Ninth Circuit Holds Extrinsic Facts Triggered Duty to Defend

In its recent decision in Burlington Ins. Co. v. CHWC, Inc., 2014 U.S. App. LEXIS 3941 (9^th Cir. Mar. 3, 2014), the United States Court of Appeals for the Ninth Circuit, applying California law, had occasion to consider an insured’s obligation to consider extrinsic facts in determining a duty to defend.

The underlying incident in Burlington involved injuries allegedly suffered by the plaintiff when forcibly removed by bouncers from the insured nightclub, Crazy Horse.  Claimant’s original lawsuit contained a cause of action for assault and battery for the alleged incident, as well as causes of action for negligent hiring and premises liability.  Crazy Horse’s insurer, Burlington, was provided copies of the pleadings as well as police reports concerning the incident.  The initial police reports were consistent with an assault and battery.  A supplemental report, however, indicated that while claimant was being removed from the club, he became defiant and began to resist removal.   One of the witnesses interviewed in the supplemental report stated that during this period of heightened tension, the claimant backed into a stool and fell down and that this is what may have caused his injuries.

Based on these facts, in particular the allegations in the complaint alleging that plaintiff’s injuries resulted solely from an assault and battery, Burlington denied coverage to Crazy Horse pursuant to its policy’s assault and battery exclusion.  Burlington later received summary judgment in its favor from a California federal district court.  The lower court held that due to the assault and battery exclusion, and the allegations in the underlying complaint, “there was never a possibility of coverage.”

On appeal, however, the Ninth Circuit held that the reference in the police report to the claimant falling on a stool raised the possibility that his injuries were not solely the result of an assault and battery.  Citing to the seminal California decision in Gray v. Zurich Ins. Co., 419 P.2d 168, 176 (Cal. 1966) concerning an insurer’s duty to consider extrinsic facts in determining the duty to defend, the court noted that while some aspects of the police reports substantiated an assault and battery, “some of the witness statements provided to Burlington stated that [claimant] was injured when he tried to sit down on a stool, lost his footing, and hit his head on the wall.”  This version of event, explained the court, if truly the cause of claimant’s injuries, would not fall within the assault and battery exclusion. 

Thus, explained the court, notwithstanding the actual allegations in the pleadings, and notwithstanding the witness statements in the police reports suggesting that claimant was injured solely as a result of force applied by the Crazy Horse bouncers, the extrinsic facts at least raised the possibility of coverage, which was sufficient to trigger a duty to defend.  As the court explained:

Although as originally pleaded [claimant’s] negligence claim was predicated on the theory that he had been assaulted, the extrinsic facts available to Burlington revealed the possibility that [claimant] could amend his negligence claim to allege theories of liability that would fall outside the assault-or-battery exclusion. Under well-settled California law, that possibility was enough to trigger Burlington's duty to defend.

New York’s Highest Court Vacates Its Decision in K2

In its February 18, 2014 decision in K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co., New York’s Court of Appeals – New York’s highest court – had occasion to revisit its prior ruling concerning the effect of an insurer’s breach of the duty to defend.

By decision dated June 11, 2013, the Court of Appeals seemingly articulated a new rule regarding the consequences of an insurer’s breach of the duty to defend.  K2 Inv. Group, LLC v. American Guar. & Liab. Ins. Co., 21 N.Y.3d 384 (NY 2013).  Specifically, the Court held that by having wrongfully denied a defense to its insured under a professional liability policy, American Guarantee “lost its right” to rely on certain policy exclusions for indemnity purposes.  Relying on its decision in Lang v. Hanover Ins. Co., 3 N.Y.3d 350 (NY 2004) – a case involving the insurer’s right to contest the insured’s liability for an underlying loss after breaching the duty to defend – the Court explained the new rule as follows:

… we now make clear that Lang, at least as it applies to such situations, means what it says: an insurance company that has disclaimed its duty to defend "may litigate only the validity of its disclaimer." If the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.

The Court justified this rule on fairness grounds, explaining that:

This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain. It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured's defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify. 

In so ruling, the K2 Court notably did not cite to its prior decision in Servidone Construction Corp. v. Security Ins. Co., 64 N.Y.2d 419 (NY 1985), wherein the Court held that an insurer’s breach of the duty to defend cannot operate to enlarge a policy’s coverage.  Thus, the decision in K2 stood in direct conflict with Servidone. 

Following the Court’s June 11, 2013 decision, American Guarantee moved for reargument, primarily on the basis that the Court failed to address the decision in Servidone, and thus created an inconsistency in the case law.  The Court granted American Guarantee’s motion for reargument – a relief afforded by the Court of Appeals on only rare occasions – and a second round of oral argument was held on January 7, 2014.

