Law and Insurance

Conflict of Interest Issue Eludes Court

Downhole Navigator, L.L.C. v. Nautilus Ins. Co., No. 4:10-0695 (S.D. Tex. May 9, 2011)

The bargain universally made between the policyholder and the liability insurer is that insurer promises to defend and indemnify the policyholder against all the risks of legal liability alleged in the lawsuit, and in return, the insurer has the right to call the shots on the best way to defend the lawsuit, including the right to select the defense attorney.  However, that right to control the defense may shift if the lawsuit alleges one or more claims that the insurer believes are not covered by the insurance policy, and the insurer notifies the policyholder that the insurer is defending subject to its right to deny coverage for this, that, and the other uncovered claim.  The "reservation of rights" letter, which the insurer is required to send to preserve its coverage defenses, may put the policyholder in the driver's seat if (and this is the big if illustrated by this case) the insurer's reservation of rights creates a "conflict of interest" between the insurer and the policyholder.

This shift of control of the defense became a fixture of Texas law in North County Mut. Ins. Co. v. Davalos, 140 S.W.3d 685, 688 (Tex. 2004).  The Texas Supreme Court held that a conflict of interest created by a reservation of rights letter would shift to the policyholder the right to select defense counsel on the insurer's nickle.  However, the Court said that, if an insured rejects the insurer's defense without a sufficient conflict, the insured loses the right to recover defense costs.  So what constitutes a "sufficent conflict"? 

The test is deceptively simple.  "[W]hen the facts to be adjudicated in the liability lawsuit are the same facts upon which coverage depends, the conflict of interest will prevent the insurer from conducting the defense." Id.at 689.  A example of this is the lawsuit alleging that John Doe either was negligent when he smashed into his neighbor's tree, or he did it on purpose because he had a heated argument with the neighbor an hour before the accident.   The neighbor bringing the lawsuit is probably hedging his bets.  It's easier to prove negligence, but he has a shot at even more damages if he can convince a jury that the act was intentional.  However, the defendant's insurance policy covers negligence but not deliberate acts.  Presumably, the insurer will send a reservation of rights letter, explaining to the insured that it will defend the lawsuit because negligence is alleged, but the insurer will not pay any damages should the jury find the damage was intentional.

This letter creates a conflict of interest because the facts to be adjudicated at trial (did he act with intent or negligence?) are the same that determine coverage or not.  Unpacking this a little, the core concern is that the attorney hired by the insurer, who probably depends on the goodwill of insurance companies for her daily bread, might work against the defendant's best interests and, ever so slightly, nudge the development of the case to highlight the heated argument and benefit the insurer.

 In the Downhole case, an oil drilling company was sued after it allegedly "slacked off" over the drill and caused various forms of damage:

including. but not limited to: loss of profit; loss of business opportunity; loss of investment opportunity; loss of value of lease; loss of minerals; cost of delay in performance, anticipated remedial costs and other damages.

The driller sought defense and indemnity, and Nautilus sent a reservation of rights letter, which stated:

Nautilus Insurance company will provide your company wit a defense to these claims.  However,Nautilus reserves all rights to disclaim any duty to indemnify for claims and judgments which fail to seek "damages" under the policy, as further set forth below.

The policy covers only "property damage," defined as physical injury to tangible property.  The lawsuit alleged a host of damages that are not "property damage," such as delay damages, loss of investment, and other non-tangible economic losses.  Yet the lawsuit at least potentially alleges physical injury to the well itself.  So, did the reservation of rights create a conflict of interest?

The magistrate judge said no.  "The question for the court, then is whether the 'facts to be adjudicated' in the lawsuit are the 'same facts upon which coverage depends."  The court then reasoned that, because the lawsuit alleged that the driller was negligent, that is not an issue upon which coverage depends.  The court was using as its yardstick a case called Housing Authority of Dallas v. Northland Ins. Co., 333 F. Supp.2d 595, 601 (N.D. Tex. 2004), in which the coverage determnation turned on whether the alleged wrongful conduct was willful or not.  The magistrate judge in the Downhole case concluded that Northland did not apply since willfulness was not alleged.

But that misses the point.  The conflict of interest frequently arises from alternative allegations of negligent and willful conduct, but that is not the only issue that can create the conflict.  In this case the driller argued that the conflict resided in the alternative forms of damage, some of which were not covered.  So a defense lawyer hired by the insurer could nudge the development of the case in such a way as to emphasize the uncovered damages or to fail to develop any evidence of physical damage to the well.  And voila, the jury awards nothing but intangible losses that the insurer happily refuses to pay.  How is that not a conflict of interest?

The district court judge might want to review this one.

David S. White, Thompson & Knight LLP

www.tklaw.com

Policyholder Fails To Show That Insurer Wrongly Relied On Hired-Gun Expert To Deny Ike Claim

Lee v. Catlin Specialty Ins. Co., No. H-09-2792 (S.D. Tex. Feb. 27, 2011), see Decision

Insurance bad faith law has had its ups and downs in Texas.  When I started practicing law in the late 1980's, skewering insurance companies under the recently adopted tort of bad faith was a popular blood sport.  With a shift in the political winds, however, it appeared by the mid-1990's to be impossible to win a bad faith case, at least on appeal, until a Texas Supreme court case opened the door a crack.  In State Farm Lloyds v. Nicolau, 951 S.W.2d 444 (Tex. 1997), the court upheld a verdict that the insurer breached its duty of good faith and fair dealing by relying exclusively on a disputed engineering report of foundation water damage from the insurer's "hired-gun" expert, an engineering firm that the insurer used routinely because it almost never opined that foundation damage could be the result of plumbing leaks (which was covered).  The policyholder in Nicolau had introduced abundant evidence to support the covered claim and to show the expert's bias. The jury found that the insurer unreasonably failed to consider the policyholder's evidence, relied only on its expert, and so committed bad faith. 

