Insurance Recovery Law - May 2015 #2

In This Issue:

  • Recent Lawsuit Underscores Critical Lessons for Purchasers of Cyber Insurance
  • Where Not Specifically Listed as a Pollutant, Lead Paint Does Not Invoke Pollution Exclusion
  • “Tenuous” Connection to Professional Services Not Enough to Trigger Exclusion, Ninth Circuit Rules
  • N.J. Court Finds Underlying Settlement Reasonable, Orders Insurer to Pay
  • Court Finds Policyholder Waived Privileges by Placing Them “At Issue” in Coverage Dispute

Recent Lawsuit Underscores Critical Lessons for Purchasers of Cyber Insurance

Why it matters: Columbia Casualty Company v. Cottage Health Systems was filed on May 7, 2015, in the Central District of California. Cottage Health is one of the first cases nationwide—if not the first case—in which the scope of a “best practices” or “minimum required practices” exclusion within a modern cyber insurance policy is being tested.

Detailed discussion: In Cottage Health, Columbia Casualty Company seeks reimbursement of amounts it paid under a reservation of rights to defend and settle a data breach class action against its insured, Cottage Health. In the data breach action, it was alleged that confidential medical records of Cottage Health’s patients stored electronically on its servers were available to the public on the Internet. It further was alleged that Cottage Health failed to utilize proper encryption or other security measures in violation of the California Medical Information Act.

Columbia issued a cyber liability policy to Cottage Health, which provides coverage for a number of cyber-related risks, including “Privacy Injury Claims and Privacy Regulation Proceedings.” However, the policy contains a specific exclusion for:

Any failure of an Insured to continuously implement the procedures       and risk controls identified in the Insured’s application for this       Insurance and all related information submitted to the Insurer in       conjunction with such application whether orally or in writing . . .

Columbia claims the improper disclosure of patient medical records was caused by Cottage’s failure to continuously implement the procedures and risk controls identified in its coverage application. Thus, Columbia asserts, the exclusion applies to preclude coverage for the class action.

These types of “best practices” exclusions are all too common in cyber policies. They vary in form and language, but typically purport to exclude coverage where a policyholder fails to take steps to design, maintain, or upgrade its cyber security. From a policyholder perspective, these exclusions are particularly pernicious because insurers may assert, as Columbia Casualty asserts here, that they apply to almost any security failure. Even worse, they are contrary to policyholders’ reasonable expectations that their liability insurance (including their cyber liability insurance) will protect them against their own negligent conduct. But as written, these exclusions actually may be triggered by policyholders’ negligence (i.e., their failure to take certain steps to maintain or upgrade their cyber security). This turns traditional notions of liability insurance on their head.

This case could go a long way in determining the value of cyber policies to many current and potential purchasers. In the case of “best practices” or “minimum required practices” exclusions, the very acts and omissions that some policyholders think they are insuring against could, in some circumstances, be what their insurer asserts triggers the exclusion. So for companies that do purchase cyber policies, it is imperative that they read through the terms of their policies carefully to fully appreciate the potential breadth of these exclusions. They also should seek to negotiate appropriate limits to these exclusions, or seek to eliminate them altogether, when purchasing the coverage. And when in doubt, they should consider seeking advice from experienced coverage counsel.

Where Not Specifically Listed as a Pollutant, Lead Paint Does Not Invoke Pollution Exclusion

Why it matters: Do personal injuries resulting from lead-based paint fall under a pollution exclusion in a commercial general liability policy? According to a decision from a Georgia appellate court, the answer is “no.” In this case, the owner of a rental property was sued for failing to abate lead-based paint in a rental property, which allegedly resulted in injuries to a tenant. When the property owner tendered the tenant’s complaint to its insurer, the insurer denied coverage based on the pollution exclusion. In the declaratory judgment action that ensued, the trial court granted summary judgment for the insurer. The appellate panel reversed, holding that, in contrast to certain types of industrial pollution, it was not clear from the language of the pollution exclusion that the presence of leaded materials in a private residence was excluded. If the insurer intended to include lead paint in the exclusion, it should have done so expressly.

