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Excess Insurers’ Obligation Not Triggered When Insured Settled With Its Primary Carrier for Less Than The Primary Policy’s Limit
Elizabeth Caraballo, Associate in the New York Office
The insured’s settlement with its primary insurer for less than the full limits of liability under its primary policy did not trigger coverage under the excess carriers’ policies as the primary policy had not been properly “exhausted.” Citigroup Inc. v. Federal Ins. Co., et al., No. 10-20445, 2011 U.S. App. LEXIS 16316 (5th Cir. Aug. 5, 2011)
Citigroup Inc. (Citi) sought coverage from its excess carriers for a statewide class action filed in California state court alleging violations of the California Unfair Business Practices Act, fraud and deceit, negligent misrepresentation and other claims, and for an action brought by the Federal Trade Commission (FTC) alleging violations of the truth in lending statutes. Citi provided notice to its insurers of the suits, but entered into a total settlement with the claimants of approximately $263 million without the insurers’ consent. The insurers initially denied coverage for the actions. However, Citi negotiated a settlement with its primary insurer, Certain Underwriters of Lloyd’s of London (Lloyd’s) under which Lloyd’s paid $15 million of the $50 million primary limit of liability. After the present suit was filed, Citi settled with the first excess layer carriers, and proceeded to arbitration with two of its second excess layer carriers. This action involved several of the second excess layer carriers not subject to arbitration.
Applying Texas law, the district court granted summary judgment in favor of the excess insurersholding that, as a matter of law, based on the language of the excess insurers’ policies, their liability to provide coverage did not attach until Lloyd’s paid its full $50 million limit of liability. The Fifth Circuit affirmed.
Citi argued that the exhaustion language contained in the four excess policies at issue (which were not identical) was ambiguous and should be construed strictly in its favor. Citi urged the court to apply the Second Circuit’s holding in Zeig v. Massachusetts Bonding & Insurance Co.1 that, if an excess insurance policy’s definition of “exhaustion” is ambiguous, the fact that the policyholder enters into a settlement with the primary insurer (regardless of the amount) is sufficient to constitute exhaustion of the underlying policy.
At the outset, the Fifth Circuit rejected the Zeig rule, noting that it had never been adopted in Texas and the “exhaustion” language of the excess insurers’ policies was not ambiguous. The court engaged in a careful examination of the language of each of the excess policies and declined to read any ambiguity into any of them regardless of the different “exhaustion” language employed by each. For example, the excess policy issued by Federal Ins. Co. specified that coverage attaches only after “(a) all Underlying Insurance carriers have paid in cash the full amount of their respective liabilities; (b) the full amount of the Underlying Insurance policies have been collected by the plaintiffs, the Insureds or the Insureds’ counsel; and (c) all Underlying Insurance has been exhausted.” The excess policy issued by St. Paul Mercury Ins. Co. stated that coverage does not attach until the underlying policy’s “total” limit of liability has been paid “in legal currency.” Steadfast Ins. Co.’s excess policy provided that coverage attached in the event “of the exhaustion of all of the limit(s) of liability of such ‘Underlying Insurance’ solely as a result of payment of loss thereunder.” Despite the differences in the “exhaustion” language used by the excess insurers, the Fifth Circuit concluded that their “plain meaning” was simply unambiguous and therefore had to affirm the grant of summary judgment.
1 23 F.2d 665 (2d Cir. 1928).
2 See e.g. Comerica Inc. v. Zurich Am. Ins. Co., 498 F. Supp. 2d 1019, 1031 (E.D. Mich. 2007); Premcor USA, Inc. v. Am. Home Assur. Co., 2004 U.S. Dist. LEXIS 9275 (N.D. Ill. May 20, 2004) (noting that Zeig’s holding that “exhaustion” of the primary policies’ payments does not require collection of the primary policies as a condition precedent to the right to recover excess insurance is contrary to Seventh Circuit precedent).
Tressler Comments: Further to our discussion in the August 2011 edition of this newsletter, this decision is yet another rejection of the Second Circuit’s Zeig rule. The Zeig rule has also been rejected by courts in the Sixth and Seventh Circuits.2 Here, the Fifth Circuit went out of its way to reject Citi’s arguments that Zeig applied even though it would not have been bound by it. It is noteworthy that the Fifth Circuit analyzed no fewer than four different exhaustion provisions and found that none were ambiguous. Also of note is the court’s indication that Citi had not secured the insurers’ consent before it settled with the underlying claimants, and appears to be a slap of Citi’s hand for failing to obtain the insurers’ consent.
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Multiple Separate Claims of Embezzlement Constitute a Single “Related Claim”
Kathryn Formeller, Associate in the Chicago Office
Multiple claims arising from a law firm employee’s embezzlement scheme constituted “related claims” subject to a single “each claim” limit of liability, according to an Illinois appellate court in Continental Casualty Co. v. Howard Hoffman & Associates, 2011 Ill. App. LEXIS 876 (1st Dist. August 15, 2011).
Continental Casualty Company (“Continental”) issued a lawyer’s professional liability policy to the law firm of Hoffman and Associates (“Hoffman”). During the policy period, Hoffman informed Continental that a non-lawyer employee had embezzled funds from at least 16 probate estates that were represented by the firm. Claims for losses, including three lawsuits, were asserted against Hoffman by 12 of the estates. The employee, while engaged in the management of the firm’s probate and estate files, forged checks to herself and caused the bank statements to be destroyed to conceal her withdrawals from a reviewing attorney. Hoffman estimated its total losses from the employee’s embezzlement scheme exceeded $300,000. Continental’s policy contained a $100,000 limit of liability per claim and a $300,000 limit in the aggregate.
