New York Court Allows Disgorgement Coverage Action to Proceed

In its recent decision in J.P. Morgan Securities, Inc. v. Vigilant Ins. Co., 2013 N.Y. LEXIS 1465 (NY June 11, 2013), New York’s Court of Appeals – New York’s highest court – had occasion to consider whether an insured can seek recovery against its insurers for amounts described as “disgorgement” by the Securities and Exchange Commission.

The J.P. Morgan decision relates to coverage under a professional liability insurance program for a payment made pursuant to a settlement with the SEC.  The insureds, various Bear Stearns entities, had been the subject of an SEC investigation in connection with its alleged practices of facilitating late trading and engaging in deceptive market timing for certain favored customers.  While Bear Stearns did not admit to liability, it ultimately settled with the SEC by agreeing to a payment in the amount of $160 million and a separate civil penalty payment in the amount of $90 million. The SEC order described the $160 million payment in an order as one for disgorgement. New York’s Appellate Division for the First Department held as a matter of public policy that both the disgorgement payment was uninsurable, and that as such (and because the $90 million penalty was not covered), the underlying declaratory judgment action brought by J.P. Morgan on behalf of Bear Stearns could not survive a motion to dismiss.

On appeal, the Court of Appeals agreed that New York has recognized that public policy will prohibit insurance coverage when the underlying damages result from the insured’s conduct intended to cause harm.  The Court of Appeals nevertheless held that at the pleadings stage, it could not be determined that Bear Stearns willfully violated federal securities laws, and in particular, the SEC order was not determinative of this issue.  As such, it was premature to conclude as a matter of law that Bear Stearns could not, as a matter of public policy, be indemnified for the payment to the SEC.  The insurers also argued that as a matter of public policy, a party cannot be insured for disgorgement of ill-gotten gains.  Bear Stearns agreed that as a matter of principle, such amounts are uninsurable, but contended that the majority of its payment to the SEC should not be characterized as a disgorgement, notwithstanding the SEC’s label to the contrary.  Rather, Bear Stearns contended that at least $140 million of its payment “represented the improper profits acquired by third party hedge fund customers, not revenue that Bear Stearns’ itself pocketed.”  The court found validity in this argument, noting:

Contrary to the Insurers' position, the SEC order does not establish that the $160 million disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned as a result of its securities violations. Rather, the SEC order recites that Bear Stearns' misconduct enabled its "customers to generate hundreds of millions of dollars in profits." Hence, at this CPLR 3211 [New York’s civil procedure rule for motions to dismiss] stage, the documentary evidence does not decisively repudiate Bear Stearns' allegation that the SEC disgorgement payment amount was calculated in large measure on the profits of others.

The court further reasoned that the facts involved were notably different than in other New York cases where courts that insureds as a matter of law were not entitled to coverage for disgorgement of ill-gotten gains, such as the decisions in Millennium Partners, L.P. v Select Ins. Co., 889 N.Y.S.2d 575 (1^st Dep’t 2009) and Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 782 N.Y.S.2d 19 (1^st Dep’t 2004):

Bear Stearns alleges that it is not pursuing recoupment for the turnover of its own improperly acquired profits and, therefore, it would not be unjustly enriched by securing indemnity. The Insurers have not identified a single precedent, from New York or otherwise, in which coverage was prohibited where, as Bear Stearns claims, the disgorgement payment was (at least in large part) linked to gains that went to others. Consequently, at this early juncture, we conclude that the Insurers are not entitled to dismissal of Bear Stearns' insurance claims related to the SEC disgorgement payment.

As such, the Court of Appeals held that the declaratory judgment action should be reinstated, allowing Bear Stearns to pursue its insurance recovery action.  In doing so, the court noted that its decision was based solely on whether the allegations in the underlying complaint could survive a motion to dismiss.  As the court explained, “although we certainly do not condone the late trading and market timing activities described in the SEC order, the Insurers have not met their heavy burden of establishing, as a matter of law on their CPLR 3211 dismissal motions, that Bear Stearns is barred from pursuing insurance coverage under its policies.”

