1995 Summer - Insurance Newsletter
July 1, 1995

NINTH CIRCUIT APPLIES “LARGER SETTLEMENT RULE” TO ALLOCATION OF SECURITIES FRAUD SETTLEMENT UNDER DIRECTORS’ AND OFFICERS’ POLICY

In Nordstrom, Inc. v. Chubb & Son, Inc., 54 F.3d 1424 (9th Cir. 1995), the United States Court of Appeals for the Ninth Circuit held that the “larger settlement rule” is the appropriate standard by which to determine how to allocate directors’ and officers’ insurance coverage in the settlement of a suit against a corporation and its directors and officers.

The shareholders of Nordstrom, Inc. filed a securities fraud class action suit alleging that Nordstrom concealed from investors the existence of material adverse risks arising out of a company-wide policy requiring Nordstrom employees to work “off the clock.” After the suit was filed, Nordstrom gave notice to Federal Insurance Company and its managing agent, Chubb & Son, Inc., (collectively “Federal”), which had issued to Nordstrom a policy of insurance covering “all loss” stemming from the wrongful acts of the corporate directors and officers (the “D & O policy”). The D & O policy provided in relevant part:

The Company shall pay on behalf of the Insured Organization all Loss for which the Insured Organization grants indemnification to each Insured Person, as permitted or required by law, which the Insured Person has become legally obligated to pay on account of any claim first made against him, individually or otherwise, during the Policy Period . . . for a Wrongful Act committed, attempted, or allegedly committed or attempted, by such Insured Person(s) before or during the Policy Period.

Pursuant to this policy, Federal agreed to reimburse Nordstrom subject to an allocation as between covered and non-covered claims.

The parties to the action eventually agreed upon a settlement that required a payment to the shareholders of $7.5 million and provided that the corporate entity and the directors and officers were jointly and severally liable for the sum. Federal consented to the settlement as reasonable, but contended that the uninsured corporate entity was partially responsible for the loss, and thus only agreed to pay half of the settlement sum. Accordingly, Nordstrom brought an action seeking payment under the D&O policy for the full amount of the settlement. The district court granted partial summary judgment in favor of Nordstrom, finding that Federal was liable for the entire amount of the settlement (in excess the amount of the deductible). Federal appealed.

On appeal, Federal argued that it should not be required to pay the full amount of the settlement agreement because the D & O policy did not provide for indemnification to Nordstrom for liability of the corporate entity. Therefore, Federal argued, it must be determined whether any portion of the settlement sum was attributable solely to the corporate entity.

Nordstrom, on the other hand, offered three arguments to support the lower court’s decision without ever having to reach Federal's allocation argument. All of these arguments were rejected by the Court of appeals.

Nordstrom first argued that there was no basis for Federal's appeal since the D & O policy lacked an express allocation clause. The court rejected this argument, stating that Washington law (the agreed upon governing law) permits allocation even in the absence of an express allocation clause. In addition, since the policy only covered losses which “the Insured Person has become legally obligated to pay on account of any claim first made against him during the Policy Period ... for a wrongful Act ... allegedly committed ... by [an] Insured Person,” the corporate entity’s independent liability would not constitute a “loss” under the meaning of the policy, and allocation would therefore be unnecessary.

Nordstrom next argued that the joint and several liability provision of the settlement agreement foreclosed any right to allocation by rendering the directors and officers “legally obligated to pay” the entire settlement sum. The court reasoned that the policy would not cover acts that were solely attributable to the corporate entity, even if the directors and officers were joint and severally liable for the corporation’s independent acts.

Finally, Nordstrom argued that Federal was estopped from denying full coverage because it violated its duties to investigate Nordstrom’s claim promptly and to provide a reasoned explanation of the facts and law supporting its denial of coverage. The court found that the record did not support this claim. Federal had reserved its rights to seek allocation later on in order to facilitate ongoing settlement discussions.

The court next addressed the issue of how settlement payments and defense costs should be allocated between directors and officers and the corporate entity when they are joined as co-defendants, an issue of first impression in the Ninth Circuit. The court adopted the “larger settlement rule,” which provides that a portion of the settlement will be allocated to an uninsured party only if the acts of the uninsured party increased the amount of settlement. This occurs only if the corporate entity alone is liable for a particular claim, or if the corporate entity’s liability would exceed that of the directors and officers on any claim for which the corporation was both independently and jointly liable.

