The Critical Path: Tools for Resolving Construction Disputes : California Construction Lawyer & Attorney for Dispute Resolution in Los Angeles, San Diego & the S.F. Bay Area

Insurance for construction defect claims is not a one way street. Comprehensive general liability policies impose duties and obligations that apply to both parties to the insurance contract. On claims that are potentially covered by the policy, the insurer has a duty to pay for the defense of the construction defect litigation. For defect claims that are covered by the policy, the insurer has a duty to indemnify the contractor or, in other words, pay for the cost of repair. Given these responsibilities, the policy generally grants the insurer the right to control the litigation.

On the other hand, CGL policies impose on contractors the duty of cooperation throughout the claims and litigation process. A contractor who breaches this duty can unwittingly give its insurance company a free pass that excuses the insurer from its duties to defend and indemnify the contractor. Such was the result in Travelers Property v. Centex Homes, a United States District Court for the Northern District of California case. As a district court case, it has no precedential value but it is a cautionary tale for those who take positions that could be construed as a violation of the duty to cooperate. Centex could appeal the decision to the Ninth Circuit Court of Appeals in which case there may be more to report in the future.

Centex Homes was the defendant in two construction defect cases pending in the Sacramento Superior Court. Centex was being defended by its wrap policy insurance carriers (a wrap policy covers all parties in a construction project under one umbrella policy, including the owner, general contractor, and the subcontractors). Two of the subcontractors on the project, though, had separate CGL policies and Centex, as a named additional insured on the policies, tendered its defense to Travelers, the subcontractors' insurer. For each tender, Centex stated that the tender only applied to non-wrap homes.

Travelers acknowledged the tenders and on several occasions asked for information concerning the wrap policies, construction contracts for non-wrap homes, pleadings in the lawsuits, and the attorney fee rates and budgets of Centex's attorneys for the litigation involving the three "non-wrap" homes in question. Believing it had not received satisfactory information, Travelers filed a declaratory relief action in federal court and, eventually, a motion for summary judgment on the grounds that Centex breached the duty to cooperate. The district court granted the motion which meant that Travelers was excused from its duties to defend and indemnify Centex.

The factual details and legal authority supporting the district court's decision can be reviewed by clicking here. However, there are some recurring issues that are worth noting.

• When an insurance company agrees to defend under a reservation of rights, a conflict of interest or at least the perception of a conflict of interest can arise. The reservation of rights means that the insurer will pay for the defense and maybe even the indemnity but reserves the right to demand the reimbursement of those funds in the event the claims are not actually covered by the policy.
• The concern for the contractor is this: what if the attorneys hired by the insurance company to defend the contractor steer the defense of the case towards a conclusion that the claims are not covered by the policy, leaving the contractor to pay for the repair costs and the obligation to reimburse the insurance company for the defense costs?
• From the contractor's perspective, the perception is that the attorneys assigned by the insurance company may feel a divided loyalty: (1) to the contractor client and (2) to the insurance company that is paying the bills.
• From the insurer's perspective, the policy grants it the right to control the litigation, including the right to assign defense counsel to the case, and the policy also gives the insurer the right to expect the cooperation from its insured in terms of providing information and taking other steps to assist the insurer evaluate and defend the claims.
• When an actual conflict of interest exists because of the insurer's control over the litigation, the contractor is entitled to independent counsel at the expense of the insurer under California Civil Code section 2860. Independent counsel hired under this statute are sometimes know as "Cumis counsel" based on the decision in San Diego Credit Union v. Cumis Ins. Society (1984) 162 Cal App 3d 358.
•  Under California law, there are four circumstance in which a conflict will require the insurer to pay for independent counsel are: (1) where the insurer reserves its rights on an issue and the outcome of that coverage issue can be controlled by the insurer's retained attorneys; (2) where the plaintiff (property owner) and the defendant (contractor) are both insured by the same insurance company; (3) where the insurer files a lawsuit against the insured; and (4) where the insurer pursues a settlement for an amount that exceeds the policy limits without the insured's consent and leaves the insured exposed to claims by third parties.
• Contesting these types of issues must be done carefully in light of the insured's duty to cooperate. Actions to secure independent counsel or the protection of other rights under the policy must be done in such a way that does not undermine the perception that the insured is cooperating with the insurer and meeting all of its obligations under the terms of the policy. All communications from the contractor to the insured, including letters, faxes, and e-mail, should be written with the cooperation clause in mind. The same is true for telephone conversation as discussions with insureds and others are routinely noted in the claim adjuster's log.
• Pursuing a strategy of obtaining Cumis counsel has its own risks and rewards. Policyholders need to understand that an insurance company's obligations to pay for independent counsel are limited and that the potential exists that the policyholder will have to pay for a portion of the fees. This may happen, for example, when Cumis counsel's hourly rate is higher than the rate the insurance company is obligated to pay. 

