Another Victory for Arbitration: The UK Supreme Court

June 20th, 2013

By Mark Chudleigh, Sedgwick Bermuda

The United Kingdom’s highest court, the Supreme Court, has confirmed that English courts may intervene to issue an “anti-suit” injunction to restrain a party from bringing court proceedings in violation of an arbitration clause even if there are no arbitration proceedings in existence. This will be welcome news to the many insurers and reinsurers who incorporate London arbitration clauses into their policies, including carriers in the Bermuda market who frequently stipulate for coverage disputes to be resolved through arbitration in London under the English Arbitration Act 1996.   

The appeal arose out of a high value dispute involving the operation of a hydroelectric power plant in Kazakhstan and a concession agreement that provided for disputes to be arbitrated in London.  The owner of the plant issued court proceedings in Kazakhstan and obtained an order declaring the arbitration agreement invalid.  The operator then filed court proceedings in England seeking a declaration that the arbitration agreement was valid and enforceable and an anti-suit injunction to restrain the owner from continuing the Kazakhstan proceedings in violation of the arbitration clause. However, the operator chose not to file arbitration proceedings seeking any relief in relation to the concession agreement.

The English court granted both the declaratory and injunctive relief sought. The owner then appealed to the Supreme Court on the grounds that English courts have no jurisdiction to restrain foreign proceedings brought in violation of an arbitration clause where no arbitral proceedings have been commenced or are proposed.  In dismissing the appeal, the Supreme Court affirmed that the English courts have a long-standing and well-recognized jurisdiction to restrain foreign proceedings brought in violation of an arbitration clause even where no arbitration is on foot or in contemplation.

While the Supreme Court’s ruling is unlikely to come as a surprise to most arbitration practitioners, its unequivocal support of the arbitration process – even in light of a contrary ruling by a foreign court – will provide comfort to the many insurers and reinsurers who chose London as the venue for any arbitrations arising under their polices.  

Ust-Kamenogorsk Hydropower Plant JSC (Appellant) v AES Ust-Kamenogorsk Hydropower Plant LLP (Respondent) [2013] UKSC 35

California Court Holds That Broker’s Duties to Its Clients Did Not Extend to Loss Payee Investor

June 14th, 2013

By Daniel Dehrey*, Sedgwick New York

In Travelers Property Casualty Company v. Superior Court, 215 Cal.App.4th 561 (2013), the California Court of Appeal held that an investor who obtained ownership of a condominium development and sustained a loss that was not covered by the insurance policy purchased by the original developer had no remedy at law against the developer’s insurance broker because the broker owed no duty of care to the investor.

Joy Investment Group (Joy) obtained a construction loan from East West Bank (EWB) to develop a condominium building in Los Angeles.  The terms of the loan required Joy to purchase a construction insurance policy through broker Koram Insurance Center, Inc. (Koram).  Joy defaulted on the loan while the insurance policy was still in effect.  EWB thereafter sold the loan note and assigned its deed of trust to investor Michael Braum.  After the assignment, but before the foreclosure sale, Joy represented to Koram that a homeowners association had been created and, therefore, on Koram’s suggestion, Joy replaced its expiring construction policy with a condominium policy from Travelers for the homeowners association.  The policy contained a vacancy exclusion.

In February 2009, shortly after the Travelers policy was issued, the condominium building was vandalized.  Joy subsequently filed for bankruptcy and Braum foreclosed on the property.   In September 2010, Braum submitted a claim to Travelers for the purported vandalism loss but, because the building was not yet occupied, Travelers denied coverage due to the vacancy exclusion (which voids coverage if a structure is vacant for a defined period of time before the loss).

The Court of Appeal vacated the trial court’s denial of Koram’s and Travelers’ respective motions for summary judgment and instructed the court to grant the motions.  The Court of Appeal determined that the vandalism loss was not covered due to the vacancy exclusion, as there was no dispute that the building was vacant for 60 days prior to the loss.  The court also held that Koram, the broker, did not owe a duty to Braum, the investor, as a loss payee.  The court concluded that there is no general rule that a broker owes a duty to the victim (or loss payee) of an insured whenever a claim is denied pursuant to an exclusion or limitation for which the insured reasonably contracted.

