Insurance Recovery Law -- Oct 18, 2013

by Manatt, Phelps & Phillips, LLP

In This Issue:

New York Court Rules That Conflict Between Exclusion and Grant of Coverage Created Ambiguity in Exclusion Requiring Trial

Why it matters: In a coverage dispute arising out of the Madoff debacle, a financial bond affirmatively provided coverage for losses resulting from dishonest acts of any outside investment advisor named in the attached schedule but also sought to exclude coverage for losses arising out of dishonest acts of investment brokers. Madoff wore both hats, which the court found created an ambiguity in the application of the exclusion. Significantly, the court did not rule that in the face of such ambiguity, the policyholder automatically prevailed. Nevertheless, the court placed the burden on the insurer to prove through extrinsic evidence that its interpretation was the only reasonable interpretation; otherwise, the ambiguity would be interpreted against the insurer. Here, the insurer’s letter denying coverage conflicted with the testimony of its claims’ personnel. The court ruled that the insurer’s testimony was not credible and could not be reconciled with the record. Policyholders should similarly scrutinize the carrier’s pleadings, reservation of rights letters, and denial letters to evaluate inconsistencies at trial or on summary judgment that clearly undermine self-serving testimony or after-the-fact argument by insurer counsel. The heavy burden placed on insurance companies can be made impenetrable through careful consideration of all available evidence.

Detailed Discussion
Jacobson Family Investments and related entities Nine Thirty FEF Investments, LLC, and Nine Thirty VC Investments, LLC, had the misfortunate of investing sizable sums of money with Bernard Madoff and his firm, Bernard L. Madoff Investment Securities LLC. The investments seemingly performed well over the years until the details of Madoff’s Ponzi scheme were revealed in 2008. The investment funds had balances of roughly $14.7 million when Madoff’s fraud was uncovered.

Seeking to recover its losses, JFI turned to United States Fire Insurance Company based on a Financial Institution Bond in effect during the relevant period. The bond included Exclusion (x), which prohibited coverage for “loss resulting directly or indirectly from any dishonest or fraudulent act or acts committed by any non-Employee who is a securities, commodities, money, mortgage, real estate, loan, insurance, property management, investment banking broker, agent, or other representatives of the same general character.”

In contrast was Rider 9, an endorsement, which provided coverage for losses arising from dishonest acts of Outside Investment Advisors, including named party Bernard L. Madoff Investment Securities.

U.S. Fire denied coverage for JFI’s Madoff-related losses. Critically, US Fire relied on Exclusion (x), because Madoff was acting as a broker. However, US Fire later claimed in its complaint and on summary judgment that a mere showing that Madoff and Madoff Securities were registered securities brokers during the relevant period was sufficient to trigger the exclusion.

JFI contended that Madoff was acting in the capacity as an investment advisor, thus Rider 9 explicitly provided coverage and Exclusion (x) was inapplicable.

After a bench trial, Judge Jeffrey K. Oing ruled for the policyholders. Looking to the insurer’s letter disclaiming coverage, he noted that U.S. Fire wrote that Madoff “was acting as a broker” – not that he was simply registered as a securities broker. That inconsistency created an ambiguity with respect to the exclusion, especially when juxtaposed with Rider 9. The court held that in light of the ambiguity, U.S. Fire could only defeat coverage if it could prove that its interpretation was the only reasonable one.

“U.S. Fire failed to establish by credible testimonial or documentary evidence that its construction and interpretation of Exclusion (x) is the only proper meaning for that provision,” Judge Oing wrote. “As such, failing to resolve the ambiguity in its favor, I am compelled, as a matter of law, to hold that Exclusion (x) excludes coverage under Rider 9 if Madoff and Madoff Securities were ‘acting’ as securities brokers.”

Judge Oing then concluded that neither Madoff nor his firm was acting as securities brokers.

