Fifth Circuit Addresses Contractual Liability Exclusion

In its recent decision in Crownover v. Mid-Continent Cas. Co., 2014 U.S. App. LEXIS 20737 (5th Cir. October 29, 2014), the United States Court of Appeals for the Fifth Circuit withdrew its prior ruling and held that the contractual liability exclusion did not preclude an insurer’s duty to indemnify its insured for an award resulting from the insured’s defective construction.

Doug and Karen Crownover (the “Crownovers”) entered into a construction contract with Arrow Development (“Arrow) to construct a home on their land in Sunnyvale, Texas. The contract contained a warranty-to-repair clause that provided that Arrow would “promptly correct work….failing to conform to the requirements of the Construction Documents” (“paragraph 23.1”). After the work was completed, cracks began to appear on the walls and the foundation of the Crownovers’ home. There were also problems with the heating, ventilation, and air conditioning system that caused leaking in the exterior lines and air ducts of the home. The Crownovers spent several hundred thousand dollars to fix the problems. The Crownovers sent demand letters to Arrow, which Arrow sent to its insurer, Mid-Continental Casualty Co. (“Mid-Continent”). After failing to obtain the relief demanded, the Crownovers initiated an arbitration proceeding against Arrow. At the conclusion of the arbitration proceeding, the arbitrator awarded damages to the Crownovers for Arrow’s breach of paragraph 23.1 of the construction contract.

After the arbitration award, Arrow filed for bankruptcy. The bankruptcy court ruled that Crownovers could pursue recovery from any applicable insurance. As a result, the Crownovers sent a letter to Mid-Continent demanding that it pay the arbitration award. Citing several insurance policy exclusions, Mid-Continent denied their demand. The Crownovers then sued Mid-Continent for breach of contract.

In support of its denial, Mid-Continent cited the contractual liability exclusion in the Mid-Continent policy, which provided: “[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.” The exclusion also contained an exception for “liability…[t]hat the insured would have in the absence of the contract or agreement.” Mid-Continent took the position that the contractual liability exclusion applied because the arbitrator’s award to the Crownovers was based only on Arrow’s breach of paragraph 23.1 of the construction agreement.

The Crownover’s argued that the exception to the exclusion applied because Arrow would have been liable in the absence of the express warranty to repair. Specifically, the Crownovers contended that the implied warranty of good workmanship continued to apply to the contract they had with Arrow because the contract contained no express disclaimer of the implied warranty.

The district court granted judgment in favor of Mid-Continent and held that the contractual liability exclusion applied because the arbitrator’s award to the Crownovers was based solely on Arrows breach of the express warranty to repair nonconforming work. In rejecting the arguments raised by Crownovers, the district court explained that its analysis was confined to the arbitration award based on Arrow’s contractual liability. The Crownovers appealed.

In its initial June 2014 opinion, the United States Court of Appeals for the Fifth Circuit affirmed the district court’s ruling. Relying on Gilbert Texas Const., L.P. v. Underwriters and Lloyds London and Ewing Const. Co. v. Amerisure Ins. Co., the Fifth Circuit’s original opinion held that the contractual liability exclusion applied only if Arrow “assumed” a duty in its contract with the Crownovers that exceeded the liability it would have under general law. As the arbitration award was based on Arrow’s agreement to repair any damages under paragraph 23.1 of the contract, the court ruled the contractual liability exclusion applied.

The Crownovers subsequently filed a petition for rehearing with the Fifth Circuit, and the court withdrew its prior opinion and entered a ruling awarding summary judgment to the Crownovers. The court first ruled that the judgment in favor of the Crownovers awarded recovery for “property damage” caused by an “occurrence” as the award was for cracks in the walls and foundation and loss of use of the HVAC system.

Turning to the contractual liability exclusion, the court recognized that the burden was on Mid-Continent to prove application of the exclusion. Citing Gilbert and the Texas Supreme Court’s more recent decision in Ewing Construction Co. v. Amerisure Insurance Co., the court held that “the insurer must prove that a contractually-assumed duty effected an expansion of liability beyond that supplied by general law.” Although the source of Mid-Continent’s liability was its express contractual duty to repair, that alone was not sufficient to implicate the exclusion. Instead, the contractual liability must expand the general liability otherwise imposed on Arrow in its work. In this case, the contractual obligation to repair damages was no greater than Arrow’s general obligation to repair damages resulting from its failure to exercise reasonable care in performing work. Mid-Continent failed to establish that Arrow’s contractual duty to repair non-conforming work under the contract constituted an expansion of liability.

The court then analyzed the application of three other exclusions in the policy. It first determined that the “your work” exclusion could not preclude coverage for the award as the policies implicated by the award contained an exception that restored coverage for damage caused by the work of a subcontractor. Additionally, exclusions j.(5) (“property damage” to “that particular part of real property on which you or any contractors or subcontractors … are performing operations”) and j.(6) (“property damage” to “that particular part of any property that must be restored, repaired or replaced because ‘your work’ was incorrectly performed on it”) did not apply as the evidence established that the damage suffered by the Crownovers occurred after Arrow completed its work. Therefore, the Court reversed the district court’s ruling and awarded summary judgment in favor of the Crownovers.