The first reported decision on insurance coverage for policyholders facing claims and lawsuits arising from allegedly defective “Chinese drywall” was issued by the U.S. District Court in the Eastern District of Virginia on March 24. Builders Mutual Ins. Co. v. Dragas Mgmt. Corp. et al., 2:09-cv-185 (E.D. Va.). The decision by Judge Rebecca Beach Smith granted the insurer’s motion to dismiss the policyholder’s cross-claims seeking to establish a defense and indemnity obligation for the costs associated in investigating and remediating property damage to homes allegedly arising from the defective drywall.

The decision, which applies Virginia law, was based on a narrow issue relating to the specific facts of this case. The court found that the policyholder’s remediation efforts, and associated expenses, were initiated “voluntarily” and before any lawsuits or threats of lawsuits had been made. The dismissal ruling permitted the policyholder to amend its complaint to allege, if it could, facts that may demonstrate suits or threats of suits prior to the remediation activity. The court limited its ruling to this fact-specific issue and did not address other defenses raised by the insurer.

The case began when Builders Mutual Insurance Company (Builders Mutual) sued its policyholder Dragas Management Corporation (Dragas), seeking to establish that its primary and umbrella-level general liability policies did not cover losses arising from allegedly defective “Chinese drywall” installed by subcontractors in homes constructed by Dragas. Dragas counterclaimed for breach of contract and to establish a defense and indemnity obligation.

Prior to the suit, Dragas had received complaints from homeowners regarding property damage tied to the allegedly defective drywall. In response, Dragas initiated a remediation program to address the homeowners’ concerns. Dragas also tendered the claims to its insurers, including Builders Mutual. Builders Mutual then preemptively sued Dragas to establish no coverage. After the coverage suit was filed, apparently four underlying lawsuits were filed against Dragas. However, these suits were settled and dismissed while the coverage action was pending. Op. at 5-7.

In its motion to dismiss, Builders Mutual argued that Dragas had not been sued prior to incurring remediation expenses and had not alleged suits or threats of suits in its cross-complaint. Accordingly, Builders Mutual argued that Dragas was not “legally obligated to pay” sums “as damages” as those terms were used in the insuring agreements of the applicable policies. The court agreed with Builders Mutual.

First, the court examined a number of decisions in various jurisdictions, finding that “[c]ourts are split as to whether a ‘legal obligation’ to pay can arise before a lawsuit is filed against the insured.” Op. at 12. The court also recognized that “[c]ourts are further split as to whether an insured can have a legal obligation to pay sums ‘as damages,’ if a third-party lawsuit has not been filed.” Op. at 13. As to Dragas, the court found:

Currently, Dragas has alleged no facts regarding the extent to which the remediation plan has been executed or why it was undertaken at the juncture that it was. Importantly, Dragas has failed to specifically allege any threats of lawsuits by individual homeowners, or even that specific demands were made by the homeowners before the plan was implemented. While these facts may also affect other aspects of coverage, at minimum, there has to be some factual support for a legal obligation to remediate, other than a voluntary business decision by Dragas after initiating its own letter inquiry to homeowners.

Op. at 14. As a result, and based on Virginia law, the court held that Dragas had failed to plead sufficient facts to demonstrate a “legal obligation” to pay “damages” and granted the insurer’s motion to dismiss. However, the court granted Dragas 14 days in which it could amend the cross-complaint to allege facts that may demonstrate suits or threats of suits sufficient to show a “legal obligation” to remediate. Op. at 15-16.

In light of this limited ruling, the court did not reach other defenses raised by the insurer, including whether the drywall claims constitute an “occurrence” under the Builders Mutual policies. Op. at 16- 12.

There are a number of points to draw from this decision:

  • Insurance coverage issues are subject to the laws of individual states, such that choice of law may be dispositive on an interpretative dispute. Insurers recognize the importance of forum selection, and will not hesitate to sue their policyholders in perceived favorable jurisdictions in order to take advantage of choice-of-law rules.
  • The old maxim “No good deed goes unpunished” might apply here. Dragas attempted to “do the right thing” by responding to its customers’ complaints and initiated remediation efforts before lawsuits had been filed. Though the court recognized that Dragas may have “made an appropriate and well-conceived decision to remediate from a business, public relations and moral standpoint,” the court had to follow the literal language of the insurance policies and could not rewrite them to further those ends. Op. at 15.
  • The decision was narrowly decided. In particular, the court did not address the numerous defenses raised by insurers in the drywall coverage cases, including whether drywall losses arise from an occurrence, whether pollution exclusions apply, whether owned or impaired property exclusions apply, and whether mitigation efforts prior to suits could be covered under appropriate factual circumstances.  

There are currently a number of coverage lawsuits over allegedly defective drywall pending in North Carolina, Florida, and Virginia. Insurers appear to be favoring Florida as a hospitable jurisdiction, and have preemptively sued a number of policyholders in Florida courts seeking to avoid coverage for these evolving claims. The decision can be viewed online at http://www.morganlewis.com/pubs/BuildersMutualVDragas.pdf.