California Court of Appeal Holds That the Right to Repair Act Prohibits Class Actions Against Manufacturers of Products Completely Manufactured Offsite

Gus Sara | The Subrogation Strategist | January 10, 2019

In Kohler Co. v. Superior Court, 29 Cal. App. 5th 55 (2018), the Second District of the Court of Appeal of California considered whether the lower court properly allowed homeowners to bring class action claims under the Right to Repair Act (the Act) against a manufacturer of a plumbing fixture for alleged defects in the product. After an extensive analysis of the language of the Act, the court found that class action claims under the Act are not allowed if the product was completely manufactured offsite. Since the subject fixture was completely manufactured offsite, the Court of Appeal reversed the lower court’s decision. The court’s holding establishes that rights and remedies set forth in the Right to Repair Act are not available for class action claims alleging defects in products completely manufactured offsite.

In Kohler Co., homeowners instituted a class action against Kohler, the manufacturer of water pressure and temperature regulating valves that were installed into their homes during original construction. The class action was filed on behalf of all owners of residential dwellings in California in which these Kohler valves were installed as part of original construction. The complaint asserted, among other claims, a cause of action under the Act. Kohler filed a motion for anti-class certification on the ground that causes of actions under the Act cannot be certified as a class action. The trial court denied the motion with respect to the Act but certified its ruling for appellate review. Kohler filed a petition with the Court of Appeals, arguing that certain sections of the Act explicitly exclude class action claims under the Act.

The Act revised and codified the laws applicable to construction defect claims related to newly constructed homes. The Act sets forth the standards for home construction, as well as rights and remedies for homeowners. When the Act was passed, it essentially became the exclusive remedy to individual homeowners for losses resulting from construction defects within their homes. The Act also established a builder’s right to attempt to repair a defect before a homeowner can file an action in court.

One of the essential purposes of the Act is to have construction defect disputes resolved expeditiously, and, if possible, to avoid litigation. The Act is specific as to the types of claims that fall under its purview and explicitly excludes certain types of claims. Section 896 of the Act states that the “title does not apply in any action seeking recovery solely for a defect in a manufactured product located within or adjacent to a structure.” The Act defines a “manufactured product” as “a product that is completely manufactured offsite.” In addition, section 931 identifies certain claims that are not covered by the Act, which include class actions. However, the last sentence of that section states that for “any class action claims that address solely the incorporation of a defective component into a residence, the named and unnamed class members need not comply with this chapter.”

The court acknowledged that while section 931 excludes class actions generally, the last sentence of that section sets forth an exception for class actions pertaining “solely [to] the incorporation of a defective component into a residence.” However, the court found that this provision needed to be reconciled with section 896, which excluded claims solely for defects within manufactured products. The court noted that a manufactured product qualifies as a defective component. Thus, in an effort to harmonize the two sections, the court held that the class action exception applies only to those claims related solely to the incorporation into the home of a defective component other than a product that is completely manufactured offsite. Based on this interpretation of the statute, the court reversed the lower court’s decision and granted Kohler’s motion for anti-class certification.

The Kohler Co. case narrowed plaintiffs’ ability to use the Act to pursue class action claims. The court’s interpretation of the Act establishes that plaintiffs cannot use the Act to assert class action claims for defects in manufactured products. Thus, the Kohler Co. decision reminds us that a cause of action under the Act is not permitted for any claims, whether individual or class actions, against manufacturers for alleged defects of products completely manufactured offsite. On the flipside, this decision also reminds us that product manufacturers are not afforded the defenses of the Act.

Naughty or Nice. Contractor Receives Two Lumps of Coal in Administrative Dispute

Garret Murai | California Construction Law Blog | January 7, 2019

So, how were your holidays? Hopefully you were good and didn’t receive a lump of coal from Santa. For one contractor, 2018, wasn’t such a good year. And as its name, Black Diamond, suggests, it did indeed receive a black diamond from the courts. Actually, two of them.

