Critical Issues to a Determination of Coverage and Effective Reservation of Rights

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Faced with cross motions for summary judgment in a declaratory judgment action seeking coverage determination, the United States District Court for South Carolina recently employed exacting scrutiny in its analysis of the policies, the reservation of rights letters and the parties’ respective positions. Stoneledge at Lake Keowee Owners Association, Inc. v. Cincinnati Insurance Company and Builders Mutual Insurance Company, 2018 WL 4689135 (September 28, 2018).  

Plaintiff, a South Carolina non-profit corporation, manages Stoneledge at Lake Keowee, a horizontal property regime that includes 80 dwelling units. Alleging various construction defects, Plaintiff brought suit against, inter alia, Marick Homes Builders, LLC (“Marick”) and its principal, Rich Thoennes (collectively the “Insureds”), asserting they acted as the general contractor of certain units. Plaintiff also alleged the Insureds, along with IMK Development, LLC (“IMK”) and its principals, placed certain of the units into the stream of commerce. The causes of action included negligence, breach of the implied warranty of habitability, breach of the implied warranty of workmanlike service and breach of fiduciary duty. The case was divided into two separate actions; Phase I and Phase II. Plaintiff secured a verdict in Phase I, following which Plaintiff and the Insureds stipulated the amount of damages due Plaintiff for Phase II, eliminating the necessity of trial. Because Cincinnati Insurance Company (“CIC”) and Builders Mutual (collectively the “Insurers”), had issued commercial general liability (“CGL”) policies to the Insureds, they were parties to the stipulation. Plaintiff and Insurers agreed to proceed with this declaratory judgment action in which Plaintiff sought an order finding the Insurers responsible for payment of damages on Phase I and Phase II. The Insurers sought a determination they were not obligated to provide coverage based upon the standard “your work” exclusion; the policies did not provide coverage for any breach of contract or warranty claims; certain policies did not have coverage to the extent the “property damage” did not occur during the particular policy period as well as other grounds.

1. General South Carolina Insurance Law

As frequently addressed in this forum, insurance policies are subject to the general rules of contract construction. The language of the contract must be given its plain, ordinary and popular meaning. If terms are ambiguous or conflicting, they must be construed liberally in favor of the insured and strictly against the insurer. Despite the requirement of liberal construction in favor of an insured in the event of an ambiguity, the court may not rewrite a policy nor may it grant substantive rights when the meaning of the policy is clear. 

2. “Your Work” Exclusion

Standard CGL policies exclude coverage for “property damage” to “your work” arising out of it or any part of it and included in the “products completed operations hazard.”

Here, Marick arrived on the project and completed work performed by a previous contractor. The original work resulted in certain water instruction issues. At trial, Marick was found responsible for Plaintiff’s damages resulting from water intrusion in Phase I.  In the instant action,  Builders Mutual used Marick’s liability as a basis for its contention that if Marick was found responsible for the Phase I work,  that work must have been Marick’s and thus excluded from coverage.  Plaintiff conversely alleged the “your work” exclusion did not apply to the water intrusion issues because they resulted from the work of the previous contractor and the damages were therefore covered. Because there was evidence of property damage to work performed by the first contractor before the engagement of Marick, Builders Mutual was not entitled to summary judgment on the “your work” exclusion.

3. Applicable Policy Periods

CIC argued it had no obligation to provide coverage under certain of its policies because they were not effective until after the underlying action began. As to another of its policies, it contested coverage alleging Marick was on notice of Plaintiff’s claims before the commencement of the policy term. While not definitively decided, because there was evidence before the court upon which the factfinder could reasonably conclude  the Insureds did not learn “property damage” had occurred or had begun to occur until the commencement of the first policy period, CIC was not entitled to exclude coverage on that basis.  

