[authors: Christopher T. Micheletti and Jose M. Umbert]
The California Supreme Court recently issued an important decision concerning the forum for litigation of construction defect claims. However, as a practical matter, the court’s ruling may not have significant implications for construction defect disputes that also involve disputed first-party property insurance coverage claims.
Construction defect claims often result in complex litigation involving numerous parties, such as the property owner, the architect or engineer, the general contractor, and subcontractors and suppliers. In addition, property owners typically submit claims to their first-party property carriers, to recover damages for the physical loss or damage allegedly experienced by their property and/or business as a result of the construction defects. The amounts at stake in these disputes can be very substantial. For example, in September, a real estate developer filed a lawsuit in the Los Angeles Superior Court against its excess insurers, seeking coverage for the policy limits of $95 million, as well as bad faith damages, for alleged losses caused by a design defect in a condominium project.
In August, the California Supreme Court issued an important decision in the area of construction defect litigation. In Pinnacle Museum Tower Ass’n v. Pinnacle Mkt. Dev. (US) LLC, 55 Cal.4th 223 (2012), an action brought by a homeowners’ association against a condominium developer, the court held that agreements to arbitrate construction disputes, set forth in a recorded declaration, are enforceable against homeowners and their associations. The Supreme Court noted that binding arbitration benefits both developers and homeowners by providing a speedy and relatively inexpensive means to resolve construction defect disputes. The decision has been welcomed by the California building industry, which filed an amicus curiae brief in the case. Nevertheless, in practice, Pinnacle may only have a limited impact on litigation in California arising out of construction defects, at least when there are also disputes as to the existence and amount of first-party property insurance coverage.
Pursuant to well-established principles of arbitration law, which Pinnacle did not alter, an insurance carrier cannot be required to submit its coverage dispute with the insured property owner to binding arbitration in the absence of an arbitration provision in the policy. Thus, the insured will be unable to add its property carrier as a party to any arbitration proceeding against the builder or other participants in the construction project. This may result in duplicative proceedings addressing identical issues.
For example, establishing the cause of an alleged construction defect is critical to the resolution of the underlying construction dispute, as it will determine which parties are liable for the damages suffered by the property owner. At the same time, causation will be a crucial issue in the coverage action, particularly where, as is often the case in an insurance claim arising out of alleged construction defects, the property owner’s alleged loss is caused by multiple risks or perils. Under California’s “efficient proximate cause” doctrine, when a loss is caused by a combination of covered and excluded risks, the loss is covered if the covered risk was the efficient proximate cause of the loss – i.e., the predominant or most important cause – even if an excluded peril contributed to the loss. See, e.g., Julian v. Hartford Underwriters Ins. Co., 35 Cal.4th 747 (2005). A causation determination may thus be necessary to ascertain the existence of insurance coverage.
Further, the applicability of the exclusion in property policies for faulty design, workmanship, and materials is often a key issue in construction defect coverage litigation. This provision precludes coverage for physical loss or damage caused by a defect in the design and/or construction of a building. The exclusion is, however, typically subject to an “ensuing loss” exception, which restores coverage for physical loss or damage that results from the excluded faulty workmanship but is caused by a separate covered peril, such as a fire or an explosion. California courts define an “ensuing loss” as a loss separate and independent from the original excluded peril. See, e.g., Sapiro v. Encompass Ins., 221 F.R.D. 513 (N.D. Cal. 2004) (insureds’ water intrusion losses were directly attributable to a contractor’s negligent work and thus excluded). Here again, the determination of the cause of the physical loss or damage is critical to the outcome of the coverage dispute.
California law provides courts with a mechanism to avoid this duplication of proceedings (the procedure applies only to arbitrations governed by the California Arbitration Act, not to those subject to the Federal Arbitration Act). Pursuant to Section 1281.2(c) of the California Code of Civil Procedure, where a party to an arbitration is also involved in litigation with a third party arising out of the same transaction or series of related transactions, and there is a possibility of conflicting rulings on a common issue of law or fact, the trial court may refuse to enforce the arbitration agreement, and order joinder of all parties in the pending litigation.
This provision, which was not at issue in Pinnacle, may well apply to the situation described above, where a property owner has (i) claims subject to arbitration against some of the parties involved in the construction, and (ii) nonarbitrable claims against its insurance carrier and other parties. Indeed, in a decision issued earlier this year, the California Court of Appeal held that, where the purchaser of a home sued the developer for construction defects, and the seller of the property for nondisclosure, the trial court properly refused arbitration of the claims against the seller, because all the claims arose out of related transactions and there was a risk of inconsistent rulings concerning the existence of the construction defects. Lindemann v. Hume, 204 Cal.App.4th 556 (2012).
The Pinnacle decision was applauded by the building industry, and is expected by some to have a major impact on construction defect litigation in California. However, when property insurance coverage issues are also involved, the ruling may have a limited practical effect because, notwithstanding the Supreme Court’s pronouncement in favor of arbitration of construction defect disputes, lower courts will have the discretion to order parties to litigate their construction defect claims together with the insurance coverage claim in the court action. The benefits of resolving all the issues in a single action may outweigh any perceived advantages of arbitration. Moreover, consolidation of the proceedings can streamline discovery and facilitate settlement, to the benefit of all parties involved.
--By Christopher Micheletti and Jose Umbert, Zelle Hofmann Voelbel & Mason LLP
Chris Micheletti and José Umbert are partners with Zelle Hofmann Voelbel & Mason in the firm’s San Francisco office.