Law and Insurance

Federal Courts Reach Opposite Results Over Scope of Insured vs Insured Exclusion in D&O Policies

Home Federal Sav. & Loan Ass'n v. Federal Ins. Co., No. 06-CV-3053 (N.D. Ohio, September 14, 2007); 

 

Westechester Fire Ins. Co. v. Wallerich, No. 07-2145 (D. Minn., September 25, 2007)

 

These two Federal District Courts reached opposite results on whether an "insured vs. insured" (IvI) exclusion in a directors & officers (D&O) liability insurance policy excludes all coverage for the entire lawsuit when only one of several plaintiffs is an insured under the policy.  (As the name implies, the IvI excludes any “Claim” brought or maintained by any insured).  The Minnesota court held that because the policy defined “Claim” as “a civil proceeding . . .,” the exclusion should apply to the entire lawsuit, not just to the insured’s claim.

 

The Ohio court held that the exclusion applied only to the insured plaintiff's claim and allowed coverage for the claims asserted by the other plaintiffs, because the term “Claim” could refer to separate civil proceedings had each plaintiff filed its own lawsuit.  Therefore each plaintiff’s claim is separable.

 

Also, the Ohio court held that “Claim” may be ambiguous because the term is used elsewhere in the policy to refer to the allegations asserted, not the civil proceeding as a whole.  Specifically, the Ohio court looked at the policy’s defense-cost-allocation clause that pre-sets the percentage of total defense costs the insurer will pay when a lawsuit alleges both covered and uncovered “claims.”  Therefore, the insured’s Claim may be separated from the other Claims and excluded without excluding the other Claims.

 

Apparently, neither policyholder argued that the Claims should be separated because the definition of ”Claim” includes more than just “a civil proceeding, . . .”  Most D&O policies include “a written demand for monetary or non-monetary relief” as a “Claim.”  Accordingly, any case that was preceded by several demand letters, as often happens, began with several “Claims.”  Arguably, most courts would be reluctant to accept an interpretation of the term that allowed a different result depending on whether the demand letter or the civil action was used as the operative “Claim,” or whether the plaintiffs wrote separate demand letters. 

 

The Minnesota court may have reached its decision based on the fact that the plaintiffs were husband and wife, and the wife had nothing really to do with the company other than to receive assets in the marital estate.  In other words, the lion’s share of the “Claim” was against the insured husband.  In the Ohio case, by contrast, the insured plaintiff was one of many shareholders suing the company.

"Loss in Progress" Challenge to Duty to Defend Rejected By Texas Court

Maryland Cas. Co. v. South Texas Medical Clinics, P.A., No. 13-06-089 (Tex. App.--Corpus Christi, January 10, 2008)  See Maryland Cas. Decision.

This decision is notable primarily for the court's rejection of the insurer's fortuity, or "known-injury," defense, which insurers seem to be asserting with increasing frequency these days, particularly after a "known loss" limitation was added to standard CGL policies in 2001.  See Insurers Lose First Challenge to "Known Loss" Exclusion in CGL Policies, for discussion of a similar case.  Maryland Cas.'s assertion of this defense is all the more noteworthy because it was combined with the defense that the underlying pleadings were too vague to trigger a duty to defend.  In other words, the insurer rejected any obligation to defend because (1) the insured knew before it purchased the policy that it was engaging in wrongful conduct, and (2) the plaintiff's allegations of wrongful conduct were too vague to trigger coverage.  Do these two positions seem inconsistent to anyone else?

Texas Medical and its president and chief surgeon were sued by former employees for sexual discrimination, negligence, intentional infliction of emotional distress and invasion of privacy involving alleged "closed door" hypnosis sessions that for a period of 9 years the plaintiffs were "forced" to undergo.  Specifically, the chief surgeon allegedly detained the plaintiffs and prevented them from leaving the sessions by using a "alyce clamp," which allegedly injured one of the plaintiffs.  The defendants sought defense and indemnity from their CGL insurers arguing that lawsuit alleged false imprisonment that was covered by the policy.

