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Harleysville Group Insurance v. Heritage Communities, Inc.

Supreme Court of South Carolina

January 11, 2017

Harleysville Group Insurance, a Pennsylvania Corporation, Appellant/Respondent,
v.
Heritage Communities, Inc., a South Carolina Corporation; Heritage Magnolia North, Inc., a South Carolina Corporation; Buildstar Corporation, a South Carolina Corporation; Magnolia North Horizontal Property Regime; Magnolia North Property Owners Association, Inc., a South Carolina Corporation; and National Surety Corp., Defendants, Of whom Heritage Communities, Inc., a South Carolina Corporation; Heritage Magnolia North, Inc., a South Carolina Corporation; Buildstar Corporation, a South Carolina Corporation; and National Surety Corp. are Respondents, and Magnolia North Horizontal Property Regime and Magnolia North Property Owners Association, Inc., a South Carolina Corporation, are Respondents/Appellants. And Harleysville Group Insurance, a Pennsylvania Corporation, Appellant/Respondent,
v.
Heritage Communities, Inc., a South Carolina Corporation; Heritage Riverwalk, a South Carolina Corporation; Buildstar Corporation, a South Carolina Corporation; Riverwalk at Arrowhead Country Club Horizontal Property Regime; Riverwalk at Arrowhead Country Club Property Owners Association, Inc., a South Carolina Corporation; National Surety Corp.; and Tony L. Pope and Lynn Pope, individually and representing as a class all unit owners at Riverwalk at Arrowhead Country Club Horizontal Property Regime, Defendants, Of whom Heritage Communities, Inc., a South Carolina Corporation; Heritage Riverwalk, a South Carolina Corporation; Buildstar Corporation, a South Carolina Corporation; National Surety Corp.; and Tony L. Pope and Lynn Pope, individually and representing as a class all unit owners at Riverwalk at Arrowhead Country Club Horizontal Property Regime, are Respondents, and Riverwalk at Arrowhead Country Club Horizontal Property Regime and Riverwalk at Arrowhead Country Club Property Owners Association, Inc. are Respondents/Appellants. Appellate Case No. 2013-001281 Appellate Case No. 2013-001291

          Heard January 14, 2016

         Appeal from Horry County John M. Milling, Special Referee

         AFFIRMED AND AFFIRMED AS MODIFIED

          C. Mitchell Brown, William C. Wood, Jr., and A. Mattison Bogan, all of Nelson Mullins Riley & Scarborough, LLP, of Columbia; and Robert C. Calamari, of Nelson Mullins Riley & Scarborough, of Myrtle Beach, for Appellant/Respondent.

          John P. Henry and Philip C. Thompson, Sr., both of Thompson & Henry, P.A., of Conway, for Respondents/Appellants.

          KITTREDGE, JUSTICE

         These cases present cross-appeals from declaratory judgment actions to determine coverage under Commercial General Liability (CGL) insurance policies issued by Harleysville Group Insurance (Harleysville). These cases arise from separate actions, but we address them in a single opinion as they involve virtually identical issues regarding insurance coverage for damages stemming from the defective construction of two condominium complexes in Myrtle Beach: Magnolia North Horizontal Property Regime (Magnolia North) and Riverwalk at Arrowhead Country Club Horizontal Property Regime (Riverwalk). The Special Referee found coverage under the policies was triggered and calculated Harleysville's pro rata portion of the progressive damages based on its time on the risk. We affirm the findings of the Special Referee in the Magnolia North matter, and we affirm as modified in the Riverwalk matter.

         I.

         The Riverwalk and Magnolia North developments were constructed between 1997 and 2000. After construction was complete and the units were sold, the purchasers became aware of significant construction problems, including building code violations, structural deficiencies, and significant water-intrusion problems. In 2003, the purchasers filed suit to recover damages for necessary repairs to their homes.

         The lawsuits were filed by the respective property owners' associations (the POAs), which sought actual and punitive damages for the extensive construction defects under theories of negligent construction, breach of fiduciary duty, and breach of warranty.[1] As to the Riverwalk development, individual homeowners also filed a class action to recover damages for the loss of use of their property during the repair period.[2] The defendants in the underlying suits were the related corporate entities that developed and constructed the condominium complexes: Heritage Communities, Inc. (the parent development company), Heritage Magnolia North, Inc. and Heritage Riverwalk, Inc. (the project-specific subsidiary companies for each separate development), and Buildstar Corporation (the general contracting subsidiary that oversaw construction of all Heritage development projects), to which we refer collectively as "Heritage."

