Courts Address the Contractual Liability Exclusion—How Far Does It Go?

The liability insurance policy contains certain exclusions that may apply in whole or in part and affect available coverage.

1. Exclusion b.—Contract Exclusion

The policy provides that the insurance does not apply to:

2. "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) That the insured would have in the absence of the contract or agreement; or

(2) Assumed in a contract or agreement that is an "insured contract," provided the "bodily injury" or "property damage" occurs subsequent to the execution of the contract or agreement....

Generally speaking, the majority of courts interpreting this exclusion have held that the exclusion applies to a limited category of cases in which the insured assumes the tort liability of another, such as in an indemnity or hold harmless agreement.¹ But this is not always the case.

Gilbert Texas Construction v. Underwriters at Lloyd's, London

The Texas Supreme Court broadened this general position on the issue of contractual liability exclusions, holding that exclusion 2.b. applies to any liability assumed by the insured under a contract or agreement that does not fit within the stated exceptions. In Gilbert Tex. Constr. LP v. Underwriters at Lloyd's, London, 327 S.W.3d 118 (Tex. 2010), the Dallas Area Rapid Transit (DART) contracted with Gilbert to construct part of the DART light rail system. During construction, a building adjacent to the construction site owned by RT Realty (RTR) was flooded. The contract between DART and Gilbert obligated Gilbert to "protect from damage all existing improvement and utilities ... on adjacent property of a third party" and to "repair any damage to those facilities, including those that are the property of a third party, resulting from failure to comply with the requirements of this contract or the failure to exercise reasonable care in performing the work." RTR sued Gilbert and others for its damages. RTR originally sued on tort and statutory theories of liability and then added a breach of contract claim. Gilbert moved for summary judgment on governmental immunity grounds, and the trial court granted partial summary judgment in favor of Gilbert, dismissing all claims except for the breach of contract claim.

Gilbert was insured under a primary policy issued by Argonaut, which assumed Gilbert's defense. Gilbert was also insured by Lloyd's of London under a series of "follow form" excess policies. Lloyd's issued several reservations of rights letters throughout the pendency of the suit. After the trial court granted partial summary judgment in favor of Gilbert on the immunity defense, Lloyd's issued another reservation of rights letter taking the specific position that the contractual liability exclusion applied to exclude the remaining breach of contract claim. Gilbert settled RTR's claim for $6.175 million, and Lloyd's denied coverage for the settlement, relying on this exclusion.

In the ensuing coverage dispute, Gilbert argued that the contractual liability exclusion only applies when the insured assumes the liability of a third party (such as in a contractual indemnification agreement) and does not apply to a situation where, such as in this case, the insured assumes direct liability to a third party by contract. Gilbert also argued that even if the exclusion applies, an exception to the exclusion brings the breach of contract claim back into coverage because Gilbert would not have been liable to RTR in the absence of its contract with DART. The trial court held in favor of Gilbert, but the case was reversed on appeal.

The Texas Supreme Court affirmed, holding that the contractual liability exclusion applied to exclude coverage for Gilbert's liability to RTR. Applying general rules of contract construction, the court held:

Considered as a whole, the contractual liability exclusion and its two exceptions provide that the policy 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, except for enumerated, specific types of contracts called "insured contracts" and except for instances in which the insured would have liability apart from the contract.

Gilbert, 327 S.W.3d at 129.

The court found that Gilbert agreed in its contract with DART to repair any damage to the property of a third party resulting from its failure to comply with the terms of the contract or exercise reasonable care in its work. The only theory of liability remaining at the time Gilbert settled with RTR arose from this contractual obligation. Thus, the Texas Supreme Court held that the exclusion unambiguously applied to preclude coverage for Gilbert's settlement with RTR. In reaching this conclusion, the court rejected Gilbert's argument that the contractual liability exclusion only applies when the insured assumes the liability of another, such as in a contractual indemnity agreement. The court held that if the exclusion was intended to apply only to a contract in which the insured assumes liability of another party via an indemnity or hold harmless agreement, it would have been simple to state this, and the court declined to judicially rewrite the policy. The "insured contract" exception to the contractual liability exclusion reinforced the court's conclusion because it specifically reinstated the very type of coverage Gilbert contended the entire exclusion was limited to—contractual liability of a third party assumed by the insured. This exception to the exclusion demonstrated that the parties were capable of using specific, narrowing language when that was their intent.

