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Additional Insured Issues

Who Provides the Defense in Construction Defect Suits?

Joseph Postel | October 1, 2001

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Gavel on building plans with construction helmet and measuring tape

Subcontractors' insurers must provide a complete defense to the developer/general contractor, but can they force others to pitch in? Joe Postel examines recent case law.

A recent California decision has subcontractors and their commercial general liability (CGL) insurers crying foul and heading back to the drawing board. In Presley Homes, Inc. v American States Ins. Co., 90 Cal App 4th 571, 108 Cal Rptr 2d 686 (Cal App June 11, 2001), the California Court of Appeal held that a subcontractor's CGL insurer was obligated to pay all of its additional insured developer's defense costs in a construction defect suit. This was despite the fact that the additional insured coverage was expressly limited to liability arising out of the named insured subcontractors' work, but the construction defect suit alleged both liability arising out of those subcontractors' work and liability not arising out of their work.

Although the subcontractors' insurer did not have to pay any settlement or judgment on behalf of the additional insured developer, subcontractors having read this decision correctly recognize that the defense costs for a large, complicated construction defect suit can be enormous. Some raise the specter of the doorknob subcontractor's insurer being forced to bear all of the developer or general contractor's defense costs for a large, complicated construction defect suit seeking damages that are 99 percent unrelated to doorknobs.

The Presley Case

Presley was the developer for a residential construction project in southern California called Andora. American States insured two of Presley's subcontractors: Darrell Link Construction and Sunrise Framers. Link was hired to do concrete work, such as foundations, driveways, walkways, and stoops. Sunrise did the framing.

Presley's subcontracts with Link and Sunrise required each of them to add Presley as an additional insured to its CGL policy. Both policies were endorsed to make Presley an additional insured, and each endorsement provided that its coverage was primary and not diminished by the availability of other insurance.

Link's policy contained a CG 20 09 endorsement, and Sunrise's contained a CG 20 10. The difference was immaterial to the case, however, as American States did not deny that it owed a duty to defend Presley in the ensuing construction defect suit brought by a homeowner in Andora.

Each endorsement, of course, limited the coverage for Presley to its liability arising out of the named insured's work (Link or Sunrise). Although American States admitted that the homeowner's complaint alleged liability arising out of Link and Sunrise's work, i.e., it alleged defects in the concrete and framing, American States contended that the complaint also alleged liability not arising out of Link and Sunrise's work, i.e., not related to the concrete or framing, and therefore not covered by American States. Therefore, American States refused to provide a full funding of Presley's defense, instead attempting to secure an agreement with Presley for a partial funding, reflecting only those portions of the homeowner's complaint alleging defects in concrete or framing. When agreement proved elusive, Presley demanded a full defense from American States, which American States refused.

American States then settled the construction defect suit without any contribution from Presley. But Presley had incurred significant costs defending the suit, and filed a declaratory judgment action seeking reimbursement of those costs from American States. The trial judge ruled that American States did not have to fund the entire defense, but the California Court of Appeal reversed.

The court quoted the seminal decision in Buss v Superior Court, 16 Cal 4th 35, 939 P2d 766 (Cal 1997):

[T]o defend meaningfully, the insurer must defend immediately. To defend immediately, the insurer must defend entirely. It cannot parse the claims, dividing those that are at least potentially covered from those that are not.

Therefore, the court held, American States was not permitted to delay providing a defense to Presley while it attempted to separate those allegations that potentially arose out of its named insured subcontractors' work from those that did not. American States was obligated, the court said, to provide a full and immediate defense to Presley.

In response to American States' concern about bearing more than its fair share of the defense costs, the court pointed out that subcontractors' insurers are already protected by their right of equitable contribution from other insurers also obligated to defend the developer. The hypothetical doorknob subcontractor's insurer can seek equitable contribution with respect to defense costs from any other subcontractor's insurer, if that insurer also had a duty to defend.

So, in the hypothetical, even if somehow the doorknob subcontractor's insurer ended up footing the whole bill for the developer's and general contractor's defense costs, the insurer could obtain reimbursement from the other subcontractors' insurers for their pro-rata share of those costs.

Obstacles to Reimbursement

Subcontractors' insurers may not find it so easy to obtain adequate reimbursement by means of an action for equitable contribution, in light of Maryland Casualty Co. v Nationwide Mut. Ins. Co., 81 Cal App 4th 1082, 97 Cal Rptr 2d 374 (Cal App 2000), and Schal-Bovis v Casualty Ins. Co., 732 NE2d 1179 (Ill App 2000).

