In a case that has attracted substantial national attention, the Texas Supreme Court has now resolved major issues in favor of insurance coverage for Texas contractors. The court held that defective workmanship that results in unexpected and unintended property damage is an "occurrence" of "property damage" as defined in the standard commercial general liability (CGL) insurance policy.
At the same time, the opinion went well beyond its holding, debunking nearly every argument advanced by insurers that defective workmanship cannot give rise to coverage under the policy.
The Background of Lamar Homes v. Mid-Continent
Texas has served as a microcosm of the debate over whether defective construction work performed in breach of a contractor's contract is an "occurrence" of "property damage" as defined in the standard commercial general liability (CGL) insurance policy. That debate has now been settled in a long-awaited opinion from the Texas Supreme Court in Lamar Homes, Inc. v. Mid-Continent Cas. Co., 2007 WL 2459193 (Tex. Aug. 31, 2007).
The case reached the Texas Supreme Court over a long and labored course. The lower court decision was issued by the Federal District Court for the Western District of Texas, in which it was determined that the damage arising out of the defective construction of a home that was the subject matter of the contract between the insured builder and the homebuyer was foreseeable and not an occurrence or property damage. The insured homebuilder appealed, and the Fifth Circuit certified the questions before it to the Texas Supreme Court. Lamar Homes, Inc. v. Mid-Continent Cas. Co., 335 F. Supp. 2d 754 (W.D. Tex. 2004), questions certified by, 428 F.3d 193 (5th Cir. 2005).
Disagreement over the issue of defective construction as an occurrence has been brewing in Texas since 2000. Then, the Houston Court of Appeals held that property damage to a home arising out of the builder's breach of warranty was natural and foreseeable and not an occurrence, despite the fact that the work had been performed by a subcontractor.1
That decision led to conflicting opinions among lower appellate courts and federal district courts attempting to apply Texas law. It was this conflict that compelled the U.S. Court of Appeals for the Fifth Circuit to certify the following questions from Lamar v. Mid-Continent to the Texas Supreme Court nearly 2 years ago:
When a home buyer sues his general contractor for construction defects and alleges only damage to or loss of use of the home itself, do such allegations allege an "accident" or "occurrence" sufficient to trigger the duty to defend or indemnify under a CGL policy?
When a home buyer sues his general contractor for construction defects and alleges only damage to or loss of use of the home itself, do such allegations allege "property damage" sufficient to trigger the duty to defend or indemnify under a CGL policy?2
In a nutshell, Lamar Homes v. Mid-Continent made its winding journey to the Texas Supreme Court as part of a disturbing trend among some courts to accept a questionable interpretation of the CGL policy. Based on the definition of "occurrence," that interpretation is relied on by some insurers, particularly some regional insurers, to deny claims involving defective work on the theory that the performance of defective work that breaches the insured's contract is foreseeable and outside the coverage grant of the CGL policy. The major purpose of this argument has been to avoid the coverage preserved for defective work claims under the carefully drafted property damage exclusions by radically attempting to rewrite longstanding law on occurrence and property damage. In Lamar Homes, the Texas Supreme Court called those insurers' bluff, particularly as to their effort to avoid the coverage preserved under the subcontractor exception to Exclusion (l), the Your Work Exclusion.
The Lamar Homes v. Mid-Continent Opinion
In its opinion, the Texas Supreme Court reaffirmed that property damage arising out of defective work is treated no differently from other property damage, i.e., that if it is unexpected and unintended, it constitutes an occurrence, but it meticulously rejected each and every one of the contrary arguments raised by the insurer (and the dissenting opinion). Moreover, the court rejected these arguments "with an edge," employing terms such as "witticism," infatuation," and "stalking horse" in reference to the insurer's position, a position that the majority made clear was based on false assumptions and a departure from the policy language.3
As stated, the Texas Supreme Court considered and resoundingly rejected every argument made by the insurer for the sweeping proposition that defective construction damaging the work itself is not an occurrence, nor property damage. The major arguments made by the insurer and the court's rejoinder, are as follows:
A CGL policy distinguishes between tort liability and breach of contract. No, it does not. "The proper inquiry is whether an 'occurrence' has caused "property damage,' not whether the ultimate remedy for that claim lies in contract or in tort. An "occurrence" depends on the fortuitous nature of the event, that is, whether the damage was expected or intended from the standpoint of the insured," citing King v. Dallas Fire Ins. Co., 85 S.W.3d 185, 191-92 (Tex. 2002).
