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February 2, 2008

Cleaning Up the Mess in Texas: Insurer Funding Payment of Liability Claims When Coverage Is Doubted

In May 2005, the Texas Supreme Court unanimously held that a liability insurer that voluntarily settles a claim against an insured may recover the payment against its own insured if it proves that the claim is uncovered and it reserved its right to seek recoupment. The Texas Supreme Court, while unanimous in result, was badly splintered in rationale.

Two years ago, the Court granted rehearing. Yesterday, the Court changed course, with a majority ruling that an insurer does not have a unilateral right or an equitable claim to recover a settlement payment. Excess Underwriters v. Frank's Casing (Tex. Feb. 1, 2008). The court reaffirmed its prior decision in Matagorda County, which barred a primary insurer from seeking recoupment of defense cost. Recent case law in other jurisdictions have split on the issue, but the more robust recent opinions (Illinois, Massachusetts, Wyoming) line up with Texas.

I analyzed the Supreme Court’s original opinion from May 2005 at some length previously, criticizing it fairly strongly on a number of its points and approaches. In the new iteration issued yesterday, the three opinions (majority and two dissents) adopt three approaches: (i) the contract is silent and insurers should fix the drafting omission; (ii) the contract is silent but equity should balance out the resolution (and generally permit recoupment); and (iii) in this particular instance, the contract is not so silent that when combined with the facts there was created a new implied in fact or new implied in law agreement to reimburse.

The Frank's Casing case was challenging in that an undeserving insured stood before the court – the insurer owed no obligation to pay. Had the insurer refused to pay, it would not have breached its contract and would not (on this basis) be liable for any bad faith or extra-contractual obligation. And the policyholder did not settle the case in reliance on the insurers forfeiting whatever claim they may have possessed at the time to obtain reimbursement.

The majority, per Justice O’Neil, found there was no fundamental unfairness in allowing the insured to reap the benefit of the settlement even when the claim is shown not to be covered. Settlement paid by the insurer is a welcome relief for the policyholder – unless the “other shoe” drops and the carrier seeks to prove in a separate suit both (i) the tort plaintiff was right and the insured-defendant truly was liable, (ii) the insured’s liability was such that it was entirely excluded from coverage and (iii) the insurer alleges the insured must reimburse it for all the money it paid. This result is essentially worse for the insured than is “rolling the dice” at trial, because if the case is triable then a reasonable jury could rule in favor of the insured. By the insurer’s settling, the insured loses the opportunity to have an outcome whereby it walks scot free.

Faced with a reasonable settlement offer from the tort plaintiff, what is the carrier to do? An insurer surely has a privilege to reject an unreasonable settlement offer, but a reasonable settlement offer cast against doubtful coverage places the insurer in a difficult situation. If the insurer doubts the existence of coverage but later is proven wrong, and the settlement offer was reasonable but spurned, the insurer is at risk of being held liable for the entirety of the verdict against the insured even if the verdict exceeds policy limits. This is a consequence of the law of “third party” bad faith or what is called in Texas “Stowers.” An insurer that unreasonably fails to settle a third-party claim that results in a verdict adverse to the insured is potentially liable for all the damages stemming from its unreasonable conduct, i.e., the value of the verdict that could have been averted had the settlement been accepted.

The insurers and their backers in the Texas Supreme Court found it unfair that the insurer could be set up or pressured to make payment on behalf of an insured yet be unable to prove that coverage was not properly owed. The split between the majority and dissent might be thought of as a difference in opinion whether the insurers are required to put into the policy some sort of provision addressing the situation of a reasonable settlement that might or might not be covered. The majority holds the insurer that fails to clarify its contract on this point bears the consequences, that is, if it makes the payment to extinguish the insured’s liability it does so without recourse against the insured (unless the insured expressly agrees to a right of reimbursement). The articulate dissent by Justice Hecht reasons that because the policy is silent the insurer should be able to pay under protest (i.e., with a reservation) such that it can mount an equitable claim to recover the benefit conferred on the insured that was never owing to begin with (assuming that coverage does not apply).

Justice Hecht’s dissent argues cogently that principles of equity generally permit a party that doubts performance is owed to tendered performance subject to a reservation; the dissent then argues that there is no distinction between insurance companies and other contracting parties. Assuming Justice Hecht is right in his premise on what equity generally provides, policyholders need to fashion a persuasive response as to why insurance is different.

I think the difference lies in the fact that other kinds of contracting parties do something else in the world other than make contracts. If I make widgets and you are a supplier, and you then think that you don’t owe me some delivery, equity (apparently) will permit you to provide performance to me, subject to straightening it all out later. No doubt the parties’ contract does not address this situation, that is, of uncertain obligations to perform, and the law or equity seeks to ensure a fundamentally fair outcome and does not blame the parties for not accounting for this situation ex ante.

That widget makers and their suppliers do not lay out in their contracts what happens in these circumstances is understandable. They are in the business of widgets, and their making a contract is ancillary to what they do. But insurance companies are different.

Insurers are professional contract-writing companies; what they sell are not widgets but contracts. Insurers have the knowledge that there are many circumstances where coverage may be uncertain but a reasonable settlement will be presented. What the insurer may do or may be required to do might be deemed to be something in the insurer’s superior knowledge vis a vis a prospective insured, such that an omission in the contract can be considered to be deliberate by the insurer. Under this approach, an insurer’s failure to clarify what might happen in a situation that is not altogether unlikely to arise can be considered a species of sharp practice such that Justice Hecht’s equitable remedy will not lie. It is well established that he who seeks equity must do equity, and that doctrines such as unclean hands will preclude the exercise of equity power. Accordingly, while the dissent makes a powerful argument that in an ordinary circumstance payment under protest is allowable and equity will reallocate, an insurer that finds itself in this situation and has not clarified its intentions in its contract has only itself to blame, such that equity should not intervene.

Instead, insurers should write out how such claims will be handled, and allow insurance regulators and market forces to scrutinize and differentiate among insurance products. This is the essence of the holding of the new majority opinion in Frank’s Casing:

We resolved this quandary in Matagorda County, determining that the risk of coverage uncertainties was best placed with the insurer. Id. We reasoned that “[r]equiring the insurer, rather than the insured, to choose a course of action is appropriate because the insurer is in the business of analyzing and allocating risk and is in the best position to assess the viability of its coverage dispute.” Id. at 135. An insurer in this situation has a number of options. If the insurer assesses its coverage position as strong, it may refuse to participate in settlement and rely on its coverage action, leaving the insured to negotiate a settlement with its own resources. Or, an insurer may seek prompt resolution of its coverage dispute, a course we have encouraged insurers in this position to take. Id. at 135 (citing State Farm Fire & Cas. Co. v. Gandy, 925 S.W.2d 696, 714 (Tex. 1996); Farmers Tex. County Mut. Ins. Co. v. Griffin, 955 S.W.2d 81, 84 (Tex. 1997)). Or, if an insurer’s coverage position is difficult to assess, as is sometimes the case, the insurer can leverage the coverage dispute during settlement negotiations to lower the claimant’s demand; by paying the negotiated claim, the insurer eliminates its own potential bad-faith liability, saves defense costs, and avoids protracted coverage litigation with its insured. Or, at the outset, the insurer may include a reimbursement right in the policy, which may yield a lower premium than a policy that does not contain such a right.

Slip op. at 7. Texas joins the high courts of Massachusetts and Illinois, among others, in placing the initial onus on insurers to state their intentions ex ante and not to permit case by case adjudication after the tort claim is settled. An insurer that has a contract that is silent on the point can choose to settle the claim against the insured and fund the settlement, can arrange with the insured to provide it with a loan to fund a settlement while the coverage issues are worked out, or can refuse to pay for a settlement and hope to prove there is no coverage or that its refusal to perform at least was reasonable. There is no reason for courts to create one further remedy for insurers when they are well-positioned to protect themselves at the point of contract. The Texas Supreme Court in its majority opinion contributes to stability in contract relationships and cleans up what had been a real mess conceptually in the initial opinion in Frank’s Casing.

Posted by Marc Mayerson at 9:03 AM | Comments (0) | TrackBack

January 16, 2008

The Covenant to Provide Notice: Materiality or Prejudice Needed To Refuse Payment

Sometimes courts get it right, both analytically and in the result. This was true in the landmark decision of the Texas Supreme Court in PAJ, Inc. v. Hanover Insurance Co. (Texas Jan. 11, 2008). In this case, the Texas court holds that “an insured’s failure to timely notify its insurer of a claim or suit does not defeat coverage if the insurer was not prejudiced by the delay.” While I agree with the holding, what may be more significant is the court’s adoption of the right analytical approach, specifically, considering the notice provision as covenant whose breach discharges the insurance company’s performance only where that breach constitutes a material breach of the contract.

The Texas Supreme Court sought to fashion a rule that avoided “draconian consequences for even de minimis deviations from the duties the policy places on insureds” (which is how it characterized the position of the dissent). Both the majority and the dissent embraced the principle that contractual provisions should be construed as covenants rather than conditions, owing to the fact that a breach of condition works a forfeiture. This principle applies even if a provision is in the “conditions” section of the policy. In PAJ, which I wrote about previously, the dispute between the majority and dissent centered on whether the particular provision should be considered to be a true condition or not.

Certainly, an unexcused breach of the obligation to provide timely notice is not sympathetic, and insurers have legitimate interests in knowing of the existence of claims against their insureds, in investigating claims while the evidence is fresh, and taking steps to safeguard their insureds’ interests and their own. The question in PAJ and other notice cases is whether it is best to set up a system that results in automatic forfeiture in all cases where notice is late or other “conditions” are violated. The Texas Supreme Court ruled that a “no harm, no foul” or “little harm, minor penalty” approach was fair to both sides. Accordingly, a policyholder that violates an obligation under the policy in general will be considered to have violated a covenant, not a condition. This was the holding also in the recent California appellate case of Belz v. Clarendon Am. Ins. Co. (Cal. App. Dec. 28, 2007), which while ostensibly focused on the question whether the particular clause at issue was a "no voluntary payments" or (merely) a "cooperation" clause adopts the equivalent framework considering material (prejudicial) versus immaterial breaches of policyholder duties.

Classifying a policy provision as a covenant does not mean that the insurer’s legitimate interests cannot be recognized. An immaterial breach of contract allows the non-breaching party a right to damages or set off; however, the non-breaching party is not allowed to suspend its promised performance completely. Put differently, to the extent the insurer can show that a policyholder’s breach of covenant in fact worked a harm to it in some way, the insurer is free to seek to prove the extent of that harm. If that harm is “immaterial” – that is, does not vitiate the entirety of the contract – then the insurer is able to set off its obligations (subject to the usual rules of proving damages). If the harm is material, then the insurer’s obligation to perform may be excused entirely. See generally Belz , slip op. at 15 ("'To establish actual prejudice, the insurer must show a substantial likelihood that, with timely notice, and notwithstanding [any] denial of coverage or reservation of rights, it would have settled the claim for less or taken steps that would have reduced or eliminated the insured’s liability.'") (citation omitted).

But it does not make sense to allow an insurer to keep the policyholder’s premium and refuse to perform when the policyholder’s late notice works no harm. Most policyholders do not have multiple claims under a single policy, and a strict forfeiture rule would create the situation that in the sole instance where the policyholder might achieve value from its insurance investment the insurer is excused from performing even though it has not in fact been harmed from late notice (all the while keeping the policyholder’s premium).

The confusion in the law has stemmed in part from the nomenclature adopted by courts in this area, where they have sought to protect insureds that or who gave “late” notice by requiring the insurer to show “prejudice” (or the policyholder to prove the absence of prejudice). But it makes no sense from a contract-law vantage point to characterize a provision as a condition but only to enforce it if the other party has been prejudiced from its nonperformance. The casual reference by courts to notice provisions as “conditions” and the adoption of the “notice/prejudice” rule itself has created confusion in the law.

The right approach is to presume that all contractual provisions setting forth policyholder duties are covenants, whose breach if immaterial entitles the innocent party to set off or if material entitles the innocent party to refuse performance. As the dissent in PAJ recognizes, “’[m]agic words are not controlling; labeling something a ‘condition precedent’ does not make it so.”

The right question is whether the specific language and the particular obligation is one whose performance should be completed before the other party’s obligation matures or is required at all. If an insurance company wishes to make notice a true condition precedent, it should make the contract provision absolutely clear that noncompliance will work a forfeiture. We see the equivalent of this in claims-made-and-reported policies which require that reporting of the claim (i.e., providing notice) occur during the policy period in order for the insuring agreement to be satisfied. As a leading English judge wrote in a key notice ruling there, “If insurers consider that they want or need such protection, they can and should try to express it in their insurance contracts and see if insureds and the broking market will accept it.” Friends Provident Life & Pensions Ltd. v. Sirius Int’l Ins., [2005] EWCA Civ. 601 (per Lord Mance).

PAJ was a split decision, 5 to 4, with strong majority and dissenting opinions. From the perspective of insurance law, it is a very positive development that the Texas justices all accepted the framework of determining whether notice was a condition or a covenant and if so the consequences of breach. Adopting the right framework not only produces correct results, as in PAJ, but also clarifies for insurers and insurance regulators how to approach revising the policy language to make clear – if intended – that punctilious compliance is requisite on pain of forfeiture. Were this made pellucid, then insurance regulators could step in to protect consumers or the marketplace could respond by pricing such policies commensurate with the traps they lay. Most important, insurers should say what is expected and what they require and make clear to purchasers the consequences of noncompliance (in plain, unambiguous language, and labeling something a "condition precedent" certainly fails on that score).

Regardless whether a particular jurisdiction is a “notice/prejudice” state, see Prince Georges Cty. v. Local Gov't Ins. Trust (Md. 2004) at n.9 (classifying 38 states as "notice/prejudice" and discussing most others), policyholders in all circumstances should seek to involve their insurers as soon as practicable, and they timeously should consider whether claims against them potentially implicate coverage. As always, rather than arguing about conditions versus covenants and material versus immaterial breach, policyholders are advised to abide by the rule that notice is like voting in Chicago – do it early and often.

Posted by Marc Mayerson at 2:09 PM | Comments (0) | TrackBack

January 21, 2007

Cone of Silence or Echo Chamber: A Policyholder’s Privileged Communications and its Insurers

An insurance company that receives a claim from one of its policyholders inevitably wears both a white hat and a black one. The insurer is there to help its insured deal with the claim – it may dispatch claims handlers or service providers to help the policyholder in its time of need; the insurer, however, also is the insured’s adversary in the sense that it must determine whether it has any obligation to pay the insured. To the latter extent, the insured and the insurer have directly adverse interests. (The law of first-party insurance bad faith is predicated on the recognition in part of this fundamental adversity of interests between the insurer and its insured, especially at the precise moment when the insured is calling upon the insurer for performance.)

The insurer’s wearing two hats poses the opportunity for mischief when those roles get confused or blurred. Take the example of a defense lawyer hired by an insurance company to defend the insured: the defense attorney plainly has an attorney-client relationship with the insured, the touchstone of which is confidentiality. Assume that the defense lawyer is told a fact by the insured that supports the insurer’s denying coverage: the insured confesses to being drunk while driving, the insured acknowledges that it knew of a latent problem before it purchased the policy, or the insured knew of the potential claim against it for a long time but had simply hoped it would go away and so did not notify the insurer sooner. The insurance company might wish to learn of this fact because it might permit it to terminate its defense obligation and avoid paying anything on the claim. In these circumstances, may the defense counsel tell the insurance company about this admission from the insured?