Maryland argued that it had issued policies to the medical center for only 6 of the 9 years of alleged abuse, and the insured knew when it first purchased the insurance that it was engaging in the allegedly harmful closed-door sessions.  This, says Maryland, violated the fortuity doctrine that bars purchasing insurance to cover a known existing loss or a loss in progress.  ["A loss in progress occurs when the insured is, or should be aware of an ongoing progressive loss at the time the policy is purchased," observed the court.] 

The court rejected this argument because there was no evidence in the record that the insured had even received any complaints about the sessions, and Maryland could not point to any other basis for arguing that the insureds knew or should have know that an ongoing loss was in progress.

Maryland next argued that the lawsuit never actually alleged false imprisonment.  However, the court compared the factual allegations with the legal elements of a false-imprisonment action and found that the lawsuit at least potentially alleged conduct that could support such a claim, even though the court admitted to having no idea what an alyce clamp was.

Finally, the insurer argued that it should be able to allocate defense costs and pay only two-thirds of the total defense costs for the time it actually covered the insured.  Maryland argued that this allocation issue was one of first impression under Texas law.  Wrong, said the court.  Settled Texas case law has held for a decade that the duty to defend could not be allocated based on "time on the risk" or any other allocation theory.

Coverage Upheld For Other's Property In Insured's Control

Lone Star Heat Treating Co. v. Liberty Mut. Fire Ins. Co., 233 S.W.3d 524 (Tex. App.-- Houston [14th Dist.] 2007, no pet.)

This case concerns a dispute over a seldom-used provision found in many commercial general liability policies that cover the insured’s liability for the personal property of others in the insured’s care, custody or control.  The legal issue is whether this coverage was excluded under a fairly standard provision, the “dishonesty exclusion.”  In order to resolve this issue, the appellate court takes a rather lengthy, yet probably necessary, tour through the brambles of agency law.  Here, again, is an example of judges taking pains to get it right.

 

The insured engaged in the business of heat treating metals.  Customers typically shipped metal products to Lone Star for treatment and, after treatment, picked them up during business hours.  In this case, a person arrived at the loading dock after normal hours and pointed to two pallets of treated steel that he was purportedly sent to retrieve.  In this circumstance, the employee on duty was supposed to call the shipping supervisor, a man named Bierman, to confirm the pick up.  Instead, the employee said he could not release the pallets without proper documentation.  The “customer,” who identified himself as “Robert Smith,” said that Bierman knew about the pick-up arrangement but agreed to fill out a ticket for the product, which the employee accepted.  In fact, pallets belonged to different customers, and the steel was never recovered.

 

Lone Star’s general liability policy covered its liability to owners of property in the named insured’s possession.  However, the insurer denied the claim for $78,723.85 based on an exclusion of any loss “caused directly or indirectly by … dishonesty or criminal acts by you, any of your … employees … or anyone to whom you entrust the property for any purposes: (1) acting alone or with others; …”  In an ensuing coverage lawsuit, the trial court agreed with Liberty Mutual that the loss was excluded because it was caused by the dishonesty of Robert Smith to whom Lone Star entrusted the property.

 

Not so fast, Lone Star argued on appeal. “You” is defined in the policy as the Named Insured, not the broader class of other insureds, like Lone Star’s employees.  Because an employee, not Lone Star itself, handed the pallets over to Smith, and the employee was not acting dishonestly, the exclusion shouldn’t apply.  Liberty Mutual countered this argument by pointing out that corporations necessarily act through their representatives.  Because the employee was acting within the course and scope of his employment, he was acting on behalf of Lone Star.  Thus, the exclusion should apply.

 

The court held that the policy clearly distinguished between “you” as named insured and other insureds and rejected any wholesale identification of the corporation and its employees.  “The pivotal question is whether Lone Star entrusted the property. . . .  Accordingly, our focus is on common law doctrines that pertain to the two-party relationship between employee and employer.”  The court determined that Lone Star did not entrust the property to Smith because (1) Lone Star had a defined procedure for authorizing after-hours pick-ups (the employee was supposed to call and get authority from the shipping supervisor); (2) Bierman was not called; and (3) the employee knew he was not otherwise authorized to release the product, and there was no evidence that Lone Star had taken any action that might lead the employee to believe he could deviate from his instructions.