The Maryland Case

Nielsen Construction Company was hired to build a residential development in southern California. Nielsen retained numerous subcontractors. Two of these subcontractors were West Coast Sheet Metal and R.W. Strang Mechanical, Inc.

Both subcontracts required that Nielsen be added to the subcontractor's CGL policy as an additional insured, and that the additional insured coverage be sole primary and not contributing with Nielsen's own CGL coverage. In fulfillment of these requirements, West Coast and Strang each purchased CGL coverage from Nationwide. Each Nationwide policy contained a non-Insurance Services Office, Inc. (ISO), endorsement making Nielsen an additional insured, but "only to the extent that [Nielsen] is held liable for your acts or omissions arising out of and in the course of operations performed for [Nielsen]."

The West Coast endorsement also provided, in typewritten language:

Coverage provided to the additional insured under this endorsement is primary, but only with respect to acts or omissions of the named insured. Any other insurance maintained by the additional insured is deemed to be excess.

Nielsen had its own CGL policies with Maryland Casualty and AIG.

When Nielsen was sued for construction defects, it tendered its defense to its own insurers, and to all of the subcontractors' insurers. Maryland and AIG ultimately paid all of Nielsen's defense costs, however. But when they sued the subcontractors' insurers, all but Nationwide admitted a duty to reimburse, and Maryland and AIG reached settlements with all of those insurers.

Maryland and AIG's suit against Nationwide resulted in a judgment for Nationwide, which was reversed on appeal. The court in the first appeal held that Nationwide had a duty to defend. Maryland Casualty Co. v Nationwide Ins. Co., 65 Cal App 4th 21 (Cal App 1998).

On remand, Maryland and AIG sought reimbursement from Nationwide of all of their defense costs, on an equitable subrogation theory. The court entered judgment against Nationwide for all of the defense costs, and Nationwide appealed. Nationwide contended that Maryland and AIG were entitled only to a portion of their defense costs from Nationwide, under an equitable contribution theory.

On appeal, the court again reversed the trial court, holding that Maryland and AIG were entitled only to a portion of their defense costs from Nationwide, not all of them. The court discussed the difference between equitable subrogation and equitable contribution. Equitable subrogation allows an insurer that has paid coverage or defense costs to be placed in the insured's position to pursue a full recovery from another insurer who was primarily liable for the loss. Because the doctrine of equitable subrogation shifts the entire cost burden, the insurer that is suing must show that the other insurer was primarily liable for the loss. Typically, this doctrine would apply in an action by an excess insurer that paid a loss against a primary insurer that didn't. Equitable contribution, on the other hand, applies to apportion costs among insurers who share the same level of liability on the same risk as to the same insured.

Maryland and AIG conceded that they both wrote primary policies to Nielsen, but argued that the typewritten sole primary language in the additional endorsement to West Coast's Nationwide policy rendered Maryland's and AIG's coverage excess over Nationwide's. This excess status invoked the doctrine of equitable subrogation and entitled them to recover all of their defense costs from Nationwide, they argued. After all, despite the limitation in Nationwide's additional insured endorsement (limiting coverage to vicarious liability for the acts or omissions of Strand and West Coast), Nationwide had a duty to defend the entire construction defect complaint.

This duty, together with the typewritten sole primary language in West Coast's endorsement to its Nationwide policy, rendered Maryland and AIG excess, they argued. Therefore, they could recover all of their defense costs from Nationwide.

The court disagreed. The court reasoned that because the typewritten sole, primary language reiterated the vicarious liability limitation of Nielsen's additional insured coverage, it would be illogical and inequitable to ignore that limitation in apportioning defense costs. The court held that despite Nationwide's duty to defend the entire complaint, Maryland and AIG had a "parallel duty" to defend the entire complaint—despite the typewritten sole primary language in the West Coast endorsement. Because their coverage was broader than Nationwide's; it potentially encompassed allegations not covered by Nationwide's policy, such as Nielsen's direct (as opposed to vicarious) liability, or its vicarious liability for the acts or omissions of other subcontractors besides West Coast and Strang.

The court reversed the judgment in favor of Maryland and AIG, and remanded the case for the purpose of determining how to equitably apportion the defense costs between Maryland and AIG on the one hand, and Nationwide on the other.

