1996 Fall - Insurance Newsletter
October 1, 1996

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NEW YORK COURT OF APPEALS UPHOLDS DISMISSAL OF UNION INDEMNITY LIQUIDATOR’S CLAIMS AGAINST REINSURERS BASED ON ADMISSIONS OF FRAUD AND MATERIAL NON-DISCLOSURE

On November 14, 1996, the New York Court of Appeals ruled that a ceding insurer’s insolvency is a “material fact” to reinsurers, material to the risk reinsured, requiring its disclosure under the doctrine of uberrimae fidei. In so doing, the Court affirmed an order of the Appellate Division, First Department, which itself affirmed an award effectively granting reinsurers of Union Indemnity Insurance Company of New York (“Union”) rescission, based upon Union’s failure to disclose its insolvency at the time it placed reinsurance with its reinsurers. The unanimous decision was issued in In re Union Indemnity Insurance Company of New York (Michigan National Bank-Oakland v. American Centennial Insurance Company) (“Michigan National”).

The Michigan National case began shortly after Union was placed into liquidation by the Superintendent of Insurance (the “Liquidator”) in July, 1985. Michigan National Bank-Oakland (“Michigan”) had issued a promissory note in connection with the financing of a small, independent film. Repayment of the loan was secured by a bond issued by Union. Because Union had been placed into liquidation, and its liabilities were frozen, Michigan sought to recover under the bond directly from Union’s reinsurers, which had reinsured Union’s surety underwriting on a pro rata basis. Insurance policyholders are generally not considered third party beneficiaries of their insurer’s reinsurance. However, Michigan argued that a direct right of action was granted by New York’s Insurance Law §4118, pursuant to which provision Union had been required to obtain the reinsurance (because, without the security there on, the bond would have exceeded more than 10% of Union's surplus to policyholders).

At the same time Michigan was trying to recover from the reinsurers, the Liquidator had put the reinsurers on notice that all reinsurance claims should be paid to the Liquidator. Upon the Liquidator’s consent, an interpleader action was commenced by two of the reinsurers named in Michigan’s complaint requesting that the competing claims to the reinsurance proceeds of Michigan and the Liquidator be resolved in one proceeding, while denying that any such proceeds were owing to either claimant. On April 3, 1986, Michigan’s suit was consolidated with the interpleader action.

In answering the interpleader action, the Liquidator asserted its own claim to all reinsurance proceeds due under the reinsurance treaties by way of a third-party complaint. The reinsurers answered this claim by denying liability, asserting, among other things, that their participation in the treaties had been induced by fraud. Their allegations in this regard were based upon the Liquidator’s allegations in an action commenced against Union's parent company, Frank B. Hall & Co. (“Hall”), a number of Hall subsidiaries and affiliates (the “Hall companies”), and Union’s officers and directors. In the action, the Liquidator contended that Union had been operated by Hall while it was insolvent, that the insolvency had been concealed so that Hall and the Hall Companies could continue to place insurance with Union to generate commissions, and that as a consequence Union’s insolvency had been increased by approximately $140 million. The reinsurers asserted both affirmative defenses of fraud in the inducement and counterclaims for rescission.

When the defendants in the Hall action moved to dismiss, the Liquidator offered an attorney’s affidavit attaching statements from witnesses and other information gathered from the Liquidator’s investigation into the causes of Union’s insolvency to provide factual support for the allegations. At the same time, the Liquidator moved to shift the burden of proof to the Hall defendants to prove a fraud wasn't committed. In the affidavits and legal memoranda submitted on the motions, the Liquidator contended that its investigation had revealed that: Union had been purchased by Hall in 1977 for the purpose of being operated as a “loss leader”; that it had been insolvent no later than December 31, 1982, and probably earlier; that the insolvency had been concealed from the public by officers and directors of both Hall and Union; that insurance and surety risks had been underwritten which posed horrendous risks or were underwritten without applying appropriate underwriting criteria in order to generate commissions for the Hall companies or to satisfy Hall clients; and that these practices all led to expanding and deepening Union’s insolvency because had the public known about Union’s insolvency, no one would have continued to do business with Union, both policyholders and reinsurers alike.

