Michigan Court Holds Pollution Exclusion Applies to Emissions Permit Violation

In its recent decision in Arch Ins. Co. v. Commercial Steel Treating Corp., 2013 U.S. Dist. LEXIS 121574 (E.D. Mich. Aug. 27, 2013), the United States District Court for the Eastern District of Michigan had occasion to consider the application of a pollution exclusion in a D&O policy to a violation of an air emissions permit.

Arch insured Curtis Metal Finishing Company (“Curtis”) under a Private Company Management Liability and Crime Insurance policy.  Curtis operated a zinc-phosphate plating operation in Sterling Heights, Michigan.  As a result of a windstorm that damaged its exhaust equipment, Curtis operated its facility without the benefit of all required air emissions control technologies for a period of nearly three months, thereby violating its air use permit issued by the Michigan Department of Environmental Quality.  Following several inspections, the Michigan Department of Natural Resources and Environment (“MDNRE”) issued a Violation Notice to Curtis.   

Curtis forwarded a copy of the notice to Arch, and requested coverage for any subsequent criminal proceedings that might be brought by the state.  Arch, in turn, denied coverage based on a pollution exclusion arising from, based upon, or attributable to any:

a.   discharge, dispersal, release, escape, seepage, migration or disposal of Pollutants, . . . or any threat of such discharge, dispersal, release, escape, seepage, migration or disposal; or

b.   direction, request or voluntary decision to test for, abate, monitor, clean up, remove, contain, treat, detoxify or neutralize Pollutants . . . .

In fact, the Macomb County prosecutor later commenced criminal proceedings against Curtis, alleging a count for failure to report an equipment malfunction and a count for failure to comply with its emissions permit.  As a result of Arch’s denial of coverage, Curtis retained its own counsel and eventually negotiated a plea of no contest in return for payment of $90,000 to be used for an environmental study.  Arch later brought a coverage action against Curtis seeking a declaration that it had no coverage obligations with respect to the settlement or Curtis’ defense costs.

On motion for summary judgment, Arch argued that both subparagraphs of the pollution exclusion applied.  With respect to subparagraph b., Arch contended that the air use permit initially issued to Curtis was a “direction to … clean up … Pollutants,” and that the underlying criminal action, therefore, arose out of or was attributable to this direction.  Alternatively, Curtis argued that subparagraph a. of the exclusion was applicable since the underlying criminal action arose out of Curtis’ improper discharge of pollutants into the atmosphere.  Curtis, on the other hand, argued that the underlying complaint contained no allegation of a discharge of pollutants, and that because its facility is kept at a negative air pressure, any emissions would have been into its own building rather than into the atmosphere.  The court rejected Curtis’ argument, noting that the plain language of the exclusion applied to any discharge of pollutants, or any threatened discharge of pollutants, and that the exclusion did not specific the location of the discharge.   In other words, the court refused to read into the exclusion a distinction between traditional environmental pollution and indoor air pollution.

Curtis also argued that the underlying criminal action pertained to permitting violations and failure to disclose rather than a discharge of pollutants.   The court rejected this argument, finding that Curtis could not ignore purpose behind the permit:

The purpose of the Air Use Permit was to prevent the release of potentially hazardous fumes ... A direct result of Defendants' operation of Lines 11 and 14 without a functioning scrubber, in violation of the Air Use Permit, is the release of fumes from Lines 11 and 14 into the Sterling Heights facility. There is thus "significantly more than a remote connection" between Defendants' permit violations and the actual or threatened release of pollutants from Lines 11 and 14 … Furthermore, even if there was no threatened or actual release of pollutants from Lines 11 and 14, the criminal charges arise out of a direction or request from MDNRE, via the Air Use Permit, to abate potentially hazardous pollutants. Accordingly, both subparagraphs a. and b. of the Pollution Exclusion apply to bar the criminal charges against Defendants.

The court also rejected Curtis’ arguments that the amount of actual emissions from the facility was insignificant, explaining:

Whether any pollutants actually leaked is immaterial where Defendants have clearly violated their Air Use Permit, which directed Defendants to abate pollutants. The Pollution Exclusion expressly applies to such criminal charges. Plaintiff thus properly denied coverage for Defendants' claims under the Policy, and Plaintiff is entitled to summary declaratory judgment that the Policy does not apply to the underlying criminal matters.

While the court held that the pollution exclusion operated to preclude Curtis’ right to coverage, the court also agreed in passing that the $90,000 payment made by Curtis to settle the underlying matter – an amount to be used to conduct a study of a nearby lake – did not qualify as “loss” under the Arch policy, a term specifically defined to exclude fines.

