New York Court Holds Pollution Exclusion Applicable to Pollution Caused by Covered and Uncovered Causes

In its recent decision in Matter of Midland Ins. Co., 2017 N.Y. App. Div. LEXIS 5065 (N.Y. 1st Dep’t June 22, 2017), the Supreme Court of New York, Appellate Division, First Department, had occasion to consider the application of the absolute pollution exclusion to contamination resulting from different sources, only one of which was clearly excluded.

At issue in Midland was coverage for the insured’s liabilities under CERCLA for lead contamination of soils in a residential area in Omaha, Nebraska.  The lead was partially a result of the insured’s mining operations, but also a result of the chipping and flaking of lead based paint on the houses in the area.  While the insured did not paint the houses, or manufacture the paint used on the homes, it was jointly and severally liable for the soil contamination under CERCLA, and thus responsible for remediating the soils.

The insured argued that under New York law, chipping and flaking of lead paint is not necessarily excluded by the pollution exclusion.  Westview Assocs. v Guar. Nat’l Ins. Co., 717 N.Y.S.2d 75 (2000); Herald Sq. Loft Corp. v Merrimack Mut. Fire Ins. Co., 344 F Supp 2d 915 (S.D.N.Y. 2004).  As such, the insured argued that at the very least, the exclusion should not apply to the entirety of the cleanup costs and that the costs should be allocated between lead contamination resulting from its mining operations and lead contamination resulting from lead paint chipping and flaking.

The court agreed that under some circumstances, lead paint does not come within the exclusion.  It nevertheless concluded these cases inapplicable since “the combined effect of the lead emissions and the lead paint was soil contamination – of the same soil.”  As the court observed, any soil solely contaminated as a result of lead paint would not have come within the scope of CERCLA.  As such, the court agreed that the exclusion applied to preclude coverage for the entirety of the underlying remedial costs.

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New York Court Holds General Liability Insurer Has Duty to Defend Odor Claim

In its recent decision in Hillcrest Coatings, Inc. v. Colony Ins. Co., 2017 N.Y. App. Div. LEXIS 4519 (N.Y. 4th Dep’t June 9, 2017), the Supreme Court of New York, Appellate Division, Fourth Department, had occasion to consider coverage under a general liability for allegations of odor emanating from a recycling facility.

Hillcrest operated a glass, paper and paper recycling facility in upstate New York.  Suit was filed against it by nearby residents complaining that Hillcrest operated its facility in a negligent fashion, thereby allowing hazardous materials and other substances to be discharged into areas where plaintiffs worked and resided.  The suit also alleged that Hillcrest’s facility created a pervasive malodorous condition.

Hillcrest sought coverage for the underlying suit under its general liability policy issued by Colony.  The policy contained a hazardous materials exclusion, which like a pollution exclusion, barred coverage for bodily injury or property damage “which would not have occurred in whole or [in] part but for the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of ‘hazardous materials’ at any time.”  The policy defined hazardous materials as “pollutants” as well as “lead, asbestos, silica and materials containing them.”  “Pollutants,” in turn, was defined by the policy as “any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste. Waste includes materials to be recycled, reconditioned or reclaimed.”

In an ensuing coverage action, Colony maintained that its policy’s hazardous materials exclusion barred coverage for the underlying suit.  The Fourth Department, affirming the trial court’s ruling on summary judgment, held that Colony had a duty to defend since it was not clear from the face of the complaint that the allegations of odor came within the scope of the exclusion.  As the court explained, “[a]lthough many of the factual assertions in the second amended complaint allege that the odor resulted from hazardous materials, those are not the only factual allegations therein. Indeed, foul odors are not always caused by the discharge of hazardous materials.”