         During the period of construction from 1997 to 2000, the various Heritage entities each maintained several liability insurance policies with Harleysville with per-occurrence limits totaling between $3, 000, 000 and $4, 000, 000 on the primary policies and between $9, 000, 000 and $13, 000, 000 on the excess liability policies.[3]Heritage was uninsured after the last policy lapsed in 2001, and the financial strain of numerous construction-defect lawsuits caused Heritage to go out of business in 2003.[4]

         After receiving notice of the lawsuits, Harleysville informed its insureds that it would provide for their defense; however, Harleysville contends this was done under a full reservation of rights. 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. There is no dispute that Harleysville would control the litigation. Harleysville contends that all coverage issues would be litigated following the entry of any adverse jury verdict.

         At the outset of each trial, Harleysville's counsel for Heritage conceded liability, and in both trials, the trial court directed a verdict in favor of the POA on the negligent construction cause of action. See Magnolia North Prop. Owners' Ass'n v. Heritage Cmtys., 397 S.C. 348, 369-70, 725 S.E.2d 112, 123-24 (Ct. App. 2012) (observing that "during opening arguments, counsel [for Heritage] conceded liability" and affirming the trial court's decision to direct a verdict in favor of the POA); Pope v. Heritage Cmtys., 395 S.C. 404');">395 S.C. 404, 429-30, 717 S.E.2d 765, 778-79 (Ct. App. 2011) (quoting Heritage's concessions of liability during opening statements and finding no error in the trial court's decision to direct a verdict in favor of the POA). Thus, the only contested issue in the underlying trials was the nature and extent of the damages resulting from the admitted negligent construction.

         In this regard, the parties presented various experts who offered widely different estimates of the costs to correct the construction defects. According to the POAs' experts, the cost of necessary repairs totaled approximately $9, 200, 000 at Magnolia North and $8, 600, 000 at Riverwalk. In contrast, defense experts testified the necessary repairs would cost much less-approximately $2, 400, 000 at Magnolia North and $2, 500, 000 at Riverwalk. Ultimately, the juries declined to adopt any one expert's estimate, instead returning verdicts somewhere between the parties' figures. In the Magnolia North matter, the jury returned a general verdict for $6, 500, 000 in actual damages and $2, 000, 000 in punitive damages, and in the Riverwalk suit, the jury returned a general verdict of $4, 250, 000 in actual damages and $250, 000 in punitive damages in favor of the POA and $250, 000 in loss-of-use damages and $750, 000 in punitive damages in the class action.

         Following these general jury verdicts against its insureds, Harleysville filed the present declaratory judgment actions to determine what portion of the judgments in the underlying construction-defect lawsuits would be covered under Heritage's CGL policies. In filing these suits, Harleysville contended that, under the terms of the policies, it has no duty to indemnify Heritage for these judgments.

         Alternatively, if any of the damages were found to be covered, Harleysville sought an accounting to somehow parse the jury verdicts and determine which portion of the juries' general verdicts constituted covered damages. Harleysville further argued it could be responsible for only that portion of damages occurring during the period of time its policies provided coverage.

         The matter was referred to a Special Referee, who held an evidentiary hearing in December 2010. Because this Court's decision in Crossmann Communities of North Carolina, Inc. v. Harleysville Mutual Insurance Co.[5] was pending at the time, the parties agreed for the Special Referee to stay the matter until Crossmann was resolved. After Crossmann was decided in August 2011, the parties agreed for the Special Referee to reopen the evidentiary hearing in December 2011 to hear arguments and testimony regarding the applicability of the time-on-the-risk formulation as set forth in Crossmann. The POAs objected to the admission of evidence regarding time on the risk, arguing that it was inappropriate to parse the juries' general, unallocated verdicts by evaluating Harleysville's time on the risk.