In its February 18, 2014 decision, Judge Robert Smith, writing for a four-judge majority (two judges dissented and one judge abstained) acknowledged that the Court’s June 11, 2013 holding was irreconcilable with its prior decision in Servidone.  While the Court reaffirmed its prior holding in Lang that an insurer is not permitted to relitigate issues in the underlying case if it breaches its duty to defend, the Court recognized that this issue is distinct from whether an insurer is permitted to litigate its indemnity obligation subsequent to a wrongful denial of its duty to defend.

In so holding, the Court noted that “[t]here is much to be said for the rule” it articulated in its initial June 11^th decision.  The Court nevertheless acknowledged that the majority of jurisdictions follow the Servidone rule – the principle exceptions being Illinois and Connecticut.  The Court further observed that K2 failed to present “any indication that the Servidone rule has proved unworkable, or caused significant injustice or hardship, since it was adopted in 1985.”  Under the circumstances, the Court found it preferable to follow its prior holding in Servidone, explaining:

When our Court decides a question of insurance law, insurers and insureds alike should ordinarily be entitled to assume that the decision will remain unchanged unless or until the Legislature decides otherwise. In other words, the rule of stare decisis, while it is not inexorable, is strong enough to govern this case.

With this in mind, the Court turned to the application of the policy exclusions, and concluded that these exclusions presented a sufficient question of fact to defeat K2’s underlying motion for summary judgment.

Writing for a two-judge dissent, Judge Victoria Graffeo expressed her belief that an insurer should be penalized for breaching the duty to defend.  In her opinion, Servidone should be limited to questions of coverage “in the first instance,” i.e., whether a loss falls within a policy’s insuring agreement.  While she agreed that an insurer that breaches a duty to defend should not be made to indemnify a loss not falling within the scope of a policy’s insuring agreement (i.e., “a homeowner's policy would not provide malpractice liability coverage”), she reasoned that this rule should not apply to policy exclusions. As she explained, “[p]rohibiting exclusions from being collaterally invoked provides an insurer with an incentive to appear on behalf of the policyholder in the underlying lawsuit, as it agreed to do in return for the payment of premiums.”

With the Court of Appeals’ decision to vacate its earlier ruling in K2, New York now returns comfortably to the majority rule that acknowledges an insurer's right to contest its indemnity obligation is separate and apart from any issue of its duty to defend.

Texas Court Holds Suit Under D&O Policy Not Ripe for Declaratory Judgment

In its recent decision in American Construction Benefits Group, LLC v. Zurich Am. Ins. Co., 2014 U.S. Dist. LEXIS 5147 (N.D. Tex. Jan. 15, 2014), the United States District Court for the Northern District of Texas had occasion to consider whether a D&O insurer’s coverage obligations were triggered by a threatened, but not yet filed, derivative action lawsuit.

Zurich insured ACBG under a directors and officers policy. ACBG procured reinsurance for its member company, J.D. Abrams, L.P., through a third company.  While negotiating a renewal of the reinsurance, ACBG’s president agreed to an exclusion for a specific medical procedure that had been performed on a child of an Abrams employee.  The reinsurer subsequently denied coverage for the $1.2 million in costs associated with the procedure.  ACBG later sought coverage for this amount from Zurich, claiming that its president committed a wrongful act when it agreed to the exclusion in the reinsurance contract.  While Zurich acknowledged ACBG’s claim, it never formally asserted a coverage position. 

ACBG members later filed a declaratory judgment action against Zurich.  Zurich, in turn, moved to dismiss the complaint, asserting that the suit was premature since no claim had yet been asserted against ACBG that could trigger Zurich’s duties to defend or indemnify.  In response, ACBG members acknowledged that while no derivative suit had yet been filed, they were contemplating one and it therefore was imminent.

The court observed that the existence of an underlying pleading is a prerequisite under Texas’ “eight corner rule” for determining a duty to defend.   As such, and because ACBG’s members had not yet filed their allegedly imminent derivative action, the court determined that the duty to defend question was not ripe for judicial consideration.  The court ruled similarly with respect to Zurich’s potential duty to indemnify, noting that under Texas law, an insured cannot obtain a ruling on a duty to indemnify absent a judgment or settlement of an active litigation.  In passing, the court noted that:

ACBG's complaint is devoid of any allegation that it will be harmed if this court withholds declaratory relief. Because there is no underlying suit, ACBG faces no immediate risk that it will be forced to contribute to a settlement agreement or face a bad-faith suit. And ACBG does not allege that its members have threatened to sue unless ACBG relinquishes its rights.

The court also rejected ACBG’s claim against Zurich for violation of Texas’ claims handling statute based on Zurich’s failure to promptly affirm or deny coverage.  Because there was no underlying suit that could trigger Zurich’s duty to defend or indemnify, explained the court, it necessarily followed that it could not be held to have improperly delayed its decision with respect to such duties.

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. 

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.

Missouri Federal Court Rejects Bad Faith Claim

In its recent decision in Hullverson v. Liberty Ins. Underwriters, 2013 U.S. Dist. LEXIS 101640 (E.D. Mo. July 22, 2013), the United States District Court for the Eastern District of Mississippi had occasion to consider the issue of whether Missouri law permits an insured to assert a bad faith claim sounding in tort based on an insurer’s breach of the duty to defend.

