D&O Insurers Take Note: U.S. Supreme Court Modifies the “Basic” Game

June 23rd, 2014

By Matthew M. Ferguson and Katelin O’Rourke Gorman, Sedgwick New York

Today, the U.S. Supreme Court issued a unanimous¹ decision in the securities fraud case, Halliburton Co. v. Erica P. John Fund, which was highly anticipated by many who follow the federal securities laws, including D&O insurers.  573 U. S. ____ (June 23, 2014). Although Halliburton expressly upheld Basic’s “fraud-on-the-market” presumption in order to satisfy the reliance requirement for a class of investors, Halliburton also held that defendants will be able to rebut this presumption earlier – at the class certification stage – with evidence that the misrepresentation did not, in fact, affect stock price.  Thus, while Halliburton does not scrap the fraud-on-the-market theory and its ability to satisfy reliance, as announced in Basic Inc. v. Levinson, 485 U. S. 224 (1988), Halliburton certainly changes the landscape as there likely will be additional costs incurred in connection with a defendant’s efforts to rebut the presumption of reliance at an earlier stage of the case; however, some classes may not be certified following those efforts.  Both of these issues may have implications for D&O insurers.

In its decision, the Supreme Court addressed whether to continue to apply the Basic holding, which permits securities fraud plaintiffs to establish a presumption of class-wide reliance for alleged misrepresentations based on the fraud-on-the-market theory. Under this approach, plaintiffs are not required to demonstrate each class member’s individual reliance on the alleged misstatements, based on the theory that securities markets operate efficiently, and thus the price of publically traded securities accurately reflects all publically available information about the traded company – including the impact of the “public material misrepresentations.”  Basic, therefore, enabled class plaintiffs to establish collective reliance on the misstatement(s) based on the market price of the security, and avoid individualized issues that could defeat class certification.  Prior to Halliburton, defendants were allowed to rebut the presumption at trial, but not at the class certification stage.

Petitioner Halliburton, the defendant in the underlying securities action, challenged the economic assumptions of the efficient market theory, which it believes have been “widely rejected” by economists since the Basic decision.  In its brief, Halliburton argued that Basic “was wrong when decided, and time has only made things worse.”  Halliburton argued that a securities plaintiff should be required to demonstrate that the “alleged misrepresentations actually affected the stock price” in order for a presumption of reliance to apply or, at the very least, that defendants should be allowed to rebut the presumption at the class certification stage with evidence establishing that “the misrepresentation did not distort the market price[.]”

The respondents argued that Basic is “well-settled[,]” has been cited repeatedly and favorably in recent Supreme Court securities decisions, and is essential to maintain and supplement the enforcement of the federal securities laws.  Respondents also contended that Congress considered, but flatly rejected, calls to overrule Basic when it enacted the PSLRA in 1995, and argued against an additional evidentiary step at the class certification stage, claiming that it would improperly and prematurely insert a merits inquiry into an otherwise preliminary stage of the litigation.  Respondents characterized such a move as incompatible with federal class certification rules, and other Supreme Court decisions on class issues.

Ultimately, the Supreme Court took a measured approach in rejecting the defendant’s outright calls to overturn Basic’s presumption of reliance, finding that there has not been a “fundamental shift in economic theory” to overrule a signature doctrine in securities-fraud laws.  However, the Halliburton Court seemingly agreed with Basic that the presumption was not conclusive, but rather rebuttable, in expressly empowering defendants with the ability to rebut plaintiff’s presumption of reliance at or before class certification.  (Halliburton at 22.) (“[Price impact] thus has everything to do with the issue of pre­dominance at the class certification stage.  That is why, if reliance is to be shown through the Basic presumption, the publicity and market efficiency prerequisites must be proved before class certification.  Without proof of those prerequisites, the fraud-on-the-market theory underlying the presumption completely collapses, rendering class certification inappropriate.”).  As a result, when plaintiffs seek to rely on the presumption, defendants will seek to rebut the presumption earlier. We expect the class certification stage to be even more contentious, with increased briefing, evidentiary submissions, and expert testimony/analysis to the trial court on the issue of price impact.

Clearly, Halliburton’s continued affirmance of Basic’s fraud-on-the-market presumption of reliance, while somewhat unsurprising based on the line of questioning during oral arguments that were heard in March, is nonetheless disappointing for directors, officers, and entity defendants (and their insurers), because it makes it easier for a plaintiff to claim class-wide reliance based on alleged misrepresentations.  The silver lining for defendants, however, is that they may now challenge the application of this presumption earlier, at the class certification stage.  While this presents an opportunity for defendants potentially to avoid class-wide liability, and may cause some cases not to be certified (a benefit to D&O insurers), it also may increase the cost of defending such matters earlier in the process.  Thus, Halliburton may create additional cost pressures for D&O insurers as there will be, among other things, additional expert and evidentiary efforts at the class certification stage to review the misrepresentations and any actual price impact.  Along with the potential long-term implications of the decision, insurers should also be aware that a number of securities cases stayed, pending a decision in Halliburton, will recommence in the short-term.
_____________________________________

¹ Roberts, delivered the opinion of the Court, in which Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan joined. Ginsburg, filed a concurring opinion, in which Breyer and Sotomayor, joined. Thomas, filed an opinion concurring in the judgment, in which Scalia and Alito, joined.

