Late notice to insurer costs Maryland bank millions

Insurance law generally imposes on a policyholder the duty to give timely notice of claims to its insurance company. Sometimes, because of forgetfulness, ignorance, neglect, or a number of other reasons, companies fail to immediately give notice of loss and potential losses to insurers. In those circumstances, insurers often raise the defense of “late notice.” As a result, a number of courts have devised a “notice prejudice rule” which limits the use of the late notice defense to situations when the delayed notice actually caused prejudice to the insurer.

In St. Paul Mercury Insurance Company v. American Bank Holdings, Inc., the Fourth Circuit, applying Maryland law, addressed the question of what qualifies as “prejudice.” In that case, American Bank Holdings, Inc., did not provide notice to its insurer until after a $98.5 million default judgment had been entered against it in the underlying claim. St. Paul raised the defense of late notice, argued that it was prejudiced, and denied coverage.

 Although the bank was eventually successful at overturning the $98.5 million default judgment, it still spent $1.8 million resisting collection on the judgment and having the judgment set aside. All of this was because the underlying complaint had been served on the bank’s CFO, who had left employment at the bank. Another officer later found the complaint and transmitted it to an outside lawyer, who claims he never received the complaint. This procedure was described by the district court as “a variety of screw-ups” such that “significant suit papers that should have gotten immediate attention didn’t.” Writing for a unanimous panel, Judge Niemeyer of the Fourth Circuit explained that “corporate screw-ups” are not a basis to excuse the failure to give timely notice to an insurer, if the corporation expects to be indemnified for the defense of the claim.

 “Actual prejudice” was shown in this case by the insurer, because the bank’s failure to give timely notice prevented the insurer from selected counsel, consulting with counsel on the defense of the claim, prevented the timely raising of a personal jurisdiction defense, and prevented the possibility of settlement discussions with the underlying plaintiff either prior to the entry of default judgment or prior to the expenditure of $1.8 million spent to resist and set aside the default judgment. These were all rights which the insurer has under the insurance contract, and all rights which it was not able to exercise because of the bank’s failure to give timely notice. As a result, actual prejudice was shown and St. Paul's declaratory judgment was granted on the basis that it had no duty to pay for American Bank's defense costs.

Sanctions for failing to investigate insurance under Federal Rule 26

In two recent cases, lawyers have been sanctioned for failing to understand their client’s insurance program. These cases (along with others from the past) illustrate that courts are increasingly placing a burden on defense lawyers to have a basic understanding of insurance and to thoroughly discuss insurance matters with their clients.

North Carolina attorney sanctioned for failing to disclose umbrella policy

Last December, the United States District Court for the Western District of North Carolina sanctioned an insurance defense lawyer with a $1,000 sanction because the Court found that she failed to properly discuss and review the applicable insurance her client had for a claim. Further inquiry would have revealed a $10 million umbrella policy above the first $1 million layer of commercial general liability insurance. Palacino v. Beech Mountain Resort, Inc., 2015 WL 8731779 (W.D.N.C., Dec. 11, 2015).

Under Federal Rule of Civil Procedure 26(a)(1)(A)(iv), a defendant must disclose, relatively early in a case, “any insurance agreement under which an insurance business may be liable to satisfy all or part of a possible judgment in the action or to indemnify or reimburse for payments made to satisfy the judgment.” In this case, the umbrella policy was only disclosed after mediation and after discovery closed. The Court concluded that this was a violation of Rule 26, as “Defendant was legally obligated to disclose both [insurance] policies in its Initial Disclosures, and its failure to do so violated its obligations under the Federal Rules of Civil Procedure and the Court’s Pretrial Order.”

By only disclosing the first $1 million in coverage under the CGL policy – presumably the policy which the attorney was retained under – the attorney neglected to investigate the full range of available insurance and to disclose the $10 million umbrella. The attorney submitted an affidavit stating that, in responding to Rule 26, the Risk Manager for the defendant was asked to provide all applicable insurance policies. However, the Court ruled that this was not enough. It noted that the attorney's affidavit in opposition to sanctions did not state that the attorney "independently verified the completeness of the information provided" or that "additional steps [were taken] to ensure that the information" provided in the Initial Disclosures was complete "or that a reasonably inquiry was made prior to providing the Initial Disclosures." The Court goes on to state that the attorney should have been able to "represent to the Court that she undertook [an] independent inquiry to verify whether the information provided by [the Risk Manager] was complete prior to signing the" Initial Disclosures. However, the Court gave no guidance as to how a retained defense attorney is to show that “a reasonable inquiry [into insurance policies] was made prior to providing the Initial Disclosures” other than asking the Risk Manager – presumably the most knowledgeable employee of the defendant – to provide all insurance policies. Does this require asking other employees of the client? Reaching out to the client's insurance broker? Physically inspecting the client's files?