*Not yet admitted to practice

Blood, Money & the Duty to Defend

June 13th, 2013

By Melissa L. Gardner, Sedgwick Dallas

In Peerless Indemnity Insurance Company v. Phillips, No. H-12-1145 (S.D. Tex. Apr. 17, 2013), the United States District Court for the Southern District of Texas granted in part and denied in part the insurer’s motion for summary judgment.  The court found that the insurer had no duty to defend a law firm and one of its partners for allegations of conversion and negligent defamation because the alleged injuries arose out of intentional statements made by the law firm partner with knowledge of their falsity.  The court, however, determined that the duty to indemnify was not ripe because the underlying lawsuit is still pending in state court.

In 2006, Michael Phillips of Phillips Akers Womac represented Dinesh Shah in a civil suit filed by Joan Johnson, an heiress to the Exxon fortune.  After Johnson won a substantial money judgment, Shah offered and Phillips accepted thousands of private documents that Shah had stolen from Johnson. Phillips ultimately used the stolen documents to write and publish a book entitled Monster in River Oaks, which describes Shah’s victimization of Johnson and her children (the Johnsons).  Consequently, the Johnsons filed suit against Phillips, his law firm, and the publishing company in Harris County, Texas.  The Johnsons alleged that Phillips intentionally converted the Johnsons’ property by depriving them of the stolen items, and published a multitude of defamatory statements causing injury.  The Johnsons further contended that Phillips’ defamatory statements were committed with gross negligence.

Phillips sought a defense from his insurer, Peerless Indemnity Insurance Company.  Peerless refused and filed a declaratory judgment action in which it moved for summary judgment on the grounds that the alleged property damage was not caused by an “occurrence” and the “knowledge of falsity” exemption excludes any damages resulting from “personal and advertising injury.”

Noting that the Peerless policy only covers property damage caused by an “occurrence,” which the Policy defines as an “accident,” the court found that the underlying petition did not support Phillips’ claim that he only used documents of public record to write the book.  Because the underlying petition alleged that Phillips intentionally deprived the Johnsons of their property, the court held that the property damage was not accidental and, therefore, not an “occurrence.”

In further analyzing whether the Peerless policy provided coverage for the Johnsons’ defamation claim, the court observed that, although the underlying petition may have stated a claim for negligence, the “knowledge of falsity” exemption applied because the petition made no factual contentions constituting negligent, careless, or reckless behavior.  Thus, Peerless had no duty to defend.

Nevertheless, the court denied Peerless’ motion as it related to the duty to indemnify.  The court explained that such a duty will turn on facts the Johnsons might actually prove in the underlying action.  Because the action is still pending, the court deferred resolution of the indemnity issues.   


Like a Rolling Stone – You Don’t Always Get What You Want

June 7th, 2013

By Carol J. Gerner, Sedgwick Chicago

On June 4, 2013, the Second Circuit Court of Appeals ruled in favor of excess insurers and against former directors and officers (collectively, the “Directors”) when it concluded that the excess insurers did not have to “drop down” based on the “plain language of the relevant excess insurance policies required the ‘payment of losses’ – not merely the accrual of liability – in order to reach the relevant attachment points and trigger the excess coverage.”  Ali v. Fed.  Ins. Co., No. 11-5000-CV, 2013 WL 2396046 (2d Cir. June 4, 2013). 

In an unusual procedural posture, the Second Circuit was asked to review a final judgment that resulted from a voluntary dismissal following the denial of the Directors’ motion for summary judgment.  After the Second Circuit concluded it had appellate jurisdiction to review the District Court’s decision, it addressed the merits of the “drop down” argument that the Directors raised when two of their excess insurers in an eight-layer insurance tower, Reliance Insurance Company (“Reliance,” which insured the first and fourth excess layers) and Home Insurance Company (“Home,” which insured the third and sixth excess layers), ceased operations and liquidated their assets.  

Federal Insurance Company (“Federal,” which insured the second and fifth excess layers) filed a declaratory relief action against the Directors in the Southern District of New York.  Federal sought a declaration that, under the terms of the relevant polices, it was not required to “drop down” to cover liability that would have otherwise been covered by Reliance and Home.  The Directors filed a counter-claim and also brought in the Travelers Casualty and Surety Company of America (“Travelers,” which insured the seventh excess layer), seeking a declaration that Federal’s and Travelers’ coverage obligations were triggered after the total amount of the Directors’ defense and/or indemnity obligations exceeded the limits of any insurance policies underlying their respective policies, regardless of whether such amounts were actually paid by the underlying insurance companies. 

