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Insurer that Delayed in Disputing Coverage Estopped from Asserting Defenses Against Assignee of Policy
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August 3, 2009
By Christian Henel
Howrey LLP
The Arizona Court of Appeals has held that a defendant subcontractor may assign its rights against its insurance carrier to a plaintiff property owner in a construction defect case and that the assignment includes the right to estop the insurer from disputing coverage.
Stucco on the exterior of a townhouse development suffered substantial cracking, allowing water to enter the interior. The Pueblo Santa Fe Townhomes Owners’ Association (HOA) brought construction defect claims against the general contractor, two construction managers and a number of subcontractors, including stucco subcontractor Palo Verde Plastering (PVP).
PVP had obtained a commercial general liability insurance policy from Transcontinental Casualty Co. When PVP was named in the lawsuit, it filed a notice of claim with the insurer, and the carrier agreed to defend PVP. It did not issue a reservation of rights letter.
However, after 18 months had gone by, the insurer informed PVP that it reserved the right to assert the policy’s “your work” exclusion as a defense to coverage should the HOA obtain a judgment against PVP. That exclusion disclaimed coverage for damage to PVP’s own work and to materials, parts or equipment employed in connection with PVP’s own work. According to the insurer, only resulting damage to the interior of the homes was covered; the cost to repair or replace the stucco itself was not covered. No reason was given for the insurer’s delay in seeking to reserve its rights.
During the 18 months before the insurer issued its reservation of rights letter, PVP believed it was covered by the policy and allowed counsel hired by the insurer to control its defense.
In that same period, the litigation proceeded forward. The trial court set a deadline for completion of destructive testing, and testing was conducted before the deadline. But, PVP’s insurer-appointed counsel chose not to participate in it and did not inform PVP of the deadline.
By the time the insurer asserted its reservation of rights and PVP retained independent counsel, the deadline for destructive testing had passed, and the HOA refused to allow any more.
An expert witness for the HOA had prepared a report blaming the stucco cracking on the chemical content of the stucco mix that PVP had used. This left PVP fearing that a substantial judgment would be entered against it.
Although PVP’s insurer-appointed counsel eventually retained an expert who believed the stucco cracking might have been caused by defective framing, the expert was unable to do the necessary testing to confirm his theory because the destructive testing deadline had passed.
Facing a claim of $2.1 million for stucco repair and overhead asserted by the HOA and concerned that other defendants were settling with the HOA and assigning their indemnity rights against PVP to the HOA, PVP entered into an settlement agreement with the HOA just before trial. In the agreement, PVP stipulated to liability of $1.1 million and assigned to the HOA most of its claims against its insurer in return for the HOA’s promise that it would not execute on the judgment against PVP. Under Arizona law, such agreements are permitted and are known as “Morris Agreements.” See, United Services Auto. Assn. v. Morris, 154 Ariz. 113, 741 P.2d 246 (1987).
Pursuant to the Morris Agreement, the HOA filed a coverage action against the insurer, and the carrier asserted the “your work exclusion.” The HOA maintained that the carrier should be estopped from asserting the “your work” exclusion because it had failed to timely reserve its right to assert defenses under the policy. The Superior Court held for the HOA, concluding that PVP had been prejudiced because its expert did not have a chance to participate in destructive testing at a time when PVP did not know that the insurer disputed coverage. The insurer appealed. The Court of Appeals affirmed. Pueblo Santa Fe Townhomes Owners’ Assn. v. Transcontinental Insurance Co., 218 Ariz. 13, 178 P.3d 485 (Ariz.Ct.App. 2008).
On appeal, the insurer argued that estoppel could not be asserted by assignees under a Morris Agreement because the insured’s rights had been protected by the agreement and because the assignee was a not a party of the insurance agreement.
The Court of Appeals concluded that when PVP assigned its rights against the insurer to the HOA, it assigned all pertinent rights, including the right to assert estoppel against the insurer – that is, the HOA “steps into the shoes” of the insured. The assignment does not alter the defenses and equities available to the assignee. The appeals court noted that the insurer had put forward no legal authority to support its argument. The appeals court concluded that it would not adopt a rule that enabled insurers to avoid responsibility for failing to promptly notify insureds of a reservation of rights.
The insurer also argued that it should not be estopped because the HOA failed to show that PVP suffered actual harm as a result of the insurer’s late reservation of rights. The insurer characterized its 18-month delay as a “harmless mistake.” The appeals court rejected this argument. It noted that the HOA early on had made stucco repair or replacement a major part of its claim, with the cost of repair or replacement estimated at $2.3 million. The insurer had concluded that covered resulting damages amount to only about $20,000. Thus, the insurer knew that PVP was exposed to nearly all of the claim.
The appeals court found ample evidence of prejudice. If the insurer had made a timely reservation of rights, PVP would have participated in the destructive testing in an effort to prove that the cracking was not caused by PVP’s stucco mix but by some other cause such as foundation movement, unstable framing or other structural problems. This is because PVP’s only hope of avoiding liability was to establish another cause for the cracking. But, because PVP believed that the insurer would be paying any judgment from the policy, PVP had no reason to question the decisions made by insurer-retained counsel. Because the insurer delayed 18 months in informing PVP of its reservation of rights, PVP lost the opportunity to mount a defense.
The appeals court held that the insurer must pay the $1.1 million judgment, with interest running from the date the trial court approved the Morris Agreement, and must pay attorney fees of $469,831.
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For more information about the issues covered in this report, please contact Christian Henel in our Washington office at 202-383-7360 or at HenelC@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.
©2009 Howrey LLP
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