The D&O E&O Monitor - Monitoring Issues and Trends in Directors & Officers and Errors & Omissions Liability and Coverage.

In Isilon Systems, Inc. v. Twin City Fire Ins. Co., Case No. C10-1392 (W.D. Wash. April 10, 2012) [see here], the Court handed down what some may view as a surprising ruling upon the defendant excess insurer’s Motion for Partial Summary Judgment.

The underlying facts are rather straightforward. The excess insurer attached with a policy limit of $5 million excess of $20 million underlying limits.[1] The claim at issue was one brought by the SEC against a former CFO of the insured company. It was resolved with an award of injunctive relief, but with the incurrence of significant defense expenses estimated at about $5 million in excess of the $20 million underlying limits. The company paid these defense expenses by way of its indemnification obligations to the former CFO and sought reimbursement from the insurer before the underlying limits were fully exhausted.

The insurer denied coverage on the basis that the CFO had knowledge or information that could lead to a claim at the time the application for the policy was completed. It based its coverage determination upon documents provided by the company to the SEC. The company then brought the instant litigation against the insurer challenging its denial of coverage. A few months later, the insurer withdrew its denial and stated that it would pay its $5 million limit as soon as it received proof of exhaustion of the underlying limits. The insurer in fact paid the $5 million after receiving proof of the exhaustion of the underlying policy.

End of story and all lived happily ever after?

Noooooo!

Among the company’s claims in its lawsuit against the insurer were ones based on the following.

• Violation of Washington’s Consumer Protection Act (“CPA”)
• Breach of the insurance contract
• Breach of an implied covenant of good faith and fair dealing (the bad faith claim)
• Violation of Washington’s Insurance Fair Conduct Act (“ICFA”)

First, the court granted summary judgment to the insurer on the CPA claim because the company could not establish an injury once the insurer performed under the contract by paying its limits at the time it was first obligated to do so. Likewise, the insurer was also granted summary judgment on the breach of contract claim for essentially the same reasons.

So far, so good, at least from the insurer’s perspective. But, here is where it gets interesting.

The Court declined to grant summary judgment on the bad faith claim. Applying Washington law, the Court held that there remained an issue of whether, at the time of the application, the former CFO had subjective knowledge of facts that might give rise to a claim. The Court found that the insurer did not establish its good faith because, at the time of the denial, it was open to question, at least on an objective basis, whether the former CFO had in fact violated the prior knowledge warranty question on the application.[2] The Court also declined to grant summary judgment on the statutory ICFA claim based on the same reasoning.

Dependent upon what may transpire in continuing litigation at the trial level or upon any appeal that might be taken, this case stands for the proposition that an insurer may still have a bad faith exposure grounded in its initial denial of coverage, even after it pays its full policy limits when first contractually obligated to do so.

[1] It appears that the policy may have been an excess Side A DIC, but whether it was of that variety or a follow form excess is of no moment to the Court’s decision and reasoning.

[2] The Court’s Opinion does not indicate whether it was this former CFO who signed the application.

One of the oldest and most frequently cited cases in the annals of insurance jurisprudence is Zeig v. Massachusetts Bonding & Ins. Co., 23 F.2d 665 (2d Cir, 1928).  In very short summary, arguably applying New York law to particular excess policy language and a discrete set of underlying facts, Zeig held that the excess policy at issue was attached by allowing the insured to fill in any gap in coverage because the underlying insurer failed to pay its full limit of liability.

A number of jurisdictions in decisions over the past several years have declined to follow Zeig,[1] instead holding that the excess policy at issue does not attach until all of the underlying insurance is exhausted by actual payment of the full policy limits by those insurers.

In a very recent decision, however, Maximus, Inc. v. Twin City Fire Ins. Co., 2012 U.S. Dist. LEXIS 32970 (E.D. Va. March 12, 2012),  a Virginia federal court elected to follow Zeig despite no compulsory reason to do so and no indication that New York law was even applicable.[2]

As typical in these cases, Maximus involved a settlement that did not fully exhaust the underlying insurers’ limits by actual payment from those insurers.  Arguably, the insured Maximus had stepped in to fill any gaps. The key excess policy language provided as follows.