Property damage to the project flowing from a breach of contract is foreseeable and not an "occurrence" under the CGL policy. No, one does not necessarily follow from the other. "Applying our prior decisions, the Fifth Circuit has concluded that the terms "accident" and "occurrence" include damage that is the "unexpected, unforeseen or undesigned happening or consequence" of an insured's negligent behavior, including "claims for damage caused by an insured's defective performance or faulty workmanship," citing Federated Mut. Ins. Co. v. Grapevine Excavation, Inc., 197 F.3d 720, 725 (5th Cir. 1999). The court also stated that, "[t]he CGL policy, however, does not define an 'occurrence' in terms of the ownership or character of the property damaged by the act or event. Rather, the policy asks whether the injury was intended or fortuitous, that is, whether the injury was an accident."
The economic loss rule determines the existence of property damage under a CGL policy. No, it does not. "The economic-loss rule, however, is not a useful tool for determining insurance coverage. The rule generally precludes recovery in tort for economic losses resulting from the failure of a party to perform under a contract. Southwestern Bell Tel. Co. v. DeLanney, 809 S.W.2d 493, 494-95 (Tex. 1991). Its focus is on determining whether the injury is to the subject of the contract itself. In operation, the rule restricts contracting parties to contractual remedies for those economic losses associated with the relationship, even when the breach might reasonably be viewed as a consequence of a contracting party's negligence.… It is a liability defense or remedies doctrine, not a test for insurance coverage."
Damages flowing from defective work in breach of a construction contract are necessarily an uninsured economic loss. No, not if that defective work causes physical injury to tangible property. "If, on the other hand, the dissent's opening statement is meant to imply that selling property (the contractor's work) with a latent defect that subsequently causes a "physical injury to tangible property" is not "property damage" under the CGL's insuring agreement, then we disagree.… The dissent's infatuation with the economic-loss rule as a policy-construction tool leads to the conclusion that 'property damage' does not mean what the policy plainly says, but rather is code for tort damages. Texas law, however, requires that insurance policies be written in English, preferably plain English, not code."
Upholding coverage for property damage arising out of defective work transforms the CGL policy into a performance bond. No, it does not. "Any similarities between CGL insurance and a performance bond under these circumstances are irrelevant, however. The CGL policy covers what it covers. No rule of construction operates to eliminate coverage simply because similar protection may be available through another insurance product. Moreover, the protection afforded by a performance bond is, in fact, different from that provided by the CGL insurance policy here," pointing out the differences between a CGL policy as a risk-sharing device as opposed to the financial guarantee nature of a performance bond."
Defective workmanship is an uninsurable business risk. Not necessarily true, particularly as to certain construction risks. "The standard-form CGL, however, has not always provided coverage for this business risk. At one time, CGL policies routinely excluded property damage to the homebuilder's work without regard to its cause. In 1976, however, insurers began offering an endorsement, known as the Broad Form Property Damage (BFPD) endorsement, that extended coverage for damage to the builder's work if it were caused by a subcontractor. In 1986, the Insurance Services Office incorporated this aspect of the broad-form endorsement directly into the standard CGL policy by inserting the subcontractor exception into the 'your-work' exclusion. SeeAmerican Family Mut. Ins. Co. v. American Girl, Inc., 673 N.W.2d 65, 82 (Wis. 2004). By incorporating the subcontractor exception into the 'your-work' exclusion, the insurance industry specifically contemplated coverage for property damage caused by a subcontractor's defective performance. More recently, the Insurance Services Office, Inc. (ISO), has issued an endorsement that may be included in the CGL to eliminate the subcontractor exception to the 'your-work' exclusion. Rather than confront this exception directly, the insurer argues the economic-loss rule, urging that damage to the insured's own work is not 'property damage' but rather a contractual, economic loss."
Coverage for an insured builder for its subcontractor's work cannot be created by an exception to an exclusion. The subcontractor exception to Exclusion (l) does no such thing. "[W]e have not said that the subcontractor exception creates coverage; rather, it reinstates coverage that would otherwise be excluded under the your-work exclusion."
The court's opinion makes it clear that the court was attuned to the arguments, not only of the insured homebuilder, but of the amici curiae, including construction industry groups such as the national and state chapters of the Associated General Contractors, the American Subcontractors Association, and the National Association of Home Builders. Those briefs addressed the manner in which the limitations on the business risk doctrine evolved to provide coverage for certain types of defective construction, particularly property damage arising out of the defective work of subcontractors of the insured contractor, and pointed out the inconsistencies of the insurer argument as an attempt to avoid the effect of those limitations. At least in Texas, those inconsistencies and the dubious assumptions underlying them have been exposed.
