Insurance Recovery Law - March 2015

Manatt, Phelps & Phillips, LLP

In This Issue:

  • New York Federal Court Rejects Insurer’s Request for Recoupment
  • Houses Can Be Advertisements, Triggering Coverage for Infringement Suit
  • Late Notice Prevents Coverage in Thousands of Asbestos Suits
  • Insurer Obligated to Provide Defense for FCA Suit

New York Federal Court Rejects Insurer’s Request for Recoupment

Why it matters: The federal court, applying New York law, held that an energy drink manufacturer’s advertising coverage claim—arising from underlying tort claims alleging that the policyholder’s “all natural” energy drinks in fact contained an illegal and dangerous methamphetamine analog—was excluded, but denied the insurer’s effort to recoup defense costs incurred to date. The policy did not include a recoupment provision and the policyholder had rejected the insurer’s effort to negotiate a recoupment agreement. The insurer argued that the policyholder was unjustly enriched, because it received a partial defense on an uncovered claim, but the court refused to impose by common law a recoupment provision that was included in the policy itself.

This decision recognizes the breadth of the duty to defend. Policyholders should be careful in placing coverage to avoid, to the extent possible, policies with recoupment provisions, and be wary if an insurer subsequently seeks such an agreement. Policyholders should clearly contest in writing an insurer’s reservation of the supposed right to recoupment.

Detailed discussion: Policyholder Driven Sports, Inc., produced and sold a pre-workout energy supplement called “Craze.” In 2013, consumers filed multiple class actions against the company alleging that it contained an illegal and potentially dangerous methamphetamine analog. Driven turned to General Star Indemnity Company for coverage under its insurance policy.

Driven’s insurer, General Star, provided a defense to these claims, subject to a complete reservation of rights, including the asserted right to recoup defense costs paid in the event the claims were determined not to be covered. General Star filed a declaratory judgment seeking a ruling that the claims were not covered based on a “Failure to Conform” exclusion, which applied to advertising injury claims arising out of the failure of products “to conform with any statement of quality or performance made in [Driven’s] ‘advertisement.’ ” Here, the “statement of quality” was “All Natural,” and the alleged violation was in the alleged inclusion in the product of an illegal and dangerous methamphetamine-like substance.

The insurer also sought to recoup its expenses in defending the underlying lawsuits. Because the policy did not provide for recoupment (and Driven had explicitly rejected such a provision when negotiating the policy), General Star based its claim on a theory of unjust enrichment.

Finally, in the alternative, General Star sought a ruling that, if it was not entitled to recoupment of paid defense costs, those payments eroded the policy limits.

U.S. District Court Judge Joseph F. Bianco first decided that the claims were excluded under the “Failure to Conform” exclusion. The court noted by way of example that one complaint cited Driven’s “blatant misrepresentations” of Craze, “which is marketed as containing a natural extract as its active ingredient, when, in fact, it contains illegal analogs to methamphetamine.” A different complaint challenged the failure of Craze to contain only natural ingredients, as promised in Driven’s advertisements.

All of the allegations were that “Craze’s actual quality (containing a synthetic and potentially dangerous ingredient) did not match its advertised quality (containing only natural ingredients),” the court said, concluding that the alleged misstatements triggered the Failure to Conform exclusion, barring coverage.

The court was not persuaded by Driven’s argument that the underlying complaints made additional, covered claims, such as disparagement. “[A]s much as defendant attempts to re-brand the underlying claims as advertising injuries, they plainly arise out of how Craze actually performed, which left its consumers exposed to an allegedly dangerous and synthetic substance,” Judge Bianco wrote.

As to recoupment, the federal court noted that four New York state court cases have permitted recoupment. In two, recoupment was unopposed. In the third case, the court awarded recoupment because there was no evidence that the policyholder refused to consent to the insurer’s reservation of the right to seek recoupment. The federal court noted that there was little analysis in the fourth case, but that the state court there cited only a single case in which the reservation of rights was unopposed.

“Thus, although some courts have awarded recoupment, it is unclear under New York law whether that remedy is appropriate, or even authorized, under these circumstances, where defendant effectively resisted the idea of recoupment from the very beginning by rejecting plaintiff’s offer of a separate recoupment agreement,” the federal judge explained.

Because General Star’s argument was not based on a recoupment provision in the policy, the court analyzed the claim under the law of unjust enrichment. New York law generally precludes an unjust enrichment claim as to an issued covered in a contract. The policy obligated General Star to “pay ‘all expenses’ with respect to the underlying lawsuits, and plaintiff did not include a recoupment provision in the Policy.” The court therefore refused to, “in essence, create [a] recoupment agreement and re-write the Policy by relying on a quasi-contract theory, when plaintiff could have addressed recoupment in the Policy, but chose not to.”

