Usually, one of the concerns for many contractors is the variation among
state laws as to whether construction defects constitute an "occurrence,"
"property damage," or are excluded under a contractor's commercial general
liability (CGL) insurance policy. For example, under Florida law, property
damage arising out of a construction defect constitutes an occurrence as
long as it is unexpected and unintended,1 but under Pennsylvania
law, property damage arising out of a construction defect is viewed as
foreseeable and is not an "occurrence."2
The recent case of Gilbert Tex. Constr., LP v.
Underwriters at Lloyd's, London, No. 08–0246 (Tex. June 4, 2010),
illustrates another difficult challenge presented to the construction
industry in its quest for predictability in managing and transferring the
risks associated with construction defects. In Gilbert, the
Supreme Court of Texas departed from well-established case law to the
contrary and applied Exclusion b, the contractual liability exclusion, to a
claim involving a direct breach of contract, as opposed to an indemnity or
hold harmless agreement. Suffice it to say, no one could have predicted such
a result.
The Coverage Dispute
In Gilbert, the insured entered into a
contract with Dallas Area Rapid Transit Authority (DART), as general
contractor, to construct a commuter railway system. During the course of the
project, heavy rains damaged neighboring buildings owned by RT Realty (RTR).
RTR sued DART, Gilbert, and other entities for statutory violations,
nuisance, and trespass. RTR claimed third-party beneficiary status as to the
contract between Gilbert and DART, asserting that Gilbert was liable to RTR
for breach of contract. This claim was based on a contractual provision with
DART that obligated Gilbert to protect all existing improvements and
utilities at or near the work site or on adjacent property of a third party,
and to repair any damage to them. In the event Gilbert failed to perform the
repairs, the contract further provided that DART could undertake the repairs
and charge the costs back to Gilbert.
Since DART was a public entity, the doctrine of sovereign immunity barred
all negligence claims, and the case instead proceeded as a breach of
contract claim by RTR against Gilbert. Gilbert's primary insurer contributed
its limits to settle the suit, but Underwriters at Lloyd's, the excess
insurer, refused to contribute to the settlement, so Gilbert funded the
large shortfall and filed a coverage suit against Underwriters.
Under governing Texas case law, the claim against Gilbert involved an
"occurrence" of unexpected and unintended "property damage" to a third
party's property, and, as such, it had all the earmarks of a covered claim
under Gilbert's excess policy.3 Despite the fact that the excess
policy followed the form of the primary, Underwriters took an approach that
was 180 degrees from the coverage position of the primary insurer, arguing
that Exclusion b, the contractual liability exclusion, nevertheless applied
to deny coverage for Gilbert. That exclusion states that the insurance does
not apply to:
"Bodily injury" or "property damage" for which the
insured is obligated to pay damages by reason of the assumption of liability
in a contract or agreement. This exclusion does not apply to liability for
damages:
(1) Assumed in a contract or agreement that is an
"insured contract"; or
(2) That the insured would have in the absence of the
contract or agreement.
The policy goes on to define the term "insured contract" to include
various types of indemnity agreements commonly encountered, including a real
property lease, a railroad sidetrack agreement, an elevator maintenance
agreement, and the commonplace indemnity clause contained in most
construction contracts in which the insured indemnitor assumes the tort
liability of another party to pay for bodily injury or property damage to a
third person.
The Court's Reasoning
Both this definition and the
terms of Exclusion b itself make it clear that the scope of the contractual
liability exclusion extends only to indemnification or hold harmless
agreements in which the insured assumes the liability of a third party. Even
the Texas Supreme Court in Gilbert acknowledged the nearly
universal case law dating back to Olympic, Inc. v. Providence Washington Ins.
Co., 648 P.2d 1008 (Alaska 1982), that held that the
predecessor exclusion from the 1973 edition Insurance Services Office, Inc.
(ISO), policy form applied only to the "assumption of liability" of a third
party in the indemnification context. The Texas Supreme Court had additional
guidance from the Fifth Circuit Court of Appeals in Federated Mut. Ins. Co.
v. Grapevine Excavation, Inc., 197 F.3d 720 (5th Cir. 1999), in
which the court, applying Texas law, held that an assumption of liability
for purposes of the contractual liability exclusion did not apply where the
insured is being sued for its own conduct in breaching a contract, but only
as the contractual indemnitor of a third party's conduct.
