The term “coverage” is somewhat of a misnomer, because it broadly refers to two distinct obligations on the part of an insurer: 1) the duty to indemnify, and 2) the duty to defend. The duty to indemnify requires the insurer to pay on behalf of the insured any monetary amount that the insured is legally obligated to pay as a result of a covered claim.
"An insurer's contractual duty to indemnify an insured is ordinarily not breached until an injured tort claimant has obtained a determination of liability and damages in an underlying tort action, and the insurer refuses to pay." Jones v. Hyatt Ins. Agency, Inc., 356 Md. 639, 649, 741 A.2d 1099, 1104 (1999). The duty to defend requires the insurer to pay on behalf of the insured the costs, fees and expenses necessarily incurred in defending third-party claims. Because these costs include expenses such as attorney’s fees, expert witness fees, and investigative costs, some Maryland courts have referred to the CGL insurance policy as "litigation insurance."
Under a CGL policy, the insurer has an obligation to defend any claim that is either actually covered or potentially covered under the policy. In Brohawn v. Transamerica Ins. Co.,276 Md. 396, 407, 347 A.2d 842, 850 (1975), the seminal Maryland case on the issue of the duty to defend, the court explained that:
[t]he obligation of an insurer to defend its insured under a contract provision . . . is determined by the [Plaintiff’s] allegations . . . If the plaintiffs . . . allege a claim covered by the policy, the insurer has a duty to defend. . . . Even if a tort plaintiff does not allege facts which clearly bring the claim within or without the policy coverage, the insurer still must defend if there is a potentiality that the claim could be covered by the policy.
276 Md. at 407-408; 347 A.2d at 850. Thus, the potentiality rule “broadens the insurer’s duty to defend beyond the scope of the duty to indemnify . . . As a result, the allegations in the underlying complaint may trigger the duty to defend [even] where it is unclear whether the insurer is ultimately obligated to indemnify the insured”; i.e., pay the claim. State Auto. Mut. Ins. Co. v. Old Republic Ins. Co., Civil Action No. RDB-14-2989, 2015 WL 4476097, 5, (D. Md. July 16, 2015) (internal citations omitted).
An overarching issue that permeates most construction defect coverage disputes is whether claims for faulty workmanship and/or construction defects constitute an occurrence under a standard CGL policy. CGL coverage is triggered in the context of a construction defect claim when there is a loss involving property damage caused by an occurrence that is not otherwise excluded. The term “property damage” is defined in 1986 ISO CGL policy to mean “[p]hysical injury to tangible property, including all resulting loss of use of that property.” The term “occurrence” is defined as “an accident, including continuous or repeated exposure to substantially the same general harmful conditions.” The CGL policy does not define the term “accident.”
However, under Maryland law an accident is an event that is neither expected nor intended from the subjective standpoint of the insured. Sheets v. Brethren Mutual Ins. Co., 342 Md. 634, 652, 679 A.2d 540, 548 (1996). Thus, unless otherwise excluded, a construction defect claim will trigger a duty to defend (and potentially a duty to indemnify) if there is an act that results in physical injury to tangible property or loss of use of tangible property, which was not reasonably anticipated to have occurred from the subjective standpoint of the insured contractor.
The 1986 ISO CGL Policy contains several exclusions, of which the “your work” exclusion is of particular significance when evaluating coverage for construction defects. The “your work” exclusion excludes coverage for property damage to a) the “work or operations performed by [the insured contractor] or on [the insured contractor’s behalf]”; b) the “materials, parts or equipment furnished in connection with such work or operation”; and c) “warranties or representations made at any time with respect to the fitness, quality, durability or performance of any of these items.” Thus, in the case of a contractor, the term “your work” necessarily includes all components of the project that the insured contractor is obligated to perform pursuant to its contract. For a general contractor, this typically encompasses the entire construction project. See, e.g., Mutual Ben. Group v. Wise M. Bolt Co., Inc.,227 F.Supp.2d 469 (D. Md. 2002) (holding that the work of a custom home builder is an entire house).