Maryland seems inconsistent with Presley. Whereas the Presley court emphasized the insurer's duty to provide a complete defense, without regard to any coverage limitations that might ultimately have an impact on indemnity analysis, the Maryland court thought it inappropriate to ignore coverage limitations in apportioning defense costs. What this means, as a practical matter, is that once again, no good deed goes unpunished. Honest, upright subcontractors that add their customers as additional insureds by means of a CG 20 10 endorsement, instead of using manuscript endorsements that provide little coverage or only illusory coverage, will end up getting less than full and fair reimbursement from subcontractors' insurers that do employ drafting chicanery.

However, note: Maryland involved only the issue of whether the excess clause in the defending insurer's policy applied where the additional insured coverage in the subcontractor's policy was narrower than the coverage of the policy that defended. It is an open question whether this holding applies in an action between two primary subcontractors' insurers. I see no obvious reason that the reasoning of Maryland would not apply to such a context, however.

The California Supreme Court may ultimately need to provide clarity on these issues. It would be interesting to know how the trial judge in the Maryland case would have apportioned defense costs on remand from the court of appeal, had the case not settled after remand. Thanks to coverage lawyer Robert Closson of San Diego, who represented Maryland Casualty in that case, for the information about the post-remand settlement.

The Schal-Bovis Case

Of course, the hypothetical doorknob subcontractor's insurer is really going to be left out in the cold in any jurisdiction that would make the mistake of following Schal-Bovis v Casualty Ins. Co., 732 NE2d 1179 (Ill App 2000), a decision I criticized in my last column. That decision held that one subcontractor's insurer that paid a loss on behalf of its additional insured general contractor could not obtain equitable contribution from a different subcontractor's insurer that also provided additional insured coverage to the general contractor.

The rationale for this result was the erroneous proposition that since each insurer's additional insured endorsement limits coverage to liability arising out of its own named insured's work, the two insurers therefore insure different risks, so they cannot obtain contribution from each other.

The Presley decision underscores just how wrong the Schal-Bovis decision was. In a scenario where a court would apply both Presley and Schal-Bovis, the hypothetical doorknob subcontractor's insurer would have to pay all of the developer's and the general contractor's defense costs, but would not be able to recover any of those costs from other subcontractors' insurers. No one could justify such a result.

One possible distinction, however, is that Schal-Bovis involved insurers seeking equitable contribution as to settlement costs, not defense costs. Arguably, the Schal-Bovis decision does not apply to defense costs, since the duty to defend is broader than the duty to pay. But to apply the rationale of Schal-Bovis to either indemnity or defense costs produces an inequitable result, as the Presley court implicitly recognized in its discussion of American States' equitable contribution rights against other subcontractors' insurers.

Subcontractors and their insurers outside Illinois, take heart! Courts in other jurisdictions are unlikely to follow Schal-Bovis.

Equitable Contribution: a Valuable but Sometimes Imperfect Remedy

The right of the subcontractor's insurer to seek equitable contribution could prove an imperfect remedy, at least to our hypothetical doorknob subcontractor. Consider again the hypothetical situation where the doorknob subcontractor's work represented only 1 percent of the defects on a project. Assume that there are only a total of four other subcontractors providing additional insured coverage to the developer/general contractor. Assume further that all five of the subcontractors (including the doorknob subcontractor) have the standard ISO CG 00 01 other insurance clause, that provides for sharing by equal shares.

We know from Presley that despite the existence of the additional insured coverage for the developer/general contractor under the other subcontractors' policies, the doorknob subcontractor's insurer must provide a full defense. We also know from Presley that his remedy for being stuck footing the whole bill is to obtain equitable contribution from the other subcontractors' insurers. But how much contribution will he obtain?

This will be determined simply by the number of subcontractors' policies, assuming that we are talking about defense costs, and thus, that limits issues don't complicate matters. In the hypothetical, the doorknob subcontractor's insurer will obtain reimbursement for 80 percent of the total defense costs, leaving his net contribution at 20 percent. While that is a whole lot better than paying 100 percent, it's a whole lot worse than the 1 percent of the total damages that the doorknob subcontractor's work represented.

Yet, courts have not fashioned a method for basing defense cost apportionment in this scenario on percentages of fault, or involvement, in the underlying case. Frankly, it seems that any attempt to do so would be fraught with complications and difficulty, and probably would create more problems than it solves. Arguably, something like this would have awaited the trial judge on remand in the Maryland case.

At any rate, if subcontractors are heading back to the drawing board, it ought to be to undo Schal-Bovis, not Presley. The problem subcontractors think they see in Presley is one with a pretty good—though not always perfect—solution in equitable contribution.

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