Insurance Law Update Construction Defect Coverage

1. Insurance Law Update Construction Defect Coverage Lee H. Shidlofsky Shidlofsky Law Firm PLLC 512.685.1400 lee@shidlofskylaw.com We’ve Got You Covered

2. INSURANCE COMPANY RHETORIC . . . (A Bit of History) CGL policies are not Performance Bonds Faulty workmanship is a “business risk” to be assumed by the insured Damages flowing from faulty workmanship are economic losses and do not constitute “property damage” Damages flowing from faulty workmanship are not an “occurrence” because they are not accidental

3. Lamar Homes v. Mid-Continent242 S.W.3d 1 (Tex. 2007) • Performance bond theory rejected • Business Risk Rationale subsumed by exclusions • Damage to the work itself can constitute “property damage” (i.e., no requirement for third-party property damage) • Damage to the work itself can constitute an “occurrence” (i.e., it is no less accidental) • Foreseeability is not the test for determining “occurrence” • The insuring agreement does not have a tort vs. contract distinction (i.e., breach of contract is okay) • The economic loss rule is not a useful tool for determining insurance coverage

4. FAVORITE INSURANCE LINE Suffice to say, that if a [CGL] policy taken out by a contractor is not generally intended to cover “construction,” it might surprise the Texas Supreme Court; it seems to treat this conclusion as axiom. Essex v. Hines, 385 F. App’x 596 (5th Cir. 2010)

5. ARE WE RETREATING FROM Lamar Homes? 2007-2009 2010-2012 2013 ?

6. “PROPERTY DAMAGE” “Property damage” means: a. Physical injury to tangible property, including the loss of use of that property. All such loss of use shall be deemed to occur at the time of the physical injury that caused it; or b. Loss of use of tangible property that is not physically injured. All such loss of use shall be deemed to occur at the time of the “occurrence” that caused it.

7. KEY ISSUES UNDER PRONG I • Defect vs. Physical Damage • Incorporation theory • Damage to the insured’s own work vs. third-party property • emerging middle ground • Pure economic loss vs. consequential damages • damages “because of” . . . • Rip and Tear coverage

8. THE CRUX OF THE DEBATE • A difference exists between a claim for the costs of repairing or removing defective work and a claim for the costs of repairing damage caused by the defective work.

9. THE PERCEIVED PROBLEM • When the property damaged is the insured’s work, and the nature of the problem is characterized as “faulty” or “defective” workmanship, some courts have tendency to inquire whether “property damage” covers the repair or replacement of poor workmanship. • Conflation of business risk exclusions / rationale with the insuring agreement.

10. DEFECT VS. PHYSICAL DAMAGE • The “physical damage” prong distinguishes between physical injury to tangible property and a mere defect. • Physical Injury • Plain meaning connotes an alteration in appearance, shape, color, or in other material dimension (e.g., cracking, breaking, blistering, deflecting, corroding, rusting, rotting, peeling, dissolving, and so on). • Odor? / Noise? / Aesthetic disappointment?

11. DEFECT VS. PHYSICAL DAMAGE • A mere defect is not “property damage” (e.g., painting a room the wrong color) • Tangible Property • Can you touch or see it? • Property interests (i.e., easements) • What about costs incurred to prevent “property damage”? • Most jurisdictions say no . . . but some split for environmental and life-safety

12. DEFECT VS. PHYSICAL DAMAGE • Incorporation Theory • Many courts have adopted the position that the presence of a defective product within a larger whole, without some attendant physical injury to the larger structure, does not constitute “property damage.” • Some courts have focused on the amount of destruction that will occur to the larger whole in order to repair the defective component.