Continental filed a lawsuit seeking a declaratory judgment against Hoffman and the 12 estate claimants that Hoffman’s claims regarding the embezzlement scheme constituted “related claims” subject to the policy’ single $100,000 limit of liability. The trial court found that Continental’s policy contained definitions for “related claims” and “related acts or omissions” that were clear and unambiguous and that those definitions controlled any interpretation of the policy. The trial court further determined that the claims of all of the estates were connected to the employee’s embezzlement scheme and therefore should be treated as a single, related claim under the policy subject to the “each claim” policy limit of $100,000.
The Illinois appellate court affirmed the trial court’s decision. The appellate court focused on the policy language and the definition of the terms “claims” and “related claims.” The policy defined “claim” as “a demand received by the Insured for money or services arising out of an act or omission… in the rendering of or failing to render legal services.” “Related claims” was defined as “all claims arising out of a single act or omission or arising out of ‘related acts or omissions’ in the rendering of legal services.” The language “related acts or omissions” was defined as “all acts or omissions in the rendering of legal services that are temporally, logically, or causally connected by any common fact, circumstance, situation, transaction, event, advice or decision.” The policy further provided that if “related claims are subsequently made against the Insured and reported to the Company, all such related claims, whenever made, shall be considered a single claim first made and reported to the Company within the policy period in which the earliest of the related claims was first made and reported to the Company.”
The appellate court determined that the definitions of “related claims” and “related acts or omissions” were not ambiguous simply because they included the language “logically…connected.” The Court pointed out that at least two other jurisdictions have found that the same policy language was unambiguous and enforceable. The Court further rejected the estate claimants’ argument that there was an ambiguity in the terms “each claim,” “single claim,” and “all claims.” When combined together, the plain language of the policy provisions clearly provides that all claims arising out of all acts or omissions in the rendering of legal services that are temporally, logically or causally connected by any common fact, circumstance, situation, transaction, event, advice or decision shall be considered a single, related claim subject to the “each claim” limit of $100,000.
Applying the policy language, the Court found that the non-lawyer employee’s intentional decision to embezzle from Hoffman’s probate estate accounts fell directly within the policy’s “related claims” provision. Although the scheme involved the accounts of several different estates, the employee’s acts had “common ties” and involved the same “modus operandi.” The Court classified the non-lawyer employee’s embezzlement scheme as “an action in general” or “wrong or unlawful deed” further noting that the embezzlement scheme was a “sum of essential and environmental character-istics” or a “combination of circumstances.”
As for the estate claimants’ claims against Hoffman for poor management, the Court found that Hoffman’s acts and omissions were sufficiently logically and casually connected to the employee’s embezzlement scheme to be considered a “related claim.” Thus, all of the claims against Hoffman arising from the embezzlement scheme fell squarely within the “related claims” provisions constituting a single claim subject to the $100,000 “each claim” policy limit.
Finally, the Court held that the “cause theory” adopted by the Illinois Supreme Court in prior cases was not relevant to the determination of whether acts or omissions in the rendering of legal services constitute “related claims.” The “cause theory” applies only to “occurrence” based policies. The Court also refused to apply the reasonable expectations doctrine finding that the plain and unambiguous language of the policy provided that the estate claims at issue are related and are subject to the single, $100,000 policy limit. The Court further pointed out that a number of courts have held that the “reasonable expectations” doctrine does not apply in Illinois.
Tressler Comments: This is an important decision as the Illinois court refused to look any further than the plain language of the policy in determining whether claims were “related claims” subject to a single limit of liability. While the court acknowledged that the policy’s language defining “related claims” was broad, it rejected the notion that because the language was broad, it was necessarily ambiguous. These cases are of course factually specific. Thus, while the claims in this case fell plainly within the “related claims” provisions, variations on the fact pattern may yield a different result.
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Fidelity Corner: Court Mistakenly Construes Insuring Agreement (E) As Imposing No Duty to Inquire as to Authenticity of Collateral
Jim Knox, Partner in the Chicago Office
A specter is haunting the financial institution bond—the risk it will be construed to cover sloppy banking. Usually this proves a chimera but sometimes a spooky decision jumps out. In Peoples State Bank v. Progressive Cas. Ins. Co., No. 10-0086, 2011 U.S. Dist. LEXIS 75318 (W.D. La. July 11, 2011), the insured bank, Peoples, engaged in warehouse lending. Its borrower, First Fidelity, a lender itself, made home loans secured by mortgages. It pledged them as collateral for a line of credit at Peoples.
Each time a home loan closed, First would send the loan package to Peoples (perfecting Peoples’ security interest), sell the loan on the secondary market, and use the sale proceeds to repay the line of credit. This worked for six years but then First submitted three packages with forged or falsified documents to Peoples. Two of these used information from authentic loans that had already been funded through another bank. An employee of First copied parts of the authentic loans, forged the borrowers’ signatures and submitted them to Peoples as originals. The third package was completely falsified—there never had been a genuine underlying transaction.
Peoples suffered a loss and sought coverage from Progressive under Insuring Agreement (E), which covers loss caused directly by an extension of credit on the faith of forged or counterfeit documents of a certain type, subject to a number of conditions. Progressive contended there was no coverage because Peoples did not extend credit “on the faith of” the documents (i.e., genuinely rely on them as manifested by a review and an attempt to verify authenticity).
The federal court for the Western District of Louisiana disagreed. The insuring agreement expressly requires that the bank have physical possession of the documents in advance of funding, but Peoples could show this. The court conceded that “on the faith of” also requires “some reliance,” but found enough of this from the mere fact that the bank had extended credit in exchange for a security interest in the documents. With all due respect, this reads “on the faith of” out of the bond. The insuring agreement already contemplates potential coverage whenever credit is extended in exchange for a security interest in a document rendered unenforceable by forgery or counterfeiting. “On the faith of” is intended as a restriction on that potential coverage, not a needless restatement.
The court compounded its error by asserting that the bank would not have made the loan had it known the documents were forged (or counterfeit). This usually shows up as an argument not to show reliance but to show causation in a fictitious document case where the counterargument is that the forgery caused no loss if the transaction was fictitious because there would still be a loss even if the signature was genuine. Most courts have held against banks on this point. The court here evidently did not consider this, not even against that part of the loss that did not even at least involve duplication of what had been a genuine loan.