 

Because Lone Star did not give actual authority to its employee to hand the product over to Smith, and the employee had no other instructions that might induce him to believe he could use his own judgment in the matter, the court held that the exclusion did not apply.  Had Liberty Mutual developed evidence that employees routinely acted without express authority, and Lone Star knew about such deviations but took no action to correct them, the outcome might have been different.  The lesson for policyholders is to have and follow reasonable procedures for handling business.  Failure to do so can have unexpected consequences, such as loss of insurance coverage.

CGL Insurers Must Prove Prejudice To Avoid Coverage For Late Notice of Claims

PAJ, Inc. v. Hanover Ins. Co., No. 05-0849, (Tex. January 11, 2008)

This decision puts Texas squarely in the national majority position on what happens when the insured fails to give its liability insurer timely notice of a claim or suit.  It is now clear that in all types of claims, the insurer may not refuse to defend or indemnify the insured unless the delay prejudiced the insurer's rights under the policy.  However, this decision probably does not require the insurer to prove prejudice for late notice under a claims-made type policy.  (For more information on claims-made policies, see Late Notice Under Claims-Made Policy).

Standard Commercial General Liability (CGL) occurrence-type policies require the insured to send notice of a claim or suit "as soon as practicable"  (how soon varies with the facts of each case, but most courts require notice within a couple of months).  Before 1973, under Texas law, failure to do so resulted in forfeiture of coverage for that claim, without regard to any evidence of actual prejudice to the insurer.  The State Board of Insurance issued a 1973 order requiring CGL policies to preclude forfeiture of the claim unless the insurer is prejudiced by the late notice but only for bodily injury or property damage (which in 1973 is all that a standard CGL policy covered.  Later, CGL policies began covering what is now called "personal and advertising injury," at issue in the PAJ case).  Between 1973 and the present, Texas courts have split between holding that the insurer must prove prejudice in all cases or just in bodily injury/property damage cases. 

PAJ, Inc. is a jewelry manufacturer that was sued for copyright infringement, that qualified for coverage as an "advertising injury" under its CGL policy.  Apparently not realizing that the lawsuit might be covered by insurance, PAJ failed for four months to send Hanover notice of the lawsuit (PAJ stipulated that notice was not "as soon as practicable").  Hanover denied coverage but stipulated in court that the delayed notice did not cause prejudice.  The lower courts held that Hanover had the right to deny coverage without having to prove prejudice because the notice clause constituted a "condition precedent," not a "covenant."  And this is the legal distinction that the Texas Supreme Court had to parse.

A "condition precedent" in a contract is a condition that must be met before performance is due.  The "condition precedent" is viewed legally as an essential basis for the contract, at the heart of the bargain.  For example, suppose I want to donate land to a city to be used as a park.  If I grant the land to the city but only for so long as it is used as a recreational park, this is a condition precedent to my gift.  The grant is rescinded if the city tries to develop condos on the land.  If the condition precedent fails, the contract (or land grant in this case) fails.

A "covenant," by contrast, is simply a promise or obligation.  A contract usually contains a number of covenants.  In an insurance contract, the insurer promises to pay money or take certain action upon the occurrence of covered risks; the insured agrees in return to pay a premium.  The policy contains other terms and provisions that further define the parties' obligations, in light of anticipated circumstances that affect the contract.  The key distinction about covenants is that a party's performance may in some respect fall short of what was promised, but unless it materially affects the fundamental purpose of the contract, the deficiency will not result in a complete forfeiture of the bargained-for exchange.  Breach of a covenant may be material or immaterial.  If the breach is material, the breaching party may lose the benefit of the bargain.  If immaterial, then the breach may be overlooked or require only a reasonable modification.