13. WHAT HAS TO BE DAMAGED? • Insured’s Own Work vs. Third-Party Property • Claimant need not have an ownership interest in the property • Definition of “property damage” does not support a distinction between damage to work itself vs. third-party property (i.e., look to exclusions)

14. WHAT HAS TO BE DAMAGED? • Emerging Middle Ground… • Defective work itself, even if physically damaged, is not “property damage” • Damage to otherwise non-defective parts of the “project”―even to the insured’s own work―can constitute “property damage” • No real support in the “property damage” definition but viewed as a compromise position

15. WHAT HAS TO BE DAMAGED? • Florida • Amerisure Mutual Ins. Co. v. Auchter Company, 673 F.3d 1294 (11th Cir. 2012) • Colorado • Greystone Construction, Inc. v. National Fire & Marine Ins. Co., 661 F.3d 1272 (10th Cir. 2011)

16. WHAT HAS TO BE DAMAGED? • Texas • Bldg. Specialties, Inc. v. Liberty Mut. Fire Ins. Co., 712 F. Supp. 2d 628, 640 (S.D. 2010) • “The Lamar Homes court did not discuss whether the defective foundation design or construction could be ‘property damage’ without allegations that the defective foundation caused damage to other parts of the home.”

17. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential • Damages “because of” “property damage” • Transformation of otherwise “economic loss” into covered damages • Diminution in Value • Profit / Overhead • Increased Costs of Construction / Extended General Conditions • Attorneys’ Fees

18. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential • Lennar v. Great Am. Ins. Co., 200 S.W.3d 651 (Tex. App.—Houston [14th Dist.] 2006, no pet.) (distinguishing between: (i) the costs to repair water damage to the homes; (ii) the costs to remove and replace EIFS as a preventative measure; and (iii) overhead costs, inspection costs, personnel costs, and attorneys’ fees)

19. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential (Lennar) • Depending on the home, the water damage included wood rot, damage to substrate, sheathing, framing, insulation, sheetrock, wallpaper, paint, carpet, carpet padding, wooden trim, and baseboards, mold damage, and termite infestation.

20. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential (Lennar) • Costs to repair water damage to the homes and costs to remove EIFS solely to repair underlying water damage are covered “property damage,” while costs to remove and replace EIFS as a preventative measure are not covered “property damage”

21. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential (Lennar) • “While Lennar may have been legally obligated to pay the third-party EIFS claims by replacing EIFS, making repairs, and/or making cash payments, it was not legally obligated to incur its own overhead costs, inspection costs, personnel costs, and attorneys' fees in connection with settling the claims”

22. PURE ECONOMIC LOSS VS. CONSEQUENTIAL DAMAGE • Economic vs. Consequential • D.R. Horton, Inc. v. Am. Guarantee & Liab. Ins. Co., 4:11-CV-039-A, 2012 WL 1893977 (N.D. Tex. May 22, 2012) • “In order to prevail on an insured property damage claim, the insured must distinguish, and apportion, the insured property damage costs from the non-insured costs, such as repairs or replacements necessary to remedy the construction defects themselves, incidental costs, and the cost of repairs or replacements to prevent future property damage.”

23. RIP AND TEAR • Rip & Tear • Most jurisdictions hold that the repair cannot create the “property damage” • But “rip and tear” expenses covered if the requisite “property damage” exists in the first place • Texas seemingly follows this approach (e.g., Lennar Corp. and Building Specialties).

24. LOSS OF USE OF TANGIBLE PROPERTY (PRONG II) • A claim by a property owner who alleges that his business sustained economic losses during a construction delay. • Gibson & Associates, Inc. v. Home Ins. Co., 966 F. Supp. 468 (N.D. Tex 1997)

25. LOSS OF USE OF TANGIBLE PROPERTY (PRONG II) • The key is that there must be an actual loss of use of property. Merely pleading (or proving) a loss of revenue is not sufficient. Such losses may be covered under a policy, but only when caused by physical injury or loss of use of tangible property. • Nat’l Fire Ins. of Hartford v. C. Hodges & Associates, PLLC, 825 F. Supp. 2d 792, 799 (W.D. Tex. 2011)

26. PLEADING “PROPERTY DAMAGE” • Should be relatively simple . . . but: • “In its petition, Royal states that it has suffered ‘property damage’ as a result of PPI’s conduct, and then defines ‘property damage’ in a way that precisely mirrors the terms of the Policy.” • “As mere legal assertions, these statements do not qualify as ‘allegations’ for purpose of the eight-corners rule. Thus, the Court will not consider them in evaluating Defendant Liberty’s duty to defend.” PPI Tech. Services, LP v. Liberty Mut. Ins. Co., 2012 WL 130389 (S.D. Tex. Jan. 17, 2012)