Ratting out the insured in this fashion would be found to be a breach of the lawyer’s duties to his or her client (the policyholder). What happens if the insurance company acts on this information to deny coverage? Has the insurer breached any duty?

Different courts have approached this question somewhat differently, but no court (to my knowledge) is comfortable with the insurer acting on this information. The Arizona Supreme Court has held that the insurer has committed an act of bad faith if it denies coverage based on defense counsel’s breach of the policyholder’s confidence. In Parsons v. Continental National American Group, 660 P.2d 94 (Ariz. 1976), the court held:

When an attorney who is an insurance company’s agent uses the confidential relationship between an attorney and a client to gather information so as to deny the insured coverage . . . . we hold that such conduct constitutes waiver of any policy defense, and is so contrary to public policy that the insurance company is estopped as a matter of law from disclaiming liability.

550 P.2d at 99. Other courts have adopted an exclusionary-rule approach, barring the insurer from using the information or any fruit from the poisonous tree in service of a denial of coverage Employers Cas. Co. v. Tilley, 496 S.W.2d 552, 560-61 (Tex. 1973); Snodgrass v. Baize, 405 N.E.2d 48, 54 (Ind. App. 1980). These cases recognize that mixing the insurer’s two roles – mixing up its white and black hats – is at a minimum inappropriate and potentially abusive. This double betrayal – of confidence and using the confidence as a weapon against the insured – calls for some remedy.

But let’s vary the situation somewhat, from an insurer that has provided defense counsel to an insurer that has not provided counsel when the insured believes it should have done so. In those circumstances, the insured will defend the liability case against it and separately pursue coverage against the insurer in a coverage case. Routinely, we see insurers seeking discovery of underlying defense counsel’s files. Often, this is seemingly an effort to obtain evidence that will embarrass the insured and sway the jury – for example, a memo from defense counsel to the insured evaluating the liability case and stating something like “the [insured] company’s conduct flagrantly disregarded standards for appropriate conduct and safety and this led directly to the injury.” In a coverage case, the insurer would like to proffer this kind of document against the insured to argue that the insured expected/intended the injury and thus coverage should not be provided. (Moreover, carrier counsel wants to argue at closing that “even the insured’s defense counsel agrees that the insured flagrantly disregarded safety standards, etc. etc.”) Discovery of this kind of document also makes carrier counsel’s job easier because the defense lawyer has investigated and synthesized the facts leading to the liability claim.

Insurers have argued that they are entitled to the discovery of this information in the coverage case on the ground that it fits within the scope of discovery and that, although the documents constitute privileged communications, no privilege is properly assertable as against them. The rationale insurers offer is that they share a common interest with the insured in these privileged communications.

A tiny number of jurisdictions have accepted this argument, and the vast majority of cases have rejected it. In Illinois for example, where the argument has been accepted, insurance companies have an unfettered right of access to defense counsel’s files. Waste Management Inc. v. International Surplus Lines Ins. Co., 579 N.E.2d 332 (Ill. 1991). The Illinois Supreme Court reasoned that, even though the insurer was alleged to have breached its contract with the policyholder, the insurers nonetheless shared a “common interest” with the insured in defeating the underlying plaintiff’s claim against it. Because the insurers “shared” in the privilege, relevant materials could not be withheld on this ground. (In other words, like Big Brother, in Illinois one’s insurers are always looking over defense counsel’s shoulder, even where the insurer has breached its contract to perform.)

Thus, even though there is direct adversity of interests between the insurers and the policyholder at the time that the insurers are seeking discovery of defense counsel-s files, the Illinois courts hold that at the time of document creation (as opposed to disclosure) the insurer’s are privy to the thoughts of defense counsel.

Policyholders find this argument preposterous; the insurer may be in breach of contract and unquestionably is seeking bullets to fire at the insured. Ruling that insurers are on the same side as the policyholder and therefore get access to defense counsel’s files confuses the two different roles of insurers – in service of a coverage denial insurers plainly have adverse interests with the insured, and when the insurer has failed to perform they have failed to come to the insured’s aid and rescue (the role that forms the premise for the Illinois courts’ ruling that insurers have a common interest with the insured). As the Fifth Circuit observed in a related context:

We know of no case in which the insured’s duty of assistance and cooperation has been used to force a putative insured to divulge to the insurer every jot and tittle of information which may aid the insurer in defeating his claim for coverage but which in no way hinders the insurer’s ability to provide the insured with a proper defense.

Martin v. Travelers Indemnity Co., 450 F.2d 542, 553 (5th Cir. 1971).

Most courts have rejected the Illinois approach, on a variety of rationales. See Remington Arms. Co. v. Liberty Mut. Ins. Co., 142 F.R.D. 408, 418 (D. Del. 1992). One is that, properly understood, the common interest “privilege” is no privilege at all but rather is a shorthand way of considering whether the disclosure of otherwise privileged communications effects a waiver of the privilege. See United States v. McPartlin, 485 F.2d 1321, 3336 (7th Cir. 1979). As a result, whether there is a common interest depends on the circumstances at the time of disclosure. In these circumstances, while the coverage war is en flagrante there will typically not be a common interest. Put differently, the insured’s privilege still exists and may properly be interposed as a basis for refusing to produce otherwise relevant documents and materials. In Re Envtl. Ins. Declaratory Judgment Actions, 612 A.2d 1338, 1341-43 (N.J. Super. App. Div. 1992). An insurer cannot force a waiver by the fact that a coverage suit is pending. (Relatedly, courts uniformly hold that the mere fact that the insured has been required to file a suit against its insurer does not waive privilege or put all privileged communications “at issue” (which is simply another variant of waiver principles). See FDIC v. US, 527 F. Supp. 942, 950-51 (S.D.W.Va. 1981) (advice-of-counsel defense places communications at issue and subject to discovery); Long Island Lighting Co. v. Allianz Underwriters Ins. Co., 749 N.Y.S.2d 488, 496 (App. Div. 2002); Home Ins. Co. v. Advance Mach. Co., 443 So. 2d 165, 168 (Fla. 1st Dist. App. 1983); Rockwell Int’l Corp. v. Superior Court, 26 Cal. App. 4th 1255, 1268 (1994).)

Nor is the insured’s duty of cooperation with its insurers construed as a waiver of privilege. Metropolitan Life Ins. Co. v. Aetna Cas. & Sur. Co., 730 A.2d 51, 63-64 (Ct. 1999); Martin, 450 F.2d at 553. See also Gulf Ins. Co. v. Transatlantic Reinsurance Co., 788 N.Y.S.2d 44 (1st Dep’t 2004).

So, insurers cannot compel insureds to provide them with privileged (or work product) information. This is true both informally and in the context of coverage litigation. Nevertheless, insureds and their insurers may wish to exchange defense counsel’s evaluation of a case, for example. Can an insured provide its carrier with privileged communications without fear that it has effected a broad waiver with respect to the tort claimants? Does a policyholder need fear that its carrier will use that communication against it to deny coverage?

Policyholders may wish to share defense-counsel’s analysis with its insurers to facilitate the insurers decision to pay to settle a case. I have found it reasonably common in the directors’ and officers’ liability insurance, fiduciary-liability insurance, and errors and omissions insurance contexts that policyholders and their insurers do share privileged communications, reflecting the reality that in many cases the insurers will pay for settlement of the underlying claim against the insured. On the other hand, in the product-liability and mass-tort context, such sharing of information is seemingly more rare.

If an insured elects to share privileged information, is there a risk of finding of waiver? While I am reluctant to provide a definitive conclusion one way or the other, no doubt there is a risk that a court may find waiver.

The starting point for any analysis of this problem is that, in most jurisdictions, there is no insured-insurer privilege. Linde v. Resolution Trust Corp., 5 F.3d 1508, 1514-15 (D.C. Cir. 1993) (“we now firmly reject any sweeping general notion that there is an attorney-client privileged in insured-carrier communications”). As the Linde court ruled:

An insured may communicate with its carrier for a variety of reasons, many of which have little to do with the pursuit of legal representation or the procurement of legal advice. Certainly, where the insured communicates with the carrier for the express purpose of seeking legal advice with respect to a concrete claim, or for the purpose of aiding an insurer-provided attorney in preparing a specific legal case, the law would exalt form over substance if it were to deny application of the attorney-client privilege. However, a statement betraying neither interest in, nor pursuit of, legal counsel bears only the most attenuated nexus to the attorney-client relationship and thus does not come within the ambit of the privilege. . . . . [I]f what is sought is not legal advice, but insurance, no privilege can or should exist.

Linde, 5 F.3d at 1515. See also Aiena v. Olsen, 194 F.R.D. 134, 136 (S.D.N.Y. 2000). As the Alaska Supreme Court explained, “communications between insured and insurer are not in the same class as communications between client and attorney, because the insurer may use its information for purposes inimical to the interests of the insured.” Langdon v. Champion, 752 P.2d 999, 1002-03 (Alaska 1988). Thus, some courts have found that otherwise privileged communications lose their protection from sharing them with an insurer. See Go Medical Indus. Pty., Ltd. V. C.R. Bard, Inc., 1998 WL 1632525 (D. Conn. Aug. 18, 1998); Hartford Fire Ins. Co. v. Guide Corp., 206 F.R.D. 249, 250-51 (S.D. Ind. 2001).

Even if both the carrier and its policyholder would benefit from a defense victory over a tort plaintiff, that may not be sufficient to establish a “common interest” to maintain privilege. See Shamis v. Ambassador Factors Corp., 34 F. Supp. 2d 879, 893 (S.D.N.Y. 1999) (holding that the fact that two entities would benefit from a judgment in favor of the plaintiff, that is not sufficient to find that they share an identical legal interest). What constitutes a common interest has been defined in the following manner:

A community of interests exists among different persons or separate corporations where they have an identical legal interest . . . . The key consideration is that the nature of the interest be identical, not similar, and be legal, not solely commercial. The fact that there may be an overlap of a commercial and legal interest for a third party does not negate the effect of the legal interest in establishing a community of interest.

North River Ins. Co. v. Columbia Cas. Co., 1995 WL 5792, at *3 (S.D.N.Y. Jan. 5, 1995) (citation omitted). The court continued, “What is important is not whether the parties theoretically share similar interests but rather whether they demonstrate actual cooperation toward a common goal.” Id. at *4. Stated further, the same court held in International Insurance Co. v. Newport Mining Corp., 800 F. Supp. 1195 (S.D.N.Y. 1992):

The “common interest,” logically viewed, and New York law supports, which makes the privilege inapplicable, is where an attorney actually represents both the insured and the carrier – joint representation – and accordingly both clients are working together with a single attorney toward a common goal.

Id. at 1196 The International Insurance court found that, while the insurance carrier and its insured shared the same desire for a successful defense of a legal claim against the insured, this was insufficient to find a common legal interest. Id. The International Insurance case involved a defendant-insured seeking to withhold from a plaintiff-carrier materials that were privileged. When the plaintiff-insurer argued that the common-interest exception should apply and the privileged materials (which were otherwise relevant) therefore should be produced, the court disagreed. The court stated:

I conclude that while the insurer had the same ‘desire’ as its insured to have a successful defense of [the actions that necessitated the case at bar], for if coverage was later determined to exist, it would be responsible for any obligation of its insured remaining, this in my view is an insufficient ‘common interest’ to warrant invasion of the attorney-client relationship with the privilege . . .

By extension, and this is the key point, if the insured provided these types of materials to its insurers, then it is providing the communications to an entity that does not share a common interest; therefore, privilege (or immunity) may not be preserved vis a vis (other) third parties. Kansas City Fire & Marine Insurance Corp., 351 N.Y.S.2d 767, 768 (App. Div. 1974).

In Go Medical Industries Pty, Ltd. v. C.R. Bard, Inc., 1998 WL 1632525, a patent-infringement action, the defendant sought production of the plaintiff’s communications with its insurance carrier, which included certain opinions of its lawyer that had been provided to the carrier. The plaintiff alleged the common-interest extension of the attorney-client privilege shielded these documents from discovery. The court in Go Medical disagreed, finding that the plaintiff and its insurance carrier did not share common legal interests:

Go Medical’s [the plaintiff] purpose in providing these documents to CIC [its insurance carrier] was to try to obtain coverage from CIC for expenses Go Medical would incur in litigation to stop the alleged infringement of its patent. However, whereas Go Medical’s interest is in protecting its patent, CIC has no interest in the [] patent. CIC’s interest in Go Medical’s infringement claim is limited to CIC’s coverage of Go Medical’s litigation expenses. An insurer’s contractual obligation to pay its insured’s litigation expenses does not, by itself, create a common interest between the insurer and the insured that is sufficient to warrant application of the common interest rule of the attorney client privilege.

Id. at *3.

So, can communications with an insurer be conducted in a manner that does not result in a waiver? Certainly, if the insurer acknowledges coverage and takes over control of the defense, unquestionably in that circumstance the insurer is functioning as the insured’s lawyer and is entitled to no less protection. When the insurer has not yet provided full-throated acknowledgement of coverage, the insured and the insurer need to lay a foundation to show that, in the particular circumstance, the exchange of privileged information should not be deemed to be a waiver. To accomplish this, the parties are advised to make clear that there is a purpose related to the settlement or defense of the underlying case that justifies sharing the information – that is, the justifies extending the cone of silence over lawyer-client communications of the policyholder to include the carrier. (The carrier’s merely sharing the hope that the policyholder may win the liability case is not likely to be sufficient basis for proving sufficient commonality of interest. E.g., Shamis, 34 F. Supp. 2d at 893.)

So the issue for all counsel involved – policyholder, carrier, tort plaintiffs, government investigators – is whether a foundation has been established that satisfies a showing that in the particular circumstance disclosure of privileged/work product material is consistent with preserving the confidentiality protections we otherwise protect them with. See Cutchin v. State of Maryland, 143 Md. App. 81 (2002); Metroflight Inc. v. Argonaut Ins. Co., 403 F. Supp. 1195 (N.D. Tex. 1975); Reavis v. Metro Property & Liability Ins. Co., 117 F.R.D. 160 (S.D. Cal. 1987); Bellman v. District Court, 531 P.2d 632 (Colo. 1975); Grand Union Co. v. Patrick, 246 So.2d 474 (Fla. Dist. Ct. App. 1971); People v. Ryan, 197 N.E.2d 15 (Ill. 1964). Some courts have ruled that statements to an insurance adjuster are protected by the work-product doctrine, and thus the plaintiff who later sues the insured making the statement cannot obtain its discovery. In re Fontenot, 13 S.W.3d 111 (Tex. App. 2000); Heidebrink v. Moriwaki, 706 P.2d 213 (Wash. 1985). Some courts have employed seemingly more stringent proof requirements to show that privilege should be preserved. In Re Bevill, Bresler & Schulman Asset Mgmt Corp., 805 F.2d 120, 126 (3d Cir. 1986); Government of Virgin Islands v. Joseph, 685 F.2d 857, 862 (3d Cir. 1982); Sheet Metal Workers Int’l Ass’n v. Sweeney, 29 F.3d 120 (4th Cir. 1994); Ft. Howard Paper Co. v. Affiliated FM Ins. Co., 64 F.R.D. 694 (E.D. Wisc. 1974); Travelers Ins. Cos. v. Superior Court, 143 Cal. App. 3d 436 (1983).