Not Feeling It: Court Nixes Claim for Feng Shui Fees and Finds No Bad Faith

June 17th, 2014

By Timothy Kevane, Sedgwick New York

In Patel v. American Economy Ins. Co., — F. Supp. 2d. —, 2014 WL 1862211 (N.D. Cal. May 8, 2014), the U.S. District Court for the Northern District of California granted the insurer’s motion for partial summary judgment, finding no coverage for the fees of a feng shui consultant, rejecting business losses outside the specified period, and concluding there was no bad faith.

The insured dental office suffered smoke damage due to a fire in the basement of premises it occupied.  Among other expenses submitted to its property insurer was a bill for $50,000 from its feng shui consultant who provided advice with respect to crystal replacements, energy balance restoration, furniture placement, and the alignment of Qi forces.  The court held that such expenses did not constitute a “direct physical loss” covered by the policy as they did not involve damage to tangible, material objects.  Furthermore, there was no evidence these expenses were incurred to minimize the suspension of the business and to continue operations (as a covered “extra expense”).  The court held that the extra expense provision was not rendered vague simply because it did not specifically exclude feng shui costs from coverage.

The court also rejected the insured’s supplemental claim for lost business income when it had to shutter its business in 2014 due to additional repairs to the building relating to the original fire, which occurred five years earlier.  The insured argued that the policy covered twelve months’ worth of lost income, and because it initially claimed only one month of lost income immediately after the fire, it remained eligible for another eleven months of coverage.  The court rejected this argument as the business income coverage was limited to the defined “period of restoration,” subject to the requirement that lost income must be sustained within twelve consecutive months from the date of loss.  The court found that it made no difference that restoration work may have resumed outside this limiting period.

Lastly, the court rejected the claim that the insurer disregarded in bad faith the insured’s need to relocate in 2014, citing the absence of any underlying contractual obligation to cover the 2014 lost income.

 

Second Circuit Vacates Judge Rakoff’s Rejection of SEC Settlement: Consent Decree “Fair and Reasonable” Even Without Admission of Wrongdoing

June 13th, 2014

By Katelin O’Rourke Gorman, Sedgwick New York

D&O insurers should be mindful of a recent development in the Second Circuit that could have implications for D&O insurers.  The developments stem from a key decision in the Southern District of New York in 2011.  On November 28, 2011, in a surprising and much-publicized decision, Judge Jed S. Rakoff refused to approve a consent decree jointly proposed by the SEC and Citigroup Global Markets.  See SEC v. Citigroup Global Markets Inc., 827 F. Supp. 2d 328 (S.D.N.Y. Nov. 28, 2011).  The consent decree required Citigroup to pay $285 million and refrain from future Securities Act violations after allegedly misrepresenting the company’s structuring and marketing of a billion dollar fund largely collateralized by subprime securities.  During the settlement hearing, Judge Rakoff asked, among other things, why the court should approve a consent judgment in which Citigroup neither admitted nor denied any of the “serious securities fraud violations” alleged by the SEC.  Apparently unpersuaded by the parties’ response, Judge Rakoff concluded that the proposed settlement was “neither fair, nor reasonable, nor adequate, nor in the public interest … because it does not provide the court with a sufficient evidentiary basis to know whether the requested relief is justified[.]”   According to Judge Rakoff, “when a public agency asks a court to become its partner in enforcement … the court, and the public, need some knowledge of what the underlying facts are[.]” Unsurprisingly, the SEC and Citigroup appealed.

 Last week, applying an “abuse of discretion” standard, the Second Circuit vacated and remanded Judge Rakoff’s decision.  SEC v. Citigroup Global Markets Inc., ___ F.3d ___, 2014 WL 2486793 (2d Cir. June 4, 2014).  Among other things, the Second Circuit concluded that it was “an abuse of discretion to require … that the SEC establish the truth of the allegations against a settling party as a condition for approving the consent decrees.”  As the court explained, “[t]rials are primarily about the truth.  Consent decrees are primarily about pragmatism. … It is not within the district court’s purview to demand cold, hard, solid facts, established either by admissions or by trials as to the truth of the allegations in the complaint as a condition for approving a consent decree.” 
 
