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Construction Defect Coverage

Complex Construction Defect Claims: Who Pays First?—Part 2

Patrick Wielinski | July 1, 2006

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Gavel on building plans with construction helmet and measuring tape

Due to the potential overlap between the performance bond and the commercial general liability (CGL) policy with regard to defective workmanship claims, a performance bond surety may be put in the position of taking over or financing the completion of a defaulted project that involves defective workmanship by its bonded principal, the contractor.

That contractor is also insured under a CGL policy that may provide some coverage in the event the defective work caused property damage to the project. This potential overlap was the subject of the first article in this series of two. 1

In the event the performance bond surety suffers a loss on its bond, it may seek to recoup that loss from other third parties who may also be responsible to pay it. This includes the CGL insurer for the contractor.

There are at least two ways a performance bond surety can establish standing to pursue an action on the contractor's CGL policy. First, the surety can assert its rights under the principle of equitable subrogation, "standing in the shoes" of the defaulting contractor. Alternatively, the surety may obtain an assignment of the contractor's rights against the CGL insurer, so long as doing so does not contravene the general indemnity agreement.

Equitable Subrogation by the Surety Against the CGL Insurer

Subrogation is the equitable right of the surety who has paid the obligation of its principal to "step into the principal's shoes" to enforce the surety's rights of reimbursement. The right exists under the law and equity and is not tied to a contract or an assignment. Equitable subrogation is entrenched as an established concept in surety law and does not depend on any contractual relationship between the parties. Rather, it is a matter of equity, and it arises through the legal consequences of the acts and relationships of the parties. In other words, since it is a creature of equity, it depends on the equities of the parties, rather than a contract, and arises by operation of law.

Equitable subrogation in the performance bond /CGL context is recognized by the courts. In Auto Owners Ins. Co. v. Travelers Cas. & Surety Co., 227 F. Supp. 2d 1248 (M.D. Fla. 2002), Reliance, the surety, made a claim against the defaulting contractor's CGL insurers after it paid out on its performance bond. Auto Owners and Northbrook, the CGL insurers, filed a declaratory action to avoid coverage, raising lack of standing by the surety as one of the grounds.

Sun subcontracted the installation of the underground galvanized piping system at Wellcraft's manufacturing plant. After completion, it was determined that the pipe system leaked. Some repairs were performed, then the leaking line was abandoned, and Wellcraft began using an overhead line, which was not installed by Sun, to transfer the acetone into the lay-up building. Later, Wellcraft sued Sun, its owners, the surety, and the subcontractor for damages related to the acetone leak and its environmental consequences. The lawsuit included a claim by Wellcraft against Reliance on the performance bond. Reliance and Wellcraft settled the claims.

Sun also entered into a contract for the construction of three facilities for the City of Pinellas Park, Florida (the "Pinellas Contract"). Reliance issued a public construction bond to the City. Sun filed suit against the City for nonpayment under the Pinellas Contract. The City filed a counterclaim against Sun for breach of contract, negligence, and breach of warranty, and a claim against Reliance on the Pinellas bond. The City's claims were based on the alleged negligence and faulty installation of a roof and stucco by Sun's subcontractors. The court stated the applicable principles of equitable subrogation as follows:

  • At common law, a surety who performs or pays on behalf of an obligee steps into the shoes of the obligee to the extent of the performance or payment. Accordingly, if Reliance, as Sun's surety, performed or paid on behalf of Sun an obligation that is covered by the policies issued by Auto Owners and Northbrook, then Reliance stands in Sun's shoes to that extent, is equitably subrogated to the rights of Sun, and is considered a first-party claimant on the CGL policies. Reliance therefore has standing as both a first-party claimant and a third-party claimant to assert claims for insurance coverage against Auto Owners and Northbrook.

The court, however, ultimately concluded that the CGL policies issued by Auto Owners and Northbrook did not provide coverage for defective workmanship, and that coverage was barred for other fact-specific reasons. Nevertheless, the Auto Owners decision provides an example of a surety's equitable subrogation to the rights of the insured contractor.

Another such case is Gulf Ins. Co. v. TIG Ins. Co., 86 Cal. App. 4th 422, 103 Cal. Rptr. 2d 305 (2 Dist. 2001), in which Gulf was the surety on a performance bond issued on a construction contract. During the course of the construction work, the contractor caused damage to adjacent real property. Then the contractor defaulted on the construction contract. Gulf completed the contract and performed repair and restoration of the damage to the adjacent property. The surety brought an action against the contractor's CGL insurer, TIG, for among other things, declaratory relief, equitable indemnity, and contribution. The court recognized the surety's right of equitable subrogation to the claims of the insured contractor, relying on California law as to equitable subrogation by an excess insurer to the insured's rights against its primary insurer. The court defined the cause of action for equitable subrogation as follows:

  • An insurer's cause of action for equitable subrogation contains six elements: (1) the insured has suffered a loss for which the party to be charged is liable; (2) the insurer has compensated for the loss; (3) the insured has existing, assignable causes of action against the party to be charged, which the insured could have pursued had the insurer not compensated the loss; (4) the insurer has suffered damages caused by the act or omission which triggers the liability of the party to be charged; (5) justice requires that the loss be shifted entirely from the insurer to the party to be charged; and (6) the insurer's damages are in a stated sum, which is usually the amount paid to the insured, assuming the payment was not voluntary and was reasonable.