The key lesson is that, if one desires to preserve the privilege (or immunity) that would otherwise attach to a statement shared with an insurance company, the circumstances surrounding sharing the statement should indicate that it is being provided to assist the insurer in the defense or in evaluating the settlement of the claim. E.g., Exxon Corp. v. St. Paul Fire & Marine Ins., 903 F. Supp. 1007, 1010 (E.D. La. 1995). In other words, to the extent that one can show that the insurer’s role is in protecting the interest of the insured, then the communication is more likely to remain protected. If the role of the insurance company is more ambiguous – that is, if it is unclear which hat the insurer is wearing and whether the statement might be used against the insured in service of a denial of coverage – then the risk of a court finding waiver is increased. See Hedebrink, 706 Pl.2d at 220 (Goodloe, J., dissenting) (“The use of the statement for a purpose adverse to the interest of the insured is certainly inconsistent with the claim of privilege upon his behalf.”); see also Vermont Gas Systems, Inc. v. United States Fid. & Guar. Co., 151 F.R.D. 268, 277 (D. Vt. 1993); cf. Great American Surplus Lincs, Inc. v. Ace Oil Co., 120 F.R.D. 533 (E.D. Cal. 1988) (preserving insurer’s privilege re information shared with reinsurer). Ideally, the policyholder and the insurer will enter into an agreement that pledges the insurer will maintain the communication in confidence, is receiving the communication for the purpose of evaluating the defense of the claim or settlement of the claim, and will not use the communication as a basis to deny coverage to the insured (subject to the insurer’s being able to use the documents in defense of a failure-to-settle bad-faith claim and allowing the insurer to seek the identical discovery in a coverage case against the insured, though without being able to argue that sharing the information effected a waiver). Such an approach differentiates the insurer's white hat and black hat and allows the policyholder's privileged information to be kept under the insurer's hat.

Posted by Marc Mayerson at 4:08 PM | Comments (8) | TrackBack

December 26, 2006

‘Round and ‘Round the Tort Liability Goes – When It Stops, Whither the Insurance Chose?

Generally, the law allows “choses in action” to be alienated (sold). This is a change that has been adopted over the course of the last 100 years or more. See W.W. Cook, The Alienability of Choses in Action, 29 Harv. L. Rev. 816 (1916). Because claims under insurance contracts properly viewed are choses in action, (Black’s Law Dictionary (5th ed. 1979) at 219), most courts have allowed insurance claims to be sold, too, even when the transaction takes the form of an “assignment.”

This is different from assigning the policy. Policies cannot be assigned, but what we mean by that is to change the named insured under the policy. Let me give an example: I have a car that I want to sell, which is worth $800. And let’s assume that I have an auto insurance policy with four months left in the policy term. What I cannot do is say, “buy my car for $1000 and I’ll throw in my insurance coverage” (as if you can be covered for the remaining policy term). This is changing the “named insured” going forward; the insurers haven’t checked out the buyer’s driving record, who might be a worse driver or a driver with a slew of speeding tickets.

But let’s change the scenario a little: let’s assume the day before I’m supposed to meet with you to sell my car I run into a bollard, which dents my fender and causes $200 of damage. Is there anything wrong with the idea that (assuming the $200 repair bill would be covered by my auto insurance) I can sell you my car for $700 plus the receivable from my insurance company for $200?

Most insurance policies state that “assignment of interest under this Policy shall not bind the [insurer] without its prior written consent.” Is selling the receivable – the chose in action – something that violates the policy terms? Is the chose an “interest under this Policy”? And if I breach this provision, is coverage vitiated (i.e., is this anti-assignment clause a condition precedent to coverage or a term whose breach is considered to be material to the contract as a whole)?

A more common real-life scenario is this: an insured-defendant settles with the tort plaintiff where one element of the consideration is the receivable owed from the insurance company (the insured’s claim for reimbursement of its defense costs and ultimately the value of its settlement with the plaintiff). See generally Enserch Corp. v. Shand, Morahan & Co., Inc., 952 F.2d 1485 (5th Cir. 1992) (Wisdom, J.) (approving of a “two tier” settlement whereby plaintiffs received certain monies up front and then additional monies on the back end depending on the recovery against the defendant-insured’s carriers). In these circumstances, the courts typically have held that the assignment of the chose in action to the insurers has not expanded the carrier’s risk, that choses are freely assignable, that the insurer is not at risk of double payment, and that the plaintiff may proceed against the insurer to assert on behalf of the insured its (pre-existing) contractual claims against the insurer. See generally International Rediscount Corp. v. Hartford Acc. & Indem. Co., 425 F. Supp. 488 (D.Del. 1977); Ardon Constr. Corp. v. Firemen’s Ins. Co., 185 N.Y.S.2d 723 (1959). Courts have held similarly regarding whether a fire insurance policy applies after property transfer. National Am. Ins. Co. v. Jamison Agency, Inc., 501 F.2d 1125 (8th Cir. 1974); Imperial Enter., Inc. v. Fireman’s Fund Ins. Co., 535 F.2d 287 (5th Cir. 1976); University of Judaism v. Transamerica Ins. Co., 61 Cal. App. 3d 93 (1976).

As with my selling my car and throwing the auto insurance in, there are countervailing concerns: in the auto example, the insurance company – at least insofar as liability insurance – elected to insure me and set a premium based in part on my driving record (although zip codes nowadays may be a stronger determinant of premium); if my insurance could be transferred to a riskier driver then the insurance company’s risk has changed – and the courts will invalidate that transfer on any number of grounds including “prejudice” or expansion of the risk to the carrier. See Muslin v. Frelinghuysen Livestock Managers Inc., 777 F.2d 1230, 1233 (7th Cir. 1985) (first-party mortality insurance on a racehorse not assignable).

Note that the issue on which I am focused concerns the anti-assignment provision. Courts (and insurers) sometimes also focus on the “duty to cooperate” and the “no action” provision in disputes involving to some extent assignments of the chose in action under an insurance policy. Hamilton v. Maryland Casualty Co., 27 Cal. 4th 718 (2002); Miller v. Shugart, 316 N.W.2d 729 (Minn. 1982). Unique policy provisions or unique interests may affect whether a transfer of the right to collect from an insurance company is proper or whether pre-transfer insurance policies apply, but until the last few years the courts in virtually all states have allowed transfers of the insured’s chose in action, reasoning in part that an insurer has been paid to accept the transfer of risk, and if that risk has come to pass it matters not to whom the check is cut – the original insured or an assignee.

(In fact, it doesn’t matter who litigates against the insurer – an assignee or an assignor, so long as the absent party is bound to the result in the coverage case. See Greco v. Oregon Mut. Fire Ins. Co., 12 Cal. Rptr. 1802 (Cal. App. 1961); Clarkson Co. Ltd. v. Rockwell Int’l Corp., 441 F. Supp. 792 (N.D. Cal. 1977); Urrutia Aviation Enterprises, Inc. v. B.B. Burson & Assoc., Inc., 406 F.2d 769 (5th Cir. 1969); Icon Group, Inc. v. Mahogany Run. Dev. Corp., 829 F.2d 473, 478 (3d. Cir. 1987); Prosperity Realty, Inc. v. Haco-Canon, 724 Supp. 254, 258 (S.D.N.Y. 1989).)

And the reason for this consistent string of outcomes is that courts typically have found that there is no legitimate interest in allowing an insurance company to refuse to perform when its risk has not been (materially) altered and it has received payment for the transfer of that risk.

Nevertheless, there have been inconsistent results (spurring further litigation) regarding large-scale liability claims that came to rest on some corporate-successor-in-interest to the original tortfeasor-insured following a series of complex corporate transactions – which should cause serious concern for corporate-transactions lawyers who ignore the insurance consequences of the deals they put together. The Ohio Supreme Court just decided a case allowing insurers to get off the hook completely for mass lead-paint liability claims, not because the claims were not covered but rather because the insurance mysteriously evaporated along the way of a number of corporate transactions, leading to the tort liability flowing through to the successor but inadvertently stripped of the insurance protection that would have otherwise applied to the claims had the corporate transactions never occurred. See Glidden Cos. v. Lumberman’s Mut. Cas. Co. (Ohio Dec. 20, 2006).

Until the modern coverage wars broke out, however, the courts routinely allowed whoever ended up with the tort liability to tap the insurance coverage that would have applied before the later corporate transaction took place. See Ocean Acc. & Guar. Corp. v. Southern Bell Telephone Co., 100 F.2d 441 (8th Cir. 1939); Chatham Corp. v. Argonaut Ins. Co., 334 N.Y.S.2d 959 (N.Y. Supr. 1972); Aetna Life & Cas. v. United Pac. Reliance Ins. Cos., 580 P.2d 230 (Utah 1978); Paxton & Vierling Steel Co. v. Great American Ins. Co., 497 F. Supp. 673 (D. Neb. 1980); Brunswick Corp. v. St. Paul Fire and Marine Ins. Co., 509 F. Supp. 750 (E.D. Pa. 1981); Travelers Ins. Co. v. Western Fire Ins. Co., 709 P.2d 639 (Mont. 1985); Oklahoma Morris Plan Co. v. Security Mut. Cas. Co., 455 F.2d 1209 (8th Cir. 1972).

But the modern, large-dollar coverage cases often involve detours and frolics into corporate transactions, all ultimately concerned about whether the entity paying the liability of some historic predecessor somehow or another is naked as far as insurance coverage goes. Note that the issue does not involve any expansion of the insurers’ obligations beyond that which would exist had the original insured not been merged out of existence, sold its assets, or otherwise sliced, diced, chopped, and slawed. In each instance, the entity claiming the benefit of the coverage is paying for the historic insured’s liability, and the only question is whether the insurers somehow or another get off the hook – as in Glidden – because of the manner in which some legitimate post-injury corporate transaction took place. Indeed, in one of my coverage cases, the parties no doubt spent a million dollars exhuming various corporate transactions – all to the end that the court concluded that none of these really mattered so long as the insurers could be assured that nobody else would sue the insurance companies for the same obligations being claimed by the entity before the court.

Earlier this year, in rebuffing the effort of an insurer to deny coverage based on the assignment of the chose in action, the Pennsylvania Supreme Court likewise allowed the transfer of the right to collect. As that court explained:

The assignment changed only the identity of the party who was entitled to recover under the Gulf policy, in the event an excess verdict was obtained. [B]ecause [the insurer’s] risk was not increased following the assignment, [and] since the assignment was subject ‘to such claims, demands, or defenses as the insurer would have been entitled to make against the original insured,’ [citation omitted] the Superior Court correctly determined that the assignment was valid.

Egger v. Gulf Ins. Co. (Pa. Aug. 23, 2006). Indeed, several months ago, the California Supreme Court went so far as to hold that not only the insured’s coverage benefits but also first-party insurance bad-faith damages could be recovered by an assignee. Essex Ins. Co. v. Five Star Dye House Inc. (Cal. July 6, 2006).

In sharp contrast, the Oregon Supreme Court recently allowed an insurer off the hook because of an assignment of the chose in action. Holloway v. Republic Indem. Co. of Am. (Ore. Nov. 16, 2006) . As the Oregon court framed the question presented: “The central issue in this insurance contract case is whether an anti-assignment clause providing that ‘[y]our rights or duties under this policy may not be transferred without our written consent[]’ is ambiguous and thus should be construed against its drafter.” In Holloway, the court ruled that the policy’s anti-assignment provision was clear, thus eschewing any difference between pre-loss assignments (changing the named insured) with post-loss assignments (transferring the chose in action) and held that a post-loss assignment of the right to collect under the policy vitiated coverage.

Some courts, as in Holloway, look at the question in terms of whether the terms of the anti-assignment provision applies – but most courts as did the Pennsylvania Supreme Court in Egger find that the terms of that provision do not apply or are ambiguous in their application to the assignment of the right to collect and thus must be construed against the drafter. The court in Holloway put on blinders and failed to examine whether there was any real consequence to the insurer from changing who was asserting the insured’s rights (the original insured or someone else suing in the name of the insured or suing for the benefits owed the insured); instead, the Holloway court (like Glidden) viewed the anti-assignment clause as being applicable and absolute.

But even if one were to accept that analysis at face value, Holloway plainly goes wrong in not asking what is the consequence of the violation of the anti-assignment provision. In other words, it is never enough to say that the terms of a contract were violated – before the non-breaching party’s performance is excused, the breach must be one that is either material to the contract as a whole or whose satisfaction is a (valid) condition precedent to performance. Holloway simply stops after finding that the assignment at issue was subject to the policy provision – and the court does not address whether its violation constitutes a material breach of the contract as a whole.

This is another way of backing into the argument that assignments of the chose in action – as distinct from an assignment of the policy itself, i.e., changing the named insured – is not material in the ordinary case. The only real difference is to whom the insurance company is supposed to write its check. As in Egger, the insurance company is free to argue that the nature of the damages are uncovered or that the conduct leading to the claim is uncovered – but that is different from saying that because someone other than the original insured is knocking on the carrier’s door with the original-insured’s hat in hand the insurer somehow escapes paying.

Even though had the original insured pursued the identical claim for damages the insurance company would be required to pay, the courts in Holloway and Glidden allow insurers to distract them from the merits, expose managers to claims of waste from making good on the legal obligation of the tortfeasor-insured – sometimes decades later and many corporate-predecessors removed, permit insurers to keep the premiums for risks they were paid to assume and which came to pass, or allow tort victims who pursue collection against the tortfeasor’s insurer to go uncompensated, all because the court concludes the twain did not meet between the liability and the insurance. In contrast, the rule in Egger and cases like it ensures that the contracting parties achieve the benefits (or detriments) of the original bargain in the event the risk the insured sought to transfer-- and for which the insurer collected premium -- comes to fruition.

Posted by Marc Mayerson at 6:02 PM | Comments (2) | TrackBack

June 13, 2006

Running Out of Time: Statute of Limitations for Liability Insurance Policies

Liability-insurance policies were introduced in 1881, yet there is no great certainty in most states as to when the statute of limitations commences for bringing suit on an insurance policy for performance. Somewhat complicating matters – and simplifying it too – is the availability of declaratory relief, a remedy designed in part to pull insurance disputes into court. So to understand the application of statute of limitations in this context, one must draw distinctions among several concepts: (i) anticipatory repudiation of contract, which is considered a present breach of contract; (ii) anticipatory relief of seeking a declaration of rights before breach of contract; (iii) continuing breach of the duty to defend by an insurer; and (iv) breach of the duty to indemnify. The Alaska Supreme Court recently confronted these issues and elected to follow the California Supreme Court's approach to the questions presented.

Declaratory judgments are meant as a vehicle for obtaining a ruling from a court, typically in advance of a breach of contract. E.g., Cal. Civ. § 1060 (“The declaration may be had before there has been any breach of the obligation in respect to which said declaration is sought.”). They are not meant ony for policyholders: an insurance company may seek a negative declaration from a court that there is no obligation to defend or indemnify; in the absence of a declaratory-relief remedy a carrier could not sue at common law for non-breach of contract. Declaratory relief – a form of equitable remedy (and not a separate cause of action) – does not require a breach of contract at the time of bringing suit; it is properly directed in futuro, that is, before the time for contractual performance is due. The power of a court to entertain a declaratory judgment is constrained by the advisory-opinion doctrine; in other words, one can bring a declaratory judgment so long as the dispute is sufficiently mature that a court ruling would be helpful, concrete and not advisory. See Marc Mayerson, Executability of Article III Judgments and the Limits of Congressional Discretion, 35 DePaul L. Rev. 51, 58-61, 63-64 n.71 (1985). If a case is nonjusticiable, then it is axiomatic that a statute of limitations cannot have started.

Just because a case is justiciable is not sufficient, however, to initiate the statute of limitation, which protects interests of repose and guards against staleness of evidence (among other things). There is some confusion, however, as to whether if one can bring a suit whether one must bring a suit.