Contractors’ State License Board v. Superior Court (Black Diamond No. 1)

In Contractors’ State License Board v. Superior CourtCourt of Appeals for the First District, Case No. 1154476 (October 11, 2018), the Contractors State License Board (“CSLB”) brought disciplinary proceedings against Black Diamond Electric, Inc. (“Black Diamond”), a C-10 Electrical Contractor, for violating: (1) Labor Code section 108.2, which requires individuals performing work as electricians to be certified; and (2) Labor Code section 108.4, which permits uncertified persons seeking on-the-job experience to perform electrical work so long as they are under the direct supervision of a certified electrician.

The CSLB filed an accusation against Black Diamond in March 2017. In response, Black Diamond filed a “Notice of Defense” claiming that “the work its employees were performing required neither certification nor supervision” and that the CSLB’s interpretation of the applicable Labor Code sections were erroneous. In its request for relief, Black Diamond sought a “permanent injunction barring any disciplinary action for violation of Labor Code sections 108 et seq.”

In April 2018, an administrative law judge heard the accusation and found that Black Diamond had violated the Labor Code by having individuals perform electrical work without certification or direct supervision by a certified electrician and recommended revocation of Black Diamond’s contractor’s license. The CSLB Registrar adopted the proposed decision, but before the decision became effective, Black Diamond asked the CSLB to stay entry of the decision so it could file a motion for reconsideration. The CSLB granted the request.

Meanwhile, while the administrative proceeding was pending, Black Diamond filed a complaint in the Contra Costa County Superior against the CSLB seeking a declaration that the CSLB was “knowingly enforcing Labor Code § 108, et seq. illegally” and seeking a “permanent injunction enjoining and restraining the [CSLB] from seeking to enforce the ‘direct supervision’ provision of Labor Code section 108.4(a)(3) until the [State Legislature] provides the [CSLB] with further clarification.”

In response, the CSLB filed a demurrer to the complaint arguing that the Superior Court lacked jurisdiction because Black Diamond had not yet exhausted its administrative remedies in the parallel administrative proceeding. The trial court overruled the demurrer on the ground that Black Diamond’s complaint for declaratory relief was “not limited to the pending administrative proceeding, but is based on the [CSLB’s] interpretation of [Labor Code] section 108 and how the [CSLB] will apply its interpretation to [Black Diamond] going forward.” The CSLB appealed.

On appeal, the First District Court of Appeal overturned the decision of the trial court finding that the Administrative Procedure Act permitted Black Diamond to object to an accusation not the ground that it “does not state acts or omissions upon which the agency may proceed” and to “[o]bject to the form of the accusation . . . on the ground that it so indefinite or uncertain that the respondent cannot identify the transaction or prepare a defense.” The Court of Appeal also noted that the Administrative Procedure Act allows Black Diamond to conduct discovery and to move to compel discovery if necessary.

As such, held the Court of Appeal, “[s]ince the relevant statutes provide [Black Diamond] with an administrative remedy, it must first exhaust that remedy before it may seek redress in court.”

Lump of coal number one.

Contractors’ State License Board v. Superior Court (Black Diamond No. 2)

In Contractors’ State License Board v. Superior Court (2018) 23 Cal.App.5th 125, while Black Diamond’s action with the Contra Costa County Superior Court was pending, Black Diamond served interrogatories and a request for production of documents on the CSLB and noticed the deposition of David R. Fogt, the Registrar of the CSLB.

In response, the CSLB filed a motion for protective order to prevent deposition, arguing that: (1) the deposition was improper before the court heard the CSLB’s demurrer; (2) the deposition was noticed for the purpose of harassing Mr. Fogt and was burdensome because the deposition sought to depose Mr. Fogt on the definition of statutory terms, which are issues of law, not fact; and (3) the deposition notice was improper because top government executives are normally not subject to deposition. In opposition to the motion, Black Diamond argued that it’s deposition notice was permissible.

In February 2018, the trial court issued a tentative ruling denying the CSLB’s motion for protective order finding that Mr. Fogt “has direct factual information and that he was directly involved in issues related to this case before his appointment as Executive Officer.” The CSLB appealed.