[The Policy] shall apply only after all applicable Underlying Insurance with respect to an Insurance Product has been exhausted by actual payment under such Underlying Insurance, and shall only pay excess of any retention or deductible amounts provided in the Primary Policy and other exhausted Underlying Insurance. (emphasis added)

The Court inexplicably (in my opinion) found this language ambiguous, despite the presence of “actual payment” language so essential to the excess insurers prevailing in many of the cases cited in Footnote 1.

The explanation offered by the court was the following.

[The Policy] conspicuously lacks a definition of ‘actual payment under such Underlying Insurance’.  It neither states that actual payment requires payment of the full limit of an underlying policy by the lower-tier carriers, nor does it expressly preclude the insured from filling the gap to exhaust the underlying policy.

The Court recognized that JP Morgan was decided in favor of the excess insurer where there was substantially identical language.  Nonetheless, the Court noted that JP Morgan was not decided under Virginia law and thus of no binding precedential value.

Assuming this decision is not reversed on appeal, has not the Court at least provided an opinion as to how to “fix” the problematic policy language?  Indeed, the Court recognized that these policy provisions can be written unambiguously so “as to overcome the public policy concerns articulated in Zeig.”[3]

However, as I have stated before in this space, coverage decisions like Maximus may soon become little more than a tempest in a teapot.  That is because most excess policy language has evolved to allowing for payments from the insured and other sources to be recognized in exhaustion of underlying limits.

[1] See, e.g., Citigroup Inc. v. Federal Ins. Co., 649 F. 3d 367 (5^th Cir. 2011); Great Am. Ins. Co. v. Bally Total Fitness Holding Corp., 2010 U.S. Dist. LEXIS 61553 (N.D. Ill., June 22, 2010); Comerica Inc. v. Zurich Am. Ins. Co., 498 F. Supp. 2d 1019 (E.D. Mich. 2007); Qualcomm, Inc. v. Certain Underwriters at Lloyd’s, London, 73 Cal. Rptr. 3d 770 (Cal. Ct. App. 2008).

Even a New York court, while perhaps not expressly overruling Zeig, nonetheless did not permit “filling the gaps” by an insured to substitute for actual payments by underlying insurers.  JP Morgan Chase & Co. v. Indian Harbor Ins. Co., 930 N.Y.S. 2d 175 (N.Y. Sup. Ct., May 26, 2011).

I concede, nevertheless, that all of these decisions, like Zeig, were peculiar to the excess policy language before the respective courts.

[2] It should be noted first that Twin City was not the insurer at the center of this dispute, as they reached a settlement agreement before this matter was decided.  The next layer down, however, continued to dispute its attachment with the insured.

The Court held that Virginia law was in fact applicable, but both the insured and insurer agreed that the outcome of their dispute would be the same under either New York or Virginia law.  Hence, the Court had its “invitation” to apply Zeig.

[3] It is very important to note that, even if the insured prevails upon any further appeal, there remains a very critical hurdle in this and similar cases for an insured to clear.  Specifically, the insured must establish that all of the payments made by it and the underlying insurers constitute covered Loss.  Regardless of being allowed to fill the gaps, the insured is not entitled to credit any items of non-covered Loss to an exhaustion of the underlying limits. The Court’s discussion of some of the damages and other monetary components of the settlement in this case leave the answer uncertain as to whether the insured can clear that hurdle.

This question was answered in the negative in a recent New York Court of Appeal decision. Federal Ins. Co. v. International Business Machines Corporation, Slip Op. No, 2o, Decided February 21, 2012. A copy of the Opinion of Chief Judge Lippman is attached [here].