If a breach-of-contract claim exists, the right way to plead the matter is one for damages or other relief appropriate to the contract claim. In other words, it is not necessary or really proper to plead an declaratory count for a declaration of duty (on an existing set of facts) and then a count for damages; such a claim is more properly styled as a breach-of-contract claim based on an existing set of facts; if the set of facts that would ripen a contractual duty has not yet occurred, then a declaratory-relief action would be proper.

Declaratory relief may lie regarding any issue of contractual interpretation, though a court maintains a residuum of discretion not to hear an action that otherwise is proper. Wilton v. Seven Falls Co.., __ U.S. __ (1995). In fact, declaratory relief actions were largely designed to facilitate the resolution of insurance disputes. Edwin Borchard, Declaratory Judgments and Insurance Litigation, 34 Ill. L. Rev. 245-270 (1939); Edwin M. Borchard, Declaratory Judgments (2d ed. 1941).

In the context of liability insurance, when a claim has been made against an insured, an insurer will then have a present obligation to respond. If the insurer does not assume the defense, for example, the duty to defend may have been breached. If it is anticipated that the claim will continue to be prosecuted against the insured, then the insurer will have future obligations to the insured, i.e., a declaratory relief action as to the insurer’s obligations in the future will be proper.

An insurer, like any other contractual party, can renounce its obligations even before the time for performance has occurred. This is an anticipatory repudiation, which is considered a present breach of contract at the time of repudiation. Hall v. Allstate Ins. Co., 880 F.2d 394, 397 (11th Cir. 1989); Snow v. Western Savings & Loan Ass'n, 730 P.2d 204 (Ariz. 1986). The nonbreaching party is as of that moment vested with the option to bring its breach of contract claim and obtain whatever damages it can show, subject to the rules for mitigation and proof of damages. (In the meantime, the insured may be freed of its obligations to provide further notice, provide proofs of loss, and the like.) However, through a repudiation, the breaching party cannot accelerate the running of the statute of limitations; the law allows the nonbreaching party the option to bring an immediate action for breach of contract or to await the time for contractual performance and bring an action at that time. See Lane v. Nationwide Mut. Ins. Co., 582 A.2d 501, 505 (Md. 1990). The nonbreaching party is vested with that option to allow the repudiator the opportunity to have a change of heart and to perform its obligations. Cf. Mobley v. New York Life Ins. Co., 295 U.S. 632 (1935).

This in part is the context for a recent decision of the Alaska Supreme Court, which addressed the question when the statute of limitations commences. Brannon v. Continental Cas. Co. (Alaska June 9, 2006). The court first ruled that “[a] cause of action for denial of coverage under an insurance policy accrues when coverage is disclaimed and the insured is notified.” Id. at 7 (footnotes omitted). While a breach-of-contract action may lie at that moment, the question is whether the insured necessarily must commence a lawsuit or risk forfeiting its claim for coverage. Usually, courts find that an insured is not required to bring an action for breach of the duty to defend until the claim against it is over. See Moffat v. Metropolitan Cas. Ins. Co., 238 F. Supp. 165, 175 (M.D. Pa. 1964). This avoids insureds being doubly burdened from the carrier’s nonperformance – fighting the defense case on its own and being required to sue its insurer simultaneously.

The Alaska court, following the California Supreme Court, held that, while the cause of action for breach of contract accrues upon the carrier’s refusal to perform, the limitations period is tolled while the underlying action is pending. Id. at 10. The Alaska court recognized that its holding was consistent with the majority result, which sometimes finds that due to the continuing nature of the breach by the insurer the insured’s damages are not finalized until the underlying action is concluded, and thus the statute of limitations does not commence. Under either approach, equitable tolling or simply ruling that the insured’s damages must be complete before the statute of limitations commences, the court found that “any prejudice [from awaiting until the underlying action was completed] should not be held against the insured” because “the insurance company has the ability and motivation to gather evidence.” Id. at 11. The court further recognized the unfairness of “requir[ing] the insured to file a lawsuit against the insurance company while simultaneously defending himself in the underlying lawsuit.” Id. at 12 (fn. omitted).

Regardless of the particular rationale, most courts that have carefully analyzed the question hold as the Alaska Supreme Court did that the insured must be permitted to await the conclusion of the underlying action before being at risk of losing its rights to insurance recovery. Yet to ensure that the value of the insurer's timely help is not lost, the insured has the option to bring an action seeking a declaration of the insurer’s obligation to defend on an ongoing basis and potentially for specific performance of the duty to defend. See Marc Mayerson, Insurance Recovery of Litigation Costs, 30 Tort & Ins. L. J. 997 (1995).

Posted by Marc Mayerson at 3:36 PM | Comments (0) | TrackBack

May 27, 2006

Late Notice by Liability Insurance Policyholders as Excuse Not to Pay – of Notice, Covenants, Conditions, Material Breaches, Innominate terms, and American versus English Law

Courts continue to struggle with claims where the policyholder may not have provided notice as soon as one might have liked, and the coverage litigation typically centers on whether the dispositive argument is “no harm, no foul” -- that is, policyholders will argue that coverage is not lost unless the insurer has been prejudiced in some fashion from the allegedly “late” notice. The Illinois Supreme Court and a Texas appellate court both have confronted this question recently, and these are largely consistent with recent holdings from New York’s highest court finding that the notice provision must be enforced as written – no ifs, ands or buts.

I dare say that policyholders – and most insurer-side representatives – are astonished by this seeming trend vitiating coverage where insurers have suffered no harm from noncompliance. The clear “modern” trend has been to move away from a forfeiture approach to one that requires a showing of harm to the insurer before coverage will be lost – and most properly then only to the extent of the harm. (Different courts have assigned the burden of proof differently, but the undisputed trend has been towards liberality.) Usually, this trend is called the “notice-prejudice” rule, the idea being that unless the insurer has been prejudiced from the late notice coverage is not forfeited.

Policyholders promise to notify their insurers of loss, or circumstances that may lead to loss, and insurers will deny coverage if they believe that obligation has been breached. Accordingly, the first question is whether notice is “late” at all or whether the policyholder’s performance of its obligation to provide notice has complied with the policy terms. Most courts supply a reasonableness of time requirement, taking into account the purpose of the policy and the function of the notice policy therein. E.g., Blanton v. Vesta Lloyd Ins. Co., (Tex. App. Dallas March 9, 2006) (“an insured's failure to give notice of an accident or occurrence is excused, that is, there is no duty to report it, when the insured has complied with his full duty to acquaint himself with all the facts surrounding an accident, and it appears from such investigation that the occurrence was of such a nature that it could not reasonably be expected to result in any claim or liability.”); Mighty Midgets, Inc. v. Centennial Ins. Co., 47 N.Y.2d 12 (N.Y. 1979).

Carriers often purport to justify forfeiture based on the notice provision’s placement in the conditions section of the policy.. Yet, the “conditions” section contains numerous provisions that are not conditions precedent or even conditions at all. The Premium Audits provision, for example, contains peripheral promises made by both insured and insurer. The Bankruptcy clause cannot plausibly be considered a condition to performance at all. Other provisions may be considered at best conditions subsequent, such as the other-insurance clause. The conditions section in fact collects boilerplate provisions that do not neatly fit in the Insuring agreement, Definitions, or Exclusions section. That the notice provision appears in this section is not significant because the title of a contractual section does not determine the legal effect of its contents so as to be a basis to deny coverage. E.g., Zimmerman v. Continental Life Ins. Co. 99 Cal. App. 723, 726 (1929); Cock-N-Bull Steak House, Inc. v. Generali Ins. Co., 466 S.E.2d 727, 729 (S.C. 1996). Moreover, nowhere in the notice provision does it state that the policyholder waives coverage for costs incurred before notice is given.

Courts typically treat the insured’s notice obligation not as a condition precedent, but rather as a covenant (i.e., a separate promise of performance.) E.g., Abrams v. Am. Fidelity & Cas. Co., 32 Cal. 2d 233 (1948); Sherwood Brands, 698 A.2d 1078. This treatment is significant because one party’s breach of a covenant excuses the non-breaching party’s performance only when the breach is material to the contract as a whole. A breached condition precedent, by comparison, excuses performance entirely. Restatement (Second) of Contracts 224, 237 (1981). The converse also must be true: if the breach of a provision does not discharge the non-breaching party’s obligation to perform as a matter of right and in all cases, that provision cannot be considered a true condition precedent.

One area where late notice has been played out concerns recovery of defense costs incurred before notice. Sometimes this dispute has been called coverage for “pre-tender” defense costs, introducing a double incoherence given that nothing in the insurance policy requires that the insured “tender” the defense. Policies do not require that the policyholder use “magic words” to seal its right to obtain a defense; policies require only that the insured provide notice. E.g., Samson v. Transamerica Ins. Co., 30 Cal. 3d 220, 239 (Cal. 1981) (“Transamerica argues that it . . . did not refuse to defend the lawsuit, since [the insured] never demanded a defense. The same argument was rejected [previously] as ‘sheer sophistry.’”); Cincinnati Cos. v. West Am. Ins. Co., 701 N.E.2d 499, 505 (Ill. 1998) (noting that the ‘tender’ rule “requires an insured to jump through meaningless hoops toward an absurd end: telling the insurer something it already knows. . . [T]he only benefit of such a rule is to create a possibility – where none would otherwise exist – for an insurer to escape an obligation it otherwise owes its insured.”).

The issue in these pre-notice coverage cases is not whether the insurer is to be entirely excused from performance, but rather whether the insurer may refuse to pay for defense costs incurred in the period before notice was provided. Courts will sometimes then say that notice is a condition to performance, and therefore the carrier cannot possibly have an obligation to pay prior to notice. See, e.g., Towne Realty, Inc. v. Zurich Ins. Co., 548 N.W.2d 64 (Wisc. 1996) (finding tender of defense was condition precedent to a duty to defend). That characterization is a bit too pat, which many courts have recognized. See Stephen A. Klein, Insurance Recovery of Prenotice Defense Costs, 34 Tort & Ins. L. J. 1103 (1999). That the carrier cannot breach its obligation to defend before it receives notice is different from whether, once it has received notice, its policy requires it to pay for all defense costs of the suit, including pre-notice defense costs. Sherwood Brands, Inc. v. Hartford Acc. & Indem. Co., 698 A.2d 1078, 1083 (Md. 1997).

The notice-prejudice nomenclature is inapt, for it’s hard to reconcile a prejudice prerequisite to a “condition” (because breach of a condition suspends or vitiates the counterparty’s performance), but just because the nomenclature is less that perfect does not mean that the result is not sound. This is an example where plain old contract-law doctrines were adequate to the task but insurance law got bollixed up by adopting its own rule. As a result, a conceptual incoherence and thus instability was introduced that has led several courts to tack back. But if one looks at the question as notice being a covenant and the counterparty’s not being excused unless the breach of covenant constitutes a material breach of the particular contract then the notice-prejudice cases are sound. This analysis applies equally to questions of “tender,” pre-tender defense costs or pre-notice defense costs, and late notice itself. See TPLC, Inc. v. United Nat’l Ins. Co., 44 F.3d 1484, 1493 (10th Cir. 1995). The majority rule stands on the broader principle too that a carrier should not be permitted to deny its policyholder the benefit of the bargain based on a technical breach that does not harm the carrier’s interests, a principle consistent with the carrier’s well-recognized duties to deal with its insured fairly and in good faith. When the insured’s noncompliance does not significantly prejudice the insurer’s ability to perform, the insurer is not disadvantaged by that breach, and “there is no reason to excuse the insurer from its promise.” Roberts Oil Co. v. Transamerica Ins. Co., 833 P.2d 222, 233-34 (N.M. 1992). Denying coverage when the insurer in no way has been prejudiced would frustrate “the consumer’s reasonable expectation that coverage will not be defeated on arbitrary procedural grounds.” Estes v. Alaska Ins. Guar. Ass’n, 774 P.2d 1315, 1318 (Alaska 1989).

When an insured’s breach of its obligations prejudices the carrier, the carrier may be entitled to relief flowing from and commensurate with the breach. A carrier should be allowed to show the marginal impact from the insured’s breach (which may be a counterclaim or set off for the “damages” the insurer incurred or the insured’s failure to mitigate or unreasonable incurrence of costs that would have been avoided by the carrier). See Alaska Energy Auth. v. Fairmont Ins. Co., 845 P 2d 420 n.5 (Alaska 1993). Otherwise, the injury to the carrier is only theoretical: its right to control the defense may be temporarily impinged but in no significant way are its rights harm.

This all brings us to several reasonably recent cases on notice. One ruling is from the Illinois Supreme Court, Country Mut. Ins. Co. v. Livorsi Marine, Inc., (Ill. May 18, 2006). In Livorsi, the Illinois court concluded:

[W]e hold that the presence or absence of prejudice to the insurer is one factor to consider when determining whether a policyholder has fulfilled any policy condition requiring reasonable notice. We also hold that once it is determined that the insurer did not receive reasonable notice of an occurrence or a lawsuit, the policyholder may not recover under the policy, regardless of whether the lack of reasonable notice prejudiced the insurer.

The policyholder in Livorsi case largely sought to convince the court based on what it claimed the majority rule was; the problem with these arguments is that they do not preponderate -- they are observation of what (non-governing) courts did when faced with similar circumstances; but those arguments don’t ask why is the rule sensible here. The second argument was framed in terms of “public policy,” which is subject, as in Livorsi, to the cogent rejoinder that balancing public policy is a job for the legislature, not the courts. N.H. Indem. Co. v. Budget Rent-A-Car Sys, 148 Wn.2d 929 (Wash. 2003) (“An insurance policy will not violate public policy unless the challenged provision is 'prohibited by statute, condemned by judicial decision, or contrary to the public morals'”). Further, the court stated that the policyholder could protect its own interests.

This should not be taken to imply that the policyholder’s points were wrong; rather, the way in which the points were argued detracts from their persuasiveness because they do not come to grips with the fundamentals of (insurance) contract law.

One case that did address these contract law points is PAJ, Inc. v. Hannover Ins. Co. 170 S.3d 258 (Tex. Civ. App. 2005). PAJ is a bad case for policyholders not only because it embraces a no-prejudice approach (but see Hernandez v. Gulf Group Lloyds, 875 S.W.2d 691 (Tex. 1994); Shelton v. Ray, 570 S.W.2d 419 (Tex. 1978)), but also because it addresses expressly the ordinary rule that contact provisions should be construed as covenants rather than conditions so as to avoid forfeiture and to preserve the benefit of the bargain. Crucially, PAJ was decided by an intermediate appellate court, and for which a petition for review is pending, so the panel was constrained by existing precedent that routinely referred to the notice provision as a “condition,” even if there was not a governing holding requiring construing the provision that way.

A recent New York trial court decision seeks to reconcile the ordinary contract law rules of condition versus covenants and material versus immaterial breach of contract with the insurance law rule in New York that prejudice is not required for a carrier to be excused from performing on late notice grounds. In American Transit Ins. Co. v. B.O. Astra Mgmt. Corp., 2006 WL 1152506 (N.Y. Sup. April 17, 2006). B.O. Astra presented good facts from the policyholder perspective, given that it involved an accident victim whose attorney provided notice directly to the tortfeasor’s insurer, thus providing notice of occurrence and notice of potential claim (and attorney involvement). Moreover, that attorney provided a copy of his motion for a default judgment to the insurer once the tortfeasor failed to answer the complaint. The insurer rather than moving to prevent entry of default (which it could have done under New York procedure) instead chose to file a declaratory-judgment action against its insureds saying no coverage because of late notice.