         Ultimately, the Special Referee found coverage under the policies was triggered because the juries' general verdicts included some covered damages. Although the Special Referee found that the costs to remove and replace the faulty workmanship were not covered under the policies, the Special Referee concluded that it would be improper and purely speculative to attempt to allocate the juries' general verdicts between covered and non-covered damages. Accordingly, the Special Referee ordered the full amount of the actual damages in the construction-defect suits would be subject to Harleysville's duty to indemnify in proportion with its time on the risk. The Special Referee made factual findings regarding the dates of the progressive damages period and the period during which Harleysville provided coverage. The Special Referee thereafter calculated Harleysville's pro rata portion of the progressive damages based on Harleysville's time on the risk. Lastly, the Special Referee found punitive damages were covered and that no policy exclusion applied to preclude coverage for any portion of those damages.

         The parties subsequently filed cross-appeals. Harleysville is the primary Appellant. Upon the parties' joint motion, these matters were certified from the court of appeals to this Court pursuant to Rule 204(b), SCACR.

         II.

         "A declaratory judgment action is neither legal nor equitable, and therefore, the standard of review is determined by the nature of the underlying issue." Auto Owners Ins. Co. v. Newman, 385 S.C. 187, 191, 684 S.E.2d 541, 543 (2009) (citing Colleton Cnty. Taxpayers Ass'n v. Sch. Dist. of Colleton Cnty., 371 S.C. 224, 231, 638 S.E.2d 685, 688 (2006)). "When the purpose of the underlying dispute is to determine whether coverage exists under an insurance policy, the action is one at law." Id. (citing Auto-Owners Ins. Co. v. Hamin, 368 S.C. 536, 540, 629 S.E.2d 683, 685 (Ct. App. 2006)). "In an action at law tried without a jury, the appellate court will not disturb the trial court's findings of fact unless there is no evidence to reasonably support them." Id. Indeed, this Court's scope of review "'is limited to correcting errors of law.'" City of Hartsville v. S.C. Mun. Ins. & Risk Fin. Fund, 382 S.C. 535, 543, 677 S.E.2d 574, 578 (2009) (quoting State Farm Mut. Auto. Ins. Co. v. James, 337 S.C. 86, 93, 522 S.E.2d 345, 348-49 (Ct. App. 1999)).

         The threshold question in determining coverage under a CGL policy is whether the claim at issue is for "property damage" caused by an "occurrence" within the general grant of coverage in the CGL insuring agreement. Specifically, the CGL policies at issue in these cases provide:

We will pay those sums that the insured becomes legally obligated to pay as damages because of "bodily injury" [or] "property damage" . . . to which this insurance applies. . . .
a. This insurance applies only:
(1) To "bodily injury" or "property damage":
(a) That occurs during the policy period; and
(b) That is caused by an "occurrence." [6]

         The CGL policies define "property damage" as "physical injury to tangible property, including all resulting loss of use of that property, " and define an "occurrence" as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions."[7] Applying these terms to ascertain the scope of coverage in construction-defect cases has resulted in considerable litigation, not just in South Carolina, but across the country.

         In L-J, Inc. v. Bituminous Fire & Marine Insurance Co., 366 S.C. 117, 621 S.E.2d 33 (2005), this Court explored the issue in determining whether costs to repair negligently constructed roadways were covered under the general contractor's CGL policy. Id. at 122, 621 S.E.2d at 35. Observing there was no claimed damage to property other than to the defectively constructed roadway-in other words, the completed work itself-this Court held the claimed losses were not covered by the CGL policy. Id. at 123-24, 621 S.E.2d at 36-37. However, in L-J, we foreshadowed that the coverage question would be resolved differently under different circumstances. Specifically, we explained that where a claimed loss is for damage to property other than the faulty workmanship itself, such as where continuous or repeated water intrusion causes damage to otherwise non-defective construction components, then the claim may be covered under the terms of the policy, as it would not constitute a mere allegation of faulty or defective workmanship. Id. at 123-24, 621 S.E.2d at 36 (citing High Country Assocs. v. N.H. Ins. Co., 648 A.2d 474 (N.H. 1994)).

         Consistent with our projection in L-J, several years later in Auto Owners Insurance Co. v. Newman, 385 S.C. 187, 684 S.E.2d 541 (2009), we held that a subcontractor's negligent application of stucco, which allowed water to seep into the plaintiff's home causing damage to the home's framing and exterior sheathing, constituted an occurrence under the builder's CGL policy. Although the Court found the damages caused by the continuous moisture intrusion resulting from this negligent construction were covered by the CGL policy, the Court emphasized that the costs of removing and replacing the defective stucco itself amounted to faulty workmanship, which was not covered. [8] Id. at 194, 684 S.E.2d at 544-45.

