Fifth Circuit Holding Breathes Life Back Into the Contractual Liability Exclusion

by Carlton Fields

Fifth Circuit Holding Breathes Life Back Into the Contractual Liability Exclusion

Liability insurance policies typically exclude coverage for obligations arising out of the insured’s “assumption of liability in a contract or agreement.”  Earlier this year, the Texas Supreme Court took a narrow view of this exclusion:  in the landmark decision in Ewing Construction Co. v. Amerisure Insurance Co., 420 S.W.3d 30 (Tex. 2014), the court held that a contractor’s agreement to perform construction work “in a good and workmanlike manner” did not assume any obligations which the common law did not already impose—and so that the contractor’s agreement did not bring it within the scope of the contractual liability exclusion.  But in June, in Crownover v. Mid-Continent Cas. Co.,No. 11-10166 (5th Cir June 27, 2014), the U.S. Court of Appeals for the Fifth Circuit declined to apply Ewing to a contractor’s promise to “promptly correct work … failing to conform to the requirements of the Contract Documents.”

This ruling provides reason for optimism that the exclusion still has some teeth, but it also highlights another area that calls for caution in the defense of claims against insureds.

The Facts of Crownover

Karen and Doug Crownover hired Arrow Development, Inc., to construct a new home on their property in Sunnyvale, Texas. They executed a construction contract in which Arrow warranted that its work would be “free from defects not inherent in the quality required or permitted.”  The contract also contained a “warranty to repair” clause, which provided that Arrow would “promptly correct work … failing to conform to the requirements of the Contract Documents.” Soon after Arrow completed construction, the Crownovers discovered cracks in the walls and foundations of the home, as well as problems with the HVAC system.

The Crownovers went to arbitration, asserting several claims against Arrow, including breach of the warranty to repair clause and violation of the warranty of good workmanship that was implied under Texas law.  The arbitrator ruled for the Crownovers, but the decision rested solely on the warranty to repair.  Having found for the Crownovers on that issue, the arbitrator declined to rule on their other claims, which Arrow defended as time-barred.

Arrow subsequently filed for bankruptcy, and the bankruptcy court limited the Crownovers’ recovery to any amount they could recover under Arrow’s commercial general liability policy,  issued by Mid-Continent Casualty Company (“Mid-Continent”).  That policy contained a contractual liability exclusion, which stated that “[t]his insurance does not apply to[ ] ‘property damage’ for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.”

However, under an exception to this exclusion Mid-Continent agreed to provide coverage for “liability … [t]hat the insured would have in the absence of the contract or agreement.”

After Mid-Continent denied the Crownovers’ demand, citing several policy defenses and exclusions, the Crownovers filed a declaratory judgment action against Mid-Continent. The district court granted the insurer’s motion for summary judgment, and the Crownovers appealed

The State of the Law

Two recent Texas Supreme Court decisions figured prominently in the Fifth Circuit’s analysis.

In Gilbert Texas Construction, L.P. v. Underwriters at Lloyd’s London, 327 S.W.2d 30 (Tex. 2010),  the Dallas Area Rapid Transit Authority (“DART”) contracted with Gilbert Construction to build a light rail system.  In its contract, Gilbert agreed to repair any damage its work caused to an adjacent property. After damage occurred, the owner of that property sued DART and Gilbert. The Texas Supreme Court held that Gilbert’s obligation to repair the adjacent property was an assumption of liability that triggered the contractual liability exclusion. The court reasoned that Gilbert would not have been liable in the absence of its agreement, because, as a contractor for DART, it enjoyed governmental immunity.

In Ewing Construction Co. v. Amerisure Insurance Co., 420 S.W.3d 30 (Tex. 2014), a school district in Corpus Christi, Texas, hired a contractor to construct tennis courts. After the tennis courts began cracking and flaking, the school district filed a construction defect action in Texas state court. The Fifth Circuit certified the following question to the Texas Supreme Court:

Does a general contractor that enters into a contract in which it agrees to perform its construction work in a good and workmanlike manner, without more specific provisions enlarging this obligation, ‘assume liability’ for damages arising out of the contractor’s defective work so as to trigger the Contractual Liability Exclusion?

The Texas Supreme Court answered “no” to this question, holding that the contractual liability exclusion would not bar coverage. The court distinguished Gilbert, finding that the Gilbert’s agreement to repair or pay for damage to an owner of adjacent property extended beyond the obligations it had under “general law principles.”  In Ewing, on the other hand, the insured’s agreement to perform its work in a good and workmanlike manner did not enlarge its obligations beyond the common-law duty to which it was already subject.

The Fifth Circuit’s Decision

The central question presented by the Crownovers’ appeal, therefore, was whether the arbitration award against Arrow constituted a “liability … [t]hat the insured would have in the absence of the contract or agreement,” within the meaning of the exception to the contractual liability exclusion.  The Fifth Circuit concluded that the exception did not apply, because Arrow’s contractual obligation to repair extended the contractor’s obligations beyond its “obligations under general law.” As the court stated:

Whereas contractually agreeing to repair damage resulting from a failure to exercise reasonable care in performing the work or agreeing to perform work in a good and workmanlike manner would mirror a contractor’s duty under general law, contractually agreeing to repair damage resulting from a failure to comply with the requirements of the contract would not.

The Crownovers argued that Arrow’s conduct had also violated a separate warranty that was contained in the parties’ contract, and which mirrored the implied warranty imposed by the common law of Texas.  The Fifth Circuit found stated that this argument was “misplaced,” because the underlying arbitration award had been based solely on Arrow’s breach of the warranty to repair.

Key Considerations

In Crownover, the Fifth Circuit held that Arrow’s promise to “correct work … failing to conform to the requirements of the Contract Documents” imposed a duty beyond what the common law required.  But since the underlying claim of non-conformity was based on cracks in the walls and HVAC problems, the court could conceivably have found either that the two sets of legal obligations overlapped under the circumstances of this case, or that the question involved a disputed issue of fact.

The decisive factor appears to have been that the Crownovers had sought—and could possibly have obtained—relief for a violation of standards of conduct that were imposed by law, but that these efforts had failed.  Arrow’s liability arose solely out of the arbitrator’s ruling that it had breached the contractual warranty to repair, and the Fifth Circuit admonished that it could not “look beyond the arbitration award.” Furthermore, although the arbitrator had not addressed the issue, the insured had argued that the other claims asserted by the

Crownover shows that contractual liability exclusions are still viable, but that much will depend on how the underlying claim against the insured is resolved.  Insurers should study the underlying record carefully when making coverage decisions.

Crownover also poses something of a paradox for insurers who are defending the underlying claim.  To discharge its duty to defend, the insurer must avoid defending the underlying action in a way that might impair the insured’s position in the coverage dispute.  In Crownover, the insured’s coverage position suffered when the arbitrator declined to rule against it in the underlying proceedings on any claim other than the one based on the warranty to repair clause.  From the point of view of coverage, that is, it would have benefitted from a less successful defense of the claim for breach of the warranty implied by law.

This is not usually much of a problem:  insurers clearly have a right to provide a vigorous defense of weak claims that plaintiffs have added just to reach the defendant’s liability coverage.  But in Crownover, the difference between the plaintiffs’ two theories was not obvious, and the case law provides very little guidance as to how that difference must be treated.

Image source: Rama (Wikimedia)

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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