Liberty International Underwriters insured the Hullverson law firm under a professional liability policy.  The firm and several individual attorneys were sued in connection with various activities relating to the firm’s advertising.  Liberty denied coverage for the suit, prompting Hullverson to commence a declaratory judgment action against Liberty.  In addition to asserting causes of action for declaratory judgment and breach of contract, Hullverson’s complaint stated a cause of action for vexatious refusal to pay in violation of Missouri Revised Statutes §§ 375.296 and 375.420, and a cause of action for bad faith failure to defend and indemnify.

Liberty moved to dismiss Hullverson’s bad faith cause of action, arguing that Missouri’s vexatious refusal to pay statutes preempt such a cause of action.  The court agreed that as a general proposition, a bad faith cause of action for breach of duty to defend is not permissible under Missouri law.  The seminal decision on the issue, observed the court, is Overcast v. Billings Mut. Ins. Co., 11 S.W.3d 62 (Mo. 2000), in which the Missouri Supreme Court held that “an insurance company's denial of coverage itself is actionable only as a breach of contract and, where appropriate, a claim for vexatious refusal to pay.”  These decisions, explained the Hullverson court, make clear that absent wrongful conduct independent of the denial of the duty to defend, an insured cannot recast a breach of contract claim as a tort claim.   With this general rule in mind, the court concluded that Hullverson failed to alleged the requisite independent conduct that would permit a bad faith claim:

Plaintiffs have failed to plead or argue any conduct in Count IV that is distinct from conduct alleged in Counts I, II, and III. The bad faith claim is not wholly independent of their breach of contract and vexatious refusal claims. This is not they type of independent tort claim contemplated by Overcast. Plaintiffs have merely stated a claim for bad faith based almost wholly on Liberty's refusal to pay their insurance claim. Missouri courts have consistently interpreted the holding in Overcast to preclude these types of claims.

As such, the court agreed that Hullverson was limited to its claim for vexatious refusal to pay, and that its bad faith claim must be dismissed.

Maine Federal Court Holds Assault and Battery Exclusion Applicable

In its recent decision in Iasbarrone v. First Financial Ins. Co., 2013 U.S. Dist. LEXIS 86605 (D. Maine June 20, 2013), the United States District Court for the District of Maine had occasion to consider the scope of an assault and battery exclusion, particularly in the context of a liability insurer’s duty to defend.

First Financial Insurance Company (“FFIC”) insured Samaritan, Inc., a food pantry, under a general liability policy.  Underlying plaintiff, Lisa Iasbarrone, alleged that she was turned away from Samaritan, and that when she attempted to reenter Samaritan’s premises, she was grabbed by her left wrist and pulled down, causing her to sustain injuries to her wrist.  Ms. Iasbarrone later filed suit against Samaritan, and the complaint specifically alleged that an agent of Samaritan “grabbed Plaintiff by the wrist and pulled down in an effort to prevent the Plaintiff from entering the property.”  Samaritan tendered its defense to FFIC, which denied coverage on the basis of an assault and battery exclusion barring coverage for bodily injury:

(2) Arising in whole or in part out of any "assault" or "battery" committed or attempted by any person. . . . [or] (4) Arising in whole or in part out of any actual or threatened verbal or physical confrontation or altercation committed . . . by any person . . . .

Ms. Iasbarrone later settled her suit against Samaritan for $98,000 and an assignment of rights against FFIC.  She later filed a direct action against FFIC to recover the settlement amount plus legal fees she claimed FFIC owed to Samaritan for having breached its duty to defend.

On motion for summary judgment, FFIC argued that the allegation that plaintiff’s injuries were caused by physical contact demonstrated that the claim fell entirely within the exclusion.  Ms. Iasbarrone, on the other hand, argued that notwithstanding the allegations in her own complaint, facts might be established at trial demonstrating that she was injured through other causes.  For instance, she claimed that “the trial evidence could have established that [the insured’s agent] did not grab her, but injured her as she pulled on a door to the premises while [the agent] inadvertently pushed on the door.” 

The court rejected Ms. Iasbarrone’s attempt to argue that facts could demonstrate causation other than what she alleged.   The court specifically concluded that by having alleged specific facts regarding the cause of her injury, she could not then rely on the possibility that evidence introduced at trial could prove an alternate, potentially covered, cause injury.  As the court explained:

The Plaintiff attempts to introduce the possibility that there was no physical contact between herself and Lavoie by inserting a door into the narrative. But this fundamentally changes the allegations of the complaint. In the complaint, the Plaintiff claims that Lavoie's negligence was the "unreasonable amount of force" he applied to her wrist. She does not claim that Lavoie injured her by pulling a door closed. Unlike a plaintiff who does not know how her injury was caused, the conduct that injured Iasbarrone--a wrist grab--was known to her, and it was part of the short and plain statement of her claim.