Federal’s and Travelers’ policies provided that their coverage would only attach after the Underlying Insurance has been exhausted by “payment” of claims or losses.  The Second Circuit readily affirmed the District Court’s holding that the excess coverage was not triggered until the underlying insurance was exhausted “solely as a result of payment of losses,” and not solely by the “aggregation” of the Directors’ covered losses.  The Directors unsuccessfully argued that the excess liability coverage was triggered when “defense and/or indemnity obligations” reach the attachment point.  The Second Circuit did not have any difficulty concluding that “obligation” was not synonymous with “payments” of those obligations.  It also noted, however, that the District Court did not specify which party was obligated to make the requisite payment because that issue was not raised by the Directors in the underlying proceeding. 

Significantly for insurers, the Second Circuit did not find persuasive the Directors’ reliance on the oft-cited decision in Zeig v Massachusetts Bonding & Insurance Co., 23 F.2d. 655 (2d Cir. 1928) and related cases, addressing situations in which policies were deemed exhausted as a result of an insured’s below-limit settlement of indemnity claims.  While not overruling Zeig, the Second Circuit found that the Directors neglected to address the critical distinction that Zeig involved a first-party property insurance policy as opposed to an excess liability policy.  The Second Circuit agreed with the District Court that the Directors’ requested relief, which focused on their obligations to pay third parties as opposed to seeking indemnification for out-of-pocket losses, was a relevant distinction for purposes of policy interpretation. 

While a favorable decision for insurers, the Second Circuit did not address the ramifications of the “drop-down” argument when payment is made by someone other than an insolvent underlying excess insurer.  The Second Circuit did, however, note the District Court’s observation that the relevant excess insurance policies contemplated continued coverage even if the Directors failed to maintain the underlying policies.   Accordingly, whether payment by someone other than a nonoperational insurance company will trigger attachment will depend upon the specific language of an excess policy.

Tenth Circuit Applies Broad Interpretation Of “Interrelated Wrongful Acts” Under New York Law

June 6th, 2013

By Sean R. Simpson, Sedgwick Irvine

In Brecek & Young Advisors, Inc. v. Lloyds of London Syndicate 2003, ___F.3d ___, 2013 WL 1943338 (10th Cir. (Kan.) May 13, 2013), the United States Court of Appeals for the Tenth Circuit broadly applied the definition of “Interrelated Wrongful Acts” commonly found in errors and omissions and directors and officers liability policies and held that, under New York law, numerous unsuitability claims constituted a single claim first made prior to inception of the policy.

In May 2007, Paul and Marie Wahl brought an arbitration proceeding against Brecek & Young Advisors, Inc. (BYA), alleging that the Wahls received financial advice from B&G Financial Network, Inc. (B&G).  BYA acted as the broker-dealer through which B&G sold the Wahls several of its investment products.  The complaint alleged that the Wahls were sold unsuitable investments and that BYA engaged in the frequent “flipping” and “churning” of the investments.  The Wahls amended their complaint to add additional claimants who similarly alleged unsuitability and flipping/churning. 

Lloyds of London Syndicate 2003 (Lloyds), which issued a professional liability policy to BYA, agreed to defend BYA, but asserted that each of the claimants in the Wahls action presented a separate Claim, subject to a separate $50,000 retention, pursuant to the following policy provision: “All Claims based upon or arising out of … Interrelated Wrongful Acts shall be considered a single Claim…”  The phrase “Interrelated Wrongful Act” was defined as Wrongful Acts that are, inter alia, “connected by reason of any common fact, … or one or more series of facts…” 

BYA sued Lloyds and the district court granted summary judgment for BYA.  The court held that the Wahls’ arbitration constituted a single claim, but permitted supplemental briefing on an alternative position raised by Lloyds as to whether the Wahls’ action and earlier claims brought by investors Knotts and Colaner in 2005 and 2006 constituted a single claim first made prior to inception of the Lloyds policy.  BYA argued that the claims were not sufficiently related and that Lloyds’ argument was precluded by the doctrines of waiver or estoppel.  The court rejected the waiver/estoppel argument, but held that the Wahls matter was not related to the earlier Knotts and Colaner claims.

