To Expand Contractual Liability Exclusion or Not to Expand?

The construction industry has been aware of the important role that contracts play in business since before “artisans” became known as “contractors.” It is difficult to imagine a modern construction project without a contract. Most contractors purchase commercial general liability (CGL) insurance policies that are composed of similar—if not identical—terms and provisions, regardless of the type and location of the project. Because any suit against a contractor for failures or defects in a completed project that lead to injury or property damage can be expected to result in notice to the contractor’s CGL carrier, the question of whether the contractual liability exclusion excludes coverage for such suits is quite important.

The contractual liability exclusion can be found in the exclusions section of Insurance Services Office’s (ISO’s) CGL coverage form, CG 00 01 (12/07), and it has been copied almost verbatim in numerous insurer-drafted liability coverage forms. Under the contractual liability exclusion, liability is excluded for claims that an insured is required to pay because of an assumption of liability in a contract or agreement. However, the exclusion does not apply to liability the insured would have had absent the contract or liability assumed through “insured contracts.” Id.

In Ewing Construction Co., Inc. v. Amerisure Insurance Co., 684 F.3d 512, 519 (5th Cir. 2012), withdrawn, 690 F.3d 628 (5th Cir. 2012), the Fifth Circuit ruled that a construction contract that included a clause agreeing to complete work in a workmanlike manner triggered the contractual liability exclusion under the contractor’s CGL policy. The Fifth Circuit later vacated this ruling and instead certified two questions to the Texas Supreme Court. The impact of the Texas Supreme Court’s response to these certified questions and the forthcoming Fifth Circuit ruling in this case have the potential to be felt by all construction contractors and the industry as a whole.

Olympic and the Majority View of the Contractual Liability Exclusion

Since 1966, the ISO CGL form has provided some degree of contractual liability coverage. See Peter J. Kalis, Thomas M. Reiter & James R. Segerdahl, Policyholder’s Guide to the Law of Insurance Coverage 9–5 (Aspen 1997). The mechanics of how that coverage has been provided requires a more in-depth analysis of the coverage form’s provisions. The first mention of contractual liability is in the contractual liability exclusion itself. Although written as an exclusion, the provision also adds coverage back to the insured for liability the insured would have incurred absent the contract or agreement and for liability incurred from a specific set of enumerated “insured contracts.” This exclusion and its exceptions have changed very little in the various updates to the general liability coverage form. The current form provides in pertinent part as follows:

This Insurance does not apply to:

ISO CG 00 01 at 2 (12/07) (emphasis in original).

As most practitioners are aware, the CGL policy insures the policyholder against liability for property damage and personal injury suffered by third parties. The contractual liability exclusion generally excludes coverage for liability the insured assumes through contract. Exceptions to the exclusion restore contractual liability coverage for liability the insured would have had notwithstanding any contract and for “insured contracts.” The ISO form CGL policy defines “insured contract” to include very specific types of contracts: for a lease of premises, a sidetrack agreement, an easement or license agreement, an obligation required by ordinance to indemnify a municipality, an elevator maintenance agreement, and “[t]hat part of any other contract or agreement pertaining to your business . . . under which you assume the tort liability of another party to pay for ‘bodily injury’ or ‘property damage’ to a third person or organization.” This final type of insured contract is further clarified to indicate that “[t]ort liability means liability that would be imposed by law in the absence of any contract or agreement.” ISO CG 00 01 at 13 (12/07).

In 1982, the Alaska Supreme Court in Olympic, Inc. v. Providence Washington Insurance Co., 648 P.2d 1008 (Alaska 1982), interpreted the contractual liability exclusion. It should be noted that the version of the contractual liability exclusion in this case used the phrase “liability assumed by contract,” whereas the updated version uses the slight variation “by reason of the assumption of liability.” The court found that “‘liability assumed by contract’ refers to a particular type of contract—a hold harmless or indemnification agreement—and not to the liability that results from breach of contract  . . .” This view, which now represents the majority approach, interprets the exclusion in a manner designed to enforce what several courts have seen as its purpose.

