Expert Commentary

Glorifying Form Over Substance: "Legally Obligated" in the CGL Insuring Agreement

Insurers may deny claims where a contractor, absent the filing of a lawsuit, repairs property damage caused by an obvious accident. Pat Wielinski discusses the scenarios, issues, case law, and provides practical pointers for avoiding this situation.


Construction Defect Coverage
August 2001

Construction defect claims often raise many insurance coverage issues between the parties, not the least of which is the existence of an occurrence or property damage under the policy. However, what if there has been a clear accident resulting in unexcluded property damage to a project? Even under these circumstances, claims go denied under commonly recurring scenarios. The purpose of this article is to discuss one of those scenarios: where a contractor, absent the filing of a lawsuit, repairs property damage caused by an obvious accident. It is this type of claim that often is denied or is hotly contested by many commercial general liability (CGL) insurers.

The Scenarios

Consider a frequently encountered scenario. The insured general contractor is renovating a building. While hoisting a new HVAC unit to the top of the building, the crane topples, causing $1 million in damage to parts of the building that are not the insured's work. The insured fails to repair the damage to the rest of the building despite a provision in the contract requiring the insured to protect adjoining property, so the owner sues. The insured contractor tenders the defense of the owner's lawsuit to its CGL insurer. Not surprisingly, a judgment is entered for $1 million in damages plus attorney fees, costs, and interest, and the insurer pays the judgment. Nothing earth-shattering here.

Consider a second scenario involving similar facts. After the crane accident, the insured repairs the damage, incurring $1 million in extra costs, since, under the terms of the contract, the contractor is required to protect adjoining property from damage. The contractor notifies its CGL insurer of the accident, but much to its disappointment, receives a letter in response that costs incurred in repairing damage to the project are not covered, "However, should the Owner file a lawsuit against you, please notify us at once." The contractor keeps its CGL insurer advised of the progress and cost of the repairs, but the insurer maintains its position denying coverage.

In substance, there appears to be little difference between the above scenarios. In the first scenario, the contractor defaulted on its obligations to repair adjoining property and the owner recovered the $1 million in repair costs from the contractor, plus attorney fees, costs, and interest. In the second scenario, the contractor fulfilled its contractual obligation and incurred the $1 million in repair costs itself, thus obviating the necessity for the lawsuit by the owner. In essence, it "did the right thing." In the process, it saved attorney fees, costs, and interest, and most likely, its reputation. In both scenarios, there was a classic "occurrence," i.e., a crane accident that resulted in property damage to the building. This is a prime example of a CGL claim.

The Issue

The second scenario is the far more common method of conducting business in the construction industry. Moreover, all variables for coverage under CGL policies were held constant in both scenarios: an occurrence of covered property damage for which no exclusion applies. Why, then, do some insurers treat those scenarios differently under identical policies? The answer lies in divergent interpretations of the insuring agreement of the CGL policy, which states that:

We will pay those sums that the insured becomes legally obligated to pay as damages because of "bodily injury" or "property damage" to which this insurance applies.

Specifically, some insurers take the position that in order to be "legally obligated" for purposes of coverage under a CGL policy, there must be a legally binding judgment entered against the insured. Of course, since most cases are settled on behalf of insureds by their CGL insurers, this requirement often requires, at a minimum, that a lawsuit asserting liability be filed against the insured.

Obviously, this causes a quandary for the contractor faced with an occurrence of property damage that it is obligated to repair under its contract. By proceeding with repairs, in order to mitigate damages for all concerned, and to avoid a breach of contract, the insured contractor runs the risk of its CGL insurer taking the position that absent a lawsuit, the contractor is not entitled to coverage under its CGL policy. The contractor runs this risk even where the insurer is promptly notified and kept apprised of the cost and progress of repairs. This glorification of form over substance is not warranted under the terms of the insuring agreement and is clearly contrary to best construction practices, where any delay in repairing damage, let alone litigation between the parties, only prevents timely completion of the project.

Related Issue

Before examining the "legal obligation as judgment" position, it is helpful to review an issue related to the "legal obligation" requirement. That issue involves the viewpoint that the CGL policy provides coverage for only tort damages and not damages arising out of breach of contract.1 Very briefly, the genesis for this point of view developed in a line of California cases which has been, for all intents and purposes, laid to rest by the California Supreme Court in Vandenberg v Superior Court, 12 Cal 4th 815, 88 Cal Rptr 2d 366, 982 P2d 229 (1999). There, even though the insured was sued for breach of contract pursuant to a lease obligating it to clean up contaminated premises, the court nevertheless held that for purposes of CGL coverage, the distinction between breach of contract and tort damages was rejected. Rather, the focus should be on whether there has been an occurrence resulting in property damage, regardless of the cause of action pled. This case is of obvious importance to the construction industry where most occurrences of property damage on a job site involve a breach of contract.2

Back to the Construction Contract

While Vandenberg appeared to lay many of these issues to rest, the issue for many contractors still remains wide open: that is, whether contractually mandated costs to repair property damage caused by an occurrence are covered under a CGL policy. Simplistically viewed, a contractor's contractual obligations are clearly "legal obligations," once the false contract versus tort distinction debunked by Vandenberg is abandoned. Nevertheless, for most contractors, a suit awarding those repair costs as damages will never be filed. As such, the insuring agreement of the CGL policy does not appear to match up very well with the realities of the construction business.

