First Circuit Holds Prior Knowledge Exclusion Applicable

In its recent decision in Clark School for Creative Learning, Inc. v. Philadelphia Indemnity Ins. Co., 2013 U.S. App. LEXIS 21568 (1^st Cir. Oct. 23, 2013), the United States Court of Appeals for the First Circuit, applying Massachusetts law, had occasion to consider the application of a known circumstances exclusion in a directors and officers policy.

Philadelphia Indemnity Insurance Company (“PIIC”) insured the Clark School (the “School”) under a claims made and reported D&O policy issued for the period July 1, 2008 to July 1, 2009.  The Clark School is a non-profit, private school located in Danvers, Massachusetts. In May 2008, as a direct result of the School’s precarious financial difficulties, the School received a $500,000 donation from a family of three enrolled students, subject to the conditions that the family would receive a security interest in the land on which the School is located and that the funds would be used to construct a new high school.  The donation was reflected in a financial statement published prior to the inception date of the PIIC policy.  In May 2009, the family sued the School and its director for failing to satisfy these conditions.  It was alleged that the School’s director caused the School to pay $175,000 of the donated funds to his own mother and sister “purportedly for the repayment of loans.”

PIIC’s policy contained a manuscript exclusion titled Known Circumstances Revealed In Financial Statement Exclusion, which stated:

[T]he Underwriter shall not be liable to make any payment for Loss in connection with any Claim made against the Insured based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving any matter, fact, or circumstance disclosed in connection with Note 8 of the Financial Statement . . . submitted on behalf of the Insured.

Note 8 of the financial statement referred to in this exclusion specifically described the School’s financial difficulties and the $500,000 donation:

Subsequent to the date of the accompanying financial statement, in May of 2008 the School was a recipient of a major gift totaling $500,000 (see Note 7). The donation is unrestricted and will be used to support the School's general operations as management's plans for the School's future are implemented and allowed time to succeed. Management feels that its plans and the subsequent major gift will enable the School to operate as a going concern.

Note 7, referenced in this paragraph, made further reference to the $500,000 donation.

PIIC disclaimed coverage to the School for the underlying suit on the basis of this exclusion, and in the ensuing coverage litigation, the United States District Court for the District of Massachusetts ruled in PIIC’s favor.  On appeal, the School argued that the exclusion should be read to relate solely to the School’s financial difficulties and not to and claims involving the donation.  The School also argued that various rules of contract construction, including the concept of reasonable expectations, required a more limited reading than applied by the lower court. 

The First Circuit disagreed with the School’s arguments regarding the exclusion, observing that it was plain and unambiguous on its face.  With respect to the School’s argument that the exclusion should be limited to financial difficulties alone, the court concluded that the reference in Note 8 to $500,000 donation, as well as to Note 7, which also described the donation, indicated that the exclusion could not be read as being limited to losses resulting from the School’s financial difficulties.  The court also rejected the School’s argument that the phrase “in any way involving” as used in the exclusion must include a “causal element,” and that the underlying loss was not caused by the donation.  The court the phrase “in any way involving” to represent “a mop-up clause intended to exclude anything not already excluded by” the other terms of the exclusion.  Regardless, the court held that even if a causation element was required, this was more than satisfied as the underlying loss was caused by the School’s misrepresentations concerning the donations.   Finally, the court rejected the School’s reasonable expectations argument on the basis that the exclusion was not ambiguous and that there could be no reasonable uncertainty as to what its scope.

Alabama Supreme Court Holds Faulty Workmanship May Be An Occurrence

In its opinion in Owners Insurance Company v. Jim Carr Homebuilder, LLC, 2013 Ala. LEXIS 122 (Ala. Sept. 20, 2013), the Supreme Court of Alabama the court had the occasion to consider what constitutes an “occurrence” as defined under a CGL policy in the context of a construction defect claim.