So it is no longer impossible to win a bad faith case in Texas, but, as the present decision illustrates, the policyholder must build a careful and substantial record to do so.  Lee's commercial property in Houston was hit by Hurricane Ike in 2008, sustaining roof damage.  Lee submitted the claim, and Catlin put the investigation in the hands of Engle Martin (EM), a company that Catlin had hired to adjust all Ike damage claims in the region.  Lee hired his own representative, Mike Bass, to investigate the damage.  EM reported evidence of previous damage and hired another company to perform an infrared scan to identify which damages were attributable to Ike winds, and which to faulty prior repairs or natural deterioration.  More reports.  More inspections.  At the end of the day, EM submitted its final report that none of the damage was caused by wind, and the roof could be repaired for $22,864.77.  Mike Bass put the cost at $871,187.50 for the roof and $3.1 million for the entire building.  Litigation ensued.

On just a cursory look, the policyholder's case looks pretty good:  a "hired gun" expert with an exclusive contract with the insurer to do all the Ike work, disputed engineering evidence, only EM's part of which Catlin relied on, even a piece of correspondence seeming to show that EM was working to build a one-sided case against coverage.  The plaintiff's attorney had good reason to expect at least high settlement value.  The judge, however, gave more than a cursory look at the evidence and granted summary judgment for the insurer.

The criterion for bad faith is whether Catlin knew or should have known that the damage was covered when it denied the claim.  The judge considered this standard in light of Nicolau and found that the policyholder had failed to introduce anything near the kind of evidence presented in Nicolau, which included detailed reports from a foundation-repair contractor, a structural engineer, and a licensed civil engineer, all of whom concluded that the foundation damage was attributable to a significant leak in the plumbing system.

Lee's evidence, by contrast, was limited to an estimate of the cost of repairing the roof and the building.  The judge observed, "the record does not contain a report with conclusions that contradict those formulated by [EM].  . . .  [or] any statements or conclusions relating to the cause of the damage."  The judge also found nothing in the record indicating that Catlin's adjusters were unqualified, anything showing what percentage of EM's business comes from insurance companies (or even that EM in fact investigated other Ike claims), or any evidence showing that EM's conclusions were biased.  The one piece of correspondence, showing that EM was working to support arguments against coverage, was written after EM had completed its reports, and so did not prove bias. "The evidence shows no more than a bona fide dispute between Catlin and Lee as to whether the damages to the roof were covered by Lee's policy." 

With a little more sweat work, time and attention, the policyholder should have been able to build the kind of record that could have survived summary judgment.  The huge discrepancy in the two estimates screams that one side or the other was really off base.  A Houston jury would probably have found it hard to believe that a storm like Ike did not cause some damage to Lee's roof and that a large shopping center roof could be repaired for just over $22K.  But before you get to a jury, you have show that there are genuine issues of material fact.  That wasn't done here.

David S. White, Thompson & Knight, LLP

www.tklaw.com

"Governmental Authority" In Pollution Exclusion Does Not Include Cities, Says Texas Court

Dallas National Ins. Co. v. Sabic Americas, Inc., No. 01-08-00758-CV (Tex. App.--Houston [First Dist.] March 10, 2011) See Decision

This case is worth a look for two reasons.  First, it shows that it is still possible (maybe I should say, now possible) to obtain some pollution coverage in a commercial general liability policy.  Second, the court held that the term, "governmental authority" was ambiguous.  Policyholder-side lawyers throughout Texas will add this to a list of cases finding ambiguous policy terms.  They can be the silver bullets of coverage litigation.

Sabic was one of scores of defendants sued by cities and municipal water districts alleging that their water supply systems were contaminated by methyl tertiary butyl ether (MTBE) that the defendants had added to their petroleum products since the 1970's.  The plaintiffs alleged that Sabic and others knew or should have known the unique dangers that MTBE would cause to groundwater and sought:(1) removal of contaminants from groundwater, (2) testing and monitoring of groundwater, and (3) recovery of damages, both for testing and monitoring and for damage to water wells and other property.

The insurer, Dallas National, had issued CGL policies to Sabic from 2003-2007, but refused to defend or indemnify on 3 grounds: the suit does not allege "property damage," Sabic knew of the loss well before 2003, and the pollution exclusion barred coverage.  The court curtly dismissed the first two arguments (the suit explicitly alleged property damage, and the plaintiffs alleged both intent and negligence, so voiding a known-loss defense).  The pollution exclusion, however, gave the court pause.  The provision excluded coverage for:

any loss, cost, or expense arising out of any: (a) request, demand, order or statutory or regulatory requirement that any insured or others test for, monitor, clean up, remove, contain, treat, detoxify or neutralize, or in any way respond to, or assess the effects of "pollutants": or

(b) claim or suit by or on behalf of a governmental authority for damages because of testing for, monitoring, cleaning up, removing, containing treating, detoxifying or neutralizing, or in any way responding to, or assessing the effects of "pollutants."

The court accepted the insurer's premise that there would be no duty to defend if the plaintiffs were "governmental authorities."  Sabic won, however, by persuading the court that the term was ambiguous.  Ok.  Stop here for a minute.  How could the court believe that cities and municipal water districts were not "governmental authorities"?  Before answering, it is important to understand two important rules of policy construction in Texas.  First, the court may not consider any evidence beyond the terms of the policy and the pleading (although the insurer may have missed a step by not asking the court to take judicial notice of state statutes creating the various plaintiffs).  Second, The policyholder wins by persuading the court that its interpretation of the disputed exclusion is merely reasonable, even if the insurer's interpretation is also reasonable, or even more reasonable.