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New York’s Highest Court Applies Proximate Cause Test To Additional Insured Endorsement

In The Burlington Insurance Company v. NYC Transit Authority, et al., (N.Y. June 6, 2017), the New York Court of Appeals – New York’s highest court – held that when an insurance policy states that additional insured coverage applies to bodily injury “caused, in whole or in part” by the “acts or omissions” of the named insured, the coverage applies to injury “proximately caused by the named insured.” The Court rejected the argument that an additional insured obligation is owed under this language when the named insured is without fault. In so holding, the Court concluded that the Appellate Division “erroneously interpreted” this policy language as extending coverage to injury only causally linked to the named insured and “wrongly concluded that an additional insured may collect for an injury caused solely by its own negligence, even where the named insured bears no legal fault for the underlying harm.” Thus, the Court of Appeals rejected the notion that “caused, in whole or in part” equates to “but for” causation. The Court also rejected the First Department’s conclusion that the phrases “arising out of” and “caused by” do not “materially differ.”

Burlington concerned coverage for an underlying matter arising out of a project in which New York City Transit Authority (“NYCTA”) contracted with Breaking Solutions, Inc. (“BSI”) to provide equipment and personnel and for BSI to perform tunnel excavation work on a New York City subway. BSI purchased CGL insurance from Burlington with an endorsement that afforded additional insured coverage to NYCTA, MTA and the City as additional insureds “. . . only with respect to liability for ‘bodily injury’ , ‘property damage’. . . caused, in whole or in part, by” 1. Your acts or omissions; or 2. The acts or omissions of those acting on your behalf.”

During the policy period, an MTA employee fell off an elevated platform as he tried to avoid an explosion after a BSI machine touched a live electrical cable that was buried in concrete at the excavation site. Suit was filed against the City and BSI asserting claims under New York’s Labor Law, as well as for general negligence and loss of consortium. Burlington assumed the defense of BSI and accepted the City’s tender under a reservation or rights. The City impleaded NYCTA and MTA, asserting claims for indemnification and contribution based on a lease of certain transit facilities. NYCTA tendered its defense to Burlington as an additional insured.

Burlington initially accepted NYCTA’s defense subject to a reservation of rights. However, discovery revealed that the BSI machine operator could not have known about the location of the cable or the fact that it was electrified and, the trial court, as a result, dismissed the plaintiff’s claims against BSI with prejudice. Thereafter, Burlington settled the underlying case, disclaimed coverage to NYCTA and MTA and commenced a subrogation and coverage action against NYCTA and MTA. The trial court granted Burlington’s motion for summary judgment, concluding that NYCTA and MTA were not additional insureds. The Appellate Division reversed, concluding that “the act of triggering the explosion . . . was a cause of [the employee’s] injury” within the meaning of the policy.”

On appeal to the Court of Appeals, NYCTA and MTA argued that “caused, in whole or in part” means “but for causation.” The Court disagreed and sided with Burlington, concluding that there was no coverage obligation because, “by its terms, the policy endorsement is limited to those injuries proximately caused by BSI [the named insured].” The Court reasoned that not all “but for” causes result in liability and “[m]ost causes can be ignored in tort litigation.” In contrast, “’proximate cause’ refers to ‘legal cause’ to which the Court has assigned liability.” The Court acknowledged that “but for BSI’s machine coming into contact with the live cable, the explosion would not have occurred and the employee would not have fallen or been injured,” but “that triggering act was not the proximate cause of the employee’s injuries.” As such, BSI was not at fault and the plaintiff’s injury was “due to NYCTA’s sole negligence in failing to identify, mark, or de-energize the cable.”

In reaching its conclusion, the Court discussed the amendment of the ISO form in 2004 to replace the “arising out of” language with “caused, in whole or in part,” noting that the change was “intended to provide coverage for an additional insured’s vicarious or contributory negligence, and to prevent coverage for the additional insured’s sole negligence.”



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Second Circuit Holds Pollution Exclusion Applicable to Sewage-Related Claims

In its recent decision in Cincinnati Inc. Co. v. Roy’s Plumbing, Inc., 2017 U.S. App. LEXIS 9729 (2d Cir. May 31, 2017), the United States Court of Appeals for the Second Circuit, applying New York law, had occasion to consider the application of a pollution exclusion to a case involving the release of sewage.