The underlying claim was a class action brought on behalf of plan participants against International Business Machines Corporation (IBM) and the IBM Personal Pension Plan (collectively “IBM”). The key allegations in the class action were that certain amendments to IBM plan violated ERISA provisions relating to age discrimination. The action was settled and IBM appears to have successfully sought and obtained reimbursement under a $25 million limit primary policy for payments it had to make for plaintiff attorney fees. The instant case involved their pursuit of coverage for those fees from the first excess layer insurer upon exhaustion of the primary limits.

Although the court does not make clear what type of policy is at issue, it appears to be fiduciary liability coverage by virtue of the following definition of Wrongful Act in the primary policy, to which the excess followed form.

[Wrongful Act means] 1. Any breach of the responsibilities, obligations or duties by an Insured which are imposed upon a fiduciary of a benefit Program by the Employee Retirement Income Security Act of 1974, as amended, or by the common or statutory law of the United States, or ERISA equivalent laws in any jurisdiction anywhere in the world; 2. any other matter claimed against an Insured solely because of such Insured’s service as a fiduciary of any Benefit Program; 3. any negligent act, error or omission in the administration of any Benefit Program. (emphasis added)

The Court held that IBM was sued in the underlying action as a plan sponsor and settler of the plan, and not in any fiduciary capacity under ERISA. The only reasonable interpretation of the Wrongful Act definition was that coverage is limited to acts undertaken in the capacity of an ERISA fiduciary.

IBM had argued that “fiduciary” is an undefined term in the policy and, thus, should not be limited only to fiduciary duties under ERISA. The Court rejected this argument, finding that the clear intent of the disputed language was “easily understandable to the average insured” and would not encompass the broad interpretation sought by the insured. IBM also unsuccessfully argued that Clause 2 in the definition would be rendered meaningless by virtue of the Court’s interpretation of Clause 1, and that later changes the excess insurer made to its own fiduciary liability policies evidenced the ambiguity of the disputed definition.

Accordingly, the Court ruled in favor of the insurer and awarded costs against the insured.

The language at issue here is similar to that in many other fiduciary liability policies and this decision should serve as good guidance in applying the coverage to claims similar to the one at issue here.

I have always maintained, and continue to do so, that rescission is a drastic remedy and not one that is sought often and undertaken lightly by insurers. A recent decision in which an insurer successfully rescinded only illustrates why few situations are egregious enough to warrant rescission and the pitfall for the insured when it has its policy rescinded. Chicago Ins. Co. v. James A. Capwill, 2011 U.S. Dist. LEXIS 147086 (N.D. Ohio, No. 1:01-cv-2588, December 21, 2011).

Capwill involved applications for accountants professional liability insurance submitted in 1997, 1998 and 1999. In each successive application, the principal in the accounting firm made and reaffirmed certain representations as to the nature of his business.

The Court found that the insured had indisputably made intentional misrepresentations on the applications for insurance*, including statements with regard to his investment activities and fee income (fees for servicing fraudulent viatical insurance policies for individuals afflicted with AIDS) and prior license revocation. The insurer successfully rebutted arguments that it was barred by laches because it waited too long to assert its rescission defense. The Court found that the insurer diligently proceeded to develop evidence of material misrepresentation and that the insured was not prejudiced when the insurer timely asserted rescission after developing the supporting evidence.

The Court also held that the determination of materiality is made from the perspective of the insurer, not the insured applicant, and its conclusion is strikingly blunt.

[The insured] lied when he applied for insurance with the [insurer]. He persisted in his falsehoods when he applied for renewal.  His motive and intent when he did so are manifest. The questions he fraudulently answered were material to the [insurer’s]decision to issue and then renew the policies, and the pricing thereof. There can be no question that, had [the insurer] been told the truth, it would not have accepted the applications. Its entitlement to rescission is clear.

Neither laches nor doctrines of estoppels, acquiescence or waiver bar the right to rescind.

The cautionary tale here is that, despite the high hurdle of having to prove both a material and intentional misrepresentation, an insurer can still prevail on a rescission claim under the egregious circumstances presented in this case.