As such, and because the allegations of grabbing and pulling constituted an excluded act of battery, the court agreed that FFIC had no duty to defend or indemnify.

California Court Holds Insurer Precluded from Suing Defense Counsel

California’s First District Court of Appeal n J.R. Marketing, LLC v. Hartford Casualty Ins. Co. (1^st District, June 11, 2013), recently considered whether an insurance carrier had a right to directly sue the insured’s independent counsel for reimbursement for payment of fees and costs which were allegedly unreasonable or otherwise outside the scope of the insurer’s contractual defense obligations.

The court of appeal’s opinion was its third decision arising from a coverage action involving two liability insurance policies issued by Hartford Casualty Insurance Company to Noble Locks Enterprises, Inc. and J.R. Marketing, LLC.  Hartford had originally denied the tender of defense to it, was sued by various tendering parties, reconsidered the tender and agreed to provide a defense but then delayed in paying defense bills.  The trial court subsequently entered an “enforcement order” requiring Hartford to

… pay the insured cross-defendants’ outstanding invoices within 15 days and to pay “all future reasonable and necessary defense costs within 30 days of receipt.”  Acknowledging a right of reimbursement, the enforcement order provided, “[t]o the extent Hartford seeks to challenge fees and costs as unreasonable or unnecessary, it may do so by way of reimbursement after resolution of the Avganim matter.  (Citation omitted.)

The court further held that Hartford was not entitled to any of the protections afforded insurers in California Civil Code section 2860 because it had breached and continued to breach its obligations to pay reasonable and necessary defense expenses and to provide “Cumis” counsel.  The enforcement order was affirmed in 2007 by the appellate court in an unpublished decision.  Hartford subsequently paid over $15 million to the insureds’ independent counsel for its fees and costs.

The present appeal was taken from a judgment of dismissal following the sustaining of demurrers, without leave to amend, to a cause of action for reimbursement against the law firm defending the insureds in the underlying actions (and which had prosecuted the coverage action), and against a non-insured also represented by that law firm.

Initially, the appellate court reiterated that Hartford did not have any rights under section 2860 because of its original breach of the duty to defend.  Included in those rights is the right to arbitrate fee disputes.  The court stated that allowing Hartford to sue the independent counsel for reimbursement would frustrate several of the underlying principles behind section 2860, including the insured’s right to control the defense when the insurer has breached its obligations to defend the insured:

As set forth above, it is clear California law bars an insurer, like Hartford, in breach of its duty to defend from thereafter imposing on its insured its own choice of defense counsel, fee arrangement or strategy.  This court now takes the law one slight step further by holding Hartford likewise barred from later maintaining a direct suit against independent counsel for reimbursement of fees and costs charged by such counsel for crafting and mounting the insureds’ defense where Hartford considers those fees unreasonable or unnecessary. 

It was stated that to hold otherwise would give a breaching carrier greater rights than an insurance carrier which had complied with its duty to defend an insured, by allowing the breaching carrier to have a court determine the fee dispute.  It was also noted that the court was not determining whether an insurer could sue independent counsel for fraudulent billing practices.  Instead the decision was that where a carrier has breached its duty to defend and a billing dispute subsequently arises with regard to the fees and costs incurred by independent counsel, the insurer’s sole remedy is a claim against the insured, not independent counsel.

The court also found that there were no grounds to reverse the dismissal of the reimbursement claim against the non-insured party also defended by the independent counsel in an underlying action, because Hartford had failed to allege facts supporting such a claim and had not supported its appeal by reference in its opening brief to legal authority and citations to the appellate record.

New York Court of Appeals Sets Forth New Rule for Breach of Duty to Defend

In its recent decision in  K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co., 2013 N.Y. LEXIS 1461, 2013 NY Slip Op. 4270 (NY June 11, 2013), New York's Court of Appeals – New York’s highest court – announced a new rule regarding the consequences for breaching a duty to defend under New York law.

Prior to the decision in K2, New York courts at both the state and federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for the purpose of contesting an indemnity obligation.  See, e.g., Servidone Construction Corp. v. Security Ins. Co., 488 N.Y.S.2d 139 (NY 1985) (holding it is impermissible for a court to enlarge a policy’s coverage on the basis of an insurer’s breach of a duty to defend); Hotel des Artistes, Inc. v. Gen. Accident Ins. Co. of Am., 775 N.Y.S.2d 262 (1^st Dep’t 2004); Robbins v. Michigan Millers Mut. Ins. Co., 633 N.Y.S.2d 975 (3d Dep’t 1997); Hugo Boss Fashions, Inc. v. Fed. Ins. Co., 252 F.3d 608 (2d Cir. 2001). In fact, this rule was reaffirmed as recently as June 11, 2013 – the same day as the K2 decision – by the United States Court of Appeals for the Second Circuit in CGS Industries, Inc. v. Charter Oak Fire Ins. Co., 2013 U.S. App. LEXIS 11700 (2d Cir. June 11, 2013). 