The court further stated that insurers “bear the risk of not providing for recoupment in the Policy itself, and plaintiff is not saved by its later, unilateral reservation of rights,” noting General Star’s awareness of this risk in its attempts to provide for recoupment in a separate agreement after Driven tendered its claims. The policyholder rejected that offer, “and as a matter of equity and good conscience, the Court will not now imply the same agreement into the Policy.”

Finally, the court also ruled that insurer defense payments reduced the limits of insurance, based on express policy language.

To read the order in General Star Indemnity Co. v. Driven Sports, Inc., click here.

Houses Can Be Advertisements, Triggering Coverage for Infringement Suit

Why it matters: The U.S. Court of Appeals for the Fifth Circuit, in a per curiam, unpublished decision, ruled that an insurer must cover the defense of a copyright infringement suit. The lawsuit involved allegations by an architecture firm that a builder copied the architecture firm’s proprietary building design in building hundreds of houses without paying licensing fees. The architecture firm’s business was to design homes and then license the designs to builders. Here, the builder paid for licenses for 11 different house designs, but then built hundreds of additional copies, each of which required payment for a further license. The architecture firm obtained a judgment of more than $3.2 million against the builder.

The builder’s insurer filed a declaratory judgment for a finding that the judgment was not covered. The policies at issue excluded copyright infringement, but carved out from that exclusion “an ‘advertising injury’ arising out of infringement in [the builder’s] “advertisement.’ ” The Court of Appeals, affirming the district court’s award of summary judgment in the policyholder’s favor, ruled that the homes, in and of themselves, were advertisements of their design and the judgment therefore arose out of an advertising injury, requiring indemnification.

This case shows how important the framing of the underlying pleadings is to a coverage determination. Here, the architecture firm framed its allegations specifically to complain about the builder’s advertisements, including the inclusion of infringing materials in such advertisements.

Detailed discussion: Hallmark Design Homes purchased 11 house designs from Kipp Flores Architects (KFA). Pursuant to the contract, Hallmark was authorized to build one house per design unless it paid for additional licenses.

Nevertheless, after building the first licensed copy of each of the 11 house plans, Hallmark built several hundreds more houses without paying KFA any further license fees. KFA sued Hallmark, alleging that Hallmark had “created, published and used non-pictorial depictions of structures based on KFA’s Copyrighted Works in promotional and advertising materials.” Although Hallmark went bankrupt, the case went to trial because Hallmark was potentially covered under policies issued by Mid-Continent Casualty Company.

The jury returned a verdict in favor of KFA for approximately $3.2 million, and KFA demanded indemnification from Hallmark’s insurer, Mid-Continent, because the policies provided that the holder of a judgment against Hallmark could sue the insurer directly.

The applicable policies provided coverage to Hallmark for “advertising injury,” defined as “injury … arising out of one or more of the following offenses: … infringing upon another’s copyright, trade dress or slogan in your ‘advertisement.’ ” “Advertisement” was defined as “a notice that is broadcast or published to the general public or specific market segments about your goods, products or services for the purpose of attracting customers or supporters.”

The policies also contained a copyright infringement exclusion, which contained the following carve-out: “ ‘Personal and advertising injury’ arising out of the infringement of copyright, patent, trademark, trade secret or other intellectual property rights. However, this exclusion does not apply to infringement, in your ‘advertisement,’ of copyright, trade dress or slogan.”

Mid-Continent—which had paid for Hallmark’s defense (unlike the previous case, the insurer apparently did not seek recoupment)—filed a declaratory judgment arguing that the jury verdict was excluded because it was for copyright infringement and not an “advertising injury.” It argued that because the “judgment said nothing of ‘advertising injury,’ the jury never had to decide whether there was an advertising injury[,]” and thus the claim did not fall within the exclusion’s carve-out.

KFA responded that its complaint against Hallmark specifically asserted that Hallmark infringed KFA’s designs “in promotional and advertising materials” and that the construction company “used the structures themselves to advertise their infringing structures.” Buyers don’t buy a house unseen, the architecture firm added, and Hallmark conceded its only marketing efforts were promoting the houses themselves.

A panel of the Fifth Circuit, applying Texas law, agreed with KFA, declaring Mid-Continent’s interpretation of the policies and the judgment “too narrow,” even though the district court had applied the wrong test (one applicable to the broad duty to defend, rather than the duty to indemnify). The Court of Appeals rejected Mid-Continent’s effort to limit the evidence to what was in the trial record, recognizing that coverage cases regularly require additional evidence in view of the fact that coverage determinations may involve different issues, and require different facts, than an underlying liability claim. And here, “advertising injury” was irrelevant in the action below.