Sabic argued that "governmental authority," in the context of this pollution exclusion, should be limited to a government agency that has some authority to issue and/or enforce environmental cleanup demands or orders.  After noting that the term was undefined in the policy, the court distinguished  several cases offered by the insurer that characterized munipalities as "governmental authorities."  These cases, said the court, were not dealing with CGL interpretation issues.  From there, it was a short step to finding that, all in all, Sabic's interpretation was not unreasonable, so Dallas National is flushed.

Reading between the lines, I think the insurer became overconfident.  How could cities not be governmental authorities?  But I doubt it would have had to look very far to find insurance cases that identify municipalities or water districts as governmental authorities, or at lease as governmental somethings.  Having no insurance cases even in the ball park left the court free to make what seems to be a pretty bold distinction.

In Texas, "governmental authority" in any exclusion is now fair game for policyholders to attack as ambiguous.

David S. White, Thompson & Knight LLP

www.tklaw.com

Court Determines That Insurer Failed To Prove Prejudice, a Tough Standard Under Texas Law

East Texas Medical Center Regional Healthcare System v. Lexington Ins. Co., No. 6:04-cv-165 (E.D. Tex. Feb. 25, 2011).  See Decision

This coverage suit arising from a medical malpractice action is the latest in a series of Texas cases addressing the question: when may an insurer deny coverage under a claims-made policy for a lawsuit on the basis of late notice of the claim?  "Claims-made" refers to the type of liability policy that covers "claims" first asserted against the insured during the policy period, even though the covered event or wrongful act occurred before the policy period (as opposed to "occurrence" policies that cover events or conduct occurring during the policy period, even though the claim or suit is brought after the policy period). 

Well settled Texas law holds that failure to send the insurer notice of the claim within the policy period excuses the insurer from any obligation under a claims-made policy, even if the late notice caused no prejudice to the insurer.   Moreoever, where, as in this case, the policy also requires that notice be sent "as soon as practicable," the Texas Supreme Court has held that the insurer must prove prejudice if notice was given within the policy period but not as soon as practicable.  See Prodigy Comm. Corp. v. Agricultural Excess & Surplus Ins. Co., 288 S.W.3d 374, 382 (Tex. 2009).  See my earlier discussion of  Prodigy here.  The court in East Texas had to determine what exactly constitutes prejudice to Lexington. 

ETMC's malpractice policy expired on June 8, 2003.  In March 2003, ETMC received a letter alleging serious medical negligence, which ETMC sent to Lexington in April.  This letter constituted a "claim"  that was timely sent to Lexington.  On May 27, the plaintiff filed suit, but ETMC failed to send notice of suit until January 15, 2004.  It had earlier been decided that ETMC had a separate obligation to send notice of the suit, but that Lexington had to prove prejudice to deny coverage on the second notice.

Lexington argued that it was prejudiced by the delay because three treating nurses admitted during depositions in December 2003 that their treatment had been negligent.  By losing the right to participate in the defense of the case, argued Lexington, and particulalrly the depostions, it was prejudiced.  Because of the nurses' admissions, the underlying court entered summary judgment  in August 2004, finding that ETMC's negligence proximately caused the plaintiff's injuries.  Prejudice indeed.

The court held otherwise.  "Prejudice," said the court, was the "loss of a valuable right or benefit," which occurs when the insurer suffers a "material change in position due to the late notice."  Moreover, the insurer must show "the precise manner in which its interests have suffered."  In this case, the insurer would have to prove that its participation at the depositions would have resulted in a different outcome to the case.  What did the insurer show?

Lexington offered expert testimony that the nurses had not been adequately prepared for their depositions.  The nurses themselves testifed that thay didn't feel that they had been prepared, and in fact the medical records revealed that the nurses' conduct had not been negligent.  They simply had not reviewed the records before their depositions.  Also, Lexington produced a memo detailing a plan of action that its adjuster was to follow, stating that the adjuster would have:

investigated and analyzed the facts, assessed opposing counsel, timely engaged experts, determined the value of the case, appointed counsel, assisted ETMC's counsel in preparing witnesses and familiarizing them with the medical records, evaluated early settlement opportunities . . . requested summaries of interviews with ETMC's staff as well as deposition summaries.

 But the court noted "a glaring omission from this memo."  There was no indication that Lexington intended to participate in the depositions themselves (presumably, the court understood the part about preparing witnesses and familiarizing them with medical records meant trial preparation).  The court also found that Lexington produced no evidence that the nurses' deposition testimony would have been different had it participated.  On this point, the judge is playing it very close to the chest, as it seems a fair inference that review of the medical records would have resulted in testimony that their treatment met the standard of care.  Still, it appears that Lexington failed to solicit that precise testimony from the nurses, and the judge was not in an inference-drawing mood.

The nail in the coffin, so to speak, was Lexington's failure, during the 3 months it was involved in the case before the court entered summary judgment, to attempt to clarify the nurses' testimony, submit other evidence, or challenge causation.  The court concluded:

Although the nurses' deposition testimony presented an obstacle for Lexington, it did not rise to the level of a material change in position. . . . Lexington's inability to proceed in the easiest or most preferred manner is not enough to show prejudice.

You might think that this was a tough judge, but the decision is in keeping with other cases  demonstrating that an insurer has a near impossible task to prove prejudice, as long as it received notice before trial.