Georgia Court Holds No Coverage For Embezzlement Claim

In its recent decision in National Reimbursement Group Inc. v. Gemini Ins. Co., 2013 U.S. Dist. LEXIS 118435 (M.D. Ga. Aug. 21, 2013), the United States District Court for the Middle District of Georgia had occasion to consider whether a company insured under a professional liability policy was entitled to coverage for a claim arising out of embezzlement of client funds committed by one of its employees.

Gemini Insurance Company insured National Reimbursement Group (“NRG”) – a medical billing and collection service company – under a professional liability policy.  Sometime during the policy period, NRG received notice from the U.S. Department of Health and Human Services that it was undertaking an investigation into whether a former NRG employee diverted medical insurance checks intended for a client of NRG’s into her own personal bank account.  NRG sought coverage for the investigation, but Gemini disclaimed coverage.  NRG’s client subsequently filed suit, seeking repayment of the diverted funds.  Gemini did not provide coverage for this suit either.  NRG ultimately settled with the client for approximately $134,000 and then filed a declaratory judgment action against Gemini.  Gemini moved to dismiss NRG’s complaint, arguing that the conduct alleged did not qualify as a wrongful act (defined by the Gemini policy as “any negligent or unintentional breach of duty imposed by law, or Personal Injury, committed solely in the rendering of Professional Services by an Insured”) or that coverage was precluded based on various exclusions. 

The parties disputed what conducted should be considered the “wrongful act” for the purpose of analyzing coverage.  NRG contended that the wrongful act was its own negligent supervision of its dishonest employee while Gemini contended that the wrongful act was the employee’s intentional diversion of client funds, which by its very nature could not be considered a negligent or unintentional breach of a duty. Gemini further argued that negligent supervision of an employee did not fall within the policy definition of wrongful act because NRG’s obligations to its client with respect to the stolen funds arose out of a contract, and its breach of the contractual relationship could not be considered a “breach of a duty imposed by law.”  The court rejected Gemini’s arguments, observing that (a) failure to supervise could be considered the wrongful act since employers have a reasonable duty of care in supervising their employees, and (b) the existence of a contract between NRG and its client did not preclude NRG from breaching a duty imposed by law.  With respect to the latter point, the court reasoned that Gemini’s interpretation would essentially be render coverage under the policy illusory since NRG, presumably, had a contract with each of its clients.

While the court held that the underlying conduct qualified as a wrongful act in the first instance, it agreed with Gemini that coverage was barred based on an exclusion applicable to claims arising out of any actual or alleged criminal, fraudulent, dishonest, or knowingly wrongful act or omission committed by or with the knowledge of any insured.  The policy specifically defined the phrase “arising out of” to mean “connected to, incidental to, originating from or growing out of, directly or indirectly resulting from.”  Looking to Georgia case law construing this phrase in the context of similar exclusions, the court concluded that the test for whether a claim “arises out of” the prohibited conduct is a “but for” test, that requires the court to look to whether the claim would exist in the absence of the prohibit conduct.  In applying this analysis, the court agreed that the underlying negligent supervision claim was barred from coverage since the claim “would not exist but for, and therefore arises out of, [the employee’s] embezzlement.”

In reaching its conclusion, the court considered NRG’s argument that the exclusion did not apply since the individual employee did not qualify as an insured when diverting client funds for her own use, since in doing so, she was operating outside the scope of her employment.  The court rejected this argument, noting that while creative, it was clear that the employee was engaged in billing practices and thus was an insured.  The fact that she embezzled funds while engaged in those billing practices did not have the effect of changing her insured status. 

Georgia Court Holds No Coverage for Restitutionary Amounts

In its recent decision in Fidelity Bank v. Chartis Specialty Ins. Co., 2013 U.S. Dist. LEXIS 110935 (N.D. Ga. Aug. 7, 2013), the United States District Court for the Northern District of Georgia had occasion to consider whether an insured was entitled to indemnification for return of ill-gotten gains.

Chartis insured Fidelity under a Management and Professional Liability for Financial Institutions Policy.  Fidelity sought coverage for an underlying class action lawsuit brought by customers alleging that the fees charged by Fidelity for overdrafts amounted to a usurious interest charge in violation of Georgia law.  The underlying suit pled causes of action against Fidelity for violations of Georgia’s civil and criminal usury laws, for conversion, and for money had and received.  Chartis agreed to reimburse Fidelity for its defense in the underlying suit, but took the coverage position that Fidelity would not be entitled to indemnification for any amounts awarded.  Fidelity subsequently settled with the underlying plaintiffs and then commenced a declaratory judgment action against Chartis.  Specifically, Fidelity sought indemnification of the settlement amounts pursuant to the policy’s professional liability part, under which Chartis agreed to pay losses resulting from wrongful acts of Fidelity in the rendering or failure to render “professional services,” a term defined, in relevant part, to mean services, including online banking services, provided to clients for customers or clients in return for a fee.