Detailed discussion: Amy Smith lived in a rental property with her daughter Tyasia Brown for several years, beginning in 2004. Alleging that her daughter suffered severe and permanent injuries as a result of having ingested lead-based paint in the house, Smith sued the owner of the property. She claimed that a 2007 inspection of the premises by the health department revealed that Brown had been exposed repeatedly and continuously to the lead-based paint that was cracking, chipping, and peeling throughout the house.

When the property owner requested defense for the suit under its commercial general liability policy issued by Georgia Farm Bureau Mutual Insurance Company (GFBM), the insurer denied the request and filed a declaratory judgment action in Georgia state court.

GFBM told the court that it was not required to provide coverage for the alleged injuries or to defend the policyholder because the claimed injuries came within the policy’s pollution exclusion.

The pollution exclusion stated that the policy did not apply to “ ‘[b]odily injury’ or ‘property damage’ arising out of the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of ‘pollutants’: (A) At or from any premises, site or location which is or was at any time owned or occupied by, or rented or loaned to, any insured.” The policy defined “pollutants” as “any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste. Waste includes materials to be recycled, reconditioned or reclaimed.”

The trial court judge granted summary judgment to GFBM. The Court of Appeals reversed.

“We agree . . . that lead-based paint is not clearly a ‘pollutant’ as defined by the policy,” the court wrote. “The policy’s definition of ‘pollutant’ does not include the words ‘lead,’ ‘lead-based paint,’ or even ‘paint.’ Whether lead-based paint is properly classifiable as one of the substances specifically enumerated in the policy’s definition of ‘pollutant’ is not clear.”

The question of whether lead-based paint constitutes a “pollutant” for the purposes of a pollution exclusion clause was one of first impression in Georgia, the panel noted, and cited a conflict in judicial opinions from other jurisdictions on the issue. A review of the other cases convinced the court that the exclusion did not bar coverage for injuries allegedly arising out of the ingestion or inhalation of lead-based paint. In particular, the court noted a Maryland case in which the state’s highest court found that the terms “contaminants” and “pollutants” in a similar pollution exclusion were ambiguous, and did not clearly exclude “leaded materials in a private residence.”

The Georgia appeals panel adopted the same position. “We hold that if GFBM had intended to exclude injuries caused by lead-based paint from coverage in the policy at issue in this case, it was required, as the insurer that drafted the policy, to specifically exclude lead-based paint injuries from coverage,” the panel wrote. “Inasmuch as ambiguities in an insurance contract are strictly construed against the insurer as drafter of the document, and an exclusion from coverage sought to be invoked by the insurer is likewise strictly construed, as in this case, the trial court erred by holding that [lead-based paint] claims came within the policy’s exclusions.”

Reversing the trial court, the appellate panel held that GFBM had a duty to defend the tenant lawsuit.

To read the opinion in Smith v. Georgia Farm Bureau Mutual Insurance Company, click here.

“Tenuous” Connection to Professional Services Not Enough to Trigger Exclusion, Ninth Circuit Rules

Why it matters: Finding a connection between allegedly wrongful conduct by a policyholder and the policyholder’s professional services to be too tenuous, the Ninth Circuit Court of Appeals ruled that an insurer owed coverage for an action pending before the Financial Industry Regulatory Authority (FINRA). In this case, a group of investors filed arbitration proceedings with FINRA, alleging that after they invested funds in a real estate venture with ePlanning, the company encumbered the properties with an additional mortgage without their authorization. Insurer Brit UW Limited refused to provide coverage for the proceedings, taking the position that a “professional services” exclusion applied. A federal court judge in California agreed, holding that the allegations in the proceedings were “in connection with” the professional services of ePlanning. A panel of the Ninth Circuit reversed, writing in an unpublished opinion that, because the “alleged wrongful act is so tenuously connected to the rendering of professional services,” the professional services exclusion did not operate to bar the possibility of coverage.

Detailed discussion: A group of investors initiated arbitration proceedings with FINRA against ePlanning, which sold them investment interests in certain real properties. Among the investors’ allegations was that, after they had already invested their funds through ePlanning in certain real estate, ePlanning encumbered the real estate with an additional mortgage without the investors’ consent.

ePlanning’s insurer, Brit UW Limited, declined to provide a defense to the proceedings, relying on a Partial Professional Services Exclusion in ePlanning’s policy. The exclusion provided that Brit was not liable for any claim under the policy “for any act, error or omission in connection with the performance of any professional services by or on behalf of [ePlanning] for the benefit of any other entity or person.”

ePlanning assigned its rights against Brit to the investors. They filed suit against Brit, alleging that Brit breached the terms of its policy, as well as its duty of good faith and fair dealing, by refusing to defend ePlanning.