Seizing upon these submissions, the reinsurers named as defendants and third-party defendants in Michigan National moved for summary judgment dismissing the claims of Michigan and the Liquidator, and granting them summary judgment on their cross-claims for rescission. The trial court judge hearing both the Michigan National and the Hall actions granted the motion, characterizing the Liquidator’s admissions of fraud in one case, and attempts to collect upon reinsurance procured by the fraud in another, as “unseemly.” On reargument and renewal, the trial court judge ruled that the counterclaims for rescission were barred by the order placing Union into liquidation. He again granted summary judgment to the reinsurers, however, holding that the reinsurance treaties were unenforceable under theories of both fraud in the inducement, and misrepresentation and concealment of material facts under the doctrine of uberrimae fidei (“utmost good faith”). After the Appellate Division, First Department affirmed the decision, a second motion to renew was denied, that decision was affirmed by the Appellate Division and a judgment was entered, the case was accepted on appeal by the Court of Appeals. Before the Court of Appeals, the Liquidator made a number of arguments based upon both evidentiary rules and public policy grounds. Among the myriad arguments presented, the Liquidator relied primarily upon the contention that: (1) the statements were not admissions because they were made without actual knowledge by counsel for the Liquidator, as opposed to Union officers and directors; (2) the admissions did not support an award of summary judgment in any event because the insolvency of a ceding company does not affect the risk reinsured; and (3) as a matter of policy reinsurers should not be permitted to avoid their reinsurance losses without first paying the claims, and then making claims to recover these funds from the Union estate in liquidation, so that the reinsurers would not obtain a “preference” over Union's policyholders and “other” creditors.

With respect to the “admissions” arguments, the Court of Appeals noted that the Liquidator had several opportunities in the trial court to offer evidence refuting the admissions, and failed to do so, responding:

The admissions made by counsel for the Liquidator and filed with the supportive documentation in the Hall action documented that Union’s officers and directors made material omissions and misrepresentations regarding the operations and financial condition of the company and that a plan to utilize Union for Hall’s purposes was in operation – contrasted to running the corporation as an independent entity, as required by Insurance Law §§1507 and 1505. These facts are admissible against the Liquidator as informal judicial admissions.

It would be unseemly, to say the least, to permit the Liquidator to renege on its court-submitted evidence and, in effect, to use quasi-official assertions as both a sword and a shield by simultaneously documenting Union’s fraud and failure to disclose its insolvency and yet later trying to deny the relevance and applicability of the same admissions and data in an action involving the reinsurers. Moreover, the

Liquidator was given full and fair opportunity to rebut the nonconclusive material, attempted to do so, and failed on the record before the nisi prius court and now the appellate courts, within our respective review powers.

Turning then to the “materiality” of Union’s concealment of its insolvency, the Court framed the issue as follows: “whether the failure of the ceding insurance company to disclose its insolvency to the potential reinsurer constitutes fraud in the inducement.” Then, summarizing the parties’ contentions, the Court noted:

The premise of the Liquidator’s argument is that Union's financial status during the negotiation of the reinsurance agreements is irrelevant and, therefore, proof of Union’s failure to disclose its insolvency does not support rescission. The Liquidator contends that a ceding insurance company’s insolvency, being a neutral factor, does not adversely affect reinsurers because it does not relate to the risk they undertake and underwrite; regardless of Union’s insolvency, the Liquidator asserts, the reinsurers remain liable to pay all losses reinsured. Additionally, the Liquidator argues that the duty of utmost good faith (uberrimae fidei) only mandates the disclosure of information, material to the reinsured risk, and since insolvency does not relate to the risk, disclosure is not required.

The underlying counterpoint from the reinsurers is that their reinsurance agreements are rescindable for Union’s failure to disclose its insolvency. They emphasize that Union was acquired by Hall as a loss leader for Hall’s brokerage business, hiding the fact that Hall caused Union to write bond business not acceptable to underwriting standards. The reinsurers argue that insolvency is material and its disclosure crucial, because one way to conceal insolvency is for an insurer to simply keep writing additional premiums on bad risk situations. The reinsurers further argue that the writing of substandard and underpriced risks, which were then subsumed within the reinsurance, constitutes a material fact subject to disclosure because the reinsurers’ true risks would not be generating sufficient premiums to justify such unknown exposures. The reinsurers also contend that the reinsurer has no duty to investigate such activity because the absolute duty to fully disclose the risk insured is on the primary insurer. A viola tion of that duty, they argue, vitiates the reinsurance. Additionally, the reinsurers assert that had they been aware of Union’s insolvency, they would not have underwritten reinsurance for it – a circumstance relied upon by the courts below and conceded by the appellants throughout – particularly in light of the greater responsibility imposed on reinsurers by Insurance Law §1308 in the event the ceding insurer is liquidated, whereby the reinsurer must pay the Liquidator on reinsured claims even if the Liquidator has not yet paid the policyholder’.

