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.2 One 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.
Hard Lessons
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.
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