Although at first blush, the “your work” exclusion appears to exclude coverage for any claim asserted against a contractor for property damage to its work, the 1986 ISO CGL policy, contains an express exception to the “your work” exclusion which specifically states that the “your work” exclusion “does not apply if the damaged work or the work out of which the damage arises was performed on [the insured contractor’s] behalf by a subcontractor.” While the interplay between these insurance clauses, definitions, and exclusion may be difficult to grasp in the abstract, a review of some real world applications helps clarify the issues.
In Lerner Corp. v. Assurance Co. of Am., 120 Md.App. 525, 707 A.2d 906 (1998), the Maryland Court of Special Appeals made it clear that claims for the cost to cure the defective work performed by or on behalf of the insured does not meet the definition of an occurrence. Thus, if a claim is made against a contractor to repair or replace defective work performed by that contractor, there is no coverage available under the CGL Policy.
In Lerner, a developer and construction management firm sued their commercial general liability insurers seeking indemnity for the costs they were required to pay to repair defectively installed stone veneer on an office building they constructed. Id. at 908. The trial court granted summary judgment in favor of the defendant insurance carriers and held that the damages alleged arose out of the insureds’ breach of contract and, therefore, were not covered. Id.
On appeal, the Maryland Court of Special Appeals affirmed, and held that the insured developer and construction manager’s liability to correct the defectively installed veneer did not constitute an occurrence because the loss resulted from the insured’s failure to fulfill their contractual obligation to properly construct the building, not from “the happening of an ‘accident.’” Id. at 911. In reaching this conclusion, the Lerner Court reasoned that “[i]f the damages suffered relate to the satisfaction of the contractual bargain, it follows that they are not unforeseen. In other words . . . it should not be unexpected and unforeseen that, if the [b]uilding delivered does not meet the contract requirements of the sale, the purchaser will be entitled to correction of the defect.” Id. at 912.
It is significant that the only damage claim asserted in Lerner was a claim for the cost to repair the insured’s defective work. No claim was made for damage to other non-defective components of the building, and no claim was made for damage to other property, such as the owner’s personal effects. The Lerner court recognized this distinction and left open the question of whether coverage would exist had there been damage to property other than the defective work itself. In dicta the court reasoned that “if the [the defective veneer had caused] unrelated and unexpected ... property damage to something other than the defective [veneer] itself;” such as “if a collapse of the veneer had injured a user of the facility or damaged property other than the veneer itself, these may well be covered.” Id.
The question left open by the Lerner court was answered in French v. Assurance Co. of America, supra, by the U.S. Court of Appeals for the Fourth Circuit. In French, the court was called upon to determine whether a general contractor had coverage under its CGL policy for claims asserted against it for the cost to repair synthetic siding, which its subcontractor had improperly installed, and for damage to sheathing, drywall and flooring caused by moisture penetration through the defective siding.
The French court began its analysis by reviewing the Lerner decision and noting that Lerner “did not involve property damage to otherwise non-defective parts of the building.” Id. at 703. Thus, for analytical purposes, the court found it necessary to separate the owner’s property damage claim into two categories: 1) damages relating to the cost to repair the defective work itself; and 2) damages relating to the cost to repair non-defective components of the house damaged as a consequence of the moisture intrusion. Id. at 703.
As to coverage for the first category of claimed damages, the French Court concluded that Lerner unequivocally answered the question. The court explained that “just as the defective application of the building’s stone facade in Lerner did not constitute an ‘accident,’ and therefore [was] not an ‘occurrence’ . . . the defective application of the EIFS exterior to the Frenches’ home [did] not constitute an ‘accident,’ and therefore, not an ‘occurrence’ under the 1986 ISO CGL Policies.” Id. at 703. The court then reiterated that “[t]he obligation to repair the facade itself is not unexpected or unforeseen under the terms of the sales contract. Therefore, the repair or replacement damages represent economic loss and consequently would not trigger a duty to indemnify under a CGL policy.” Id. at 703.
The French court next focused on the issue left open by the Court of Special Appeals in Lerner; namely, does an insured contractor have coverage under its CGL policy when a subcontractor’s faulty workmanship causes damage to the otherwise non-defective work product of the insured contractor? The French court answered this question affirmatively, and based its decision upon dicta in Lerner, and the holding of the Supreme Court of Wisconsin in American Family Mut. Ins. Co. v. American Girl, Inc., 268 Wis.2d 16, 673 N.W.2d 65 (2004), which it cited with approval.