A federal district court sided with Brit and dismissed the investors’ complaint. The investors appealed. On appeal, Brit argued that the post-sale misconduct alleged by the investors was “in connection with” the performance of ePlanning’s professional services, specifically, the sale of securities. Brit emphasized the connection between the two actions: ePlanning sold interests in properties and then proceeded to encumber them, so the post-sale misconduct was not unrelated to the professional services ePlanning provided.

In an unpublished opinion, the Ninth Circuit Court of Appeals disagreed with Brit and reversed. According to the appellate panel, Brit’s reading of the professional services exclusion was a stretch.

“Brit’s broad construction is not consistent with ‘the requirement that the court construe policy exclusions narrowly,’ ” the court opined, and cited two decisions from the California Court of Appeal demonstrating that California state courts take a more narrow interpretation of the “in connection with” language in the context of a professional services policy exclusion. The state courts have found that the “existence of some connection” is insufficient to establish that a claim is excluded, the panel concluded.

Brit also contended that, because the investors brought their claims in a FINRA arbitration proceeding, they effectively had admitted that their claims were in connection with ePlanning’s professional services. The appellate panel also rejected this contention. “First, the FINRA rule and the professional services exclusion are worded differently,” the panel wrote. “Second, we decline to attribute a concession regarding the question before this court to the investors’ decision to include the encumbrance issue in the FINRA proceedings.”

Finding “[n]o convincing indication” that the state’s highest court would rule differently, “we conclude the California Supreme Court would refuse to apply this professional services exclusion where the subsequent alleged wrongful conduct is so tenuously connected to the rendering of professional services as is the post-sale encumbrance here,” the Ninth Circuit opined. “As some of the investors’ allegations were not barred by the professional services exclusion, the exclusion did not bar the possibility of coverage.”

To read the decision in Ambrosio v. Brit UW Limited, click here.

N.J. Court Finds Underlying Settlement Reasonable, Orders Insurer to Pay

Why it matters: A New Jersey appellate panel ruled that an insured’s settlement of an underlying action involving alleged defective installation of windows was reasonable and ordered the insurer to pay the amount of the settlement. In this case, a condominium association sued Home Improvements by Randy (HIBR), a window installation company, after discovering water damage due to allegedly defective installation of windows in the association’s buildings. HIBR tendered the suit to three of its insurers that provided liability policies during the relevant time period. Two of the insurers provided a defense, but National Grange Mutual Insurance Company refused to participate. HIBR settled the underlying suit and assigned its rights in its insurance to the condo association, which then sued National Grange. A trial court ruled that National Grange was not required to pay the underlying settlement because the association had not demonstrated that the amount of the settlement was reasonable. But the appellate panel reversed, determining that the deal was reasonable. “In view of the probability of the association’s success and the size of the possible recovery at a potential trial, the association met its burden of showing that a reasonable factfinder could have found that a settlement for thirty percent of the damages that expert reports attributed to HIBR was reasonable,” the court said.

Detailed discussion: The Rockaway Condominium Association manages fourteen buildings and a clubhouse in an age-restricted residential condominium development in New Jersey known as Fox Hills. The first building was completed in 1999 and construction on the last building was completed in 2003. A few years later, an engineering company discovered substantial damage at Fox Hills resulting from continual exposure to moisture that had entered the buildings through defectively installed windows. The association filed suit against 77 entities alleging construction defects, product defects, and breach of contract.

One of the defendants was Home Improvements by Randy (HIBR), which was a subcontractor hired to install most of the windows at Fox Hills between April 2000 and March 2003. During the relevant time period, HIBR was covered by three insurance policies: one issued by Ohio Casualty Insurance Company, effective from 1995 through 2002; one issued by Zurich Insurance Company, effective from July 2003 through July 2004; and one (plus a separate umbrella policy) issued by National Grange Mutual Insurance Company, effective July 2003 through July 2007.