Although the Second Circuit noted that other cases may require more of a showing (such as where a district court suspects a consent decree has been entered into as a result of improper collusion between the SEC and the settling party), such circumstances did not appear to be present here.  Indeed, the Second Circuit noted that Judge Rakoff, “with the benefit of copious submissions by the parties, likely had a sufficient record before it on which to determine if the proposed decree was fair and reasonable.”  Of course, if Judge Rakoff “deem[ed] it necessary” on remand, the Second Circuit noted he could ask the SEC and Citigroup to provide “additional information sufficient to allay any concerns … regarding improper collusion between the parties.” 
 
If Judge Rakoff’s decision had been affirmed, meaning that SEC consent decrees likely would need to include party admissions to the wrongful acts alleged, then the “personal profit” and/or “fraud” exclusions typically present in D&O policies would be triggered, as “final adjudication” language often incorporated into those exclusions would be satisfied.  D&O insurers’ exposure, therefore, would be significantly limited in such matters, with defense costs likely presenting the only exposure.  Thus, the Second Circuit’s reversal significantly blunts, if not outright kills, the immediate trigger of the personal profit and/or fraud exclusion(s) which could have been available to insurers had Judge Rakoff’s decision been affirmed. 

Despite potentially disarming the “personal profit” and “fraud” exclusions, the Second Circuit’s decision does not affect a typical D&O policy’s “loss” definition.  The amounts due from the insured in the usual consent decree, which include mostly fines, penalties, and disgorgement, arguably fall outside the typical “loss” definition.  As a result, while the Second Circuit’s decision may be disappointing to D&O insurers, other strong coverage defenses such as the definition of “loss” continue to be viable with respect to both consent decrees and any parallel civil actions that exist.

 

 

New York High Court Finds that New York Insurance Law §3420(d)(2)’s Prompt Notice Requirement Does Not Extend to Claims Limited to Environmental Damage

June 11th, 2014

By Martin L. Eide, Sedgwick New York

In KeySpan Gas East Corp. v. Munich Reinsurance America, Inc., et al., — N.Y.3d –, (N.Y. June 10, 2014), a case involving two environmental damage claims, the New York Court of Appeals reversed an appellate decision which found that three excess insurance carriers had waived their right to disclaim insurance coverage for failure to timely raise late notice as an affirmative defense, citing N.Y. Insurance Law § 3420(d)(2).

KeySpan arises out of the clean-up and remediation of two former manufactured gas plants (“MGP”) located in Bay Shore and Hempstead, New York which were operated by the Long Island Lighting Company (“LILCO”).  LILCO initially notified its excess insurance carriers of potential environmental liabilities in connection with the two MGPs and sought indemnification for environmental damages.  In response, the carriers issued broadly worded reservation of rights letters to LILCO, including the right to disclaim coverage based on late notice, and requested additional information regarding the MGP sites.  LILCO provided additional information to the carriers in compliance with their request for information, but the carriers did not issue supplemental coverage position letters. 

Later, LILCO filed a declaratory judgment action in New York state court seeking indemnity for damages arising out of the cleanup and remediation of the MGPs.  Each carrier answered the complaint and asserted late notice as an affirmative defense – this defense had not previously been asserted as basis for a coverage disclaimer.  On cross motions for summary judgment, the trial court found that the carriers had no duty to indemnify LILCO for the Bay Shore site because of LILCO’s late notice of an occurrence.  But, as to the Hempstead site, the court denied the carriers’ motion because the reasonableness of LILCO’s notice was a disputed issue of fact.  Further, the trial court rejected LILCO’s claim that the carriers’ late notice defense, as asserted for the first time in the answers to the complaint, was untimely.  Following this decision, KeySpan received an assignment from LILCO to pursue the MGP claims and was added as a party to the litigation.

On appeal, the Appellate Division, Second Department, modified the trial court’s order by vacating the declaration in favor of no coverage for the Bay Shore site, but otherwise affirmed the order.  In this regard, the Appellate Division noted that issues of fact existed regarding the carriers’ coverage investigation, including whether coverage disclaimers should have been issued to LILCO as soon as reasonably possible after LILCO provided additional information to the carriers as requested in their reservation of rights letters.         

The carriers appealed to the New York Court of Appeals regarding whether the Appellate Division incorrectly applied the timeliness standard under section 3420(d)(2) when considering whether defendants had waived their rights to disclaim based on LILCO’s late notice of the MGP claims. 