At issue in Roy’s Plumbing was coverage for a lawsuit alleging that the insured negligently performed inspection work and construction of a sewer refurbishment in the Love Canal area.  This allowed for pressure to build in the sewage system causing sewage and toxic “Love Canal materials” to be released from the sewers and onto the homes and properties of nearby residents.  On motion for summary judgment, the United States District Court for the Western District of New York held that the total pollution exclusion in Cincinnati’s general liability policies was unambiguous and applied to all aspects of the underlying claim, including the allegations of release of raw sewage.

The Second Circuit affirmed, holding that it had “no doubt that sewage is generally recognized in the industry or government to be harmful or toxic to persons,” and thus a pollutant for the purpose of the exclusion.  The court also rejected the insured’s argument that the allegations in the underlying suit relating to pressure fell outside of the exclusion, noting that the pressure described was merely the mechanism allowing for the pollutants to escape the sewer, and not a separate form of property damage in and of itself.

In addition to these arguments, the insured argued on appeal that if the pollution exclusion applied to sewage-related claims, then as a plumber, the coverage under its general liability policies essentially would be negated for most damages due to plumbing work.  The court rejected this assertion, noting that under New York law, the pollution exclusion only applies to traditional environmental harm, citing to Belt Painting Corp. v. TIG Ins. Co., 742 N.Y.S.2d 332 (2d Dep’t 2002), aff’d, 763 N.Y.S.2d 790 (2003).  The court concluded that this limitation on the exclusion “eliminates the overbreadth” complained of by the insured.

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Washington Supreme Court Applies Efficient Proximate Cause Test to Pollution Exclusion

In its recent decision in Xia v. ProBuilders Specialty Ins. Co. RRG, 2017 Wash. LEXIS 443 (Wash. Apr. 27, 2017), the Supreme Court of Washington had occasion to address the concept of efficient proximate cause as it relates to the application of a pollution exclusion.

At issue in Xia was ProBuilders’ coverage obligation under a general liability policy for an underlying claim involving a hot water heater in a new home constructed by its insured.  An exhaust vent for the heater had not been properly installed, thus allowing for carbon monoxide to be released directly into the home and causing injury to the home purchaser.  ProBuilders denied coverage to its insured on the basis of its policy’s pollution exclusion, as well as on the basis of another exclusion not at issue on appeal.

The Court began its analysis by looking to its prior case law concerning the pollution exclusion, in particular its decisions in Cook v. Evanson, 920 P.2d 1223 (1996), Kent Farms, Inc. v. Zurich Ins. Co., 969 P.2d 109 (1998), and Quadrant Corp. v. American States Insurance Co., 110 P.3d 733 (2005).  Through these decisions, the Court limited application of the pollution exclusion to traditional environmental harms or to harms inflicted on persons as a result of pollutants acting as pollutants.

In Kent Farms, the Court held that the exclusion was inapplicable where an individual was injured as a result of being sprayed by diesel fuel whereas in Quadrant, the Court held the exclusion applied to a claim involving alleged injuries resulting from decking sealant.  The Court harmonized these cases by noting that in Kent Farms, the claimant was not injured as a result from the diesel fuel acting as a pollutant, but instead from the force and impact of the spray. By contrast, in Quadrant, the claimant was injured as a result of the toxicity of the sealant.  As the Court noted:

As discussed in Quadrant, the facts in Kent Farms did not result in a pollutant acting as a pollutant in such a way that would trigger the pollution exclusion. If the diesel fuel in Kent Farms had been replaced with water, for example, the liquid would still have struck, choked, and engulfed the victim just as surely as the diesel fuel—albeit with less severe consequences. As this court noted, the toxic nature of the pollutant was not central to the event that triggered coverage under the insurance policy. Id.