The jury determined that the houses themselves infringed KFA’s copyright. As such, “the determinative question for coverage under the policies is whether the houses themselves were ‘advertisements.’ ”

Under both the policy terms and the facts of the case, the answer was yes, the Fifth Circuit concluded. “KFA has always contended that Hallmark infringed KFA’s copyright in its advertisements and that the structures themselves constituted advertisements,” the court said. “KFA presented evidence that the houses themselves were used to attract customers, in addition to evidence of website and print promotional materials.”

The court disagreed with Mid-Continent that a house could not be a “notice” or “broadcast or published” for policy purposes. “Mid-Continent cites no controlling authority that might require the narrow reading proposed,” the panel said. “It is important to note that the policies never specify that ‘notice’ must take any particular form (e.g., a writing or a website) and never excluded from the definition a physical object, nor do they define ‘broadcast’ or ‘published.’ ”

Dictionary definitions of such terms include the “act of imparting information” for “notice” and “to make public or generally known” for “publish.” Advertising does not need to be distinct from the product being advertised.

“In this case, it is undisputed that Hallmark’s primary means of marketing its construction business was through the use of the homes themselves, both through model homes and yard signs on the property of infringing homes it had built, all of which were marketed to the general public,” the court explained. “Under the undisputed facts, Hallmark’s use of the infringing houses satisfies not only the policies’ expansive definition of ‘advertisement’ and Texas law’s similarly broad construction of the term but also common sense. We therefore conclude that the infringing houses in this case, as used by Hallmark, all qualify as ‘advertisements’ under the policies.”

Finding that KFA claimed Hallmark infringed its copyright in a number of ways that gave rise to a single recovery, the panel held the architecture firm was not required to segregate damages from the underlying verdict, ordering Mid-Continent to pay the full award.

To read the opinion in Mid-Continent Casualty Company v. Kipp Flores Architects, click here.

Late Notice Prevents Coverage in Thousands of Asbestos Suits

Why it matters: The U.S. Court of Appeals for the Fifth Circuit, in another per curiam, unpublished decision, held that a policyholder failed to give timely notice of asbestos claims to National Union with respect to a primary policy, leaving the policyholder without coverage for thousands of prior asbestos claims under that National Union policy.

The policyholder faced approximately 2,700 asbestos claims from 1987 to 2008. It sued a group of excess insurers in 2007 and during the litigation discovered a primary policy from National Union that did not exclude coverage for asbestos claims. The policyholder quickly, in 2009, tendered claims to National Union and added that insurer to the pending coverage action.

The Court of Appeals ruled that, although the policyholder had had some discussions with National Union about asbestos claims prior to 2009, those discussions did not concern the specific primary policy. As such, the court held that the policyholder’s notice was untimely with respect to the primary policy and all claims filed before the tender.

This case highlights the importance of carefully cataloging and reviewing all potentially relevant insurance policies when claims arise, particularly in the context of long-tail and mass tort claims. This case further shows that policyholders must be careful and thorough in providing notice, because some insurers, and some courts, will take a technical approach to notice that creates obstacles to obtaining full coverage.

Detailed discussion: Anco Insulations, Inc., sold, installed, repaired, and distributed insulation materials that contained asbestos from approximately 1972 through the early 1980s. As a result, the company faced about 2,700 asbestos-related lawsuits.

National Union sold some excess insurance policies to Anco that evidently contained asbestos exclusions. In the late 1980s, National Union told Anco that National Union’s policies did not cover asbestos claims. In 2000, National Union requested to and did review the asbestos files of one of Anco’s primary insurers. In 2000 and 2001, Anco notified National Union of certain asbestos claims, referencing certain of National Union’s policies, which apparently contained asbestos exclusions, but not an as-yet undiscovered primary policy.

In 2007, Anco filed an asbestos coverage action against a group of excess insurers. During the course of discovery in 2009, Anco became aware of a 1987 National Union primary policy that did not contain an asbestos exclusion. On April 23, 2009, the company tendered all of its asbestos suits to National Union and then added the insurer as a defendant to the coverage action.

National Union filed a motion for summary judgment, contending that it was not liable for any of Anco’s past asbestos claims and defense costs due to Anco’s late tender date of April 23, 2009. A federal district court granted the motion and denied Anco’s attempt to recover statutory penalties for the insurer’s failure to timely participate in its defense, and Anco appealed.