The court found that the “larger settlement rule” best effectuated the reasonable expectations of the parties, and noted that it was applicable because the terms of the policy indicated that Federal was responsible for any amount of liability that was attributable in any way to the wrongful acts or omissions of the directors and officers, regardless of whether the corporate entity could be found concurrently liable on any given claim under an independent theory. The court then considered whether Nordstrom faced any independent, nonconcurrent liability. The court concluded that there was no such exposure, rejecting both theories by which Federal claimed that there was independent and nonconcurrent liability.

First, Federal argued that Nordstrom might have been independently liable because it was exposed to vicarious liability based on the acts of uninsured corporate employees. The court rejected this argument concluding that the officers and directors were “controlling persons” under the Securities Exchange Act of 1934 since the insured directors and officers approved the wrongful acts (i.e., the allegedly misleading public disclosures and press releases). The court also rejected Federal’s argument that the directors and officers could invoke the good faith defense, stating that it is not available to directors and officers who induce a fraud by approving allegedly misleading public statements.

Federal next argued that Nordstrom might have direct corporate liability for the securities fraud and that such liability is not concurrent with directors’ and officers’ liability because the directors and officers might have defenses unavailable to the corporation. Specifically, Federal argued that it was conceivable that none of the directors and officers had the requisite intent for securities fraud, but that the corporate entity had such intent under a theory of “collective scienter,” whereby the cumulative knowledge of the corporate agents are imputed to the corporation. The court, however, found no case law supporting this theory. In addition, the court found that there was no evidence to support such a theory without finding that a defendant director or officer had the requisite intent as well. As the court noted, corporate scienter relies heavily on the awareness of the directors and officers. In this case, there was no way Federal could show that Nordstrom – but not its directors and officers – had the requisite intent to defraud.

VIOLATION OF LOCAL LAW CLASSIFYING LEAD PAINT AS HAZARDOUS HELD NOT TO IMPOSE ABSOLUTE LIABILITY

New York’s Appellate Division, First Department has held that a violation of a local law classifying as hazardous lead paint in multiple dwellings housing children under the age of seven does not impose absolute liability, but does constitute negligence per se.

In Juarez v. Wavecrest Management Team Ltd., __ A.D.2d __ , 627 N.Y.S.2d 620, (1st Dep’t 1995), plaintiffs were renting a bedroom in an apartment from the tenant of record. According to the infant’s mother, the apartment in which they resided was replete with peeling paint, and paint chips were falling from the ceiling, windows, pipes and radiators. About one year after plaintiffs moved into the apartment, the infant plaintiff complained of stomach pains and was diagnosed as having lead poisoning. The New York City Department of Health determined that there were within the apartment numerous violations of Administrative Code §27-2013(h) (known as “Local Law 1”).

A principal of the building owner testified that he inspected the apartment when he originally purchased the building, at which time he did not see paint chips falling. He never had the apartment painted, but did give the tenant of record one month of rent-free tenancy with the understanding that the tenant would use the money to paint the apartment.

Plaintiffs commenced an action against the managing agent and the owners of the building claiming that the infant suffered severe personal injury from ingesting lead-based paint chips. The trial court granted plaintiffs’ motion for summary judgment and defendants appealed.

On appeal, the Appellate Division rejected plaintiffs’ contention that a violation of Local Law 1 should create absolute liability, finding no overriding valid public policy reason to impose such liability. As the court stated:

[w]ere a rule of absolute liability to be imposed, owners would not merely have a duty to inspect for lead paint conditions but an absolute duty to succeed in finding every lead paint hazard everywhere in every property held. If a landlord was not successful in finding all of the lead paint -- no matter how diligent the search or understandable the failure -- the landlord would be absolutely liable, without any cognizable defense. As a matter of public policy, this rule of absolute liability seems draconian.

The court did, however, find that a violation of Local Law 1 constituted negligence per se. (This has the effect of stamping a defendant’s conduct as negligence, with all of the effects of common law negligence, but with no greater effect. For example, there still remains open such questions as the casual relationship between the violation and the harm to the plaintiff.) The wrongful nature of the act was fixed by statute, and the breach claimed here was one of a specific statutory safety provision constituting a significant structural defect. The court noted that while the defective condition must be visible and longstanding, this requirement was indeed satisfied in plaintiffs’ apartment.