The New York Court of Appeals’ June 11, 2013 decision in K2, however, departs from this long-established jurisprudence.  K2 involved loans made by two limited liability companies to a third company, Goldan.  The loans were to be secured by mortgages, but the mortgages were not properly recorded.  The two LLCs subsequently brought suit against Goldan and its two principals, one of whom, Jeffrey Daniels, was an attorney.  The suit asserted a claim of legal malpractice against Mr. Daniels for having failed to record the mortgages.  Mr. Daniels sought coverage from his errors and omissions carrier, American Guarantee, but American Guarantee disclaimed coverage on several grounds. Mr. Daniels subsequently defaulted in the underlying action, and plaintiffs took a judgment in excess of the policy limits of the American Guarantee policy.  The LLCs then asserted a direct action against American Guarantee for breach of contract and failure to settle within policy limits.

American Guarantee moved for summary judgment on the basis of its policy’s “business enterprise” exclusions. It argued that the claim against Mr. Daniels arose out of his capacity or status as a member or owner of Goldan, and that as such, the exclusions applied.  The trial court granted summary judgment in favor of the claimants, and on appeal, New York’s First Department held that the exclusions were “patently inapplicable,” at least for duty to defend purposes, since the essence of the underlying claim was that Mr. Daniels committed legal malpractice.  The Appellate Division, however, was divided as to whether the exclusions applied for the purposes of American Guarantee’s duty to indemnify. 

On appeal to the New York Court of Appeals, American Guarantee essentially conceded that it had breached its duty to defend Mr. Daniels, but argued that it could still rely on the exclusions to avoid a duty to indemnify.  The Court of Appeals disagreed, holding that by having breached its duty to defend Mr. Daniels, American Guarantee “lost its right” to rely on the exclusions for indemnity purposes.  Relying on its decision in Lang v. Hanover Ins. Co., 787 N.Y.S.2d 211 (NY 2004) – a case involving the insurer’s right to contest the insured’s liability for underlying loss after breaching a duty to defend – the court articulated its new rule:

… we now make clear that Lang, at least as it applies to such situations, means what it says: an insurance company that has disclaimed its duty to defend "may litigate only the validity of its disclaimer." If the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify. This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain. It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured's defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.  (Emphasis supplied.)

The K2 Court conceded that there may be exceptions to this new rule, such as where public policy precludes indemnification for an underlying loss.  Further, the ruling appears limited in its reach to consideration of whether exclusions can apply after a duty to defend has been breached.  Presumably, this rule will not apply where the underlying loss is covered in the first instance, i.e., not when the loss falls outside the scope of a policy’s insuring agreement. These and other questions, and the reach of K2, will undoubtedly be the subject of future controversy and litigation.

Third Circuit Addresses Insured Status for Lessor of Commercial Auto

In its recent decision in Koons v. XL Insurance Company, 2013 U.S. App. LEXIS 5870 (3d. Cir. Mar. 25, 2013), the United States Court of Appeals for the Third Circuit, applying Pennsylvania law, had occasion to consider concepts of ownership and lessor liability in the context of a commercial auto liability policy.

The Koons decision involved two separate business entities with a common ownership.  Stephen Koons owned Miller Concrete and ran it as a sole proprietorship.  Miller Concrete’s sole business was selling and installing underground septic tanks.  Koons also was the sole shareholder of a separately run business, Ches-Mont Disposal, a waste collection enterprise.  In 2001, Miller Concrete purchased a trash disposal truck and immediately leased it to Ches-Mont.  While Ches-Mont did not actually make payments to Miller Concrete under the lease, there was no dispute that the truck was only used by Ches-Mont and was only useful to Ches-Mont’s business.  While the lease between Ches-Mont and Miller Concrete expired in 2004, Ches-Mont maintained sole and uninterrupted possession of the vehicle thereafter and, in fact, the Pennsylvania Department of Transportation continued to identify the vehicle as being owned by Miller Concrete but leased by Ches-Mont.  All vehicle maintenance and repair was performed by Ches-Mont rather than by Miller Concrete.  Ches-Mont was later involved in a corporate restructuring whereby it became a subsidiary of a holding company owned by Koons and two other investors.

The underlying lawsuit pertained the 2008 death of a Ches-Mont employee while operating the truck.  The employee’s estate sued Koons individually as the owner of the truck.  Ches-Mont was not named as a defendant, and the estate did not specifically identify Koons as a defendant based on his relationship with Ches-Mont.  Instead, Koons’ alleged liability was premised solely based on his purported ownership of the vehicle.  XL, as the auto insurer for Ches-Mont, denied coverage to Koons on the theory that he did not qualify as an insured under its policy.  That policy defined insured to be the Named Insured as well as “3. your [the Named Insured‟s] partners, joint venture members, executive officers, employees, directors, stockholders or volunteers while acting within the scope of their duties as such.”  The United States District Court for the Eastern District of Pennsylvania held in favor of XL on summary judgment, concluding that no reasonable jury could conclude that Koons had purchased the truck in his role as the owner of Ches-Mont and therefore he was not being sued for conduct committed while acting within the scope of his duties on behalf of Ches-Mont.