Specifically, the French court concluded that “under Maryland law the [1986 ISO CGL policy] provides liability coverage for the cost to remedy unexpected and unintended property damage to the contractor’s otherwise non-defective work-product caused by the subcontractor’s defective workmanship.” Id. at 706. In reaching this holding, the court found that the general contractor did not subjectively expect or intend that the non-defective structure and walls of the house would be damaged by moisture intrusion. As such, the court concluded that the moisture intrusion and resulting damage was an accident, and therefore, an occurrenc”, which was not expected or intended from the standpoint of the insured. Id. at 704.
Last summer, the U.S. District Court for the District of Maryland reached a similar result in State Auto. Mut. Ins. Co. v. Old Republic Ins. Co., supra. There, the court adopted the Fourth Circuit’s reasoning in French, and concluded that under Maryland law, damage to otherwise non-defective components of a heating, ventilation, and air conditioning system caused by a subcontractor’s failure to perform necessary water treatment was an “occurrence” under the insured contractor’s CGL policy, and triggered the insurer’s duty to defend. Id. at 4.
As the court explained, “[w]hen determining whether an “occurrence” transpired, Maryland law divides property damages into two categories. . . . The first category—foreseeable or expected damage—is not an “occurrence,” and thus implicates no obligations of the insurer under the CGL policy. . . The second category—damage to “otherwise nondefective” work—is unexpected and unforeseen, thereby triggering the duty of the insurer to defend the insured.” Id. (internal citations omitted).
In analyzing the holdings of French and State Auto. Mut. Ins. it is important to understand a few points. Initially, in both cases, the defective workmanship was performed by a subcontractor, not by the insured contractor. Had the siding installation in French and the improper water treatment in State Auto. Mut. Ins. been performed by the insured contractor itself, the subcontractor exception to the “your work” exclusion would be inapplicable. Under such circumstances, the claim for curing the defective work and the claim for repairing damage to the otherwise non-defective work of the contractor would both have been excluded.
It is also important to understand that in both French and State Auto. Mut. Ins. the only damage categories addressed by these courts were the costs to repair the defective work itself, and the cost to repair otherwise non-defective work damaged as a consequence thereof. Neither court focused on other categories of potential property damage, such as damage to the owner’s personal effects and furnishings, damage to items installed outside of the insured contractor’s scope of work and/or damage to work performed by the owner after completion of the initial construction. Hypothetically, if such items are damaged as a consequence of defective work, the “your work” exclusion is not applicable to those claims, and there is no need to analyze the subcontractor exception.
The case of Mutual Ben. Group v. Wise M. Bolt Co., Inc., supra is instructive on this point. In Bolt, suit was filed by an owner against the insured general contractor alleging that it had defectively constructed a custom home. In addition to damages for the costs to repair the contractor’s defective work, the owner claimed damages to other property including the owner’s furnishings. After suit was filed, the contractor tendered the claim to its liability insurer who denied coverage and filed a declaratory judgment action, arguing that it did not owe the contractor a duty to defend the owner’s claim.
The U.S. District Court for the District of Maryland granted summary judgment in favor of the insured contractor and concluded that because the owners were alleging damages to property other than the house itself the “your work” exclusion did not apply and the insured was required to defend the claim. Id. at 478. Specifically, the Bolt court explained:
On the record here, this Court concludes that the [owners] have alleged in the underlying action property damage caused by an “occurrence.” The central question in this case is whether the [owners] have alleged damages to something other than the [contractor’s] product, namely the house. The Court concludes from a review of the amended complaint that the [owners] have alleged damages both to the house and to other property. . . . The amended complaint therefore contains allegations which are potentially covered by the Policy even though they may be attenuated.
Id. at 476 (citing Sheets, 342 Md. at 643, 679 A.2d 540).
What we can take away from this discussion is that in Maryland, the question of whether a CGL insurance policy provides a contractor with coverage for defective work does not have a one size fits all answer. Resolving this question necessarily involves identifying the relationship between the party whose work is at issue and the insured, and analyzing the nature and cause of the damages being claimed. Often, as was the case in French, the answer is both “yes” and “no.”
David B. Applefeld is the chair of litigation at Adelberg, Rudow, Dorf & Hendler, LLC, Baltimore.