SPECIAL REPORT: Reservation of Rights

Insurer’s failure to advise policyholder of its interest in allocated damages results in coverage for general verdict.

The South Carolina Supreme Court has concluded that: (1) an insurance company’s reservation of rights letter was insufficient and the insured had therefore waived its coverage defenses; (2) even if the reservation of rights had been effective, the general verdict was covered by the liability policies because the insurer failed to request special interrogatories or a special verdict form; (3) punitive damages were covered; (4) the period of progressive damages during which a time on the risk analysis could be conducted could be compressed into the time between the completion of the buildings and the point at which the building components were damaged to the point they required replacement; (5) loss of use damages could be apportioned on the same time on risk basis; and (6) punitive damages were not subject to that time on the risk apportionment. Harleysville Group Ins.  v. Heritage Communities, Inc., 27698 (S.C. Sup. Ct. filed Jan. 11, 2017) (Shearhouse Adv. Sh. No. 2 at Op. No. 21). 

The opinion resulted from cross-appeals from a declaratory judgment action to determine the amount of coverage applicable to jury verdicts arising from two construction defect actions.  The general contractor/developer (“Heritage”) constructed the two condominium developments between 1997 and 2000. The construction defect lawsuits were filed in 2003. Harleysville insured Heritage from 1997 through 2001.  Heritage was thereafter uninsured, and went out of business in 2003. Harleysville accepted the defense of Heritage under a reservation of rights. Following jury verdicts against Heritage, Harleysville filed declaratory judgment actions to determine the portion of the judgments covered under the policies. The declaratory judgment actions were referred to a Special Referee who found, inter alia, that Harleysville had failed to correctly preserve its rights and as a result, its policies provided coverage for the majority of the general verdict. Both parties appealed.

Reservation of  Rights Letters:  The Court held that Harleysville’s general reservation of rights, coupled with verbatim recitation of most of the policy provisions, was insufficient to properly reserve its right to contest coverage. The letters included no discussion of Harleysville’s position as to the various provisions or explanation of its reasons for relying on those provisions.  This was in contrast to Harleysville’s specific explanation as to why punitive damages would not be covered by the policy.

The Court emphasized that none of the letters advised Heritage of the need for allocation of damages between covered and non-covered losses, referenced the possible conflict of interest, or Harleysville’s intent to pursue a declaratory judgment action.

Failure to Request Special Interrogatories: The ruling emphasized that because the insurer has the right to control the litigation, it is in the best position to see to it that the damages are allocated between covered and non-covered damages. Thus, even if the reservation of rights letters had been adequate, the disposition would remain unchanged as the Special Referee concluded that it had no basis to assess the jury’s purpose when it awarded a general verdict as to negligent construction, breach of warranty, and breach of fiduciary duty claims. The Special Referee refused to “engage in unguided speculation with respect to this issue of [allocating losses], particularly when the dilemma now confronting Harleysville is of its own making.” 

In affirming the Special Referee’s holding, the Court cited to Magnum Foods, Inc. v. Continental Cas. Co., 36 F.3d 1491 (10^th Cir. 1994), for the proposition that the right to control the litigation carries with it certain duties, including the duty not to prejudice the insured’s rights by failing to request special interrogatories or a special verdict in order to clarify coverage of damages.  Magnum Foods, however, arose from an underlying claim that a restaurant manager sexually assaulted an employee, and the opinion centered on the insurability of punitive damages. The Magnum Foods court cited to Duke v. Hoch, 468 F.2d 973, 975 (5^th Cir., 1972) for the proposition that, “[i]f the burden of apportioning damages between covered and non-covered were to rest on the insured, who is not in control of the defense, the insurer could obtain for itself an escape from responsibility merely by failing to request a special verdict or special interrogatories.” Duke had sued his accountants alleging both negligence and intentional acts, and the jury returned a general verdict. Thus, neither Duke nor Magnum applies this principal within the construction defect context.