Whether to interpret the contractual liability exclusion to include breach of contract claims has been the key question faced by courts in deciding cases involving the exclusion. See, e.g., Younglove Constr., LLC v. PSD Dev., LLC, 767 F. Supp. 2d 820, 823–24 (N.D. Ohio 2011); James v. Burlington N. Santa Fe Ry. Co., No. CV05-04106-PCT-NVW, 2007 WL 2461685, at *5 (D. Ariz. Aug. 27, 2007); Am. Family Mut. Ins. Co. v. Am. Girl, Inc., 673 N.W.2d 65, 80–81 (Wis. 2004). The key language for many courts in deciding this issue has been the phrase “by reason of the assumption of liability.” ISO CG 00 01 at 2 (12/07) (emphasis added). Specifically, courts have held that “[t]he term ‘assumption’ must be interpreted to add something . . . [as] [r]eading the phrase to apply to all liabilities sounding in contract renders the term ‘assumption’ superfluous.” Am. Family Mut. Ins. Co. v. Pleasant Co., 652 N.W.2d 123, 129–31 (Wis. Ct. App. 2002), rev’d on other grounds, 673 N.W. 2d 65 (Wis. 2004). This reading gives force to the exclusion’s first exception concerning liability “the insured would have in the absence of the contract or agreement . . . ” Absent a contract to perform work, an insured can still be held liable for its own negligence or under a variety of other legal theories. For that reason, the courts following the majority view have held that breach of contract claims based on the insured’s negligence do not constitute “assumed” liability and therefore do not fall within the contractual liability exclusion.

Contrary Interpretations More Prevalent Than Many May Believe

A National Perspective
The interpretation of the contractual liability exclusion in Olympic has been followed and cited by numerous other courts. See, e.g., Provident Bank of Md. v. Travelers Prop. Cas. Corp., 236 F.3d 138 (4th Cir. 2000); Federated Mut. Ins. Co. v. Grapevine Excavation, Inc., 197 F.3d 720 (5th Cir. 1999); Musgrove v. Southland Corp., 898 F.2d 1041, 1045 (5th Cir. 1990); David Lewis Builders, Inc. v. Mid-Continent Cas. Co., 720 F. Supp. 2d 781, 788 (N.D. Tex. 2010); United Nat’l Ins. Co. v. Int’l Petroleum & Exploration, No. 2:04-CV-00631, 2007 WL 4561460, at *8 n.46 (D. Utah Dec. 20, 2007); James v. Burlington N. Santa Fe Ry. Co., No. CV05-04106-PCT-NVW, 2007 WL 2461685, at *4–5 (D. Ariz. Aug. 27, 2007); Am. Family Mut. Ins. Co. v. Am. Girl, Inc., 673 N.W.2d 65, 80–81 (Wis. 2004); Gibbs M. Smith, Inc. v. U.S. Fidelity & Guar. Co., 949 P.2d 337, 341 (Utah 1997); Broadmoor Anderson v. Nat’l Union Fire Ins. of La., 912 So. 2d 400, 407 (La. Ct. App. 2005).