With this context in mind, the Court agreed that the underlying claim in Xia, involving injuries as the result of exposure to carbon monoxide, could come within the pollution exclusion.  The Court nevertheless observed that per the rule of efficient proximate cause, when a “covered peril” sets in motion a causal chain, the last link of which is an “uncovered peril,” then there is coverage under the policy.  The Court reasoned that this analysis should apply in the context of a general liability policy if a covered “occurrence” gives rise to a loss that might otherwise be excluded.  The Court noted, however, that there are limitations to this rule:

… the efficient proximate clause rule applies only “when two or more perils combine in sequence to cause a loss and a covered peril is the predominant or efficient cause of the loss.” … It is perfectly acceptable for insurers to write exclusions that deny coverage when an excluded occurrence initiates the causal chain and is itself either the sole proximate cause or the efficient proximate cause of the loss.

But such an exclusion, explained the Court, cannot overcome the efficient proximate cause rule.  The Court reasoned that the non-standard pollution exclusion in ProBuilders’ policy applicable to any harm “regardless of the cause of the pollution and whether any other cause of said bodily injury, property damage, or persona injury acted jointly, concurrently, or in any sequence with said pollutants or pollution” was improperly broad since it would have circumvented the efficient proximate cause rule.  The Court, therefore, held that this causation language was unenforceable.

With this in mind, the Court turned to the question of what was the efficient proximate cause of the underlying claim.  The Court observed that the underlying suit alleged that the carbon monoxide resulted from the improper installation of the hot water heater’s venting, which in and of itself would be a covered “occurrence” under ProBuilders’ policy.

ProBuilders’ argued that the Court’s application of the efficient proximate cause rule would essentially negate the pollution exclusion, since all acts of pollution can be traced to an accident or an instance of negligence that could qualify as an “occurrence” under a general liability policy.  The Court did not agree, observing that when the pollution event is the first step in the chain of causation leading to the injury, such as application of flooring sealant, then the pollution exclusion will apply.  The Court further reasoned that ProBuilders could have drafted a more specific exclusion applicable to the occurrence giving rise to the pollution, such as an exclusion applicable to installation of home fixtures of hot water heaters, which would have avoided the efficient proximate cause rule.

In summing up its decision, the Court explained:

Pollution exclusion clauses are an important tool for insurers to avoid liability stemming from loss caused by pollutants acting as pollutants where the insured has paid no premiums for such coverage. However, emphasis must be given to the phrase “caused by.” The efficient proximate cause rule continues to serve the underlying purpose of insurance policies and applies just as effectively to these facts as it has in prior cases. We hold that the efficient proximate cause of Xia’s loss was a covered peril: the negligent installation of a hot water heater. Although ProBuilders correctly applied the language of its pollution exclusion to the release of carbon monoxide in Xia’s home, ProBuilders breached its duty to defend in the face of an alleged covered occurrence that was the efficient proximate cause of the loss.

The Court therefore held that ProBuilders improperly breached its duty to defend, and did so in bad faith.

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Third Circuit Finds Coverage for Faulty Workmanship Claim

In its recent decision in Travelers Prop. Cas. Co. of Am. v. USA Container Co., 2017 U.S. App. LEXIS 6602 (3rd Cir. Apr. 18, 2017), the United States Court of Appeals for the Third Circuit, applying New Jersey law, had occasion to consider the scope of coverage afforded under a general liability policy for property damage resulting from faulty workmanship.

Travelers’ insured, USA Container, was hired by Meelunie B.V./Amsterdam, a corn syrup distributor, to arrange for the transfer of corn syrup from rail cars to drums, so that the product could be shipped overseas.  USA Container subcontracted out a portion of the work requiring heating of the syrup so that it could be transferred from the rail cars.  The subcontractor accidentally overheated the product, thereby damaging it.  As a result, Meelunie’s overseas customers rejected the product.  Meelunie eventually sold the product at a reduced rate and then asserted a claim against USA Container for lost revenue. Travelers, denied coverage for the claim on the basis that it did not fall within the policy’s insuring agreement and on the additional grounds that various business risk exclusions applied.