Is the notice obligation a condition precedent or a covenant?  Often it looks like a condition precedent when it uses conditional language, such as [insurer will cover the claim] "unless" or "unless, as a condition precedent thereto," [notice is not given as soon as practicable].  In PAJ, the Supreme Court appeared to cut the Gordian Knot of arcane legalese and hold that it would treat these notice provisions as covenants regardless of the phraseology used.  In doing so, the Court recognized it was following the modern trend in favor of requiring proof of prejudice.

PAJ drew a spirited dissent joined by three other justices condemning what was perceived as a departure from established law on the interpretation of conditions precedent.  The dissent pointed out that the insurance industry recently changed the standard CGL policy by including an endorsement requiring prejudice for personal and advertising injury claims as well as bodily injury/property damage claims.  It if for legislative bodies or the contracting parties, not the courts, to alter the policies, says the dissent.

The PAJ decision brings a measure of certainty to the claim analysis when notice is delayed.  Policyholders in fact have an incentive to provide timely notice to their insurers, who have no obligation pay defense costs incurred before they receive notice.  So, I do not think this decision will result in tardier habits among risk managers.  Also, as mentioned before, courts will not require insurers under claims-made policies to show prejudice, at least as long as notice is sent within the policy period.

Court Finds Indemnity's Express-Negligence Language Enforceable

XL Specialty Ins. Co. v. Kiewit Offshore Services, LTD, No. 06-41785 (5th Cir. January 2, 2008).  See XL Specialty Decision

The legal issue in this case is whether an indemnification clause in a construction contract is enforceable under Texas law, thus requiring the subcontractor's insurer to defend the indemnitee general contractor.  Both the lower court and the Fifth Circuit held that it is enforceable.  The wonder is why the insurer challenged coverage in the first place.  I suspect that indemnification law is so tricky and misunderstood in Texas that XL thought its denial was worth a shot.  Thus, this case presents yet another teachable moment about the arcane operation of the "express negligence" rule under Texas law.

Kiewit was the general contractor performing welding services on the Skyway Bridge San Francisco Bay Project and hired a subcontractor to do the welding.  An employee of the sub was killed in an explosion when working in a closed space.  The families of the deceased sued both Kiewit and the sub.  The subcontract required the sub to purchase insurance, add Kiewit as an additional insured to the liability policy, and indemnify Kiewit against liability.  The sub's insurer refused to defend or indemnify Kiewit against the lawsuit.  The case does not say why the insurance failed to cover Kiewit as an additional insured.  Instead, the courts focused on whether the insurer had a duty to defend Kiewit by virtue of the indemnity clause in the subcontract.  (General liability policies typically cover its insured's enforceable indemnification obligations)

The indemnification required the sub: "To defend and indemnify [and save harmless Kiewit] against any and all claims . . . on account of acts or omissions of [Sub] whether or not caused in part by the active or passive negligence or other fault of [Kiewit]; provided however ... not if such claims . . . are caused by the sole negligence of [Kiewit]."  [Emphasis added.  Actually the original clause is all-capped to meet a requirement under Texas law that indemnifications must be conspicuous.]

Texas law is almost unique in requiring that indemnifications must meet the "express-negligence" test, that is, must expressly state that the indemnitor [sub] will indemnify the indemnitee [Kiewit] against the indemnitee's negligence, or words that that effect.  Several Texas courts, including at least one Texas Supreme Court, have held that the language quoted above meets the express negligence test.  In other words, it is enough for me to agree to defend and indemnify you against [all claims arising from the contract operations, or the premises, or whatever else we are contracting about] whether or not you are negligent.

XL tried to distinguish other cases by arguing that this subcontract used different causal language than that approved by the Texas courts.  This contract covered liability "on account of" the sub's acts or omissions.  The other cases approved clauses covering liability "arising out of" the indemnitor's conduct.  However, the Fifth Circuit refused to accept this reasoning.  It is true that in other contexts, the Texas Supreme Court has held that "arising out of" connotes much broader causality than other causal phrases, like "due to," but Texas courts have never judged indemnification clauses on the breadth of the causal phrase used to link the liability to the conduct.  And in this case, because the sub's employee was performing the welding, no reasonable judge will quibble over whether accident arose out of the welding operation or was on account of the welding operation. 