*Under applicable Ohio law, it is necessary to establish that the misrepresentations must be material and made with intent to mislead the insurer.  In many other jurisdictions, there is no intent requirement in addition to the requirement of materiality.

On December 22, 2011, the Fourth Circuit reversed a decision of the United States District Court for Maryland in favor of an accountants professional liability insurer with regard to the applicability of an insurance agents and brokers errors and omissions exclusion in the policy. Trice, Geary & Myers, LLC v. CAMICO Mut. Ins. Co., No. 10-1473, 2011 U.S. App. LEXIS 25462 (4^th Cir., December 22, 2011). The insurer filed its Petition for Rehearing and Rehearing En Banc on January 5, 2012. Copies of both the Opinion and the Petition are attached.

The underlying claims against the insured accounting firm involved the creation of defined benefit plans under § 412 (i) of the Internal Revenue Code. The insured helped arrange for the funding of those plans by certain life insurance policies to be purchased by its client, for which it received commission income from the life insurer. The insured advised its client that the premiums paid for those policies would be tax deductible. Ultimately, the IRS disallowed the deduction, allegedly causing significant loss to the client, which sued the insured.

The insurer denied coverage for these claims against the insured based upon exclusionary provisions pertaining to acts as an insurance agent or broker. The key exclusionary language provided as follows.

This insurance does not apply to any Claim in connection with or arising out of any act,   error or omission by any Insured in his/her capacity as an agent or broker for the placement or renewal of insurance products or for the sale of annuities. (emphasis added)

The District Court found the exclusion sufficiently broad enough to preclude coverage despite the insured’s arguments that the gravamen of the claim involved negligent tax advice re the deductibility of the premiums paid for the life policies. The insurer successfully argued that although one of the principals of the insured firm may have in fact rendered tax advice, the claims arose from his acts as an insurance agent in procuring the policies.

The Fourth Circuit reversed finding that the exclusion was not broad enough to preclude coverage, essentially because it believed negligent tax advice was the principle underlying claim and that in fact there was another agent involved in placing the life insurance. It also concluded that the receipt of commission income did not affect its conclusion that the insured was not acting as an insurance agent.

I believe this case was wrongly decided and, unless it is reversed upon rehearing, it should be of significant concern to insurers in drafting preamble language to exclusionary provisions. While tax advice may well have been at issue in causing the client damage, and there is no dispute that negligent tax advice is clearly within the scope of coverage under an accountants professional liability policy, the Court apparently lost sight of what should have been the determinative question – did the claims against the insured arise from its acts in procuring the life policies?

Perhaps even more amazing is the Court’s conclusion that, although the underlying claims referenced the insured’s receipt of commissions, it did not specifically allege that they were acting as an insurance agent. Maybe I am being a bit impertinent but, if one receives commissions from an insurance company, what else can that one be but an agent or broker? 

The exclusion language here in the “arising out of” format is typically referenced as “absolute” and should have been sufficient to uphold the application of the exclusion to the underlying claim. Although it is uncertain whether this Fourth Circuit panel would have been persuaded otherwise, perhaps insurers need to consider utilizing the “super absolute” language along the lines of “this insurance does not apply to any Claim in connection with or arising out of, whether in whole or in part, any act, error or omission by any Insured.” This may have alleviated the Court’s apparent concern that the claim here arose from more than broking activity.

Typically, when the CEO of an organization makes a material misrepresentation on an insurance application as to knowledge (including his or her own) of acts, errors or omissions that might give rise to a claim, an insurer would be able to successfully rescind that policy. A recent decision, however, illustrates why that may not always be the case. Bancinsure, Inc. v. U.K. Bancorporation Inc./United Kentucky Bank of Pendleton County, Inc., C.A. No. 11-109-DLB-CJS, 2011 WL 5570704 (E.D. Ky., November 16, 2011).