Perhaps because searching for such realities in court cases is a debatable pursuit, very few courts have effectively dealt with these issues. Those that have seem to have reached inconclusive results. Nevertheless, since CGL policies are heavily litigated contracts, the task of examining and reconciling court cases interpreting their standard language is hard to avoid.

With that in mind, the first case to address this issue is San Diego Housing Comm'n v Industrial Indemnity Co., 68 Cal App 4th 526, 80 Cal Rptr 2d 393 (1998). In that case, the Housing Commission incurred repair costs at a low-income housing project in response to tenant complaints. It sought coverage for those costs as an additional insured on the general contractor's CGL policy, contending that it had contractual and statutory duties to tenants and the Department of Housing and Urban Development (HUD) to maintain the premises. In turn, those duties rendered the Housing Commission "legally obligated to pay damages." The court reviewed the potential exposure of the Housing Commission and stated as follows:

First, did Housing become legally obligated to pay these repairs costs, due to potential adverse orders which could have been issued in any suits filed by the tenants, HUD, or the Authority against the Commission? The answer is clearly no, because neither the tenants nor HUD sued Housing, nor did the Authority sue its sister agency, the Commission, for failure to make needed repairs. Here, while Housing incurred expenses to repair the property, the statutory and contractual duties on which it relies are not enough to implicate this liability policy, even if they constitute separately owed public obligations. Those duties do not of their own force create insurance coverage. They did not create "damages" paid out by Housing . . . [Citations omitted.]

The court found it troubling that the Housing Commission's potential liability for damage to the tenants or HUD was never formalized by means of suit, let alone a claim. Under those circumstances, the court found that there was no legal obligation on the part of the Housing Commission to a third party. Any obligation of the Housing Commission appears to have been particularly ephemeral since it was never clearly articulated to the court and was based on a statute exposing a public entity, under a mandatory duty to protect against a particular kind of injury, to liability for failure to discharge that duty. It was also based on the tenant leases, although the provisions of the leases were not discussed. Therefore, the duties of the Housing Commission, whether statutory or contractual, were at best vaguely articulated in the opinion, which contributed to the court's ultimate decision to deny coverage. Had the contractual duties involved in San Diego Housing been more clear and concrete, perhaps the result may have been different.

A case involving more substantive contractual obligations is Continental Casualty Co. v Major Constructors, 2000 Tex App LEXIS 4800 (Tex App—Houston 2000). In that case, Major, the insured, was the prime contractor on a construction project during which one of its subcontractors accidentally caused water damage to a building at the Johnson Space Center. Major requested Continental, its CGL insurer, to reimburse NASA for the damages. Continental refused, maintaining that pursuant to the CGL policy it was only required to pay sums that Major became legally obligated to pay as damages. Even though no one claimed that Major was at fault for the damage, Major contended it was nevertheless "legally obligated to pay" NASA for the damage pursuant to its contract which specifically required Major to repair damage to the premises. When NASA instituted collection procedures pursuant to the Federal Acquisition Regulations, Continental contended that the insured's legal obligation could only be established by judgment. This position ignored the fact that the liability of a government contractor is usually determined administratively and not by judgment.

On appeal, the court reversed the summary judgment on behalf of the insured contractor. It remanded the case to the trial court, inviting the parties to develop a record in order to clear up issues of material fact as to Major's obligations under its contract with NASA. In doing so, the court appeared to operate on the assumption that if in fact the contract obligated Major to repair the property damage, there would be coverage under the CGL policy.

A somewhat similar case is Acceptance Ins. Co. v S&S Telecom, Inc., 2001 WL 844749 (Tex App—San Antonio 2001). In that case, the insured, S&S, entered into a contract with Southwestern Bell to remove telephone equipment from a plant. During the removal, S&S employees cut through cable trays enclosing telephone switching equipment. Metal shavings from the cable trays fell into the switching frames, damaging them in the amount of $66,000. Southwestern Bell demanded that S&S pay the repair costs, and S&S turned the claim over to Acceptance, its CGL insurer, seeking coverage for the loss. Acceptance denied the claim and S&S did not pay for the repairs. Southwestern Bell consequently withheld $66,000 from contract payments to S&S, causing S&S to file suit against Southwestern Bell for breach of contract. At trial, the court ruled that Southwestern Bell did not breach the contract by withholding the repair costs due to the negligence of S&S employees.