Gilbert also argued that the second exception to the contractual liability exclusion (damages the insured would have been responsible for in the absence of the contract) brought the settlement back into coverage. Gilbert reasoned that, if no contract existed in the first place, it would not have had immunity and RTR's negligence claim against Gilbert would not have been subject to an immunity defense. The Texas Supreme Court rejected this argument as well, holding that "Gilbert had asserted no other basis for its settlement than the breach of contract claim; thus, Gilbert's settlement payment for which it seeks indemnity simply was not a liability for damages it had apart from its contract with DART, as it must have been for the second exception to apply." The court explained:

Gilbert would have us disregard the actual facts underlying its settlement and hold that the exception applies even to potential liability that Gilbert might have had if it had not entered into a contract with DART. We decline to do so. Indemnity under a liability policy depends on actual facts and adjudicated liability, not possible scenarios that did not occur.

Id. at 133, 134 (emphasis in original).

Ewing Construction v. Amerisure—District Court

Following the Gilbert case, a federal district court had the first opportunity to address the scope of the Gilbert decision in the case of Ewing Constr. Co. v. Amerisure Ins. Co., 814 F. Supp. 2d 739 (S.D. Tex. 2011). On February 25, 2010, Ewing was sued in a lawsuit styled Tuloso-Midway Indep. Sch. Dist. v. Liberty Mut. Ins. Co., Cause No. 10–603421, in County Court at Law No. 1 of Nueces County, Texas (the "Underlying Lawsuit"). The plaintiff in the underlying lawsuit, Tuloso-Midway Independent School District ("Tuloso-Midway"), sought damages from Ewing with regard to allegedly deficient construction of a tennis facility in Corpus Christi, Texas, pursuant to a contract between Ewing and Tuloso-Midway (the "Contract"). One issue was the application of the contractual liability exclusion. The contractual liability exclusion to the policy provided, in relevant part:

This insurance does not apply to:

b. Contractual Liability

"[B]odily injury" or "property damage" for which the insured is obligated to pay damages by reasons of the assumption of liability in a contract or agreement. This exclusion does not apply to liability for damages:

(1) That the insured would have in the absence of the contract or agreement; or

(2) Assumed in a contract or agreement that is an "insured contract" ...

The district court was faced with the interpretation of Gilbert. It held that:

With respect to the "assumption of liability" part of the exclusion, the Texas Supreme Court in Gilbert explained that the exclusion is not limited to situations where "the insured assumes the liability of another, such as in an indemnity or hold-harmless agreement," but rather "the exclusion's language applies without qualification to liability assumed by contract [with two exceptions.]" Id. at 128-29. The court concluded that the contractual liability exclusion "means what it says," and "applies when the insured assumes liability for bodily injuries or property damages by means of contract, unless an exception to the exclusion brings a claim back into coverage or unless the insured would have liability in the absence of the contract or agreement." Id. at 132....

Upon review, the Court concludes that the allegations in the underlying petitions sufficiently demonstrate that Ewing assumed liability for its own construction work pursuant to the parties' contract. In other words, by entering into the contract with Tuloso-Midway, Ewing is liable if the work it agreed to perform under that contract is defective. This finding is consistent with Gilbert and the case law relied upon therein. See, e.g., TGA Development, Inc., 62 F.3d at 1091-92 (stating that policy excluded coverage of injuries "[f]or which the insured has assumed liability in a contract or agreement," and finding that this "language plainly excludes coverage for contractual claims made for [insured's] failure to provide [third party] with a condominium unit free from defects.") (cited in Gilbert, 327 S.W.3d at 130 n. 9); Monticello Ins. Co., 1998 WL 1969611, at *2 ("Liability under a contract does not arise only when a party assumes the liability for another party. Any party to a contract assumes potential liability under the agreement."). Applying Gilbert, the Court concludes that Ewing assumed liability for its own defective work when it entered into the contract with Tuloso-Midway for construction of the tennis courts at issue....