In finding that insolvency was, in fact, material to the reinsurers, the Court noted that because the reinsurance involved treaty reinsurance, there was a broader duty of disclosure, given the fact that (1) there is no individual risk scrutiny by the reinsurer, (2) the reinsurer is obligated to accept covered business, and (3) the relationship is expected to be of a long-term nature, so that profitability can only be measured over time based upon the skill of the ceding insurer’s underwriters. Citing the doctrine of uberrimae fidei as “the core duty accompanying reinsurance contracts,” the Court held that because the solvency of the ceding company was a fact that was “likely to influence the decisions of [its] underwriters,” it was material and had to be disclosed. “Insolvency,” the Court concluded, “not unlike extended coverage or an unusual term, has a potent potential impact on the reinsurers’ risk sufficient to trigger the uberrimae fidei obligation for disclosure.”

Finally, with respect to the Liquidator’s public policy argument, the Court noted that “[o]ver 40 years ago, in Bohlinger v. Zanger, (citation omitted), this court concluded that ‘[l]iquidation does not change the situation and the Liquidator should not and may not be placed in a better position than the company he takes over and demand that which is not owed’ (citation omitted).” The Court pointed out that it had reaffirmed this reasoning in In re Midland Ins. Co., 79 N.Y.2d 253, 590 N.E.2d 1186, 582 N.Y.S.2d 58 (1992), holding that “‘liquidation cannot place the Liquidator in a better position than the insolvent company he takes over, authorizing him to demand that which the company would not have been entitled to prior to liquidation.’” •

DEBATE OVER RETROACTIVITY OF WORKERS' COMPENSATION REFORM ACT BEGINS

In the Summer 1996 issue of the INSURANCE NEWSLETTER, we reported that the New York State Legislature passed a Workers’ Compensation Reform Act (“Act”) limiting third-party indemnification and contribution actions against a plaintiff’s employer to cases based upon a written contract entered into prior to the accident or where the employee’s injury falls within the statute’s narrow definition of “grave injury”, .e.g., death, amputation, quadriplegia or brain damage. The Act, signed by Governor Pataki on September 10, 1996, therefore severely restricts instances where a defendant can interpose a third-party action against a plaintiff’s employer, even if the employer’s negligence caused the injury. See New York Workers’ Compensation Reform Plan Passed by Legislature, OHRENSTEIN & BROWN INS. NEWSLETTER, Summer 1996 at 1.

The Act is silent as to whether its passage would extinguish pending third-party actions. As evidenced by three recent trial level court decisions, the issue of the retroactive effect of the Act, if any, remains unresolved. As reported in an Addendum to the Summer 1996 issue, in a case of first impression, an Albany County Supreme Court Judge held in Gleason v. Holman Contract Warehouse, Index No. 5174-93 (Sup. Ct. Albany Co. 1996), that the law's restrictions on third-party lawsuits against employers would apply only prospectively to accidents occurring after the accident date and that pending third-party claims would be preserved. See Governor Signs Workers’ Compensation Reform Bill and Court Holds that it Applies Prospectively, OHRENSTEIN & BROWN INS. NEWSLETTER, Summer 1996 Addendum. Since the Gleason decision, two other courts have ruled with respect to this issue, reaching different conclusions. In Flynn v. New York Life Insurance Co., et al., Index No. 9121750 (Sup. Ct. Suffolk Co. 1996), the holding in Gleason was followed, as the court held that the Act was intended to limit third-party actions against employers to cases involving accidents which occurred on or after the date of enactment, September 10, 1996. On the other hand, in Majewski v. Broadalbin-Perth Central School District, Index No. 83054 (Sup. Ct. Fulton Co. 1996), the court held that the Act should be applied retroactively and dismissed the third-party action pending against an employer for an accident that took place prior to the passage of the Act.

In Flynn, plaintiff commenced an action for personal injuries sustained during a demolition project while in the employ of third-party defendant H. C. Kranichfeld, Inc. (“Kranichfeld”). Plaintiff sued the New York Life Insurance Company (“New York Life”), the owner of the building in which the plaintiff was working at the time of the occurrence. Prior to the enactment of the Act, New York Life commenced a third-party action against the plaintiff’s employer, Kranichfeld, seeking common law indemnification or contribution and alleging that Kranichfeld was careless and negligent in failing to provide for the safety of its employee.