On appeal, the First District Court of Appeal noted that “[t]he general rule in California and federal court is that agency heads and other top governmental executives are not subject to deposition absent compelling reasons” unless: (1) “the deposing party . . . show[s] that the government official ‘has direct personal factual information pertaining to material issues in the action . . . ” (emphasis in original); and (2) “the deposing party  . . . also show[s] “the information to be gained from the deposition is not available through any other source.”

In response to Black Diamond’s argument that it was not seeking to depose Mr. Fogt in his executive capacity, but rather, was seeking  information that Mr. Fogt had gained during his earlier career with the CSLB, the Court of Appeals held that “[I]t does not matter that [Black Diamond] claims to seek information Fogt gained before he was elevated to his current position. The rule prohibiting the deposition of agency heads and other highly placed public officials is grounded on the concern that such proceedings will consume the officials’ time and hamper them in the conduct of government business.”

Further, held the Court of Appeal, Black Diamond’s purported purpose of deposing Mr. Fogt “to inquire about the CSLB’s] prior administrative interpretations fo the statute, and prior applications to it, that occurred by his direction, through his authority since his appointment as Enforcement Chief,” sought information on issues of law alone, thereby precluding his deposition, not facts. “The only information relevant to the [CSLB’s] interpretation of the Labor Code will be the text of the statutes, legislative history, and perhaps official administrative interpretations,” explained the Court, and “[Black Diamond] is not permitted to ask agency officials how they personally interpret statutes administered by the [CSLB], since their personal views are irrelevant to the purely legal issue of statutory construction.”

Lump of coal number two.

Property Damage Is Not Necessarily Physical In Calif.

Catherine L. Doyle and Jan A. Larson | Jenner & Block LLP | December 10, 2018

In a recent decision, Thee Sombrero Inc. v. Scottsdale Insurance Company, a California appellate court ruled against insurers seeking to limit coverage for loss of use damages related to an ownership interest in tangible property. The appellate court held that the “loss of use” need not be a loss of all possible uses of the property and recognized that the loss of a particular use was sufficient to constitute the required property damage. In addition, the appellate court authorized the use of economic loss calculations as an appropriate measure of this covered property damage. In so holding, the appellate court challenged the reasoning of other opinions in a sister state and elsewhere in California, and its detailed analyses of the more insurer-friendly holdings may provide persuasive support for policyholders facing similar issues throughout the country. We suggest that policyholders facing similar situations familiarize themselves with this opinion when advocating for coverage for loss of a particular use of tangible property, resulting in economic losses.

A unanimous panel of the Court of Appeals for the Fourth District of California recently issued an opinion construing a commercial general liability policy’s coverage for property damage as extending to economic losses stemming from a loss of use of that property for a particular purpose. In Thee Sombrero Inc. v. Scottsdale Insurance Company, a judgment creditor of the policyholder brought suit against the policyholder’s liability insurer to recover the loss of value that resulted from the revocation of a municipal permit to operate a nightclub. The insurer sought to circumvent coverage by contending that the loss of a permit was merely the loss of an intangible right, and that the plaintiff had only suffered economic damages. The insurer argued the plaintiff’s claims therefore fell outside of the scope of the liability policy’s coverage for property damages. In ruling in favor of coverage, the appellate court undertook a rigorous analysis that refuted the insurer’s arguments and distinguished contrary authority that had taken a more insurer-friendly position.

Thee Sombrero Inc. owned commercial property in Colton, California. Sombrero also possessed a conditional use permit, or CUP, issued by the city, which authorized the operation of a nightclub on the premises. In 2007, Sombrero leased the property to lessees who ran a nightclub under the CUP. Among other conditions, the CUP required city approval of the property’s floorplan and mandated that the approved floorplan could not be modified without further city approval. The city inspected the property in connection with the lease and approved the floorplan, which included a single entrance to the nightclub, equipped with a metal detector.

Crime Enforcement Services was hired to provide security services for the nightclub. Unknown to Sombrero at the time, CES converted a storage area on the property into a “VIP entrance” without a metal detector. On June 4, 2007, a fatal shooting occurred inside the nightclub. Sombrero subsequently learned about the “VIP entrance,” and the owner of CES admitted that the gun used in the shooting had entered the club via this unauthorized second entrance.