David S. White, Thompson & Knight LLP

www.tklaw.com

Extrinsic Evidence Admissible to Find No Duty to Defend, Says 5th Circuit

Atlantic Cas. Ins. Co. v. Gonzalez, No. 10-20296 (5th Cir. November 24, 2010) see Decision

Only in Texas does a court have to fudge the law a little to get around the state's absolute "8-corner" rule to reach what is obviously the correct result.  The 8-corner rule, also called the "complaint allegation rule," bars a court from considering any evidence beyond the terms of the insurance policy and the allegations in the complaint to determine whether a liability insurer owes a duty to defend its insured in a lawsuit.  Most states follow this rule but none so strictly as Texas, which adopted an arguably absolute application of this rule in Guideone Elite v. Fielder Road Baptist Church, 197 S.W.3d 305 (Tex. 2006).  The problem with an absolute application of this principle is that a plaintiff can plead a covered case out of coverage or, as attempted here, an uncovered case into coverage, simply by manipulating the allegations in the lawsuit.

The plaintiff was electrocuted while working for a friend, who was working as an independent contractor for the insured, PV Roofing Corp.  As a result, the plaintiff lost both arms and and legs and sued PV Roofing.  The plaintiff's original petition alleged that he was an employee of the insured.  He amended that pleading and alleged merely that he was working at home.  Later, in a third and then a fourth amended petition, the plaintiff alleged explicitly that he was not an employee or independent contractor of PV Roofing, but was "engaged in residential roofing" and had control over "the job."  PV Roofing sought defense and indemnification from its CGL carrier, Atlantic Casualty, which denied coverage.

The policy contained an exclusion barring coverage for:

(i) "bodily injury" to any "employee" arising out of or in the course of (a) Employment by the insured; or (b) Performing duties related to the conduct of any insured's business

(ii) "bodily injury" to an "contractor" arising out of or in the course of performing services of any kind for which the insured may become liable in any capacity . . .

The policy defines "employee" to include any person "hired, leased, contracted or volunteering for the purpose of providing services to or on behalf of any insured, whether or not paid for such services" (the plaintiff alleged that he was not paid).

Can anyone reasonably believe that the plaintiff did not meet this definition of an "employee"?  Yet he explicitly alleged in his most recent pleading that he was not an employee or contractor.  Under the 8-corner rule, the court is supposed to take the allegations as they are on face value and not consider any other evidence beyond the allegations.

In fact, the court considered extrinsic deposition evidence that the plaintiff was working at the direction of a PV Roofing contractor.  In doing so, the court fudged a little, as I said.  First, the court noted that "Gonzalez has not contested this testimony or the use of this extrinsic evidence."  However, that is not relevant to whether the court may consider that extrinsic evidence.  On that point, the court relied on a 1993 5th Circuit decision permitting consideration of extrinsic evidence "when a petition's factual allegations are insufficient to determine if there is a possible case for coverage."  W. Heritage Ins. Co. v. River Entm't, 998 F.2d 311 (5th Cir. 1993).  The court did not consider whether this 1993 decision might no longer represent Texas law on the subject after the Guideone decision, which I think is the fudge factor here.  The court upheld judgment for Atlantic and refused to find a  duty to defend.

The result is certainly correct.  However, I don't think the court needs to consider extrinsic evidence.  The allegation that the plaintiff was not an employee is more legal than factual, a point the court mentioned, and only factual allegations are relevant to the coverage analysis.  More compelling than the absence of factual allegations is the logical disconnect between the plaintiff's seeking legal liability from PV Roofing and his denial of any outside control over his work.  I think the court should be permitted, even within the 8-corner rule, to draw the necessary inference, from the plaintiff's own allegations, that PV Roofing's legal liability must be based on some control by the defendant.  The factual allegations are certainly vague but necessarily imply that PV Roofing had some responsibility for Gonzalez's work; otherwise, how could he seek to hold the insured legally liable? 

Also, the policy itself excludes bodily injury to a contractor performing services "for which any insured may become liable in any capacity."  If PV Roofing may be held liable, then the exclusion applies, and the policy applies only if legal liability is sought against he insured.  Coverage is a logical impossibility.

The point here, however, is that Texas's absolute 8-corner rule should be modified to allow courts some leeway to consider extrinsic facts.  Otherwise, plaintiffs may manipulate a defendant's coverage simply by artful pleading.

 David S. White, Thompson & Knight LLP

www.tklaw.com

 

Texas Courts Reach Inconsistent Results In Number-of-Occurrence Cases

Westchester Surplus Lines Ins. Co. v. Maverick Tube Corp., #H-07-540 (S.D. Tex. June 28, 2010) see Decision

One of the most vexed and confused liability insurance coverage issues under Texas law is the determination of the number of occurrences that cause covered damage or injury under standard CGL policies.  This case illustrates the problem.  An oil-field pipe manufacturer sold 1.306 pieces of pipe to a distributor, who in turn sold the pipe to a drilling company, who used the pipe in four different gas wells.  The pipe failed in all four wells due to a manufacturing defect.  The driller sued the manufacturer basically for the cost to redrill the four wells. 

The manufacture was covered under a standard CGL policy and an umbrella for over $25  million, but the CGL policy was subject to a $350,000 self-insured retention on a per occurrence basis.  This means that the manufacturer must pay a separate retention for each occurrence.  An "occurrence" is typically defined as "an accident, including continuous or repeated exposure to substantially the same general harmful conditions" that cause damage or injury.  The insurance company argued that each damaged well represented a separate occurrence.  The manufacturer said that the manufacturing defect was the single cause of the failures; hence, only one occurrence.

