A policyholder bonanza: Texas Supreme Court decides Lamar Homes

The Supreme Court also disagreed with the district court’s common sense ruling that faulty workmanship that damages the property of a third party is a covered “occurrence,” whereas faulty workmanship that damages the property of the insured contractor is not.

For many years now, the Texas Supreme Court has been generally evenhanded in its dealings with insurance coverage issues. In most instances, it has carefully and reasonably construed language of policy terms without stretching the boundaries of credulity simply to find coverage where it was never intended. It has also been thoughtful in limiting the scope of extra-contractual claims to those circumstances where there is real merit and overreaching by insurance carriers. This decade long approach may be at an end.

This apparent turning point relates to two of the more vexing insurance issues that have been pending before the Texas Supreme Court for literally years (the Lamar Homes case was appealed to the Supreme Court in 2005, and oral argument was in February 2006) — the scope of the term “occurrence” in the general liability policies involving construction defect claims and the potential applicability of Article 21.55 (now recodified at § 542.051 of the Texas Insurance Code), the Texas Prompt Payment of Claims Statute, to an insurer’s duty to defend under a liability policy. This issue has been around so long that we have discussed it in “Legal Beat” columns dating back to Jan. 28, 2002, and March 8, 2004!

After years of waiting, on Aug. 31, 2007, the Texas Supreme Court issued a lengthy, argumentative 6-3 opinion in Lamar Homes vs. Mid-Continent Casualty Co., holding that under standard commercial general liability policies (1) allegations of unintended construction defects may constitute an “accident” or “occurrence” and (2) allegations of damage to, or loss of use, of the home itself may also constitute “property damage” sufficient to trigger the duty to defend. In addition, and potentially of greater impact, the Court ruled that the Texas Prompt Payment of Claims statute applies to an insurer’s duty to defend under a liability policy. As interesting as the rulings themselves, the harsh disagreement of the majority and dissenting opinions indicate a fundamental difference of opinion by the Court’s members as to how insurance coverage matters should be approached.

Background of Lamar Homes

The factual pattern at issue is surprisingly common. Vincent and Janice DiMare purchased a new home from Lamar Homes Inc. and encountered problems that they attributed to foundation defects. They sued Lamar Homes and Lamar Homes tendered the claim to Mid-Continent Casualty Company, seeking defense and indemnification under its CGL policy. Mid-Continent refused to defend, and Lamar Homes subsequently filed a declaratory judgment action. Lamar Homes also sought recovery under the Prompt Payment Statute for Mid-Continent’s alleged breach of its duty to defend.

The federal district court granted summary judgment for Mid-Continent, concluding it had no duty to defend Lamar Homes for construction errors that harmed only Lamar Homes’ own product, reasoning that the purpose of a CGL policy is “to protect the insured from liability resulting from property damage (or bodily injury) caused by the insured’s product, but not for the replacement or repair of that product.” Noting disagreement among Texas courts about the decisive legal issues, the Fifth Circuit Court of Appeals certified three questions to the Texas Supreme Court (I paraphrase):

1. When a homebuyer 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?

2. When a homebuyer 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?

3. If the Court answers “yes” to those questions, does Article 21.55 apply to a CGL insurer’s breach of the duty to defend?

The Texas Supreme Court answered “yes” to all three questions.

The Texas Supreme Court’s ruling

As to the first question, the insurer argued — and the district court agreed — that a CGL policy’s purpose is to protect the insured from tort liability, not claims of defective performance under a contract. As the dissenting opinion, written by Justice Scott Brister, put it, “Selling damaged property is not the same as damaging property.” (Italics in original). Although the underlying homebuyer plaintiffs alleged negligence, the insurer argued that the claim actually sounded in contract because the economic-loss rule dictates that all damages arising from defective work constitute economic damages for breach of contract rather than property damage. Further, the insurer contended that defective work cannot be an “occurrence” as it is not accidental because a general contractor should expect that faulty workmanship will result in damage to the project itself.