         Two years later, in Crossmann, the Court reaffirmed the result in Newman-that costs to repair faulty workmanship itself are not covered under a CGL policy but costs to repair resulting damage to otherwise non-defective components are covered-while clarifying that the relevant policy term in the insuring agreement is "property damage, " rather than "occurrence." 395 S.C. at 48-50, 717 S.E.2d. at 593-94 (explaining the use of the phrase "physical injury" in defining property damage suggests that such property was "not defective at the outset, but rather was initially proper and injured thereafter"). We clarified that faulty workmanship was not covered because it did not constitute property damage-not because it did not meet the definition of "occurrence." Id. (explaining the ongoing water penetration fell within the expanded definition of occurrence-namely, the "continuous or repeated exposure to substantially the same general harmful conditions"-and thus constituted the relevant occurrence). This Court further found the scope of an insurer's duty to indemnify was limited to damages accrued during the insurer's time on the risk, overruling earlier case law that held an insurer's liability was joint and several. Id. at 59-64, 717 S.E.2d at 599-01.

         In so holding, the Court acknowledged that, when property damage is progressive (as is the case with damages resulting from water intrusion), "it is often 'both scientifically and administratively impossible'" to determine precisely what quantum of property damage occurred during each policy period. Id. at 64, 717 S.E.2d at 601 (quoting Boston Gas Co. v. Century Indem. Co., 910 N.E.2d 290, 301 (Mass. 2009)). Thus, the Court determined that where it is impracticable to calculate the exact measure of damages attributable to the injury that triggered each policy, the default rule is that an insurer's pro rata share of the damages is a function of the total number of years damages progressed and the portion of those years a particular insurer provided coverage. Id. at 64-65, 717 S.E.2d at 602.

         Although Crossmann represented a sea change in terms of adopting the time-on-the-risk approach (and abandoning the "joint and several" approach), Crossmann left unchanged the basic concept, first signaled in L-J then formally adopted in Newman, that the cost of repairing faulty workmanship is not covered under CGL policies but resulting property damage beyond the defective work product itself is covered. With these principles in mind, we turn to the legal issues presented on appeal.

         III. Coverage Issues

         Harleysville and the POAs each contend the Special Referee made various errors in declaring the scope of coverage under the policies. We disagree and address these claims of error below.

         A. Reservation of Rights to Contest Coverage

         Harleysville first contends the Special Referee erred in finding it failed to properly reserve the right to contest coverage as to the underlying damages that constitute faulty workmanship, which are not covered under South Carolina law. We disagree. It is axiomatic that an insured must be provided sufficient information to understand the reasons the insurer believes the policy may not provide coverage. 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. That is precisely what happened here, with the exception of the coverage dispute concerning punitive damages.

         A basic understanding of reservation of rights to contest coverage may be helpful. "A 'unilateral reservation of rights' is a notice given by the insurer that it will defend [the insured in the lawsuit] but reserves all rights it has based on noncoverage under the policy . . . ." 14 Couch on Ins. § 202:38. A reservation of rights is a way for an insurer to avoid breaching its duty to defend and seek to suspend operation of the doctrines of waiver and estoppel prior to a determination of the insured's liability. Id. "Although a reservation of rights may protect an insurer's interests, it also is intended to benefit the policyholder by alerting the policyholder to the potential that coverage may be inapplicable for a loss; that conflicts may exist as between the policyholder and the insurer; and, that the policyholder should take steps necessary to protect its potentially uninsured interests." 12 New Appleman on Insurance § 149.02[2][a].