Thomas and Pat Johnson hired JCH, a licensed homebuilder, to construct a new home in January 2006. Within a year of completion the Johnsons noticed several issues with water leakage which resulted in damage to other parts of the home. After JCH’s attempts at remedying the water infiltration issues were unsuccessful, the Johnsons sued for breach of contract, fraud, and negligence. JCH promptly tendered its defense to Owners Insurance Company, its general liability insurer. Owners provided counsel under a reservation of rights. After the dispute between the Johnsons and JCH was settled through arbitration, the trial court granted JCH’s motion for summary judgment holding that Owners policy covered the entirety of the arbitrator award.

On appeal, Owner’s argued that the property damage was not an “occurrence” as defined in the policy and as such no coverage would apply. In accordance with previously established principles, the court noted that whether faulty workmanship constitutes an “occurrence” depends on the nature of the damage caused by the faulty workmanship. On its own, however, faulty workmanship is not an “occurrence.”  The court further clarified that “faulty workmanship performed as part of a construction or repair project may lead to an occurrence if that faulty workmanship subjects personal property or other parts of the structure outside the scope of that construction or repair” to harmful or damaging conditions.

The court differentiated between instances in which a contractor is retained to perform work on an existing structure and the existing structure is damaged, and when a new structure is built and defective work results in damage to the new structure.  Where the contractor is hired to construct the entire structure, and a claim for damage to that structure results from the contractor’s defective work, the contractor is not entitled to coverage as the claim does not constitute an “occurrence.”

Florida Court Holds Contract Claim Does Not Trigger E&O Policy

In its recent decision in Public Risk Mgmt. of Fla. v. One Beacon Ins. Co., 2013 U.S. Dist. LEXIS 150091 (M.D. Fla. Oct. 18, 2013), the United States District Court for the Middle District of Florida had occasion to consider whether a breach of contract claim can constitute a professional liability claim.

Public Risk Mgmt concerned coverage for a payment dispute arising out of a  construction contract entered into between the City of Winter Garden (“Winter Garden”) and a contracting entity named Dewitt involving utility relocation along a Florida highway.  The contract called for Winter Garden to pay certain amounts for Dewitt completing the work within an established timeframe.  During the course of the contract, Dewitt encountered conditions out of its control, some of which was attributable to Winter Garden having provided incomplete information concerning the scope of work involved, that made it impossible for Dewitt to complete the project on time.  Upon completion of the work, Winter Garden withheld a portion of the contract funds from Dewitt, prompting Dewitt to file suit for breach of contract and for violation of Florida’s Sunshine Statutes. 

Public Risk Management of Florida (“PRM”) insured Winter Garden under a public official’s errors and omissions liability policy.  The PRM policy insured against “wrongful acts,” defined as “any actual or alleged error or miss-statement, omission, act or neglect or breach of duty due to misfeasance, malfeasance, and nonfeasance . . . .”  OneBeacon, in turn, reinsured the PRM policy. 

PRM provided Winter Garden with a defense in the Dewitt lawsuit, and paid some $286,000 in legal fees before the matter settled.  PRM then sought reimbursement of these defense costs from OneBeacon under the reinsurance contract.  OneBeacon, however, denied any payment obligation to PRM, contending that PRM should not have defended Winter Garden in the underlying lawsuit since a breach of contract claim is not covered under a professional liability policy.  OneBeacon also asserted that coverage was unavailable to Winter Garden based on a policy exclusion in the PRM policy applicable to intentional breaches of contract.  PRM contended that its policy was triggered as a result of the following assertions in Dewitt’s complaint:

19. Performance of Dewitt's work was far more time-consuming and costly than Dewitt reasonably could have anticipated at the time of contracting as a result of errors and omissions in the City's plans and specifications and the City's engineer's gross under-estimate of quantities of various items, Dewitt would be required to furnish.

                                          *          *          *

24. Dewitt would have timely completed its Work but for the City's misleading information about the utility locations, errors and omissions in the City's plans and specifications, and other hindrances attributable to the City, the FDOT Contractor, and/or other third parties.

PRM contended that these two paragraphs expressly alleged wrongful acts by Winter Garden in connection with its planning of the construction project, and that these wrongful acts are what gave rise to the contract dispute. 