As a result of the shooting at the nightclub, the city revoked the CUP. Sombrero negotiated with the city and secured a modified CUP, allowing for use of the property as a banquet hall instead of a nightclub. However, this restricted use as a banquet hall was less lucrative than the prior use as a nightclub.

In 2009, Sombrero sued CES for breach of contract and negligence, alleging that CES did not frisk the shooter and that CES’s failure to screen the shooter led to the shooting, which in turn caused the revocation of the original CUP. The loss of the CUP “lower[ed] the resale and rental value of the [p]roperty” and caused “lost income,” since renting the property as a nightclub had been more profitable than renting it as a banquet hall. Sombrero sought damages against CES for “the reduction in fair market value of the [p]roperty” and “lost income.” The president of Sombrero attested that the difference in value of the property under the original CUP versus the modified CUP was $923,078. In 2012, the court entered a default judgment against CES for the $923,078 of lost value.

CES had a general liability policy issued by Scottsdale Insurance Company, which covered CES’s liability for “property damage” caused by an occurrence. The policy defined “property damage” as either “[p]hysical injury to tangible property, including all resulting loss of use of that property,” or “[l]oss of use of tangible property that is not physically injured.” As a judgment creditor of CES, Sombrero initiated a direct action against Scottsdale in 2015 seeking coverage for the loss of use, expressed as the $923,078 in economic losses, caused by CES.

Scottsdale moved for summary judgment, arguing that the revocation of the original CUP was not a loss of use of tangible property. Rather, according to Scottsdale, the loss of the original CUP was merely the loss of an intangible right to use the property in a particular way. Scottsdale further asserted that property damage, as contemplated by the policy, did not include economic loss. Sombrero responded that it lost the use of tangible property because of the revocation of the original CUP and argued that the economic loss resulting from the loss of use of tangible property did constitute property damage covered by the policy. The trial court agreed with Scottsdale and granted the motion for summary judgment in 2016. In its order, the trial court held, “[l]ost value is economic loss, but economic loss is not lost use of tangible property.”

Sombrero appealed, reiterating its argument that the loss of use of the property resulting from the revocation of the original CUP constituted “loss of use of tangible property that is not physically injured.” The appellate court noted that the interpretation of an insurance policy is a question of law subject to de novo review under settled rules of contract interpretation. Among those well-settled rules of interpreting insurance contracts, the appellate court construes ambiguous language to protect the objectively reasonable expectations of the policyholder.

At the outset of its analysis, the appellate court declared that it “defies common sense to argue” that Sombrero’s loss of its ability to use its property as a nightclub is not, by definition, a loss of use of tangible property. The appellate court then dispatched conflicting authority, including a Washington appellate court decision also involving Scottsdale with “strikingly similar” facts. In Scottsdale Insurance Co. v. Int’l Protective Agency, the dispute centered on the loss of a restaurant’s liquor permit caused by the negligence of Scottsdale’s policyholder, a security company that permitted a minor to enter the restaurant. The opinion in IPA did not persuade the appellate court in Thee Sombrero to abandon its “common-sense position.” In the view of the appellate court, the coverage analysis properly focused on the loss of use of property that results from the loss of an entitlement and not the loss of the intangible entitlement itself. Although a permit or license is not tangible property itself, its loss means the owner of the property can no longer use that property in a particular way. Furthermore, the reasonable expectations of the policyholder would construe “loss of use” to include the loss of any significant use of the property, not merely the total loss of all possible uses. Finally, the appellate court parted ways, in dictum, with the IPA court’s assertion that a right to occupy premises is not a tangible property interest. To the contrary, at least under California law, a lease is considered a conveyance of an estate in real property. Moreover, regardless of the technical legal contours, a policyholder would understand “tangible property” in an insurance policy to include leased real property. In any event, the appellate court determined that Sombrero, as the owner of the property at issue, plainly owned an interest in tangible property.