The court agreed with the insured and relied on a 2009 case from the Southern District of Texas, National Union Fire Co. v. Puget Plastics Corp., 649 F. Supp.2d 613 (S.D. Tex. 2009), which held that defective plastic water chambers incorporated into over 800 water heaters constituted a single occurrence that resulted in multiple failures.  The cause of the multiple failures was the single manufacturing defect.

So why do I say that this issue is a hopeless muddle under Texas law?  It seems fairly straightforward, right?  But consider Maurice Pincoffs Co. v. St. Paul Fire & Marine Ins. Co., 447 F.2d 204 (5th Cir. 1971), in which the court held that defectively manufactured bird seed sold by 8 separate dealers to customers constituted 8 occurrences, not one, even though no one disputed that the cause of the bird injuries was the defective manufacture of the seed.  The Westchester court considered the Pincoffs decision and distinguished it by noting that the defendants were product distributors, not manufacturers, and the cause of the injury was the sale, or rather, the multiple sales, of the defective seed by the 8 distributors.  I doubt, however, that this reasoning will stick in the next case where a defective product sold by multiple distributors causes damage to multiple, multiple customers.

The heart of the problem is that the number-of-occurrence cases fall into two categories: one, as here, in which policyholders benefit from a finding of only one occurrence (because the insured pays only one retention or deductible), and another that rewards the policyholder for multiple occurrences (because the insured receives the benefit of an additional limit of insurance for each separate occurrence).  It should come as no surprise that Pincoffs falls into the second category.  The real dispute in Pincoffs was between the primary insurer, whose policy provided an occurrence limit of $50,000 but an aggregate limit of $100,000, and the umbrella insurer, who argued that the primary insurer should pay the aggregate limit because there were multiple occurrences.

Now, I am not saying that judges are so shamelessly result-oriented that they decide the number-of-occurrence issue in whichever way maximizes the amount of coverage for the policy holder, but it is spooky how many multiple-occurrence findings involve the number of limits that may be stacked, and the sole-occurrence decisions are about the number of retentions that must be paid.

Nor am I saying that the Westchester court got it wrong.  The judge's decision is well reasoned and well supported.  But I am not convinced that the cause of damage in a product-defect case changes from the manfacturing process to the sale of the product depending on whether the manufacturer or the distributor is the defendant.  The physical cause of damage should be the same in either case.  Just wait until the next stacking-limits case raises the number-of-occurrence issue.  Pincoffs will no doubt seem a lot more appealing, even if the manufacturer is the defendant.

David S. White, Thompson & Knight L.L.P.

www.tklaw.com

Stanford Judge Refuses to Stay Discovery of Insurer's Requests for Admissions

Pendergast-Holt v. Certain Underwriters at Lloyd's of London, No. H-09-3712 (S. D. Tex. Aug. 11, 2010) see Order.

This seemingly minor order denying the insureds' motion for a protective order barring certain discovery probably marks the begining of the end for Robert Allen Stanford's (and other directors of the doomed Stanford financial entities) quest for D&O insurance coverage for their criminal defense expenses.  You remember Stanford and his fellow directors, who sued Lloyd's in 2009 to restart the flow of insurance proceeds to fund one of the costliest criminal defense trials of the modern age.  (Lloyd's had initially agreed to fund defense costs but stopped after one of the directors, Leornard Davis, copped a plea and told the bizarre tale of Stanford's ponzi operations.  In Lloyd's judgment, Davis's plea triggered an exclusion in the policy by establishing "in fact" deliberate wrongdoing).  The judge presiding over the criminal trial also ruled in the coverage lawsuit that Lloyd's had to continue funding the criminal defense.  On appeal, the 5th Circuit remanded the case back to the lower court for a new determination by a different judge but ordered Lloyd's to continue paying defense costs until the new judge ruled.  I described the peculiar circumstances of the 5th Circuit ruling here.

The new judge understood her instructions from the 5th Circuit as follows: (1) whether excluded conduct "in fact" occurred was something that Lloyd's could not arbitrarily decide on its own; a court must decide; (2) the court overseeing the criminal trial could not also determine the insurance issues; and (3) Lloyd's must continue to advance defense expenses until the court decides whether, and at what point, excluded conduct was judicially established "in fact" (i.e., when Davis pled out, when Stanford et al. admit to wrongdoing, or some other trigger the court decides).  The new judge noted that as of July 30, 2010, Lloyd's had advanced more than $15 million for defense costs (out of potential total limits of $90 million). 

Which brings us to this discovery order.  Because the coverage action is a civil lawsuit, Lloyd's gets to ask the other side questions in interrogatories and, more important, gets to ask the directors to admit or deny certain things, like all of Davis' admissions in his plea.  Like many criminal defendants, Stanford et al. are, or will be, standing on their 5th amendment right to remain silent rather than self-incriminate, a right they say answering Lloyd's discovery will violate.  Hence the motion for protective order that they not be required to answer the discovery.

The court denied the motion.  Following the lead of the 5th Circuit, the court noted that the insureds bargained for a D&O policy with an "in fact" trigger for the relevant exclusion.  Also available are so-called "actual adjudication" policies, under which the conduct exclusions do not apply until a fact finder establishes the excluded conduct in the trial itself.  Lloyd's, therefore, is entitled to an "in fact" determination of the conduct "in which all admissible evidence is welcome," said the 5th Circuit.  Also, Lloyd's continues to bleed.

[The insureds] will not be permitted to seek through this suit ... continued payment of defense costs under the Policy, while simultaneouly denying [Lloyd's] discovery that [Lloyd's] seeks in an effort to defend themselves against Plaintiffs' claims and thus liability for those costs.