Although CIC’s assertion that the underlying action was initiated after the commencement of its subsequent policies was factually correct,  Plaintiff argued and the court agreed, CIC failed to adequately disclose to the Insureds its intention to contend coverage was limited based upon the “known loss” provisions of its policies. Relying on Harleysville, the court concluded CIC did not provide proper notice of its intent to later litigate which policy periods applied nor did it inform the Insureds that a conflict of interest may have existed. Therefore, the court concluded CIC waived the right to contest coverage on the “known loss” exclusions.

4. Breach of Warranty Claims

The Insurers argued they had no duty to provide coverage for any claims “based upon contract” including breach of warranty claims founded upon the Insureds’ failure to replace or repair their defective work. The court agreed with the Insurers’ arguments that repair of faulty workmanship was not covered under the CGL policies. Again, however, relying on the reservation of rights letters, and the Harleysville standard under which such letters are analyzed, the court found the Insurers did not effectively reserve the right to challenge coverage for the claims based upon breach of warranty and repairs for defective construction.  

In its reservation of rights letters, Builders Mutual indicated there may be coverage issues and further indicated the Insureds may want to associate their personal attorney, at their expense. Builders Mutual made nothing more than a broad statement that work product was not covered. CIC’s reservation of rights letters referenced several exclusions but failed to explain CIC’s position as to those exclusions. In its analysis of the reservation of rights letters, the court found that none of them adequately advised the Insureds of the need for allocation of covered and non-covered losses or a possible conflict of interest.  Further, none of the letters advised of the Insurers’ intent to pursue a declaratory judgment action following an adverse verdict. Thus, the court found the Insurers failed to effectively reserve their rights to challenge coverage for the claims for breach of warranty and repairs.

5. Breach of Fiduciary Duty Claim

Insurers argued the breach of fiduciary duty claim was not covered inasmuch as neither IMK, nor Thoennes, a principal of IMK, were insureds under the applicable policies. This claim was particularly critical to Plaintiff as South Carolina recognizes a claim for breach of fiduciary duty against developers but no such claim has been allowed against contractors. The court made a detailed review of Plaintiffs' several factual allegations in support of its claims that IMK was the alter ego of Marick and that IMK and Marick should be viewed as amalgamated. Because the record before the court on the cross motions for summary judgment did not include sufficient evidence to determine what rulings, if any, were made in the underlying action as to those theories, the court denied Insurers’ motions for summary judgment, seemingly allowing leave for a second visit of that issue upon supplementation of the record.

6. Allocation Between Covered and Non-Covered Damages

It was clear that at least a portion of the verdict against the Insureds was covered.  Consequently, because the Insurers’ exclusions were found ineffective, the entire verdict was subject to the Insurers’ duty to indemnify. 

While Builders Mutual’s reservation of rights letters expressly informed Insureds their work product was not covered, it failed to inform that it intended to litigate the damages attributable to non-covered faulty workmanship or dispute coverage as to the breach of warranty and breach of fiduciary duty claims. Further, Builders Mutual failed to inform that a conflict of interest may have existed or that Insureds should protect their interests by requesting an allocated jury verdict. CIC’s reservation of rights letters suffered similar deficiencies. As a result, the Phase II damages were determined to be subject to indemnity.

While the court directed close attention to a number of issues in its examination of  the Insurers’ duties, it is clear the Harleysville opinion and the obligations it outlines for insurers, particularly as to reservation of rights letters, was a significant factor in the court’s analysis and resulting decisions. Stoneledge enforces the concept that the broad and general reservation of rights letters of old, with cut and paste references to policies, should be kept in the past. Rather, Stoneledge highlights the importance of thorough, detailed and precise reservation of rights letters, specifically detailing each coverage exclusion the insurer intends to assert and clearly setting forth what it views as obligations of the insured, such as securing a verdict allocating covered as opposed to non-covered damages. This opinion likewise emphasizes the significance of disclosing to an insured the insurer’s intention to pursue a declaratory judgment should it be faced with an adverse verdict.