Most troubling of all, the court concluded the bond’s “on the faith of” condition required no review or verification of the documents at all; a bank’s own negligence is not a coverage defense. The court did not think that this failure to even look at documents violated the bond’s separate “good faith” requirement either. The court is mistaken. Allowing a bank to recover in spite of some negligence is one thing; letting a bank take on risk with a blindfold is another. Insuring Agreement (E) is premised on a bank at least attempting to conduct due diligence when it takes in documents as collateral—some effort to ascertain that the collateral is genuine. Failure to do so is commercially unreasonable and the bond does not cover such a lapse.
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Delaware Elects Not to Follow Twombly and Iqbal Pleading Standard
David Yuen, Associate in the Chicago Office
The Supreme Court of Delaware held that the pleading standards to overcome a motion to dismiss are minimal and Delaware cases are not subject to the heightened pleading standards required by the United States Supreme Court in Bell Atlantic Corp v. Twombly, 550 U.S. 544 (2007) and Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009). Central Mortgage Company v. Morgan Stanley Mortgage Capital Holdings, LLC, 2011 Del. LEXIS 439 (Del. August 18, 2011).
Morgan Stanley frequently purchases residential mortgage loans, pools them together and sells them to investors in bulk or securitized. It also sells servicing rights for those loans to third party servicers, which handle the operational aspects of mortgage lending, including billing, payment collection and remitting of payments. Central Mortgage is one of these servicers and usually retains as compensation a small percentage of payments collected.
In July 2005, Morgan Stanley agreed to sell approximately $1 billion in servicing rights to Central Mortgage. The parties entered into a Master Agreement, which gave Central Mortgage the opportunity to purchase servicing rights on specific pools of loans. The loans were ones that Morgan Stanley had planned to sell to Fannie Mae and Freddie Mac (“the Agencies”).
Between March 2006 and August 2007, Central Mortgage made six purchases of servicing rights from Morgan Stanley. Central Mortgage eventually became aware that the loans it purchased were not performing at the level expected. As a result, Morgan Stanley agreed to reduce the price of the servicing rights by 2 percent. The parties entered into an amendment to the Master Agreement that required Morgan Stanley to repurchase servicing rights at Central Mortgage’s option for any loans that fell delinquent by 90 or more days within the first 12 months of the sale date. In 2008, the Agencies began making demands of Central Mortgage, as servicer of the loans, to repurchase the loans because many of the mortgages allegedly did not satisfy Agency guidelines. The Agency Transfer Agreements obligated Central Mortgage to either repurchase the loans or to pay make whole amounts. Central Mortgage simply forwarded the repurchase or make whole requests to Morgan Stanley, who repurchased the loans or reimbursed Central Mortgage for the whole amounts on 47 occasions.
Eventually, Morgan Stanley stopped repurchasing the loans and reimbursing Central Mortgage. Central Mortgage then repurchased or paid make whole payments on about 50 loans. Central Mortgage filed suit against Morgan Stanley alleging that it breached the agreements between the parties by failing to cure these loans, and also breached the implied covenant of good faith and fair dealing. At the time of filing suit, there were approximately 140 additional repurchase or reimbursement demands.
Morgan Stanley moved to dismiss the complaint. The trial court granted the motion on the basis that Central Mortgage failed to follow the notice provision requirements. The trial court specifically determined that Central Mortgage did not provide Morgan Stanley adequate notice of the alleged breaches nor did it provide a 60-day opportunity to cure those breaches. The court found that attaching an exhibit to the complaint was not proper notice under the Master Agreement and that the exhibit did not provide Morgan Stanley with an opportunity to cure since it was provided after the suit was filed. In addition, the court held that the exhibit did not specify what the breaches entailed.
The Delaware Supreme Court however stated that pleading standards at the motion to dismiss stage are minimal in Delaware. Vague allegations should be accepted if they provide the defendant with notice of the claim and the motion should be denied unless the plaintiff could not recover under any reasonably conceivable set of circumstances. The Court recognized that the U.S. Supreme Court held that the proper pleading standards for a motion to dismiss required plausibility and not conceivability in Bell Atlantic Corp v. Twombly, 550 U.S. 544 (2007) and Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009). This is a higher standard and requires the court to determine if the complaint states a plausible claim for relief, which is more than a mere possibility.
This case was the first opportunity for the Delaware Supreme Court to adopt the plausibility standard. However, the court elected not to do so mainly because the issue was not litigated by either party in the trial or appellate court. Instead, the Court re-emphasized that the current pleading standard in Delaware to survive a motion to dismiss is reasonable conceivability. Based on this standard, the ruling of the trial court was reversed since Central Mortgage satisfied the minimal pleading requirements currently governing in Delaware.
Tressler Comments: This decision is especially instructive due to the fact that a number of companies are incorporated in Delaware. This is likely to have an effect on directors and officers liability cases. It will hamper the ability of counsel who defend breach of fiduciary duty claims in Delaware, to dismiss the case in the early stages. In addition, plaintiffs are more likely to file suit in Delaware due to the lenient pleading requirements.
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Investment Banker Allegedly Lost $1 Billion Investing in Subprime Securities Even After its Parent Knew Subprime Market “Could Go Up in Smoke”
Elizabeth Mathieson, Associate in the Chicago Office
A breach of contract claim against an investment banker recently survived a motion to dismiss where the plaintiff seeks to recover damages for the loss of more than $1 billion from investment accounts managed by the investment banker. Ambac Assur. UK Ltd. v J.P. Morgan Inv. Mgt., Inc., 2011 NY Slip Op 5942, 1-2 (N.Y. App. Div. 1st Dep’t, July 14, 2011).