Several courts within the states of the Fifth Circuit, however, have cited Olympic but held counter to that case’s holding. See Deville v. Conmaco/Rector, No. 09-7391, 2010 WL 4003996 (E.D. La. Oct. 12, 2010); Brookshire Bros. Holding, Inc. v. Total Containment, Inc., No. 04-1150, 2006 WL 3692770, at *7 (W.D. La. Dec. 11, 2006); Gilbert Tex. Constr., L.P. v. Underwriters at Lloyd’s London, 327 S.W. 3d 118 (Tex. 2010). Other decisions within the Fifth Circuit have been decided similarly but have not specifically cited Olympic. See Doucet v. Huffine Roofing & Constr., 841 So. 2d 916 (La. Ct. App. 2003); Allstate Ins. Co. v. Roy, 653 So. 2d 1327 (La. Ct. App. 1995). A few others throughout the country had also held counter to Olympic. See Am. Nat’l Prop. Cas. Co. v. Blocker, 165 F. Supp. 2d 1288, 1296–97 (S.D. Ala. 2001); State Farm Fire & Cas. Co. v. Tillerson, 777 N.E.2d 986 (Ill. 2002); Hertz Corp. v. Smith, 657 A.2d 1316 (Pa. 1995); Silk v. Flat Top Constr., Inc., 453 S.E.2d 356 (W. Va. 1994). Others have since joined them in moving away from what has been viewed as the majority interpretation of the contractual liability exclusion—as discussed above—and have instead applied the exclusion literally, thereby broadening its scope and excluding all liability incurred by an insured through work conducted pursuant to contract. Owners Ins. Co. v. Shep Jones Constr., Inc., No. 08-AR-514-S, 2012 WL 1642169, at *6 (N.D. Ala. May 3, 2012); Younglove Constr., LLC v. PSD Dev., LLC, 767 F. Supp. 2d 820, 826 (N.D. Ohio 2011); Assurance Co. of Am. v. Admiral Ins. Co., No. 10-0117-CG-C, 2011 WL 1897589, at *7–8 (S.D. Ala. May 18, 2011); Westfield Ins. Co. v. Dan “K” Service Co., No. 4:04CV69-R, 2006 WL 250480, at *4 (W.D. Ky. Feb 1, 2006). This includes third-party tort liability assumed through contract as well as negligent breach of contract. Many legal scholars have stated that this interpretation of the contractual liability exclusion has “received little reception in the courts . . . .” 4 Philip L. Bruner & Patrick J. O’Connor, Jr., Bruner & O’Connor Construction Law § 11:109 (West 2002). However, the Fifth Circuit’s vacated opinion in Ewing Construction case could hardly be considered an outlier.

One of the earliest cases to acknowledge the possibility that the contractual liability exclusion could be applied to any claim based on work related to a contract is Cal-Farm Insurance, Co. v. TAC Exterminators, 218 Cal. Rptr. 407 (Cal. Ct. App. 1985). Although that case involved a hold harmless agreement and was decided on other grounds, the California Court of Appeal’s ruling presented an interpretation that served as a catalyst for the anti-Olympic view of the contractual liability exclusion. The Cal-Farm court stated in its opinion that the exclusion “refers to liability assumed under contract, but it does not specify what kind of contract. While it could be referring to an indemnity contract . . . it could also mean any contract [an insured] might enter into in the ordinary course of business.” Id. at 414 (emphasis in original). Although this view of the contractual liability exclusion did not take hold in California, the California Court of Appeal’s willingness to expand the exclusion to any contract entered into during the ordinary course of business is an early example of a court applying the exclusion in a manner counter to the majority view. This alternative application would soon be seen in the construction context as well.

One of the first construction cases to apply the contractual liability exclusion to breach of contract claims was Silk v. Flat Top Construction, Inc., 453 S.E.2d 356 (W. Va. 1994), a case decided in 1994 by the Supreme Court of Appeals of West Virginia. In that case, the Silks operated as their own general contractor in building their home, but they entered into a contract with Flat Top Construction to serve in a supervisory capacity over the project. When the home’s construction was completed over budget and late, the Silks sued Flat Top for breaching the “supervisory consultant agreement” between the parties. When Flat Top’s CGL insurer refused to defend the claims, Flat Top filed suit against the insurer. Although the claims against Flat Top were couched as breach of contract, some of the claims could be argued to actually be negligence claims. These claims included failure to “properly supervise and inspect the work,” materials, and expenditures, as well as failure “to ensure that the construction of the house conformed to the Contract Documents and plans.” Although the court acknowledged Flat Top’s argument that the claims could be brought under a common-law duty of care theory, the court dismissed that argument and held that Flat Top’s liability was a result of the contract with the Silks and was therefore excluded by the contractual liability exclusion. Id. at 357, 358, 360.