California Court Holds Insurer Precluded from Suing Defense Counsel

California’s First District Court of Appeal n J.R. Marketing, LLC v. Hartford Casualty Ins. Co. (1^st District, June 11, 2013), recently considered whether an insurance carrier had a right to directly sue the insured’s independent counsel for reimbursement for payment of fees and costs which were allegedly unreasonable or otherwise outside the scope of the insurer’s contractual defense obligations.

The court of appeal’s opinion was its third decision arising from a coverage action involving two liability insurance policies issued by Hartford Casualty Insurance Company to Noble Locks Enterprises, Inc. and J.R. Marketing, LLC.  Hartford had originally denied the tender of defense to it, was sued by various tendering parties, reconsidered the tender and agreed to provide a defense but then delayed in paying defense bills.  The trial court subsequently entered an “enforcement order” requiring Hartford to

… pay the insured cross-defendants’ outstanding invoices within 15 days and to pay “all future reasonable and necessary defense costs within 30 days of receipt.”  Acknowledging a right of reimbursement, the enforcement order provided, “[t]o the extent Hartford seeks to challenge fees and costs as unreasonable or unnecessary, it may do so by way of reimbursement after resolution of the Avganim matter.  (Citation omitted.)

The court further held that Hartford was not entitled to any of the protections afforded insurers in California Civil Code section 2860 because it had breached and continued to breach its obligations to pay reasonable and necessary defense expenses and to provide “Cumis” counsel.  The enforcement order was affirmed in 2007 by the appellate court in an unpublished decision.  Hartford subsequently paid over $15 million to the insureds’ independent counsel for its fees and costs.

The present appeal was taken from a judgment of dismissal following the sustaining of demurrers, without leave to amend, to a cause of action for reimbursement against the law firm defending the insureds in the underlying actions (and which had prosecuted the coverage action), and against a non-insured also represented by that law firm.

Initially, the appellate court reiterated that Hartford did not have any rights under section 2860 because of its original breach of the duty to defend.  Included in those rights is the right to arbitrate fee disputes.  The court stated that allowing Hartford to sue the independent counsel for reimbursement would frustrate several of the underlying principles behind section 2860, including the insured’s right to control the defense when the insurer has breached its obligations to defend the insured:

As set forth above, it is clear California law bars an insurer, like Hartford, in breach of its duty to defend from thereafter imposing on its insured its own choice of defense counsel, fee arrangement or strategy.  This court now takes the law one slight step further by holding Hartford likewise barred from later maintaining a direct suit against independent counsel for reimbursement of fees and costs charged by such counsel for crafting and mounting the insureds’ defense where Hartford considers those fees unreasonable or unnecessary. 

It was stated that to hold otherwise would give a breaching carrier greater rights than an insurance carrier which had complied with its duty to defend an insured, by allowing the breaching carrier to have a court determine the fee dispute.  It was also noted that the court was not determining whether an insurer could sue independent counsel for fraudulent billing practices.  Instead the decision was that where a carrier has breached its duty to defend and a billing dispute subsequently arises with regard to the fees and costs incurred by independent counsel, the insurer’s sole remedy is a claim against the insured, not independent counsel.

The court also found that there were no grounds to reverse the dismissal of the reimbursement claim against the non-insured party also defended by the independent counsel in an underlying action, because Hartford had failed to allege facts supporting such a claim and had not supported its appeal by reference in its opening brief to legal authority and citations to the appellate record.

New York Court of Appeals Sets Forth New Rule for Breach of Duty to Defend

In its recent decision in  K2 Investment Group, LLP v. American Guarantee & Liability Ins. Co., 2013 N.Y. LEXIS 1461, 2013 NY Slip Op. 4270 (NY June 11, 2013), New York's Court of Appeals – New York’s highest court – announced a new rule regarding the consequences for breaching a duty to defend under New York law.