The Appellate Division of the New York Supreme Court rejected defendant’s attempt to characterize plaintiff’s claim as one of “failure to achieve” so it could utilize precedent mandating dismissal of a breach of contract claim for failure to achieve an investment objective. The court instead found that plaintiff’s claim rests on the allegations that, notwithstanding its adherence to certain limitations on purchasing subprime securities, the defendant failed to manage the accounts in accordance with the agreed upon objective: “to obtain reasonable income while providing a high level of safety of capital.”
In this case, plaintiff, Ambac Assured U.K., guaranteed timely payment for certain notes issued by Ballatyne, an entity established to reinsure term life insurance policies. To capitalize itself and finance the required reserves, Ballatyne issued more than $2 billion in securities. In May 2006 Ballatyne entered into an investment management agreement (the “IMA”) with defendant, J.P. Morgan Investment Management, Inc., a subsidiary of J.P. Morgan Chase. Under the IMA, defendant had full investment authority subject to the investment guidelines, which state the goal of the investment policy “is to obtain reasonable income while providing a high level of safety of capital.”
The guidelines set forth the percentage of account assets that could be invested in each class sector. Permitted securities included home equity loan assets-backed securities and mortgage backed securities. The IMA contained a discharge of liability provision where defendant did not guarantee the performance of the accounts and liability for losses. An action could only be sustained for gross negligence or willful misconduct of the defendant.
By October 2008, the accounts allegedly had lost $1 billion of the $1.65 billion entrusted to the defendant just 30 months earlier. In June 2009 plaintiff filed a lawsuit seeking, inter alia, damages arising from defendant’s alleged breaches of the IMA.
The plaintiff’s allegations stem from a September 2008 article in Fortune magazine where J.P. Morgan Chase CEO was quoted as having concluded as early as October 2006 that the subprime securities market “could go up in smoke.” He instructed his subordinates to watch out for subprime, and directed the head of securitized products to “sell a lot of our positions.”
Plaintiff alleged defendants, through their parent company, J.P. Morgan Chase, had evidence of the growing risk of the collapse of the subprime securities market. However, while J.P. Morgan was actively selling off its risky subprime mortgages it had originated, the defendant did nothing about the risky subprime mortgages it maintained in the subject accounts even though it knew they were not in line with the investment objective of seeking a “reasonable income and a high level of safety of capital.”
Defendant claimed that since plaintiff conceded that the subject subprime securities did not exceed the percentages provided in the IMA, the breach of contract claim must be dismissed. The court disagreed and found the defendant was confusing the “limitations” provision in the IMA as a “requirements” provision.
The IMA had no specific requirements as to investing in any particular types of securities. The diversification provision listed mortgage back securities as permitted securities in which the defendant was permitted to invest up to certain percentage limits of the accounts assets, but the diversification provision did not require the defendant to invest in them at all.
Plaintiff asserted and the court agreed that:
[A]dhering to the maximum contractually permitted percentages despite “seismic changes to the economy, to world markets and J.P. Morgan’s own internal conclusion[s] [about an impending financial meltdown in the housing market], suggest the very opposite of managing the accounts and exercising discretion as to whether the securities should be held at all.
Plaintiff’s claim was not based on the failure to achieve, even though the defendant tried to posture it that way. Plaintiff’s claim was based on allegations that even though defendant adhered to certain limitations in the IMA, it did not manage the accounts in accordance with the agreed upon objective. Once the defendant acquired information about the riskiness of subprime securities, it knew that those securities were not in line with the investment objective but did nothing.
The court found the breach of contract claim was sufficient to overcome the motion to dismiss.
Tressler Comments: The court’s ruling is notable in that it tends to impute a parent company’s knowledge and business decisions concerning the subprime collapse on a subsidiary company, and finds the subsidiary company potentially grossly negligent for failing to realize and/or act on that knowledge.
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California Insurance Code Section 533 Applies to Bar Coverage for All Criminal Actions
Dana Sheridan, Partner in the Los Angeles Office
In a recent decision rendered in a Los Angeles County Superior Court, the court held that California Insurance Code Section 533 bars reimbursement of an insured doctor’s defense fees and costs incurred relative to a federal indictment against him. Mt. Hawley Insurance Company v. Lopez, No. BC434879, 2011 WL 329555.
The insured, Dr. Robert J. Lopez, Jr. (“Dr. Lopez”), was indicted by a Federal Grand Jury for criminal conduct relative to a liver transplant. Dr. Lopez sought coverage for his defense fees and costs relative to the indictment under an insurance policy issued by Mt. Hawley Insurance Company (“Mt. Hawley”). Mt. Hawley denied a duty to defend Dr. Lopez relative to the criminal indictment based on California Insurance Code Section 533.5 (b). Mt. Hawley also filed a declaratory relief action against Dr. Lopez seeking a declaration that it did not owe a duty to defend or indemnify Dr. Lopez in connection with the indictment. Mt. Hawley moved for summary judgment and a Los Angeles County Superior Court Judge granted the motion, finding that Section 533 “bars coverage for all criminal actions.”
Dr. Lopez, who was practicing at St. Vincent Medical Center, was alleged to have wrongfully transplanted a liver into one patient, instead of a different patient who was next in line on the United Network for Organ Sharing’s (UNOS) list of persons eligible for organ transplant. The patient who was supposed to get the liver, but did not, died. Dr. Lopez and other employee personnel affiliated with the hospital were alleged to have acted in conspiracy to cover up details and circumstances relating to the transplant, including the identity of the patient who actually received the transplant.
St. Vincent subsequently closed down its entire liver transplant program and several civil lawsuits were filed against the doctors and the hospital. Dr. Lopez was ultimately indicted by a federal grand jury for criminal conduct (conspiracy, concealment and records falsification) relative to the cover up of the transplant.
