C L A I M D E N I E D November 2003 A publication of the - - PDF document

C L A I M

D E N I E D

November 2003

A publication of the Lowenstein Sandler Insurance Law Practice Group

A

Minnesota appellate court recently weighed in on the

• n-going debate over whether com-

puter data constitutes “tangible property” such that claims for dam- ages associated with computer data will trigger a coverage obligation under a general liability coverage

• grant. See Compaq Computer Corp.
• v. St. Paul Fire & Marine Ins. Co.,

2003 Minn. App. LEXIS 1087. After being sued in two class actions alleging that “Compaq intentionally sold computers that contained defective floppy-diskette controllers (FDCs) and FDC microcodes, [which] in turn caused the loss of use, corruption, and destruction of data without any prior warning to the user”, Compaq sought coverage under its technolo- gy errors and omissions liability pol- icy, technology commercial general liability policy, and technology umbrella excess liability policy. Coverage was found to be unavail- able under the E&O policy because the nature of the plaintiffs’ claims involved intentional conduct. A similar argument was advanced to bar coverage under the CGL and umbrella policies. Nevertheless, Compaq pursued coverage for asserted breach of warranty claims

• n the theory that computer data

constitutes “tangible property” and plaintiffs were, in part, seeking damages for damage, corruption, and destruction of their computer

• data. As such, Compaq argued,

coverage should be available under the general liability policy. The court rejected Compaq’s argu- ment on the grounds that plaintiffs’ claims were based on the FDCs inability to retain or retrieve comput- er data from the disk. Plaintiffs were not claiming damage to pre-existing

• data. Rather, they were claiming

damages because they could not suc- cessfully store data on a disk or

• btain access to stored data. The

court noted that, under applicable governing Texas law, information

This document is published by Lowenstein Sandler PC to keep clients informed about current issues. It is intended to provide general information only.

A L D

Inability to Store or Retrieve Data Held Insufficient to Establish Property Damage

By Lynda A. Bennett, Esq., and David Malekan, Esq.

Inside

CORPORATE GOVERNANCE: FAILURE TO PROCURE OR MAINTAIN “ADEQUATE INSURANCE” MAY PRECLUDE D&O COVERAGE — SEVERABILITY FOR INNOCENT INSUREDS: THE PUBLIC POLICY CASE FOR COVERAGE — www.insurance-lowenstein.com

alone is not “tangible”, even if it may be communicated by a fax machine, telephone, telegram or computer. Information only becomes “tangible” when it merges with physical proper- ty, such as when it is put on paper or when, as was the case in Retail Sys.,

• Inc. v. CNA Ins. Cos., 469 N.W

.2d 735, 737 (Minn. App. 1991), a com- puter tape and the data stored on the tape were “of permanent value and were integrated completely with the physical property of the tape.” In this case, the court found that “the dispute centers on the alleged inability of Compaq FDCs to retrieve

• r store data property onto a floppy
• disk. Moreover, the class action

plaintiffs made no claim for damages for loss or destruction of data.” Indeed, plaintiffs’ complaint specifi- cally stated that the class was not seeking consequential damages as a result of the actual loss or corruption

• f data. Plaintiffs were seeking a

refund of the purchase price, repair

• r replacement of the defective com-

puter or component parts, and attor- neys fees. As such, the court held that no coverage was available under the GL policy. Compaq is a troubling decision because it appears to set a precedent that policyholders are at the mercy of the plaintiffs’ bar to use the “right words” in their Complaints seeking relief for damage to computer data. It is hard to reconcile the notion that coverage will exist if computer data may be reproduced in printable form but that no coverage will apply to a situation like Compaq where the plaintiff is alleging the inability to retrieve data, which may then be reproduced in printable form. Perhaps the most disturbing aspect of the Compaq decision is that Compaq had procured an insurance program that purportedly was designed specif- ically to cover “technology” risks and the insurer was able to successfully block coverage under all of the poli- cies for a relatively plain vanilla, though potentially costly, third-party liability. Most companies do not have the coverage that they need for loss of data, under either first party or third party policies. Identification of expo- sures in this area and purchase of necessary coverage should be a prior- ity for every policyholder.

CORPORATE GOVERNANCE: FAILURE TO PROCURE OR MAINTAIN “ADEQUATE INSURANCE” MAY PRECLUDE D&O COVERAGE

By Adam S. Cantor, Esq. In the current hard insurance mar- ket, the insurance industry’s scaling back of coverage previously available under directors’ and

• fficers’

(“D&O”) liability remains a serious

• concern. One change to the stan-

dard D&O policy sought by insurers

• ver the past 12-18 months is the

addition of a ‘Failure to Maintain Insurance’ (“FMI”) exclusion, which is designed to preclude coverage for claims against directors and officers alleging that they failed to purchase

• r maintain insurance sufficient to

protect the company’s assets. A recent version of the exclusion reads: The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured alleging, aris- ing out of, based upon or attrib- utable to any failure or omission

• n the part of any Insured to

effect or maintain adequate insurance.1 The FMI exclusion was commonly used during the 1980s insurance cri- sis when it was difficult to obtain broad coverage, particularly in the excess market. The exclusion was almost universally eliminated from

2003

Most companies do not have the coverage that they need for loss of data. Identification of exposures should be a priority for every policyholder.

policies throughout the 1990s when insurers were required to offer the broadest coverage possible to remain competitive in the race to secure pre- mium dollars. Now the exclusion is making a come back. While the impact of this coverage change is not as “high profile” as certain other cur- rent policy modifications, such as the restriction or elimination of corpo- rate entity coverage, the removal of ‘final adjudication’ wording from fraud and personal profit exclusions, and retrenchment on policy sever- ability - not to mention reduced lim- its and higher premiums and/or deductibles - there are serious issues associated with inclusion of an FMI exclusion in today’s D&O policy. One concern is the exclusion’s use of the adjective “adequate”. FMI exclusions often refer to a ‘fail- ure to maintain adequate insurance’

