Showdown in Texas

Such claims amount to breach of contract or breach of warranty claims that are not covered under a CGL policy and damages resulting from shoddy work by the contractor are foreseeable and, thus, are not an accidental or unexpected loss.

By contrast, other courts have found an occurrence existed when the builder or contractor negligently (as opposed to intentionally) performed shoddy work and/or the resulting damage was unexpected and, thus, accidental.

Courts also have disagreed about whether repair costs or loss of value caused by faulty workmanship constitutes property damage under a CGL policy. Applying the business-risk doctrine or economic-loss rule, some courts here have refused to find any property damage resulting from faulty workmanship. Rejecting coverage under policies, these courts usually conclude that such economic loss does not constitute damages from "physical injury to or loss of use of tangible property" within the definition of property damage covered under a CGL policy. However, other courts have determined that damages resulting from construction defects constitute property damage covered under a CGL policy regardless of whether the only damage to tangible property is damage to the building or other structure itself.

Due to conflicting court decisions, there has been a significant increase in construction defect coverage disputes in most jurisdictions, including Texas, in recent years.

The Lamar Homes Case

In 1997, the DiMares purchased a home from Lamar Homes. When the home showed foundation problems several years later, the DiMares sued Lamar Homes and its foundation subcontractor in a Texas state court, claiming that Lamar Homes was negligent and failed to design and construct the foundation in a good and professional manner in accordance with implied and expressed warranties.

Lamar Homes tendered its defense to its liability insurer, Mid-Continent, which provided CGL coverage for the builder from July 2001 through July 2002. After Mid-Continent refused to defend it, Lamar Homes filed a judgment action seeking a declaration that Mid-Continent owed a defense to Lamar Homes under its policy. Mid-Continent removed the case to a federal district court.

The district court held that the underlying claim for construction defect damages was essentially based upon breach of contract or warranties — business risks not covered under a CGL policy. Therefore, Mid-Continent had no duty to defend Lamar Homes under its policy. Because the gravamen of the claims sought relief for breach of contract resulting in a pure economic loss, the court also reasoned that there was no coverage under the CGL policy.

On appeal, the Fifth Circuit Court of Appeals recognized that the resolution of the issues presented involved interpreting the terms occurrence and property damage under the Mid-Continent policy. However, the Fifth Circuit noted that, as is typical in many jurisdictions, there was no guidance from the Texas Supreme Court, and the state courts of appeal were also conflicted on application of these terms to claims against an insured-contractor sued by a building owner for alleged damages arising from shoddy building construction. In addition, there was disagreement among federal court decisions in Texas on the issue.

Not wanting to go out on a limb and guess how the Texas Supreme Court would deal with these issues, the Fifth Circuit in Lamar Homes certified questions relating to the occurrence and property damage issues to the Texas Supreme Court, who agreed to hear the case. No sooner had the parties filed their respective briefs did a number of interested outside parties, including other insurers, policyholder associations, home builders and contractors associations, filed amicus (friend of the court) briefs. The case was argued on Feb. 14, 2006.

Key to Resolution

It is unknown when and how the Texas Supreme Court ultimately will deal with the issues presented. However, the briefing in Lamar Homes and recent decisions, including Gehan Homes v. Employers Mutual Casualty Co. and Lennar Homes v. Great American Ins. Co., suggest that the resolution of these issues may come down to:

Whether the court will apply the business-risk doctrine or economic-loss rule or whether the court will interpret the policy, particularly the subcontractor exception to the "your work" exclusion, to include coverage for faulty workmanship claims in cases where a subcontractor was involved in the work.

In Lamar Homes, Lamar relied upon court decisions construing the subcontractor exception to provide coverage for some claims related to defective construction from damage to an insured's work whenever a subcontractor had been involved. Lamar Homes contended that the line of cases cited by Mid-Continent, holding that construction defect claims do not involve an occurrence resulting in property damage, inappropriately relied upon the business-risk doctrine and ignored the 1986 amendments to the standard CGL policy. Based upon the language of the subcontractor exception, Lamar Homes argued that it was improper to deny coverage for claims against a contractor under the business-risk doctrine when the claims arose from work in which a subcontractor was involved.

On the other hand, Mid-Continent contended that Lamar Homes cannot supplant the business-risk doctrine, and it should not be allowed to use an exception to the policy exclusion to create coverage.

Thus, the subcontractor exception to the "your work" exclusion has had, and may continue to have, broad and unintended consequences. Due to the prevalent use of subcontractors on construction projects and the expansive interpretation of the subcontractor exception by some courts, the effect of the "your work" exclusion has been dramatically limited or curtailed by those courts. As a result, those courts have recognized coverage for such construction defect claims.

Practice Pointers

In addition to keeping an eye on the Lamar Homes, Gehan Homes, and Lennar Homes cases in Texas, claim professionals should consider the following when handling construction defect claims seeking repair costs or diminution of value in other jurisdictions:

• Determine whether the state supreme court has addressed the occurrence and property damage issues. In the areas where the state supreme court has not spoken, claim professionals should identify the prevailing views of the state courts of appeal on these issues. If there is no governing law, claim professionals likely will find themselves in a battle on these issues.
• Find out whether or not there is a subcontractor exception to the "your work" exclusion in the implicated policy or policies.
• Encourage underwriters to consider using the recent Insurance Services Office endorsement in CGL policies that eliminates the subcontractor exception from the "your work" exclusion. The use of this endorsement should make it difficult for insureds to argue that there would be coverage for construction defect claims arising from damage to the work, regardless of whether a subcontractor was involved. This is especially important to add in jurisdictions where the courts have rejected the insurers' business-risk arguments against coverage for such claims.

Whatever the outcome in these cases, claim professionals on the front line should be armed to confront these complex and all-too-common disputes.

Gene F. Creely, II, is a member of the Houston law office of Cozen O'Connor, which is ranked among the top 100 law firms in the United States. Concentrating his practice in insurance coverage, bad faith, and product liability matters, Creely regularly advises and represents insurers in coverage disputes related to construction defect claims.