Having disposed of Scottsdale’s argument that Sombrero had only lost an intangible right to use its property in a particular way, the appellate court went on to address other points of disagreement with the trial court’s ruling. The trial court had granted summary judgment for Scottsdale under the rationale that a “mere economic loss” is not property damage. Generally speaking, strictly economic losses — such as lost profits, loss of an investment, loss of goodwill or loss of an anticipated benefit of a bargain — will not constitute tangible property damage as contemplated by a commercial general liability policy. However, where the intangible economic losses provide a measure of damages to tangible property that is covered by the policy, the policy will provide coverage for those damages. In other words, loss of economic value is an appropriate method of measurement to calculate property damage in the commercial general liability policy context. The diminution of property value is not merely economic loss but damages sustained because of property damage. Therefore, the appellate court articulated that the correct principle is not that economic losses can never constitute property damage; rather, only losses that are exclusively economic and that lack any accompanying physical damage or loss of use of tangible property are not property damage. Under this principle, Sombrero suffered a loss of use of tangible property under the policy. Further, the loss of value was a proper measure of those damages. Sombrero’s use of the diminution of value calculation to measure its damages did not provide an escape hatch for Scottsdale to avoid coverage.

The appellate court also dispensed with other precedent offered by Scottsdale. Referring back to the policy language, “[l]oss of use of tangible property that is not physically injured,” the appellate court distinguished a California Supreme Court case that sided with an insurer on claims based on the loss of an easement, which was not itself tangible property, and resulting in loss in value but no physical damage to the injured party’s property. The appellate court also distinguished a 2007 decision from the Second District appellate court involving a case brought by a lessee against its landlord for the landlord’s failure to maintain the property in the condition in which the landlord had contracted to maintain it, as this amounted to a breach of contract claim over leasehold interests and not the loss of use of tangible property.[4] Although the appellate court in Thee Sombrero again expressed doubt, in dictum, over the expressed proposition in the Golden Eagle opinion that leasehold interests are not tangible property, it relied upon Sombrero’s status as property owner to hold that its claim for diminution of value or its ownership interest constituted a claim for loss of tangible property.

Since the appellate court ruled in favor of Sombrero on grounds that the loss of the original CUP was anchored to the covered loss of use of tangible property and was properly measured by the loss of value economic damages, the court declined to address alternative arguments raised by Sombrero. Questions of whether the loss of the original CUP itself constituted a loss of use of tangible property and whether the construction of the unauthorized VIP entrance constituted physical damage to tangible property (arguably not an “occurrence,” defined as an “accident” by the policy) were thus reserved for another day.

The appellate court’s opinion in Thee Sombrero underscores the benefit to policyholders of express policy language that encompasses the loss of use of tangible property that has not sustained physical damage. We recommend policyholders review their commercial general liability policy provisions, including the definitions, and consider the appellate court’s analysis in Thee Sombrero when evaluating whether their policy may extend to claimed loss of use damages, even where property is not physically damaged. Policyholders may find persuasive support in the methodical examination of the practical, “common sense” connection between the loss of a right to use tangible property and the covered loss of use of such property. The opinion also provides an analytical foundation for the applicability of economic losses as the correct measure of the property damages. The strongest support may be for property owners above lessees in Thee Sombrero, although the appellate court articulated certain reservations that suggest it may be persuaded by future arguments regarding similar loss of use claims made by lessees, as well.

Class Actions Under California’s Right to Repair Act. Nope. Well . . . Nope.

Garret Murai | California Construction Law Blog | December 17, 2018

It’s the holidays. A time when family and friends, and even neighbors, gather together.

And nothing brings neighbors closer together than class action residential construction defect litigation.

In Kohler Co. v. Superior Court, Case No. B288935 (November 14, 2018), the Second District Court of Appeal addressed whether neighbors can bring class action lawsuits under the Right to Repair Act. For those who are regular readers of the California Construction Law Blog you’re familiar with the Right to Repair Act codified at Civil Code sections 895 et seq.

For those of you who aren’t here’s a short history. In 1998, in Aas v. Superior Court (1998) 64 Cal.4th 916, the California Supreme Court held that economic damages arising from construction defects, say a defective roof (as opposed to damage to your holiday gifts as a result of water damage resulting from the defective roof), are not recoverable if the basis for liability is negligence (e.g., faulty workmanship) or strict liability (e.g., defective materials).