The Effect of Lamar Homes v. Mid-Continent
The immediately preceding column in this series on defective construction as occurrence described the most recent case law and the cases of particular importance where the issue is on appeal.4 While that column included an observation that the outcome of various appeals may be too close to call, the result in Lamar Homes indicates that where the court focuses on the language of the policy, policy interpretation will triumph over insurers' impermissible attempts to engraft concepts from contract and remedies law into the policy. While that same result could give rise to a sense of exuberance in insured contractors, the wholesale rejection of the "breach of contract as no occurrence" position is not all that astounding since it is the only conclusion that can be reached based upon the language of the CGL policy.
As to other states, the Florida Supreme Court faces the same issue, whether to apply the language of the policy before it or to forsake it for the same arguments of the insurers that have now been rejected in Texas. Those cases include J.S.U.B. v. U.S. Fire Ins. Co., Case No. SC05-1295 and Auto-Owners v. Pozzi, Case No. SC06-779, both of which were consolidated and heard on oral argument on March 5, 2007. In J.S.U.B. v. U.S. Fire Ins. Co., 906 So.2d 303 (Fla. 2nd D.C.A. 2005), review granted, April 5, 2006, both of which are described in my May 2007 article. Oral arguments in those cases were held in March 2007, and the Lamar Homes opinion is sure to be submitted to the court for consideration in its deliberations.
Even in states where the breach of contract approach has been accepted, it is quite possible that Lamar Homes will have repercussions. For example, in L-J, Inc. v. Bituminous Fire & Marine Ins. Co., 621 S.E.2d 33 (S.C. 2005), the South Carolina Supreme Court held that damage to a roadway due to cracking caused by a subcontractor's work was not an occurrence since the only damage was to the road, the insured contractor's work. Despite that pronouncement, a federal district court in South Carolina recently certified the question as to whether the South Carolina Supreme Court's holding in L-J v. Bituminous applies to deny coverage for property damage caused by continuous exposure to moisture which results from faulty workmanship.5
That issue was also addressed in Okatie Hotel Group v. Amerisure Ins. Co., 2006 WL 91577 (D. S.C. Jan. 13, 2006), where the court determined that L-J v. Bituminous stands for the proposition that no occurrence exists if the damage is restricted to the defective work itself. However, if the damage extends beyond the defective work to otherwise nondefective work, there is an occurrence; upholding coverage for a claim involving water intrusion damage to the interior of a hotel resulting from other defective work.
Thus, even though L-J was heralded as a major victory for the regional insurers touting the "defective work is not an occurrence" argument, it has met with some resistance from other courts, particularly federal districts courts in South Carolina. In the event the South Carolina Supreme Court exercises its discretion to answer the certified question as to coverage for moisture damage, it may present an opportunity for the court to reconsider its entire holding, beyond the narrow question certified to it. The fact that the Texas Supreme Court has weighed in on this issue, reaching a contrary result, may influence the South Carolina Supreme Court in that regard.
While the ultimate reach of the Lamar Homes v. Mid-Continent opinion is yet to be seen, at least for Texas construction insureds, the opinion was well worth the wait. For now, the "defective work as occurrence" issue has been properly and emphatically resolved according to the policy language and in favor of coverage.
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.
Hartrick v. Great Am. Lloyd's Ins. Co., 62 S.W.3d 270 (Tex. App. 2000). The controversy over these types of cases, not only in Texas, but nationally, has been analyzed in Patrick J. Wielinski, Insurance for Defective Construction, 2d. ed. (IRMI 2005), as well as in numerous earlier IRMI.com articles:
Sore Knees: Recent Case Law Ignoring the Subcontractor Exception, November 2004
Trying To Reconcile the Irreconcilable: Making Sense of Recent Case Law on Occurrence; December 2005
2 A third question was certified: "Does Article 21.55 of the Texas Insurance Code apply to a CGL insurer's breach of the duty to defend? That statute, now codified as Tex. Ins. Code §§ 542.051-.061, and also known as the Prompt Payment of Claims Act, applies to delayed payment of first-party claims. The court held that defense costs constitute a first-party benefit to an insured where the insurer has wrongfully refused to defend a lawsuit against the insured, and are subject to the statutory 18 percent penalty. This aspect of the opinion was also a clear victory for Texas insureds.
Those cases include Builders Mut. Ins. Co. v. The Burton Company, 2007 WL 2284576 (D.S.C. Aug. 7, 2007; Builders Mut. Ins. Co. v. C.C.W. Marketing, Inc., 2007 WL 2284584 (D.S.C. Aug. 7, 2007); Fidelity & Guar. Ins. Underwriters v. Robert W. Booher Const., Co., 2007 WL 2351010 (D.S.C. Aug. 5, 2007).