What about the directors' 5th amendment rights?  The judge acknowleged that other courts have on occasion stayed discovery in a civil action rather than force criminal defendants to choose between their right to remain silent and some advantage in a civil suit.  The difference here is that the insureds filed the coverage lawsuit; the insureds were defendants in the other cases.  Also, Lloyd's is under a continuing injuction to fund the criminal defense to the tune of millions of dollars. 

The plaintiff who retreats under the cloak of the Fifth Amendment cannot hope to gain an unequal advantage against the party he has chosen to sue.  To hold otherwise would, in terms of the customary metaphor, enable plaintiff to use his Fifth Amendment shield as a sword.

With this loss, the Stanford defendants must either find a way to respond to Lloyd's discovery requests that does not establish "in fact" the excluded wrongdoing or go down to swift defeat by summary judgment.  Maybe the directors might hope to raise fact questions in their responses that avoid summary judgment and keep the tap flowing until a jury decides the coverage issues.  But even so, the civil trial is likely to occur on an expedited basis before the criminal trial.

David S. White, Thompson & Knight LLP

www.tklaw.com

Second Circuit Finds "Insured-vs-Insured" Exclusion Ambiguous

Macey, et al. v. Carolina Casualty Ins. Co., No. 08-6067 (2d Cir. June 30, 2010), see Decision

This decision from the U.S Court of Appeals for the Second Circuit created an immediate buzz in the Directors-and-Officers insurance world because the court held that the so-called "insured-vs-insured" exclusion was ambiguous, always a terrifying word for insurers.  D&O insurance protects officers and directors against lawsuits alleging a wide assortment of wrongful acts while in office, usually shareholder actions in response to a stock plunge.  Excluded from coverage, however, are claims brought by one D or O against another.  Insurers are not keen to fund inter-corporate squabbles or revenge suits brought by a former director against the scoundrels that threw her out of office.  If courts strike down the insured-vs-insured exclusion as ambiguous, insurers might have to cover a whole lot more lawsuits.

But insurers take heart.  The Macey case probably does not portend the demise of the insured-vs-insured exclusion due to the unsual facts uderlying the decision.  In fact, the court did not actually say that the exclusion was ambiguous.  It remanded the case to the lower court to determine if the plaintiffs in the underlying lawsuit were in fact directors of the insured corporation.  In other words, the court held that the exclusion might or might not apply, depending on whether the insured corporation existed when the plaintiffs were directors.  The facts, you see, are complicated.

An Illinois corporation, call it CRA-Illinois, reorganized in May 2004 and merged with an investment company.  It emerged as a Delaware corporation, CRA-Delaware, later that year with new majority ownership.  The directors of CRA-Illinois became minority shareholders (named "Legacy Shareholders") and also became directors of CRA-Delaware but, according to the Share Purchase Agreement, only for the purpose of signing the paperwork necessary to complete the reorganization.  The Agreement also required that two of the three Legacy Shareholders resign from the board in order to close the merger.  The Agreement named as new directors three other inviduals (Macey et al.), who were later sued by the Legacy Shareholders.

After the merger, the company applied for D&O insurance, making the following representation:

On May 3, 2004, the company had a merger with an investment entity.  A new Chariman and Chief Executive Officer was installed.  The prior ownership remained in a minority capacity but were no longer participants on the Board or officers of the corporation.  On August 2, 2004 a Chief Financial Officer was hired.

The policy that issued incorporated the application as part of the insuring agreement, arguably becoming a stipulation of facts in the policy.  A year later, CRA-Delaware effected yet another merger, which pushed the Legacy Shareholders out completely, whereupon they sued the new directors.  The defendants sought coverage, which the insurer denied based on the insured-vs-insured exclusion.  The coverage action followed.

The lower court agreed with the insurer that the plaintiffs were former directors of CRA-Delaware, however slight their tenure may have been, and applied the exclusion.  On appeal, however, the court said that the lower court had not looked at the record closely enough.  Applying Virginia law to interpret the policy, the Second Circuit noted that an insurance provision is ambiguous if it is reasonably capable of two different intepretations.  The court continued:

The parties' opposing arguments are both reasonable interpretations of when CRA-Delaware came into existence.  On the one hand, [Macey, et al.] argue that CRA-Delaware came into being only at closing when it merged with CRA-Illinois, which occurred at the same time [the Legacy Shareholders] resigned, an interpretation that is captured in the [application].  On the other hand, Carolina argues that CRA-Delaware came into being at some point before the execution of all the documents and issuance of stock, and thus the Legacy Shareholders rightly fall within the "insured vs. insured" exclusionary clause.  Both of these interpretations rely on the language of the Policy and are reasonable in light of the various provisions of the Policy.

The court held that the exclusion appeared to be capable of two reasonable interpretations and remanded the case to the lower court to determine if the Legacy Shareholders should be considered "insureds" under the policy.  So why is this ruling not the death-knell of the insured-vs.-insured exclusion, at least in the Second Circuit, given that most courts will interpret an ambiguous policy in favor of coverage?

The court noted that there are two kinds of ambiguity: (1) when the provision is ambiguous on its face, called patent ambiguity, and (2) when the contract, though clear when written, "because of subsequently discovered or developed facts, may reasonably be interpreted in either of two ways," or latent ambiguity.  Although the court does not explicitly say so, this is probably a case of latent ambiguity, which should not have much persuasive effect on future court decisions.  The facts of this case are not likely to be repeated, particularly a representation in the policy itself that some individuals are not directors.  A finding of patent ambiguity might start the ball rolling in other courts.  Latent ambiguity may be a harder sale for policyholders.

