In This Issue:

  • In the Context of a Bad Faith Claim, Insurer’s Defense That Coverage Denial Was Reasonable Put at Issue Otherwise Protected Attorney-Client and Work Product Communications
  • Coverage for False Ad Suit Precluded by Breach of Contract Exclusion
  • California Court: Insurer Waived Right to Rescind Policy by Not Investigating Application’s Misrepresentations
  • Texas or New York? With Texas Law Applying, Court Says Late Notice Does Not Preclude Coverage

In the Context of a Bad Faith Claim, Insurer’s Defense That Coverage Denial Was Reasonable Put at Issue Otherwise Protected Attorney-Client and Work Product Communications

Why it matters: Recognizing the “conflicting policy concerns,” a federal court judge in South Carolina nevertheless ruled that an insurer affirmatively waived both the attorney-client and work product protections from disclosure because it raised a defense that its coverage of denial was reasonable. The policyholder ultimately was hit with a $55 million judgment and sued the insurer, alleging claims of bad faith failure to settle. In its affirmative defenses to the complaint, the insurer argued that it had a reasonable basis to deny coverage in the underlying litigation. In response, the policyholder sought discovery to test that defense and issued a subpoena to the insurer’s coverage counsel, seeking disclosure of communications prior to the commencement of the litigation. The court rejected the insurer’s objections to such discovery with respect to attorney-client privilege, holding that “insurers’ thoughts and knowledge are at the center of a claim for bad faith.” Thus, “where an insurer in a bad faith claim asserts an affirmative defense that it acted reasonably and in good faith, the insurer puts at issue the evidence it had before it at the time it denied the claim, including communications with counsel relevant to its state of mind and directly pertains to its “thoughts and knowledge.” With respect to work product, the court ordered disclosure relying on the exception to such protections because the policyholder had no other means to discover the relevant facts.

Detailed discussion: In December 2010, the East Bridge Lofts Property Owners Association sued Creekstone Builders and related parties over a renovation performed on its condominium buildings. When Creekstone requested defense in the suit from Crum & Forster Specialty Insurance Co. pursuant to multiple commercial general liability policies, the insurer filed a declaratory judgment action seeking an order that it was not obligated to defend, indemnify, or provide liability coverage to the policyholder.

Meanwhile, the parties in the underlying litigation conducted a mediation session prior to trial. Although the insurer attended the mediation, it otherwise did not participate in the case. At trial, a jury awarded East Bridge $55 million.

Alleging bad faith failure to settle, Creekstone and East Bridge sued Crum & Forster, contending that the insurer “failed to make a meaningful offer” in the underlying litigation. Crum & Forster responded that it had a reasonable basis for denying the claim.

The plaintiffs then issued a subpoena to the insurer’s coverage counsel requesting his entire file for the time period beginning October 1, 2012, and ending June 19, 2014, regarding the insurance policies issued by Crum & Forster and pertaining to the underlying litigation.

In its motion to quash the subpoena and motion for a protective order, Crum & Forster argued that the requested communications were protected by both the attorney client privilege and work product protection.

But U.S. District Judge Richard M. Gergel found otherwise.

Courts must broadly construe rules enabling discovery and narrowly construe limitations on discovery, he said, and in South Carolina, the party asserting the privilege must establish lack of waiver.

Although the court acknowledged that determining “whether a communication has been put ‘at issue’ in a bad faith action is particularly nettlesome,” implicating conflicting policies, “[n]evertheless, ‘[a]n insurer’s thoughts and knowledge are at the center of a claim for bad faith,’ and the basis for the insurer’s evaluation of a claim is highly relevant—if not essential—to proving those ‘thoughts and knowledge.’ ”

Therefore, “where an insurer in a bad faith claim asserts as an affirmative defense that it acted reasonably and in good faith, the insurer puts at issue the evidence it had before it at the time it denied the claim, including communications with counsel relevant to its state of mind,” Judge Gergel wrote.