The Court of Appeals analyzed the plain language of section 3420(d)(2), its legislative history, and controlling New York case law interpreting the law, and held that the statute does not extend to environmental damage claims.  The court noted that “[t]he environmental contamination claims at issue in this case do not fall within the scope of Insurance Law § 3420 (d)(2), which the Legislature chose to limit to accidental death and bodily injury claims, and it is not for the courts to extend the statute’s prompt disclaimer requirement beyond its intended bounds.”  The court also mentioned, in a footnote, that certain cases that may have extended section 3420(d)(2) to apply to claims that were not based on death or bodily injury “were wrongly decided and should not be followed.”  See Estee Lauder Inc. v. OneBeacon Insurance Group, LLC, 62 A.D.3d 33 (1st Dep’t 2009); Hotel des Artistes, Inc. v Gen. Accident Ins. Co. of Am., 9 AD3d 181, 193 (1st Dep’t 2004), leave dismissed 4 N.Y.3d 739 (2004); Malca Amit N.Y. v Excess Ins. Co., 258 A.D.2d 282,282 (1st Dep’t 1999).

 

Illinois “Blasts” Non-TCPA Causes of Action Out of Coverage

June 10th, 2014

By Stephanie Sauvé, Sedgwick Chicago

In G.M. Sign, Inc. v. State Farm Fire & Cas. Co., 2014 IL App (2d) 130593 (May 2, 2014), the Illinois appellate court enforced a policy’s Violation of Statutes Exclusion endorsement to preclude coverage for a settlement arising out of an underlying blast-fax lawsuit that alleged various causes of action.

The underlying lawsuit was a class action in which G.M. Sign sued Michael Schane (“Schane”) and Academy Engraving Company for sending unsolicited fax advertisements. G.M. Sign asserted three causes of action in its amended complaint:  violation of the federal Telephone Consumer Privacy Act of 1991 (“TCPA”), conversion, and violation of the Illinois Consumer Fraud and Deceptive Business Practices Act.  The latter two counts made no express reference to the TCPA, but each count was based on the sending of unsolicited fax advertisements to G.M. Sign and others.  Schane later entered into a settlement agreement in which he stipulated to the entry of judgment against him for $4.9 million, to be satisfied with insurance proceeds.

Schane tendered the suit to his insurer, State Farm.  His insurance policy contained a Violation of Statutes Exclusion endorsement precluding coverage for property damage or advertising injury “arising directly or indirectly” out of any action or omission that violates or is alleged to violate the TCPA or any other statute that prohibits or limits the sending, transmitting, communicating, or distribution of material or information.  Citing this exclusion, the insurer denied coverage because the amended complaint alleged violations of the TCPA.

Thereafter, G.M. Sign filed a declaratory judgment action against State Farm claiming coverage under Schane’s policy.  On cross-motions for summary judgment, the trial court found that the insurer had a duty to defend and indemnify Schane, but the appellate court reversed.  The appellate court determined that the insurer had no duty to defend in connection with the amended complaint because the exclusion applied to all counts in the amended complaint.  The court reasoned that the proper analysis of the “arising out of” language in the Violation of Statutes exclusion is a “but for” analysis — if the alleged injury would not have occurred “but for” a violation of the TCPA, then the exclusion barred coverage for the alternative causes of action which arose from the same conduct underlying the alleged TCPA violation.

Look here for more Sedgwick articles related to insurance coverage for violations of the TCPA.

Washington’s Insurance Fair Conduct Act Does Not Apply to Liability Insurance Claims

June 7th, 2014

By Robert Meyers, Sedgwick Seattle

 On May 16, 2014, Judge Marsha Pechman of the U.S. District Court for the Western District of Washington dismissed an insured’s cause of action against his liability insurer under Washington State’s Insurance Fair Conduct Act (“IFCA”), declaring that an insured under a liability insurance policy does not have a right of action under IFCA.  Cox v. Continental Cas. Co., 2014 WL 2011238 *5 (W.D. Wash. May 16, 2014). The Court reasoned that only a “first party claimant” has a right of action against IFCA, and observed that a liability insurance policy is a “third-party” insurance policy, and the Washington Supreme Court consistently has recognized that there are material differences between first-party insurance and third-party insurance. It thus declared that an insured under a third-party liability policy does not have a right of action under IFCA.

This decision is notable, as it is the first decision in which a Washington judge has dismissed a cause of action against a liability insurer under IFCA on that basis.  In certain cases involving first-party insurance, Washington judges have opined that IFCA applies only to cases involving first-party insurance. However, in other cases involving third-party liability insurance, certain judges have summarily applied IFCA to those cases, without analysis and presumably without any briefing on the issue.

Although the decision is not binding precedent, it is well reasoned and should serve as highly persuasive precedent in future Washington suits. In turn, the decision should help to mitigate liability insurers’ exposure to an award of uncapped treble damages and reasonable attorneys’ fees under IFCA.