California Insurance Code section 533.5 (b) provides that: “No policy of insurance shall provide, or be construed to provide, any duty to defend… any claim in any criminal action or proceeding or in any action or proceeding brought pursuant to Chapter 5 (commencing with Section 17200) of Part 2 of, or Chapter 1 (commencing with Section 17500) of Part 3 of, Division 7 of the Business and Professions Code in which the recovery of a fine, penalty, or restitution is sought by the Attorney General, any district attorney, any city prosecutor, or any county counsel, notwithstanding whether the exclusion or exception regarding the duty to defend this type of claim is expressly stated in the policy.” We also note that Section 533.5 (a) contains the same provision but is applicable to the duty to indemnify.
However, Section 533 contains no mention of the type of criminal action for which it would bar coverage. In other words, the statute is silent as to whether it bars defense only for state or local criminal actions, but not defense fees and costs associated with a federal indictment. In fact, relying on previous state court decisions that held that Section 533 only applies to state or local actions, Dr. Lopez argued that Section 533 would not be a bar to defense costs incurred relative to the federal indictment against him. The court disagreed and held that Section 533 eliminates coverage for all criminal actions, even in those circumstances when the policy at issue would arguably extend coverage for such an action.
Tressler Comments: In the April issue of Tressler’s Specialty Lines Advisory, I wrote an article on the 9th Circuit’s decision in Greenwich Insurance Co., et al. v. Media Breakaway LLC, et al., No. 09-56347, 9th Cir (2011), where I noted that the issue of California Insurance Code Section 533 and its reach into specialty/professional lines coverage is an issue that California coverage practitioners are interested in seeing evolve and resolve. This is because specialty type coverage often provides coverage for intentional conduct of an insured, whereas Section 533 would generally bar defense/indemnity for damages due to the willful conduct of an insured.
Here, it is implied in the decision that the Mt. Hawley policy would have covered defense fees and costs associated with the federal indictment, but the court still held such a defense was barred from coverage by virtue of Section 533. So, at least one court has answered the question I posed in the April issue, albeit in the context of criminal conduct and not generally willful or intentional conduct. Additionally, the court also specifically refused to consider whether Dr. Lopez would have been entitled to defense for a related criminal investigation of his conduct. Would costs associated with an investigation have been covered, whereas costs associated with an actual criminal action would not? Splitting hairs, I suppose; but the devil is in the details. Further, often times professional lines or specialty coverage will contain a criminal acts exclusion – but such exclusions routinely only preclude coverage upon adjudication of criminal conduct. I wonder what our courts would do should criminal investigatory costs be at issue and should the policy at issue both cover intentional conduct of an insured, and also preclude coverage for damages associated with such conduct only when there is an adjudication that such conduct was criminal. Can Section 533 reach that far? … Stay tuned.
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Is the “Eight Corners” Duty to Defend Rule Dead in Utah?
Mary McPherson, Partner in the Orange County Office
Last month, the Utah Supreme Court added another step to that state’s “duty to defend” analysis, which represents a significant departure from established insurance law in Utah by requiring insurers to consider facts outside the complaint in determining whether there is a duty to defend under certain circumstances.
Similar to many other states, Utah now requires an insurance company to look beyond the “eight corners” of the policy and the complaint to determine the duty to defend. However, and unlike many other states that allow extrinsic evidence to be considered at the duty to defend stage, use of such information is necessary only when the duty to defend as defined in the policy at issue requires consideration of facts outside the complaint. This signals a significant change in Utah insurance law, which all insurers need to consider and apply. Equine Assisted Growth & Learning Association v. Carolina Ins. Co., 2011 UT 49 (2011 WL 3052331) (Utah August 19, 2011).
In this case, Greg Kersten (“Kersten”), the former CEO of Equine Assisted Growth and Learning Association (“Association”) sued the Association’s Board of Trustees the day after he was fired. Kersten captioned the complaint so it appeared that the Association was the plaintiff and that he was suing them in his capacity as “President and CEO” of that organization. Although Kersten had no authority to sue on the Association’s behalf, he nevertheless obtained a Temporary Restraining Order (“TRO”) giving him control of the organization. The Association’s board members eventually were able to convince the court that Kersten was no longer affiliated with its organization and had no standing to sue in the name of the organization. The District Court dissolved the TRO and Kersten voluntarily dismissed the case. However, the Association had incurred substantial costs defending itself and its board members against the lawsuit.
The Association tendered the suit to its insurance carrier, Carolina Casualty. The Carolina Casualty policy covered the “Cost of Defense” and defined a “Claim” as a “written demand for monetary or nonmonetary relief, including . . . a civil, criminal, administrative or arbitration proceeding.” However, the policy contained an “Insured vs. Insured” exclusion, precluding coverage for “any claim made against an insured . . . by, on behalf of, or in the right of the insured entity.” Carolina Casualty, relying solely on the allegations of the
complaint and its policy; i.e., the “eight corners rule”, denied coverage based on that exclusion. Carolina Casualty maintained its denial even after the Association explained that Mr. Kersten was no longer affiliated with it at the time he filed the lawsuit.
The Association sued Carolina Casualty for the costs of defending Mr. Kersten’s unsuccessful suit. Carolina Casualty moved for summary judgment and the trial court ruled in favor of Carolina Casualty finding that under the “eight corners rule” (followed by Utah courts), it could not consider any extrinsic evidence in deciding the duty to defend. Thus, no coverage was owed because, on its face, the complaint fell within the “Insured v. Insured” exclusion. The Court of Appeals reversed, explaining that whether extrinsic evidence is admissible in deciding the duty to defend turns on the terms of the insurance contract. It concluded that under the language of the insurance policy, extrinsic evidence was admissible to determine whether the complaint was “actually” filed by, on behalf of, or in the right the insured association. Mr. Kersten sought review by the Utah Supreme Court. The Utah Supreme Court affirmed.
Reviewing the history of Utah law on the duty to defend analysis, Utah’s highest court concluded that if the duty to defend is based on objective facts that are not apparent from the face of the complaint, then the court may look at extrinsic evidence to
determine that duty. In reaching this conclusion, under Utah Law, the court provided a road map on analyzing the duty to defend:
- Whether a court may consider extrinsic evidence depends on how the duty to defend is described in the insurance contract.