The court rejected PRM’s argument, explaining that the two paragraphs in the complaint on which PRM relied had to be read in the context of the entire complaint, which at its core was a simple payment dispute rather than a claim for any professional negligence.  As the court explained:

The FDOT Project was alleged to have been more complex than originally thought, partly due to information from and actions by Winter Garden. Dewitt alleged it could not finish on schedule and that the materials and labor costs increased due to forces outside of its control, therefore, it claimed that it was owed additional funds under the terms of the Construction Contract.  All of Dewitt's claims in Count I relied on the Construction Contract as the basis for Winter Garden owing it additional money, Dewitt did not rely on negligence.

The court, therefore, concluded that the Dewitt complaint did not allege loss arising out of a “wrongful act” that came within the PRM policy’s coverage.  In passing, the court also noted that the policy’s exclusion applicable to intentional breach of contract served as a secondary basis for noncoverage since the Dewitt complaint alleged that Winter Garden intentionally refused to pay money owed under the construction contract. 

Oklahoma Court Enforces Terms of Pollution Buy-Back

In its recent decision in Star Ins. Co. v. Bear Prods., Inc., 2013 U.S. Dist. LEXIS 148559 (E.D. Okl. Oct. 16, 2013), the United States District Court for the Eastern District of Oklahoma had occasion to consider the coverage afforded under a pollution buy-back endorsement.

Star Insurance Company insured Bear Products under a primary general liability policy as well as an umbrella liability policy.  Bear was named as a defendant in a class action lawsuit alleging personal injury and property damage resulting from exposure to “produced fluid waste,” described as waste fluids and solids generated as a result of oil and gas drilling operations.  Specifically, produced fluid waste is described to include “saltwater, sand, acid, oil-based drilling fluids, water-based drilling fluids, completion flowback fluid, frack flowback fluid, workover flowback fluid, rainwater gathered on drilling and productions sites, drilling cuttings, pit water, including frack, mud, circulation and reserve pits, and numerous other fluids and solid wastes generated during the exploration and completion of oil and gas wells.”  Bear Products was identified as having transported produced fluid waste to a disposal pit located in the vicinity of the plaintiff class.

Both the primary policy and umbrella policies issued by Star Insurance contained a total pollution exclusion.  The primary policy also contained an endorsement giving back limited pollution liability at designated well sites for bodily injury, property damage or environmental damage caused by a “pollution incident.” The endorsement set forth the following limitations on coverage:

This insurance applies to "bodily injury", "property damage", and "environmental damage" only if:

(1)       The "bodily injury", "property damage", or "environmental damage" are caused by a "pollution incident"

(a) on or from a "designated well site" in the "coverage territory", and

(b) that begins and ends within 72 hours of the incident; and

(c) that is accidental; and

(d) that is reported within 90 days of the incident

(2)       The "bodily injury", "property damage", or "environmental damage" first occurs during the policy period[.]

The court agreed that produced fluid waste was a pollutant for the purpose of the policies’ respective pollution exclusions.  Bear Products nevertheless contended that at the very least, coverage was available under the primary policy’s pollution buy-back endorsement.  The court disagreed.  Looking to the allegations of the complaint, the court observed that the conditions necessary to trigger the pollution coverage under the buy-back were not satisfied.  Notably, the waste was alleged to have been generated and disposed of prior to the policy period, the pollution condition lasted more than 72 hours, and the pollution condition was not accidentally generated.  Bear Products argued that if strictly enforced, the buy-back would be rendered illusory, since the majority of pollution incidents for which it could be liable would not satisfy these conditions precedent to coverage.  The court rejected this argument, explaining:

…  Bear is a corporate business. It bargained for an exception to the pollution exclusion. Bear is entitled only to the coverage for which it negotiated and paid. Bear argues that read literally, the policies provide virtually no coverage for risks inherent to its business. In fact, the policies do provide coverage for some risks inherent to Bear's business. For example, the policies cover liability as a result of an accidental spill of waste (a "pollution incident") or an accidental collision of one of Bear's trucks with another vehicle, object or person. Though it is unfortunate that the policies do not cover liability for pollution as alleged in the Underlying Complaint, the court may not rewrite the policies.