Despite Madoff holding himself out as a broker, creating and sending to JFI fake trade confirmations and bogus monthly brokerage accounts, it was all part of a fictitious world. “Madoff and Madoff Securities were not rogue brokers churning brokerage accounts to generate exorbitant fees; he was doing nothing more than running an elaborate confidence game – he was a con man,” the court said. U.S. Fire tried to avoid the “imposter defense,” but the court found that JFI had not assumed the risk of loss. Madoff and Madoff Securities had complete and total discretion without any supervision or oversight from the insureds. “Because the insureds did not reserve for themselves any duty to review and approve what Madoff and Madoff Securities did with their investment accounts, whether the insureds should have to bear the loss depends not on Madoff and Madoff Securities’ status as securities brokers...but on whether they were acting as securities brokers,” the judge wrote.

The true relationship between the insureds, Madoff, and Madoff Securities was more akin to investors and outside investment advisors, given the fact that “the entire brokerage relationship was phony and a figment of the insureds’ imagination.” Madoff himself, in his guilty plea allocution on March 12, 2009, said he “never invested these funds in the securities as I promised.”

“The totality of such evidence compels me to conclude that Madoff and Madoff Securities were not acting as securities brokers within the meaning of Exclusion (x) so as to trigger its exclusionary language, and that Madoff and Madoff Securities were acting solely as Outside Investment Advisors,” Judge Oing concluded, with coverage available under Rider 9.

To read the decision in U.S. Fire Insurance Co. v. Nine Thirty FEF Investments, LLC, click here.

Texas Court Scrutinizes Definition of “Insured Services”

Why it matters: The policyholder was unable to obtain a defense because the allegations of the complaint did not track the scope of services provided by the insured and as defined by the policy. Here, the policyholder was a mortgage broker, but, as alleged, the losses resulted from misuse of funds. Even though the duty to defend is broadly applied and the allegations of the complaint are liberally construed, this case shows that a defense cannot be taken for granted. The coverage provided by the policy still must align with the nature of the dispute.

Detailed Discussion
A Texas federal court judge determined that a lawsuit by investors is not entitled to coverage because the acts undertaken by the policyholder were not listed in the “Insured Services” provision of the policy.

A group of individuals invested almost $5 million with Halo Companies. Halo employees touted an investment scheme where the money would be used to purchase nonperforming residential mortgages, restructure their terms, and reconstitute the mortgages into performing loans.

But according to the investors, Halo never purchased the proposed assets and never returned the investment funds. In a lawsuit seeking the return of the almost $5 million, the investors alleged that Halo failed to ensure the purchase of the mortgage, neglected to inform the investors that their funds were not being used for the intended purchase, and made false assurances regarding the intent to use the funds or manage the mortgages.

Halo turned to Axis Surplus Insurance Co. for defense and indemnification against the claims. Axis declined and filed a declaratory judgment in Texas federal court, arguing that the allegations in the underlying complaint did not fall under the “Insured Services” defined in the policy.

“Insured Services” are defined by the policy as “Mortgage broker services consisting of counseling, taking of applications, obtaining verifications and appraisals, loan processing and origination services in accordance with lender and investor guidelines and communicating with the borrower and lender. Debt settlement and credit services including arbitration and negotiations; real estate sales and brokerage services."

The description of mortgage broker services in the policy provides the exhaustive definition of covered activity, Axis argued. Alternatively, Halo told the court the phrases were merely an incomplete list of examples.

Relying on the eight corners of the policy and the underlying complaint, U.S. District Court Judge A. Joe Fish sided with the insurer.

“The allegations in the underlying action are fundamentally based on the Halo defendant’s misuse of the [investors’] funds, not in mortgage broker services,” he wrote. “Taking the allegations in the petition as true, none of the funds even went to purchase mortgages. The fact that the proposed investment scheme was supposed to involve mortgages does not overshadow the fact that the allegations ultimately stem from fraud and misappropriation of funds.”

Halo tried to hang its hat on the “real estate sales” language in the definition, to no avail. “The court cannot conclude that the parties truly intended for ‘real estate sales and brokerage services’ to apply to mortgage investment schemes; the provision unambiguously refers to the purchase and sale of real property,” Judge Fish wrote.

The court denied summary judgment on the issue of whether Axis had a duty to indemnify, however, holding that under Texas law that issue cannot be decided until liability is settled.

To read the opinion in Axis Surplus Ins. Co. v. Halo Asset Management, click here.