To limit the application of the Aas case to newly constructed residential housing, including single family homes and condominiums (but not condominium conversions), the California legislature enacted SB 800 also known as the Right to Repair Act. The Right to Repair Act permits homeowners of newly constructed residential housing to sue for economic damages alone if new residential construction does not meet certain enumerated construction standards set forth under the Right to Repair Act and the homeowner satisfies the pre-litigation procedures of the Act.

One aspect the Right to Repair Act does not clearly address, however, is if homeowners can join together and bring a class action lawsuit under the statute.

Kohler Co. v. Superior Court

In Kohler, two homeowners, Joanna Park-Kim and Maria Cecilia Ramos, filed a lawsuit against Kohler Co. on behalf of themselves and others similarly situated  throughout California. The plaintiffs alleged that “Rite-Temp Pressure Balancing Valves” and “Mixer Caps” manufactured by Kohler, which are used to regulate water flow and temperature in household plumbing, were “corroding, failing, and/or will inevitably fail” and violated the construction standards of the Right to Repair Act.  Kohler sold approximately 630,000 of these valves and mixer caps in California during the relevant period.

While the case was pending, Kohler filed a motion claiming that the Plaintiffs could not bring a class action lawsuit under the Right to Repair Act. The trial court denied Kohler’s motion but certified its ruling for appellate review finding that the issue presented a controlling question of law upon which there were substantial grounds for differences of opinion.

The Appellate Court Decision

On appeal, the Second District Court of Appeal focused on Section 931 of the Right to Repair Act, which provides that, when construction defect claims combine causes of action or damages that are not covered under the Right to Repair Act (i.e., construction defects that are not among enumerated construction standards of the Act) with other claims involving construction defects that are covered by the Act, that those defects that are covered by the Act are to be administered according to the Act (i.e., the pre-litigation procedures of the Act). Specifically, Section 931 provides:

If a claim combines causes of action or damages not covered by this part, including, without limitation, personal injuries, class actions, other statutory remedies, or fraud-based claims, the claimed unmet standards shall be administered according to this part, although evidence of the property in its unrepaired condition may be introduced to support the respective elements of any such cause of action. As to any fraud-based claim, if the fact that the property has been repaired under this chapter is deemed admissible, the trier of fact shall be informed that the repair was not voluntarily accepted by the homeowner. As to any class action claims that address solely the incorporation of a defective component into a residence, the named and unnamed class members need not comply with this chapter.

Describing Section 931 as “somewhat obtuse,” the court noted that while the inclusion of the term “class actions” in the first sentence implies that class actions cannot be brought under the Right to Repair Act, the last sentence of the section that “any class action claims that address solely the incorporation of a defective competent into a residence” suggests that certain class actions might be able to be brought under the Act.

Looking to the legislative history of the Right to Repair Act, the Court of Appeals held that class actions may not be brought under the Right to the Repair Act, “with one very narrow exception.”

The Court of Appeal referred to a Senate bill analysis of SB 800 discussing the pre-litigation procedures of the Right to Repair Act, which stated: “The bill establishes a mandatory process prior to the filing of a construction defect action. The major component of this process is the builder’s absolute right to attempt a repair prior to a homeowner filing an action in court. Builders, insurers and other business groups are hopeful that this right to repair will reduce litigation.” The Court concluded that “it makes sense” that “the Legislature intended to exclude class actions for virtually any claim under the Act, because class actions make prelitigation resolution impossible.” Moreover, held the Court:

Even if the named plaintiffs bringing a class action comply with the prelitigation process, thus giving the builder of their homes an opportunity to attempt to repair whatever defect is claimed as to their homes, the builders of other homes are given no such opportunity with respect to the unnamed class members, thus thwarting one of the most significant aspects of the Act.

However, held the Court of Appeal, Section 931 does carve out one narrow, or, as the Court stated, one “very narrow” exception to the Right Repair Act.  And that is claims that solely involve the incorporation of a defective component into a home.