In Essex Builders Group, Inc. v. Amerisure Ins. Co., ___ F. Supp. 2d ___, 2005 WL 3981766 (N.D. Fla. 2005), the court recognized the surety's right of equitable subrogation against the CGL insurer. In that case, subcontractors of the insured general contractor performed defective workmanship resulting in water infiltration into an apartment project after completion. Travelers, the successor-in-interest to Reliance, the performance bond surety, intervened in the contractor's insurance coverage lawsuit against its CGL insurers for breach of the CGL policies. Travelers, as the equitable subrogee of the contractor, sought recovery of the $6,250,000 it had paid to resolve the owner's claim for defective workmanship on the project. In that case, the court recognized the surety's right to intervene in order to be paid the first $6,250,000 of the loss it had suffered because of the default of the contractor.

Assignment of Rights from the Principal to the Surety

An actual assignment of the contractor's rights against its CGL insurer may not be necessary in light of the surety's equitable subrogation rights. In some instances, such an assignment may not even be possible to obtain due to the adversarial relationship between the surety and its principal in a default scenario. Where a surety asserts a right of subrogation, by assignment or otherwise, and where the right is clear, an assignment adds little to that right; thus, if it recovers, it is by virtue of a right in equity, not by virtue of a legal right under an assignment. See, 73 Am. Jur. 2d Subrogation § 65 (2004).

Nevertheless, in American Oil Co. v. L.A. Davidson, Inc., 290 N.W.2d 144 (Mich. App. 1980), a CGL insurer argued that an express assignment from the insured contractor to its surety constituted a waiver of equitable subrogation rights against the CGL insurer by the surety. The court rejected this contention, holding that the rights obtained under an assignment are independent from rights derived from equitable subrogation. Often, an assignment can add another layer of complexity to an already complicated default situation.

There are cases where an assignment was obtained and recovery by the surety was upheld. For example, in Fidelity & Deposit Co. of Maryland v. Hartford Cas. Ins. Co., 189 F. Supp. 2d 1212 (D. Kan. 2002), F&D, the surety on the performance bond, sought recovery of a loss from the CGL insurer of one of the subcontractors, after F&D had obtained an assignment from both the insured subcontractor and the general contractor. In its opinion, the court did not address the specifics or necessity of the assignment in detail, but focused, instead, on the CGL coverage issues, ultimately upholding recovery by the surety against Hartford, the CGL insurer for a subcontractor on whose policy the bonded contractor was an additional insured.

The Surety's Right to Indemnity

As part of the underwriting process and issuance of a performance bond, the surety requires that the contractor-principal, as well as its individual owners or officers, execute an indemnity agreement, usually referred to as a general indemnity agreement (GIA), in which those parties agree to indemnify the surety in the event of any losses arising out of the issuance of the bond. Typically, the GIA broadly states that the indemnitors will indemnify the surety against any and all liabilities and losses sustained by the surety by reason of the surety having provided bonds on behalf of the principal.

The GIA raises issues as to the contractual liability exclusion, Exclusion (b), in the standard CGL policy which states that the insurance does not apply to property damage for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement. The exclusion does not apply to liability for damages that the insured would have in the absence of the contract or agreement; or assumed in a contract or agreement that is an "insured contract." The term "insured contract" is defined in the policy as that part of any contract or agreement pertaining to the named insured's business under which it assumes the tort liability of another party to pay for bodily injury or property damage to a third person or organization. Tort liability means a liability that would be imposed by law in the absence of any contract or agreement.

The contractual liability exclusion applies to the liability assumed by the principal and the indemnitors under a contract such as a GIA. It has been specifically held that a GIA does not fall within the scope of an "insured contract." Thus, coverage for the indemnity obligation of the principal and indemnitor is excluded under the contractual liability exclusion, since that definition only applies to hold harmless agreements assuming the tort liability of a third party. For this reason, the surety's cause of action for equitable subrogation, an action that arises outside of contract, is particularly useful for the surety in seeking recovery against the CGL insurer.

All participants in the construction industry are well aware of the proliferation of construction defect litigation. While many residential projects are not typically bonded, contractors involved in public, commercial, and commercial residential (condominium and apartment) projects are usually required to provide bonding. Thus, the industry should see a corresponding proliferation in subrogation suits being filed by performance bond sureties that have suffered losses in connection with defaults involving defective workmanship. Thus, where equitable subrogation claims by performance bond sureties by CGL insurers were once the exception, they may now become the rule.

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.



For a more in-depth discussion of the issues set out in this column see Patrick J. Wielinski, Insurance for Defective Construction, 2nd ed. (IRMI 2005).