On motion for summary judgment, Chartis argued that it had no indemnity obligations to Fidelity for several reasons.  First, Chartis argued that the Fidelity’s conduct was not a “wrongful act” as that term was defined by its policy (i.e., an act, error or omission), but instead a deliberate business decision to charge overdraft fees.  Chartis also argued that the underlying suit did not arise out of Fidelity’s “professional services.”  More significantly to the court, Chartis argued that the settlement amounts were uninsurable as a matter of law and that in any event, the policy contained an exclusion stating that Chartis is not:

… liable to make any payment for Loss in connection with any Claim made against any Insured . . . alleging, arising out of, based upon or attributable to, directly or indirectly, any dispute involving fees, commissions or other charges for any Professional Service rendered or required to be rendered by the Insured, or that portion of any settlement or award representing an amount equal to such fees, commissions or other compensations; provided, however, that this exclusion shall not apply to Defense Costs incurred in connection with a Claim alleging a Wrongful Act;

While the court rejected Chartis’ first two arguments concerning professional services and wrongful acts, it found the latter two arguments compelling.  Requiring Chartis to indemnify Fidelity for amounts it wrongfully charged its clients in the first instance, explained the court, would result in a windfall since such a ruling would mean that Fidelity “is free to collect fees and make profits from its customers through illegal conduct, and the insurer is on the hook when the customers sue while Plaintiff keeps the ill-gotten gains.”  While the court acknowledged the lack of any Georgia case law addressing the issue, it observed that courts in many states have held that one cannot insure against the risk of having to return money or property wrongfully acquired.  Ultimately, however, in an effort to avoid announcing a “new” rule under Georgia law, the court reached its holding on the basis of the policy exclusion, which it noted “speaks to exactly this type of claim.”  Thus, the court held that Chartis had no indemnity obligation in connection with the underlying suit. 

Massachusetts Court Allows Consideration of Extrinsic Evidence

In its recent decision in BioChemics, Inc. v. AXIS Reinsurance Co., 2013 U.S. Dist. LEXIS 111218 (D. Mass. Aug. 7, 2013), the United States District Court for the District of Massachusetts had occasion to consider when an insurer is entitled to rely on extrinsic evidence for determining its duty to defend.

AXIS insured BioChemics under a claims made and reported directors and officers policy for the period November 13, 2011 to November 13, 2012.  BioChemics sought a defense in connection with an SEC enforcement action filed during the period the policy was in effect.  BioChemics also sought a defense for two SEC subpoenas issued by the SEC during the policy period.  AXIS, however, took the position that BioChemics was not entitled to coverage for these matters because they related back to a series of subpoenas served by the SEC prior to the policy’s date of inception, at a time when BioChemics was insured by a different carrier.   In support of its position, AXIS relied on a provision in its policy’s Limits of Liability section stating that:

All Claims, including all D&O Claims . . . arising from the same Wrongful Act . . . and all Interrelated Wrongful Acts shall be deemed one Claim and such Claim shall be deemed to be first made on the earlier date that: (1) any of the Claims is first made against an Insured under this Policy or any prior policy . . . .

Notably, the subpoenas served by the SEC both prior to and subsequent to the AXIS policy’s date of inception all had the same SEC matter identification and number.

BioChemics filed a declaratory judgment action and subsequently moved for summary judgment on the duty to defend before the commencement of discovery, asserting that the duty to defend is based solely on the complaint and the policy, and that as such, discovery was not necessary.  AXIS opposed the motion, asserting that at the very least, it was entitled to discovery into communications between BioChemics and the SEC so that it could confirm whether, in fact, the subpoenas served prior to its policy’s inception were interrelated with the subsequent subpoenas and the enforcement action, thus comprising a “single, ongoing claim” first made prior to the policy period.

The court acknowledged a line of cases cited by BioChemics standing for the proposition that insurers cannot rely on extrinsic evidence for the purpose of determining a duty to defend.  The court went on to note, however, that this line of cases does not apply to extrinsic facts that will not be litigated in the underlying matter.  The court further observed that in the context of claims made and reported policies, the rule against consideration of extrinsic facts cannot be rigidly applied since coverage issues such as the timing of the claim are unlikely to be alleged in the underlying complaint.  While the court acknowledged it a close question, it ultimately held that:

… an insurer may use extrinsic evidence to deny a duty to defend based on facts irrelevant to the merits of the underlying litigation, such as whether the claim was first made during the policy period, whether the insured party reported the claim to the insurer as required by the policy, or whether the underlying wrongful acts were related to prior wrongful acts.