On appeal, the parties agreed that the principle issue on aggregation of the claims was whether there existed a “sufficient factual nexus” between the claims.  Emphasizing that “Wrongful Acts” are interrelated if they are “connected by reason of any common fact,” the Tenth Circuit concluded that there were “several common facts” connecting all of the claims, including:  they named the same respondents, they alleged misconduct occurring in the same general time period, they alleged that the respondents had been sold unsuitable investments, they involved allegations of flipping or churning, and they were predicated by BYA’s liability on theories of vicarious liability and failure to supervise.  As such, the Tenth circuit concluded that the Wahls, Knotts and Colaner matters constituted a single “Claim” under the policy.  In addition, although the court rejected BYA’s waiver argument on the basis that coverage under an insuring clause or the application of exclusions from coverage cannot be waived, it held that the district court abused its discretion in ruling that that BYA could not establish estoppel, and thus  the case was remanded so that the district court could  consider the extent to which BYA detrimentally relied on Lloyds’ representations of coverage.


Failure to Provide Timely Notice Proves Costly For Insured

June 5th, 2013

By John S. Na, Sedgwick Los Angeles

A federal district court in Missouri granted insurer Philadelphia Indemnity Insurance Company’s Motion for Summary Judgment in a coverage dispute finding that the insured, Secure Energy, Inc., did not provide timely notice of a claim as required under the D &O Policy.  In Secure Energy, Inc. v. Philadelphia Indemnity Insurance Company, case number 4:11-cv-01636 (E.D. Mo. May 16, 2013), the court found that not only did Secure Energy wait too long before reporting the claim, but also that the insurer did not have to demonstrate it was prejudiced by the late notice.

Secure Energy was insured under several D&O policies issued by Philadelphia between October 11, 2007 and October 11, 2012, which provided coverage on a “claims made” basis.  The policies required that Secure Energy provide notice to Philadelphia of all claims as soon as practicable but no later than 60 days after the expiration of the policy.  On December 20, 2007, Secure Energy received a memorandum from a former employee seeking payment of unpaid commissions totaling $1,800,000.  On May 16, 2008, the former employee filed suit against Secure Energy seeking his commission plus $2,000,000 in punitive damages.  Secure Energy’s first notice to Philadelphia was on May 4, 2011.  Philadelphia denied Secure Energy’s tender on the ground that the notice was untimely.  Secure Energy filed suit seeking a declaratory judgment that Philadelphia was obligated to provide coverage for the defense and indemnity costs incurred in the former employee’s lawsuit.

Secure Energy argued that, although it did not strictly comply with the notice requirement under the D&O policies, Philadelphia could not deny coverage unless it first established that it was prejudiced by the late notice.  In support of its position, Secure Energy cited to a number of decisions in Missouri which held that under an “occurrence” policy the insurer must first demonstrate that it was prejudiced by the insured’s late notice.  The federal district court rejected Secure Energy’s argument, finding that the Missouri Supreme Court distinctly held that an insurer is not required to show prejudice resulting from an untimely notice under a “claims made” policy.  In reaching its decision, the court noted that, unlike an “occurrence” policy where the occurrence of an act or omission during the coverage period triggers coverage, a “claims made” policy provides coverage when the act or omission is discovered and brought to the attention of the insurer, regardless of the occurrence date.  Because there was no question that Secure Energy failed to provide timely notice, the court held that, under Missouri law, Philadelphia was not required to demonstrate that it was prejudiced by the late notice.

California Insurance Code Section 533.5(b) Does Not Preclude Insurers From Providing A Defense For All Criminal Actions

June 5th, 2013

By Andrea M. Kendrick, Sedgwick San Francisco

In Mt. Hawley Ins. Co. v. Lopez, –Cal. Rptr. 3d–, 2013 WL 1818627 (Cal. App. 2 Dist. May 1, 2013), a California court of appeal held that California Insurance Code section 533.5(b) does not preclude insurers from providing a defense for all criminal actions, and the statute does not apply to criminal actions brought by federal prosecutors.  Section 533.5(b) precludes insurers from providing a defense for criminal actions brought under California’s unfair competition and false advertising laws—commonly referred to as UCL and FAL actions—by the four state and local agencies listed in the statute.