In the case at hand, the insurer retained its lawyer to provide legal advice on insurance coverage matters, including responding to correspondence from counsel for the Creekstone entities raising questions as to coverage matters.

“Defendant has asserted as an affirmative defense that it ‘had a reasonable basis for’ its decision to deny coverage,” the court said. “On this evidence, the Court finds that [Crum & Forster] has failed to establish a lack of waiver of the attorney-client privilege for at least part of the time period to which the subpoena applies.”

The judge set the relevant time period for the waiver from October 2012—when Crum & Forster first responded to the notice of the underlying lawsuit—until April 10, 2014, the day the insurer denied coverage for Creekstone.

Turning to work product, Judge Gergel again found that the insurer waived its protection for the relevant time period, rejecting Crum & Forster’s contention that it ended sooner when coverage litigation was anticipated.

The plaintiffs “have presented evidence that many of the documents asserted to be work product may be discoverable,” the court said. “First, the documents prepared by [counsel] to aid Defendant’s coverage determination are likely not prepared in ‘anticipation of litigation.’ Further, because the insurer’s thoughts and knowledge are central to Plaintiffs’ bad faith claim, these documents are likely to be the only method by which Plaintiffs may prove their claim.”

Evidence arising after a coverage denial period is irrelevant to the question of an insurer’s pre-denial conduct, the court noted, so the waiver was inapplicable after the denial occurred.

Crum & Forster also requested that the court exclude privileged communications it accidentally provided to the plaintiffs as part of an earlier discovery request, which it sought to pull back pursuant to Federal Rule of Civil Procedure 502. But the correspondence—e-mails between the carrier and its former coverage counsel dated July 23, 2013, through August 1, 2013—was similarly not privileged, Judge Gergel said.

“For the same reasons that [the subsequent counsel’s] files are not fully protected by attorney-client privilege and the work-product privilege, the Court finds that the correspondence at issue here is not privileged,” the court wrote. “The information contained in [the e-mails] reflects [the attorney’s] legal advice to Defendant on coverage matters, provided prior to Defendant’s decision to deny coverage. Defendant has asserted an affirmative defense that it ‘had a reasonable basis for’ its decision to deny coverage. Accordingly, the Court concludes that the attorney-client privilege and the work-product privilege do not apply to this correspondence, and, therefore, there is no basis to exclude it.”

Crum & Forster has already filed a motion for reconsideration in the case.

To read the order in East Bridge Lofts Property Owners Assoc. v. Crum & Forster Specialty Insurance Co., click here.

Coverage for False Ad Suit Precluded by Breach of Contract Exclusion

Why it matters: A breach of contract policy exclusion precludes coverage for a cross-claim against a policyholder alleging fraud and breach of contract, according to a California federal court. Claiming that Biotab Nutraceuticals failed to pay for advertising services, Inter/Media Time Buying Corp. filed suit seeking reimbursement based on contracts between the parties. Biotab cross-claimed that Inter/Media breached the parties’ contracts and committed fraud. Inter/Media turned to Axis Insurance Co. for a defense pursuant to a multimedia liability policy that included an errors and omissions endorsement for advertising services. Axis rejected the request, arguing that the policy’s exclusion for breach of contract applied. The court agreed, finding that all of the allegations in the counterclaim were contract-based, which nullified the applicability of the endorsement.

Detailed discussion: Inter/Media Time Buying and Biotab Nutraceuticals entered multiple contracts that required Inter/Media to provide various advertising services in return for payment. The most recent agreement, from November 2010, included a guarantee on Biotab’s part to pay previously accrued debts as well as provisions regarding the exclusivity of the advertising relationship and the disclosure of media costs.

Two years later, Inter/Media filed suit against Biotab to collect debts owed. Biotab responded with a cross-complaint against Inter/Media and related entities alleging breach of contract with respect to the exclusivity requirement and the full disclosure of media costs as well as fraud and other claims.