OCI and Zurich provided HIBR with a defense in the Fox Hills litigation, but National Grange denied coverage and refused to defend. Prior to trial in the underlying case, the parties stipulated that, between 1999 and 2007, water infiltrated each of the buildings and caused damage due to a variety of causes, including defectively installed windows. An engineering company provided a report attributing 30 percent of all water infiltration damage—or $4.5 million—to HIBR’s defective window installation.

HIBR eventually settled the claims against it for $1.9 million. Of this amount, HIBR settled its insurance claims against OCI and Zurich for $159,436 and $140,563, respectively. HIBR then assigned its claims for coverage of the remaining $1.6 million against National Grange to the Association.

The association then sued National Grange. At trial, the parties agreed to numerous stipulations, including the expert reports that attributed 30 percent of the damage to HIBR and the timeline for when the damage occurred.

National Grange moved to dismiss the association’s claims, arguing that the $1.6 million settlement amount was not reasonable in light of HIBR’s potential liability. National Grange also argued that HIBR’s settlement of its claims against OCI and Zurich for only $300,000 (combined) was unreasonable because the other two insurers paid far less than the amount being demanded from National Grange despite their having provided coverage for a longer period of time. The association countered that the expert reports showed that the water damage increased as time went on and peaked during National Grange’s coverage period. The trial court agreed with National Grange and granted its motion to dismiss.

The association appealed, and the appellate panel reversed, finding that the settlement was reasonable in amount and entered into in good faith, as required by New Jersey law. “The Association provided ample proof to determine the reasonableness of the HIBR settlement,” the court opined.

It was not contested that HIBR defectively installed windows at the development, causing substantial property damage, the court noted. While National Grange submitted no expert testimony on liability or damages, the association provided an expert report with “a spreadsheet detailing the exact amount of damages incurred by each injury to the property, the source of that damages amount if no invoice was available, and the parties responsible for each injury.” Examining the risk to the settling parties, the panel emphasized that expert testimony established HIBR was exposed to liability of up to $4.5 million. “The Association settled its claims against HIBR for $1.86 million, which amounts to approximately thirty percent of HIBR’s potential liability,” the panel wrote.

Moreover, the amount of the settlement that National Grange was required to assume was not unreasonable when compared to the settlement amounts of the other insurers, the court added, because the damage caused by HIBR’s defective installations manifested during 2005, within National Grange’s coverage period. “The damage did not manifest during the coverage periods of OCI or Zurich, and their liability exposure was consequently less” than National Grange, the panel opined.

“Given these proofs and [National Grange’s] refusal to settle or provide a defense, HIBR was bearing ‘the full burden of protecting its own interests’ at a trial with the Association,” the court said. “The extent of its liability was demonstrated by expert reports, ‘not mere allegations in the plaintiffs’ complaint.’ Although HIBR’s ‘actual liability’ was not fully established, more than the required potential liability was shown to exist here. In view of the probability of the Association’s success and the size of possible recovery at a potential trial, the Association has met its burden of showing that a reasonable factfinder could have found that a settlement for thirty percent of the damages that expert reports attributed to HIBR was reasonable.”

To read the decision in Fox Development Co. v. Praetorian Insurance Co., click here.

Court Finds Policyholder Waived Privileges by Placing Them “At Issue” in Coverage Dispute

Why it matters: In a cautionary case for policyholders, a federal court in Florida found that an insured waived the attorney-client privilege and work product protections for certain communications with its defense counsel and insurance broker. In a coverage lawsuit between Sun Capital Partners, Inc., and Twin City Fire Insurance, Twin City sought to compel the production of communications between Sun Capital and its defense counsel and broker during the course of underlying litigation. Sun Capital objected to producing these communications, relying on the work product doctrine and attorney-client privilege. While acknowledging that such communications normally would be protected, a federal district court ordered production in this case because Sun Capital had placed the communications “at issue” in the coverage dispute. Upholding the attorney-client privileges in such circumstances would, the court held, deny Twin City access to information vital to its defense.

Detailed discussion: Sun Capital Partners, Inc., and Twin City Fire Insurance Company were engaged in a lawsuit involving coverage for an underlying claim. In the course of defending the lawsuit, Twin City filed a motion to compel Sun Capital’s communications with its insurance broker about its claims for coverage arising from the underlying litigation, as well as insurance coverage analyses contained in case status reports sent to Sun Capital by its defense counsel in the underlying litigation. After an in camera review of the documents, the court ordered the production of many of these documents.