On appeal, the court ruled that Anco’s pre-tender claims were not covered, because they were untimely and prior general communications about asbestos claims were “not relevant to the question whether Anco timely tendered its claims under the Policy [],” at issue. Certain prior letters from Anco to National Union referred only to another policy, not the policy at issue, and the court ruled that such communications did not constitute notice as to the policy at issue.

Anco’s alternative argument, that its untimely tender should be excused because National Union breached its duty to investigate the claims, also failed. The court found no case law to support the testimony of Anco’s expert that National Union “should have conducted a policy search for all of the policies it sold Anco and identified them for Anco,” and found that the testimony therefore was “irrelevant to the question of when Anco first tendered defense of its claims under the Policy.”

Further, because Anco breached the “timely notice” provision of the policy, National Union was not responsible for any costs incurred on or after April 23, 2009, as to the approximately 2,700 asbestos lawsuits filed between 1987 and 2008. While Louisiana law generally requires a demonstration of prejudice by the insured’s late notice to deny coverage, the court said that where timely notice is an express condition precedent to coverage, prejudice is not required.

The decision left open the possibility that Anco could obtain coverage under the primary policy at issue for new claims that are timely noticed.

To read the opinion in Anco Insulations, Inc. v. National Union Fire Insurance Co., click here.

Insurer Obligated to Provide Defense for FCA Suit

Why it matters: In a victory for the policyholders, a federal court judge in Illinois held that an insurer owed a duty to defend under a claims-made employment practices liability insurance policy to a company and individual defendant for a False Claims Act (FCA) lawsuit initiated by a former employee. In a ruling that highlights the need to read all policy terms carefully and measure them against all allegations in the underlying litigation, particularly in the context of the broad duty to defend, the court ruled that although the gist of the FCA claim concerned allegations of fraudulent contracting, the lawsuit also contained allegations concerning “harassment, wrongful termination, retaliation or discrimination,” which triggered coverage under the policy.

Detailed discussion: Lawrence McCarthy filed a six-count complaint pursuant to the FCA in Illinois federal court against Marathon Technologies, Sigmatek, Inc., and their mutual owner, Jerry Kozlowski. McCarthy formerly was an employee of both Marathon and Sigmatek, both arms manufacturers that had contracts with the United States Army. Both entities, as required, certified that their products satisfied contract terms and design specifications, and could be used safely in military combat and exercises.

Relator McCarthy alleged that the certifications were false and fraudulent because the products did not pass the quality assurance program, a fact that the defendants fraudulently conspired to conceal from the U.S. government.

McCarthy claimed that, while still employed, he reported the false certification to Kozlowski, who advised him to violate the government specifications and falsify documents. McCarthy further alleged that he “was forced to terminate his employment” because of Kozlowski’s behavior toward him.

The defendants tendered the suit to United States Liability Insurance Company (USLI) under an employment practices liability insurance (EPLI) policy. The insurer denied coverage, filed a declaratory action and moved for judgment on the pleadings, arguing that the suit was a qui tam action based in fraud and the policy issued to the defendants was for employment practices liability.

The court denied the insurer’s motion, ruling that the complaint alleged not just fraud against the government but wrongful employment practices as well, including harassment, wrongful termination, retaliation, and discrimination. Such allegations were covered.

“USLI correctly notes that McCarthy does not assert a separate claim for wrongful employment practices. However, when considering whether an insurance company has a duty to defend, a court ‘should not simply look to the particular legal theories pursued by the claimant [in the underlying action], but must focus on the allegedly tortious conduct on which the lawsuit is based,’ ” Judge Castillo wrote. “Thus, McCarthy’s failure to assert a separate count for wrongful employment practices is not dispositive to this coverage dispute.”

The court emphasized that McCarthy requested a broad prayer for “all relief, both in law and equity, to which … [h]e may reasonably appear entitled,” while realleging all prior paragraphs in the complaint, including the employment-related allegations.

The FCA provides employees with “all relief necessary to make that employee … whole,” including “reinstatement with the same seniority status that employee … would have had but for the discrimination,” as well as back pay, interest on the back pay, and compensation for any special damages sustained as a result of the discrimination.

“Because the Court is required to view the complaint in the light most favorable to the insured, the Court finds that incorporating Section 3730(h) in each count, along with his broad prayer for all relief to which he may reasonably appear entitled to, is sufficient to assert a claim for relief for wrongful employment practices,” Judge Castillo wrote.

The court therefore held that USLI has a duty to defend Sigmatek, Marathon Technologies, and Kozlowski in the McCarthy lawsuit. Because the underlying suit remained pending, however, the court dismissed without prejudice the policyholders’ request for indemnification.

To read the opinion in United States Liability Insurance Co. v. Sigmatek, Inc., click here.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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