27. PLEADING “PROPERTY DAMAGE” • Should be relatively simple . . . but: • “Alvarez cannot trigger Evanston’s duty to defend by simply alleging the tissues were her property even if they were not. Whether the tissues are property is a legal conclusion, and we defer only to factual allegations in a complaint when examining the duty to defend.” Evanston Ins. Co. v. Legacy of Life, Inc., 370 S.W.3d 377, 385 (Tex. 2012)

28. “PROPERTY DAMAGE” QUIZ

29. “PROPERTY DAMAGE” QUIZ

30. “PROPERTY DAMAGE” QUIZ

31. Contractual Liability Exclusion The Debate Heads to the Supreme Court of Texas 2013

32. CONTRACTUAL LIABILITY EXCLUSION • Gilbert Tex. Construction, L.P. v. Underwriters at Lloyd’s London, 327 S.W.3d 118 (Tex. 2010) • Ewing Construction Co. v. Amerisure Ins. Co., 814 F. Supp. 2d 739 (S.D. Tex. 2011), aff’d, 684 F.3d 512 (5th Cir. 2012), vacated and certified, 2012 WL 3205557 (5th Cir. Aug. 8, 2012); • Crownover v. Mid-Continent Cas. Co., Civil Action No. 3:09-CV-2285-0 (N.D. Tex. Jan 13, 2011) (pending on appeal to Fifth Circuit) • Indian Harbor Ins. Co. v. KB Lone Star, Inc., 2012 WL 3866858 (S.D. Tex. Sept. 5, 2012)

33. THE EXCLUSION b. Contractual Liability “[B]odily injury” or “property damage” for which the insured is obligated to pay damages by reason of the assumptionof 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” . . . .

34. Gilbert Texas Construction Gilbert Tex. Construction, L.P. v. Underwriters at Lloyd’s London, 327 S.W.3d 118 (Tex. 2010) The Court recognized that it was adopting the “minority” view. “We disagree, by and large, with courts’ and treatises’ conclusions that the language of the contractual liability exclusion before us applies only to indemnity or hold-harmless agreements….” Holding: Underwriters had no duty to indemnify and held exclusion applied (and exception did not) because Gilbert could not have been liable to RTR but for its specific assumption to “protect and repair.”

35. Gilbert Texas Construction It is not at all clear exactly what the Court was saying in the opinion: Is the contractual liability exclusion a pure breach of contract exclusion? What does it mean to “assume” liability? Has Lamar Homes been overruled? Is the case limited to its unusual facts (e.g., contractual assumption mixed with governmental immunity)?

36. Gilbert Texas Construction Did the Court provide a hint? Hypothetical based on Lamar Homes: What if the claimant waited three years after discovery of the damage to bring the lawsuit? What if the insured in Lamar Homes moved for summary judgment on the economic loss rule and won? “We understand Gilbert’s concerns, but speculation about coverage of insurance policies based on surmised factual scenarios is a risky business because small alterations in the facts can warrant completely different conclusions as to coverage. It is proper that we await a fully developed, actual case to decide an issue not presented here.”

37. Ewing Opinion Basic garden-variety commercial construction defect claim involving cracking and flaking of tennis courts. Contractor (Ewing) entered into contract with school district for construction of tennis courts. State court lawsuit against GC and design team with claims of negligence, breach of contract, and breach of warranty. Amerisure denied a duty to defend based on the contractual liability exclusion. Coverage lawsuit commenced during pendency of underlying construction defect lawsuit.

38. Ewing Opinion Duty to Defend Denied: Amerisure contended that the economic loss rule defeats the pending tort claims because the only real basis for Ewing’s liability is in contract or warranty and that is excluded by the contractual liability exclusion. Say it isn’t So: Ewing contended that the construction contract contains no express assumption of liability for damages comparable to Gilbert and, in any case, the coverage court cannot issue an advisory opinion on the economic loss rule when the negligence claims remain pending in the underlying lawsuit.

