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The California Court of Appeal, Second Appellate District, reversed a trial court judgment dismissing an insured's complaint against its insurer for breach of contract, bad faith and declaratory relief. The Court of Appeal held the trial court erred granting the insurer's motion for summary judgment on the basis of a development/construction exclusion. Although the exclusion broadly precluded coverage for any wrongful act based on or arising out of the "design, construction, renovation or rehabilitation of any…structure or other improvement," the Court of Appeal held this exclusion applied only if the insured undertook the construction.
Executive Risk Indemnity, Inc. ("Executive") issued a directors and officers liability policy (the "D&O Policy") to Marquez Knolls Property Owners Association, Inc. ("Association"). In its application the Association indicated its "[p]rimary function is [to] encourage compliance with CC&R restrictions in deeds of members of the association, for the benefit of the community."
Executive's D&O Policy covered the Association's wrongful acts, defined to include any "actual or alleged error, omission, misstatement, misleading statement or breach of duty." The policy included an endorsement precluding coverage for "Claims for Wrongful Acts based on [or] arising out of …(1) the development, planning or landscaping of any real property …(4) the design, construction, renovation or rehabilitation of any building, structure or other improvement on any real property."
The Association sought coverage under the D&O Policy for a lawsuit brought by two Association members, Nicholas and Yasuko Valery. The Valerys asserted causes of action for fraud, bad faith, and other claims based on the Association's alleged mishandling of a dispute between the Valerys and another member of the Association, Robertson. The dispute between the Valerys and Robertson involved the Valerys' construction of an enclosed structure at their home. Robertson contended this structure interfered with her views, in violation of the Association's covenants, conditions and restrictions ("CC&R's").
The Association offered to provide the Valerys with informal, non-partisan assistance to resolve the dispute. The Valerys gave the Association information to aid in the resolution process but, after meeting with the Association, decided to resolve the dispute on their own. The Valerys alleged the Association then urged Robertson to apply for a written determination of the dispute. When Robertson did so, the Association issued a determination that the Valerys' remodeling violated the CC&R's and called for the removal of the disputed structure.
Robertson then sued the Valerys, seeking an order requiring compliance with the Association's determination. The Association then allegedly aided Robertson in prosecuting her lawsuit. It declined to provide the Valerys with similar assistance.
The Valerys then sued the Association, alleging it exercised powers arbitrarily and capriciously. The Valerys alleged in part that the Association allowed original Association members unlimited ability to build and expand their homes while severely restricting newer members' construction.
The Association tendered the Valerys' lawsuit to Executive for defense and indemnity. Executive declined the tender, concluding the Valerys' claims fell within the development/ construction exclusion. The Association then sued Executive for breach of contract, bad faith and declaratory relief.
Executive moved for summary judgment. It asserted the development/construction exclusion precluded coverage for the Valerys' claims. The trial court granted the motion. It concluded the exclusion was broadly drafted and precluded coverage for claims "in any way involving... improvement on any real property." Since the Association sought coverage for claims that it committed a wrongful act attempting to coerce the Valerys to alter their renovations, the exclusion applied.
The Court of Appeal disagreed. It held the trial court erred because it omitted "the requirement of a connection between the risks the policy insures against or excludes and the insured." The Court of Appeal concluded the exclusion was intended to apply only to the insured's "design, construction, renovation or rehabilitation," not someone else's. Any other interpretation "would be contrary to principles of contract interpretation …; would result in a policy that is almost entirely illusory; has no support in the cases on which [Executive] relies; and would defy common sense."
The Court of Appeal cited several well-established rules of construction in support of its decision. Coverage clauses are interpreted broadly, but exclusionary clauses are construed narrowly. An exclusion clause must be clearly drafted to "apprise the insured of its effect." (Gray v. Zurich Insurance Co. (1966) 65 Cal.2d 263, 269, fn. omitted.) Insurance policy terms are given the "objectively reasonable meaning a lay person would ascribe to them," and "the context in which a term appears is critical." (Century Transit Systems, Inc. v. American Empire Surplus Lines Ins. Co. (1996) 42 Cal.App.4th 121, 126 (internal citations omitted).)
Applying these rules the Court of Appeal concluded the development/construction exclusion "necessarily refers only to the insured's design, construction, renovation or rehabilitation." The Court of Appeal reasoned that the Association's insurance coverage is for its own wrongful acts, and thus any exclusion from that coverage "must necessarily be addressed to the Association's wrongful acts, not to the wrongful acts of a third party."
The Court of Appeal further concluded the Association's "wrongful act" at issue in the Valerys' lawsuit was confined to its activities in connection with the dispute between two of its members. The Court of Appeal found this activity to be "clearly covered by the policy." To conclude otherwise, i.e., that the exclusion applied, "would exclude the sole purpose of the Association's existence," i.e. to resolve disputes among members.
The Court of Appeal acknowledged the phrase "arising out of" is generally interpreted broadly under California law. Nevertheless, the Court of Appeal held this phrase did not dispense with the requirement of a connection between the excluded risk and the insured.
The Court of Appeal therefore reversed the trial court's ruling with directions to enter an order denying Executive's motion for summary judgment. This opinion is not final. Though it has been certified for publication, it may be withdrawn from publication, modified on rehearing, or granted review by the California Supreme Court. Should any of these events occur, the opinion would be unavailable for use as authority in other cases.
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