Kranichfeld moved for an order dismissing the third-party complaint based upon the new law. While Section 90 of the Act provides that it “shall take effect immediately”, the statute does not specify whether the partial bar to contribution and indemnification claims against employers applies to all actions now pending, or to all claims which may accrue as of the date of the enactment and thereafter, or to all actions which involve accidents occurring on or after the date of enactment.

The third-party defendant/employer argued that since causes of action for indemnification and/or contribution do not accrue until after the third-party plaintiff satisfies a judgment, a claim against an employer so accruing after the date of enactment (September 10, 1996) should be barred. The court noted that the intent of the Act was to “increase safety in the workplace while substantially lowering workers’ compensation premium costs and increasing benefit levels for injured workers”. As noted by the court in Gleason, a “windfall” profit would be enjoyed by workers’ compensation insurance carriers who were paid premiums to defend employers against claims relating to accidents prior to September 10, 1996, if such claims were to be barred by the Act.

The court held, therefore, the Act was intended to limit third-party actions against employers to actions involving accidents which occurred on or after the date of enactment, September 10, 1996. In both Gleason and Flynn, it appears that the Courts were attempting to blunt the harsh impact of the new law upon plaintiffs as well as defendants who were not actively negligent.

In Majewski, plaintiff was employed by Adirondack Mechanical Corp., and fell off a ladder (and allegedly suffered injuries) in December, 1994 while working at the Broadalbin-Perth Central School District in Upstate New York. He commenced suit against the School District, which in turn filed a third-party action against Adirondack. The employer moved for summary judgment, claiming the injury was not grave, and should be dismissed under the statute.

In holding that the Act should be applied retroactively, the court looked to a provision of the Act which calls for the Superintendent of Insurance to determine how much insurance companies have reduced their reserves because of the change in the law. Specifically, the statute calls for all insurance companies that cover Workers’ Compensation claims to pay the State $98 million out of their savings from the change in the law. The Superintendent of Insurance is required to audit the companies at the end of 1996 year what each company will owe. Adirondack argued that if pending suits were not dismissed under the Act, the insurers would be unable to reduce their reserves and there would be no savings to audit. The court agreed, noting that the audit provision “would have no meaning or purpose” absent retroactive application of the statute.

The reasoning in Majewski differs from that of Flynn and Gleason to the extent that Flynn and Gleason found that the statute’s purpose is to attract new business to the state and retroactive application would give insurance companies already doing business in the state a windfall profit through the reduction of their reserves.

The retroactive application of the Act is an issue that is likely to ultimately be decided by the New York Court of Appeals. Until then, there will exist a measure of uncertainty with respect to thousands of cases where there are pending third-party actions. Of course, we will continue to follow the judicial interpretations of the Act and provide periodic updates.

BATTLE CONTINUES OVER APPLICATION OF POLLUTION EXCLUSION TO LEAD PAINT CLAIM AS NEW YORK FEDERAL COURT TERMS CLAUSE “AMBIGUOUS”

In a decision notable for the distinction drawn between “environmental” pollution and other forms of “non-environmental” exposures, the United States District Court for the Southern District of New York, interpreting and applying New York law, held that a pollution exclusion clause in a general liability policy was ambiguous as applied to a lead paint claim. As a result, the insurer was obligated to defend its insureds.

The plaintiff in LeFrak Organization, Inc. v. Chubb Custom Ins. Co., ___ F.Supp. ___, 1996 WL 603964 (Oct. 22, 1996, S.D.N.Y.), a building owner and managing agent, was a defendant in a negligence action commenced by an infant and her mother residing in an apartment in one of plaintiff's buildings. It was alleged that the infant suffered serious injuries resulting from exposure to lead paint in the apartment.

The policy at issue afforded the insured coverage for bodily injury, property damage and personal injury, but excluded from coverage damages resulting from:

1. bodily injury or property damage arising out of the actual, alleged, or threatened discharge, dispersal, seepage, migration, release or escape of pollutants:

   a. at or from premises which are or were at any time owned or occupied by, or rented or loaned to any insured;

   b. at or from premises, site or location which is or was at any time used by or for any insured or others for the waste;

   c. which are or were at any time transported, handled, stored, treated, disposed of, or processed as waste by or for any insured or any person or organization for whom you may be legally responsible; or

   d. at or from any premises, site or location on which any insured or any contractors or subcontractors working directly or indirectly on any insured's behalf are performing operations:

   i. if the pollutants are brought on or to the premises, site or location in connection with such operations by such insured, contractor or subcontractor; or ii. if the operations are to test for, monitor, clean up, remove, contain, treat, detoxify, or neutralize, or in any way respond to, or assess the effects of pollutants . . . .