And, here, because the plaintiffs’ claims against Kohler alleged that the defective valves and mixers violated several of the enumerated construction standards set forth under the Right to Repair Act causing damage to other components in their homes, the Court of Appeal held that their claims did not solely involve incorporation of a defective component in their homes, and further, involved an allegedly defective manufactured product that is excluded under Section 896 of the Right to Repair Act, which excludes “any action seeking recovery solely for a defect in a manufactured product located within or adjacent to a structure.”

“In short,” held the Court of Appeal, the Right to Repair Act “does not permit class action claims except when those claims address solely the incorporation into the home of a defective component other than a product that is completely manufactured offsite.”

So there you go. Something for everyone this holiday season. Kind of.

Conclusion

Kohler Co. clarifies that, with one very narrow exception, class action lawsuits cannot be brought under the Right to Repair Act. Furthermore, while the Court did not directly address what constitutes a “defective component other than a product that is completely manufactured offsite,” it would seem that this is indeed, as the Court of Appeal stated, a very narrow exception that would exclude class action claims involving most  manufactured products except products built in whole or in part at a project. Maybe I’ve had too much eggnog, but I can’t even imagine what those types of products might be.

California Court Finds Coverage When “Property Damage” Doesn’t Require Physical Injury By Definition

Tamara Boeck | Ahead of Schedule | November 7, 2018

Although it may seem strange at first, the recent ruling by the California Fourth Appellate District Court in Thee Sombrero, Inc. v. Scottsdale Co., (2018 EL 5292072), holding that an insurer must pay for a claim where there was no actual physical property damage, is not as odd as it may seem to non-insurance coverage lawyers.  The reason?  It all depends on the policy language and the definition of “Property Damage” where there is an “occurrence.”

The underlying facts are noteworthy in that there was no dispute that the plaintiff-claimant, Thee Sombrero, Inc. (Sombrero), lost revenue and the value of its real estate (diminished value) when the security company it hired to provide security guards failed to keep guns out of Sombrero’s nightclub.  A fatal shooting due to that alleged negligence (“an occurrence”) resulted in a lost ability by Sombrero to operate its property as a nightclub.  That specific loss of use totaled almost a million dollars in diminished value of the Sombrero property.  Sombrero sued the security company for the lost value, and the security company defaulted.  Sombrero then pursued the security company’s insurer, Scottsdale, under California Insurance Code section 11580, which allows a prevailing claimant to file a direct action against the insurer for coverage under the applicable insurance policy.

Scottsdale filed a motion for summary judgment not long after the section 11580 action was filed against it, arguing that the loss of the “use permit” for a nightclub was not lost use of tangible property, but merely the loss of an intangible right to use property in a certain way, and really economic loss that is not covered as property damage under the policy. The trial court agreed.  Sombrero appealed and argued in essence that “[t]he loss of the ability to use the property as a nightclub is, by definition, a ‘loss of use’ of ‘tangible property.’” To which the appellate court commented, “It defies common sense to argue otherwise.”  At the same time, however, the appellate court identified contrary authority involving Scottsdale (albeit in Washington State) that was “strikingly similar” to the present case, yet distinguished the prior Scottsdale decision on three grounds:  1) the focus should be on the loss of use of the tangible property that results from the loss of the entitlement, not just the entitlement, 2) the loss is not defined in the policy as requiring a “total loss” and therefore under normal interpretation standards “any significant use” lost would be within the reasonable expectation of the insured for coverage, and 3) acknowledging that a leasehold of a specific type of property is an actual property right, and the loss of such use of a property right is therefore a loss of use of tangible property.   In stating the “correct principal,” the appellate court held that “losses that are exclusively economic, without any accompanying physical damage or loss of use of tangible property, do not constitute property damage.”  Here, because the Scottsdale policy “expressly defined property damage as including” ‘[l]oss of use of tangible property that is not physically injured,” the appellate court disregarded the distinguishable California cases with differing policy language under consideration.

While this case did not arise out of a construction defect dispute, the points of insurance coverage may be applicable in a future construction defect context where there has been an “occurrence” but no physical injury to the property, only a valuable loss of use of that property.  Of course, it will always depend on the specific language of the insurance policy, which is why it is so important to understand the insurance policies and potential for coverage in any dispute.