Duty to Defend Owed In Chinese Drywall Case

This April 9, 2012 decision (Great American Fidelity Insurance Co. and Great American E&S Insurance Co. v. JWR Construction Services Inc. and Gulf Reflections Condominium Association, No. 10-61423 (S.D. Fla. April 9, 2012)) by Judge Huck of the Southern District of Florida (Fort Lauderdale) is interesting for several reasons.  The declaratory judgment action was filed by Great American against a general contractor and condo association.  Great American was trying to get out of its obligation to defend an underlying Chinese Drywall case in Lee County Circuit Court (Case No. 10-CA-000371).  In the underlying case, the GC and condo association were sued by unit owners for damages caused by the installation of Chinese Drywall.

The court granted summary judgment for the policyholders, and ordered Great American to reimburse past defense costs and establish a continual defense fund to provide for the policyholders’ future defense costs.  The court also ordered Great American to pay the policyholders’ attorneys fees spent in defending against the declaratory judgment action under Fla. Stat. § 627.428 (which is a bit perplexing, given that the New York substantive law applied to the dispute and § 627.428 has been held to be substantive for Erie purposes).  This clearly was not the result Great American had hoped for when it filed the declaratory judgment action.

Although the court applied New York substantive law, it looked to Florida law on the application of the “your work” exclusion, which is unusual in itself, given that New York coverage law is much more developed than Florida law on most topics.  But after J.S.U.B. and Pozzi Window, Florida has become a leading jurisdiction on this topic.

A further twist – and in my view the most important take-away from this decision – is that the Great American policy did not have a subcontractor exception to the “your work” exclusion.  This exception, which played such a prominent role in J.S.U.B. and Pozzi Window, reinstates CGL coverage for the costs to remedy defective construction work when the work was performed by a subcontractor.  Despite the lack of a subcontractor exception, the court found that the “your work” exclusion did not apply because there was no “by or on behalf of” language in the policy provision defining the insured’s “work”.

In most CGL policies, a GC’s “work” is defined to include the work of subcontractors.  Thus, faulty work by a subcontractor constitutes faulty work by the general contractor.  Without a subcontractor exception, the cost to repair or replace this faulty work would be excluded from coverage.  However, without the “by or on behalf of” language in the definition of the GC’s “work”, the subcontractor’s work is not considered the GC’s work under the policy, so the “your work” exclusion never comes into play and there is no need for the subcontractor exception.

The reason why this particular policy lacked the “by or on behalf of” language is probably because it was not a standard CGL policy.  The policy provided broader coverage, including pollution coverage.  This is why Great American did not go for the insurer weapon of choice in Chinese Drywall coverage actions: the pollution exclusion.  In any event, given that substantive New York law applied, and given that New York law is much better from a policyholder perspective than Florida law on the pollution exclusion, the pollution exclusion would not have been of great utility to Great American in this case even if the policyholder had not purchased pollution coverage.  (Kudos to JWR and its broker for having the foresight to purchase pollution coverage.)

Again, if one thing can be taken from this decision it is this: READ YOUR POLICY.  Insurance coverage cases are contract cases.  While many policies have standard forms, it should not be assumed that the policy language is the same as that found in controlling caselaw.  Subtle differences in policy language – often found in the endorsements to the policy – can make the difference between winning and losing a coverage case.

Despite the fact that the GC did not actually install the Chinese Drywall, the insurer attempted to argue that the lack of “by or on behalf of” language was irrelevant because the complaint alleged that the GC installed the drywall.  Apparently, this same complaint was filed against several contractors, distributors, and installers of Chinese Drywall (including supplier Banner Supply and installer C.A. Steelman), and the plaintiffs lawyers were too lazy to tailor the complaints to each individual defendant.  So the “cookie cutter” complaint alleged the GC installed the Chinese Drywall, whereas the undisputed facts were that the drywall was installed by a subcontractor.

Although the duty to defend usually is determined by the allegations contained in the “four corners” of the complaint, most jurisdictions, including New York, allow a policyholder to introduce facts outside of the complaint to prove that a duty to defend exists.  Note that this is a one-way street: an insurer cannot use extrinsic facts to prove that it does not have a duty to defend.  Rather, an insurer is stuck with the allegations of the complaint, whereas the policyholder can make use of the true facts.  In this case, the true facts triggered the duty to defend.

Finally, the court correctly noted that the duty to indemnify was not ripe, since the underlying complaint is still pending, and there are no settlements or judgments.  Thus, the court stayed further proceedings in the case, and left the indemnity determination for another day.