On appeal, the Third Circuit concluded that the lower court erred in holding that there was no evidence in the record from which a jury could conclude that that Koons purchased and leased the truck in his capacity as the founder and sole owner of Ches-Mont.  Looking to the facts alleged, the court reasoned that there was sufficient evidence from which a jury could infer that Koons’ purchase of the truck was in his capacity as the original founder and owner of Ches-Mont.  As the court explained:

The Truck is specially designed for waste disposal purposes; it is a trash truck. The Truck was purchased by Koons d/b/a Miller Concrete, even though Miller Concrete sold and installed septic tanks. At the time of purchase, Koons was also the sole owner of Ches-Mont Disposal, a waste disposal company. The fact that Koons purchased a specially designed trash disposal truck, and at the time owned both a septic tank company and a trash disposal company, would allow a reasonable jury to infer that he purchased the trash disposal truck "in his capacity as the founder and sole owner" of the trash disposal company, rather than for the benefit of the tank installment company.

The court found additional support for this potential inference based on the lease arrangement and the fact that the vehicle was at all times owned, operated and maintained by Ches-Mont rather than Miller Concrete.  These facts, explained the court, would allow a reasonable jury to infer that Koons was being sued in his capacity as an owned of Ches-Mont such that summary judgment in XL’s favor was inappropriate.  As the court stated, “[t]o conclude otherwise, we would have to hold that every reasonable jury would find that Koons had purchased the $136,000 trash disposal truck and provided it to the trash disposal company that he owned, without compensation, for reasons other than his ownership of the company. We are unwilling to do so.”

Eleventh Circuit Allows Consideration of Extrinsic Evidence

In its recent decision in American Safety Indemnity Co. v. T.H. Taylor, 2013 U.S. App. LEXIS 5072 (11^th Cir. March 14, 2013), the United States Court of Appeals for the Eleventh Circuit, applying Alabama law, had occasion to consider when and under what circumstances an insurer can rely on extrinsic evidence in determining whether a duty to defend is triggered.

American Safety insured T.H. Taylor under a commercial general liability policy.  T.H. Taylor had been hired as a general contractor to construct a residential home.  Prior to completion of the project, with approximately 20% of the project yet to be completed, the owners suspended construction.  As of that time, T.H. Taylor had been paid nearly the full value of the original budget.  T.H. Taylor and the owners were sued in several underlying lien actions filed by subcontractors and suppliers in Alabama state court.  In these suits, the owners asserted a cross-claim against T.H. Taylor, alleging a cause of action for fraud.  Specifically, the owners alleged that T.H. Taylor intentionally misrepresented the status of the construction project as well as how much the subcontractors and suppliers had been paid.  The cross-claim specifically alleged that T.H. Taylor made these representations, knowing them to be false, for the purpose of receiving an advance on a construction loan.

The state court dismissed the owners’ cross-claims on the basis of a provision in the construction contract requiring all disputes to be arbitrated.  The owners later commenced an arbitration proceeding against T.H. Taylor, but in doing so, the arbitration petition did not allege any specific causes of action, nor did it contain the specific assertions regarding T.H. Taylor’s intent to deceive.  Instead, the petition alleged only that T.H. Taylor presented requests for payment in an amount not equal to the work that actually had been performed.  American Safety took the position that the specific assertions in the cross-claims filed in state court precluded any finding of an “occurrence,” and that as such, it had no duty to defend.  T.H. Taylor, on the other hand, argued that American Safety could not look beyond the arbitration petition in determining whether it had a duty to defend.

The United States District Court for the Middle District of Alabama held in favor of American Safety, and on appeal, the Eleventh Circuit agreed.  The court noted that Alabama law requires that in determining a duty to defend, an insurer cannot rely solely on the theories of liability pled by a plaintiff, but instead must consider the specific factual assertions in a complaint.  If these factual assertions “could reasonably support a legal theory of recovery that is an insured risk under the policy, the insurer has a duty to defend the claim.”  The court further noted, however, that T.H. Taylor’s arbitration proceeding contained no specific legal theories or specific detail concerning the operative facts.  Under such circumstances, observed the court, Alabama law permits an insurer to look beyond the pleadings to examine other available evidence in determining a duty to defend.  As such, the court concluded that it was permissible for American Safety to have relied on the facts alleged in the underlying cross-claim in determining a duty to defend:

The principal determinant in a duty-to-defend inquiry is the state of the pleadings in the underlying litigation, and here, those pleadings did not cease to exist simply because of a change of forum from the state court to private arbitration. The arbitration proceeding was ordered by the court and was ancillary to the state court litigation. It constituted a continuation of the same dispute between the same parties arising out of the same facts. Additionally, even if the arbitration complaint is viewed as somehow displacing the owner's cross claim as well as the claims made by the plaintiffs in the state court litigation, such that the arbitration complaint became the principal pleading driving the duty-to-defend issue, those underlying pleadings in the state court would still be admissible evidence with respect to the proper interpretation to be made of the non-specific complaint in arbitration.