- The duty must always begin with a comparison of the policy language and the complaint. The analysis ends there only if the policy terms when compared with the allegations definitively indicate that there is or is not a duty to defend.
- However, if the policy’s definition of the scope of the duty to defend requires consideration of something other than the allegations in the complaint, a court may look beyond the allegations of the complaint to determine whether a duty to defend has been triggered.
Here, because the duty to defend turned on whether both the plaintiff and the defendant were actually part of the insured Association, that issue could not be determined solely by the allegations of the complaint. Rather, the insurance company had to, and the court opined, should have, considered extrinsic evidence on whether the claim was brought “by, on behalf of, or in the right of” the insured Association, i.e. whether plaintiff qualified as an insured. Because extrinsic evidence clearly showed that plaintiff was not a member of the Association when he filed the lawsuit, the “Insured vs. Insured” exclusion did not apply and a defense was owed.
Tressler Comments: When coverage is governed by Utah law, an insurance company must still first determine whether a duty to defend can be definitively decided by comparing the allegations of the complaint with the policy. If so, then its analysis can end. However, if any aspect of the duty to defend is arguably governed by facts outside objective facts that are not apparent on the face of the complaint, the insurance company must consider extrinsic evidence in deciding the duty to defend. Thus, insurers should continue to thoroughly investigate every claim – beyond the allegations of the complaint -- to determine whether it is appropriate to consider extrinsic evidence in deciding the potential for coverage and the duty to defend.
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Court Refuses to Grant Insurer’s Motion for Judgment on the Pleadings Regarding its Defense Obligations
Monica Mendes, Associate in the Los Angeles Office
Where insurer argued that there was no coverage against multiple claims involving the insured’s investments in mortgage-loan-based funds based on exclusions pertaining to investments and securities, a federal court judge in the Northern District of California denied insurer’s motion on the basis that there was a potential for coverage under a Mortgage Bankers and Mortgage Brokers Professional Liability Policy. Certain Underwriters at Lloyds London v. California Mortgage & Realty, Inc., No. C 11-00724 WHA, 2011 U.S. Dist. LEXIS 74245 (N.D. Cal. July 11, 2011).
In this case, Certain Underwriters at Lloyds London (“Lloyds”) filed a motion for judgment on the pleadings and argued that it had no duty to defend California Mortgage and Realty, Inc. (“CMRI”) or David Choo, the President of CMRI, under a Mortgage Bankers and Mortgage Brokers Professional Liability Policy, with respect to eight underlying demands and lawsuits. The underlying claims stemmed from CMRI’s investments in mortgage-loan-based funds on behalf of the underlying claimants.
The Lloyds policy at issue provided that Lloyds had a “duty to defend a suit brought against any insured for covered wrongful acts.” The policy defined “wrongful act” as “any actual or alleged negligent act, negligent error, or negligent omission, committed, omitted, or attempted . . . solely in [defendants’] performance of professional services.” Additionally, those professional services that were covered under the policy included “services conducted on behalf of others in the ordinary course of the insured’s activities as a mortgage banker or mortgage broker which constitute origination, counseling, underwriting, processing, marketing, warehousing, closing, selling, or servicing of mortgage loans secured by real property . . .” Finally, “servicing” referred to conduct “on behalf of others pursuant to a written contract for a fee,” including “remitting principal and interest to investors owning the loans.”
Lloyds argued that certain exclusions within the policy operated to preclude coverage; to wit, exclusions pertaining to claims arising out of or resulting from:
- Any purchase, sale, offer of or solicitation of an offer to purchase or sell securities, or violation of any securities law;
- Providing investment advice, or selecting an investment manager, investment advisory or custodial firm;
- Advising as to, warranting, promising or guaranteeing a future value of any investment or property, or any rate or return or interest;
- Any failure of any investment to perform as expected or desired; and
- Any security holder’s or investor’s interest in securities or obligations backed by mortgage loans, including, but not limited to, mortgage-backed securities, mortgage pass-through certificates, collateralized mortgage obligations.
In its motion, the insurer argued that, based on the above exclusions, the policy does not insure defendants for alleged malfeasance in the management of mortgage-loan-based investment funds. The court, however, concluded that there was in fact a potential for coverage under the policy. In its analysis, the court used as an example the allegations within four of the underlying lawsuits and concluded that the complaints in each of those four actions alleged some sort of negligent conduct in the performance of professional services. Specifically, the court noted that the breach of contract claims within the four complaints alleged that CMRI and Mr. Choo failed to “protect, safeguard and invest funds pursuant to certain investment criteria” and to allow investors to “withdraw funds ‘on as little as one week’s notice and assuredly on 30 days notice.’”
Additionally, the breach of fiduciary duty claims alleged that CMRI and Mr. Choo owed investors “the duty to disclose reasonably obtainable material information regarding defendant’s deviation from defendants’ investment criteria.” The court found that these allegations were examples of claims that were covered under the policy as “wrongful acts” since they were “committed, omitted or attempted” in CMRI’s and Mr. Choo’s performance of professional services, which included “servicing,” and which the policy defined as conduct “on behalf of others pursuant to a written contract for a fee,” including “remitting principal and interest to investors owning the loans.” Thus, the court found that, for purposes of defeating a motion for judgment on the pleadings, CMRI and Mr. Choo satisfied their burden of showing that the underling demands and complaints potentially fell within the scope of the policy.
Since CMRI and Mr. Choo satisfied their burden of proving a potential for coverage under the policy, the burden then shifted to Lloyds to prove that an exclusion barred coverage. However, the court found that the claims regarding the servicing of investments, as well as the alleged negligence in failing to remit funds to the investors pursuant to contractual obligations were not claims that “necessarily” fell within the scope of an exclusion. Accordingly, the court concluded that Lloyds failed to meet its burden to show that there was no potential for coverage under its policy for the underlying claims. As a result, the court denied Lloyds’ motion for judgment on the pleadings.