Note: My colleagues at  IVAMS are sponsoring a webinar on "Cumis Counsel" on June 30, 2011, at 10:00 a.m. Click here to sign up for the event. One hour of CLE credit is available to webinar participants.

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For a long time construction defects and California law seemed to go together like peanut butter and jelly. It got a little sticky, however, for trial courts trying to deal with large, complex, multi-party cases, and builders who faced sizable jury verdicts. After many years of prolific construction defect cases, numerous vanguard appellate decisions,  and some intense lobbying by the construction industry, the California legislature enacted SB 800 in 2002. The law requires home owners to give notice and an opportunity to repair construction defects to builders prior to filing a lawsuit. However, the law, now codified in California Civil Code sections 895 through 945.5, gives builders the option of implementing their own contractual pre-litigation procedures for notice and repair of construction defects. The intent is to give builders an opportunity to repair construction defects before lawsuits are filed. If all goes well, contentious, expensive litigation can be avoided altogether.

Previously I posted an article and referred to a then new case that answered the question of whether the pre-litigation procedures under SB 800 amounted to a claim for purposes of triggering an insurance company's duty to defend ( See A Case of First Impression: Duty to Defend Construction Defect Claims in Pre-litigation Proceedings, July 28, 2010). This post addresses another aspect of the law: what happens if the builder elects to implement its own pre-litigation procedures into the purchase contract, and those procedures are found to be legally unenforceable? Can the builder then compel the buyer to follow the statutory pre-litigation procedures before filing a lawsuit?  In another case of first impression regarding the interpretation of SB 800, the California 5th District Court of Appeal said no. 

In Anders  v. Superior Court (Meritage Homes of California), home owners filed a construction defect lawsuit against Meritage Homes of California. Some of the home owners purchased their homes directly from Meritage and some of them purchased their homes from the original owners who had purchased their homes from Meritage. The original purchase contracts contained the builder's version of a pre-litigation notice and opportunity to repair procedure. In response to the lawsuit Meritage filed a motion to compel the home owners to follow the contractual pre-litigation procedures. The home owners opposed the motion. The trial court ruled that the alternative contractual procedures were unconscionable and unenforceable but also ruled that the homeowners would have to comply with the SB 800 requirements before proceeding with the lawsuit, and issued an order staying the litigation pending completion of the statutory pre-litigation procedures.

The home owners then filed a writ of mandate with the court of appeal to overturn that portion of the trial court's order requiring them to comply with the statutory procedures. The home owners argued that SB 800 provides that, if the builder's alternative procedures are found to be unenforceable, the builder may not enforce the statutory pre-litigation procedures and home owners are free to file a lawsuit without compliance with those procedures. The court of appeal agreed and issued a writ directing the trial court to vacate that portion of its order that required the home owners to comply with the statutory pre-litigation procedures. This meant the stay of the lawsuit would be lifted and the home owners could proceed with their lawsuit.

Practical Applications Of The Case

• Builders may be more likely to choose the statutory pre-litigation procedures rather than attempt to draft procedures that can withstand judicial scrutiny; and
• In the event the purchase contract does contain contractual pre-litigation procedures of the builder's making, home owners may be more willing to ignore them, file a lawsuit, and argue that the contractual procedures are unconscionable and unenforceable. 

Final thoughts: As long as people try to build homes, there will be construction defects. Which means there will always be construction defect litigation. Given this fact, it is important to try to find fair and efficient ways to resolve them. SB 800 was supposed to be the answer but in my work as a mediator, I have found that the pre-litigation procedures are effective only to the extent there is some element of good will and mutual respect among the parties and for the process. The Anders case illustrates what can happen when one side seeks to impose an unfair advantage over the other side. While contracts serve the important purpose of clearly establishing the terms and conditions of the deal, when you try to leverage your position by imposing  burdensome conditions on the other party, it can put you in a real jam.

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In response to an onslaught of construction defect cases, California enacted statutory procedures to encourage settlement of claims before a lawsuit is even filed. But those procedures usually involve attorneys and experts, and they cost money, so are insurance companies obligated to pay the defense costs even though a lawsuit has not officially been filed? In a case of first impression, a California Court of Appeal has answered that question in the affirmative.

 In Clarendon America Insurance Company v StarNet Insurance Co. (2010) Cal App 4^th, Centex Homes was the developer of a residential development in Simi Valley, California known as Westwood Ranch. In July 2006, the Westwood Ranch Homeowners Association served a notice of commencement of legal proceedings pursuant to California Civil Code section 1375 on Centex that set forth a list of alleged construction defects at Westwood Ranch. This step was taken in compliance with the Calderon Act which requires that developers and homeowners associations engage in a prelitigation effort to settle construction defect claims. If the claims can nor be settled, the homeowners association is then authorized to file a lawsuit.