Applying Hardscape here, Tuloso-Midway alleges in the underlying suit that the tennis courts, the subject matter of the contract between Tuloso-Midway and Ewing, began to crack and show other structural defects soon after construction was completed. The damage alleged is damage to the subject matter of the contract, nothing else. Tuloso-Midway's original petition states that it wanted "quality tennis courts that should last at least twenty-five years," that Ewing represented that it could perform the work, and based upon these assurances the parties entered into the contract. (D.E. 18-16 at 4-5.) It further states that "Ewing gave notice of substantial completion on or about April 20, 2009 but serious tennis court cracking and flaking problems have continued after that date to the present. Chunks of the court surfaces are coming loose. Flaking, crumbling, and cracking make the courts unusable for any competitive event." (D.E. 18-16 at 5.) Tuloso-Midway states that the actions alleged "constitute breach of contract," as "[t]he construction is not in accordance with the contract plans and specifications." Notably, it pleads in the alternative that Ewing "breached its implied duty of ordinary care to Plaintiff through its negligence in the preparation and management of construction." (D.E. 18-16 at 5 (emphasis added).) Tuloso-Midway's negligence claim is also based solely upon Ewing's alleged failures in the tennis court construction process, such as failure to properly prepare for and manage construction, failure to properly retain and oversee subcontractors, and failing to take corrective action. (D.E. 18-16 at 8.) The allegations in the First Amended Original Petition do not differ materially in this regard. (D.E. 18-17 at 5.) Similar to the Original Petition, the amended petition states that Ewing breached its contract in part by "[f]ailing to exercise ordinary care in the preparation, management and execution of construction." (D.E. 18-17 at 7.) The negligence cause of action is based upon the same conduct that forms the breach of contract claim. (D.E. 18-17 at 7, 8.) The Second Amended Original Petition (presently the live pleading) also does not differ materially on this topic. (D.E. 18-18 at 4).

Ewing Construction Co. v. Amerisure—Fifth Circuit

Ewing appealed the case to the Fifth Circuit Court of Appeals (684 F.3d 512 (5th Cir. Tex. 2012)). The Fifth Circuit specifically addressed the allegations that were lodged against Ewing Construction:

The petition goes on to allege the following failures:

Serious tennis court cracking and flaking problems began shortly after completion of the work and have continued since. Chunks of the court surfaces are coming loose. Flaking, crumbling, and cracking make the courts unusable for their intended purpose, competitive tennis events....

It then alleges that Ewing breached its contract and performed negligently:

Defendant Ewing Construction has breached its contractual commitments, proximately causing damages to Plaintiff. On information and belief, Plaintiff says that Defendant Ewing and/or its subcontractors breached its contract in the following respects:

a) Failing to complete construction in accordance with the contract plans and specifications;

b) Failing to exercise ordinary care in the preparation, management and execution of construction;

c) Failing to perform in a good and workmanlike manner; and

d Failing to properly retain and supervise subcontractors.

Furthermore, Defendant Ewing Construction and/or its subcontractors was/were guilty of negligence proximately causing damage to Plaintiff in the following respects:

a) Failing to properly prepare for and manage the construction;

b) Failing to properly retain and oversee subcontractors;

c) Failing to perform in a good and workmanlike manner; and

d) Failing to properly carry out the construction so that it was in [sic] completed in accordance with the plans and specifications.

The petition also states that Ewing "breached [its] duty to Plaintiff to use ordinary care in the performance of [its] contract[ ], proximately causing damages to Plaintiff."

With respect to the general operation of the exclusion, the Fifth Circuit held that:

Gilbert, principally, stands for the proposition that a CGL policy's contractual liability exclusion excludes coverage for property damage when "the insured assumes liability for ... property damage by means of contract...." Id. at 132. The School District's complaint in the underlying lawsuit reflects that the insured, Ewing, assumed liability for defective construction by agreeing in a contract to complete a construction project, specifically to build tennis courts. Whether the breached promise was implied or express, the promise was of a contractual nature, all the same. We therefore hold that the CGL policy's contractual liability exclusion excludes coverage in the instant case.