Tressler Comments: As this case illustrates, it may be difficult to prevail on a motion for judgment on the pleadings in the context of an insurance dispute. There is a long line of decisions in California regarding which party has what burden relative to coverage under an insurance policy. The insured has the initial burden to prove that a claim potentially falls within the scope of coverage and once that burden is satisfied, the burden then shifts to the insurer to prove that any exclusion operates to preclude coverage. This case illustrates how liberally the Northern District interprets the insured’s burden and how the burden on an insurer under an exclusion is more difficult to meet, both with respect to preclusion of a defense obligation and also in the context of early pleadings. This decision, including the court’s statement that the exclusions do not “necessarily” apply, also suggests that more litigation will be needed in order to determine Lloyds’ indemnity obligations under the policy.
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A California District Court Found Coverage for Non-party Employee-Witnesses’ Attorneys’ Fees Under a Company’s D&O Policy
Jeanne Kuo Riggins, Associate in the Los Angeles Office
An issue that has been confronting insurers of late, especially with the failed bank crisis, is whether attorneys’ fees incurred in connection with the testimony of non-party corporate employees in SEC enforcement actions are covered under Directors and Officers (“D&O”)policies. Last month a Southern District of California Court determined such fees were covered under a Gulf Insurance D&O Policy. Gateway, Inc. v. Gulf Insurance Co., et. al., No. 10-cv-1720-WQH-JMA, 2011 U.S. Dist. LEXIS 91063 (S.D. Cal. August 15, 2011),
In 2003, the Securities and Exchange Commission (“SEC”) initiated an enforcement action (the “SEC Lawsuit”) against three individual officers of Gateway, Inc. (“Gateway”). During the course of the SEC Lawsuit, certain Gateway employees, who were not parties to the SEC Lawsuit and against whom no claim was made, were compelled to provide deposition testimony by way of subpoena. Gateway incurred $553,875 in attorneys’ fees associated with the employee-witnesses’ testimony.
Gateway had a total of $35 million in D&O insurance: $10 million primary layer; $10 million first excess layer; $15 million second excess layer. The primary and first excess layers of coverage had already been exhausted. The second excess layer, provided by Travelers Indemnity Company (“Travelers”), had advanced $12.18 million for defense expenses associated with the SEC Lawsuit. A total of $2.82 million remained in the second excess layer.
Gateway sought coverage from Travelers for the $553,875 in attorneys’ fees incurred with the employee-witnesses’ testimony. Travelers denied coverage, and Gateway filed suit.
The Travelers policy followed form with the primary policy, wherein Insuring Clause B states, in pertinent part: “[insurer] shall pay on behalf of the Company Loss which the Company is required or permitted to pay as indemnification to any of the Directors and Officers resulting from any Claim first made against the Directors and Officers during the Policy Period for an Individual Act.” Section II.H.2 of the primary policy defined the term “Directors and Officers” to mean “to the extent any Claim is for … a Securities Law Violation, all persons who were, now are, or shall be employees of the Company.”
The definition of “Directors and Officers” was amended by Endorsement No. 7, which states in pertinent part: “…II. DEFINITIONS H., is amended by the addition of the following: [¶] 5. employees of the Company. However, coverage for employees who are not directors or officers shall only apply when an employee is named as a co-defendant with a director or officer of the Company.”
In cross-motions for summary judgment, the Southern District of California court granted summary judgment in favor of Gateway and against Travelers because of the ambiguities in the definition of “Directors and Officers” under Section II.H. and ambiguities in Insuring Clause B.
With respect to the definition of “Directors and Officers,” Gateway argued that, within the definition of “Directors and Officers”, Sections II.H.2 and II.H.5 were independent clauses and the attorneys’ fees were incurred in connection with a “Claim” for a “Securities Law Violation” against “Directors and Officers”. Travelers, on the other hand, argued that the employee-witnesses were not considered “Directors and Officers” within the meaning of the policy because the “However” clause in Section II.H.5 operates as a limitation to the entire definition of “Directors and Officers”, including Section II.H.2.
The court found that “the clear and explicit reading of the Primary Policy … is that sub-paragraphs II.H.2 and II.H.5 are independent provisions” and that the “However” clause in Section II.H.5 applies only to the preceding sentence in Section II.H.5. Thus, the employee witnesses were considered “Directors and Officers” within the meaning of Section II.H.2. The court further stated that the two “competing interpretations” advanced by the parties “highlight an ambiguity in the Primary Policy” and allows the court to construe the ambiguity in favor of Gateway.
With respect to Insuring Clause B, Gateway argued that Insuring Clause B only requires that a claim – the SEC Lawsuit – be made against Directors and Officers, and, irrespective, the issuance of the subpoenas to the employee-witnesses constitutes a claim. Travelers argued that Insuring Clause B provides coverage for “Loss that Gateway is required … to pay as indemnification for any Directors or Officers resulting from any Claim made against these Directors or Officers.” Because the employee-witnesses were not parties to the SEC Lawsuit, Travelers argued that no Claim was made against the employee-witnesses within Insuring Clause B.
The court found that an ambiguity exists regarding the application of Insuring Clause B because both Gateway and Travelers advanced reasonable interpretations of Insuring Clause B. As a result of the ambiguity, the court interpreted coverage in Gateway’s favor.
Tressler Comments: This unpublished California District Court opinion is a surprising outcome given the apparent intent of the drafters of the Primary Policy and Endorsement No. 7 to fundamentally alter the policy’s coverage for employees under Section II.H.2 by providing broader employee coverage through Section II.H.5 - but only when the employees are co-defendants with the directors and officers. But the drafters accomplished this apparent intent in Endorsement No. 7 by amending to add policy provisions rather than amending to delete and replace the policy provisions for employee coverage. This California District Court decision serves as a reminder that language in an endorsement must accomplish its intended goal and must interact properly with the policy form to avoid creating unknowing ambiguities.