Nonetheless, we may expect directors and officers to use the Macey decision to bolster an argument that the exclusion is ambiguous.  The insured need only persuade a court that it has a reasonable interpretation favoring coverage, and finding reasonable arguments is what lawyers do.

David S. White, Thompson & Knight LLP

www.tklaw.com

Federal District Judge Says Texas' "Eight-Corner" Rule Is No Longer Law. Really?

David Lewis Builders v. Mid-Continent Cas. Co., No. 4:09-CV- 218-A (N.D. Tex. April 1, 2010), see Lewis Decision

This otherwise unremarkable decision denies defense and indemnity liability coverage to a homebuilder who had to repair or replace its own work, something excluded under exclusions j.(5) and (6) in standard CGL policies.  What is remarable, however, is an observation made in footnote 3 of the decision that the so-called "eight-corners" or "complaint-allegation " rule no longer applies under Texas law.  Say what?

I have frequently commented on "eight-corner" cases.  In fact, my very first post on this blog in April 2007 highlighted the strickness with which Texas courts apply the rule (see Good for the Gander- Strict "Complaint-Allegation Rule Not Always Beneficial for Policyholders) Under this rule, upheld by the Texas Supreme Court in GuideOne Elite Ins. Co. v. Fielder Road Baptist Church, 197 S.W.3d 305, 308 (Tex. 2006), a liability insurer's duty to defend its insured must be determined only with reference to the insurance policy and the pleading or complaint in the lawsuit.  A court is instructed not to consider any "extrinsic evidence" that might impact coverage, and so far, the high court has not recognized any exceptions to this strict rule.

For example, the Texas Supreme Court a few months ago upheld a lower court decision that a general contractor was not entitled to a defense of a claim that alleged liability for property damage only against the general, who, however, was covered only for work performed by a subcontractor.  Well, guess what, the subcontractor in fact caused the damage, and the general offered evidence to establish the fact.  (See my post, Policyholder Wins Big In Texas High Court Duty-To-Indemnify Decision).  The court reaffirmed that the insurer owed no duty to defend (because the pleading was silent on the crucial fact that established coverage), but the court accepted the evidence to require the insurer to indemnify.  The point is, the "eight-corner" rule in Texas is tighter than a tick.

So why does a federal district court judge say that it is no longer Texas law?  The court cites to an 2006 case, B. Hall Contracting Inc. v. Evanston Ins. Co., 447 F.Supp.2d 634, 644-46 (N.D. 2006) rev'd on other grounds, 273 F. App'x 310 (5th Cir. 2008), which was authored by the same judge (see B. Hall Decision).  In the B. Hall case, the court held that alleged property damage fell within exclusion j(5) and (6), just as in the Lewis case, so no duty to defend.  But the court went on to explain another reason for denying the duty to defend that depended on consideration of extrinsic evidence. 

The policy before the court required the insurer to "pay those sums that the insured becomes legally obligated to pay as damages because of bodily injury or property damage to which this insurance applies."  The court noted that this wording "is different from the wording found in most liability policies, in that it does not say that [the insurer] 'will defend any suit brought against [the insured] seeking damages, even if the allegations of the suit are groundless, false or fraudulent.'"  The court then considered that the "eight-corner" rule somehow depended on the groundless-false-or-fraudulent language in the policies the judge was accustomed to seeing, citing the GuideOne case that affirmed the "eight-corner" rule based on the broader duty owed under the duty to defend.  The B. Hall court then concluded that the language of the policy before it "makes the duty to pay and the duty to defend co-extensive."  In other words, the "eight-corner" rule is dead in Texas.

However, respectfully, this conclusion over-reads GuideOne and does not comport with the insurance industry's own understanding of the current duty-to-defend language.  Standard ISO (i.e., Insurance Services Office, which promulgates standard forms for the industry) CGL policies dropped the groundless-false-fraudulent formula after 1985 and has used the language in the B. Hall policy for 20 years before that case was decided.  ISO's own annotated treatise on the CGL policy addressed the very point raised in B. Hall:

Before the introduction of the 1986 commercial general liability form, the insurer's obligation to defend claims against the insured extended explicitly to allegations that were "groundless, false or fraudulent."  That language does not appear in the 1986 and subesequent CGL editions and its removal has occasionally raised questions as to whether the duty to defend is narrower than under older versions of CGL coverage.  Under the current language, the insurer's duty to defend does not in any way depend on whether the allegations made against the insured are true:

We will have the right an duty to defend the insured against "suit" seeking those damages [i.e., damages becasue of "bodily injury" or "property damage" to which this insurance applies].

In other words, as long as it is alleged that insured has caused injury or damage of a kind insured against by the poloicy--even if the insured did not in fact cause such injury or damage--the insurer is entitled to a defense against those charges.

[Annotated Commercial General Liability Insurance, IRMI, 15th printing 2008, at p. v.c.12].  I fail to see anything in the post-1985 formula that would offer greater inducement to consider extrinsic evidence than the older language.  Whether Texas courts should entertain some reasonable exceptions to their strict interpretation of the rule is another question.

Thus, B. Hall's report of the demise of the "eight-corners" rule appears to be greatly exaggerated.

David S. White, Thompson & Knight LLP

www.tklaw.com

Texas High Court Applies "Assumption of Liability" Exclusion to Insured's Own Conduct

Gilbert Tex. Construction, L.P. v. Underwriters at Lloyd's London, No. 08-0246 (Tex. June 4, 2010), see Decision

This Texas Supreme Court decision opens a whole can of worms insurance-wise, particularly in the construction industry, when a plaintiff sues a contractor for faulty workmanship, alleging only breach of contract, not negligence.  The case may have little effect beyond the peculiar facts presented, but insurers will argue that the decision limits the supreme court's 2007 Lamar Homes decision, which allowed CGL coverage of some faulty construction lawsuits brought under a breach-of-contract cause of action.