The court then went on to address whether the exception to the exclusion applied. The court held that it did not, ruling that:

The School District's use of the term "negligence," however, is not dispositive. See Century Sur. Co. v. Hardscape Constr. Specialties, Inc., 578 F.3d 262, 267-70 (5th Cir. 2009). We must assess the substance of the School District's petition and determine whether it alleges an action in contract, tort, or both. Id. at 267 (citing Jim Walter Homes, Inc. v. Reed, 711 S.W.2d 617, 617-18 (Tex. 1986)). To do this, we look to the "source of liability and the nature of the plaintiff's loss.... When the only loss or damage is to the subject matter of the contract, the plaintiff's action is ordinarily on the contract." Id. (quoting Sw. Bell Tel. Co. v. DeLanney, 809 S.W.2d 493, 494-95 & n. 2 (Tex.1991)).

Ewing's contract with the School District is the source of its potential liability because Ewing's duty to construct usable tennis courts arose out of contractual undertakings. Further, the damage alleged in the School District's complaint is damage to the subject matter of the contract, the tennis courts, not to any other property. The school district's claim therefore sounds in contract, regardless of the other labels that may be attached to it. Id. at 269-70. Because the liability Ewing faces is contractual, it is not liability that would arise in the absence of a contract. The exception, therefore, does not apply and coverage remains excluded. We hold that Amerisure owes no duty to defend Ewing in the underlying lawsuit.

Ewing Construction Co. v. Amerisure—Texas Supreme Court

In response to the Fifth Circuit's opinion, a motion for rehearing and rehearing en banc was filed by Ewing. This was joined by numerous amici. In response, the Fifth Circuit has certified the following questions to the Texas Supreme Court:

1. Does a general contractor that enters into a contract in which it agrees to perform its construction work in a good and workmanlike manner, without more specific provisions enlarging this obligation, "assume liability" for damages arising out of the contractor's defective work so as to trigger the contractual liability exclusion.

2. If the answer to question one is "Yes," and the contractual liability exclusion is triggered, do the allegations in the underlying lawsuit alleging that the contractor violated its common law duty to perform the contract in a careful, workmanlike, and non-negligent manner fall within the exception to the contractual liability exclusion for "liability that would exist in the absence of contract." We disclaim any intention or desire that the Supreme Court of Texas confine its reply to the precise form or scope of the questions certified.

The case was argued before the Texas Supreme Court on February 27, 2013, and the decision is pending. However, many insurers and insureds alike are looking ahead as to what can be done if the Texas Supreme Court follows the Fifth Circuit. The most popular solution seems to endorse the policy to amend Exclusion (b) to read that the insurance does not apply to:

b. "Bodily injury" or "property damage" for which the insured is obligated to pay damages by reason of the assumption of liability of a third party in a contract or agreement....

It remains to be seen whether this modification or some other modification will be necessary in order for those in the construction industry to obtain the coverage they desire.

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¹See, e.g., Ferrell v. West Bend Mut. Ins. Co., 393 F.3d 786 (8th Cir. 2005); Federated Mut. Ins. Co. v. Grapevine Excavation Inc., 197 F.3d 720 (5th Cir. 2000); Olympic, Inc. v. Providence Wash. Ins. Co., 648 P.2d 1008 (Alaska 1982); ACUITY v. Burd & Smith Constr., Inc., 2006 N.D. 187, 721 N.W.2d 33 (2006); Gibbs M. Smith, Inc. v. U.S. Fid. & Guar. Co., 949 P.2d 337 (Utah 1997). But see Nationwide Mut. Ins. Co. v. CPB Int'l Inc., No. 3:06–CV–0363, 2007 U.S. Dist. LEXIS 86506 (M.D. Pa. Nov. 26, 2007); CIM Ins. Corp. v. Mid-Pac Auto Ctr., Inc., 108 F. Supp. 2d 1092 (D. Haw. 2000); Monticello Ins. Co. v. Dismas Charities, Inc., No. 3:96–CV–550–S (W.D. Ky. Apr. 3, 1998); Silk v. Flat Top Constr., Inc., 453 S.E.2d 356 (W. Va. 1994) (exclusion removed coverage for breach of contract); TGA Dev., Inc. v. Northern Ins. Co. of N.Y., 62 F.3d 1089 (8th Cir. 1995).