Specifically, Biotab claimed that it contracted to use Inter/Media exclusively for its advertising needs but that Inter/Media used other entities to perform media buying and other ad services, adding an additional commission or markup. Inter/Media also failed to provide Biotab with proof of the specific ads and their prices, the cross-claim alleged.

Inter/Media tendered defense of the suit to Axis Insurance Company pursuant to a series of Multimedia Liability Policies. As relevant to the dispute, the policies contained an “Advertising Services Errors & Omissions Endorsement” as well as an exclusion for breach of contract.

Axis denied the tender, taking the position that no potential for coverage existed under the policy; alternatively, the insurer said the breach of contract exclusion precluded coverage.

U.S. District Court Judge Dolly M. Gee first determined that the E&O endorsement applied because some of the claims arose out of the insured’s conduct “in connection with the performance of Advertising Services” as covered by the provision.

Biotab’s fraud in the inducement of the contract with Inter/Media was not covered by the endorsement because the performance of the contract was irrelevant to that claim, she explained. However, Biotab also alleged that Inter/Media misrepresented that it had provided accurate information regarding the actual costs incurred in placing ads—allegations that concerned services rendered in the performance of advertising services, the court said.

In addition, the complaint’s contractual claims also fell under the scope of the E&O endorsement, Judge Gee said, such as allegations that Inter/Media used brokers to place advertisements rather than performing the service itself.

“Because all of Biotab’s allegations—except for the allegation that Inter/Media made misrepresentations in inducing the contract—concern Inter/Media’s performance of Advertising Services, and Axis does not dispute the other elements required for coverage, the Court finds that the Policy covers the claims in Biotab’s cross-complaint against Inter/Media,” the court wrote.

The insured’s victory was short-lived as the court then held the contract exclusion applied to preclude coverage for the Biotab cross-complaint. California courts may construe exclusions narrowly but they also interpret the term “arising out of” broadly, the judge said.

The breach of contract exclusion stated that Axis “will not be obligated to pay Damages or Claim Expense for Claims for or arising out of any actual or alleged: breach of contract … except that this exclusion shall not apply to: a. Liability which the Insured would have incurred in the absence of such contract, warranty, guarantee or fiduciary relationship.”

“Here, all of the allegations in the underlying action that are covered under the agreement’s E&O Endorsement ‘flow from’ Inter/Media’s alleged contractual obligations to purchase the advertising time slots itself and to make full disclosures of all media costs to Biotab,” Judge Gee wrote. “The exclusion applies because Biotab’s claim that Inter/Media’s representations about doing the work itself and fully disclosing actual media costs were misrepresentations only insofar as the contract allegedly created the expectation that Inter/Media would not use brokers and would fully disclose actual media costs.”

The “inextricable linkage” between the insured’s contractual obligations and the allegations in the cross-complaint, coupled with the broad “arising out of” language in the contract exclusion, “militates toward a finding that the breach of contract exclusion applies, thus precluding coverage.”

Inter/Media’s attempt to dodge the exclusion relied upon Biotab’s other allegations grounded in fraud. “This argument falters because … Defendants did not establish that the allegations related to fraud in the inducement fall within the scope of the Policy’s coverage, which encompasses only claims in connection with the performance of Advertising Services,” the court said. “Misrepresentations made to induce Biotab to enter into a contractual relationship, before any contract existed, cannot be construed to be connected with the performance of Advertising Services.”

Because Axis had no duty to defend on the basis of the contract exclusion, Judge Gee denied Inter/Media’s motion for summary judgment and instead granted summary judgment for the insurer sua sponte.

To read the order in Axis Insurance Company v. Inter/Media Time Buying Corp., click here.