Gilbert was hired by a municipal transit authority to construct a light rail system.  After very heavy rains, a  business adjacent to the project was flooded and sued Gilbert for negligent construction and for breach of contract.  Although the plaintiff was not a party to the municipal contract, it asserted rights as a third-party beneficiary based on the following language in the contract:

The Contractor shall protect from damage all exisiting improvements and utilities (1) at or near the work site and (2) on adjacent property of a third party . . . [and] repair any damage to those facilities, including those that are property of a third party, resulting from failure to exercise reasonable care in performing the work.

Gilbert's general liability insurers (Lloyd's provided excess coverage) agreed to defend under a reservations of rights.  Gilbert moved for summary judgment, and the trial court dismissed the negligence claims because Gilbert was entitled to claim the same governmental immunity enjoyed by the transit authority.  Gilbert later settled the contract claim for $6.175 million.  Lloyd's refused to contribute to the settlement, arguing no duty to indemnify Gilbert under the following standard exclusion, called a "contract" or "assumption of liability" exclusion:

[This insurance does not apply to] "Bodily injury" or "property damage" for which the insured is obligated to pay damages by reason of the assumption of liability in a contract or agreement.  This exclusion does not apply to liability for damages:  (1) assumed in a contract or agreement that is an "insured contract"; or (2) that the insured would have in the absence of the contract or agreement.

An "insured contract" is defined to include indemnity agreements under which the named insured assumes the tort liability of another to pay damages for bodily injury or property damage.

Lloyd's argument is simple on its face: (1) Gilbert expressly agreed to assume liability for damage to adjacent property; (2) the agreement does not meet the policy definition of an "insured contract"; and (3) absent the contract, Gilbert would have no liability because all other claims had been dismissed.  Nevertheless Gilbert sued Lloyd's.  The trial court granted summary judgment in favor of Gilbert, but the appellate court reversed, basically accepting Lloyd's argument that the "contract exclusion" applied. 

At the time, I thought the appellate court was off base and said so in this blog ("Assumption of Liability" Exclusion Misapplied in Coverage Lawsuit).  Like Gilbert, I understood that the "contract exclusion" and the "insured contract" exception applied only to indemnity agreements in contracts.  I thought the appellate court failed to distinguish between an "assumption of duties" and an "assumption of liabilities," which, I argued, means the insured's assumption of another's liability, not its own.

Surprise!  The Texas Supreme Court affirmed the appellate court decision, holding that Gilbert had expressly assumed the liability for the damage in question.  The court noted that several other states, as well as the federal 5th Circuit Court of Appeals, had construed the "contract exclusion" narrowly, as I had.  Still, some other jurisdictions had interpreted the exclusion broadly, as in this case. 

So, where are we?  Earlier I mentioned the Lamar Homes decision, which held that an allegation of accidental misconduct may constitute a covered "occurrence" under a liability policy, even though the plaintiff sues only under a breach-of-contract cause of action.  The Gilbert court says that its decision does not disturb the Lamar Homes ruling, but certain questions remain.  The two most important are: how broadly should courts interpret (1) "assumption of liability," and (2) liability the insured "would have in the absence of the contract or agreement."

Assumption of Liability. 

The insurance industry will probably try to expand the Gilbert ruling to include any alleged breach of contract, putting us back in the pre-Lamar Homes days when insurers argued that only tort claims could trigger CGL coverage.  In Lamar Homes, a homeowner sued his own builder for faulty construction, which the insurer argued was a breach-of-contract claim and so not covered by the policy.  The insurer lost.  However, may insurers now use Gilbert to argue that any breach-of-contract claim falls within the "contract exclusion"? 

Let's assume that the builder's contract contains no express assumption of liability.  The builder simply agrees to build such and such a structure using such and such specifications.  Homeowner sues in contract for damage due to accidental yet faulty construction.  Insurer refuses to defend builder under the "contract exclusion," arguing that every contract carries an implied duty to perform in a reasonable, workmanlike manner.  May the "assumption of liability" be implied, or must it be stated expressly, as in Gilbert?  If implied assumptions trigger the exclusion, then, insurers will argue, no breach-of-contract action can be covered.  Also, from now on, insurers will flyspeck every contract for any term that might arguably constitute an assumption of liability. 

Insureds might consider adding a provision to their business contracts that they assume no liabilities except those expressly assumed in the contract.

Liability in the absence of contract.

The "contract exclusion" does not apply if the insured would be liable absent the contract.  Gilbert was left facing only a contract claim for arguably accidental misconduct because it was protected by governmental immunity against tort claims.  Outside of government contracts, contractors don't have this defense and may be sued for negligence.  But what if the plaintiff chooses to sue only in contract, even though the insured could be subject to tort liability?  Is that liability the insured "would have" in the absence of the contract?  Insurers will no doubt argue that an insured would have no liability for something not alleged in the complaint.

Also, are insureds compelled to raise defenses that could eliminate all tort claims and insurance coverage to boot?  Defenses such as governmental immiunity and statute of limitations are affirmative defenses that the defendant may choose to waive.  This potentially creates a dilemma for defense counsel who must choose between the insured's instruction to forgo a tort-killing defense and insurer's insistence to raise it.

These and many other thorny issues will no doubt be disputed hotly in months to come.

David S. White, Thompson & Knight LLP

www.tklaw.com