In 2006, the United States District Court for the Western District of Kentucky decided Westfield Insurance Co. v. Dan “K” Construction, No. 4:04CV69-R, 2006 WL 250480 (W.D. Ky. Feb. 1, 2006). Like the court in Silk v. Flat Top Construction, this court interpreted the contractual liability exclusion to exclude coverage for breach of contract claims based on a contractor’s negligence. A buyer of a home contracted with Dan “K” to complete a home inspection prior to the home’s purchase. After completing the purchase of the home, the homeowner discovered several faults in the home that Dan “K” negligently failed to find or notify the homeowner about. Dan “K” looked to his CGL policy for coverage against the claims, and his insurer filed a declaratory judgment action to determine its duty to defend and indemnify the insured. Despite the insured’s arguments that the homeowner’s claims were based in negligence, the court found that the contractual liability exclusion excluded coverage because “Dan K would not have had these liabilities without the contract [with the homeowner].” Id. at *1, *4.

Alabama Courts and the Contractual Liability Exclusion
Alabama jurisprudence on the contractual liability exclusion is plentiful and consistent. In 1983, the Supreme Court of Alabama held that all claims based on breach of contract “fall squarely within the clear and unambiguous terms of the [contractual liability exclusion].” Carter v. Cincinnati Ins. Co., 435 So. 2d 42, 45 (Ala. 1983). The court has continued this precedent in applying the contractual liability exclusion to cases involving construction related claims. Ajdarodini v. State Auto Mut. Ins. Co., 628 So. 2d 312, 314 (Ala. 1993) (“Because the policy clearly excludes breach of contract claims from its coverage, the trial court properly determined . . . [the insurer] has no duty to pay the judgment against the [insured].”). This precedent recently led the federal district courts in both the Northern and Southern Districts of Alabama to read the contractual liability exclusion to exclude claims for contractors’ faulty workmanship.

In the Northern District of Alabama case of Owners Insurance Co. v. Shep Jones Construction, Inc., No. 08-AR-514-S, 2012 WL 1642169 (N.D. Ala. May 3, 2012), a CGL insurer filed a declaratory judgment action against its insured general contractor (GC) to determine its duty to defend and/or indemnify the GC for claims filed by a homeowner who contracted with the GC to complete renovations to her home. The homeowner’s claims were based on “breach of contract, negligence, and negligent supervision” that caused damage as a result of faulty workmanship and the “quality of the services performed by [the GC] [not meeting] the requirements of the parties’ contract.” In Owners, the district court ruled that all of the claims were excluded by the contractual liability exclusion because “[i]n Alabama . . .  an insurer is not liable for damages assumed by the insured under a contract.” Id. at *1.

This holding has been echoed by the Southern District of Alabama in Assurance Co. of America v. Admiral Insurance Co., No. 10-0117-CG-C, 2011 WL 1897589 (S.D. Ala. May 18, 2011). Similar to Owners, Assurance involved a GC sued by a homeowner who contracted with the GC to build a home. After the GC had completed the project, the homeowner experienced water damage to the home because of faulty workmanship. In the suit that followed, the complaint against the GC included only one count for breach of contract stemming from faulty workmanship. Even though the claim against the GC solely involved the GC’s failure to complete the project in a workmanlike manner, the court ruled that the claim against the GC “alleges breach of contract, [and] falls squarely with the contractual liability exclusion . . . because it plainly arises from the assumption of liability in a contract.” Id. at *1, *2, *8 (citing Carter v. Cincinnati Ins. Co., 435 So. 2d 42, 45 (Ala. 1983)).

The Evolution of the Exclusion in Texas

The Texas Supreme Court’s Holdings in Gilbert and Lamar Homes
Like Alabama, the State of Texas has also decided cases within the construction law context that have resulted in an expansion of the contractual liability exclusion. The Fifth Circuit’s vacated decision in Ewing Construction was largely based on the Texas Supreme Court’s opinion in Gilbert Texas Construction, L.P. v. Underwriters at Lloyd’s London, 327 S.W.3d 118 (Tex. 2010). Gilbert involved a Dallas Area Rapid Transit Authority (DART) contract with Gilbert Construction, a GC, to build a light rail system for the City of Dallas, Texas. The contract with DART required Gilbert to protect the area around the construction site and to repair any damage to property owned by third parties that was caused by Gilbert’s work. Heavy rains caused flooding that damaged a building near the construction site, and the building owner sued Gilbert for the building’s repair. Gilbert’s primary insurer assumed its defense, but its excess insurer maintained that it had no duty to defend and arguably no duty to indemnify. The bulk of the building owner’s claims against Gilbert were dismissed as a result of Gilbert establishing governmental immunity as a contractor for DART, but a claim for breach of contract based on the building owner’s status as a third-party beneficiary survived summary judgment. Gilbert settled with the building owner and then looked to its excess insurer for indemnification. The excess insurer denied the claim, and Gilbert sued in state court. Id. at 121–23.