StarNet Insurance had issued two successive CGL policies to one of Centex’s subcontractors on the project, and Clarendon America Insurance had issued a CGL policy to another subcontractor. Centex was a named additional insured on the policies issued by both carriers.

In December 2007, Centex filed a complaint against Clarendon seeking payment of defense fees and costs incurred in defending against the construction defect claims in the prelitigation proceeding known in California as the Calderon Process. Clarendon filed a cross-complaint against the other insurers, including StarNet, seeking a declaration they were obligated to provide Centex a defense and/or coverage. In the first amended cross-complaint, Clarendon sought indemnity, declaratory relief, and contribution from the additional insurers. Clarendon reached settlements with all of the other CGL insurers except StarNet.

StarNet moved for summary judgment asserting the prelitigation process did not constitute a "suit" within the meaning of the defense agreement in the StarNet CGL policies. The trial court denied the motion, holding the prelitigation procedure “ is a civil proceeding in which damages are alleged and therefore falls within the StarNet CGL policies' definition of ‘suit’…Additionally, the definition of 'suit' also includes alternative dispute resolution procedures to which the insured submits with the insurer's consent…Thus, even if the Calderon process is not considered to be a 'civil proceeding' if that phrase is narrowly interpreted to mean 'court action[,'] but rather is considered an 'alternative dispute resolution proceeding[',] there is a question of fact as to whether or not Star[N]et has a duty to defend once the Calderon process has begun."

After analyzing the language of StarNet’s policy according to the standard rules of insurance policy interpretation, the Court of Appeal made this important observation:

The Calderon Process is more than a prelitigation alternative dispute resolution requirement: It is part and parcel of construction or design defect litigation initiated by an association and, as such, cannot be divorced from a subsequent complaint.

In affirming the trial court’s ruling, the Court stated, “The function and significance of the Calderon Process in construction or design defect litigation, and the StarNet CGL policies' definition of "suit" to include civil proceeding, lead to the reasonable inference the parties' intended StarNet would have a duty to defend the insured in the Calderon Process. Extending the duty to defend to the Calderon Process is therefore consistent with a hypothetical insured's reasonable expectations.”

This is good news for contractors, developers and, of course, homeowner associations. Hopefully CGL carriers will be more forthcoming in participating in prelitigation procedures such as the Calderon Process in California. This holding should lead to more prelitigation resolutions of construction defect cases and facilitate the public policy reasons for the enacting such laws.

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This is part two of my series regarding insurance coverage issues in construction defect cases. In part one, I addressed common indemnity and defense issues. In this post, I will address how excess policies come into play when the exposure to liability for construction defects exceeds the policy limit of your primary insurance policy, typically a commercial general liability or CGL policy.

Depending on the size of the project, many contractors will have an added layer of insurance protection in the form of an excess or umbrella policy. These are policies that provide additional coverage for claims that exceed the limits of primary coverage and can be purchased for a relatively modest sum, compared to the premiums for primary insurance coverage.

Construction defects, which typically manifest slowly over time, will likely implicate the successive primary insurance policies of the general contractor and its subcontractors on large projects, and quite possibly their respective umbrella or excess policies. The questions of which excess policies are subject to the claims and when does an excess carrier’s duty to defend arise are common issues and often stand as barriers to the resolution of construction defect cases. The case of Padilla Construction v. Transportation Insurance Co. (PDF) illustrates some of these complexities.

Padilla Construction was a stucco subcontractor to a developer who was sued by the owners of two houses in an upscale development in Castro Valley, California. The developer filed a cross-complaint for indemnity against Padilla.  The primary defect claims that evolved over a seven year period included foundation drainage problems, excessive crawl space moisture problems, and decay and mold contamination to the under-floor framing. Padilla’s work was implicated by the allegations that the foundation vents at some locations were blocked with stucco.

Padilla was covered by various primary policies over an eight year span and one excess policy for two of those years.  The Court of Appeal summarized the applicable policies as follows:

          
The insured had four successive primary liability policies from January 1995 until March 1, 2003:
—From the beginning of 1995 to end of 1996: Transcontinental Insurance.
—From the beginning of 1997 to end of 1997: Reliance Insurance.
—From the beginning of 1998 to March 1, 2001: Legion Indemnity.
—From March 1, 2001, to March 1, 2003: Steadfast Insurance. Editor's Note: These policies required Padilla to pay $25,000 in self-insured retention (SIR) before Steadfast’s obligations came into effect.