In addition to the $1,000 sanction against the attorney, the client was also fined $500 for its failure to uncover and disclose the umbrella policy.

Tenth Circuit affirms sanction for failing to disclose D&O policy

In Sun River Energy, Inc. v. Nelson, 800 F.3d 1219 (10th Cir. 2015), decided last September, the Tenth Circuit affirmed an award of sanctions against counsel for failing to disclose the company’s directors and officers (D&O) insurance policy in its initial disclosures.

In that case, the Plaintiff had a "Directors and Officers Liability Insurance Policy including Employment Practices and Securities Claims Coverage" which arguably provided coverage for certain counterclaims which the Defendant may have made. However, by the time the policy was disclosed, any potential coverage under that “claims made” policy had lapsed.

The federal magistrate judge, in issuing the underlying sanction, wrote that counsel never “took a serious look at whether there was applicable insurance” and “exhibited deliberate indifference to the obligation of providing relevant insurance information under Rule 26.”

Importantly to defense counsel, the Tenth Circuit flatly rejected the attorney’s excuse that “counsel need not bother to review the actual terms of an insurance policy . . . before denying the existence of the potential coverage, so long as he believes the existence of coverage would be very unlikely or unusual.” Instead, defense counsel is obligated to review all applicable policies and then provide the information required by Rule 26 when completing Initial Disclosures. Implicit in the Tenth Circuit’s ruling is that the lawyer must have a basic understanding of insurance law and whether certain policies may provide coverage for the claims at issue.

Finally, no discussion of defense counsel’s potential insurance obligations is complete without reference to Shaya B. Pacific, LLC v. Wilson, Elser, Moskowitz, Edelman & Dicker, 827 N.Y.S.2d, 231 (N.Y. Sup. App. Div. 2006). In that New York case, the court held that an attorney could be liable for negligence/malpractice for failing to investigate his client’s insurance coverage for a claim or failing to notify the insurer of a claim. However, the determination of negligence would also turn on “the scope of the agreed representation.” Clarifying the scope of representation - by excluding any obligation to consult on insurance coverage - is thus important to attorneys who do not feel comfortable opining on insurance matters.

Marijuana inventory covered under commercial insurance policy (D. Colo)

As the legal markets for marijuana – medicinal and recreational grow – so do the commercial insurance implications. The United States District Court for Colorado just issued an insurance coverage opinion in a case where a marijuana company sued its insurer. Green Earth Wellness Center, LLC v. Atain Speciality Insurance Company, No. 13-CV-03452-MSK, 2016 WL 632357 (D. Colo. Feb. 17, 2016). The case may have national significance going forward because Judge Kruegar, in a 27 page opinion, ruled that the inventory itself, i.e., the marijuana, was insurable under the a "Commercial Property and General Liability Insurance Policy." The ruling contains her opinions on a number of exclusions and whether they apply to commercial marijuana production.

The Plaintiff-Policyholder, Green Earth, was in the business of commercial marijuana cultivation, which it sold through its own medical marijuana dispensary. According to the opinion, smoke and ash from a nearby forest fire entered the ventilation system of Green Earth, intruding into the growing operation, and causing damage to Green Earth’s plants and inventory.

Predictably, the Insurer argued that Green Earth was not entitled to coverage because the policy included language that excluded coverage for “contraband” and “property in the course of illegal . . . trade.” More broadly, the Insurer argued that general public policy prevented coverage for marijuana companies.

The Court characterized Green Earth as having two main types of claims under the policy: a claim for $200,000 for plants currently growing, and a claim for $40,000 of marijuana which was already harvested and being prepared for sale.

Regarding the $200,000 in standing or growing plants, the Insurer argued that the exclusion for “growing crops” applied (and, indeed, the insurance quote provided to Green Earth plainly stated “Coverage does not extend to growing or standing plants.”). This exclusion is straightforward enough and was applied by the Court. “Growing crops” includes “any body of plants tended for their agricultural yield, at least until they are harvested.” Simply put, the policy is not crop insurance, even if your crop is marijuana.