As such, and having agreed that the allegations in the cross-claims supporting a conclusion of intentional rather than accidental conduct, the Eleventh Circuit agreed that American Safety had no duty to defend. 

Alabama Supreme Court Holds PRP Letter Triggers Duty to Defend

In its recent decision in Travelers Cas. & Sur. Co. v. Ala. Gas Corp., 2012 Ala. LEXIS 174 (Ala. Dec. 28, 2012), the Supreme Court of Alabama addressed for the first time whether a PRP letter from the EPA qualifies as a “suit” for the purpose of triggering a duty to defend under a general liability policy.

The issue was certified by the United States District Court for the Northern District of Alabama, which presented the Supreme Court of Alabama with the following question:

Under Alabama law, is a 'Potentially Responsible Party' ('PRP') letter from the Environmental Protection Agency ('EPA'), in accordance with the Comprehensive Environmental Response Compensation and Liability Act ('CERCLA') provisions, sufficient to satisfy the 'suit' requirement under a liability policy of insurance?

The insured sought coverage under some forty years of general liability coverage issued during the 1940s through the 1980s.  The policies required the insurers to defend any suit alleging “injury, death, damage, or destruction and seeking damages on account thereof, even if such suit is groundless, false, or fraudulent.”  In October 2008, the insured received an informational request from the EPA.  The insurers took the position that the request for information did not rise to the level of a claim or suit triggering coverage under the policies.  In June 2009, after having informally identified the insured as the primary PRP, the EPA issued a formal PRP letter to the insured along with a draft Administrative Order on Consent.  The insured demanded a defense in connection with the PRP letter, which was denied on the basis that the letter did not qualify as a suit that would trigger a defense obligation.

Observing that the term “suit” was not defined in the policies, the court reasoned that the term must be defined “according to the meaning a person of ordinary intelligence reasonably would afford it in regard to the insurance contract at issue and the statutory and regulatory scheme that exists for the enforcement of applicable environmental laws, including the imposition of liability under those laws.”   Looking to case law throughout the country as well as expert commentary, the court sided with what it viewed to be the majority rule that a PRP letter does constitute a suit, citing to decisions such as those by highest courts of Michigan, Massachusetts and Nebraska in Millers Mutual Insurance Co. v. Bronson Plating Co., 519 N.W.2d 864 (1994); Hazen Paper Co. v. United States Fidelity & Guaranty Co., 555 N.E.2d 576 (1990) and Dutton-Lainson Co. v. Continental Ins. Co., 778 N.W.2d 433 (2010).

Central to the court’s holding was that in light of the EPA’s broad enforcement powers and “[g]iven the severe penalties for failure to cooperate and other enforcement tools available to the EPA, a decision by the EPA to designate an insured as a PRP cannot on any practical level be understood as anything less that the initiation of a ‘legal action’ constituting a ‘suit’ within the contemplation of the insurance contract at issue.”  Thus, reasoned the court, the term “suit” should not be limited only to matters that proceed in court, but instead should encompass broader legal actions and proceedings, such as regulatory proceedings under CERCLA.

Fifth Circuit Holds Negligent Drilling Did Not Result in Property Damage

In its recent decision in PPI Tech. Servs., L.P. v. Liberty Mut. Ins. Co., 2012 U.S. App. LEXIS 24571 (5^thCir. Nov. 29, 2012), the United States Court of Appeals for the Fifth Circuit, applying Texas law, had occasion to consider what damages qualify as “property damage” for the purpose of a general liability policy.

The insured, PPI, was hired by a lessor and operator of three oil leases located in Louisiana to oversee the drilling of well on a specified lease. The drilling resulted in a dry hole, which ultimately was filled in and abandoned. It was subsequently determined that PPI drilled the well on the wrong lease. PPI was later named as a defendant in two lawsuits as a result of this incident, both of which were referred to arbitration. In one of the arbitrations, claimants sought $4.2 million for PPI having drilled the well in the wrong location. In the other, claimants sought in excess of $700,000 in delay rentals to maintain the lease. Additionally, and presumably to trigger PPI’s insurance coverage, one of the arbitrations alleged that PPI’s actions caused“property damage” in the form of “physical injury to tangible property, including all resulting loss of use of the property.”

PPI was insured under a general liability policy issued by Liberty Mutual. Liberty’s policy contained a standard general liability definition of “property damage” encompassing:

a. Physical injury to tangible property, including all resulting loss of use of that property. All such loss of use shall be deemed to occur at the time of the physical injury that caused it; or

b. Loss of use of tangible property that is not physically injured. All such loss of use shall be deemed to occur at the time of the "occurrence" that caused it.