What is notable about the B.O. Astra decision for purposes here is how it characterized New York’s prevailing rule that an insurer need not show prejudice in order to deny coverage for late notice. The judge characterized this rule as the “‘no-prejudice’ exception”, going on in a footnote to explain:

The ‘no-prejudice’ rule is ‘a limited exception to two established contract principles: (1) that ordinarily one seeking to escape the obligation to perform under a contract must demonstrate a material breach or prejudice; and (2) that a contractual duty (requiring strict compliance) ordinarily will not be construed as a conditional precedent absent clear language showing that the parties intended to make it a condition.’

2006 WL 1152506 at n.3. The no-prejudice exception to the rules requiring materiality (prejudice) to avoid all performance and construe-as-a-covenant-when-possible was justified to allow the insurer to investigate claims while fresh, to protect itself against fraud and collusion, to set reserves, and to facilitate early settlement with claimants. Id. at *3. In the circumstances, those concerns had been adequately protected through the action of the plaintiff’s attorney provision of notice and alerting the insurer to the impending default judgment.

At a minimum, even in those states like New York that effectively presume prejudice from late notice, the courts should not create an absolute rule of law but instead should allow a policyholder to show that on the facts of a particular claim the prejudice presumption can be overcome. In other words, where a state presumes prejudice from late notice, the policyholder (the breaching party) nevertheless should be permitted to disprove that the insurer has suffered any prejudice to its legitimate interests and thus preserve the benefit of the bargain (i.e., indemnification in exchange for the premium already collected). See Aetna Cas. & Sur. Co. v. Murphy, 538 A.2d 219 (Ct. 1988) (“[A] proper balance between the interests of the insurer and the insured requires a factual inquiry into whether, in the circumstances of a particular case, an insurer has been prejudiced by its insured’s delay in giving notice of an event triggering insurance coverage. If it can be shown that the insurer suffered no material prejudice form the delay, the nonoccurrence of the condition of timely notice may be excused because it is not, in Restatement [of Contracts] terms, ‘a material part of the agreed exchange.’”); see also Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture, 5 Conn. Ins. L. J. 505 (1988-89).

The manner in which the B.O. Astra court describes the notice as not being subject to the ordinary rules re conditions and materiality reminds one (well, reminds me) of the manner in which some recent English cases have tried to conceptualize the late-notice question. In Alfred McAlpine plc. v. BAI (Run-Off) Ltd., [2000] 1 L1.R. 437 the leading opinion ruled that notice was an “innominate” term, which as will be seen is roughly how the New York (and Illinois) courts seem to have considered it. But the innominate notion was not accepted in the more recent case of Friends Provident Life & Pensions Ltd. v. Sirius Int’l Ins., [2005] EWCA Civ. 601 , wherein the Court of Appeal, with a leading opinion from Lord Justice Mance, addressed whether notice was a condition precedent, a covenant, or something else (viz., an innominate term). As the leading judgment explained:

In that case my Lord identified a possibility that a claims notification provision such as clause 5 might be neither a condition precedent to liability for the claim nor a clause all breaches of which sounded simply in damages. It might be an innominate term, the consequences of which, he said, might be so serious as to entitle an insurer to reject the claim albeit that the breach was not so serious as to amount to a repudiation of the whole insurance contract.

(para.19).

The Friends Provident court considered whether the breach of a notice provision could result in the repudiation of the entire insurance contract or rather only the contractual obligation of the insurer as it related to the claim at issue. The court concluded that notice was an “ancillary” obligation, the breach of which would not repudiate the contract. The court considered and did not accept the BAI rule that a breach with serious consequences for the insurer could excuse the insurer’s performance entirely.

Lord Justice Mance characterized insurance policies as “composite” contracts or contracts with divisible performance as respect claims. Id. at para. 18 (“The primary quid pro quo for insurers’ obligation to pay claims under the insurance is the premium, which is incapable of being severally allocated to any particular risk or claim.”). As respects the notice obligation, the court could not justify construing it as a condition precedent as a matter of law or an innominate term (of an aleatory contract):

A claims notification clause [ ] is an ancillary provision. Breach of such a provision is capable of sounding in damages. But I am unable as a matter of construction or implication to find in [the] clause … any provision that insurers will be free of liability in the event of a serious breach and/or a breach with serious consequences. Even if one assumes that it might or would have been reasonable for the parties to agree such a provision, reasonableness is not the test for implying a term. . . . A test of "serious breach" and/or "serious consequences" [as in an innominate term] might have some drastic and unfair consequences. Suppose a year's delay, in consequence of which insurers lost the opportunity to make or (e.g. because of insolvency) to recover a reinsurance claim or a subrogation claim worth £50,000. That would be a breach serious in nature and consequences. But suppose the insurance claim was itself for £1 million or £100,000 or even £75,000. Why should insurers have the right to reject the whole claim? Further, if the test in BAI is applied, insurers must prove serious consequences, as well as a serious breach. If they can prove serious consequences, then these will often be capable of quantification, in one way or another, even if only as losses of a chance or opportunity, and can be set off against the claim.

Id. at para. 32.

Moreover, Lord Justice Mance concluded that insurers were in a position to protect themselves by making clear that the notice provision would need to be complied with punctiliously on pain of forfeiture. Id. (Any other result would be “a novel form of protection for insurers. If insurers consider that they want or need such protection, they can and should try to express it in their insurance contracts and see if insureds and the broking market will accept it.”). Finding that “English insurance law is strict enough as it is in insurers’ favor”, Lord Justice Mance effectively concluded that notice was a covenant the breach of which ordinarily can result in a commensurate remedy (damages or setoff) rather than a disproportionate forfeiture of coverage.

The author of the leading judgment in the BAI case was also on the Friends Provident panel, and he (Lord Justice Waller) was not entirely persuaded by his brother Lord Justice. Instead, he clung to the idea that if the notice obligation were breached by the policyholder “in a way which seriously prejudices the insurer [it should have the] right to reject a claim rather than leave the insurer simply with a claim for damages.” Id. at para. 38. Essentially, Lord Justice Waller’s view is that faced with uncertainty as to whether the insurer was concretely prejudiced or might be able to prove some damages or set off, the law should protect the insurer’s interest and allow it to reject the claim. Lord Justice Mance, not known as a pro-policyholder judge, instead struggled with fashioning an exception for the benefit of insurers alone to the ordinary rules governing contract (as the New York courts have done), particularly where the insurer can redraft its contracts to seek to impose expressly a forfeiture result (if it can be approved, sold, and enforced).

Insofar as US law is concerned, the BO Astra court got it right in saying that the ordinary rules (should) govern, and the question is whether some special exception to the rules of materiality and covenant need to be created for insurance companies. That the majority of states – or at least a substantial plurality – require prejudice alone indicates that “promptness” must not be all that important to carriers; otherwise, in those states they would have redrafted their policies to make clear that celerity of notice was essential on pain of forfeiture. That they haven’t done sone undermines the arguments that staleness, reserve setting, and the like are all that crucial, and if it were so crucial there is no mischief in making plain to policyholders that forfeiture will be the result of late notice. Lord Justice Mance is absolutely right in this regard.

Indeed, that English law, of all things, is not as harsh as is the law in New York and maybe Illinois and Texas (and some other states) alone would give anyone with knowledge of both legal systems some considerable pause. Particularly where insurers can otherwise protect their interests, it is baffling that courts tender to them the windfall of pocketing the premium for a covered claim where they suffer no harm from the foul of the policyholder’s tardy notice.

Of course, policyholders should assiduously avoid giving insurers this opportunity to deny coverage for a covered claim (and given the scope of exclusions few enough claims are covered to begin with). The advice I always give policyholders is this: “Notice is like voting in Chicago – do it early and often.” See generally Marc Mayerson, Pursuing and Perfecting Liability Insurance Coverage: A Primer for Policyholders on Complying with Notice Obligations, 32 Tort & Ins. L. J. 1003 (1997).

But when a policyholder for whatever reason has not provided notice as soon as one would like, then we need to frame the legal question properly for the courts to consider, and analytically the twin principles of “materiality” and “covenant” are key. Insurers are not at the mercy of their tardy policyholders, however, in that they may have a remedy commensurate with the breach. A carrier conceivably may be released from performance if it proves actual harm to its interests from the paths not taken that it would in fact have pursued. Cf. Clemmer v. Hartford Ins. Co., 22 Cal. 3d 865, 883 n.12 (1978) (insurer would need to demonstrate that it would have (i) actually exercised control over the litigation, (ii) plotted and executed a course of action materially different from that undertaken by the insured, and (iii) obtained substantially better results). An insurer may be able to prove its damages from late notice, such as the example Lord Justice Mance provides of losing the opportunity to obtain reinsurance recovery. And no doubt policyholders should act with alacrity in providing notice and getting their insurers involved, but the issue ultimately is whether the courts should mangle the rules of contract to protect insurance companies and deny coverage to policyholders at the time of loss – their time of need. Kicking a fella when he’s down usually is not what anyone considers to be proper, and it is thus all the more surprising indeed where the kicker is a quasi-fiduciary that was paid to be there for the insured precisely at his time of need.

Posted by Marc Mayerson at 10:13 PM | Comments (5) | TrackBack

January 20, 2006

Insurance Industry Spared from Bankruptcy: Asbestos 524(g) Settlements

The California Court of Appeal has reversed a ruling holding that liability insurers of an asbestos company had immediate obligations to perform in full once a trust was established through section 524(g) of the bankruptcy code that concurrently extinguished the liability of the policyholder vis a vis the asbestos claimant creditors. Fuller-Austin v. Highlands Ins. (Cal. App. Jan. 19, 2006). The "acceleration" of insurers' obligations that these 524(g) trusts might create has caused apoplexy in the insurance industry, and the California court's reversal of the insurance ruling that the creation of the trust meant the insurers had immediate obligations to perform for the total (non-bankruptcy) value of the future claim stream no doubt produced a collective sigh of relief from the insurance industry (and their reinsurers).

There are two bankruptcy elements in these modern asbestos-driven bankruptcies that, when combined with prior rulings of courts dealing with bankruptcy effects on insurance, yielded an extraordinary result: immediate obligations of insurers to pay the future asbestos obligations of the policyholder-debtor immediately and in full. Before turning to the Fuller-Austin decision itself, it is important to understand what debtors like Fuller-Austin were trying to achieve.

The first step in an asbestos-driven bankruptcy is to take the asbestos claims stream and estimate its value. The debtor then needs to satisfy that creditor claim in the bankruptcy, which it does by setting up a trust and funding it with cash (from itself and sometimes its corporate parent), stock, and preexisting insurance rights. The debtor receives a channeling injunction that bars the assertion of any asbestos-related claim against itself (and sometimes against non-debtors, see Susan Power Johnston and Katherine Porter, Extension of Section 524(g) of the Bankruptcy Code to Nondebtor Parents, Affiliates, and Transaction Parties, 59 Business Lawyer 511-12 (2004)), and the injunction furthermore funnels all claims to the trust. In other words, the debtor is able to emerge from bankruptcy shorn of its asbestos liabilities without fear of any future claims.

The trust in turn is charged with resolving the asbestos claims and sets up an administrative compensation process, usually with relaxed standards of proof, to “adjudicate” the tort claims. The claimant may have the right further to bring an action in court, though with no ability to seek punitive damages for example.

This is the model that was used in the Manville bankruptcy and was confirmed, expanded, and modified by Congress in 1994 when the bankruptcy code was amended with the addition of section 524(g), 11 U.S.C. § 524(g), a provision specially designed to deal with asbestos-driven bankruptcies. While certain procedural and substantive changes were implemented in 524(g), from the debtor’s perspective one key was that 524(g) made clear that future claims, claims by persons exposed to asbestos but who at the time of the bankruptcy filing had no legal claim, would have their claims channeled to the trust as well. Dealing with “futures” has been the Achilles heel of several non-bankruptcy deals in the class-action context, Ortiz v. Fibreboard Corp., 527 U.S. 815 (1999); Amchem v. Windsor, 521 U.S. 591 (1997), so the express conferral of power on bankruptcy courts to limit the right to sue of future claimants was quite significant.

How did all this impact insurance companies? In most jurisdictions, the court have adopted a model of asbestos insurance recoveries where insurers from the 1940s through the mid-1980s together are liable to pay the policyholder’s defense costs and costs of settlements and judgments. There remained key questions in the insurance cases concerning the order of payment by insurers, which principally was an issue for the excess insurance carriers. The question is whether, if one were an excess insurer in 1970 that wrote coverage excess of $50 million, an amount that would represent about one-quarter of one year’s asbestos expense for a major defendant, that insurer is required to perform once the insured/asbestos-defendant pays $50 million or whether that insurer is effectively excess to the sum total of all primary and excess coverage, both before and after its policy period, that attaches lower than $50 million. E.g., United States Gypsum Co. v. Admiral Insurance Co., 643 N.E.2d 1226 (1991) (holding that an umbrella carrier was excess to policies before and after its policy year). If one assumes a constant level of $50 million annual coverage, the 1970 excess carrier might than be excess to hundreds of millions of dollars in “underlying” coverage. The key point is that the objective of excess carriers was to defer as long as possible the time at which they were required to perform; given the size of excess policy limits, the likelihood that asbestos liability will suck dry an entire insurance program, and the value of holding onto money as long as possible so as to “earn out” the value of claims, excess insurers have been banking on deferring their obligations to pay.

In this context, the developments in the bankruptcy cases took on added importance to excess insurers. Under a key decision more than a decade ago in the Seventh Circuit, UNR Indus., Inc. v. Continental Cas. Co., 942 F.2d 1101 (7th Cir. 1991), two crucial issues were resolved: (1) the debtor/insured’s establishment of the trust in exchange for the release of the asbestos claims against it (which were channeled and funneled to the trust) constituted a “judgment” as to which the insurers had a mature obligation to indemnify (even though payment to any individual claimant might not occur for decades); and (2) while a claimant might receive only a percentage payment from the insured/debtor/trust due to its limited funds, the value of the claim for insurance-indemnification purposes was the face value (not the end-of-the-day paid value) of the claimant’s damages. As to the second point, even though an individual settlement is paid in “bankruptcy dollars” in calculating the duty to indemnify the value of the claim extinguished is determinative (not the value paid to extinguish the claim, an amount that takes into account the insured’s insolvency).

The consequence of the UNR decision for excess insurers was frightful: they could be required to immediately perform calculated against the full value of the debtor’s claim portfolio, even though the trust itself might not pay out the individual claims for years to come.

The situation became more acute for excess insurers after 524(g) was passed by Congress in 1994. Section 524(g) requires 75 percent approval by creditors, typically the asbestos claimants (and commercial bondholders). Utilizing the pre-packaging structure under the bankruptcy code, through which debtors may negotiate the plan of reorganization prefiling, debtors began to file section 524(g) “pre-pack” bankruptcies wherein the debtor/insured/defendant would strike an agreement with the asbestos plaintiffs (in reality, their contingency-fee-paid lawyers) to establish a value of the portfolio of asbestos claims and payment values. This informal estimation process (with the asbestos-plaintiffs’ lawyer taking a percentage recovery) yielded huge nominal values, since they include asbestos claims that will be asserted for the next thirty years.