Prior to the decision in K2, New York courts at both the state and federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for the purpose of contesting an indemnity obligation.  See, e.g., Servidone Construction Corp. v. Security Ins. Co., 488 N.Y.S.2d 139 (NY 1985) (holding it is impermissible for a court to enlarge a policy’s coverage on the basis of an insurer’s breach of a duty to defend); Hotel des Artistes, Inc. v. Gen. Accident Ins. Co. of Am., 775 N.Y.S.2d 262 (1^st Dep’t 2004); Robbins v. Michigan Millers Mut. Ins. Co., 633 N.Y.S.2d 975 (3d Dep’t 1997); Hugo Boss Fashions, Inc. v. Fed. Ins. Co., 252 F.3d 608 (2d Cir. 2001). In fact, this rule was reaffirmed as recently as June 11, 2013 – the same day as the K2 decision – by the United States Court of Appeals for the Second Circuit in CGS Industries, Inc. v. Charter Oak Fire Ins. Co., 2013 U.S. App. LEXIS 11700 (2d Cir. June 11, 2013). 

The New York Court of Appeals’ June 11, 2013 decision in K2, however, departs from this long-established jurisprudence.  K2 involved loans made by two limited liability companies to a third company, Goldan.  The loans were to be secured by mortgages, but the mortgages were not properly recorded.  The two LLCs subsequently brought suit against Goldan and its two principals, one of whom, Jeffrey Daniels, was an attorney.  The suit asserted a claim of legal malpractice against Mr. Daniels for having failed to record the mortgages.  Mr. Daniels sought coverage from his errors and omissions carrier, American Guarantee, but American Guarantee disclaimed coverage on several grounds. Mr. Daniels subsequently defaulted in the underlying action, and plaintiffs took a judgment in excess of the policy limits of the American Guarantee policy.  The LLCs then asserted a direct action against American Guarantee for breach of contract and failure to settle within policy limits.

American Guarantee moved for summary judgment on the basis of its policy’s “business enterprise” exclusions. It argued that the claim against Mr. Daniels arose out of his capacity or status as a member or owner of Goldan, and that as such, the exclusions applied.  The trial court granted summary judgment in favor of the claimants, and on appeal, New York’s First Department held that the exclusions were “patently inapplicable,” at least for duty to defend purposes, since the essence of the underlying claim was that Mr. Daniels committed legal malpractice.  The Appellate Division, however, was divided as to whether the exclusions applied for the purposes of American Guarantee’s duty to indemnify. 

On appeal to the New York Court of Appeals, American Guarantee essentially conceded that it had breached its duty to defend Mr. Daniels, but argued that it could still rely on the exclusions to avoid a duty to indemnify.  The Court of Appeals disagreed, holding that by having breached its duty to defend Mr. Daniels, American Guarantee “lost its right” to rely on the exclusions for indemnity purposes.  Relying on its decision in Lang v. Hanover Ins. Co., 787 N.Y.S.2d 211 (NY 2004) – a case involving the insurer’s right to contest the insured’s liability for underlying loss after breaching a duty to defend – the court articulated its new rule:

… we now make clear that Lang, at least as it applies to such situations, means what it says: an insurance company that has disclaimed its duty to defend "may litigate only the validity of its disclaimer." If the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify. This rule will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain. It would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured's defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.  (Emphasis supplied.)

The K2 Court conceded that there may be exceptions to this new rule, such as where public policy precludes indemnification for an underlying loss.  Further, the ruling appears limited in its reach to consideration of whether exclusions can apply after a duty to defend has been breached.  Presumably, this rule will not apply where the underlying loss is covered in the first instance, i.e., not when the loss falls outside the scope of a policy’s insuring agreement. These and other questions, and the reach of K2, will undoubtedly be the subject of future controversy and litigation.