U.S. District Court Judge William Matthewman first considered the application of the work product doctrine. Noting that the burden is on the party withholding discovery to show the documents are protected, the court explained that a rebuttable presumption exists that all documents prepared before the final decision on an insured’s claim are not work product, while documents prepared after the final decision are considered work product.

Sun Capital told the court that it reasonably anticipated litigation with Twin City on September 2, 2010, based on an e-mail from defense counsel summarizing a call with Twin City about “two battlegrounds going forward.” However, as Sun Capital did not file suit against the insurer for another two years and the e-mail suggested the parties were still “actively working together towards a resolution to the coverage disagreements,” the court held that Sun Capital’s proposed date was too early. Ultimately, the court settled on November 2, 2012—the date of Twin City’s final denial letter—as the date on which Sun Capital reasonably anticipated litigation. Therefore, the policyholder could only claim work product protection for documents prepared on or after that date.

The attorney-client privilege consideration was a bit more complicated. The court said it was “unclear” whether Twin City could be considered a joint client of Sun Capital’s defense attorney in the underlying litigation brought against Sun Capital and declined to make a finding on the issue. “The Court does find, however, that at a minimum the parties had a ‘common legal interest’ in minimizing Sun Capital’s liability in the underlying litigation, until the point that the parties reasonably anticipated litigation against each other (November 2, 2012),” the court wrote. “Even though the parties disagreed early on as to what underlying claims were to be covered and the proper allocation of reimbursement for covered and non-covered claims, Sun Capital and Twin City appeared to be working towards a resolution of these issues and both parties had a common interest in minimizing Sun Capital’s total liability.”

Given this “common legal interest,” the court determined that “those communications exchanged between Sun Capital and its defense counsel and/or [broker] ‘for the limited purpose of assisting’ in the parties’ common litigation-related cause shall be disclosed to Twin City, including those documents relating to calculation of settlement value, evaluations of the strength of the individual claims, and any other litigation outcomes in the underlying litigation.” However, the court limited production to communications prior to November 2, 2012. Notably, the court also held that that Sun Capital’s communications with its coverage counsel regarding the current suit with Twin City were not discoverable.

The court further found that Sun Capital waived its privileges under the “at issue” doctrine because the policyholder affirmatively injected a privileged communication necessary to prove an element of its claims into the coverage litigation. Specifically, Sun Capital’s coverage complaint alleged that Twin City had breached its fiduciary duty by denying coverage for the underlying litigation and limiting its payment under an allocation provision in the policy. “[I]t appears that one of the primary disputes between the parties relates to the allocation clause of the subject policy, which allows Twin City to allocate reimbursement between any covered claims and any non-covered claims based on the relative exposure of the underlying defendants, including the relative exposure to each individual claim and as to each individual defendant,” the court explained. “While Sun Capital has not spelled out in detail what work-product communications it will rely on to prove its allegations, it will likely need to rely on attorney work-product materials from the underlying claims to show that the allocation between the covered claims and non-covered claims was proper and supported by its defense counsel’s evaluation(s).”

In addition, the court opined that upholding the privileges in the situation at issue “would deny Twin City access to information that would be vital to its defense. Sun Capital is claiming that the allocation between the covered claims and non-covered claims was proper, whereas Twin City disagrees. Defense counsel’s evaluation of the underlying claims weighs on the allocation between the covered claims and non-covered claims, and thus are vital to Twin City’s defense.”

Although communications between a policyholder and its defense counsel on such issues—the defensibility of the underlying claims, the allocation of reimbursement for covered and non-covered losses, and communications regarding the settlement of the underlying claims—ordinarily would be protected by the work product doctrine and attorney-client privileges, “because Sun Capital has placed these items ‘at issue’ in this case and these items are vital to Twin City’s defense,” the privileges are waived, the court opined. “The court finds that this provides a limited intrusion into the work-product privilege and the attorney-client privilege between Sun Capital and its defense attorneys in the underlying litigation, and strikes a careful balance between Twin City’s need to defend the allegations involved in the current litigation and Sun Capital’s right to prevent truly privileged materials from being disclosed,” the court concluded.

To read the order in Sun Capital Partners, Inc. v. Twin City Fire Insurance Company, 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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