Thus, insured/debtors/defendants would negotiate a pre-pack bankruptcy plan where often the key asset that would be used to fund the massive asbestos liabilities driving the bankruptcy was insurance rights. E.g., In re Johns-Manville Corp., 40 B.R. 219, 229 (S.D.N.Y. 1984) (insurance among “the most important assets of the estate”). Moreover, the creditors’ committee (the asbestos-plaintiffs’ lawyers) would be in charge of the trust – which insurers likened to the fox guarding the hen house. (This also resulted in strange reversals of roles where some policyholder lawyers, who for years worked for asbestos defendants, suddenly became the lawyers for the trusts/creditors, working for the asbestos claimants who were suing the asbestos-defendants who had formerly been their clients – a situation that produced intriguing professional ethics and bankruptcy issues.)

Fearing that they were being set up in these pre-pack 524(g) deals (and insurers were not alone in being critical of these pre-pack, 524(g) arrangement), insurers sought to protect their interests by intervening in the bankruptcy proceedings, leading to fights over the insurers’ standing to object to a plan (given that insurers were debtors to the estate not creditors). In Re Combustion Engineering, (3d Cir. Dec. 2, 2004); In Re A.P.I. Inc., 331 B.R. 828, 842 (Bankr. D. Minn. 2005); Barron & Budd, P.C. v. Unsecured Asbestos Claimants (321 B.R. 147, 157-52 (D.N.J. 2005); Metropolitan Life Ins. Co. v. Alside Supply Center (In Re Clemmer), 78 B.R. 160 (Bankr. E.D. Tenn. 1995). Insurers (and others) fought against each other where one insurer settled the coverage with the debtor/insured. In Re Dow Corning, 192 B.R. 415, 421 (Bankr. E.D. Mich. 1996); MacArthur Co. v. Johns-Manville Corp., 837 F.2d 89 (2d Cir. 1988); see also In Re FortyEight Insulations Inc., 133 B.R. 973 (Bankr. N.D. Ill. 1991), aff’d, 1149 B.R. 860 (N.D. Ill. 1992). Insurers sometimes would seek to litigate coverage questions against their insured in bankruptcy (though those courts often were thought to be favorable fora for the debtor/policyholder), presenting questions of core/non-core proceedings, removal, and withdrawals of reference as well as questions whether the insured must satisfy deductibles or retentions as a pre-condition to accessing coverage or whether the deductible is an affirmative claim by the insurer that gets resolved at the end of the line in the bankruptcy with other unsecured claims against the estate. E.g., Amatex Corp. v. Aetna Cas. & Sur. Co., 107 B.R. 856, 871-72 (Bankr. E.D. Pa. 1989); Kleban v. National Union Fire Ins. Co., 2001 Pa. Super. 92 (2001); Columbia Cas. V. Federal Press, 104 B.R. 56, 62-64 (Bankr. N.D. Ind. 1989); Home Ins. Co. v. Hooper, 691 N.E. 2d 65 (Ill. App. 1998); Haisten v. Grass Valley Reimbursement Fund, Ltd., 784 F.2d 1392, 1403 (9th Cir. 1986)). Some carriers sought to litigate the coverage outside of the bankruptcy, but those ran into the rule that coverage actions (including “defensive” affirmative claims) outside of the bankruptcy court may not be initiated by insurers, due to the protections of the automatic stay. ACandS, Inc. v. Travelers Cas. & Sur. Co., (3d Cir. Jan. 19, 2006); Minoco Group v. First State Underwriters Agency, 799 F.2d 517, 519 (9th Cir. 1986).

This brings us to Fuller-Austin, a company that filed a pre-pack 524(g) bankruptcy that was confirmed in September 1998. Though it had commenced coverage litigation in 1994, the case suffered litigation interruptus due to the bankruptcy filing; the case picked up again with bench trials in December 2000 and September 2001, and a jury trial in November 2002. In May 2003, the jury returned a verdict in favor of Fuller-Austin awarding $188 million in damages. The jury further found that the value of Fuller-Austin’s asbestos stream exceeded $966 million. Following that trial loss, the insurers appealed, largely challenging the jury instructions formulated by the trial judge. As crushing a defeat that the trial court judgment was, the appellate decision was equally a vindication for the insurers. The insurers won virtually every issue on appeal. The appellate court was unequivocal in its rejection and criticism of the policyholder’s arguments.

The first question presented was whether the bankruptcy court’s confirmation of the plan constituted was a binding determination of the insured’s liability to the asbestos claimants. In other words, does the amount determined in the bankruptcy court constitute the amount to which the insurer’s duty to indemnify applies? The Fuller-Austin court ruled that the determination of the insured’s liability to the class in the bankruptcy proceeding was not sufficient to constitute an actual “adjudication” of the insured’s liability. There was no actual, adversarial process of factfinding such that would effectively bind the insurer by finally establishing the insured’s liability. Compare Hamilton v. Maryland Cas. Co., 27 Cal. 4th 718 (Cal. 2002).

The California court found that the bankruptcy-confirmation process, including the formulation of a plan, was a “settlement” of the insured’s liability, which presented the question whether the insurers had the right to refuse to consent to the settlement. While the insurers did not consent in fact to the plan, the court embraced the notion that insurers did not have the power to withhold consent unreasonably. In other words, so long as the settlement is reasonable, the question of the insurers’ consent vel non is academic. Because the insurers did not establish a lack of good faith by Fuller-Austin in the process leading to the plan, the court held that the insurers were permitted to object to the settlement only to the extent they could show that, as to them, the bankruptcy plan is “unfair, unreasonable or the product of fraud or collusion.” (slip op. at 34; 52-54)

The court next turned to the key question of acceleration, whether the coverage-trial jury could “estimate the aggregate sum of an insured’s liability for present and potential future asbestos claims for the purpose of accelerating [the] insurers’ obligations;” the court concluded that the estimation of the value of the claim portfolio did not “represent the amount that Fuller-Austin is legally obligated to pay.” Slip op. at 41. The court’s discussion, on this point, is not entirely focused. The issue (at least as I understand it) is whether the claim-estimation process in bankruptcy when combined with the discharge of the debtor and funneling of all claims to the separately established trust, constitutes a then-present release of the insured’s liability to the class. If so, then the plan-confirmation process results in an immediately indemnifiable judgment as against the insured (and concurrent assignment of the choses in action under the policies to the trust). In other words, rather than a claim-by-claim exhaustion of coverage as they are adjudicated (or settled) in the ordinary course, the bankruptcy process results in the equivalent of a class-action judgment against the debtor/insured. If like a class-action the claims are resolved en masse, it matters not that the payments for the individuals will occur over time. Relative to the insured, it has extinguished its liability, not as of the time that any individual claimant receives his or her money but when the judgment is entered (which the insured/debtor satisfies by establishing the trust).

The Fuller-Austin court does not frame the question this way, and it is unclear to me whether procedurally this is precisely how the issue was served up. But the court is unequivocal in declining the follow the Seventh Circuit’s UNR decision on this point, which concededly was decided prior to the enactment of 524(g). (Notably, there is no evidence of which I am aware that Congress in enacting 524(g) intended to overturn the UNR decision.) For future bankruptcies, the Fuller-Austin decision may be inapposite or at least unpersuasive on this point.

Relatedly, the court concluded that the value of the claims of the asbestos claimants were measured by the percentage recovery they obtain from the trust rather than the “full” value of their claims. In other words, because of the limited assets of the debtor-insured, the asbestos claimants were to receive only a percentage of the value of their claims (say, 45¢ on the dollar). The court paid little heed to the standard policy provision and statutorily imposed term that the insured’s bankruptcy or insolvency was not to reduce the insurer’s obligation. This policy provision was intended expressly to overcome decisions early last century where an insurer skated out of its obligations because its insured was (otherwise) impecunious and thus was not obligated to pay for the claimant’s full damages. The California court again declined to follow the UNR decision on this point. Excusing the insurers on this basis improperly favors their interests over that of the tort claimants and indeed other asbestos defendants, which will be exposed to the shortfall under joint-and-several liability principles.

The court further addressed issues dealing with the fairness of the trial-court’s jury instructions, including one that effectively presumed the existence of coverage and required the insurers to disprove that their policies were triggered or provided coverage.

What are the implications of Fuller-Austin for asbestos and mass-tort driven bankruptcies? First, it seems likely that the case will stand within the California court system because review by the California Supreme Court seems unlikely. Second, the parties upon retrial will be litigating whether the plan was a fair estimate of the insured’s liability. Assuming the settlement will be found to reasonably approximate the insured’s liability, the insurers will be required to perform only as and to the extent that claims are resolved by the trust. The likely finality of the appellate court’s ruling that the insurers’ obligations are not accelerated and are measured only by the actual payouts are the twin pillars of the excess insurers’ victory.

It’s fair to say the Fuller-Austin decision represents a major win for insurers, but the losers are the asbestos claimants (and their lawyers). The policyholder has received its discharge through the bankruptcy process and under 524(g) is protected against future asbestos-liability claims. The insurers have become increasingly aggressive and litigious in all the spate of asbestos-driven bankruptcies, and Fuller-Austin will not quell their enthusiasm for battle.

Posted by Marc Mayerson at 10:37 AM | Comments (1) | TrackBack

October 26, 2005

When ERISA Suits Tagalong to D&O Claims the Fiduciary-Liability Coverage Might Not

Corporate directors and officers litigation today often involves claims asserted under the federal securities laws as well as under federal employee-benefits law (ERISA). The plaintiffs in these suits are conceptually different: securities-law plaintiffs are people who (and entities that) purchased or sold the company’s securities; ERISA plaintiffs are participants in employee-benefit plans that held or permitted the investment in company securities. Increasingly, ERISA cases are tagging along to securities cases: the directors and officers (who often are plan fiduciaries) are alleged to have failed to disclose certain facts about the company’s operations or finances to the market generally (for securities claims) or to participants in company-sponsored employee-benefit plans (for ERISA claims).

The United States Court of Appeals for the First Circuit recently had the opportunity to address coverage for a tagalong ERISA claim that was made four years after a securities-law class action was filed. In a very troubling opinion, the court ruled that no coverage was available for the ERISA class action because the gravamen of the complaint echoed the allegations in the earlier securities class action. The basis of the court’s ruling was not that the policyholder had failed to disclose the early securities-law class action, but rather that a generic prior-and-pending litigation exclusion barred coverage. Federal Ins. Co. v. Raytheon Co. (1st Cir. Oct. 21, 2005)

Prior-and-pending exclusions take one of two forms: a laser-beam exclusion that bars coverage for prior claims that are listed by name in the exclusion and a generic exclusion that bars coverage more generally if a claim subsequently made in the policy period is related to a prior claim. This was the type of exclusion at issue in Raytheon. In particular, the language provided:

The Company shall not be liable for Loss on account of any Claim made against any Insured . . . based upon, arising from, or in consequence of any demand, suit or other proceeding pending, or order, decree or judgment entered against any Insured, on or prior to [policy inception], or the same or any substantially similar fact, circumstance or situation underlying or alleged therein.

This is a reasonably standard version of the generic prior-and-pending exclusion that is found in many corporate policies today.

In Raytheon, there was no dispute that at least some of the allegations in the ERISA class suit had been cut and pasted from the securities class action. The dispute centered on how much overlap must there be between the two cases for the prior-and-pending exclusion to apply.

The court focused on the pivotal language in the exclusion, which is that, for the exclusion to apply, the claim in the policy period must be “based upon . . . the same or any substantially similar fact, circumstance or situation underlying or alleged therein.” The court found that the use of the term “base” meant that “situations in which the complaint in the second action does not draw substantial support form the allegations of the first” were not within the purview of the exclusion (slip op. at 17); however, the exclusion is not limited to only those claims where the “first action provide[s] the sole support for the second.” Id. Instead, the court held:

We think that the policy thus requires the allegations in the second complaint find substantial support in the first complaint, i.e., that the allegations of the second complaint substantially overlap those of the first. [For the exclusion to apply] the second complaint [must] substantially overlap the first with respect to relevant facts.

Slip op. at 17-18.

The court stated that its construction promoted the purposes of the prior-and-pending exclusion: (i) to encourage insureds to give prompt notice; (ii) to avoid stacking policy limits in successive policies; and (iii) to discourage insureds from purchasing policies knowing that claims were going to be asserted (avoiding the “adverse selection” problem). Slip op. at 18-19.

But the court’s construction does not provide an incentive for providing prompt notice – in Raytheon, there was nothing for the insured to give notice about to its ERISA liability carriers when the securities case was filed three years earlier. No ERISA claim had been made, and even if notice had been given at that time to the ERISA carriers that year, they would have had no obligations – their policies had not been triggered since no claim had been made. (Even if in the policy in effect at the time of the securities claim there was a notice-of-circumstances provision, which is an extension of coverage by which the insured at its option can lock-in coverage for post-policy period claims if it first discovers during the policy period circumstances that later may lead to claims, the insured probably would not have been able to avail itself of this protection due to the stringency of the requirements of such provisions.) Accordingly, the rationale to stimulate early notice is entirely misplaced.

The second rationale, to avoid the stacking of policy limits, is in many ways a restatement of the first – stacking results when a claim is made in year 1 and a second, related claim is made in year 2, such that the policyholder can collect under each policy for the claim made in that year. There is at a minimum a dispute in the case law whether claims-made policies permit this result in the first place, that is, whether they permit the second policy even to be triggered from the assertion of a new but related claim in year 2; many commentators and courts believe that all subsequently related claims relate back to the first claim (since most policies define claim to include a “series” of claims) such that “the” claim was “first made” in year 1. One can debate whether claims-made or claims-first-made policies really work this way as they are written, but there is certainly a large number of insurers and commentators that believe that all subsequently asserted claims relate back to the first year, such that by design there is no cumulation or stacking of policy limits. But even under this view, crucially the policyholder gets paid for the second claim under the first year’s policy. Under the First Circuit’s ruling, the policyholder does not get paid at all for the second claim.

And none of this examines whether stacking or cumulation of policy limits is something that should be avoided. There are certainly substantial arguments in terms of risk spreading and the marginal utility of (insurers’) money that support stacking policy limits; the correct analysis is to look at the obligation of each carrier separately under its contract, to recognize that it was paid a full premium for the limits it provided, and to consider the axiom that successive carriers are not third-party beneficiaries of prior coverage.

At all events, the court’s second rationale – the avoidance of stacking – is unpersuasive (or surely it is inadequately explained or justified).

The First Circuit’s third rationale is similarly unconvincing. The third justification is that it avoids “adverse selection,” that is, the propensity of those with a higher exposure to loss to seek insurance protection. Here, too, the court’s facile invocation of insurance-speak (which arguably it does incorrectly) obfuscates rather than clarifies the analysis. What must be first recognized is that by their nature claims-made policies are retrospective in the coverage they provide – in other words, they are designed to cover past events, and the insured-against contingency is whether or not a claim will be made in the particular policy year. There is no showing at all in Raytheon that the company thought an ERISA claim would be brought at all let alone in the policy year in question. More importantly, this all underscores that the way to police the so-called adverse selection problem is through underwriting. Insurers are supposed to gauge for themselves the likelihood that a policy they are considering issuing may be forced to pay out, and the underwriters have the ability to ask for information and make that assessment (or take a risk against not having adequate information). If the policyholder did not adequately respond to the underwriters’ inquiries, then the policy may be voided on nondisclosure or misrepresentation grounds. What the First Circuit’s ruling does is not to police adverse selection (bad policyholders seeking coverage) but rather encourages bad and lazy underwriting – ironically as respects policies whose very purpose is to provide retrospective coverage.