 The decision also may noteworthy consequences in insurance-related discovery disputes. In 2013, the Washington Supreme Court declared that it will presume that an insurer “in [a] first party insurance claim” may not assert the attorney-client privilege or work product protection in a bad faith lawsuit. Cedell v. Farmers Ins. Co. of Washington, 176 Wn.2d 686, 700, 295 P.3d 239 (2013).  Without analysis, and presumably without briefing on the issue, certain federal judges have applied the presumption in Cedell to bad-faith suits relating to third-party liability insurance.  That said, the distinction between first-party insurance and third-party insurance which Judge Pechman recognized in Cox for purposes of IFCA would seem to apply equally to a discovery dispute under Cedell.  Therefore, as a result of Judge Pechman’s decision, it is possible that Washington judges will be disinclined to apply Cedell in discovery disputes in bad-faith suits relating to third-party liability insurance.

District Court Seeks to Streamline Hurricane Sandy Insurance Cases Through Dismissals

June 6th, 2014

By Jeffrey Dillon, Sedgwick New York

Yesterday, in the In re Hurricane Sandy Cases, Civil Action No.: 1:14-mc-00041-CLP-GRB-RER, a committee of magistrates in the Eastern District of New York recommended that the district judges presiding over more than 150 lawsuits against insurance companies arising from Hurricane Sandy dismiss numerous state law causes of action and damages claims. The magistrates, who have been appointed to manage more than 1,000 civil actions arising from the hurricane, based their recommendation on prior rulings in Sandy-related cases that certain state law claims and types of damages are not cognizable under New York law. On February 21, 2014, the magistrates directed plaintiffs to voluntarily dismiss claims or damages not recognized by New York law, or submit letters to the Court explaining the legal basis for continuing to pursue such claims. Those plaintiffs who did not respond to the Court’s directive are now subject to the committee’s June 5th Report and Recommendation.

The committee’s recommendation is aimed at avoiding “wasteful and unnecessary” motion practice before the District Court in each of the individual Sandy-related cases, and to resolve claims that are not cognizable under New York law. Plaintiffs have 14 days from receipt of the Report and Recommendation to file objections with the Court or they will be deemed to have waived their right of appeal.

Among the state law claims to be dismissed are: (i) fraudulent misrepresentation and inducement – on the ground that plaintiffs have failed to allege the necessary elements of a legal duty owed by the insurer separate from its duty to perform under the policy and entitlement to special damages; (ii) breach of the implied covenant of good faith and fair dealing – on the ground that New York courts do not recognize a separate cause of action for breach of the implied covenant when a breach of contract claim is also pled on the same facts; (iii) bad faith denial of insurance coverage – on the ground that plaintiffs have not alleged conduct actionable as a tort, independent of the underlying insurance contract; and (iv) claims under Section 349 and 350 of New York General Business Law­ – on the ground that plaintiffs have not alleged injury independent of loss caused by an alleged breach of contract.

The committee also recommended the dismissal of demands for punitive damages, because plaintiffs have not identified that the insurers’ conduct was actionable as an independent tort, and any claims for attorney’s fees, which are not recoverable in actions against insurers to settle rights under a policy.

 

New York to D&O Insureds: “You Can’t Relate!” without Sufficient Factual Overlap

June 5th, 2014

By Matthew Ferguson, Sedgwick New York

In Glascoff v. OneBeacon Midwest Ins. Co., 2014 WL 1876984 (S.D.N.Y. May 8, 2014), the U.S. District Court for the Southern District of New York held that two claims – which seemingly contained allegations concerning deficient corporate structure, and lack of board oversight – did not share a sufficient factual nexus to be considered Interrelated Wrongful Acts to allow coverage for the second claim that was made post-policy period. The decision, which references several New York decisions on related claims, likely will make it more difficult to argue that claims are related absent specific factual circumstances common to both matters.

The claims were submitted by the former board of directors (the “Board”) of the insured, Park Avenue Bank (“PAB”), which was closed by state banking authorities and placed into receivership with the Federal Deposit Insurance Corporation (“FDIC”). Shortly after PAB’s closure, Charles Antonucci (“Antonucci”), PAB’s president, chief executive and a director, was arrested and charged with defrauding a federal bank bailout program and for self-dealing with PAB funds.

The initial claim, made during the policy period, involved FDIC demands against the Board alleging breach of fiduciary duty, negligence and gross negligence in connection with the failure of PAB (the “FDIC Claim”). The FDIC primarily alleged that the Board failed to supervise and conduct PAB’s business, and ensure compliance with banking regulations, focusing on PAB’s deficient internal and underwriting controls. The FDIC also generally asserted that the Board failed to act on allegations of improper conduct by Antonucci, which caused harm to the bank. PAB’s insurer, OneBeacon Midwest Insurance Co. (“One Beacon”), accepted the FDIC Claim for coverage under the D&O Policy (the “Policy”).