California Insurance Code section 533.5(b) provides:

No policy of insurance shall provide, or be construed to provide, any duty to defend, as defined in
subdivision (c), any claim in any criminal action or proceeding or in any action or proceeding brought
pursuant to Chapter 5 (commencing with Section 17200) of Part 2 of, or Chapter 1 (commencing with
Section 17500) of Part 3 of, Division 7 of the Business and Professions Code in which the recovery of a fine,
penalty, or restitution is sought by the Attorney General, any district attorney, any city prosecutor, or
any county counsel, notwithstanding whether the exclusion or exception regarding the duty to defend
this type of claim is expressly stated in the policy.

The United States District Attorney filed a grand jury indictment against Dr. Richard Lopez, charging him with criminal conspiracy, false statements and concealment, and falsification of records.  The indictment alleged that Dr. Lopez, who was the medical director of St. Vincent’s Medical Center Comprehensive Liver Disease Center, conspired with another doctor and other hospital employees to transplant a liver into the wrong patient.

Dr. Lopez tendered his defense to Mt. Hawley under the hospital system’s Not for Profit Organization and Executive Liability Policy.  Under the terms of the policy, Mt. Hawley agreed to pay for Loss which the Insureds are legally obligated to pay as a result of Claims.  An endorsement defined “Claim” to include “a criminal proceeding against any Insured commenced by the return of an indictment” or “a formal civil, criminal, administrative or regulatory investigation against any Insured . . . .”

Mt. Hawley alleged it had no duty to defend Lopez for reasons that included the application of section 533.5(b).  The court noted that no California court had addressed the issue raised by the appeal of whether section 533.5(b) precludes an insurer from providing a defense in all criminal actions, including federal criminal actions.  The court determined the statute was ambiguous and reviewed its legislative history.

The court concluded that the Legislature enacted section 533.5 to address a problem the Attorney General had encountered only in UCL and FAL—the defendants would tender the defense of the actions to insurers and the public entity found itself litigating with an insurance company instead of the individual whose conduct violated the provisions of the Business & Professions Code.  “The legislative history of the original 1988 statute and the 1990 and 1991 amendments makes it clear that the purpose of the statute, the circumstances of its enactment, and the Legislature’s goal in enacting the statute, were to preclude insurers from providing a defense in civil and criminal UCL and FAL actions brought by the Attorney General, district attorneys, city attorneys, and (later) county counsel.”  According to the court, at no time did the Legislature ever intend section 533.5(b) to apply to criminal actions other than UCL and FAL actions brought by state and local agencies or to apply to criminal actions brought by public entities other than the three and then four enumerated state and local agencies, such as criminal actions brought by the federal prosecuting authorities.

The court noted its interpretation of section 533.5 allows insurers to contract to provide a defense in federal and some state criminal actions.  While it is true that California law recognizes a strong public policy of discouraging certain types of conduct by barring insurance coverage for any resulting damages, that public policy applies to indemnification, not defense.

Duty To Defend Limited to Theories Pled In Complaint

May 29th, 2013

By Arthur Aizley, Sedgwick New York

In most states, including Michigan, the duty to defend is not limited to the four corners of the complaint and the insurer must look behind the allegations asserted against the insured to determine whether there is a potential for coverage. See, e.g., American Bumper and Mfg. Co. v. Hartford Fire Ins. Co., 452 Mich. 440, 550 N.W.2d 475, 481 (Mich. 1996).  As a result of the application of this principle, it may be difficult to obtain summary judgment on the duty to defend.  A recent decision from the Eastern District of Michigan takes a more restrictive view, which may prove helpful to insurers.  Certified Restoration Drycleaning Network, LLC v. Federal Ins., 2013 WL 1629291 (April 16, 2013, E.D. Mich.).

The Certified Restoration case involved a franchisor/franchisee dispute and a general liability policy issued to the franchisor which excluded claims “based upon, or arising from, or in any consequence of” any breach of contract.  The underlying complaint included causes of action for breach of  the franchise agreement and breach of the duty of good faith and fair dealing, but also included two paragraphs alleging that the franchisor made misrepresentations.  After the insurer initially denied coverage, the franchisor and franchisee executed a settlement agreement specifically averring pre-contract misrepresentations.  The pre-contract misrepresentations were also discussed in a deposition.