California Court Holds § 998 Offer Exceeding Policy Limits Made In Good Faith

In its recent decision in Aguilar v. Gostischef, 2013 Cal.App. LEXIS 816 (Cal. App. 2d Dist. Oct. 11, 2013), a California appellate court had occasion to consider whether a claimant’s statutory settlement offer under California Code of Civil Procedure, §998, knowingly made in excess of an insurer’s policy limits, could be considered a “good faith” offer.

Section 998 of the California Code of Civil Procedure permits a party to make an offer to settle and compromise a litigation. and establishes consequences if the other side rejects the offer.  Under such circumstances, if the party rejecting the offer is unsuccessful in the litigation, or less successful than the dollar amount of the offer, then the losing party may be obligated to pay a certain portion of the other party’s costs.  In order to be a valid §998 offer, it must be made in “good faith,” meaning that settlement offer must be realistically reasonable under the circumstances of the particular case.  The Aguilar decision addresses the issue of whether a claimant’s § 998 offer knowingly made in excess of the defendant’s insurance policy limits could be made in good faith.

Aguilar and Gostischef were individuals involved in a motor vehicle accident.  Gostischef was insured by Farmers Insurance Exchange (“Farmers”) under an auto liability policy with a $100,000 combined single limit.  Subsequent to the accident, Aguilar's counsel wrote to Farmers three separate occasions to obtain information on the policy limits for the express purpose of making a settlement demand. The last letter to Farmers stated: “My client has asked to know the policy limits so that he can make a policy limits demand and resolve this case and move on with his life. Unfortunately, until and unless we are advised of the limits in coverage, we are not able to make a policy limits demand. He is, however, prepared to do so upon being advised of the limits.  Once again, we entreat you to get permission from your insured to disclose the policy limits, provide them to us in the form of a certified policy and declaration, so that we can then immediately demand policy limits. Please favor us with a reply within the next two weeks.”  Farmers, however, did not respond to any of these requests.

Given Farmers’ silence, Aguilar eventually brought suit against Gostischef.  Farmers then advised Aguilar of the $100,000 policy limit and offered to pay its full policy limit to settle the case.  Gostischef later made a § 998 offer to Aguilar in the same amount.  Aguilar rejected both offers.  Instead, his counsel wrote to Farmers and advised that in light of Farmers’ failure to have previously disclosed the limits, and to settle the claim on behalf of its insured, Farmers would be liable for any judgment in excess of its policy’s limits.  A month later, Aguilar made a section §998 offer to settle in the amount of $700,000.  Farmers again offer to pay $100,000 and this was rejected.

The case was tried, and Aguilar was ultimately awarded $2,339,657.  Aguilar then sought $1,639,451.14 in costs from Farmers pursuant to §998.  Farmers argued the §998 offer in the amount of $700,000 was not made in good faith since Aguilar knew that the policy limits were $100,000.  The trial court disagreed and awarded costs, on the basis that the offer was “realistically reasonable under the circumstances.”  Farmers appealed, arguing that the offer could not have been made in good faith as there was no reasonable expectation that it would be accepted, based on plaintiff’s knowledge of the policy limits and defendant’s financial hardship.

The appellate court held that it was reasonable for Aguilar to believe Farmers could have been liable for a judgment in excess of policy limits, as case law supports the proposition that an insurer that refuses to disclose its limits may be subject to excess judgment liability in certain circumstances.  Farmers further failed to show any bad faith on plaintiff’s part; plaintiff had made its intention to seek policy limits known to Farmers, and had made three requests to Farmers for the information.  As such, the court agreed that Aguilar’s $700,000 demand was made in good faith and that Farmers was liable for the costs awarded pursuant to §998.

