breach of contract exclusion amounts to a "commercial gutted liability" policy.3
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do 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.
A partial list of those states includes Florida, Texas, Indiana, Kansas, Tennessee, and South Carolina. For a more in-depth discussion of these issues, see Patrick Wielinski, Insurance for Defective Construction (5th ed. 2018).
Nevertheless, some states still adhere to the notion that property damage arising out of a breach of contract is not an occurrence under the standard CGL policy. These states include Pennsylvania, Wyoming, Delaware, and the District of Columbia. For a summary of these and other related cases, see Wielinski.
3 The author thanks Travis Brown and Amy Rauch, his colleagues at Cokinos Young, for their contributions to this article.