In this case, the bank CEO had been embezzling funds from the bank for more than five years to the tune of over $2 million. She was also the signatory on the application completed after or during the course of her embezzlement scheme. The policy at issue was a combined financial institution bond and professional liability policy. Although not quite explicit in the Court’s Opinion, it would appear that the claim made was under the bond portion and where the insured would be the bank itself.

The Court declined to impute the knowledge of the CEO to the bank. Although normally there would be such imputation, the Court relied on an “adverse interest exception” theory to not impute. Under that theory, an agent’s (the CEO) knowledge is not imputed to her principal (the insured bank) when she would have no reason to communicate that knowledge to it, i.e. she would not have reason to disclose her embezzlement to her employer. Further, the CEO was not a de facto alter ego of the bank and was not acting in the bank’s interests by falsifying the insurance application. More specifically, although she had authority to complete the application, the Court held that such authority extended only to completing it honestly.

Finally, and perhaps this is why the result here may be specific to the nature of fidelity insurance, the Court held that the bond was specifically intended to cover the bank for the very loss caused by the embezzlement. If the application had been completed by any other bank officer, there would be no question that the CEO’s knowledge could not be imputed to the bank.*

This decision is another illustration of why successful rescission of a bond or policy is never a “slam dunk”.

______________________________________________________________________________

It does not appear that the application or the policy contained any provisions addressing imputation of knowledge or severability of interests.

In a brief decision addressing a number of coverage issues but, most importantly, rescission, a California court allowed rescission of an E&O policy and granted the insurer summary judgment despite the insured’s protestations that no misrepresentations were made by virtue of its non-response to certain application questions. The Upper Deck Co. v. Endurance American Specialty Ins. Co., USDC, S.D. Cal. (Decided December 15, 2011). Click here for a copy of the decision.

The underlying litigation brought against the insured was based upon allegations of trademark infringement, counterfeiting and unfair competition. Prior to settlement, the parties in that underlying action stipulated to a finding of willfulness with regard to the counterfeiting at issue.

The insurer took the position that it was entitled to rescission of one of the two policies it issued to the insured because the insured failed to disclose prior claims experience. The insured took the position that there was nothing to disclose, as it was not the subject of a “claim” until after the policy incepted.

The application, which was for policy renewal and dated October 22, 2008, contained certain questions that required the insured to disclose whether it was “aware of any alleged deficiencies, errors or omissions” in its work that were not previously reported to the insurer. The insured struck through these questions and left them unanswered. However, the application contained the following rejoinder after the questions.

NOTE:  It is agreed that any claim or lawsuit against the Applicant, or any principal, partner, managing member, director, officer or employee of the Applicant, or other proposed insured, arising from any fact, circumstance, act, error or omission disclosed or required to be disclosed in response to [the questions at issue] is hereby expressly excluded from coverage under the proposed policy. (emphasis added)

The Court found that the insured was aware of its intentional counterfeiting activities at the time of this renewal application. Although not named as a defendant until after the policy incepted, the Court noted that the insured had earlier been enjoined by the court in the underlying action from engaging in any counterfeiting related activities. The Court did not make clear when that injunction was issued, but it apparently was no later than the date of the renewal application on October 22, 2008.

Although insurers should not be encouraged to ignore applications returned with unanswered questions when they did not grant permission to non-respond to the questions*, the Court nonetheless found the warranty statement controlling even in light of the non-response.

*Interestingly, these types of “warranty questions” are not frequently found on renewal applications and, where the insurer is using an application form with such questions for renewal, it typically advises the insured that it does not have to answer the questions.

In most civil litigation in the United States, the so-called “American Rule” (as opposed to the “English Rule”) is applied, i.e. each side bears its own litigation costs, rather than the winner recovering from the loser.  However, in certain situations, “fee shifting” does occur, sometimes at the court’s discretion and other times as mandated by statute or practice rule.

New York has long held that such fee shifting can occur in a coverage action brought by an insurer where the insurer is not ultimately successful in the action.  New York is somewhat unique in its law that the insurers can only be liable for the insureds’ fees and costs where it initiates the action.  For this reason, insurers are often well-advised not to commence declaratory judgment actions in New York, and simply stand on their disclaimers of coverage or reservations of rights pending the initiation of a suit by the insureds.