The claim for $40,000 in inventory was more complex. This case, as much as others, highlights that the law of the forum is incredibly important to insurance coverage disputes. As a threshold matter, the Court applied Colorado state law, and this being a contract, only applied Colorado state law. Then, applying common insurance law maxims, the Court found that the policy failed to define “contraband” and, in light of Green Earth’s legal business in the Colorado medical marijuana trade, that the “contraband” exclusion was ambiguous. The Court went on to state that the “contraband” exclusion is ambiguous in light of the conflict “between the federal government’s de jure and de facto public policies regarding state-regulated medical marijuana.” Further, in Green Earth’s favor, the Insurer knew about Green Earth’s business in the marijuana industry prior to issuing the policy but never voiced any exception to insuring plants, marijuana-in-process, or the finished inventory.

The Insurer, in a last-ditch effort, then argued that in light of federal law, its own insurance policy was an illegal contract. The Court ruled that because the Insurer entered into the contract knowing full-well the scope of Green Earth’s business, it was obligated to either (1) comply with the contract or (2) pay damages for having breached it. This argument by the Insurer seems misguided: by intentionally arguing that an Insurer is in the business of marketing and selling insurance contracts that it believes are illegal under federal law, it essentially admits to collecting unearned premium for selling “illusory coverage” or committing other unfair or deceptive trade practices which are often prohibited by state statute and subject to double or treble damages.

There are other minor issues in the opinion as well. Green Earth, having survived summary judgment, will now have to prove its breach of contract, bad faith, and delayed payment claims at trial.

This ruling is important for a number of reasons. First, for the Court applied conventional insurance law to marijuana and cannabis growing. Second, it highlights the importance of choice of law, conflicts of law, and venue. In the case of marijuana-related businesses, and in the face of this opinion, the conflicts of law issues can be outcome-dispositive in future insurance coverage disputes. If the Court would have applied another state’s law, the Court may not have found the term contraband ambiguous, and the marijuana grower may have lost. Third, commercial marijuana growers need to investigate obtaining crop insurance if they wish to insure standing and growing plants.

Insurance Requirements in Commercial Contracts (Part 5)

In the final part of our series, we will address certificates of insurance.  In Part 1, we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention.  In Part 3, we explained the difference in Loss Payee versus Lender Loss Payee status.  In Part 4, we discussed theft and crime coverage.

Business lawyers and deal makers are often given a Certificate of Insurance, which was typically prepared by the counterparty’s insurance broker on a standardized form (such as the Acord 25 form for liability insurance and the Acord 27 for property insurance).

Certificates of insurance should be considered, at most, to be a snapshot in time. They are a document that evidence that on a particular day, a particular insured had the insurance in place which is generally described on the certificate. However, the certificate will typically not note important exclusions. It will not discuss the deductible on the policy or whether it is actually a self-insured retention. And, if the insured cancels the insurance the very next day (or alters the coverage limits), the certificate holder will typically have difficulty finding out that the certificate represents a policy which is no longer in effect.  

Additionally, the “boilerplate” on these forms should be carefully read and considered by anyone who receives one. Certificates of insurance typically state that they are issued only for information purposes, and that they confer no rights. Certificates of insurance are not contracts, and they are especially not insurance contracts. Certificates of insurance, as the disclaimers plainly state, do not change the coverage that the actual policy provides.  

Because of this strong disclaiming language, and the fact that the certificates are usually prepared by the insurance broker, the certificates are unlikely to be binding on the insurer. When in doubt, also request a certified copy of the actual policy; do not rely on a certificate of insurance. If a counterparty balks at producing the actual policy, be concerned.

 Conclusion

This series was intended to shed some light on insurance provisions commonly encountered by transactional lawyers or deal makers when reviewing commercial agreements.  These are just a few of the commonly-encountered insurance provisions that commonly occur.  Often, the language used in commercial contracts (whether they be financing agreements, contracts, leases, or other documents) does not actually provide for the risks which the parties sought to cover or require insurance for. Poorly worded insurance clauses can cause confusion, can require commercially-unavailable insurance, or can simply frighten away customers with unnecessary requirements. If clients or counsel are unfamiliar with insurance, they should seek assistance from their own insurance brokers or an insurance lawyer.

Insurance Requirements in Commercial Contracts (Part 4)

Welcome to Part 4 of the Insurance Requirements in Commercial Contracts series.
 
In Part 1, we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention.  In Part 3, we explained the difference in Loss Payee versus Lender Loss Payee status.  Today's blog post is about theft and commercial crime coverage.

A secured lender may wish to require the borrower to obtain coverage for “theft” of the property (equipment, inventory, etc.) which secures the loan. Otherwise, the personal property could be stolen and the secured lender would be left without any collateral securing the financing.  