Insurer Cannot Sue Policyholder’s Attorney for Malpractice, Even if the Insurer Paid the Bills

Why it matters: The Washington Supreme Court ruled that even when an insurer foots the bill, the lawyer’s duty is to the insured absent other circumstances. Simply paying for legal fees, having some alignment of interests, and being entitled to a contractual duty to stay informed do not entitle the insurer to the same duty owed to the policyholder, the actual client. For purposes of potential malpractice, the defense attorneys represent the policyholder and not the insurance company, even if it pays the bills. As the court noted, its ruling represents a split with some other jurisdictions. Courts in Arizona, California, and Michigan have allowed malpractice suits by insurers where the interests of the insureds and insurers “coincide,” “generally merge,” or do not otherwise conflict.

Detailed Discussion
The mere fact that an attorney was paid by an insurer does not create a duty of care that would allow the insurer to sue for malpractice, the Washington Supreme Court has ruled.

Sterling Savings Bank provided a loan to a borrower for the purpose of developing property. The bank included one important condition to the loan, requiring a first priority security interest on the property. But Sterling’s title insurance company, Stewart Title, failed to inspect the property before the loan was completed. Stewart Title therefore did not discover that Mountain West, the builder on the property, had already gained a mechanic’s lien as of the date of construction.

When the borrower was unable to make payments, Sterling and Mountain West faced off over priority interests. Stewart Title agreed to defend Sterling in the foreclosure action and hired the law firm of Witherspoon, Kelley, Davenport & Toole PS to represent the lender.

But Stewart Title and Witherspoon butted heads with regard to legal strategy. Seeking a quick settlement, Witherspoon stipulated that Mountain West had first priority. Stewart Title sought a more aggressive stance, arguing that equitable subrogation was a viable defense. Stewart Title fired Witherspoon to pursue its strategy, but the trial court held that the stipulation bound the parties and would not allow the alternative argument. The case was resolved in favor of Mountain West.

Stewart Title then filed a malpractice suit against Witherspoon. The law firm sought to dismiss the suit, arguing that it owed no duty to the insurer because Sterling was its client – not Stewart Title – despite the fact Stewart Title paid the bills. The Washington Supreme Court agreed.

“Witherspoon’s only client was Sterling. Stewart Title was a nonclient third party payor,” the court wrote. A lawyer or law firm may be liable to a third-party insurer based on a multifactor test employed by the state’s courts, but Stewart Title failed to meet the necessary requirements.

The alignment of interests between Sterling and Stewart Title was insufficient, the court found. Stewart Title argued that absent an actual conflict of interest between the insurer and the insured, the third-party insurer should be presumed to be an intended beneficiary and therefore able to bring a malpractice claim against the attorney. But the court said no such presumption existed, because it would create a duty of care to any third party.

“The fact that an insurer’s and insured’s interests happen to align in some respects – though perhaps not in all respects, as shown by contrasting Witherspoon’s strategy of seeking a speedy, yet just, settlement with Stewart Title’s different strategy – does not by itself show that the attorney or client intended the insurer to benefit from the attorney’s representation of the insured,” the court wrote.

Stewart Title also pointed to the retention letter, contending that the firm had a contractual duty to keep it informed about the progress of the litigation. Again, the court found this requirement insufficient. “Witherspoon’s duty to inform Stewart Title is insufficient to establish a further duty of care permitting Stewart Title to bring a malpractice claim based on an alleged breach of a different duty to a different entity – that is, Witherspoon’s duty of care to its client, Sterling.” The “limited duty to inform the nonclient third party payor does not give rise to a broad duty of care that would support a malpractice claim by the third party payor,” the court wrote. “It does not create that separate duty of care for the same reasons that the client’s and nonclient payor’s alignment of interests does not create such a separate duty: first, because acceptance of a duty to inform a nonclient third party payor does not show that the attorney’s representation was intended to benefit the third party payor...and second, because an attorney cannot contract away his or her professional duty to ‘not permit a person who pays the lawyer to render legal services for another to direct or regulate the lawyer’s professional judgment in rendering such legal services.”

Even putting both the alignment of interests and the contractual duty to inform “together does not cure the insufficiency.”

To read the decision in Stewart Title Guaranty Co. v. Sterling Savings Bank, 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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