A recent appellate decision in New York, RLI Ins. Co. v. Smiedala, 2010 WL 3817114 (App. Div,, Fourth Dep’t, Decided October 1, 2010), adds some additional gloss to this area of the law.

In Smiedala, the insurer argued that the fee-shifting rule should not apply because it was an excess insurer without a duty to defend pending exhaustion of the primary coverage and the rule was premised upon the notion that the insured’s coverage defense fees should be covered as part of an insurer’s defense obligation.  The Court, however, ruled that the lack of a defense obligation in the policy was irrelevant and the key was simply that the insurer placed the insured in a “defensive posture” by suing for declaratory relief.

Of further interest here was the fact that the coverage action involved two insured defendants, and only one prevailed.  Both defendants were represented by the same counsel, so the appellate court had to remand the matter to the trial court to determine how much to award to the prevailing party.

Of course, the lesson for an insurer here is not to never sue first.  Each case must be evaluated on its merits, and indeed here the insurer was proven correct in its coverage determination as to one of its insureds.  Also, different states have different rules with respect to fee shifting in coverage disputes and decisions as to whether to initiate a declaratory action and in which forum are ones to be carefully considered with counsel.

We too often hear two very common nostrums that get professional liability claims handlers into trouble, or at least deprive them of the opportunity to have another insurer bear all or part of a loss.

False Assumption No.1 – A Commercial General Liability (CGL) Policy Can Never Cover A Professional Liability Loss

We see this illustrated most painfully in the area of design professional liability.

While astute agents and brokers may occasionally place on notice both the general and professional liability insurer of a particular claim, especially when it is not altogether clear whether the rendering of or failure to render covered professional services is at issue, most often the agent or broker makes the call on one side or another based on their own professional assessment of the nature of the loss.  However, agents and brokers do not necessarily have the same interests as insurers, and appropriately so.

A professional liability insurer should never make an assumption that a CGL policy will have a professional liability or professional services exclusion attached to it simply because the policy is issued to a professional practice such as an architectural firm.  In some cases, the CGL insurer may have been sloppy in its practice and neglected to do so.   That may open the CGL policy to covering the same loss as the professional liability policy, regardless of whether professional services are at issue in the claim.  Dependent upon the wording of the policies’ respective “other insurance” provisions, the professional liability policy may become excess over the CGL or maybe share the loss pro-rata.

False Assumption No.2 – With The Advent of Employment Practices Liability (EPL) Insurance, There Are No Other Covers To Consider In Dealing With Employment-Related Claims

Prior to the availability of EPL, employment-related claims were routinely tended to CGL insurers for coverage, with mixed results as to whether coverage was found.  Now, most CGL policies are endorsed with a rather broad employment-related claims exclusion.  But, most does not mean all, and the diligent claims handler should be sure to obtain a complete copy of the CGL policy to be sure that there is such an exclusion and it is worded such that the claim at issue is excluded from coverage.  In the case of individual defendants in sexual harassment claims, another avenue to explore is the homeowners’ or personal umbrella policy.  Indeed, it was this type of insurance that was widely reported in the press to have been successfully tapped by former President Clinton as a result of the Paula Jones accusations in the 1990s.

Helpful Hints

Helpful Hint No.1 - - A professional liability claims handler’s best ally in pursuing these other insurers should be the insureds themselves and their professional liability broker, particularly after they are reminded that, unlike in most EPL and professional liability policies, defense costs under a CGL or personal lines liability policy are typically not subject to a deductible and supplemental to the policy limits of liability.

Helpful Hint No.2 – Like a good baseball umpire, you must call them as you see them.  That being said, most insurers are not monoliths that write only CGL or only professional liability insurance.  As a consequence, the CGL coverage you pursue may turn out to be a policy written by your own company.