California Court: Insurer Waived Right to Rescind Policy by Not Investigating Application’s Misrepresentation

Why it matters: Despite misrepresentations in a policy application, a California federal court ruled that a recycling company was entitled to almost $1 million in coverage because the insurer waived its right to rescind. Sunwest Metals Inc. purchased two commercial general liability policies for its recycling operations facility from Star Insurance Co. But when arson occurred, Star refused to cover the policyholder’s losses and instead sought to rescind the policies. Star alleged that Sunwest misrepresented the nature of its operations in its application and because it did not truthfully qualify for the “scrap dealer program,” the policy was void. Nevertheless, after a bench trial, a magistrate judge ruled that the evidence established that Star received multiple documents and communications that raised “red flags” and that put it on notice that Sunwest’s business operations were different in scope than represented and Star failed to investigate or undertake any affirmative due diligence to evaluate the discrepancies. Normally, the insurer is under no obligation to inquire into the truthfulness of the representations made in the application unless the insurer is in possession of information that “distinctly implied” that the representations were false. For its part, the insured is required to establish “distinctly implied” with “clear and convincing evidence." Here, the court determined that the insured had met that burden. Therefore, the insurer waived its right to rescind the policies and was required to provide coverage for the fire at the facility at a cost of just under $1 million.

Detailed discussion: Sunwest Metals Inc. operates a recycling collection center in Anaheim, Calif., where it collects and sorts various recyclable materials to be sold to third parties for recycling. The company’s accountant served as the primary contact with the Dunlap Insurance Agency to procure insurance policies.

Dunlap in turn worked with G.J. Sullivan, representing Star Insurance Co. Star offered a “Scrap Dealers Program” that provided policies for companies like Sunwest—as long as the insured did not derive more than 15 percent of its annual revenue from paper or plastic.

Dunlap e-mailed a questionnaire to Star for an insurance quote stating that Sunwest’s annual sales were 80 percent aluminum, 20 percent iron and steel and “small amounts” of nonmetals. The underwriter considering the application visited Sunwest’s website and noticed it referenced paper and plastic recycling and contained images of stacks of baled cardboard.

A supplemental questionnaire again mischaracterized the paper and plastics recycling operation as minimal and made other errors about payroll and revenues. Despite questions about the commodities at Sunwest, the application was approved for $5 million in coverage, subject to a loss control report.

That report—based on a 10-minute site visit—also referenced paper as one of the recycled commodities and included photographs of large bales of cardboard in the yard. An inspection by the California Workers Compensation Independent Review Board provided to the insurer noted that paper products constituted 35 percent of the commodities at Sunwest.

Even when the policy was up for renewal and the insurer again found discrepancies between the commodities listed in the renewal application and the reports, Star renewed the policy.

In April 2013, a fire occurred at Sunwest’s facility that was determined to be arson committed by an unknown person. The policyholder notified Star and requested coverage under the policy. In the course of its investigation, the insurer became aware of the nature of Sunwest’s commodities and rescinded the policy.

Sunwest sued. A federal court judge granted partial summary judgment to Star, finding it undisputed that misrepresentations were made about Sunwest’s business on the applications but that genuine issues of material fact remained as to whether Star waived its right to rescind through its failure to conduct a reasonable inquiry.

After a five-day bench trial, U.S. Magistrate Judge Douglas F. McCormick issued 50 pages of findings of fact and conclusions of law ordering Star to pay almost $1 million to Sunwest.

“Under California law, an insurer’s right to information about material facts may be waived by its neglect to make inquiries as to such material facts where they are ‘distinctly implied’ in other facts communicated to the insurer,” the court explained. “Thus, although an insurer generally has no duty to inquire as to the truth of representations of fact made by the insured or its agent in an application, a duty to inquire may arise if the insurer or its agent is made aware of facts which bring those representations under suspicion and would induce a prudent person to make an inquiry.”

The “clear and convincing evidence” at trial established that the insurer was “in possession of facts that distinctly implied that Sunwest’s applications contained material misrepresentations regarding the extent of its paper and plastic recycling operation,” the court said.

Sunwest’s website indicated that paper and plastic were recycled on-site, a fact noted by an underwriter but not followed up on, Judge McCormick said. When the insurer received revenue information for the paper recycling, it did not seek clarification as to whether the numbers were annual, quarterly, monthly, or daily to put the amount in context.