Travelers argued that the damage to the corn syrup was not the result of an “occurrence,” citing to the seminal New Jersey Supreme Court decision Weedo v. Stone-E-Brick, Inc., 81 N.J. 233, 405 A.2d 788 (N.J. 1979), in which the Court held that an insured’s defective work does not qualify as an occurrence under a general liability policy.  The Third Circuit observed, however, that the New Jersey Supreme Court’s more recent decision in Cypress Point Condominium Ass’n v. Adria Towers, L.L.C., 143 A.3d 273 (N.J. 2016) limited the scope of Weedo and ultimately concluded that faulty workmanship causing damage to otherwise non-defective work can constitute an occurrence under a general liability policy.  The Third Circuit, therefore, rejected Travelers argument that the damage to the corn syrup caused by USA Container’s subcontractor was not an occurrence.

Travelers further argued that its policy’s business risk exclusions applied to bar coverage; in particular, exclusion j(6) applicable to “that part of any property that must be restored, repaired or replaced because ‘your work’ was incorrectly performed on it” and exclusion n, applicable to product recalls.  With respect to exclusion j(6), the Third Circuit concluded that the syrup was not “restored, repaired, or replaced,” but instead sold at a discount, causing loss to Meelunie.  The court further found that the product recall exclusion had no application since Meelunie was able to sell it, albeit at a discounted price.  As such, the court held that neither of the exclusions applied and that Travelers was responsible for insuring any damages ultimately paid by USA Container to Meelunie.



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Applying The Peppers Doctrine, Illinois Appellate Court Affirms Stay Of Insurer’s Declaratory Judgment Action

In Sentry Ins. v. Cont’l Cas. Co., 2017 IL App (1st) 161785, the Appellate Court of Illinois, First District had occasion to consider whether a trial court properly entered a stay on an insurer’s declaratory judgment action when interpreting the applicability of coverage exclusions would determine an ultimate fact in the underlying litigation.

The underlying cases involve approximately 65 consolidated claims against Northwestern Memorial Hospital. The underlying plaintiffs provided semen and testicular tissue samples to Northwestern for safekeeping. The plaintiffs stored their samples with Northwestern between April and June 2012. Allegedly their samples thawed and were irreversibly damaged due to the failure of a cryopreservation tank.

Northwestern maintained a commercial general liability policy with Sentry Insurance and an excess policy with Continental. On October 16, 2014, Sentry filed a declaratory judgment against Northwestern and Continental, arguing that the Sentry policy did not provide coverage for the underlying claims against Northwestern. Pointing to discovery and various pleadings from the underlying suit, Sentry argued that the “care, custody, or control” and “professional services” exclusions established that the Sentry policy did not afford coverage for the underlying suits. On that basis, Sentry sought a declaratory judgment that it owed no duty to defend or indemnify Northwestern. Sentry further sought reimbursement of the amount spent thus far in defending the underlying lawsuits. Continental was also named a defendant in the declaratory judgment action. Continental filed an answer and counterclaim against Sentry and Northwestern, which contained substantially identical factual allegations as Sentry’s complaint.

On May 19, 2016, the trial court stayed the matter, finding it was too early in the litigation to decide whether Northwestern had exclusive control over the damaged samples or if professional services were required to handle and care for them. Sentry and Continental appealed.  Prior to the appellate court’s decision on the matter, Sentry settled with Northwestern and asked the trial court to dismiss its appeal, leaving only Continental on appeal.

On March 24, 2017, the appellate court affirmed the stay. The appellate court noted that the trial court correctly applied the ruling from the 1976 Illinois Supreme Court case, Maryland Casualty Co. v. Peppers.