The Texas Supreme Court held that the contractual liability exclusion in Gilbert’s CGL policy precluded coverage because Gilbert’s contract with DART required that Gilbert assume legal responsibility for property damage to third parties. The court reasoned that as this liability was shifted to Gilbert through contract, the contractual liability exclusion was applicable solely by its plain meaning. Id. at 127 (applying the dictionary definitions of “assume” and “liability”). The court expressly rejected the Olympic approach followed by other courts that hold “assumption of liability” means the assumption of liability of another party, such as through “a hold harmless or indemnification agreement.” Instead, the Texas Supreme Court held that the contractual liability exclusion “means what it says . . . .” Id. at 126, 129.

The Gilbert court also stated that its “interpretation of the policy accords with longstanding principles of insurance contract interpretation.” Id. at 130. Gilbert, however, had argued that such a holding was a complete divergence from the court’s ruling in Lamar Homes, Inc. v. Mid-Continent Casualty Co., 242 S.W.3d 1 (Tex. 2007), made just four years earlier. In Lamar Homes, the Texas Supreme Court specifically held that the definition of “occurrence” in a CGL policy can include breach of contract claims and that coverage for such claims is not dictated by the manner in which the claimant labels its cause of action against the insured. The court, however, dismissed Gilbert’s argument and ruled otherwise. Although the Gilbert court acknowledged that other jurisdictions—including the Fifth Circuit—have interpreted the contractual liability exclusion differently than in the analysis provided in Gilbert, the court dismissed those alternative interpretations as having been based on different versions of the exclusion. Gilbert, 327 S.W.3d at 128–30 (referring to the 1973 and 1986 ISO forms). Those versions  differed only by slight variations in terminology and have been interpreted by other courts to be consistent with the original analysis provided by the Olympic case. In 1986, the enumerated list of “incidental contracts” found in the 1973 ISO form remained unchanged, but they were retitled as “insured contracts.” See Kalis, supra. See also the cases cited above that specifically cited Olympic, Inc. v. Providence Washington Insurance Company in arriving at this holding.

Overall, the Fourth, Fifth, and Seventh Circuits, as well as various district courts and state supreme courts, have interpreted the contractual liability exclusion in the same manner. See Krueger Int’l, Inc. v. Royal Indem. Co., 481 F.3d 993, 996 (7th Cir. 2007); Provident Bank of Md. v. Travelers Prop. Cas. Corp., 236 F.3d 138 (4th Cir. 2000); Musgrove v. Southland Corp., 898 F.2d 1041, 1045 (5th Cir. 1990); United Nat’l Ins. Co. v. Int’l Petroleum & Exploration, No. 2:04-CV-00631, 2007 WL 4561460, at *8 n.46 (D. Utah Dec. 20, 2007); King Cnty. v. Travelers Ins. Co., No. C94-1751Z, 1996 WL 257135, *4 (W.D. Wash. Feb. 20, 1996); Office Structures, Inc. v. Home Ins. Co., 503 A.2d 193, 197 (Del. 1985); Smithway Motor Xpress, Inc. v. Liberty Mut. Ins. Co., 484 N.W.2d 192, 196 (Iowa 1992). But see the cases cited above that were decided counter to Olympic.