Additionally, coincident with Transcontinental's primary policy (Jan. 1995 through the end of 1997), the insured had two yearly commercial umbrella policies issued by Transportation Insurance Company.

In tabular form, over the period of the continuing loss, the policies may be expressed this way:

Initially, Padilla tendered its defense to Transcontinental which was accepted. On the other hand, Reliance and Legion were insolvent and nothing was available from either carrier by way of defense. Padilla did not want Steadfast to get involved because it did not want to pay the $25,000 self-insured retention. Instead, when the Transcontinental policy was exhausted due to the payment of defense and indemnity costs on the Castro Valley project case and other claims, Padilla tendered the defense to its excess carrier, Transportation, on the basis that all other primary policies were either exhausted or their carriers were insolvent, and that there was no primary insurance available under the Steadfast policy because Steadfast had no obligation to defend due to the self-insured retention requirement. In other words, Padilla did not have any primary insurance through Steadfast unless and until Padilla paid the first $25,000 in defense or indemnity costs.

Eventually the parties in the Castro Valley project case reached a settlement, which included a $60,000 contribution from Padilla who, in turn, filed the subject insurance coverage case against the excess carrier, Transportation. The trial court ruled in favor of the excess carrier and the California Court of Appeal affirmed, stating that  “an excess insurer does not have a duty to defend an insured until ‘primary insurance’ in the form of a so-called ‘self-insured retention’ is exhausted applies here. The statement obtains with just as much force even if the excess insurer's 'other insurance' clause does not contain a direct reference to 'self-insurance'.

For a variety of reasons, the Padilla case is useful reading for anyone facing construction defect claims and trying to figure what insurance may be available to defend and indemnify the claims.

1. The way the Court organized the chronology of the applicable insurance policies is a good template for anyone trying to figure out the availability of insurance.
2.  There is a good discussion of the duty to defend in construction defect cases involving continuous damages. In the Padilla case, the blocked vents led to allegations of damages that spanned several years and therefore, implicated many policies. Thus even though the inception of the loss occurs in the policy period of one policy, the continuous nature of the damages can spill into the policy periods of additional carriers, making the successive carriers also  responsible for the defense of the claims.
3. The case points out that in California, anyway, the duty to defend the whole action arises when any portion of the damages falls within the policy period, even though the increments of harm preceding the policy period would not be covered by way of indemnity, reminding us that a carrier’s duty to defend is broader than its duty to indemnify.
4. We are also reminded that a carrier can seek reimbursement from its policyholder for defending that portion of the claims that may come before the inception date of the policy. Thus the good news in that situation is the carrier may have to fund the defense of all of the litigation, even the defense of damage claims that precede the policy, but the bad news is the carrier has the right to seek reimbursement for defending the uncovered damages.
5. Self Insured Retention or SIR must be paid and the primary policy exhausted before the excess carrier is required to defend and indemnify a claim.
6. The case has a good definition of self-insured retention: “while there ‘is no dispositive case law differentiating deductibles from SIRs,’ a deductible ‘usually relates only to the damages sustained by the insured, not to defense costs’ where an ‘SIR is generally a specific amount of loss that is not covered by the policy but instead must be borne by the insured.’”
7.  The case also provides a good explanation of the differences between excess and umbrella policies:" Technically, there is a difference between umbrella and excess policies. Umbrella coverage is a "type" of excess coverage, typically providing, as in the present case, for losses for which there may be no "underlying' insurance." The other type of excess coverage is "‘following form" coverage” which, as the name indicates, follows the form of a specific underlying policy. Because umbrella insurance provides coverage ‘for certain losses for which there may be no underlying insurance,’ they provide ‘broader coverage than the underlying insurance. By the same token they provide broader coverage than “form following” excess policies."
8. Finally, the case identifies the timing of when an excess insurer is obligated to defend a lawsuit in California: "The rule of “horizontal exhaustion” in liability insurance law requires all primary insurance to be exhausted before an excess insurer must “drop down” to defend an insured, including in cases of continuing loss. Unless there is excess insurance that describes underlying insurance and promises to cover a claim when that specific underlying insurance is exhausted (“vertical exhaustion”), the rule of horizontal exhaustion applies to cases of alleged continuing property damage—as often happens when the insured is sued for construction defects."

Being knowledgeable about insurance is the first step in the process of getting a carrier to defend and indemnify defect claims but, as Malcolm Gladwell said in his marvelous book,Blink,: ”The key to good decision making is not knowledge. It is understanding. We are swimming in the former. We are desperately lacking in the latter (p.265).” When construction defect claims arise, it is not enough to know you have excess insurance coverage. Padilla Construction knew it had an excess policy but did not understand  when or how to access it. I hope this post (and my prior one) will help you understand how to secure the full extent of insurance protection that is available to you.  

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