In Peppers, the trial court was asked to determine whether an insurer owed a duty to defend its insured in a personal injury action that alleged intentional, negligent, and willful and wanton conduct. After a bench trial, the trial court found that the insured’s actions were intentional and, therefore, there was no coverage under the policy. In reversing the trial court’s decision, the Illinois Supreme Court stated that, under the principle of collateral estoppel, the finding in the declaratory judgment action that the injury was intentionally inflicted “could possibly establish the allegations of the assault count in the complaint and might preclude [the underlying plaintiff’s] right to recover under the other theories alleged.” Later cases aptly referred to this ruling as the Peppers doctrine. Under the Peppers doctrine, “it is generally inappropriate for a court considering a declaratory judgment action to decide issues of ultimate fact that could bind the parties to the underlying litigation.”

The appellate court in Sentry stated that a ruling that either the “care, custody, or control” or the “professional services” exclusion applied would be prejudicial with respect to the underlying case because it could, in effect, serve to estop the underlying plaintiffs from raising a theory of recovery. The court also noted that deciding the applicability of the “care, custody, or control” or the “professional services” exclusions would decide an issue crucial to the insured’s liability in the underlying case. Thus, the appellate court held that a stay was appropriate.

The appellate court also addressed Continental’s argument that, even if the court granted a stay, the trial court should have found there was no duty to defend Northwestern in the underlying matter. In rejecting Continental’s argument, the court noted the possibility of coverage leads to an insurer’s duty to defend. Since there was no way to determine whether the policy exclusions apply (without running afoul of the Peppers doctrine, as discussed above), there was still a possibility of coverage. The court noted the applicably of the policy exclusions “is not free and clear from doubt” and “we must resolve any doubts as to coverage in favor of [Northwestern].” Thus, Continental continued to owe Northwestern a duty to defend.

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Connecticut Court Holds No Coverage for Late Notice Under D&O Policy

In Zahoruiko v. Fed. Ins. Co., No. 3:15-cv-474 (VLB), 2017 U.S. Dist. LEXIS 28204 (D. Conn. Feb. 28, 2017), the United States District Court for the District of Connecticut had occasion to consider whether an insured’s late notice of a pending lawsuit can preclude D&O coverage.

Graham Zahoruiko was an officer of SpaceWeb Corporation, which was later known as Refresh Software Corporation. The company and Zahoruiko were covered under two Directors and Officers (D&O) insurance policies.

In 1999, Zahoruiko executed a debt note for a line of credit on behalf of the company. Zahoruiko also executed a personal guaranty to secure the note. The company subsequently defaulted on the note. In 2002, the note creditor filed a lawsuit against the company and Zahoruiko. In 2003, Zahoruiko and the company entered into a settlement agreement with the note creditor, which required the company and Zahoruiko to execute a second promissory note as consideration for releasing all claims under the 1999 note. Zahoruiko executed a personal guaranty on the second promissory note.

The company began missing loan payments again in May 2008. On April 29, 2010, the note creditor sent the company a demand letter regarding the debt. On July 10, 2010, the note creditor filed a second lawsuit alleging a breach of the second promissory note.

On February 3, 2012, the creditor notified the company that it intended to seek summary judgment. Ten days later, on February 13, 2012, Zahoruiko and the company notified their D&O insurer of the pending lawsuit. On February 28, 2012, the note creditor filed its motion for summary judgment, which was subsequently granted. On March 8, 2012, the D&O insurer denied coverage.

Three years later, on April 1, 2015, Zahoruiko filed suit against the company’s D&O insurer. The D&O insurer filed a motion for summary judgment, offering seven separate grounds for excluding coverage under the D&O policy. The court addresses only two: (1) pending or prior litigation exclusion; and (2) timely notification of claim.

First, the insurer argued that the 2010 and 2002 claims were related and should be treated as a single claim, and therefore coverage would be excluded by the prior litigation exclusion in the D&O policy. The court found the claims were not related because the 2002 claim was “definitively resolved and any obligations under that note were extinguished” by the prior settlement agreement. Thus, the court held that the claims were not related, and coverage for the 2010 claim was not barred by the prior litigation exclusion.