Liberty disclaimed coverage to PPI on the basis that the underlying arbitrations did not allege “property damage” resulting from an “occurrence.” Liberty argued that notwithstanding the reference to “property damage”in one of the arbitration petitions, the petition contained no specific allegations of physical injury to tangible property or actual loss of use. PPI argued, on the other hand, that the mere reference to “property damage” was sufficient to trigger a duty to defend.

The court rejected PPI’s contention, stating that it did “not consider mere use of the phrase ‘property damage’ and parroted Policy language as sufficient factual allegation.” Rather, explained the court, a claimant must identify actual property damage rather than simply allege that an insured’s activities resulted in physical injury to tangible property or loss of use thereof. “Hallow” and “cursory” allegations of “property damage” do not rise to the level of an allegation of actual property damage. The court therefore looked to the remaining allegations in the petitions, which it concluded were devoid of any allegations falling within the definition of “property damage,” such as “destruction from penetration or scorching from a blowout or fire,” or even constructive eviction caused to the owner of the lease on which the insured wrongly drilled. As such, and because the underlying petitions did not otherwise allege “loss of use,” the court agreed that there was no allegation of property damage that triggered Liberty’s duty to defend.

Illinois Federal Court Allows Consideration of Extrinsic Evidence

In its recent decision in Nautilus Ins. Co. v. Ricciardi Dev., LLC, 2012 U.S. Dist. LEXIS 161244 (N.D. Ill. Nov. 9, 2012), the United States District Court for the Northern District of Illinois had occasion to consider when and under what circumstances an insurer can rely on facts extrinsic to a complaint in evaluating whether it has a duty to defend.

The insured, Ricciardi Development was named as a defendant an underlying suit alleging that it negligently owned and maintained an apartment building in Chicago, Illinois, where a roof porch guard rail collapsed, causing plaintiffs to fall to the ground.   Among other things, it was alleged that Ricciardi has work performed on the porch rails that allowed for the accident.  Notably, the complaint alleged that the accident happened on May 24, 2009, and that Ricciardi owned and renovated the building sometime prior to that date.   The complaint did not allege a specific date on which such work was performed.

At the time of the accident, Ricciardi was insured under a general liability policy issued by Nautilus Insurance Company.  By endorsement, the Nautilus policy excluded coverage for bodily injury resulting from Ricciardi’s work completed prior to September 11, 2008 and specifically stated that Nautilus would have no duty to defend any claim alleging bodily injury arising out of Ricciardi’s work, or work completed for Ricciardi, prior to September 11, 2008.  Having learned from its own investigation that Ricciardi only owned the building only from 2000 through 2005, and thus could not have performed work subsequent to 2008, Nautilus filed suit against Ricciardi, seeking a judicial declaration that it had no duty to defend or indemnify on the basis of this exclusion.

On motion for summary judgment, the court agreed that the exclusion was clear and unambiguous, and thus applied to claims against Ricciardi involving work performed by or for it prior to September 11, 2008.  The underlying suit, however, did not allege the date on which various porch repairs were performed.  The court reasoned, therefore, that if it could only consider allegations contained in the underlying complaint, then Nautilus would have a duty to defend, explaining “[b]ecause September 11, 2008, the policy's cut-off date, is prior to May 24, 2009, the complaint alleges a claim that potentially could fall within the policy's coverage.”  The court further reasoned, however, that if it could rely on facts extrinsic to the complaint, then there was no potential for coverage since any work Ricciardi performed with respect to the porch necessarily was completed prior to 2005 when Ricciardi sold the premises.

The court observed the general rule of Illinois law, which is that an insurer may consider only the facts alleged in the underlying complaint in determining a duty to defend.   It noted, however, an exception to this rule applicable when an insurer elects to file a declaratory judgment action regarding its duty to defend.   Under such circumstances, explained the court, Illinois case law generally supports the proposition that consideration of such extrinsic facts is required except when these facts are central to the determination of an issue in the underlying suit.  Looking to these cases, the court concluded that:

… this court can and must consider the undisputed extrinsic evidence set forth by Nautilus—that Ricciardi sold the property on February 22, 2005, and completed the work on the porch and guardrail before then—in determining whether Nautilus has a duty to defend  Ricciardi and Development. There is no basis for concern that considering this evidence would "tend[] to determine an issue crucial to the determination of the underlying [state court] lawsuit." … Indeed, the opposing sides in the underlying suit unanimously agree in this case that Ricciardi sold the property in February 2005 or, at a minimum, that he did not own the property as of September 11, 2008. … If that fact were contested in or significant to the underlying suit, the opposing sides in that suit would not have agreed on that fact here.

Thus, concluding that consideration of extrinsic facts was permissible and that these facts were dispositive of the policy’s exclusion, the court agreed that Nautilus had no duty to defend.