The second claim, made two years after the FDIC Claim and post-policy period, involved a lawsuit brought by investors under state securities laws, and sought control person liability against the Board and Antonucci (the “Securities Claim”). Plaintiffs alleged that Antonucci made false statements, misrepresentations, and omissions in inducing them to invest with PAB customers; however, the investments were used to fund Antonucci’s self-dealing. The Securities Claim also alleged “lax corporate oversight” by the Board, and PAB’s lack of “sound corporate governance.”

Following submission under the Policy, OneBeacon rejected the Board’s attempts to argue that the Securities Claim and FDIC Claim involved “Interrelated Wrongful Acts,” and denied coverage for the Securities Claim as made outside the policy period. In response, the Board initiated a suit against OneBeacon.

The District Court found that the relevant policy provisions were unambiguous, including the term “Interrelated Wrongful Act,” defined as “Wrongful Acts which have as a common nexus any fact, circumstance, situation, event, transaction or series of related facts, circumstances, situations, events or transactions.”  In reviewing a wide body of New York case law, the District Court determined that the “factual overlap…is tenuous at best,” and rejected the Board’s attempts to view the claims as arising out of the deficient corporate structure at PAB or the Board’s lack of oversight, finding that the Board’s conclusory allegations of similarity between the matters lacked factual support. The District Court noted that claims could theoretically have a sufficient factual nexus even though they involved different aggrieved parties and varied theories of liability, however, it ultimately held that there was not an adequate overlay here between the wrongful acts alleged in the two matters to consider them interrelated, and a single claim made during the policy period.

 

Is Defective Construction an “Occurrence”? More States Are Answering Yes

May 27th, 2014

By Aaron F. Mandel and Stevi A. Siber-Sanderowitz, Sedgwick New York

Last year, we examined the different approaches states have adopted to resolve whether defective construction by itself is an “occurrence” within the meaning of liability insurance policies.  See Is Defective Construction Work an “Occurrence”?  The Answer Isn’t So Concrete, Insurance Coverage Law Report (May 2013).  Since then, a number of states either have seen their highest courts depart from precedent by concluding that such claims satisfy the “occurrence” requirement, or have sought to pass legislation requiring liability policies to define “occurrence” to include faulty construction work.  Below is a summary of these developments, as well as a recommendation on how to address this trend.

The trendsetter appears to have been the West Virginia Supreme Court’s decision in Cherrington v. Erie Insurance Property & Casualty Co., 745 S.E.2d 508 (W. Va. 2013).  As previously reported on the Insurance Law Blog, that case involved a lawsuit arising out of defects at a newly constructed residential project.  Only the project itself suffered damage, and the builder’s liability insurer denied coverage on the ground that, among other reasons, allegations of defective construction do not constitute an “occurrence.”  This position aligned with several prior West Virginia Supreme Court decisions.  Ignoring precedent and stare decisis, the Cherrington court overhauled West Virginia law and held that the term “occurrence” in general liability policies includes defective construction.  The court reasoned that, by defining “occurrence” to mean “an accident,” all damages or injuries unintentionally caused by an insured fall within a liability policy’s insuring agreement.  The court supported its conclusion by noting that the “your work” exclusion implied damage to the insured’s work must be within the insuring agreement.  Otherwise, the exclusion would be meaningless.

Taking Cherrington’s lead, the North Dakota Supreme Court in K&L Homes, Inc. v. American Family Mutual Insurance Co., 829 N.W.2d 724 (N.D. 2013), also reversed course and held that defective construction may constitute an “occurrence” provided that the insured did not expect or intend the faulty work and resulting damage.  There, homeowners claimed their homes were damaged because of substantial shifting caused by improper footings and inadequately compacted soil under the homes’ footings and foundations.  After examining the standard general liability form’s drafting history and surveying cases nationwide, the court concluded that defective construction could qualify as an “occurrence” under the builder’s liability policy if the builder did not intend or expect the faulty work and the “property damage” was not anticipated or intentional.  Although the North Dakota Supreme Court previously had held that faulty or defective workmanship standing alone is not an “occurrence,”¹ the K&L Homes court explained its decision by noting that previous case law incorrectly distinguished between defective construction that damages only the insured’s work, and defective construction that damages a third-party’s work or property.  The court found there is nothing in the definition of “occurrence” which supports differentiating between the two types of damage.