Second, the insurer argued Zahoruiko’s notice to the insurer was untimely within the meaning of the D&O policy. The court agreed, stating that “…an unexcused, unreasonable delay by an insured in notification of a [claim] … entirely discharges an insurance carrier from any further liability…” The court added that an insurer will only be discharged if it was prejudiced by the lack of notice. The court noted that Zahoruiko did not notify the company’s D&O insurer of any claims until February 13, 2012 – “ten days after learning that [the creditor] intended to move for summary judgment, sixteen months after being served the 2010 complaint, [and] 20 months after receiving a demand letter…” The court noted that Zahoruiko offers “no legitimate explanation for his failure to promptly notify [the insurer] of the claim.”

According to the court, this lack of timely notice also prejudiced the insurer because Zahoruiko executed a forbearance agreement, in which he waived defenses to suits for non-payment of the loan, and insured litigation costs defending the 2010 lawsuit – all without any participation of the insurer. The court stated, “[Zahoruiko] not only failed to comply with the prohibition against assuming contractual obligations and defense costs, he also prevented [the insurer] from negotiating better repayment terms or from settling the lawsuit before the defense costs were incurred.” The court therefore ruled in favor for the D&O insurer, finding that Zahoruiko unreasonably delayed notifying the insurer of the claim, and the delay prejudiced the insurer.

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California Appellate Court Holds D&O Insurer Must Pay Cost of Insured’s Appeal Despite Criminal Conviction

In Stein v. Axis Ins. Co., No. B265069, 2017 Cal. App. Unpub. LEXIS 1628 (Ct. App. Mar. 8, 2017), the Second District California Court of Appeal had occasion to consider whether a criminal conviction is a “final adjudication” such that it could bar coverage for appeal expenses under a willful misconduct exclusion.

In November 2007, Heart Tronics and its de facto officer, Mitchell Stein, purchased a $5 million director and officer (D&O) liability insurance policy from Houston Casualty Company (“HCC”). The original terms of the policy did not provide coverage for criminal acts. Nor did the original terms include coverage for “de facto” directors or officers. Because Mitchell Stein managed the company full-time without pay or a formal position or title, he was unsatisfied with the original HCC policy.

Stein and Heart Tronics obtained an amended policy from HCC that (1) changed the definition of “claim” to include criminal proceedings, up to and specifically including appeals; and (2) expanded the definition of “wrongful act” to include acts committed by those acting in their capacity as the “functional equivalent” of an officer or director. HCC allegedly represented to Stein and Heart Tronics that Stein would “absolutely” covered under the amended HCC policy.

On December 13, 2011, a federal grand jury indicted Stein on 14 counts of mail, wire, and securities fraud; money laundering; and obstruction of justice. The grand jury charged that Stein engaged, among other things, in an illegal “pump and dump” scheme. On May 20, 2013, a jury found Stein guilty on all counts. He was sentenced to 17 years in prison. Stein appealed the judgment to the Eleventh Circuit. In January 2017, the Circuit Court affirmed his conviction, but vacated the sentence and remanded the matter for resentencing. On February 7, 2017, Stein moved for an en banc rehearing before the Circuit Court.

Following his criminal conviction, Stein tendered his appeal to HCC. HCC denied coverage on the grounds that Stein was not the “functional equivalent” of a Heart Tronics officer.  HCC also invoked the willful misconduct exclusion of the policy, which stated that “Except for Defense expenses, the Insurer shall not pay loss in connection with any claim” occasioned by willful misconduct.  The exclusion made clear that it could be invoked “only if there has been a final adjudication adverse the Insured Person in the underlying action … establishing that the Insured Person” committed willful misconduct.

On June 25, 2014, Stein and Heart Tronics sued HCC in the California Superior Court of Los Angeles County alleging, among other things, fraud and breach of contract. HCC demurred to the complaint, contending that Stein was not an insured person under the policy and Stein’s defense expenses did not constitute covered losses under the policy. The trial court sustained the demurrer without leave to amend. Stein appealed.

