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Commercial Insurance Coverage Disputes

Arizona Supreme Court ruling impacts commercial insurance coverage disputes

Louis D. Lopez, Andrew R. Breavington and John Randall Jefferies
May 19, 2011

A recent ruling by the Arizona Supreme Court creates new law for commercial insurance coverage disputes and narrows defenses for insurance companies under commercial general liability (CGL) policies. The ruling on May 12 affirmed the decision of the Arizona Court of Appeals in Desert Mountain Props. Ltd. P'ship v. Liberty Mut. Fire Ins. Co., 225 Ariz. 194, 236 P.3d 421 (App. 2010).    

  1. The Facts

Desert Mountain Properties Limited Partnership (“DMP”) is a luxury community developer that completed two new Scottsdale residential subdivisions in 1995. Because each residence was built into the side of a mountain, foundations were built on a level bench filled with compacted soil. After various homeowners complained about cracks in floors and walls, DMP retained a consultant to complete a thorough investigation. The investigation revealed that a sub-contractor had inadequately compacted the soils upon which each home was built. This led to water filtering into foundations which cracked the floors, patio decking, and walls of all 50 homes.

In May 2001, DMP sought coverage for its costs to fix the damage under two CGL policies Liberty Mutual issued to DMP from August 1999 through November 2001. Liberty Mutual refused to authorize the work and reserved its right to assert the “voluntary payment clause” as a bar to coverage if DMP commenced the work. At the same time, however, Liberty Mutual would not tell DMP not to perform the work.

DMP was in an untenable position. If it did nothing and allowed the homeowners’ damages to increase, Liberty Mutual could deny the claim for failure to mitigate. Furthermore, various homeowners threatened litigation if DMP did not correct the damage. Liberty Mutual did not contribute to the approximate $7 million DMP paid to fix the damage. Liberty Mutual also refused to participate in litigation that DMP commenced to preserve its rights against its general contractor in October 2001.

Fennemore Craig brought suit on behalf of DMP after Liberty Mutual denied DMP’s claim in February 2003. After a twelve day trial, the jury found Liberty Mutual had breached its insurance contract with DMP.

  1. The Court of Appeals’ Decision

On appeal, Liberty Mutual claimed the trial court erroneously instructed the jury and erred by denying Liberty Mutual’s motion for judgment as a matter of law. The Court of Appeals’ opinion (225 Ariz. 194, 236 P.3d 421) addressed several important issues of first impression with regard to CGL insurance coverage disputes in Arizona.

  1. Court Action is not Required Before an Insured Is Legally Obligated to Pay Damages

The “insuring clause” of the CGL policy provided that Liberty Mutual would pay sums that DMP became “legally obligated to pay as damages.” Liberty Mutual asked the court to adopt the California minority view that an insurer’s duty to indemnify an insured for sums the insured becomes “legally obligated to pay as damages” only extends to amounts a court has ordered the insured to pay. Liberty Mutual argued DMP was not “legally obligated” to pay the remediation costs because DMP was not actually sued by any homeowners, no judgment was entered against DMP, and DMP had not entered into any formal settlement agreements.

The Court of Appeals refused to adopt the minority view. It held that a “legal obligation to pay” meant any obligation enforceable by law. The obligation existed independent of a lawsuit to enforce it, or a court order compelling performance. The court also rejected the notion that “damages” were only those “sums that a court orders to be paid.” Instead, the court defined “damages” as “the estimated money equivalent for detriment or injury sustained.”

  1. Absent Prejudice to the Insurer, An Insured’s Voluntary Payments Do Not Preclude Coverage

Liberty Mutual argued that because DMP voluntarily made payments without Liberty Mutual’s consent, the CGL policy’s “Voluntary Payments” clause precluded coverage of the repair costs. The Court of Appeals noted Liberty Mutual could only rely on the “Voluntary Payments” clause if DMP’s actions prejudiced Liberty Mutual’s rights to defend, settle or adjust the claim.

  1. A CGL Policy Provides Coverage for Economic Damages Arising in Contract

The CGL policy’s “insuring clause” provided liability insurance for “property damage” caused by “an occurrence.” The policy defined “an occurrence” as “an accident, including continuous or repeated exposure to substantially the same general harmful conditions.” Liberty Mutual argued that, as a general proposition, liability insurance only covered damages arising from “accidents” that result in tort claims, and not damages arising from breaches of contract. DMP’s liability to homeowners was contractual because it arose out of the purchase contracts between DMP and the homeowners.

The Court of Appeals declined to hold as a matter of law that a CGL policy does not cover liability arising out of contract. The CGL policy had various express limitations or exclusions that applied to certain contractual liabilities. None of these limitations or exclusions flatly barred coverage of all contract claims. The court would not impliedly read a limitation into the CGL policy that was absent from its plain language.

Liberty Mutual also argued for application of the economic loss doctrine, which bars recovery of damages caused by faulty workmanship if those damages are purely economic and do not arise from physical injury to persons or other property. Because the damages suffered by the homeowners under their purchase contracts with DMP were economic losses, Liberty Mutual argued the economic loss doctrine provided an independent basis to preclude coverage, separate and apart from whether or not an “occurrence” had taken place.

The Court of Appeals disagreed. It adopted the view held by Wisconsin and Texas that the economic loss doctrine is a liability defense or remedies doctrine, not a tool to interpret a CGL policy or a test to determine insurance coverage. The court held the proper inquiry should be whether “an occurrence” had caused “property damage,” regardless of whether the ultimate remedy for the claim arose in contract or tort.

  1. A “Contractual Liability” Exclusion Only Applies to Indemnity or Hold Harmless Agreements

The CGL policy’s “Contractual Liability” clause excluded coverage for property damages “for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.” Liberty Mutual argued this clause excluded coverage because DMP’s obligations arose out of its contracts and warranties with the homeowners. The Court of Appeals disagreed. It adopted the majority view that a “Contractual Liability” exclusion only applies when an insured assumes the liability of another under an agreement to indemnify or hold another harmless.

  1. The Supreme Court’s Affirmance

Upon petition by Liberty Mutual, the Supreme Court of Arizona granted review to consider: (1) whether a CGL policy covers an insured’s contractual liability for damage that caused only economic loss; (2) whether the CGL policy’s contractual liability exclusion applies only when an insured has assumed another’s liability by agreeing to indemnify or hold another harmless; and (3) whether an insured’s voluntary expenditures to repair property damages caused by construction defects resulted from a “legal obligation to pay damages.”

After considering Liberty Mutual’s and DMP’s briefs and oral arguments, the Supreme Court affirmed the Court of Appeals’ opinion on the issues presented for the reasons set forth by the Court of Appeals (--- P.3d ----, 2011 WL 1793913). In affirming without additional opinion or analysis, the Supreme Court fully endorsed the Court of Appeals’ reasoning. Arizona law, therefore, is that CGL policies do apply to liability arising out of contract.

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