Not to be outdone by its sister courts in West Virginia and North Dakota, the Alabama Supreme Court earlier this year reversed a decision less than six months old, and held that defective construction can qualify as an “occurrence” under a liability policy.  Specifically, in Owners Insurance Co. v. Jim Carr Homebuilder, LLC, the Supreme Court of Alabama held that an insured hired to build a house was not entitled to coverage for “property damage” or “bodily injury” (i.e., mental anguish) resulting from the insured’s defective construction.  No. 1120764, 2013 WL 5298575 (Ala. Sept. 20, 2013) (“Jim Carr I”).  On rehearing, the court withdrew its opinion in Jim Carr I and replaced it with a new decision that held defective construction could constitute a covered “occurrence” under a general liability policy if the damage was unintended.  Owners Ins. Co. v. Jim Carr Homebuilder, LLC, No. 1120764 (Ala. March 28, 2014) (“Jim Carr II”).  As the court explained, “the fact that the cost of repairing or replacing faulty workmanship itself is not the intended object of the insurance policy does not necessarily mean that, in an appropriate case, additional damage to a contractor’s work resulting from faulty workmanship might not properly be considered ‘property damage’ ‘caused by’ or ‘arising out of’ an ‘occurrence.’”  Because the policy did not define an “occurrence” in terms of the ownership or character of the property damage, the court concluded there was no basis for distinguishing between damages to the insured’s work and damage to third-party work.

New Jersey decided to take a different tack in addressing the “occurrence” issue.  On November 25, 2013, New Jersey State Assemblyman Gary Schaer introduced Bill No. A4510, which would have required liability policies issued, renewed, or delivered in New Jersey to define “occurrence” to include damages resulting from faulty workmanship.²  According to the bill’s interpretive statement, it required that “occurrence” be defined to address “both accidents and faulty workmanship” in order to remedy New Jersey case law that “varied in their holdings as to whether damage from faulty workmanship is accidental in nature and therefore within the definition of an occurrence.”³  Although the bill recently died in committee, its introduction demonstrates a continuing trend in states seeking to legislate the “occurrence” issue.  Laws addressing the “occurrence” issue are already on the books in Colorado, Arkansas, South Carolina, and Hawaii. See, e.g., Col. Code § 13-20-808; Ark. Code § 23-79-155; S.C. Code § 38-61-70; Haw. Stat. § 431:1-217.

The foregoing cases and proposed legislation demonstrate states’ willingness to compel liability insurers to cover risks they have not traditionally insured.  The foundation for this traditional rule is sound:  an insured can prevent damage to its own work simply by performing its work correctly.  In contrast, the reasoning behind compelling liability insurers to cover damage to an insured’s own work is shaky.  For example, courts concluding that defective construction work is covered under liability policies because there would otherwise be no reason for those policies to include the “business risk” exclusions ignore that construction defect claims often involve damage to an insured’s work and other third-party property.  The exclusions protect the insurer from having to insure uncovered damage (to the insured’s work) while preserving coverage for the covered damage (to the third-party property).  In other words, the “business risk” exclusions actually confirm that liability policies are not intended to cover damage to an insured’s work as opposed to suggesting that damage is covered in the first instance.

Despite the weak reasons courts and legislatures have cited to in compelling liability insurers to cover faulty workmanship,it is doubtful those courts and legislatures will revert back to leaving defective workmanship claims outside the realm of liability policies.  In that case, how should liability insurers respond?

Although case law and statutes declaring that defective construction qualifies as an “occurrence” within the meaning of liability policies generally leaves the policies’ “business risk” exclusions intact, we previously offered three potential responses in our earlier “Occurrence”? article:  (1) including more specific policy exclusions that eliminate coverage for “property damage” to an insured’s own work; (2) charging higher premiums for policies issued to entities engaged in the construction industry and/or issuing policies only in excess of significant self-insured retentions; or (3) refusing to issue policies to parties that perform construction work.  These options have drawbacks:  higher premiums would be passed along to project owners and developers (which would unnecessarily increase construction costs), significant self-insured retentions could limit the pool of insureds capable of performing construction work to only those that could absorb them (thus decreasing competition), and no longer affording liability coverage for construction projects may cause the construction industry to come to a screeching halt.

Absent a statute or declared public policy prohibiting insurers and their insureds from doing so, a fourth option could be that insurers specify in policies that defective construction is not an “occurrence.”  This would be the insurance equivalent of Newton’s third law (for every action, there is an opposite and equal reaction).

Limiting whether and to what extent faulty workmanship qualifies as an “occurrence” under liability policies would provide the greatest benefit to all involved:  not only would that preserve the intent of liability policies to respond only to third-party injuries caused by defective construction (such as a steel beam falling on a car or a crane collapsing onto an adjacent building), it would keep liability policy premiums down by ensuring damages to construction projects caused by faulty workmanship are addressed through traditional channels – namely, sureties.


¹  ACUITY v. Burd & Smith Constr., 721 N.W.2d 33 (N.D. 2006).