Mississippi Court Holds Pollution Exclusion Applicable to Chinese Drywall Claim

In its recent decision in Prestige Properties, Inc. v. National Builders and Contractors Ins. Co., 2013 U.S. Dist. LEXIS 146738 (S.D. Miss. Oct. 10, 2013), the United States District Court for the Southern District of Mississippi had occasion to consider the application of a total pollution exclusion in a general liability policy to underlying claims involving Chinese-manufactured drywall.

The insured, Prestige Properties, was a Mississippi contractor hired to perform repairs on a client’s home that had been damaged as a result of Hurricane Katrina.  Part of these repairs involved replacing damaged drywall. Prestige later was named as a defendant in the Chinese drywall multidistrict litigation pending in the Eastern District of Louisiana.  Prestige’s client alleged that Prestige had used defective Chinese manufactured drywall in their home and that the drywall resulted in bodily injury (eye irritation, nausea, respiratory ailments, etc.) and property damage (corrosion and damage to appliances, wiring and object with metal surfaces).

Prestige was insured for the relevant time period under a commercial general liability policy issued by National Builders.  National Builders disclaimed coverage to Prestige on the basis of its policy’s total pollution exclusion barring coverage for:

f. Pollution.

(1)  "Bodily injury" or "property damage" which would not have occurred in whole or in part but for the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of "pollutants" at any time.

(2)  Any loss, cost or expense arising out of any:

(a)   Request, demand, order or statutory or regulatory requirement that any insured or others test for, monitor, clean up, remove, contain, treat, detoxify or neutralize, or in any way respond to, or assess the effects of "pollutants"; or

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

On motion for summary judgment, National Builders pointed out that the underlying suit alleged that the drywall was defective in that it emitted various sulfide and other noxious gases through off-gassing.  These allegations, argued National Builders, fell squarely within the terms of the exclusion.  While no Mississippi court considered the application of the exclusion on similar facts (i.e., to releases of gas indoors), National Builders cited to case law from other jurisdictions holding the exclusion applicable to indoor air quality claims.  National Builders also cited to case law from other jurisdictions holding the exclusion applicable to Chinese drywall claims.  See, e.g., Evanston Ins. Co. v. Germano, 514 F. App'x 362 (4th Cir. 2013), TravCo Ins. Co. v. Ward, 284 Va. 547, 736 S.E.2d 321 (Va. 2012); Granite State Ins. Co. v. American Bldg. Materials, Inc., 504 F. App'x 815 (11th Cir. 2013).  Prestige, on the other hand, cited to the decision in In re Chinese Manufactured Drywall Prods. Liab. Litig., 759 F. Supp. 2d 822 (E.D. La. 2010), in which the Eastern District of Louisiana, applying Louisiana law on the pollution exclusion, including the seminal decision in Doerr v. Mobil Oil Corp., 774 So. 2d 119 (La. 2000), held the exclusion inapplicable to Chinese drywall claims. 

The Prestige court distinguished the holding in In re Chinese Manufactured Drywall Prods. Liab. Litig. on the basis that the Louisiana court was considering coverage under homeowners policies rather than commercial general liability policies.  The Prestige court further reasoned that Mississippi’s Supreme Court would not follow the restrictive application of the pollution exclusion as set forth by Louisiana’s highest court in Doerr, but instead would apply the exclusion pursuant to its “plain terms.”  In other words, no distinction would be drawn between traditional and non-traditional environmental pollution.  As such, the court granted summary judgment in National Builder’s favor.

First Circuit Addresses “Insured Location” Exclusion in Homeowner’s Policy

In its recent decision in Vermont Mut. Ins. Co. v. Zamsky, 2013 U.S. App. LEXIS 20569 (1^st Cir. Oct. 9, 2013), the United States Court of Appeals for the First Circuit, applying Massachusetts law, had occasion to consider the applicability of exclusions in homeowners policies limiting coverage to insured locations.