Indeed, the court does not take into account that, because they provide coverage retrospectively, claims-made policies typically include a "retro date," that is, a provision stating that the operative events leading to a claim in the policy period must take place on or after a particular date (often, the inception date of the first policy issued by the carrier to that insured). This is significant because the Raytheon court's construction sub silentio adds an additional retro-date limitation, barring coverage for past factual circumstances that are substantially similar to misconduct undergirding any prior claim made under any type of policy.

Worse, it is not unreasonable to assume on the facts that Raytheon did disclose the existence of the prior securities-law class action; it was still pending at the time of the ERISA fiduciary policy’s inception. In the circumstances, that the insurance company did not laser-beam out any subsequent claims arguably induced the policyholder to believe there would be coverage.

While the Raytheon court uses its three policy rationales to buttress its holding, it is true that they are not necessary to the court’s ruling, which is predicated on a construction of the policy language, especially the meaning of “based upon.” While we must start the analysis with the policy language, and where the language is plain it will be applied, there remains a governor on the plain-meaning rule, which is that the result must still pass a reasonableness test. There are different ways this notion is expressed: a policy will not be construed to achieve absurd results is one formulation. Here, the result in Raytheon fails any type of reasonableness review.

To illustrate, the following propositions are all supported by the facts described in the Raytheon opinion:

a. The policyholder made adequate disclosure of the securities case in the underwriting;
b. No policy is triggered until the assertion of a claim against the policyholder;
c. The constellation of plaintiffs, legal claims and theories, and remedies are different in the securities and the ERISA cases.

The Raytheon court’s ruling means that the fiduciary-liability policies never have an obligation to respond to a follow-on ERISA case that is made in any year other than the year that the securities case is brought. In other words, unquestionably had the ERISA case been filed soon after the securities case, the fiduciary-liability carriers that year would have been required to respond. But if the ERISA case is filed the next year (or thereafter), the fiduciary-liability carriers in those years will not need to respond by dint of the generic prior-and-pending exclusion.

So, where does this leave policyholders, which are increasingly facing tagalong ERISA claims to securities cases filed against their directors and officers (who often are benefit-plan fiduciaries)?

1. The Raytheon court suggests that if the policyholder wishes to preserve coverage it in effect should provoke the filing of the ERISA tagalong within the same policy year that the securities case is filed. (Similarly, plaintiffs need to be aware of the Raytheon holding and file the ERISA case promptly to assure that insurance monies may be available to fund any settlement or judgment; thus, the court's ruling stimulates the filing of claims that might otherwise not be brought at all.)

2. Policyholders should resist “generic” prior-and-pending exclusions and demand that carriers laser-beam out matters that will be excluded if a related claim is asserted later. While this may result in carriers’ seeking to exclude by name the three-year-old securities claim in Raytheon, the policyholder will have the opportunity to buy back that exclusion and, if not, to know with certainty whether there will be coverage for a tagalong ERISA case.

While I believe that generally speaking the latter result is salutary, it is an unintended consequence of the First Circuit’s decision and surely is not sufficient to justify what is otherwise an untenable holding and the untoward effects it causes. Insureds face increasing risk of tagalong ERISA claims; insurers are willing to provide coverage for that risk; and in the absence of plain and compelling policy language courts should be more reluctant to take boilerplate, general exclusions and gut crucial protection that policyholders believed they paid for.

Posted by Marc Mayerson at 11:14 PM | Comments (1) | TrackBack

August 30, 2005

Grab Your Umbrella -- and Magnifying Glass

For the past two decades, policyholders and insurers have been fighting over whether the cost of cleaning up hazardous-waste sites is covered under general-liability policies by arguing over the nature of that liability. The argument has tended to center on the meaning of the word "damages" and the insuring agreement's promise to afford indemnification for the sums payable "as damages."

Departing somewhat from the standard version of these arguments, the California Supreme Court ruled in 2001 that covered "damages" were limited to amounts awarded by a court. Now, the court has reaffirmed that holding, County of San Diego v. Ace Property & Casualty Ins. Co. (Cal. Aug. 29, 2005), but in a companion case held that an umbrella policy that afforded coverage for "expenses" in addition to "damages" unambiguously applied to clean-up costs incurred in an administrative proceeding. Powerine Oil Co. v. Superior Court (Cal. Aug. 29, 2005). The court purports to be implementing the "mutual intent" of the parties, with the result that one insured has coverage due to the inclusion of the word "expenses" and the other one does not.

It is true that the purpose of umbrella policies is to provide broader coverage than the underlying coverage and to drop down or step down and fill in any gap created by a loss that is not covered by the underlying insurance. We generally conceive of this gap- filling function as ensuring that the policyholder does not fall between two stools, when for example neither an auto policy nor a homeowners' policy applies to some strange loss involving an automobile. Nothing in the language of umbrella policies limits their coverage to these types of gaps, and the California Supreme Court apparently had no trouble at all concluding that indemnification for expenses naturally includes clean-up costs in state administrative actions, even though the underlying coverage -- which indemnifies "only" for "damages" -- does not apply. As the Powerine court explained, "We therefore conclude that under a literal reading of Central National's excess/umbrella policies, the indemnification obligation is expressly extended beyond court-ordered money 'damages' to include expenses incurred in responding to government agency orders administratively imposed outside the context of a government lawsuit to cleanup and abate environmental pollution." (Slip op. at 23)

But this was not the result for the County of San Diego, because though its policies used the term "expenses" in the "ultimate net loss" provision (thus making clear the policy indemnifies for "expenses" and indicating how the policy limits were to apply), the word "expenses" was located in the wrong place as far as the Calfornia court was concerned. As the court explained [sic] in italicized language no less: "In contrast, the defintion of 'ultimate net loss' here is neither incorporated into, referenced, nor a part of the central insuring clause of the [] policy." (Slip op. at 14, original italics omitted). Accordingly, the court holds:

We conclude that costs and expenses associated with responding to administrative orders to clean up and abate soil or groundwater contamination outside the context of a government-initiated lawsuit seeking such remedial relief, and property buy-out settlements negotiated with third party claimants outside the context of a court suit, do not fall within the literal and unambiguous coverage terms of the [] policy's insuring agreement.

Slip op. at 16 (emphasis in original). Three of the six current California Supreme Court justices, however, indicated their disagreement with the merits of the holding of the opinion for the court.

The three dissenting justices no doubt are right (in my judgment) that it is, shall we say, quirky to have the case law end up where it is as of yesterday. In some ways, a more rational result would have been to deny coverage to Powerine, too, at least to accomplish some degree of aesthetic consistency (and lest there be any misunderstanding I think the original ruling by the court in the earlier case limiting coverage to amounts awarded in court, was plainly wrong). Now, at least in California, we need to scrutinize policies not just for the word "expenses" but also for its coordinates within the policy.

There is an important, broader implication of this duet of opinions: policyholders need to be vigilant in notifying umbrella carriers (and presumably the following-form tower) whenever some form of unconventional relief, i.e., other than pure compensatory damages, is sought against it, whether it be in a court proceeding or in an administrative proceeding. Accordingly, a claim for medical-monitoring, which some insurers have challenged as "non-damages", should be noticed to the umbrella carriers to guard against the risk that those amounts might be considered to be "expenses" rather than "damages" (no matter how unreasonable that result might be). Similarly, whenever a policyholder is interested in settling with a claimant prior to litigation, the policyholder should notify the umbrella carriers, for any such payment might (under current California authority) be found not to be covered "damages" either.

Of course, this all will create new burdens on umbrella carriers, who typically rely on the primary insurer for everyday claims handling. But according to the California Surpeme Court nowadays, we simply must assume the umbrella carrier had the contractual intent to cover claims settled before court proceedings start and forms of monetary relief other than traditional compensatory damages.

Posted by Marc Mayerson at 2:49 PM | Comments (0) | TrackBack

August 3, 2005

An Insurance Company’s Duty to Consent

In many types of insurance policies, the carrier’s obligation to perform is tied to its consenting to the incurrence of costs or the settlement of an underlying case. One assumes that an insurer cannot withhold consent willy-nilly, for that would make coverage illusory. There is a dearth of authority, however, that makes express the circumstances in which an insurer is not permitted to withhold consent – that is to say, the circumstances in which it is required to consent. The Supreme Court of Iowa recently addressed that question and made clear that insurers are obligated to consent when faced with a reasonable request.

In Belleville v. Farm Bureau Mut. Ins. Co. (July 29, 2005), the court addressed uninsured motorist coverage and a settlement of a claim against the tortfeasor. The Belleville case in part is concerned with the insured’s claim of first-party bad faith, which the court rejects in a broad decision that is highly favorable for insurance companies. But for present purposes, that aspect of the decision is notable because the court distinguishes the relationship of the insurer and its policyholder in the UIM context from the ordinary first-party context in holding that with respect to UIM coverage the relationship between the two “is arms-length” and thus the insurer is freed from its ordinary obligations to consider the interests of the insured to be paramount, to construe the facts and coverage in the light most favorable to the insured, and to comport with other dictates associated with the carrier’s obligation of good faith and fair dealing. (p. 11-12).

Having concluded that the insurance company does not need to extend itself to accommodate the interests of the insured, the court nevertheless imposed on insurance companies a duty to consent (where coverage is tied to consent) where the request is reasonable. In other words, in an arms’ length relationship, the Iowa court recognized that, where a reasonable request is made, it would be unreasonable to withhold consent, and therefore the insurer has a duty to consent. Thus, an insurer has a duty to consent “unless it has a reasonable basis for refusing to do so.” (p. 17)

The court’s holding applies with greater force outside of the UIM context, where insurance companies are required to consider the interests of their insureds and reasonably construe the facts and policy language in their favor. Accordingly, the Iowa decision is helpful not only concerning consent-to-settlement clauses in UIM and in liability coverage generally, but also in directors’ and officers’ policies, errors and omissions policies, and other coverages where, for example, defense costs are recoverable only if they are incurred with the insurance company’s consent.

The Belleville decision also is pertinent in considering carrier claims of prejudice from breach of a duty by the policyholder, since so long as the policyholder acted reasonably the carrier cannot claim that it was prejudiced, since it would have had a duty to consent to the reasonable course of conduct anyway. See generally Coastal Iron Works v. Petty Ray Geophysical, 783 F.2d 577, 585 (5th Cir. 1986); Pickering v. Am. Employers Ins. Co., 292 A.2d 584, 591 (R.I. 1971).

Posted by Marc Mayerson at 10:06 PM | Comments (2) | TrackBack

July 14, 2005

Late Reporting in Claims-Made Policies: Getting to the Root of the Issue

The California Court of Appeal issued an innovative decision that fills in important gaps in the analysis of issues concerning providing notice under “claims made and reported” liability insurance policies. The case, Root v. American Equity Specialty Ins. Co., available at http://caselaw.lp.findlaw.com/data2/californiastatecases/g033818.pdf (Cal. Ct. App. June 28, 2005), involved an insured who faced falling between two stools: not having coverage under consecutive liability policies because the claim was made during one policy period and its report was made in the second. The Fourth Appellate District (Division Three) emphasized that its holding was narrow: it was not invalidating claims-made-and-reported policies but rather was implying an equitable grace period to report a claim under an expired policy.

Root is different from the litigation in the 1980s where policyholders swung for the fences and ultimately struck out: policyholders had early success, especially in New Jersey and California, arguing that claims-made-and-reported policies were in their nature against public policy. (This had been the result in France which effectively invalidated claims-made policies in 1990 until legislation reversed the decision a couple of years ago.) These early cases – which in California were wiped from the books by the California Supreme Court through its practice of “depublication” (see Rule 976(b)) – generally held that the disjunction between policyholders’ expectations of coverage and the forfeiture of coverage stemming from “late” notice (different from the no-loss-of-coverage-from-late-notice-unless-the-carrier-has-been-prejudiced rule) was so extreme as to warrant invalidating the reporting requirement (virtually) altogether.

As was obvious at the time, these decisions lacked sound analytical footing legally and failed to come to grips with the fundamental reality that the policy says what it says – coverage is triggered if a claim is made and is reported during the policy period. (Policies that are simply “claims made” are different inasmuch as the policyholder covenants to provide notice but the notice provision is not part of the insuring agreement itself.) Moreover, insurers did a good job in convincing courts – without evidence – that claims-made policies were inherently cheaper than are occurrence policies (but compare Tip's Package Store, Inc.,. v. Commercial Insurance Managers, Inc., 86 S.W.3d 543 (Tenn. Ct. App. 2002) (occurrence policy implicitly cheaper than claims-made on facts presented)), and the courts ultimately adopted a "you get what you pay for” stance, holding that the notice-prejudice rule does not apply to claims-made policies and thus that notice provisions in such policies are strictly enforced.

It is against this historical backdrop that Root becomes particularly important, because the Root court was well aware of this history and the California Supreme Court’s penchant for de-publishing decisions mitigating the notice provisions of claims-made policies, and the Root court strove in its lengthy opinion to lay out an analytical framework that was consonant with fundament principles of California practice and with the reasonable expectations of both sides of the insurance transaction. The key to the court’s decision was its embrace – following the argument of Professor Bob Works in particular and the Restatement 2d Contracts § 229 – of the principle that non-occurrence of a condition, which would otherwise suspend or excuse the counter-party’s contractual performance, should be excused where a disproportionate forfeiture otherwise will result.

The facts in Root involved a suit’s being filed with three days to go in the policy period, the suit not being served until the last day of the policy, the policyholder’s having been called by a reporter the day suit was filed asking about a possible malpractice action, and the insured’s prompt provision of notice once he had actual knowledge of the suit against him.

The policy at issue was a claims-made-and-reported policy but which did not contain any “extended reporting period” (that is, a contractually established grace period to report claims that were made during the initial policy term based on conduct occurring before the expiration of the policy), and the insured never was given the opportunity to purchase an extended reporting period. As the court described the facts, “the late report was made a de minimis time after the expiration of the policy and [ ] the insured had not been given the opportunity to be protected under an extended claim reporting endorsement.” (Slip op. at 14.)

The court then framed the question before it: “The central issue in this case, then, is whether the policy period reporting requirement is a condition precedent of coverage that may be equitably excused when it works a forfeiture.” (Slip op. at 17)

The court’s framing of the issue required that it determine whether the notice provision was a condition or something else. (Generally, contract law presumes that provisions are covenants and not conditions, in order to avoid forfeitures.)

The Root court found some diverging signals between whether the notice provision was a true condition precedent or was something else, in part because the notice obligations appears more than once in the policy. The court nicely captures its own thinking, saying “[s]uperfluity does not vitiate, and in fact there are occasions when it defines.” (Slip op. at 19), which it also characterized as the policy’s “contain[ing] the seeds of its own cognitive dissonance on the problem of whether the policy period reporting requirement is a element of coverage or a condition.” (Slip op. at 20.)

To try to understand what the policy drafters were seeking to accomplish the court sought to understand the fundamental commercial context for the introduction of – and hence the drafting of – claims made policies. As the court explained this: “The key is the pricing of premiums. The core idea behind the move to claims made insurance policies was to close the gap between the time when insurer prices a risk and the time when the insurer may incur an obligation to pay on that work.” (Slip op. at 20 (citing Prof. Works)).