Seventh Circuit Holds Contractor Bodily Injury Exclusion Inapplicable

In its recent decision in Atlantic Casualty Ins. Co. v. Paszko Masonry, Inc., 2013 U.S. App. LEXIS 11561 (7^th Cir. June 7, 2013), the United States Court of Appeals for the Seventh Circuit had occasion to consider whether a company that had bid on, but not yet been awarded a construction project, could nevertheless be deemed a “contractor” for the purpose of an employee bodily injury exclusion.

The facts in Paszko related to the construction of an apartment building in Illinois on which Prince Contractors, Inc. was the general contractor.  While construction was in process, Prince bid out work relating to caulking of gaps and joints.  Raincoat Solutions bid on the project, and its bid was accepted, subject to approval of the caulking material and subject to Prince approving the competency of the caulking employee to be furnished by Raincoat.  In an effort to secure the bid, Raincoat sent its intended employee, Rybaltowski, to the construction site to demonstrate how he would perform the caulking.  Notably, Raincoat did not expect to be compensated for the work it performed in connection with the demonstration.  After the demonstration was completed, but before Mr. Rybaltowski could leave the site, he was injured when a beam fell on him.  Only a half hour after this incident, Raincoat and Prince signed a subcontract.  Mr. Rybaltowski later filed suit against Prince and the subcontractor that had been working on the beam, Paszko.

Paszko was insured under a general liability policy issued by Atlantic Casualty.  The policy contained an exclusion for “Injury to Employees, Contractors and Employees of Contractors,” which barred coverage for bodily injury “to any 'contractor' arising out of or in the course of the rendering or performing services of any kind or nature whatsoever by such 'contractor' for which any insured may become liable in any capacity.”  The policy stated that:

… ‘contractor’ shall include but is not limited to any independent contractor or subcontractor of any insured, any general contractor, any developer, any property owner, any independent contractor or subcontractor of any general contractor, any independent contractor or subcontractor of any developer, any independent contractor or subcontractor of any property owner, and any and all persons working for and or providing services and or materials of any kind for these persons or entities mentioned herein.  (Emphasis supplied.)

Thus, coverage for Paszko, and Prince as an additional insured under Paszko’s policy, turned on the question of whether Raincoat could be considered a “contractor” at the time of Mr. Rybaltowski’s injury.

The Seventh Circuit, in a decision authored by Judge Richard Posner, began its analysis by observing that the policy definition of contractor was “poorly drafted,” since it only set forth examples of contractors rather than clearly defining the term.  This definition raised a question as to when Raincoat qualified as a contractor simply by the nature of its business.  As Judge Posner explained:

The wording of the exclusion leaves uncertain whether Raincoat was a contractor simply because companies that engage in construction are called "contractors," or whether it did not become a "contractor" until it signed a contract with Prince or until it provided materials or services other than the demonstration of caulking, or whether the demonstration itself was a service provided by a contractor.

Judge Posner acknowledged that in one sense, Raincoat was “providing services” to Prince in connection with the demonstration, even if it had not yet signed the subcontract.  In this connection, Raincoat through Mr. Rybaltowski’s efforts, did caulk a few windows as part of the demonstration, and presumably this was of benefit to Prince.  The court nevertheless concluded that the exclusion could be interpreted differently, and in fact, more narrowly.  Specifically, Judge Posner reasoned that:

Also plausible, however, is the alternative interpretation that services are not provided until the contractor (with or without a signed contract, because a provider of services is a "contractor" within the meaning of the exclusion regardless of whether he has a contract) begins to do compensated work on the project.

Thus, finding several plausible definitions of “contractor,” the court concluded the term was ambiguous and therefore must be interpreted in the insured’s favor.  While the court agreed that it would be “a little odd” to treat a construction worker such as Mr. Rybaltowski as a “passerby” just because he was demonstrating a construction service rather than performing that service for compensation, this outcome was necessitated by the ambiguity in Atlantic’s definition of “contractor.” 