The underlying loss arose out of a fire at what appears to have been a summer home which was owned by the insured but not identified in the insured’s homeowner’s policy as an “insured location.”  The insured’s daughter and several of her friends went to the house and while there tried to light a fire in a portable fire pit.  Gasoline was introduced to the fire, resulting in a large flash of flames that caused severe burns to three of the individuals present.  Suit was later brought against the insured, and the matter was tendered to the insured’s homeowner’s insurers: two primary insurers and an umbrella insurer.  The carriers agreed to provide the insured with a defense, subject to a reservation of rights to deny coverage based on what the court described as a “UL” exclusion (presumable uninsured location), precluding coverage for bodily injury:

            e. Arising out of a premises:

        (1) Owned by an "insured";

        (2) Rented to an "insured"; or

        (3) Rented to others by an "insured";

that is not an "insured location" . . .

The coverage dispute eventually resulted in litigation, and on motion for summary judgment, the United States District Court for the District of Massachusetts held that the exclusion was inapplicable because the fire did not result from a condition inherent to summer home. 

On appeal, the First Circuit observed the lack of any decisions by Massachusetts’ highest court – the Supreme Judicial Court – construing the UL exclusion.  The court nevertheless found instructive two decisions from the Massachusetts Appeals Court in Callahan v. Quincy Mutual Fire Insurance Co., 736 N.E.2d 857 (Mass. App. Ct. 2000) and Commerce Insurance Co. v. Theodore, 841 N.E.2d 281 (Mass. App. Ct. 2006).   In the Callahan decision, the Appeals Court held the exclusion inapplicable to a dog bite that happened at location owned by the insured, but not otherwise an “insured location,” because the dog was not a condition of the premises.  In Theodore, the Appeals Court held the exclusion applicable where a third party was on a premises owned by the insured, but not an “insured location,” to perform repair work on the premises.  Under such circumstances, the injury happened because of a condition inherent to the premises, and as such, the injury could be considered to have arisen out of the non-insured location.

The First Circuit reasoned that the Callahan and Theodore cases stand for the general principal that the phrase “arising out of a premises” as used in the UL exclusion means arising out of a condition of the premises.  As the court explained:

... the cases establish a dichotomy: if the covered occurrence arises out of a condition of the premises and the exclusion's other requirements are satisfied, the exclusion applies; otherwise, it does not.

The court further noted that this reading of the exclusion comported with case law from other jurisdictions, such as Louisiana and Ohio.

With this rule in mind, the court agreed that the exclusion was inapplicable to the underlying burn case because the fire was not caused by a condition of the premises.  Rather, the fire arose out of the use of the fire pit.  Because the fire pit was a portable device that was not inherently a part of the premises, and could not be considered a defect in the premises, there simply was not a sufficient connection between the home and the fire as required for the exclusion to apply.

New York Appellate Court Affirms No Coverage Under Computer Fraud Coverage

In its recent decision in Universal American Corp. v. National Union Fire Ins. Co. of Pittsburg, PA, 2013 N.Y. App. Div. LEXIS 6278 (N.Y. 1^st Dep’t Oct. 1, 2013), the New York Appellate Division, First Department, had occasion to consider the scope of coverage afforded under a computer systems fraud endorsement to a financial institution bond.

National Union’s insured, Universal, is a health insurance company that offers a number of products, including Medicare Advantage Private Fee-For-Service (MA-PFFS) plans, which are government-regulated alternatives to Medicare. Universal processes payments for medical services received by MA-PFFS plan members through its computer system on which medical service providers enter claim information directly.  Payments are thereafter made by Universal without manual review.

National Union issued a financial institution bond to Universal with a rider titled “Computer Systems Fraud,” which provides indemnification for:

Loss resulting directly from a fraudulent

(1)  entry of Electronic Data or Computer Program into, or

(2) change of Electronic Data or Computer Program within the Insured's proprietary Computer System...provided that the entry or change causes

(a)   Property to be transferred, paid or delivered,

(b)  an account of the Insured, or of its customer, to be added, deleted, debited or credited, or

(c)   an unauthorized account or a fictitious account to be debited or credited.