As such, the court allowed AXIS to proceed with discovery into the interrelatedness issue, and denied BioChemics’ motion for summary judgment without prejudice.  The court further held that under Massachusetts law, AXIS was not required to provide BioChemics with a defense pending determination of the duty to defend issue.

California Supreme Court Creates New Penalty For First Party Bad Faith Claims Handling

The California Supreme Court in its recent decision in Zhang v. Superior Court, 2013 Cal. LEXIS 6520  (August 1, 2013), considered whether alleged bad faith in handling a first party claim could support a cause of action against an insurer under the California Unfair Competition Law (“UCL”) even though the alleged conduct violates section 790.03 of the Unfair Insurance Practices Act (“UIPA”).

Yanting Zhang sued California Capital Insurance Company (“CCIC”) for breach of contract, bad faith, and violation of the UCL, arising from the handling of a claim for fire loss at a commercial property owned by Zhang.  The UCL cause of action alleged that CCIC falsely advertised a promise to provide timely coverage in the event of a compensable loss, when CCIC had no intention of paying the true value of fire loss claims.  CCIC demurred to that cause of action on the grounds that a UCL claim cannot be supported by a violation of conduct prohibited by the UIPA.  The trial court granted the demurrer and Zhang filed a petition for writ of mandate to the Court of Appeal which reversed the trial court decision.  The Supreme Court granted review.

The opinion in Zhang is the latest in a line of decisions by California appellate courts growing out of Moradi-Shalal v. Fireman’s Fund Ins. Cos. (1988) 46 Cal.3d 287, in which the Supreme Court held that there was no private right of action for violation of an insurer’s duties under the UIPA.  The decision in Moradi-Shalal ended years of third party bad faith litigation in California.  The court in Moradi-Shalal held that the UIPA only authorized administrative enforcement by the California Insurance Commissioner for violations of the UIPA, but such did not affect actions based on traditional common law theories of private recovery against insurers.  Those were said to include claims for “fraud, infliction of emotional distress, and (as to the insured) either breach of contract or breach of the implied covenant of good faith and fair dealing.”

In Manufacturers Life Ins. Co. v. Superior Court (1995) 10 Cal.4^th 257, the Supreme Court held that Moradi-Shalal did not preclude first party UCL actions based on grounds independent from the UIPA, even if the conduct also violates the UIPA.  In that case, the court allowed an action under the UCL by an insurance agent against insurers for violations of the California anti-trust statutes, known as the Cartwright Act.  The plaintiff agent had alleged an insurance industry conspiracy against it in retaliation for disclosure of the true cost of settlement annuities.  Manufacturers Life was followed by State Farm Fire & Cas. Co. v. Superior Court (1996) 45 Cal.App.4^th 1093, in which the Court of Appeal held an insured was entitled to pursue a UCL claim against its first party insurer (in a Northridge Earthquake related claim) based on fraud and common law bad faith claims handling.  A split in California law resulted when another district court of appeal disagreed with the State Farm decision, holding in Textron Financial Corp. v. Nat. Union Fire Ins. Co. (2004) 118 Cal.App.4^th 1061, that a common law first party bad faith claim could not support a UCL cause of action where the alleged bad faith conduct was the type proscribed in the UIPA.

The Supreme Court in Zhang resolved the split in California authority by disapproving Textron and agreeing with State Farm.  The majority decision, signed by five of the seven Supreme Court justices, held that a common law first party bad faith claims handling action could qualify as any of the three statutory forms of unfair competition: the conduct was said to be (1) unlawful (under the common law), (2) unfair to the insured, and (3) may qualify as fraudulent business practices.  The court noted that the concerns raised in Moradi-Shalal (primarily proliferation in litigation) would not arise because “UCL remedies are limited in scope, generally extending only to injunctive relief and restitution.”  Therefore, a UCL claim did not duplicate bad faith claims which are for damages.  The court said that its rejection of Textron did not affect its prior decisions in third party insurance claims cases.  As to the insured’s cause of action in the case before it, the court said that the UCL cause of action was supported by both the allegations of false advertising and of common law bad faith claims handling.

Justice Wenegar wrote a separate concurring decision, joined by Justice Liu, to say that the majority decision did not go far enough.  She argued that since the UIPA did not directly prohibit a private right of action, but merely did not allow one, a UCL claim could be based on its violation (raising the specter of possible third party claims).  The majority of the court disagreed with Justice Wenegar in Footnote 8, saying that her conclusion was directly contrary to the court’s holdings in Maufacturers Life and Moradi-Shalal.