On appeal, the appellate court rejected the trial court’s determination that Stein’s defense expenses on appeal were not covered losses. The appellate court held the trial court’s rationale that Stein’s criminal conviction was “final … until it is reversed” was erroneous because the HCC policy clearly and explicitly obligated HCC to cover an insured’s defense expenses as a result of an appeal from a criminal proceeding, even if a trial court determined the insured was guilty or liable for fraud.

The court distinguished the language in the willful misconduct exclusion in the HCC policy from that same provision in other policies that barred coverage for a “judgment or other final adjudication.”  As the exclusion in the HCC policy only applied to a “final adjudication,” the exclusion could not apply to preclude coverage.  The court’s ruling further explained that “a thing that is ‘final until reversed’ is not final.”  In other words, “[a]n appellate court can render an adjudication as well as a trial court can, with the added benefit [of] greater finality.”  The court concluded that the HCC’s policy “covers an insured’s litigation expenses incurred in directly appealing a conviction” because the policy specifically required HCC to pay defense costs.  The court therefore reversed the judgment against Stein.

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Seventh Circuit Finds Faulty Work Not a Covered “Occurrence”

In Allied Prop. & Cas. Ins. Co. v. Metro North Condo. Ass’n, No. 16-1868, 2017 U.S. App. LEXIS 4107 (7th Cir. Mar. 8, 2017), the Seventh Circuit had occasion to consider whether claims of faulty workmanship could constitute “property damage” caused by an “occurrence” as required by the insuring agreement of a CGL policy.

Metro North Condominium Association (“Metro North”) hired a developer to build a condominium in Chicago. The developer hired a subcontractor, CSC, to install the building’s windows, and CSC allegedly installed the windows defectively. As a result, common elements of the building purportedly suffered significant water damage and individual condominium owners allegedly suffered damage to their personal property.

Metro North sued the developer, which was insolvent. Metro North then amended its complaint and added a claim against CSC for the breach of the implied warranty of habitability. Metro North also brought a negligence claim, which was untimely and subsequently dismissed with prejudice.  The suit proceeded with only the implied warranty claim pending against CSC.  CSC tendered the suit to its CGL carrier, Allied Property & Casualty Insurance Company (“Allied”), but Allied denied coverage.

In 2015, CSC and Metro North reached a settlement agreement. The agreement required Metro North to dismiss its pending lawsuit against CSC. In return, CSC assigned to Metro North all of its rights to payment of insurance coverage from Allied. The language of the agreement specified that the right to payment had to “arise out of the claims asserted against CSC” in the underlying suit. At the time of the settlement, the only count pending against CSC was a claim for breach of implied warranty of habitability.

Upon learning of the settlement agreement, Allied brought a declaratory judgment action against Metro North seeking a judgment that it was not liable for the damages claimed in the settlement agreement.  The U.S District Court for the Northern District of Illinois granted judgment in favor of Allied, and Metro North appealed to the U.S. Circuit Court of Appeals for the Seventh Circuit.

In its opinion, the Seventh Circuit stated that Allied would only be liable if the legally recoverable damages stemming from Metro North’s claim were covered by the policy. The court, in affirming the District Court’s decision, found that the measure of damages for a breach of implied warranty of habitability claim is the cost of repairing the “defective conditions.” Under Illinois law, CGL policies do not cover the cost of repairing the insured’s defectively completed work.  As such, the insuring agreement of the policies was not satisfied.

Additionally, the Seventh Circuit held that Metro North did not have standing to assert a right on behalf of unit owners for the loss of their personal property. The court held that the Illinois Condominium Property Act only allows a condominium association to act on behalf of its unit owners when the claim involves common elements or more than one unit – not personal property. Thus, the court held, Metro North did not have standing to seek recovery for its unit owners’ loss of personal property.

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