Punitive Damages:  Harleysville argued that it had no duty to indemnify Heritage for punitive damages because the award necessarily meant the jury had concluded Heritage’s wrongdoing was not accidental, which was required for losses to amount to a covered occurrence. The Court rejected this argument on the ground that the policies required Harleysville to indemnify Heritage for “those sums” Heritage became legally obligated to pay as damages, not merely compensatory damages.

Harleysville also argued that because punitive damages were excluded by the “expected or intended” exclusion and the award of punitive damages necessarily meant the jury had concluded Heritage was guilty of a conscious failure, the results were intended or at least expected. Harleysville submitted evidence that Heritage intended to do as little work as possible, and the evidence of bad workmanship would tend to support a finding that Heritage had knowledge the projects were substandard. However, there was also evidence in the record that Heritage had actively addressed construction and water intrusion issues, and that some of the damage was the result of defective components, not defective workmanship. Further, grossly negligent conduct can form the basis for punitive damages, yet not rise to the level of an intentional act necessary to be excluded by the intentional acts exclusion.

Period of Progressive Damage: The last certificates of occupancies for the two projects were issued in January and August 2000.  The Special Referee declined to perform a building by building apportionment on the ground that the general verdicts were not issued on a building by building basis. The underlying Plaintiffs’ expert testified that when he conducted site visits in December 2003 and April 2004, many of the building components were damaged to the point they required replacement, and subsequent decay eventually caused structural failure and collapse at both developments.

The Special Referee concluded that the period of progressive damages began 30 days after the first certificate of occupancy was issued at each development, and ended on the date the Plaintiffs’ expert had last visited the projects prior to the trial. The Court affirmed, holding the Special Referee did not abuse his discretion, as there was evidence to support those findings.

Loss of Use Apportionment:

Harleysville argued that the loss of use damages should be apportioned together with the construction defect damages. The court agreed, holding that because the underlying occurrence was progressive, the loss of use damages must be deemed to have progressed over the same period of time.  

Punitive Damages Apportionment: Conversely, the Court held that punitive damages were not subject to time on the risk allocation.  Time on the risk analysis was developed to apportion damages where the injury progressed over time, and that logic did not necessarily apply to the concept of punitive damages. The court declined to establish a categorical rule, holding that Harleysville had not presented any evidence that any of the reprehensible acts upon which punitive damages were based occurred outside the relevant policy periods.

Commentary: The Heritage opinion creates, or at least fails to solve, some thorny issues with regard to apportionment of damages.  As to the period of time during which coverage is triggered, the Special Referee’s methodology was different than that approved by the Supreme Court in Crossmann Communities of North Carolina, Inc. v. Harleysville Mut. Ins. Co., 717 S.E.2d 589 (S.C. 2011), and that which has been generally accepted by participants in construction defect litigation in South Carolina. In Crossmann Communities the Supreme Court held that an insurer’s liability is limited to damages accrued during its time on the risk,  adhering to its holding in Joe Harden Builders, Inc. v. Aetna Casualty & Surety Co., 486 S.E.2d 89, 91 (S.C. 1997) (“We hold coverage is triggered at the time of an injury-in-fact and continuously thereafter to allow coverage under all policies in effect from the time of injury-in-fact during the progressive damage. Such an injury-in-fact/continuous trigger does not penalize the insured by requiring a manifestation of damage during the policy period, nor does it penalize the insurer by extending coverage from the time of the underlying event when no injury has yet occurred.”) Id.

In Crossmann Communities the parties stipulated that the damage began within 30 days of the Certificate of Occupancy date for each building and progressed until repaired or the underlying lawsuits were settled. This methodology invoked the maximum amount of insurance coverage. The approval of the Special Referee’s decision in Heritage adds a new wrinkle to progressive damage allocation. Is the end point when the damaged property has to be repaired or replaced? In Heritage, the Special Referee’s compression of the period of progressive damage increased coverage, as there would have been a long uninsured period for the developer across which the verdict would be divided.  However, in many cases that same analysis will limit the number of policies implicated by the progressive damage. 