Ordinary property coverage will typically cover many types of theft, subject to exclusions and any special terms of the policy. At the same time, the insurer may require the insured (i.e., the borrower) to have certain physical security measures in place before writing the insurance, such as fences, locked gates, security cameras, or a monitored burglar alarm. The underwriter of the insurer will typically, either prior to writing the policy or shortly after inception, verify the existence of these physical security measures. These physical security measures not only assist the insurer in helping to prevent a claim, but ultimately also inure to the benefit of the lender who will be protected when the borrower maintains physical possession and custody of the items securing the loan. However, in many cases these policies will contain an exclusion for employee theft. This is significant because, by some estimates and depending on industry, up to 80% of workplace crime is the sort of insider theft/white-collar fraud conducted by a company’s own employees. 

A commercial crime policy, often described as a fidelity bond or fidelity insurance, is designed to insure against criminal acts of a company’s own employees, as well as certain other criminal acts by non-employees. This policy is directly squarely at the theft of money, marketable securities, embezzlement, certain computer crimes, forgery, and other crimes which businesses are sometimes targets of and victims of. Dedicated crime coverage will also often cover other situations where a business is the victim, such as the receipt of counterfeit money or a financial loss which is the result of a forgery or facsimile signature. 

Like many types of insurance, a crime policy also serves as a type of credit enhancement to a lender. If a borrower already has a crime policy (or is required to obtain one) the borrower will be better able to weather an unpredicted criminal event and thus be better able to have the cash flows to service its debt obligations. 

While a crime policy will cost additional premium, it will provide much broader coverage in the event of criminal acts, particularly by “insiders” of the company such as employees, management, and often officers of the company. When drafting or insisting on contract terms which require the provision of “theft” insurance, the parties need to clarify whether the financing documents only require ordinary property coverage, or also require a commercial crime policy or fidelity bond.

Later this week we will probably post Part 5, the final installment of our series on insurance provisions in commercial contracts.

The Economics of the ALI's Principles of Liability Insurance project

Yale Law Professor George L. Priest, who teaches in the fields of insurance law and law & economics, has written the first paper that I am aware of which applies a law & economics analysis to the ALI's Insurance Principles project.  This paper gives a very good explanation of the basic law & economic explanation of liability insurance and the social benefit of liability insurance (although that explanation takes nearly 25 pages of a 43 page paper). 

As readers of this blog may know, the American Law Institute has undertaken a project to publish a "Principles of Liability Insurance," similar to the Restatements of the Law which the ALI is well-known in legal circles for publishing.  The Principles of Liability Insurance project has shifted from being little-known outside of academic circles and is now widely discussed at meetings of coverage lawyers.  Note that this is no Restatement of the law; which, by its name, would imply it simply restates the law as it exists. 

The project is currently being managed by Tom Baker of the University of Pennsylvania and Kyle Logue of the University of Michigan, along with input from a number of stakeholders, and seeks to produce a book (perhaps, a multi-volume set) to set forth the law (as the authors believe it should be) on important issues of liability insurance coverage. In states with a paucity of insurance case law, the publication by the ALI of the Principles of Liability Insurance Law will likely have a major impact; in those states, judges will be more likely to rely on the ALI's Principles project as akin to a national treatise on insurance law. 

In states which already have a well-developed body of state common law (i.e., New York, New Jersey), the impact of the Principles project will likely be less.  North Carolina would probably fall somewhere in the middle; our state's insurance law has several large areas which are underdeveloped or completely undeveloped, however we are far ahead of many states which have less reported opinions, lack an intermediate appellate court, have fewer cases decided on summary judgment (and thus fewer appeals of legal issues), and which lack courts for complex commercial disputes such as the North Carolina Business Court.    

Professor Priest clearly explains his view that the greatest aggregate social utility of liability insurance is when it is easy to obtain and thus widely distributed.  He believes, in short, that although Professor Baker and Professor Logue intend to re-write various rules to be pro-policyholder in the short term (i.e., in an individual case), that these revisions may end up harming policyholders more broadly in the long run by making liability insurance harder to obtain, thus having a net negative effect. 

Scottsdale Ins. Co. v. B&G Fitness Center, Inc. - when is the injured plaintiff an indispensable party to a coverage action under Rule 19?