In denying coverage, the insurer claimed that the withholding of repair costs by Southwestern Bell did not constitute a covered loss under the insuring agreement. The court rejected this argument, holding that the dispositive issue was not the fact that Southwestern Bell withheld fees from S&S and did not actually sue S&S, but rather, the fact that it was the negligence of the insured which caused the metal shavings to fall into the switching frames. The court focused on the negligent actions of the insured that caused property damage, not whether the insured had been sued, and in upholding coverage, it refused to glorify form over substance and found a "legal obligation on the part of the insured."

Practice Pointers

While the parameters of the "legally obligated" requirement can be debated, it is obvious that the requirement serves as a limitation on those claims an insurer must pay. Particularly, an insurer is not obligated to pay claims that the insured voluntarily pays, but only those for which it is legally bound. In other words, the insured cannot expect its insurer to pay claims for which the insured is not actually liable.

Obviously, a judgment is the ultimate means of establishing that an insured is "legally obligated" to pay damages. In order to convince an insurer to pay a claim short of judgment, the insured must take steps sufficient to satisfy the insurer that a legal obligation in fact exists. In the construction context, this requires that the insured contractor notify the CGL insurer promptly of a loss and give it the opportunity to investigate. Moreover, it needs to cooperate with the insurer and keep it apprised of progress and cost of repairs, giving it the opportunity to be involved. Often, a CGL insurer will decline to do so, but the insured should nevertheless err on the side of notification and cooperation.

In the event an insured does not do so, the claim can be severely prejudiced. For example, in Charter Oak Fire Ins. Co. v Color Converting Industries Co., 45 F3d 1170 (7th Cir 1995), an insured manufacturer represented to its largest customer that a certain type of ink could be used on the customer's packaging. The ink did not work, and the insured paid $235,000 for damaged packaging to its customer and, after the fact, sought recovery from its insurer, Travelers. Travelers attempted to investigate the claim, but the insured refused to turn over the cost data to Travelers on the ground that the data was proprietary. In light of the circumstances, the court quite understandably acknowledged that since the cost to replace the packaging appeared high, there was a danger of collusion between the insured and its customer.

While the Charter Oak v Color Converting opinion represents an extreme case, the insured contractor usually should not expect its CGL insurer to pay for repairs after the fact. In an absence of a lawsuit seeking damages against the insured, the insured needs to persuade its insurer that its damages are legitimate in amount, and that the other party, usually the owner, is looking to the insured to pay them. Toward that end, it may be necessary to encourage the owner to make a written demand against the insured and, in extreme cases, convince the owner to file suit. Due to the stance many CGL insurers take toward coverage for breach of contractual obligations, parties often resort to these types of cooperative efforts.

The court cases on the "legally obligated to pay as damages" requirement present a mixed bag of results, and none of them have adequately addressed the issue. The insured can nevertheless improve the chance of prevailing on a claim for contractually required repair of property damage by taking commercially reasonable measures. Those measures include documentation and control of costs and keeping its insurer informed as to progress. In this way, the insured can minimize the objection to the absence of a judgment in establishing its legal obligation to repair and pay the amount of those damages. The less palatable alternative is for the insured contractor to sit on its hands and wait for a disgruntled owner to sue for breach of contract and then seek coverage after the horse is already out of the barn.


1For a discussion of these issues, see Patrick J. Wielinski, Insurance for Defective Construction: Beyond Broad Form Property Damage Coverage, (IRMI 2000), Chapter 2, and Patrick J. Wielinski, "In From the Outfield: Coverage Defenses Outside the Policy Language in Defective Work Claims," IRMI 20th Annual Construction Risk Conference (November 13-16, 2000).

2The language of the CGL insuring agreement has also been the subject of much court interpretation in determining whether environmental cleanup costs mandated by an administrative agency are sums which an insured is "legally obligated to pay as damages" within the terms of the CGL insuring agreement. For example, the Supreme Court of California, in Certain Underwriters at Lloyds, London v Superior Court (Powerine Oil Co., Inc.), 24 Cal 4th 945, 103 Cal Rptr 2d 672, 16 P3d 94 (2001), decided that "damages" which the insured becomes legally obligated to pay requires a court determination. However, in AIU Insurance Co. v Superior Court, 51 Cal 3d 807, 274 Cal Rptr 821, 799 P2d 1253 (1990), the California Supreme Court held that where the government recovers or imposes environmental pollution remediation costs in a civil lawsuit, those costs are sums which the insured is legally obligated to pay as damages. Other jurisdictions have simply held that cleanup costs imposed by an administrative agency constitute sums the insured is "legally obligated to pay as damages." At best, this issue remains unresolved.


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.

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