   Pollutants means 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.

Chubb denied coverage based upon the pollution exclusion clause and the insured commenced a declaratory judgment action. In determining whether Chubb had a duty to defend its insureds, the court found that the “policy reasonably can be read to cover . . . lead poisoning claims.” In so finding, the court concluded that its decision was controlled by the interpretation of a similar pollution exclusion clause in Stoney Run Co. v. Prudential- LMI Commercial Ins. Co., 47 F.3d 34 (2d Cir. 1995). In Stoney Run, coverage was claimed by the insured for several underlying actions involving the release of carbon monoxide in its rental apartments. Relying on a similar pollution exclusion clause, the insurer in Stoney Run argued that the alleged damages resulted from the “‘discharge, dispersal, release or escape of pollutants.’” The term “pollutants” was defined in that policy as “‘any solid, liquid, gaseous or thermal irritant or contaminant, including smoke, vapor, soot, fumes, acids, alkalis, chemicals and waste.’” Reversing the district court’s decision in favor of the insurer, the United States Court of Appeals for the Second Circuit found that a pollution exclusion clause must be construed in light of its general purpose – to exclude coverage for “environmental pollution.” On that basis, the court in Stoney Run concluded that the release of carbon monoxide into an apartment could not be characterized as environmental pollution.

For similar reasons, the court in LeFrak found that the clause before it could reasonably be read to exclude only environmental pollution. In support of its conclusion, the court observed that the underly- ing lead poisoning did not result from the “discharge, dispersal, seepage, migration, release or escape” of a pollutant as required by the policy exclusion. In this regard, the court found that terms such as “discharge,” “dispersal,” “release,” and “escape” are “environmental terms of art” which could be read to apply only to injury from environmental damage. The court gleaned further support for its interpretation from the use of the term “premises” in the language of the policy, finding that the term suggests the inclusion of outdoor space surrounding a building which would qualify as “environmental” rather than merely interior space.

Further, the court stated that while the policy’s definition of “pollutants” could “arguably encompass [ ] any object, chemical or other substance that irritates or contaminates the human body,” including lead paint, the examples cited by the definition (“smoke, vapor, soot, fumes, acids . . .”) were not even “closely related” to the type presented by lead paint. Indeed, the court observed that lead paint flakes, chips and dust are not used or generated by the operation of machinery or other equipment, nor are they byproducts of such industrial applications. Rather, the court noted that “lead is an ingredient in paint that causes harm when, through age and normal use, the paint flakes off walls, and is either inhaled or ingested.” As such, the court concluded that the exclusion was ambiguous because it was “at least plausible that the pollution exclusi on was not meant to and does not apply to lead exposure claims.”

In reaching its conclusion, the court took cognizance of a number of “incongruous” state court decisions which have interpreted pollution exclusion clauses. Compare e.g., American Heritage Realty Partnership v. LaVoy, 209 A.D.2d 749, 618 N.Y.S.2d 125 (3d Dep’t 1994) (removal of insulation that released asbestos in apartment was covered by pollution exclusion); Demakos v. Travelers Ins. Co., 205 A.D.2d 731, 613 N.Y.S.2d 709 (2d Dep’t 1994) (seepage of smoke from basement to apartment was covered by pollution exclusion); Generali-U.S. Branch v. Caribe Realty Corp., 160 Misc. 1056, 612 N.Y.S.2d 296 (Sup. Ct. N.Y. Co. 1994) (ingestion of lead paint not covered by pollution exclusion); and General Accident Ins. Co. v. Idbar Realty Corp., 163 Misc. 2d 809, 622 N.Y.S.2d 417 (Sup. Ct. Suffolk Co. 1994) (ingestion of lead paint not covered by pollution exclusion), aff’d as modified, ___ A.D.2d ___, 646 N.Y.S.2d 138 (2d Dep’t 1996).

Declining Chubb’s invitation to harmonize these cases, the court noted that the range of judicial opinions construing pollution exclusions was further evidence of their ambiguity.

Accordingly, the court held that it was bound by the decision in Stoney Run, which mandated that pollution exclusion clauses be interpreted in light of their purpose to only bar coverage of environmental conditions.