Ewing Construction and the Fifth Circuit’s Initial Take
The Gilbert decision set the stage for the Fifth Circuit when Ewing Construction was appealed from the Southern District of Texas. 684 F.3d 512, 516 (5th Cir. 2012), withdrawn, 690 F.3d 628 (5th Cir. 2012). In 2008, Ewing Construction entered into a contract with the Tuloso-Midway Independent School District to build tennis courts at one of the district’s schools. Shortly after the tennis courts were completed, the surface on each court began flaking and cracking—making the court unusable for play. The school district filed suit in Texas state court against Ewing for damages from defective construction caused by Ewing’s failure to properly supervise subcontractors and to complete the project in a good and workmanlike manner. Ewing tendered defense of the suit to its general liability insurer, Amerisure Insurance Co. Amerisure denied coverage. Ewing filed suit against Amerisure in the District Court for the Southern District of Texas. Following cross-motions for summary judgment, the district court granted Amerisure’s motion, holding that “Amerisure owed no duty to defend or indemnify Ewing in the underlying lawsuit because the CGL policy’s contractual liability exclusion excluded coverage, and no exception applied.” Id.

Ewing appealed to the Fifth Circuit Court of Appeals. In June 2012, a divided panel of the Fifth Circuit affirmed the district court’s ruling on grounds that the school district’s “complaint in the underlying lawsuit reflects that the insured, Ewing, assumed liability for defective construction by agreeing in a contract to complete a construction project . . . [and] the CGL policy’s contractual liability exclusion excludes coverage in the instant case.” To reach that decision, the court looked to Gilbert and concluded that the contractual liability exclusion was to be applied literally, “[a]pplying the plain language of the exclusion, rather than grafting additional language to it.” This meant that the phrase “assumption of liability in a contract” in the contractual liability exclusion was to include the “assumption of implied contractual duties” such as completing a project in a workmanlike manner. The court supported its rationale by arguing that the plain meaning approach “preserves the longstanding principle that a CGL policy is not protection for the insured’s poor performance of a contract.” Id. at 519 (citing Lamar Homes, Inc. v. Mid-Continent Cas. Co., 242 S.W.3d 1, 10 (Tex. 2007)).

On August 8, 2012, the court vacated its June decision, 690 F.3d 628 (5th Cir. 2012), vacating as moot 684 F.3d 512, 519 (5th Cir. 2012), stating that because the case “involves important and determinative questions of Texas law as to which there is no controlling Texas Supreme Court precedent, . . .” the court was certifying two questions to the Texas Supreme Court. The two questions are as follows:

In its decision to vacate and certify, the Fifth Circuit analyzed both Lamar Homes and Gilbert before admitting that “[t]he correct application of this Texas precedent to the facts before us is unclear.” The court couched its questions to the Texas Court in the need for a clarified understanding of Gilbert’s application to express and implied warranties in the construction contract context, stating that if Gilbert “should be read as holding that the exclusion” applies to both express and implied warranties, then the contractual liability exclusion in Ewing would exclude coverage for the school district’s claims. Id. at 632.

The forthcoming response from the Texas Supreme Court and the resulting Fifth Circuit opinion based on those answers loom large over construction contractors and insurers in Texas and elsewhere. The ultimate decision in Ewing is likely to have a substantial impact on CGL policies in the construction context because what was once thought to be an isolated interpretation by a few courts may be legitimized by the Texas Supreme Court’s response and, ultimately, a Fifth Circuit opinion.

The Potential Impact of Ewing

If the Texas Supreme Court answers the questions certified to it by the Fifth Circuit in Ewing in a manner that follows its previous decision in Gilbert, and the Fifth Circuit reinstitutes the vacated opinion or issues a similar decision, the impact on general liability insurance coverage for contractors will be significant, at least in Texas. It may have ramifications beyond that, causing other courts—undecided on the issue—to follow the Texas-Alabama reasoning, or it may result in reconsideration by jurisdictions already following the reasoning in Olympic.

Keywords: construction litigation, contractual liability exclusion, commercial general liability, CGL, workmanlike manner, Texas Supreme Court, Ewing Construction Co., Inc. v. Amerisure Insurance Co.

Jim Warren and Brent Cole are with Carroll Warren & Parker in Jackson, Mississippi.

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