A common question in insurance coverage litigation is whether the injured plaintiffs in the underlying litigation are necessary parties to the coverage case. A recent, detailed opinion from Judge Fox in the Eastern District of North Carolina squarely deals with this issue and lays out a roadmap for dealing with the issue in future cases. Judge Fox concludes that the underlying plaintiffs are not necessary parties to the coverage action.  Whether the plaintiffs from the underlying litigation are necessary to the insurance coverage action - between the defendant from the underlying action and its insurance company - has broad implications for many procedural questions, as well as strategic implications.   


In Scottsdale Ins. Co. v. B&G Fitness Center, Inc., 2015 WL 4641530 (Aug. 4, 2015 E.D.N.C.), the defendant had been sued by five plaintiffs in two separate lawsuits regarding alleged surreptitious video recording in the tanning bed area of a gym (the “Underlying Actions”). Scottsdale, the insurer, then filed a declaratory judgment action in federal court, seeking a declaration that there was no coverage under its insurance policy for the torts alleged in the Underlying Actions.


The defendant, the policyholder gym who had been sued in the Underlying Actions, moved to dismiss the case under Federal Rule of Civil Procedure 12(b)(7) for the failure to join the five individual plaintiffs from the Underlying Actions as co-defendants, arguing that these were necessary parties to the insurance declaratory judgment action under Rule 19.


The Court first explained that whether a party is indispensable under Rule 19 requires a two-step inquiry. The party must be “necessary” under Rule 19(a) and if the “necessary” party cannot be joined, the party has to be determined to be “indispensable” under Rule 19(b). The moving party – here, the gym defendant – bears the burden of showing that the missing party is indispensable. The gym argued that the underlying plaintiffs were both necessary and indispensable because under Rule 19(a)(1)(B)(i) they claimed an interest in the action and that interest would be defeated or impeded by the failure to join them to the coverage action.


Judge Fox concluded that the underlying plaintiffs were, “at best, incidental beneficiaries to the insurance contract at issue” and because they were not parties to the insurance contract and did not already have a judgment against the gym, they lacked standing to have the insurance contract construed. See also, Whittaker v. Furniture Factory Outlet Shops, 145 N.C. App. 169, 172 (2001). “Without having obtained a judgment or settlement against [the gym], the third party claimants have no legal rights under the insurance contract. Because the third party claimants lack a recognized legal interest in this action, they cannot be necessary parties.” B&G Fitness Center, Inc., at *4. Judge Fox further concluded that, even if the plaintiffs from the Underlying Actions had an interest in the coverage litigation, it was aligned with the gym – they both were seeking insurance coverage under the Scottsdale policies – and thus the gym would adequately represent the interests in maximizing the insurance recovery available for the plaintiffs. In other words, only “when the insured was not actively defending the lawsuit” or is subject to a default judgment is it proper to hold that the absent third-party is indispensable. Id. at *5. But as a normal matter, “the insured’s position protects the interest of the absent party because both parties want the insurance to be viable.” Id., citing CFI Wis. Inc. v. Hartford Fire Ins. Co., 230 F.R.D. 552, 554 (W.D. Wis. 2005).


The question of whether underlying plaintiffs must be joined in the coverage action has to be considered in every coverage action. And, the outcome of this determination may be different in different jurisdictions. There are a number of federal cases from other jursidictions which hold that absent third-party tort plaintiffs are required to be joined under Rule 19. B&G Fitness is ongoing and it remains to be seen whether Judge Fox’s decision will be appealed or reviewed by the Fourth Circuit.


This question also has major implications for whether the coverage action can even succeed in federal court. Sometimes, a single federal district court may not be able to obtain personal jurisdiction over (1) the insurer, (2) the insured, and (3) the underlying tort plaintiffs. Even if a federal district court has adequate personal jurisdiction, insurance coverage litigation in federal court is typically premised on diversity jurisdiction under 28 U.S.C. § 1332. In some cases, that diversity jurisdiction only exists in the absence of the underlying plaintiffs; i.e., if the underlying plaintiffs have to be joined as indispensable parties under Rule 19, and joinder destroys diversity, then the coverage action can only be litigated in state court. Those facts typically arise when the policyholder sues the insurance company, joining the underlying tort plaintiffs as defendants in the coverage action. Of course in that case, the insurance company could move to have the parties re-aligned to reflect the true adverse interests in the suit, in which case diversity may exist. See, e.g., Earnest v. State Farm Fire and Cas. Co., 475 F.Supp.2d 1113, 1117 (N.D. Ala 2007). I have previously written about the topic of realignment in coverage cases in the Fourth Circuit, which you can find here: http://www.law360.com/articles/396074/builders-v-dragas-an-important-reminder-for-insurers