Minnesota Supreme Court Applies Pollution Exclusion to Carbon Monoxide

In its recent decision in Midwest Family Mut. Ins. Co. v. Wolters, 2013 Minn. LEXIS 304 (Minn. May 31, 2013), the Minnesota Supreme Court had occasion to consider whether an absolute pollution exclusion applies to bodily injury resulting from an indoor release of carbon monoxide.

Wolters was a general contractor that had been hired to build a home with an in-floor radiant heating system.  It was later determined that Wolters purchased and installed the wrong type of boiler for the project.  Further, the boiler itself was negligently installed.  As a result, and because the home’s carbon monoxide detectors also were negligently installed, the homeowners suffered injury as a result of severe carbon monoxide poisoning.   The homeowners later filed suit against Wolters. 

Midwest Family Mutual insured Wolters under a general liability policy.  Midwest provided Wolters with  defense in the underlying suit, but subsequently brought a coverage action seeking a declaration of non-coverage based on its policy’s pollution exclusion, which states in pertinent part:

9.   We do not pay for bodily injury or property damage:

a.   arising wholly or partially out of the actual, alleged or threatened discharge, dispersal, release or escape of pollutants: . . .

4)   at or from any premises where you or any contractor or subcontractor, directly or indirectly under your control, are working or have completed work:

    a)     if the pollutant is on the premises in connection with such work, unless the bodily injury or property damages arise from the heat, smoke or fumes of a fire which becomes uncontrollable or breaks out from where it was intended to be; or

    b)     if the work in any way involves testing, monitoring, clean-up, containing, treating or removal of pollutants.

The Midwest policy defined “pollutants” as:

a.   any solid, liquid, gaseous, thermal, electrical emission (visible or invisible) or sound emission pollutant, irritant or contaminant; or

b.   waste, including materials to be recycled, reclaimed or reconditioned as well as disposed of.

Midwest moved for summary judgment on the basis of its exclusion, and the trial court held that it would be inappropriate as a matter of law to rule the exclusion was applicable since Wolters did not cause “environmental pollution.”  On appeal, however, the Minnesota Court of Appeals observed that Minnesota courts have employed a “non-technical, plain-meaning approach” to the interpretation and application pollution exclusion.  As such, and concluding that carbon monoxide is a pollutant, the court reversed the lower court’s ruling.

On appeal to the Minnesota Supreme Court, Wolters urged the court follow the “majority rule” of courts across the country, limiting application of the exclusion to traditional environmental pollution.  Specifically, the insured argued that the definition of “pollutants” is ambiguous as applied to matters of indoor air pollution.  The Minnesota Supreme Court rejected this assertion, concluding that under the “non-technical, plain meaning” approach to interpreting the exclusion, as required by its prior decision in Board of Regents of the University of Minn. v. Royal Ins. Co. of America, 517 N.W.2d 888 (Minn. 1994), an indoor release of carbon monoxide qualifies as a pollutant.  As the court explained:

While there may be substances that are difficult to establish as "pollutants" for purposes of the absolute pollution exclusion, carbon monoxide is not one of them. It is enough for purposes of the present dispute to conclude that carbon monoxide is a pollutant under the terms of the absolute pollution exclusion; there are serious concerns associated with the breadth of the exclusion that we leave for another day, and we do not attempt to define the complete scope of the term "pollutant" in the absolute pollution exclusion. Instead, we only conclude that, based on our holding in Board of Regents, carbon monoxide qualifies as a pollutant in this case.

The court further held that the fact that the release was indoors as opposed to outdoors did not require a different outcome since the exclusion did not contain language limiting its application to traditional environmental pollution.  In so concluding, the court rejected the insured’s argument that the “reasonable expectations” doctrine required a different result since the exclusion was plainly and conspicuously labeled as such.  Such a broad application of the exclusion, noted the court, would prevent inconsistency in determining what constitutes a pollutant and under what circumstances.