The time gap between the collection of the policyholder’s performance – its payment of the premiums it promised – and the carrier’s being required to perform services or pay money following a casualty is what makes the pricing of policies and operation of insurance companies a tricky business. (See generally Richard Stewart and Barbara Stewart, The Loss of the Certainty Effect, 4 Risk Management & Ins. Rev. 29 (2002), and Insurance Scrawl, Economics of Property-Casualty Insurance Business). “Insurers like all businesses in a free market, have the fundamental problem of making decisions now that depend on future events, and their survival depends on guessing right often enough to be profitable. . . . Professional malpractice insurance underwriting is [] likewise particularly vulnerable to gaps between the time of pricing and the time obligation.” (Slip op. at 21). According to the court, this changes the nature of the transaction in a claims-made-and-reported policy: “With pure ‘claims made policies, that risk is shifted to the insured, who pays present dollars for protection against claims that will themselves be paid in those same dollars, that is, without regard to inflation and at a time relatively close to the insurer’s pricing decision.” (slip op. at 22)

While the court’s discussion of the economic rationales of claims-made policies gives some context to its ratio decidendi – though court pronouncements of the nature of insurance markets are in my judgment invariably simplistic and, frankly, inaccurate – what is more interesting and important to the decision is the court’s identification of the consequences of the reporting requirement in claims-made-and-reported policies and its impact on the contractual risks assumed by the parties inter sese.

The court found that the insured’s obligation to report claims affects the carrier’s ability to monitor potential payouts under the policy. (The court then leaps the chasm to speculate about the economic impact of this in hypothesizing, again without evidence and surely subject to challenge empirically and theoretically, that the insurer’s gaining administrative closure by learning of the existence of claims more promptly yields a benefit that “is passed on to the insured in the form of lower premiums.” Slip. Op. at 22.) The court recognizes that how much a particular claim will cost is unknown at the moment of its report, but knowing of the existence of the claims sooner is better than its opposite. (Slip op. at 22-23).

The court also found salient that the reporting requirement can be understood as a simple election provision, that is, a contractual hook to ensure that if the insured elects not to exercise its rights to coverage that that election is irrevocable (or what the court characterizes as a “naked forfeiture clause”, slip op. at 23). Considered either as an information-forcing provision or as an election clause, the court found that the reporting requirement thus operates as a true condition to coverage. As the court explains, “[t]he addition of a reporting requirement therefore doesn’t go to risk of a claim against the insured (i.e., what sort of claim might fall within the ambit of the costs the insurer promises to cover), but to the logically independent risk that the insured simply will not report the claim in time.” (Slip op. at 23)

Having found the reporting requirement to be a condition, the court then confronts the consequence of that characterization, for the failure of a condition can result in a forfeiture of contractual rights (or more strictly, the failure of a condition results in the other party’s contractual obligations not becoming mature). The Root court next considered the notice/prejudice rule, where the notice “condition” has been mitigated by requiring the carrier to prove that it was prejudiced from late notice before it could avail itself of the protection the notice condition provided; the court found that that approach was too blunt an instrument, especially in the context of a claims-made-and-reported policies, since a prejudice rule would effectively transmute such policies into simple “claims made” policies, which are different. “Application of the rule thus fundamentally rewrites the claims made and reported contract into a pure claims made contract.” (Slip op. at 24)

Instead, the court applied the well established, if little known, rule providing for the equitable excuse of the failure of a condition, finding this rule to be “more flexible, nuanced, and does no violence to the claims made and reported nature of the policy.” (Id.) Applying the rule to the case before it the court reasoned:

[I]n the present case, the fact that the insurer did not give the insured the opportunity to buy an extended reporting endorsement which would . . . have given him an extra 60 days to report any claims may be of significance. Had Root been given that opportunity, for example, equity might not require excuse of the condition, because its excuse would, in effect, be to give Root the benefit of something he had the opportunity to buy and passed up. The same might be said if Root had had sufficient time to conduct an investigation as to whether a claim had indeed been made against him, or had delayed reporting the claim beyond the day on which he received confirmation of the claim. But given this record the facts are sufficient to support the equitable excuse of the reporting condition. . . . In the [California Supreme Court’s] phrase, given these facts it would be ‘most inequitable’ to enforce the condition precedent of a report during the policy period.

(slip op. at 25, footnote omitted).

The Root court’s holding is narrow on the facts and the court cautions that its ruling should not be extended unduly. As is often the case, in these types of forfeiture cases, one wonders why the carrier pressed the issue as it did, when the facts are so compelling and the harm to the insurer non-existent. A modicum of good claims judgment would have avoided litigation and avoided what is for insurers a bad decision that opens the space for new arguments on claims-made-and-reported policies and, the court acknowledges, fewer summary-judgment rulings for carriers on late reporting (at least in reasonably compelling circumstances).

Root is important not just in terms of its impact on claims-made-and-reported policies but more generally in its embrace of the doctrine of equitable excuse of conditions precedent. The Root decision also supports the idea that one needs to analyze closely whether something that is labeled a condition is truly a condition – as opposed to a covenant (as I’ve elsewhere pointed out, ) and even if a provision is a condition whether noncompliance should be excused to avoid a disproportionately harsh result, as Restatement 2d of Contracts § 229 supports. See generally Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture: Claims-Made Formats as a Test Case, 5 Conn. Ins. L.J. 505 (1999).

Posted by Marc Mayerson at 1:45 PM | Comments (3) | TrackBack

June 27, 2005

Notice this Case

New York has been one of the last jurisdictions to hold onto the view that a policyholder’s promise to provide notice to its insurer of occurrence, claim or suit must be performed punctiliously at the risk of complete forfeiture of coverage. Following a relaxing of this rule when insurers themselves are the policyholder – that is, when they are in their capacity as cedents seeking reinsurance recovery – and given the lack of analytic foundation for New York’s formalism (addressed further below), many thought that New York would eventually adopt some form of what is usually called the “notice/prejudice” rule (probably akin to that in neighboring Connecticut, cited infra).

The New York Court of Appeal dispelled any such notion in Argo Corp. v. Greater New York Mut. Ins. Co., (April 5, 2005), available at http://www.nycourts.gov/courts/appeals/decisions/apr05/42opn05.pdf . Argo holds that an insurer in New York is not required to show “prejudice” from the policyholder’s providing notice “late” in order to be excused from coverage; on pain of a complete forfeiture of coverage, it is the policyholder’s burden to show that it reasonably complied with the obligation to provide notice.

While Argo confirms that whatever exceptions to the no-prejudice rule exist do not swallow the rule, the case that really reveals (in an ‘inside baseball’ way) the New York Court of Appeals’ perspective is the subsequent memorandum decision in Great Canal Realty Corp. v. Seneca Ins. Co., (June 16, 2005), available at http://www.courts.state.ny.us/ctapps/decisions/jun05/ssm13mem05.pdf. The reversal in Great Canal is more significant because there the Appellate Division had held that the “notice/prejudice” rule did reflect the law of New York. And that the high court decision is a mere memorandum indicates the high court’s ire.

The First Department Appellate Division opinion in Great Canal, available at http://www.courts.state.ny.us/reporter/3dseries/2004/2004_09419.htm, was notable not just because of its holding but also because of its analytical power. In a clever bit of legal craftsmanship, the Appellate Division had postured the no-prejudice rule (correctly) as an exception to the contract-law rule that an immaterial breach of contract does not excuse the other side’s performance (though it may entitle the non-breaching party to damages or set off). The Appellate Division ruled that: “Ultimately, we see no reason to extend the ‘no-prejudice’ exception to allow insurers to disclaim coverage on the basis of late notice of claim where ‘lateness’ is an arbitrary temporal standard applied to a lapse between occurrence and notice, and where contractual rights favor just one party, the insurer.”

While the Appellate Division addressed the idea of disproportionate forfeiture, compare Aetna Cas. & Sur. Co. v. Murphy, 538 A.2d 219 (Conn. 1988) (relying significantly, as did the First Department, on the “celebrated case of Jacob & Youngs, Inc. v. Kent, 230 N.Y. 239 (1921)”), the Appellate Division court could have buttressed its analysis by considering whether the notice provision is a true condition precedent or is a covenant, that is, an independent promise of performance. There is a maxim of contract construction that provisions should be construed as covenants and not as conditions, precisely to avoid forfeiture from technical breaches. Maryland’s high court correctly recognized this point in Sherwood Brands, Inc. v. Hartford Accident and Indemnity Co., 698 A.2d 1078 (1997) available at http://www.courts.state.md.us/opinions/coa/1997/104a96.pdf; see also Stephen Klein, Insurance Recovery of Pre-Notice Defense Costs, 34 Tort & Ins. L.J. 1103 (1999). This is a key insight, because it makes clear that a breach of the notice covenant does not (usually) equate to a material breach of contract by the policyholder (in the light of its other covenants and performance already rendered).

The idea that notice is a covenant, not a condition, (that is, that notice is a promise of contractural performance by the policyholder) also provides a more satisfactory framework for understanding the notice/prejudice rule. Those courts adopting a requirement of showing prejudice before nonperformance by the carrier is justified have been telling us that notice is not a condition. Were notice a “condition,” then, as the New York court held in Argo, prejudice wouldn’t matter – a condition is a condition. Because of this prospect of forfeiture, however, contract law adopts the maxim that provisions should be construed as covenants and not as conditions. But since the courts say (other than in NY) that prejudice does matter, then it follows that notice is not a condition. (Just because it is found in the “conditions’ section of the policy is not dispositive; there are other provisions there identifying aspects of the policy relationship that cannot plausibly be construed a conditions precedent to coverage.)

The covenant idea furthermore helps ground arguments about what types of things get ‘counted’ as prejudice to insurers under a notice/prejudice rule. When we then argue about whether a carrier has been prejudiced, we have a normative guidepost, for we are evaluating what happened in the light of the parties’ contractual relationship and whether whatever noncompliance is alleged so goes to the heart of the parties’ mutual contract as to constitute a material breach of the entire relationship – which then would excuse the non-breaching party’s obligations to perform at all. (The covenant framework also provides the way to analyze the question of the recoverability of pre-notice defense costs, see Klein, Insurance Recovery of Pre-Notice Defense Costs, 34 Tort & Ins. L.J. 1103.)

But the New York Court of Appeals does not address the covenant versus condition point, the idea of material versus immaterial breach, or of disproportionate forfeiture (see Restatement (2d) Contracts § 229). The Appellate Division’s now-reversed opinion in Great Canal addressed the concept of disproportionate forfeiture, a doctrine that New York led the way in adopting in Judge Cardozo’s opinion in Jacobs & Young. Yet the Court of Appeals does not even address its own prior (landmark and famous) precedent in smacking down the Appellate Division in its terse memorandum decision.

The most charitable construction of Argo and Great Canal is that the Court of Appeals did not want to disturb its own prior (if ill considered) precedent. (Protocol counsels that I refrain from invoking Emerson here.) This means that it is now up to the New York legislature to adopt remedial legislation. Or the Insurance Commissioner could act to prohibit an unfair policy term (as construed by the Court of Appeals). One would think it would be politically popular to allow policyholders (voters) to obtain the benefit of the coverage they paid for when they fail to give notice immediately to their carriers and the carrier has suffered no prejudice from the late notice. “No harm, no foul” seems like a good position politically, even if it is not a winning one in the New York court system (unless you’re a carrier).

Of course, the best position to be in for policyholders is not to need to argue about conditions versus covenants, material versus immaterial breach, prejudice, or disproportionate forfeiture: as with voting in Chicago policyholders should give notice early and often. See Marc Mayerson, Perfecting and Pursuing Liability Insurance Coverage: A Primer for Policyholders on Complying with Notice Obligations, 32 Tort & Ins. L. J. 1003 (1997), available at http://www.spriggs.com/news/pdfs/MSM-6.pdf.

Posted by Marc Mayerson at 6:12 PM | Comments (1) | TrackBack

April 9, 2005

Better by Fax? Perfecting Coverage under Notice-of-Circumstances Provisions of Claims-Made Policies

Many claims-made liability-insurance policies have an important extension of coverage that enables a policyholder to lock in coverage in one year – the year that a bad situation is discovered that later may produce claims– even though claims against the insured arising from the situation are not made until after the policy period. Under “notice of circumstances” provisions, an insured can provide written notice of such a circumstance to its claims-made carrier and later-asserted claims will be deemed to have been made during the policy period in which "notice of circumstances" was given.

Insureds may want to provide notice of circumstances because it guards against the risk that a later claims-made insurer will laser-beam out eventual claims from that situation by imposing an exclusion; the later insurer may ask in its underwriting materials for the insured to identify situations that may lead to claims during the policy year – and then exclude them. Accordingly, if the insured identifies a situation that may lead to claims it may not have coverage for claims that indeed come to fruition. (If the insured fails to disclose the existence of such a situation, the insurer may later seek to rescind the policy or assert nondisclosure as a defense to performance.)

Notice-of-circumstances provisions typically require that the insured provide this notice during the policy period, which brings us to a recent decision by the New Hampshire Supreme Court. http://www.courts.state.nh.us/supreme/opinions/2005/cmc013.htm In this case, the insured consciously sought to invoke the protections of its notice-of-circumstances provision by providing written notice to the carrier. The carrier did not dispute that the content of the notice was appropriate (which is often the point of dispute) or that the relevant claims were not from the circumstances identified (another common point of dispute). Instead, the carrier refused to perform because the insured has prepared its notice on the last day of the policy period and sent it by overnight mail. The insurance company thus did not receive the notice until the day after the policy period – though the notice was prepared and sent during the policy period – and therefore, according to the insurance company, the insured had failed to comply with the notice-of-circumstances policy provision.

The case in part turns on the meaning of the word “give” as in to “give” notice to the insurance company. Once we are debating things at that level, however, we’ve already departed from practicality (or, as some have characterized, the world of the "law merchant"). The insured plainly sought to invoke the protection of the notice-of-circumstances provision, and the insurer conceded it had suffered no prejudice from what might have been a 10 hour delay in receiving notice. Yet, the New Hampshire Supreme Court denied coverage, ruling that “give” means to receive and thus the notice-of-circumstances provision had not been complied with.

Only a lawyer could have conjured this case. Presumably, if the insured had faxed the letter to the carrier, the court would have found the notice adequate. (The mailing-rule wasn’t discussed, but that rule generally goes only to proving that someone received a letter deposited in the mail, not when he or she received it.)

A somewhat related issue was decided by the 11th Circuit in an interesting case called Cast Steel v. Admiral Insurance, http://caselaw.lp.findlaw.com/data2/circs/11th/0216511p.pdf. Cast Steel involved an extended reporting period under a claims-made policy. (Actually, the policies were “claims made and reported,” which require that both the claim and the report of the claim be made in the policy period.) The policyholder had purchased consecutive claims-made-and-reported policies, and the claim was made in one policy but reported in the next one. Facially, neither policy is triggered, since both claim and report need to occur during the policy period. Had the insured not renewed the first policy, however, it automatically would have had a grace period to report claims under the first policy, a grace period that would have picked up the few hours of the “late” report. In other words, by paying an additional premium and renewing, the insured was potentially worse off than if it had not renewed at all. As the Eleventh Circuit put it, “[t]he district court’s opinion presents a somewhat alarming scenario.” (p.7)

The Eleventh Circuit concluded that the result advocated by the carrier made no sense and found that the first policy was triggered (ruling that the policy language was ambiguous). Another ground for the court’s decision that would have been available is the doctrine of disproportionate forfeiture, see Bob Works, Excusing Nonoccurrence of Insurance Policy Conditions in Order to Avoid Disproportionate Forfeiture: Claims-Made Formats as a Test Case, 5 Conn. Ins. L.J. 505 (1999). The Cast Steel case wasn’t discussed in the New Hampshire opinion but perhaps its consideration might have encouraged that court to reach a different result.

Posted by Marc Mayerson at 3:49 PM | Comments (1) | TrackBack