The loss-control report should also have raised red flags for the insurer. “It is difficult to reconcile [the] loss-control report with Sunwest’s applications,” the court wrote. “Had anyone at Star Insurance compared the information in the loss-control report to the misrepresentations contained in the application, it is likely that Star Insurance would have discovered that Sunwest was not an appropriate risk for the Scrap Dealers Program.”

Particularly given the questions regarding Sunwest’s eligibility and the fact that neither Star Insurance nor its agents had an existing relationship with Dunlap or the applicant, the loss-control report’s “clear indication that paper was a significant part of Sunwest’s operations should have been investigated further.”

Photographs from a subsequent report—depicting large bales of cardboard in the yard—went unnoticed, and the report from the worker’s compensation inspection with numbers from Sunwest’s accountant that paper constituted 35 percent of the company’s business was ignored.

The insurer missed another opportunity when the policy was renewed, the court added.

“In sum, despite receiving several documents and communications that consistently showed that the amount of paper and plastics processing at Sunwest far exceeded that represented … and permitted under the [Scrap Program] Guidelines, Star Insurance and its agents did little to investigate or confirm the representations by the Dunlaps,” Judge McCormick wrote. “As Star Insurance’s own expert witness testified at his deposition, Star Insurance and its agents were ‘casual’ in the way they pursued the underwriting issues in this case.”

No one from the carrier ever spoke to Dunlap by phone—let alone in person—or requested a more thorough site visit than the 10 minutes spent for the loss-control report. “[T]he numerous red flags raised by the various reports and communications concerning Sunwest’s operations imposed upon Star Insurance a duty to investigate further,” the court said. “Having failed to do so, Star Insurance waived its right to rescind the Policies.”

The court ordered Star Insurance to pay Sunwest a total of $977,538.29.

Judge McCormick declined to award Sunwest damages for bad faith. A genuine dispute existed as to Sunwest’s entitlement to benefits under the policies, the court found, and Star’s decision to seek rescission was objectively reasonable, eliminating Sunwest’s claim of bad faith.

Even though the insurer did not correctly identify the reason it requested a breakdown of commodities processed by Sunwest during its investigation of the arson claim—Star said it needed them to calculate damages when it was really determining whether to rescind the policy—the court did “not find that these facts alone are sufficient to establish” bad faith by Star.

To read the findings of fact and conclusions of law in Star Insurance Co. v. Sunwest Metals, Inc., click here.

Texas or New York? With Texas Law Applying, Court Says Late Notice Does Not Preclude Coverage

Why it matters: In a unique conflict between a Texas statute and a New York choice-of-law provision contained in an insurance policy, a Texas bankruptcy judge concluded that Texas law applied. The law that ultimately would apply was outcome determination because under Texas law an insurer has to prove prejudice from any late notice whereas under New York law as applied only in maritime disputes it did not. After a thorough analysis, the court ruled that the Texas statute trumped the insurance policy’s New York choice-of-law provision. As part of the Deepwater Horizon oil spill ATP Oil & Gas Corp. was hit with a lawsuit from the federal government and subsequently filed for bankruptcy. Insurer Water Quality Insurance Syndicate refused to provide a defense or to indemnify ATP, arguing that the company failed to provide timely notice as required under the policy. The bankruptcy trustee countered that the Texas statute applied to Texas residents such as ATP, which required the insurer to demonstrate that it was prejudiced from any such late notice in order to avoid coverage. The court initially observed that “there is ambiguity as to whether to apply statutorily mandated Texas law or contract-mandated New York law,” which required that the ambiguity be resolved in the policyholder’s favor. The court further undertook an analysis of the choice-of-law factors enumerated in the Restatement and reached the same result.

Detailed discussion: Water Quality Insurance Syndicate insured ATP Oil & Gas Corporation against certain pollution-related losses pursuant to a policy issued on November 11, 2011. The policy required ATP to give “immediate notice” of any occurrence that gave rise to a claim under the policy and excluded coverage arising out of ATP’s “willful misconduct.”