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Federal Court Dismisses IndyMac Subsidiary’s Coverage Action, Finding No Standing to Seek Coverage Under D&O Policies
Elizabeth Musser, Associate in the Los Angeles Office
The Central District of California dismisses a coverage action brought by a subsidiary of failed bank IndyMac against IndyMac’s D&O insurance carriers, because the IndyMac subsidiary lacks Article III standing. IndyMac MBS, Inc. v. ACE American Insurance Company, Case Nos. 2:11-cv-2950 and 2:11-cv-2998 (Aug. 25, 2011 C.D. Cal.).
IndyMac MBS, Inc. (“IndyMac MBS”) was a subsidiary of IndyMac Bank, F.S.B., which was in turn a subsidiary of IndyMac Bancorp (“Bancorp”). IndyMac Bank failed on July 11, 2008, and Bancorp filed for Chapter 7 bankruptcy on July 31, 2008. IndyMac MBS is now in receivership with the Federal Deposit Insurance Corporation (FDIC).
In the wake of IndyMac Bank’s failure, at least 12 actions were filed against IndyMac MBS or other IndyMac entities, Bancorp’s directors and officers, and Bancorp’s bankruptcy trustee alleging “various improprieties, mostly centering around mortgage backed securities” (the “Underlying Actions”). Three of the Underlying Actions name IndyMac MBS as a defendant.
On Feb. 23, 2011, IndyMac MBS filed a declaratory relief action in Los Angeles County Superior Court, seeking a determination as to the availability of coverage under insurance policies issued to Bancorp directors and officers. One of the defendants removed to the federal court, and the action was automatically referred to the bankruptcy court, as related to Bancorp’s Chapter 7 filing. The district court granted two different groups of insurers’ motions to withdraw the reference, so the case initially filed by IndyMac MBS in state court ended up as two different, related coverage actions pending in district court before the Hon. R. Gary Klausner.
The insurer defendants provide $160 million of insurance coverage to Bancorp under 16 separate insurance policies. Eight of the policies are effective 2007-2008 (“First Tower”) and eight of the policies are effective 2008-2009 (“Second Tower”). Each tower consists of eight layers of coverage, each layer providing $10 million in policy limits. The bottom four layers in both towers provide coverage for losses resulting from the individual acts of directors and officers (side A coverage), losses resulting from Bancorp’s indemnification of directors and officers (side B coverage), and losses sustained by Bancorp and its subsidiaries for securities law violations (side C coverage). The policies provide coverage for directors and officers before providing coverage to Bancorp and its subsidiaries, including IndyMac MBS. The top four layers provide only side A coverage.
In its declaratory relief action, IndyMac MBS sought a determination of rights and liabilities for coverage of the Underlying Actions under all these insurance policies, and specifically asked the court to determine whether each action was covered under the First Tower or Second Tower, and the amount potentially available in the Underlying Actions. The carriers providing coverage under sides A, B and C (the “ABC carriers”) and the carriers providing coverage only under side A (the “side A carriers”) filed motions to dismiss for lack of subject matter jurisdiction under Rule 12(b)(1). The side A carriers also based their motion on failure to state a claim under Rule 12(b)(6).
The court specifically noted that IndyMac MBS must satisfy the constitutional “case or controversy” requirement imposed by Article III, so that the alleged injury is “definite and concrete” and “immediate and not too speculative.”
The court found that as to the ABC carriers, there is no Article III standing, because the applicable policies prioritize coverage, so that directors and officers receive any available coverage before IndyMac MBS. Accordingly, IndyMac MBS’s claim for coverage is too remote to satisfy Article III’s immediacy requirement, because for coverage to be available, any coverage available to directors and officers would need to be paid first. Judgments against the directors and officers (which are the subject of at least several Underlying Actions not involving IndyMac MBS) would need to be paid first. In addition, the insurers provide coverage in layers greater than a $2.5 million deductible, which must be exhausted before any insurance proceeds are available. Here, IndyMac MBS provided no allegation that the deductible has been paid or that the primary layers of coverage are exhausted, potentially triggering the excess layers. Accordingly, any potential for coverage is too speculative.
As to the side A carriers, the court found that because the side A carriers provide coverage only for directors and officers, IndyMac MBS has no stake in the allocation of insurance proceeds under these policies, and lacks any legal interest in the insurance proceeds available under these policies.
The District Court dismissed IndyMac MBS’s action in its entirety on Sept. 7, 2011.
Tressler Comments: More than 300 banks have failed since the beginning of the current financial crisis in 2008. IndyMac was one of the largest failed banks, with $32 billion in assets, second only to Washington Mutual. Predictably, IndyMac’s failure has given rise to a variety of lawsuits, and we can expect more lawsuits to be filed in connection with IndyMac and other failed banks. For example, the action discussed above is only one of several coverage-related actions that have been filed in the wake of IndyMac Bank’s failure.
The bankruptcy trustee for Bancorp also had a case pending before Judge Klausner in the Central District of California, which he voluntarily dismissed in the wake of the court’s ruling in the IndyMac MBS action, and re-filed in California state court. Siegel v. Underwriters, Los Angeles County Superior Court, Case No. BC469091. Presumably, the trustee is hoping that the lack of any Article III standing requirement in California state court will allow its action to proceed. The side A carriers filed a declaratory relief action against Bancorp directors and officers in a case pending before Judge Klausner, to which the ABC carriers have been added by counterclaim. XL Specialty Inc. Co. v. Perry, Case No. 2:11-cv-2078-RGK-JCG (C.D. Cal.). It appears likely that this action will provide the forum for coverage-related decisions regarding the Bancorp D&O policies to proceed.
Please note that Tressler LLP represents several of the insurer parties involved in the various IndyMac coverage actions, including the dismissed IndyMac MBS action discussed in this article.
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