39. Ewing Opinion Addressing the issue of “assumption of liability,” Judge Jack concluded that “Ewing assumed liability for its own construction work pursuant to the parties’ contract” because “Ewing is liable if the work it agreed to perform under the contract is defective.” Turning to the exception for liability that would exist in the absence of contract or agreement, Judge Jack concluded that the coverage court could look to the merits of the pending state court claims and utilize the economic loss rule in doing so.

40. Ewing Opinion – The Disconnect • “The Texas Supreme Court in Gilbert was careful to state, however ‘[w]e do not hold that the [contractual liability] exclusion . . . precludes liability for all breach of contract claims,’ but rather it ‘excludes claims when the insured assumes liability for damages in a contract . . . .’” • “Gilbert, therefore, stands for the proposition that the contractual liability exclusion applies when an insured has entered into a contract and, by doing so, has assumed liability for its own performance under that contract.”

41. Comparing Gilbert to EwingGilbert Ewing • Duty to indemnify • 3 party transaction (Gilbert –> DART –> RTR) • Express assumption of liability for damages that would not otherwise exist • All claims other than breach of contract dismissed by trial court • Duty to defend • 2 party transaction (Ewing –> Tuloso ISD) • No express assumption of liability for damages (no real reference to contract) • All claims, including negligence, remained pending at trial court.

42. NO EXPRESS ASSUMPTION OF LIABILITY FOR DAMAGES • Ewing breached its contract by: • “[f]ailing to complete construction in accordance with the contract plans and specifications” • “[f]ailing to exercise ordinary care in the preparation, management and execution of contract” • “[f]ailing to perform in a good and workmanlike manner” • “failing to properly retain and supervise subcontractors”

43. Comparing Lamar Homes to EwingLamar Homes Ewing • “The economic-loss rule . . . is not a useful tool for determining insurance coverage.” • “Contrary to the carrier’s contentions, the CGL policy makes no distinction between tort and contract damages.” • Court applied the economic loss rule to determine viability of tort claims • Court held no duty to defend or indemnify for breach of contract claims.

44. Comparing Lamar Homes to EwingLamar HomesEwing • Cracks in sheetrock determined to be “property damage” caused by an “occurrence” that falls squarely within “subcontractor exception” to “your work” exclusion • Cracks in tennis court determined to be “property damage” caused by an “occurrence” that falls within “subcontractor exception” to “your work” exclusion BUT nowexcluded by the contractual liability exclusion.

45. CAN YOU SAY SURPLUSAGE?“YOUR WORK” EXCLUSION “Property damage” to “your work” arising out of it or any part of it and included in the “products-completed operations hazard.” This exclusion does not apply if the damaged work or the work out of which the damage arises was performed on your behalf by a subcontractor. • Damage that falls within the “subcontractor exception” of the “your work” exclusion is necessarily damage to the subject matter of the contract.

46. Remember Gilbert We understand Gilbert’s concerns, but speculation about coverage of insurance policies based on surmised factual scenarios is a risky business because small alterations in the facts can warrant completely different conclusions as to coverage. It is proper that we await a fully developed, actual case to decide an issue not presented here.

47. The Court recognizes Ewing’s concern that Amerisure’s interpretation of the Contractual Liability exclusion would essentially wipe out any coverage for a general contractor for “property damage” that occurs to the project. While the Court may not read Gilbert as broadly as Amerisure does, and indeed makes no general findings about its application beyond this case, it does agree with the conclusion that it operates to exclude coverage in the present circumstance and in that sense is quite broad in application. The Ewing Quote

48. INTERPRETIVE DANCE

49. INTERPRETIVE DANCE II

50. THE FIFTH CIRCUITOriginal Opinion • 2-1 Decision Affirming the District Court • “Although other jurisdictions adopt this principle by holding that poor contractual performance is not, under a CGL policy, an occurrence causing property damage, Texas chooses to arrive at this holding through its interpretation of coverage exclusions.”