• r ‘failure to maintain adequate pol-

icy limits’. The danger is that ‘ade- quate’ is subjective: it means differ- ent things to different people. Thus, a policyholder faces real risk that its insurer will employ an exceedingly broad interpretation of ‘adequate’ to trigger the exclusion in every instance. Another concern arises, and is becoming increasingly resonant, in

• ur post 9/11 world. Coverage for

terrorism has now become available under the commercial general lia- bility (CGL) and property insurance

• policies. However, due to the

extremely high prices quoted by insurers for this cover, many policy- holders and risk managers are opt- ing to forgo purchasing this cover-

• age. That decision may well be

conscientious, researched and eco- nomically based, but nonetheless, if those companies suffer an unin- sured terrorism loss, the risk of law- suits alleging that the directors and

• fficers of the company were negli-

gent in failing to procure terrorism coverage is high. While the ‘busi- ness judgment’ rule may provide a basis to avoid liability for the deci- sion to go without terrorism cover- age, the FMI exclusion appears to preclude coverage for even the defense costs associated with such a claim. To minimize the risk of a cover- age dispute after a claim is made, policyholders faced with the addi- tion of the FMI exclusion to their D&O policies should attempt to negotiate modifications to the exclusion during the underwriting process that (i) eliminate the word “adequate”; and (ii) provide for an exception for claims alleging negli- gent failure to purchase terrorism coverage.

SEVERABILITY FOR INNOCENT INSUREDS: THE PUBLIC POLICY CASE FOR COVERAGE

By Lynda A. Bennett, Esq., and Adam S. Cantor, Esq. In a recent 6 to 1 decision, the New Jersey Supreme Court held that an insurer cannot rescind an insurance policy for an innocent insured even though it may have grounds to void coverage for other malfeasant

• insureds. First American Title

Insurance Company v. Lawson, 177 N.J. 125, 827 A.2d 230 (N.J., July 17, 2003). Lawson, Wheeler and Snyder were partners in a law firm. Wheeler and Lawson practiced in New Jersey, though only Lawson was licensed there. Snyder ran the New York office, and performed lit- tle or no work in New Jersey. By early 1997, Wheeler was misappro- priating client trust funds for his personal use. In late 1997, Wheeler failed to disclose the potential of claims from his misconduct on the firm’s professional liability applica- tion, and a policy subsequently

• issued. About the same time,

Lawson discovered Wheeler’s wrongdoing, yet joined with him in a “kiting” scheme involving more

. . . a policyholder faces real risk that its insurer will employ an exceedingly broad interpretation of ‘adequate’ to trigger the exclusion.

illicit transfers between client accounts and the firm’s business

• accounts. Lawson also skimmed

funds for personal use. Snyder was not privy, nor a party, to Wheeler and Lawson’s dishonest conduct. In January 1999, Wheeler made a further material misrepresentation to his insurance company. In order to reinstate the firm’s policy (which was almost canceled due to a missed premium payment), Wheeler war- ranted that he was unaware of any acts or circumstances that might result in a claim, despite his knowl- edge of the kiting scheme, along with several client grievances filed with the Office of Attorney Ethics (“OAE”), and a pending OAE audit

• f the firm’s books.

One week after Wheeler made his false warranty, Lawson was sus- pended from the practice of law and was ultimately disbarred. T wo title insurers, forced to repay the firm’s defrauded clients of stolen closing funds, filed lawsuits against the firm and its partners to recover those

• payments. Wheeler tendered the

suits to the firm’s professional liabil- ity carrier, which denied coverage and filed a declaratory judgment action, alleging that its policy was “void by reason of the material mis- representation in the warranty”. The trial court ruled that the pol- icy was not void per se. Rather, the court held that while the policy was not available to Lawson and Wheeler individually because of their dishonest conduct, it did cover Snyder and “the firm”, a legal entity distinct from the individual

• partners. The Appellate Division

reversed, rendering the policy void for all of the partners and the firm. The Supreme Court affirmed the lower courts’ decisions that Wheeler and Lawson were not enti- tled to coverage and held that only Snyder, not the firm, was entitled to coverage as an “innocent insured.” The Court stated that “voiding Snyder’s coverage solely because of his partners’ wrongful conduct potentially would expose Snyder to uninsured liability in a manner inconsistent with his expectations under the Uniform Partnership Law”. Moreover, the Court found that such a “harsh and sweeping result would be contrary to the pub- lic interest” of protecting members

• f the public injured by their attor-
• neys. Indeed, the Court noted that

the very reason that attorneys are required to carry malpractice insur- ance is to protect aggrieved clients. Blanket rescission of the policy pre- sented a risk that other clients, with unrelated malpractice claims against the innocent insured [Snyder], would be left unprotected. The [NJ] Supreme Court’s deci- sion significantly impacts the avail- ability of coverage for corporate policyholders, especially directors and officers. Lawson stands for the proposition that, while rescission may be an appropriate remedy for an insured who lies or omits mater- ial information on an application, strong arguments for coverage exist for innocent insureds, who unknowingly are associated with a materially deficient or knowingly false application. For more information regarding these or any other insurance coverage issues, please contact Robert D. Chesler, Chair

• f the Insurance Law Practice Group,

at 973.597.2328

• r

at rchesler@lowenstein.com. Or visit the Insurance Outpost website at www.insurance-lowenstein.com.

The [NJ] Supreme Court’s decision significantly im- pacts the availability of coverage for corporate poli- cyholders, especially direc- tors and officers.

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