Reasoning that the duty to defend depends only on the allegations of the complaint, and that the complaint alleged only breach of contract, the District Court ruled that the settlement agreement and deposition testimony were “immaterial” to the duty to defend.  Id. at *6.   The District Court also analyzed the alleged facts and concluded that there was “no doubt” that the basis of the alleged injuries arose from the alleged breach of the franchise agreement, and not the alleged misrepresentations.  Id.

There is No Coverage for Fighting in Alaska, Seriously

May 20th, 2013

By Smita Mokshagundam, Sedgwick Chicago

Late last month, the Supreme Court of Alaska affirmed the lower court’s decision in favor of an insurance company that denied coverage to insured, Kent Bearden, for liability in a civil suit filed by the victim of his assault. His insurer argued that, as Mr. Bearden had previously pleaded no contest to the related criminal disorderly conduct charge, the elements of which established he was not acting in self-defense, no coverage was available under the policy.

In Bearden v. State Farm Fire & Cas. Co., No. S-14345, 2013 WL 1777442 (Sup. Ct. Alaska April 26, 2013), the issue presented was whether the insured was collaterally estopped from relitigating the essential elements of a disorderly conduct charge so as to bring a later-filed civil suit within the scope of his homeowner’s insurance policy. The assault occurred when Mr. Bearden punched a man, with whom he had a history of nonviolent confrontations, after the man told him that, “he would like to kick [Mr. Bearden’s] ass.” Mr. Bearden was charged with assault and use of reckless force. He ultimately pleaded no contest to Disorderly Conduct, which makes it unlawful to knowingly challenge another to a fight or to engage in fighting other than in self-defense.

After paying the court ordered fine and serving 5 days in jail, he was sued civilly by the victim of the assault. Mr. Bearden sought a defense and indemnification from his homeowners policy which provided coverage, in relevant part, for damages caused by an “occurrence,” defined as an accident that is not expected or intended and is not the result of willful and malicious acts. Not surprisingly, his insurer denied coverage on the basis that there was no “occurrence” alleged, and because Mr. Bearden’s no contest plea established as a matter of law that his conduct was expected, intended and he acted willfully and maliciously.

Although Mr. Bearden claimed in response to the civil suit that he was acting in self-defense, the court found that he was collaterally estopped from arguing self-defense, having already pleaded no contest to disorderly conduct. Mr. Bearden argued that the three-part test previously articulated by the Alaska Supreme Court for determining when a no-contest plea can be used to collaterally estop a civil defendant from relitigating an issue was not met. The required showing is that the offense to which the defendant pleaded no contest was “serious,” he was afforded a full and fair hearing, and the issue was previously decided.

In this regard, Mr. Bearden argued at length that the offense to which he pleaded no contest was not “serious,” because his jail time was minimal and only a fraction of what he could have been received. The court was not persuaded, finding that although he only served five days, offenses punishable by imprisonment are deemed serious. Mr. Bearden also argued that he was not given a fair hearing, because he was not explicitly advised that in pleading no contest he would lose insurance coverage. This argument was summarily rejected. Finally, Mr. Bearden argued that the issue of whether he acted in self-defense was not previously decided because he admitted nothing by entering a no-contest plea. However, the court agreed with the insurer’s reasoning that the issues of self-defense and the state of Mr. Bearden’s mind were decided as part of the no contest plea, as the definition of disorderly conduct offense, to which he pleaded no contest, includes a knowing element, as well as the element that the fight was not in self-defense.


First Circuit Permits Insurer to Retain Policy Premiums Despite Rescission

May 15th, 2013

By Aaron F. Mandel, Sedgwick New York

Courts often require insurers to return premiums (or at least offer to return them) when rescinding an insurance policy.  Some states may even require it under statute.  The reason is that rescission is an equitable remedy intended to place the parties in the same position they were before the policy was issued, and the insurer obviously does not receive any premiums until the policy is issued.  On Monday, the U.S. Court of Appeals for the First Circuit rejected this general rule and determined that an insurer was entitled to retain premiums as special damages when it seeks to rescind an insurance policy based on rampant fraud.