The majority of the Texas Supreme Court disagreed, in a decision authored by Justice David Medina, holding that the insurer’s argument was based upon a false assumption — that the failure to perform under a contract is always intentional. Although an accident is generally understood to be a fortuitous event, the Court held that a deliberate act, performed negligently, can properly be considered an accident if the effect is not the intended or expected result. So much for the time honored axiom that insurance does not cover breaches of contract!

The Supreme Court also disagreed with the district court’s common sense ruling that faulty workmanship that damages the property of a third party is a covered “occurrence,” whereas faulty workmanship that damages the property of the insured contractor is not. The Court relied heavily on the fact that the policy did not define an “occurrence” in terms of the ownership or character of the property damaged, but rather asks whether the injury was intended or fortuitous, that is, whether the injury was an accident. Thus, it was persuaded that there was no logical basis within the “occurrence” definition for distinguishing between damage to the insured’s work and damage to a third party’s property.

As applied to the facts before it, the Court held that the lawsuit against Lamar Homes alleged an “occurrence” because it asserted that Lamar Homes’ defective construction was a product of its negligence, and did not assert that Lamar Homes intended or expected its work or its subcontractors’ work to damage the DiMares’ home.

Turning to the second question, the majority likewise disagreed with the district court’s ruling that damage to the homebuilder’s own work cannot be “property damage” because CGL insurance does not cover repair or replacement of the insured’s defective work. The Court noted that the policy’s definition of “property damage” did not exclude the general contractor’s work and that the home and its component parts are clearly “tangible property.” The DiMares alleged that Lamar Homes was negligent in designing and constructing their home’s foundation and that Lamar Homes’ defective workmanship caused the home’s sheetrock and stone veneer to crack. These allegations of cracking sheetrock and stone veneer were allegations of “physical injury” to “tangible property.”

Acknowledging that there is some basis for the district court’s assumption that liability insurance is not for the repair or replacement of the insured’s defective work, the Court noted that the basis is not found in the definition of “property damage,” but in specific exclusions found elsewhere in the policy, and must depend on the language in those exclusions, not the definition of “property damage.”

Further, the Court broke with prior law and rejected the economic-loss rule, which precludes recovery in tort for economic losses resulting from the failure of a party to perform under a contract, deciding that the rule is not a useful tool for determining insurance coverage issues.

The dissent

As quoted above, the dissenting opinion hammers on the fact that the nature of the claims sounded in contract and were not really property damage claims, and therefore would not be covered by a liability policy. The dissent complains that “the Court’s conclusion … turns the construction industry on its head. Instead of builders standing behind their subcontractors’ work and making necessary repairs, the Court shifts that duty to insurance companies.” The result of the majority’s decision is that carriers become guarantors of contracts, not insurers of accidents.

It also attacks the majority’s claim that the policy does not distinguish between tort and contract claims. “Granted, the CGL policy does not distinguish between contract and tort claims, or mention economic loss. But it does limit coverage to ‘property damage’ suits. Given the extensive jurisprudence separating property damage from economic loss, we cannot presume this policy was drafted without knowing or recognizing the difference.”

The dissent goes on to carefully outline the jurisprudence distinguishing those principles, noting that the Lamar Homes’ decision adopts a view recognized by only five state high courts and ignores fundamental insurance principles. But alas, it is to no avail, as Lamar Homes is now the law.

Prompt payment statute

The third question is the most problematic for insurance professionals. The prompt payment statute provides that an insurer, who is “liable for a claim under an insurance policy” and who does not promptly respond to, or pay, the claim as the statute requires, is liable to the policyholder or beneficiary not only for the amount of the claim, but also for “interest on the amount of the claim at the rate of eighteen percent a year as damages, together with reasonable attorney’s fees.” Tex. Ins. Code § 542.060(a). The key issue stems from the limitation of the statute to first party claims made by an insured or policyholder under an insurance policy or contract or by a beneficiary named in the policy or contract that must be paid by the insurer directly to the insured or beneficiary.