²  The proposed bill, however, noted that it was not intended to restrict or limit the “business risk” exclusions commonly found in liability policies.  In the ISO Form, the “business risk” exclusions include Exclusion j. (Damage to Property), Exclusion k. (Damage to Your Product), Exclusion l. (Damage to Your Work), and Exclusion m. (Damage to Impaired Property or Property Not Physically Injured).

³  Specifically, the bill cited to Pennsylvania National Mutual Casualty Insurance Co. v. Parkshore Development Corp., 403 Fed. App’x 770 (3d Cir. 2010) (applying New Jersey law and holding that a subcontractor’s faulty work that resulted in damage to the insured general contractor’s work was not an “occurrence”), and Firemans Insurance Co. of Newark v. National Union Fire Insurance Co., 387 N.J. Super. 434 (N.J. App. Div. 2006) (holding that faulty workmanship was not “property damage” caused by an “occurrence” under a typical general liability policy).

Lights Out for Policyholders Seeking Business Interruption Coverage Due to Loss of Electricity

May 19th, 2014

By Alex Shilliday, Sedgwick Dallas

Super Storm Sandy caused widespread power outages throughout the New York metropolitan area in late October 2012, rendering it impossible for many companies and firms to conduct business.  In Newman Myers Kreines Gross Harris, P.C. v. Great Northern Ins. Co., Civil Action No. 13-CV-2177 (S.D.N.Y. Apr. 24, 2014), a law firm with an office in New York, NY purchased a property insurance policy that included coverage for loss of business income and extra expense.  The policy provided coverage due to a business interruption “caused by or result[s] from direct physical loss or damage by a covered peril …” to the covered premises. On October 29, 2012, with the storm bearing down on New York City, the area’s electrical power servicer preemptively shut off the power to three utility service networks to preserve its equipment in the event of flooding.  The power interruption affected the law firm’s building, essentially closing it for five days. The firm filed a business interruption claim under its property policy, which the insurer denied because the law firm did not suffer a covered loss under the policy, and the law firm subsequently filed suit.

On the parties’ motion and cross-motion for summary judgment, the Southern District of New York held that preventive power outages rendering an office building unusable did not constitute “direct physical loss or damage” to the covered premises and, therefore, did not trigger coverage for loss of business income and extra expense under the property insurance policy.  The district court noted that a “direct physical loss or damage” to the covered premises was a condition precedent to coverage under the policy.

The law firm had argued that “direct physical loss or damage” did not require actual structural damage; rather, there only needed to have been a change to the covered premises from an initial satisfactory state into an unsatisfactory state caused by some external event.  The firm relied on case law from other jurisdictions, where courts applying other states’ laws found that an external event (such as an invasion of noxious or toxic gases, contamination of well water, and threat of imminent rockfall) rendering the premises unusable and uninhabitable constituted a “direct physical loss or damage” despite not being tangible, structural, or even visible. The district court distinguished those cases because each involved the closure of a building due to either a physical change for the worse, or a newly discovered risk to the physical integrity of the premises.  Conversely, the law firm’s building was closed after the decision was made to preemptively shut off power to preserve equipment at the power supply and distribution centers. The district court reasoned that the words “direct” and “physical” modified the phrase “loss or damage” and, therefore, connote a need for actual, demonstrable harm of some form to the premises in order to trigger coverage. The court found that the “forced closure of the premises for reasons exogenous to the premises themselves, or the adverse business consequences that flow from such closure,” did not constitute a “direct physical loss or damage” to the premises.  The district court held that the insured law firm failed to meet its burden of showing that the policy covered its losses and, therefore, granted the insurer’s motion for summary judgment and dismissed the case with prejudice.

The court’s holding reminds us that the phrase “direct physical loss or damage” in a property insurance policy should not be read so broadly as to include claims regarding mere loss of use of premises.  This case reinforces the requirement that there be a direct physical change for the worse to the premises, or a newly discovered risk to the physical integrity of the premises, in order to trigger loss of business income and extra expense coverage.  Without such “direct physical loss or damage” to the covered premises, the insured cannot meet its burden of proof to establish coverage.

Sedgwick Speaks
Sedgwick’s insurance attorneys regularly present to clients and other industry professionals on a wide range of topics. Click here to see a list of upcoming Sedgwick events and scheduled speaking engagements of our attorneys and here to see prior speaking engagements of our attorneys.

Our Firm
Sedgwick provides trial, appellate, litigation management, counseling, risk management and transactional legal services to the world’s leading companies. With more than 370 attorneys in offices throughout North America and Europe, Sedgwick's collective experience spans the globe and virtually every industry. more >

Search
Subscribe
Subscribe via RSS Feed
Receive email updates: