The phrase "cut-and-paste" sounds ugly. But is cutting and pasting so offensive as to create millions of dollars in liability? In a recent case, South Carolina's highest court rejected an insurer's paste-up job in a set of reservation of rights letters to its insureds and as a consequence imposed extra-contractual liability upon the insurer.
Harleysville Group Insurance v. Heritage Communities, Inc., et al., --- S.C. ---&under; (2017), concerned Harleysville's duty to indemnify its insureds for liabilities in two underlying construction defect actions. The insureds had constructed and sold condominiums in Myrtle Beach, South Carolina. Purchasers soon discovered various construction problems in the buildings, including building code violations, structural deficiencies, and water-intrusion damage. The property owners associations ("POA") for two properties commenced separate actions to recover damages for repairs, alleging negligent construction, breach of fiduciary duty, and breach of warranty. Individual home owners filed a related class action to recover damages for loss of use, which was later consolidated with one of the POA actions. Plaintiffs also sought punitive damages. Harleysville had issued primary and excess liability insurance policies to the developers covering certain periods in the years when the condominium buildings were constructed. Under these policies, and South Carolina law, these policies did not provide coverage for the cost of repairing faulty workmanship but did cover resulting property damage beyond the defective work itself.
Harleysville agreed to defend the developers subject to their reservation of their rights. As the court described it, "Harleysville's efforts to reserve its rights were generic statements of potential non-coverage coupled with furnishing most of the Heritage entities with copies (through a cut-and-paste method) of the insurance policies." The cases proceeded to trial, where defense counsel assigned by Harleysville conceded liability, and the trial court directed a verdict in favor of the POA on the negligent construction cause of action. The trials therefore only concerned the nature and extent of the damages resulting from the admitted negligent construction. Experts presented vastly differing opinions as to the cost of necessary repairs, and the juries returned general verdicts which awarded actual damages which approximately split the difference between the experts' estimates, plus punitive damages.
Harleysville then commenced the declaratory judgment action alleging that it had no duty to indemnify the insureds for the judgments. In the alternative, Harleysville sought an accounting as to what portion of the jury verdicts constituted covered damages. It further contended that it only provided coverage for that portion of damages which occurred during its policy periods. These issues were submitted to a special referee for an evidentiary hearing.
The special referee determined that Harleysville owed indemnification for the full amount of the actual damages in proportion with its time on the risk. Although costs to remove and replace the faulty workmanship were not covered under the policies, it would be improper and purely speculative to attempt to allocate the juries' general verdicts between covered and non-covered damages. The parties appealed.
The Supreme Court of South Carolina affirmed that part of the report which rejected Harleysville's reservation of rights. It held, "We agree with the Special Referee that generic denials of coverage coupled with furnishing the insured with a verbatim recitation of all or most of the policy provisions (through a cut-and-paste method) is not sufficient." Harleysville had issued several letters which "explained that Harleysville would provide a defense in the underlying suits and listed the name and contact information for the defense attorney Harleysville had selected to represent Heritage in each matter. These letters identify the particular insured entity and lawsuit at issue, summarize the allegations in the complaint, and identify the policy numbers and policy periods for policies that potentially provided coverage. Additionally, each of these letters (through a cut-and-paste approach) incorporated a nine- or ten-page excerpt of various policy terms, including the provisions relating to the insuring agreement, Harleysville's duty to defend, and numerous policy exclusions and definitions. Despite these policy references, the letters included no discussion of Harleysville's position as to the various provisions or explanation of its reasons for relying thereon. With the exception of the claim for punitive damages, the letters failed to specify the particular grounds upon which Harleysville did, or might thereafter dispute coverage."
However, the heart of the problem was the letters' failure to advise the insureds of the what was really in dispute and how the insured's rights could be affected. Except as to punitive damages, the letters "gave no express reservation or other indication that it disputed coverage for any specific portion or type of damages. Nor did the letters or testimony indicate that, in the event Heritage was found liable in the construction-defect suits, Harleysville intended to file the instant lawsuit to contest various coverage issues. Specifically, Harleysville did not expressly put its insureds on notice that it intended to litigate the issues of whether any damages resulted from acts meeting the definition of occurrence, whether any damages occurred during the applicable policy periods, what damages were attributable to non-covered faulty workmanship, and whether certain damages resulted from intentional acts by the insured and were thus excluded. And in no way did the letters inform the insureds that a conflict of interest may have existed or that they should protect their interests by requesting an appropriate verdict."
As a result, the letters were "insufficient to reserve the right to contest coverage of actual damages." In short, the court not only affirmed that the reservation of rights letter were faulty, but also affirmed that as a result the insurer would be responsible for both covered and non-covered damages.
While the Heritage decision says much about the form and content of a reservation of rights letter, it is best seen in the light of concepts of waiver and estoppel. The problems with the insurer's letters cannot be understood in isolation. Even with defects, the reservation of rights letters might have withstood challenge had the underlying action not ended in a general verdict. The general verdict against the insureds gave "no basis upon which to make a logical assessment of the jury's purpose", thus it would only be speculation to apportion the verdict to the covered and non-covered claims. The Court felt that this put the insurer in a dilemma of its own making. The dilemma could have been avoided, presumably, if the insured had been advised in such a way as to know how to protect its own interests. The letters were insufficient therefore because they failed to express how the insurer's and insured's interests were in conflict, to explain how the insurer intended to proceed, and to suggest what the insured could do to protect its own rights.
Is there a general rule to be gleaned from the Heritage case? Certainly, insurers should be careful in drafting reservation of rights letters, and not be satisfied to merely quote policy language. Yet, to many outside of South Carolina, the result - imposing liability for non-covered claims - may appear to go too far. For one thing, if a general verdict is inadequate to differentiate between covered and non-covered claims, additional proceedings, with evidence and testimony, can often bring clarity.
But also, expanding coverage beyond the scope of the policy conflicts with a good deal of settled doctrine. The situation may be different where the insurer completely fails to reserve its rights and then controls the defense to the detriment of the insured. See Gen. Acc. Ins. Co. of Am. v. Metro. Steel Indus., Inc., 9 A.D.3d 254, 254-55, 780 N.Y.S.2d 128 (1st Dep't 2004) (insurer imposed a posture and strategy on the underlying action that could not be later altered, and prejudiced the insured's ability to control the defense of the underlying action by failing to disclaiming until that action was well underway). However, on the whole, courts avoid expanding the scope of coverage provided in the insurance policy.
The New York Court of Appeals, for example, has instructed that "The duty to defend is measured against the allegations of pleadings but the duty to pay is determined by the actual basis for the insured's liability to a third person." Servidone Const. Corp. v. Sec. Ins. Co. of Hartford, 64 N.Y.2d 419, 424, 477 N.E.2d 441, 444 (1985). Thus, where an insurer breaches a contractual duty to defend its insured in a personal injury action, and the insured thereafter concludes a reasonable settlement with the injured party, the insurer is not liable to indemnify the insured if coverage is excluded by the policy. See id.; see also K2 Investment Group LLC v. American Guarantee & Liability Insurance Group, 22 N.Y.3d 578, 6 N.E.3d 1117, 983 N.Y.S.2d 761 (2014). It has long been accepted that, "insurers [do] not lose their right to the defense of noncoverage by their initial disclaimer of liability based on ... policy exclusions, since that defense is never waived by a failure to assert it in a notice of disclaimer." See Albert J. Schiff Assocs., Inc. v. Flack, 51 N.Y.2d 692, 700, 417 N.E.2d 84 (1980). Moreover, estoppel cannot be applied to create coverage where none exists. See Federated Dep't Stores, Inc. v. Twin City Fire Ins. Co., 28 A.D.3d 32, 38, 807 N.Y.S.2d 62, 67 (1st Dep't 2006); Sedgwick Ave. Assoc. v. Insurance Co. of State of Pa., 203 A.D.2d 93, 610 N.Y.S.2d 39 (1st Dep't 1994); Wausau Ins. Co. v. Feldman, 213 A.D.2d 179, 623 N.Y.S.2d 242 (1st Dep't 1995).
Whether the Heritage decision represents the beginning of an important trend, or a one-off case limited to its facts, cutting and pasting will never be quite the same.