Unfortunately, the statute does not define what a “first party claim” is, and Texas appellate cases are divided as to whether the duty to defend in a liability policy falls into that category. The majority of published cases have held that an insured’s claim for defense costs under a liability policy is not a “first-party claim” within the meaning of the prompt payment statute, while a few have decided that the insured’s claim for defense costs is a “first party claim” such that the prompt payment statute is triggered.

Lamar Homes resolves the issue by holding that a defense claim is a “first party claim” because it relates solely to the insured’s own loss. The Court reasoned that without the defense benefit provided by a liability policy, the insured alone is responsible for those costs. Thus, unlike the loss incurred in satisfaction of a judgment or settlement, the loss belongs only to the insured and is not derivative of any loss suffered by a third party.

Apparently realizing that its ruling places a great new burden on adjusters, the Court went on to moderate its ruling slightly by saying that in order to “mature” the insured’s rights under the prompt payment statute, the insured has to submit his legal bills to the insurance company. Indeed, the Court framed the question as “whether the insured would have to submit its legal bills” to ripen its claim, and the Court then puckishly answers, “The statute’s apparent answer is, yes.” So we are now getting “apparent answers” from the state’s highest court.

In any case, the Court decided that when the insurer wrongfully rejects its defense obligation, the insured has suffered an actual loss that is quantified after the insured retains counsel and begins receiving statements for legal services. These statements or invoices are the last piece of information needed to put a value on the insured’s loss. When the insurer, who owes a defense to its insured, fails to pay within the statutory fifteen day deadline, the insured’s right to reasonable attorney’s fees and the eighteen percent interest rate specified by the statute is mature. In other words, carriers have fifteen days after receipt of legal bills to pay (or arguably request more information), before the 18 percent penalty is imposed.

The immediate impact of this ruling has not been lost on the policyholder bar. Just a few days after the ruling, one well-known policyholder firm opined in a blast e-mail that, “Not merely limited to the construction industry, this holding provides all general liability policyholders the hammer necessary to compel their insurers to provide a defense.”

Simply put, defend or we can get an 18 percent penalty above our other contract damages if we prove you wrong at court. This is a powerful leverage point for policyholders, equivalent in many ways to a bad faith award.

Initial thoughts

The vigor of the disagreement between the majority and dissenting opinions is hard to overlook. The dissent does not shy away from pointing out the common sense problems and practical effects of the majority’s ruling, as well as noting the common law principles, such as the economic loss doctrine, which have been traditionally applied in the insurance coverage context but are ignored by the majority.

Likewise, the majority does not ignore the dissenting opinion, but instead attempts to engage it and to respond to the points raised.

While this may sound like healthy debate, it also indicates a deep rift in the Court’s approach to coverage issues. The consensus of recent years appears sickly, if not dead.

Another concern, at least for general liability carriers, is that while the dissent argues vigorously against the majority’s rulings as to the first two points, it does not address the prompt payment statute ruling at all. Justice Brister does say that by the dissent’s answering the second certified answer “no,” that question would dispose of the claim and he therefore “declines to decide the other “issues.” But some discussion would have been helpful in identifying the crucial points for future debate.

By having so vigorously attacked the majority decision on the construction defect issue, it seems odd that the extra-contractual issue is wholly unaddressed. My fear is that the Court does not realize the extraordinary burden it has placed on adjusters who are inundated with legal invoices in complex liability claims and now have a mere 15 days to review the bills, audit them where appropriate, place them in line for payment, and then have the checks issued. This burden to require an immediate turnaround from adjusters, by a Court that took a year and a half after oral argument to issue its opinion, should raise some eyebrows.

Topics Carriers Texas Profit Loss Claims Property Contractors Homeowners Construction