Further, the progressive damage end point is now likely to be a contested issue of fact. The Heritage opinion cited testimony of the underlying Plaintiffs’ expert that damage begins with the water entering the building, because the wood products begin to uptake the water, the damage cycle begins, and eventually the decay will begin. How much damage is required to end the period of progressive damages? Is it always the point that the building components require replacement, or can it be before or after that? Does the period of progressive damage applicable to the work of one subcontractor apply across the project?

Further, which party must establish that end date during the underlying litigation? Successive insurers will have adversarial positions, seeking either to extend or shorten the period of progressive damage. Defense counsel retained by the insurer “controlling the defense” cannot take any action which would hurt the coverage position of his client, the insured. Plaintiffs’ counsel will take different positions depending on the coverage in each case. Must special interrogatories to the jury seek a determination as to that issue, and what ability will the insurers and insureds have to provide evidence on this issue?

In Heritage, the dissent by Chief Justice Pleicones points out that the majority opinion does not provide any suggestion as to how Harleysville could have intervened in the lawsuits and asserted a defense against coverage without creating an impermissible conflict of interest. It is easy enough to have a jury specify the amount of damages attributable to a particular cause of action, thus, apportioning covered versus non-covered damages in a sexual assault or financial fraud case is not a difficult.  However, a verdict form, or answers to special interrogatories that will reflect which part of a verdict is for occurrence-based damage to property other than the work of the insured itself, is more complex. This will particularly be true when a variety of subcontractors are alleged to have contributed to water intrusion and resulting damage.

An insurer can move to intervene in the underlying litigation, through separate counsel, and request special interrogatories or a special verdict form. Indeed, many insurers have been doing that since the Court issued its opinion in Auto Owners Ins. Co., Inc. v. Newman, 684 S.E.2d 541 (S.C. 2009). In Newman, the Court held that it was not possible from the record to determine the portion of the arbitrator’s itemized list of damages attributable to the removal and replacement of the defective stucco, and that it was not the purpose of that declaratory judgment action to relitigate the issue of damages. Specifically, the court stated, “Auto–Owners had an opportunity to raise this matter when the issue of damages was litigated before the arbitrator, who issued a final, binding award on the merits.” Id. at 547.  However, South Carolina trial courts have routinely denied requests to intervene by insurers. Even if that changes, the discovery and testimony adduced in the normal course of a construction defect actions typically does not lend itself to an easy determination by a jury of the cost to repair the resulting damage caused by a particular party versus the cost to repair or replace that party’s own defective work.

With regard to the insufficiency of Harleysville’s reservation of rights letter, the Court’s holding should not come as a surprise. The majority of jurisdictions that have considered this issue have concluded that similar letters to policyholders are insufficient.  Reservation of rights letters must give fair notice to the insured that the insurer intends to assert defenses to coverage or to pursue a declaratory relief action. Without this information, the insured has no reason to act to protect its rights because it is unaware of the conflict of interest that exists between itself and the insurer. The insurer must specify in detail any and all bases upon which it might contest coverage in the future. In addition, the insurer must inform the insured of the need for an allocated verdict as to covered versus noncovered damages, and of the insured’s interest in obtaining a written explanation of the award that will permit the parties to determine which part of the verdict is covered.  

Further, both insurer and insured will have to consider whether the evidence produced at trial will be sufficient for a jury to provide such an explanation. In some cases, such as where there is ample coverage and most of the damage is covered, the litigating parties may agree to a methodology that will simplify this process. However, where no agreement can be reached the insurer should consider what steps it can take to ensure that the jury has the evidence necessary to perform the evaluation. While the burden of proving coverage is on the party seeking it, it seems likely that a failure of the insurer to present the necessary information to the jury will be held against the insurer, not the insured.