There might have been an issue if a Kiewit employee had been doing the welding that the sub should have been doing.  Would the accident then have been "on account of" the sub's conduct?  Probably the answer is yes, simply because the courts do not appear to look very closely at causation.  It is hard enough to evaluate the express-negligence language.

Given that most of the indemnification clauses I review in my practice do not meet the express-negligence test (because most rational indemnitor's do want to cover the indemnitee's negligence), this case is a good illustration of what the courts are looking for.  Really and truly, under Texas law, if the indemnity does not explicitly include the indemnitee's own negligence, it is not enforceable.

 

"Manufacturing Defect" and "Producing Cause" Are Redefined Under Texas Law

Ford Motor Co. v. Ledesma, No. 05-0895 (Tex. December 21, 2007).  For the complete Opinion, see Tx. Sup. Ct.

Although this is not an insurance case, it is worth noting because it will probably result in fewer product liability verdicts in manufacturing-defect cases (which should be good news for defendants and their insurance companies).  Also, the Texas Supreme Court took the unusual step of modifying definitions in the Texas Pattern Jury Charge (TPJC) that are published by a committee that works under the supervision of the Supreme Court.  Hence, this decision marks a significant change in prior law and practice.

In Ledesma, the owner of a pickup truck lost control of the vehicle and struck two parked cars.  The owner and the truck manufacturer agreed that the rear leaf spring and axle assembly came apart causing the drive shaft to dislodge from the transmission.  The owner alleged that this happened before he lost control due to a manufacturing defect which caused the accident.  Ford disagreed and argued that the owner lost control and hit the parked cars due to negligent handling, and the collision caused the axle separation.

At trial, the court submitted to the jury a standard question: "Was there a manufacturing defect in the [truck] at the time it left Ford's possession that was a producing cause of the incident in question?"  The jury charge included two definitions taken directly from the TPJC:

• A "defect" means a condition of the product that renders it unreasonably dangerous.
• "Producing cause" means an efficient, exciting, or contributing cause that, in a natural sequence, produces the incident in question.  There may be more than one producing cause.

The jury answered in the affirmative.  On appeal, Ford argued that the two definitions were defective, and the case should be dismissed.  The Supreme Court reversed the judgment and remanded the case to the trial court for retrial based on corrected definitions.

The Court found the TPJC definition of "defect" to be "defective" because it was impossible for a jury to distinguish a "manufacturing defect" from a "design defect."  To prove a "design defect," a plaintiff must prove the existence of a safer alternative design.  The Ledesma Court held that to avoid the danger that a jury might confuse the two types of defect, the definition of manufacturing defect should also contain the element "that the product deviated, in its construction or quality, from its specifications or planned output in a manner that rendered it unreasonably dangerous."

Although the Court did not reverse on the basis of error in the definition of "producing cause," it changed that TPJC definition as well.  "To say that a producing cause is 'an efficient, exciting, or contributing cause . . . is incomplete and, more importantly, provides little concrete guidance to the jury.  These adjectives are foreign to modern English language as a means to describe a cause. . ."  From now on, the Court instructed, producing cause should be defined as, "that cause which, in a natural sequence, was a substantial factor in bringing about an event, and without which the event would not have occurred.  There may be more than one producing cause."

Both revised definitions probably add an extra step to the plaintiff's burden of proving that an injury was caused by a manufacturing defect.  First, the plaintiff must produce evidence of deviation from design or planned output.  Second, it must persuade the jury that the defect not only brought about the incident, but also the incident would not have occurred without the defect.  Although, logically, the earlier causation definition required proof of "but-for" causation, the additional element to the definition at least appears to require an additional step in a jury's deliberation, which probably favors the defendant.