The court also held that Local Law 1 imposes upon land-owners an affirmative duty of inspection – to identify and remove lead paint hazards. The legislative intent to protect children would be rendered meaningless if a landlord were not required to remedy a lead condition until a landlord had “notice” of the condition. Accordingly, the court held, “[a]n implied duty to inspect is, therefore, necessary to ensure that a landlord will live up to the responsibilities unequivocally imposed by the Code.”

The court ultimately held that summary judgment against the original owner was proper, but that summary judgment should not have been granted against the managing agent, which was acting for a disclosed principal, and was not itself in complete and exclusive control of the building.

NEW YORK INTERMEDIATE APPELLATE COURT EXPANDS POTENTIAL LIABILITY OF PROPERTY OWNERS

A recent decision by the New York’s Appellate Division, First Department is likely to have the effect of expanding potential liability of property owners. In Granville v. City of New York, __ A.D.2d __ , 627 N.Y.S.2d 4 (1st Dep’t 1995), the plaintiff tripped and fell on an allegedly raised and defective portion of a public sidewalk in front of premises owned by defendant Lincoln Associates, a commercial landlord.

Based on the general principle that the municipality and not the private owner is responsible for maintaining a public sidewalk, Lincoln moved for summary judgment. Plaintiff's opposition was based on one of three exceptions to this rule -- that the public way was used by the private property owner for a “special use” which resulted in the accident. (The other two exceptions are: (1) the private property owner created the condition which caused the accident; and (2) a statute or law requires the private property owner to maintain the sidewalk and specifically provides that the owner will be liable for failure to do so.)

In affirming the trial court's denial of summary judgment, the Appellate Division, in a 3-2 decision, held that a concrete step, mounted on the sidewalk beneath an elevated doorway, constituted a special use for Lincoln’s benefit, which facilitated access to the premises. While the plaintiff did not trip on the step, the defendant opened itself to liability by failing to repair a crack in the sidewalk which was “contiguous” to the step. The court held that the proximity of the crack to the step raised a factual question as to “the causal connection between the owner’s special use of a portion of the public walkway and the defective condition which caused the injury.”

A strong dissent argued that the plaintiff’s claim was based on “pure speculation,” stating that “[t]he mere fact that the crack in the sidewalk leads directly to the step does not raise a triable issue. The doctrine of guilt by association has never been successfully extended to sidewalk cases.”

By expanding the special use exception to a scenario where the special use bore no causal connection to the alleged accident, the Appellate Division has unsettled a previously settled area of the law and exposed private property owners to the possibility of increased liability.

OWNER OF PREMISES STRICTLY LIABLE PURSUANT TO LABOR LAW EVEN WHERE LAW ALSO PROHIBITED OWNER'S ACCESS TO WORK SITE

A New York state trial court has held that an owner of property can be strictly liable under the New York Labor Law provision providing for the joint obligation of owners and contractors to provide safe scaffolds, despite the fact that a different provision of the Labor Law prohibits the owner from entering a work site where the removal of hazardous material was ongoing.

Perez v. Society of New York Hospital, No. 131984/93 (N.Y. Sup. May 16, 1995), involved a worker who fell from a scaffold as he attempted to traverse to a nearby ladder, thereby sustaining multiple injuries. Plaintiff brought suit against New York Hospital and Cornell Medical Center as owners of the premises, alleging a violation of, among other provisions, Section 240 of the New York Labor Law, which has been interpreted by the New York courts as providing for absolute liability where a scaffold failing to comply with the statute’s requirements was the proximate cause of a plaintiff's injury.

Defense counsel argued that because neither of the defendants exercised supervision or control over the work site and they were actually prohibited by Section 902 of the Labor Law from entering the asbestos removal work site, since they were not licensed to conduct abatement work, an exception should be made to the imposition of absolute liability.

In rejecting defendants’ argument, the court found that the distinction presented where the owner was actually proscribed from entering the work site, was not a meaningful one for purposes of liability under section 240. The court noted that the statute is broadly worded and has been construed liberally in the interests of protecting workers from hazards on the job. Moreover, the court reasoned, the fact that a job entails the additional hazard of working with deleterious materials should not be used as a basis to erode the protections afforded by the Labor Law.

As a practical matter, the court concluded, the owner, faced with strict liability, is in the best position to insure safe working conditions and can either hire licensed supervisors to oversee any work, or can have its own employees check the safety of the work site before the initiation of work with hazardous materials causes its closure.