On February 11, 2013, the United States sued ATP for discharging pollutants from an offshore platform located in the Gulf of Mexico as part of the Deepwater Horizon oil spill. The bulk of the lawsuit alleged willful misconduct by ATP. For example, the government alleged that the company constructed and operated a hidden tube to allow ATP to utilize an unpermitted chemical dispersant, which masked discharges of oil in wastewater that was discharged from the platform.

The complaint did contain a few allegations regarding negligent operations of the platform, such as a failure to properly operate the wastewater treatment system.

ATP delayed giving notice to Water Quality until September 12, 2013. The insurer refused to provide a defense based on the late notice and willful misconduct exclusion, and ATP was forced to provide its own defense.

After the company filed for bankruptcy, the trustee filed an adversary action against Water Quality seeking a declaration of rights and obligations under the policy with respect to the duty to provide reimbursement. Both parties filed motions for summary judgment.

The insurer told the court that late notice of the suit operated to eliminate any duty of coverage. ATP argued that under Texas law, an insurer must demonstrate prejudice as a result of the late notice, which Water Quality failed to do. Water Quality responded that the policy was governed by New York law, which does not require a showing of prejudice for maritime policies.

With the choice-of-law question outcome determinative in the case, U.S. Bankruptcy Court Judge Marvin Isgur first had to decide what law governed the dispute.

As no federal rule regarding notice could be identified, the court turned to the laws of the two states. In Texas, an insurer must demonstrate prejudice before it will be allowed to enforce a notice provision in its insurance policy, the court said. Alternatively, although New York statute generally requires a showing of prejudice for late notice to serve as a valid defense to coverage, the statute explicitly excludes “insurance in connection with ocean going vessels.”

Adding to the problem, the court noted “an ambiguity in the choice of law provision when applicable law is applied to the contract.” While the language of the policy itself contains a choice of New York law, “a policy of insurance, by necessity, incorporates applicable state law insurance requirements into the terms of the policy. When Water Quality issued the policy to a Texas resident, the policy effectively incorporated applicable Texas law.”

“Thus, there is ambiguity as to whether to apply statutorily mandated Texas law or contract-mandated New York law,” Judge Isgur wrote. “Because conflicts within insurance policies are resolved in favor of the insured, maritime law mandates the Court to apply Texas law because Texas law is more favorable to the insured.”

The court didn’t stop there, however, and “for the purposes of completeness,” further analyzed the question under the Restatement (Second) of Conflicts of Laws. The court considered seven factors: the needs of the interstate and international systems; the relevant policies of the forum; the relevant policies of other interested states and the relative interests of those states in the determination of the particular issue; the protection of justified expectations; the basic policies underlying the particular field of law; certainty, predictability and uniformity of result; and ease in the determination and application of the law to be applied.

Of the factors, just one favored New York law: the ease of determination of the law to be applied. “The contract specifies New York law, and the application of the laws of another state (applied through federal maritime law) requires an analysis of factual determinations such as the residence of the insured,” the court said.

But the rest of the factors were either neutral or—in the case of the needs of the interstate and international systems and the basic policies underlying the field of law—heavily favored Texas, Judge Isgur determined.

“Texas and New York both generally recognize the merits of requiring prejudice to be shown when notice is late,” he wrote. “Although New York makes a distinction in the field of maritime insurance, that distinction pales in favor of the overall concerns expressed both in Texas insurance regulatory needs, and the broader implications of requiring a showing of prejudice.”

Therefore, whether applying the Restatement factors or considering the ambiguity in the policy, Texas law ruled, the court concluded. “Texas has a substantially greater interest in the outcome of this dispute than New York,” the judge added.

With late notice not a problem, the court turned to the policy’s exclusion for willful acts. Although “the bulk” of the complaint alleged willful acts, “[t]he policy covers negligent acts,” Judge Isgur wrote. “The lawsuit alleges some negligent acts. Accordingly, under the familiar eight-corners rule, Water Quality must defend the lawsuit.”

To read the opinion in In re: ATP Oil & Gas Corp., click here.