Universal claimed to have suffered some $18 million in losses from fraudulent claims made by providers a variety of different schemes.  Universal claimed that some 80% of the losses it experienced resulted from claims submitted through its computer system, i.e., where providers entered false information onto Universal’s billing system, and that these losses should be indemnified pursuant to the Computer Systems Fraud coverage.

On motion for summary judgment at the trial court level, Universal argued that the rider extended coverage to any loss resulting from the fraudulent entry of electronic data into its own computer system, regardless of whether the provider entering the claim data was authorizes to access the system.  National Union, on the other hand, argued that the rider extended coverage only to unauthorized use of Universal’s computer system, i.e., manipulation of computer data by hackers.  The trial court agreed with National Union, concluding that the rider’s coverage is directed at misuse or manipulation of Universal’s system rather than situations involving fraudulent submission of claims where the system is otherwise “properly utilized.”

On appeal, the Appellate Division agreed that the trial court properly interpreted the rider’s scope of coverage, reasoning that the “unambiguous plain meaning” of the rider is to “apply to wrongful acts in the manipulation of the computer system, i.e., by hackers,” and that coverage was not intended to apply to claims by “bona fide doctors and other health care providers,” who were authorized users of Universal’s billing system.  Thus, regardless of the fact that these providers were submitting fraudulent bills, the fact that they were authorized to use the system in the first instance precluded coverage under the National Union bond.

Supreme Court of Washington Holds Carrier Cannot Sue Defense Counsel

In its recent decision in Stewart Title Guar. Co. v. Sterling Sav. Bank, 2013 Wash. LEXIS 769 (Wash. Oct. 3, 2013), the Supreme Court of Washington had occasion to consider whether an insurer can pursue a malpractice action against counsel in connection with its defense of an insured.

Stewart Title Guaranty Company, a title insurer, retained the law firm of Witherspoon, Kelley, Davenport & Toole PS to represent its insured, Sterling Savings Bank, in connection with an underlying lien priority action.  The matter was decided against Sterling Savings. Stewart Title later filed a malpractice action against the Witherspoon firm for its failure to have asserted the affirmative defense of equitable subrogation.  Weatherspoon argued, on motion for summary judgment, that Sterling Savings – rather than Stewart Title – was its client, and that as such, it owed no duty to Stewart Title that would permit such a malpractice claim.  Witherspoon argued in the alternative that even if Stewart Title could bring such a claim, it did not commit malpractice since the equitable subrogation theory would have been unsuccessful.  The trial court held that Witherspoon did, in fact, owe a professional duty to Stewart Title, but it nevertheless held in Witherspoon’s favor on the issue of whether it breached the duty by failing to assert the equitable subrogation defense.

On appeal, the Supreme Court of Washington affirmed the grant of summary judgment in Witherspoon’s favor, but on a different rationale than applied by the trial court.  Specifically, the court reasoned that Witherspoon owed no professional duty to Stewart Title in the first instance.  While the court acknowledged the issue of whether an insurer can sue defense counsel for malpractice was one of first impression, it found guidance on the issue from its prior decision in Trask v. Butler, 872 P.2d 1080 (1994).  In Trask, the court set forth several factors to be considered in whether an attorney may be liable for malpractice to a nonclient, the most significant factor being “[t]he extent to which the transaction was intended to benefit the plaintiff [that is, the third party suing the attorney].” 

The trial court had concluded that Stewart Title was the intended beneficiary of Witherspoon’s legal services on two grounds: (1) an alignment of interests between Stewart Title and Sterling Savings in having the underlying claim dismissed and (2) a contractual duty existed in favor of Stewart Title as a result of Witherspoon’s obligation to provide reporting on the underlying litigation.  The Supreme Court of Washington, however, rejected the notion that either factor was determinative of this issue.  While the court agreed that both Stewart Title and its insured had a shared interest in the outcome of the underlying litigation, this was not sufficient to demonstrate that Stewart Title was the clear intended beneficiary of Witherspoon’s representation.   The court further rejected the notion that Witherspoon’s reporting obligations evidenced Stewart Title’s role as the intended beneficiary, explaining that:

An attorney hired to represent a client by a third party payor may generally, as part of the terms of the retention, have a duty to keep the payor informed (within the bounds of the attorney-client privilege and the duty of confidentiality). But such a limited duty to inform the nonclient third party payor does not give rise to a broad duty of care that would support a malpractice claim by the third party payor. It does not create that separate duty of care for the same reasons that the client's and nonclient payor's alignment of interests does not create such a separate duty: first, because acceptance of a duty to inform a nonclient third party payor does not show that the attorney's representation was intended to benefit the third party payor, as Trask requires; and second, because an attorney cannot contract away his or her professional duty to "not permit a person who . . . pays the lawyer to render legal services for another to direct or regulate the lawyer's professional judgment in rendering such legal services." RPC 5.4(c).

Thus, while the court acknowledged that other jurisdictions, such as California and Michigan, permit insurers to bring malpractice claims against defense counsel, the Supreme Court of Washington concluded that such a claim is not cognizable under Washington law. 

Texas Court Holds No Duty to Defend Under Mortgage Broker E&O Policy

In its recent decision in AXIS Surplus Lines Ins. Co. v. Halo Asset Management, LLC, 2013 U.S. Dist. LEXIS 139065 (N.D. Tex. Sept. 27, 2013), the United States District Court for the Northern District of Texas had occasion to consider whether an underlying complaint alleged conduct falling within the scope of coverage afforded under a miscellaneous errors and omissions policy.

AXIS insured Halo Management under a professional liability policy, providing coverage for damages arising out of Halo’s performance of “insured services,” a term defined by the policy as:

Mortgage broker services consisting of counseling, taking of applications, obtaining verifications and appraisals, loan processing and origination services in accordance with lender and investor guidelines and communicating with the borrower and lender. Debt settlement and credit services including arbitration and negotiations; real estate sales and brokerage services. …

While the policy was in force, Halo was named as a defendant in a lawsuit regarding its participation in an investment vehicle involving the purchase of at-risk residential mortgages for repackaging as a new security.  Halo was to have processed and serviced the mortgages as part of this scheme.  The claimant alleged, however, that the underlying mortgages were never purchased and that his initial $5 million investment was never returned.  The complaint alleged that Halo failed to perform due diligence on the entity that was supposed to have purchased the mortgages, and that Halo failed to inform the claimant that the mortgages, in fact, were not being purchased as intended.  AXIS denied coverage to Halo on the basis that the underlying complaint did not allege misconduct arising out of “insured services.”

On motion for summary judgment, AXIS argued that the underlying complaint did not involve any of the services identified in the policy definition of “insured services,” and that definition provides an “exhaustive definition” of the term.  Halo, on the other hand, argued that by employing the phrase “consisting of” following the words “mortgage broker services,” the definition of “insured services” was only intended to provide examples of covered professional services.  Halo further argued that the non-legal definition of the term “broker” is broad and that as such, the concept of “insured services” should be broadly construed. 

The court rejected Halo’s reliance on a lay dictionary, noting that Black’s Law Dictionary has a specific definition of “mortgage broker,” which is an entity that markets mortgage loans and brings lenders and borrowers together, but that does not originate or service mortgage loans.  The underlying complaint, observed the court, related solely to Halo’s role in processing and servicing loans that were to have been purchased by a third party.  As such, the court concluded that:

The allegations in the underlying action are fundamentally based on the Halo defendant's misuse of the Claimant defendant's invested funds, not in mortgage broker services. Taking the allegations in the petition as true, none of the funds even went to purchase mortgages.  The fact that the proposed investment scheme was supposed to involve mortgages does not overshadow the fact that the allegations ultimately stem from fraud and misappropriation of funds.

Accordingly, the court agreed that AXIS had no duty to defend the underlying complaint.  The court, however, denied AXIS’ motion on the duty to indemnify, noting that under Texas law, the duty to indemnify cannot be determined based on the allegations in the complaint, but instead depended on facts that would be considered at trial.