NEW YORK FEDERAL COURT HOLDS THAT THE PRINCIPLE OF “FOLLOW THE FORTUNES” IS IMPLIED IN EVERY REINSURANCE CONTRACT

The federal district court for the Southern District of New York recently held that a reinsurer was bound by the good faith settlement of its ceding insurer notwithstanding the facts that the reinsurance policy did not contain a “follow the fortunes” provision and that the cedent, in settling with the insured, adopted an interpretation of the policy that was contrary to the intent of the parties to the reinsurance contract.

In Aetna Cas. and Sur. Co. v. Home Ins. Co., 882 F.Supp 1328 (S.D.N.Y. 1995), Aetna brought suit to recover expenses it paid in connection with the Dalkon Shield litigation. The dispute focused on whether the parties’ obligation to pay defense costs was exclusive of damages or whether such payments were included in and limited by the policies’ limits of liability.

Home, as a reinsurer of Aetna excess policies issued to A.H. Robins Company, Inc. refused to cover expenses once the policies’ limits of liability had been reached. Aetna argued that it had made a reasonable good faith determination after a “businesslike” investigation that the wording of the underlying policy could be construed as providing for the payment of expenses in addition to indemnification for damages up to the limit of liability.

Home, however, argued that since the insurer and reinsurer clearly intended and understood that the limits of liability were inclusive of defense costs, Aetna was not entitled to indemnification beyond the policies’ limits. Home also argued that the “follow the fortunes” doctrine did not apply to facultative reinsurance and that even if it did, the policy of reinsurance did not contain the standard “follow the fortunes” clause.

Rejecting all of Home’s arguments, the court ruled that the “follow the fortunes” doctrine applied to reinsurance generally, and that this obligation was implicitly contained in every reinsurance contract. More specifically, the court held where a settlement is made in good faith, is the product of a reasonable construction of the reinsured policy, and the settlement is not fraudulent or collusive, the reinsurer is obligated to indemnify the ceding insurer even where the actual underwriting intent of the parties would proscribe the coverage sought.

FILING OF INITIAL PROOF OF LOSS SATISFIES INSURED’S OBLIGATION UNDER NEW YORK INSURANCE LAW AND SUBJECT POLICY

A New York state trial court has ruled that insureds who filed proofs of loss in connection with initial payments for business interruption losses had fulfilled the requirements of their insurance policy as well as those of the New York Insurance Law, notwithstanding the fact that the insurer’s demands for additional proofs had been refused.

In Charlton v. U.S. Fire Ins. Co., __ A.D.2d __ , 627 N.Y.S. 2d 221 (N.Y. Sup. 1995), the court, which described the case as one of apparent first impression, permitted the insureds to continue their action to recover $395,413 for business interruption losses sustained after a fire at a Consolidated Edison substation caused the closure of their South Street Seaport restaurants for up to seven days.

U.S. Fire had made an initial payment of $115,000, for which the insureds’ representative had delivered signed proofs of loss, as initial payment for the insureds’ business interruption losses. Additional proofs of loss amounting to $240,495, intended to represent the balance of coverage, which had been prepared by U.S. Fire, were, however, rejected by the insureds as “inadequate.”

After the rejection of the first “offer,” U.S. Fire submitted blank proof of loss forms to the insureds with a letter requesting that they fulfill their obligations under the policy to “send a signed, sworn statement of loss containing the information [the company] request[s]...within sixty (60) days after our requests....” This demand was similarly rejected and U.S. Fire refused to cover further losses. Plaintiffs then brought suit to recover the balance of their claim.

As an affirmative defense, U.S. Fire raised the obligation to provide proofs of loss contained in the policy, which is also codified in Section 3407 of the New York Insurance Law. U.S. Fire argued that the failure of an insured to meet this obligation is an absolute defense to an action on the policy.

While the court agreed with U.S. Fire’s statement of the law, it rejected its applicability to the facts of this case. The court ruled that neither the New York Insurance Law nor the policy required the filing of additional proofs of loss. Thus, since proofs had been filed in connection with the initial payments, the insureds had met their obligations.

The court also rejected the argument that the insureds had failed to cooperate with the insurer by allegedly refusing to comply with the insurer’s demand for an examination under oath. More specifically, the court ruled that the insured’s were within their rights to refuse to submit to examination where the insurer also required the insureds to sign non-waiver agreements which were not mandated by the policy.