In PHL Variable Insurance Co. v. P. Bowie 2008 Irrevocable Trust, No. 12-2243, 2013 WL 1943820 (1st Cir. May 13, 2013), an insurance broker (“Rainone”) and an attorney acting on behalf of a trust (“Baldi”) submitted an application on behalf of Peter Bowie seeking a $5 million life insurance policy naming the trust as the beneficiary.  The application stated that Bowie had an annual salary of $250,000, and a personal net worth of approximately $7.5 million.  Rainone and Baldi represented that the policy premiums would not be paid by any third-party, the policy was not being purchased as part of any program to transfer the policy to a third-party within the first five years, and neither Bowie nor the trust had any agreement for any other party to take legal or equitable title to the policy.  Bowie confirmed this information to a third-party inspector working for PHL, and PHL issued the policy. 

The representations made by Rainone, Baldi, and Bowie were false.  Bowie turned out to be a retired city worker, used car salesman, and blackjack dealer who did not have a personal net worth anywhere near the $7.5 million he, Rainone, and Baldi claimed.  Bowie also could not personally afford the policy’s premium.  The premium was actually being paid by a company (“Imperial”) “whose business model consists of lending money to pay for life insurance policy premiums and, when borrowers default on those loans, taking possession of the policies as collateral”; indeed, Imperial’s loan terms made its loans virtually impossible to pay back.  A subsequent amendment to the trust documents provided that the policy would be assigned to Imperial if its loan was defaulted on and, if PHL rescinded the policy, any premiums refunded to the trust would be delivered to Imperial.

PHL eventually discovered the scheme and filed an action against the trust in the U.S. District Court for the District of Rhode Island seeking to rescind the policy.  PHL also sought to obtain the premiums paid in order to offset the damages it suffered in connection with issuing the policy.  These included costs to underwrite and issue the policy, payment of commissions and fees in connection with issuing and servicing the policy, costs incurred to investigate the scheme, and costs to initiate its rescission action.  Alternatively, PHL advised that it was ready, willing, and able to refund the premiums if the court required it to do so, and tendered the premium into the court’s registry.

Resolving cross-motions for summary judgment filed by PHL and the trust, the court determined that the sole issue was whether PHL was required by law to return the premiums, or if the court’s equity powers enabled it to permit PHL to retain the premiums as special damages.  The court determined that it could permit PHL to retain the premiums, and the trust appealed.  The First Circuit affirmed. 

Initially, the court rejected the trust’s argument that Rhode Island case law required an insurer to return premiums when seeking to rescind an insurance policy.  The court instead determined that the case law “do[es] not stand for such a broad and inflexible proposition,” and focused on equity principles that Rhode Island law permits courts to consider in attempting to make whole a party defrauded into entering a contract.  Those principles include: (1) rescission seeks to create a situation the same as if no contract ever existed; (2) parties should gain no advantage from their own fraud; and (3) a court in equity can grant all relief necessary to make the aggrieved party whole so long as it is permitted by the pleadings.  Because it concluded that PHL was deceived into issuing the policy as the result of a conspiracy, the First Circuit determined that:

these equitable principles provide ample support for the district court’s decision to make PHL whole by allowing it to retain the premium.  PHL paid a commission to Rainone of $172,365 that it would not have paid but for the misrepresentations that led it to issue the Policy.  Mere rescission of the contract would not have compensated PHL for this expense.  While PHL apparently did not provide a precise accounting of the other costs in incurred with respect to the Policy, it was reasonable for the district court to conclude that the costs alleged in PHL’s complaint — including underwriting, administration, and servicing of the Policy, as well as investigation into the misrepresentations in the application — justified awarding PHL the remaining $19,635 from the premium, particularly in light of the Trust’s fraud.

Although insurers generally are permitted to rescind policies only when there is no other adequate remedy at law, PHL Variable acknowledges that even permitting an insurer to rescind may not make it whole.  Rescission by itself does not compensate the insurer for all of the costs necessary to issue a policy, and even qualifying those costs as “overhead” does not acknowledge the insurer’s lost opportunity costs.  Accordingly, unless a statute or case law absolutely requires an insurer to return premiums in order to rescind its policy, insurers should consider their right to retain premiums as special damages.

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