         "A reservation of rights letter must give fair notice to the insured that the insurer intends to assert defenses to coverage or to pursue a declaratory relief action at a later date." United Nat'l Ins. Co. v. Waterfront N.Y. Realty Corp., 948 F.Supp. 263, 268 (S.D.N.Y. 1996). Moreover, because an insurer typically has the right to control the litigation and is in the best position to see to it that the damages are allocated, courts have found that where an insurer defends under a reservation of rights, an insurer has a duty to inform the insured of the need for an allocated verdict as to covered versus noncovered damages. See Tyger River Pine Co. v. Maryland Cas. Co., 170 S.C. 286, 170 S.E. 346, 348 (1933) (observing that where an insurer reserves the right to control the defense, the insured is "directly deprived of a voice or part in such negotiations and defense" and noting that if an insurer's interests conflict with those of its insured, the insurer is " bound, under its contract of indemnity, and in good faith, to sacrifice its interests in favor of those of the [insured]"); see also Remodeling Dimensions, Inc. v. Integrity Mut. Ins. Co., 819 N.W.2d 602, 618 (Minn. 2012) (holding that "when an insurer notifies its insured that it accepts the defense of a[] [] claim under a reservation of rights that includes covered and noncovered claims, the insurer not only has a duty to defend the claim, but also to disclose to its insured the insured's interest in obtaining a written explanation of the award that identifies the claims or theories of recovery actually proved and the portions of the award attributable to each"); id. (reasoning that the "insurer is in a unique position to know the scope of coverage and exclusions in its policies" and "the duty to notify [the insured] is not onerous").

         "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, Inc. v. Cont'l Cas. Co., 36 F.3d 1491, 1498 (10th Cir. 1994) (citations omitted) (explaining "[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" (citing Duke v. Hoch, 468 F.2d 973, 979 (5th Cir. 1972))). Therefore, by "virtue of its duty to defend, an insurer gains the advantage of exclusive control over the litigation, " and "it would be unreasonable to permit the insurer to not disclose potential bases for denying coverage." Id. (internal citations and quotation marks omitted).

         "If the insured does not know the grounds on which the insurer may contest coverage, the insured is placed at a disadvantage because it loses the opportunity to investigate and prepare a defense on its own." Desert Ridge Resort LLC v. Occidental Fire & Cas. Co. of N.C. , 141 F.Supp.3d 962, 967 (D. Ariz. 2015). Indeed without knowledge of the bases upon which the insurer might dispute coverage, "the insured has no reason to act to protect its rights because it is unaware that a conflict of interest exists between itself and the insurer." Magnum Foods, 36 F.3d at 1498 (internal quotation marks and citation omitted). Thus, "[t]he general rule precluding an insurer from raising new grounds contesting coverage in a subsequent action is justified in th[is] []context." Id.

         Where the insurer fails to adequately reserve the right to contest coverage, the insurer may be precluded from doing so. See World Harvest Church, Inc. v. GuideOne Mut. Ins. Co., 695 S.E.2d 6, 10-11 (Ga. 2010) (finding an insurer could not assert a defense of noncoverage based on its failure to effectively reserve the right to contest coverage). "For a reservation of rights to be effective, the reservation must be unambiguous; if it is ambiguous, the purported reservation of rights must be construed strictly against the insurer and liberally in favor of the insured." Id. at 10. (citations and internal quotation marks omitted); see Desert Ridge Resort, 141 F.Supp.3d. 966-68 (explaining that where an insurer undertakes and exclusively controls the defense of the insured under a reservation of rights, prior to undertaking the defense, the insurer must specify in detail any and all bases upon which it might contest coverage in the future since "[g]rounds not identified in the reservation of rights may not be asserted later by the insurer"); id. (explaining the existence of a potential conflict of interest between insured and insurer is what requires the insured to set forth the bases upon which it might contend damages are not covered in a greater amount of detail than would otherwise be required); Weber v. Biddle, 483 P.2d 155, 159 (Wash. Ct.App. 1971) (underscoring that when an insurer controls the defense of the action against its insured, "a high fiduciary duty [i]s owed by the insurer to the insured" and observing a "general notice of reservation of rights failing to refer specifically to the policy provision upon which the insurer wished to rely may be insufficient").

         At the hearing before the Special Referee, Harleysville produced letters it sent to former Heritage principals and counsel between December 2003 and February 2004.[9] These letters 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.[10] 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.

         In contrast, concerning punitive damages, Harleysville did provide in detail the basis for the potential denial of coverage:

The complaint filed against you seeks punitive damages. [Harleysville] reserves the right to disclaim coverage for these since under all of your policies, they would not arise from an "occurrence, " do not fit the definition of "bodily injury" or "property damage, " and/or were "expected and intended" within ...

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