In addition to
this precedent, the court considered numerous other cases and legal
commentaries that reached the same conclusion, i.e., that the contractual
liability exclusion does not apply to claims in which recovery is sought
against the insured for its direct liability in contract, rather than the
assumed liability of a third party in a hold harmless agreement.
Inexplicably, despite acknowledging this overwhelming precedent as to the
limited application of Exclusion b, the Texas Supreme Court applied a much
broader reading of the term "assumption of liability." Relying primarily on
the dictionary definition of "assume," defined to include "undertake," the
court further stated that had the exclusion been intended to be so narrow as
to apply only to an agreement which the insured assumes liability of another
party under an indemnification or hold harmless agreement, the CGL policy
could easily say so. The court's reasoning amounts to a highly
simplified—but strict—application of the "plain and ordinary meaning" rule,
in that it not only ignores, but forsakes prior case law.
That departure
from prior precedent causes particular distress for Texas insureds in light
of the same court's coverage-friendly stance taken barely 3 years earlier in
Lamar Homes v. Mid-Continent Cas. That case, regarded as a
landmark opinion in Texas and throughout the United States, clearly rejected
any demarcation between tort and contract liability in the context of CGL
coverage for construction defect claims that involve breach of contract. The
court held that regardless of the label of the cause of action, there was a
covered "occurrence" when property damage that was unexpected and unintended
from the standpoint of the insured is alleged.4
Obviously, the application of Exclusion b to claims that, like the one in
Gilbert, involve only breach of contract because the
application of the sovereign immunity doctrine eliminates any negligence
claim, radically alters Texas law as to coverage for construction defect
claims.
It should be noted that, in response to arguments made by Gilbert,
the insured, the court also addressed whether the "insured contract" and the
"liability in the absence of contract" exceptions to the exclusion applied.
The court determined they did not, but there was no reason to reach those
issues since there was no need to apply any exception at all. This was
because the main body of the exclusion itself ruled out coverage, applying
only to the assumption of liability, and had no application to the factual
scenario before the court involving a claim for direct breach of contract
against the insured. As such, that resort to the exception simply clouded
what should have been a relatively routine determination that the exclusion
did not apply.
Potentially Far-Reaching Uncertainty
The recitation
of the contractual liability exclusion is standard fare in many reservation
of rights letters received from insurers regarding tendered construction
defect claims. As to most of those claims, it historically amounted to
little more than a tongue-in-cheek recitation since insureds and insurers
alike acknowledged the restriction of the exclusion to the assumption of a
third party's liability in an indemnification agreement. But, particularly
in light of the influential nature of the Texas Supreme Court's prior
opinion in Lamar Homes, it is possible that in addition to
potentially standing CGL coverage on its head in Texas, it may also affect
these types of arguments nationwide. Again, the result is the creation of
disturbing uncertainty, and in this instance, uncertainty that simply should
not be generated by Exclusion b.
Admittedly, a complicating factor may
have been the rather novel terms of the contract that obligated Gilbert to
repair third-party property damage and conferred third-party beneficiary
status on the neighboring property owners, paving the way for RTR's direct
claim against Gilbert for breach of contract. Nevertheless, even though
those claims were pursued as third-party beneficiaries to Gilbert's contract
with DART, they were direct claims and not the type of indemnification
claimed under a hold harmless agreement. Most construction contracts
obligate the insured contractor to repair damage to property, and applying
the contractual liability exclusion in that context impermissibly denies
coverage.
Because of its radical departure from prior Texas case law,
Gilbert filed a motion for rehearing with the Texas Supreme Court which
garnered amicus curiae support from various parties, including national
construction organizations. If the court grants rehearing, it is hoped that
a misapplication of the contractual liability exclusion can be reversed, or
at least that application can be limited to the peculiar facts of the claim.
As it stands, Texas insureds are already seeing significant denials and
reductions of coverage in light of Gilbert, fueling uncertainty
and adding to the difficulty of pursuing coverage for otherwise covered
claims.
1U.S. Fire Ins. Co. v. J.S.U.B., 979 So. 2d 871 (Fla. 2007).
2Kvaerner
Metals v. Commercial Union Ins. Co., 908 A.2d 888 (Pa. 2006).
3Lamar Homes, Inc. v. Mid-Continent Cas. Co.,
242 S.W.3d 1 (Tex. 2007).
4For a
prior column on this website analyzing Lamar Homes v. Mid-Continent
Casualty, see Worth
the Weight (in Gold): The Texas Supreme Court Weighs in on Defective
Construction as Occurrence, September 2007.