C L A I M D E N I E D September 2002 A publication of the - - PDF document

C L A I M

D E N I E D

September 2002

A publication of the Lowenstein Sandler Insurance Law Practice Group

F

• r years companies have bene-

fited with lower rates and better coverage as insurers competed for their D&O business. Now, the combination of World Trade Center losses, declining invest- ment income, and the threat of huge losses from Enron, Worldcom and other scandals, have dramati- cally and suddenly reversed this

• trend. What should companies do

to protect their directors and offi- cers in this crisis?

• 1. Report anything that even

looks like a claim. D&O policies are claims-made, and failure to give notice of a claim will fore- close coverage. Policies use differ- ent definitions of ‘claim,’ but the tendency is to define it broadly. Thus, a ‘claim’ frequently includes ‘any written demand for monetary

• r non-monetary relief.’ The

insured’s duty to give notice thus includes not only formal com- plaints but also administrative pro- ceedings and angry letters. Failure to give timely notice can be fatal.

• 2. Report ‘circumstances’ as
• well. Most D&O policies include

a provision that allows the insured to report circumstances that are likely to give rise to a claim, and not just an actual claim. New D&O policies often exclude claims if the insured had sufficient knowledge of the claim in the pre- vious policy year. The insured does not want to be caught in a situation where it did not give notice in the first year because a formal claim was not filed, only to lose coverage in the second year because of the knowledge of a potential claim that it possessed.

• 3. Watch out for retroactive
• dates. Coverage does not exist for

acts that occur before the policy’s retroactive date. Obviously, insur- ers try to limit their risk by having a recent date; indeed, on policies issued to a new insured, insurers like to use the policy inception date as the retroactive date. Today, when statutes of limitation are often meaningless because of the discovery rule, companies should negotiate for as early a retroactive date as possible.

• 4. Obtain maximum severability

for innocent insureds. D&O pol-

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

THE D&O HARD MARKET: TOP TEN SUR VIVAL TIPS

By Robert D. Chesler, Esq.

Inside

ALLOCATION IN ENVIRONMENTAL INSURANCE: NEW YORK WEIGHS IN By Alexander J. Anglim, Esq. COURT SAYS NO TO AOL ON INSURANCE COVERAGE FOR DEFECTIVE SOFTWARE CLAIMS By Robert D. Chesler, Esq.

icy exclusions for fraud and dis- honesty often are written to deny coverage for all directors and offi- cers if any one officer or director is liable for a fraudulent act. A sev- erability provision protects the innocent insureds in this situation. This is particularly important for policy provisions that allow rescis- sion of the policy for misrepresen- tations made in the application.

• 5. Is ‘entity coverage’ a blessing
• r a curse?

Entity coverage includes the corporation as an insured on the D&O policy, which broadens coverage and avoids allo- cation issues. However, bankrupt- cy trustees are now asserting that D&O policies that provide entity coverage are assets of the estate, and that directors and officers being sued in the wake of a bank- ruptcy should not be allowed to access those policies for defense

• costs. You can address this issue by

a “priority of payment” provision, and also through a provision negating the entity coverage in the event of bankruptcy.

• 6. Obtain ‘final adjudication’
• provision. As is true of all insur-

ance policies, D&O policies do not provide coverage for intentionally wrongful

• r

fraudulent acts. Plaintiffs frequently couch their complaints against directors and

• fficers precisely in these terms. If

the complaint only alleges inten- tional or fraudulent acts, the insur- er may refuse to defend. Many D&O policies have provisions that state that in such a circumstance, the insurer must defend the direc- tor or officer until there is a final adjudication of wrongdoing.

• 7. Should a D&O policy include

employment practices liability insurance (“EPLI”)? The inclu- sion of EPLI coverage in a D&O policy is usually presented as an advantage, while in fact it presents problems as well. A D&O policy with an EPLI add-on will protect the directors and officers, but not the corporation and other employ- ees, such as the human resources

• manager. The EPLI coverage of

the D&O policy can be extended to include all of these parties. However, that leaves a D&O poli- cy with a single policy limit exposed to employment claims. A significant employment claim against the company can erode or exhaust the limits of the D&O pol- icy, leaving the directors and offi- cers unprotected against the claims for which the policy was intended.

• 8. Review the ‘insured v.

insured’ exclusion and negotiate with the insurer for the least restrictive language. This exclu- sion applies to claims by current or former directors or officers — pre- cisely the people who frequently bring suits. Some insurance com- panies are now writing more favor-

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• r by email to kcerreto@lowenstein.com.

able ‘insured v. insured’ exclusions. For example, one insurer does not apply the exclusion to shareholder derivative actions, and another

• nly applies it to present, but not

former directors and officers. If there is a choice, look for the poli- cy with the narrowest ‘insured v. insured’ exclusion.

• 9. Beware allocation, choice of

law and arbitration provisions. Many complaints name as defen- dants both insured directors and

• fficers and uninsured individuals

and entities. Thus, allocation of defense and damages between the insured and the uninsured defen- dants becomes a contested issue. In most states, the insureds have won this issue, and the law on allo- cation is very favorable. As a result, insurers frequently attempt to insert provisions into the policy designed to undo the victories won in the courts.

• 10. PAY ATTENTION!!!

All D&O policies are not the same. While negotiation over policy terms is increasingly difficult in today’s hard market, examine the proffered policy carefully and go back to the insurer with a list of

• amendments. Where possible,
• btain quotes from different insur-

ers and compare their policy provi-

• sions. While everyone hopes that

they will never need to make a claim under the D&O policy, make sure that you have the best possible policy if a claim does arise. Allstate Insurance Company, Slip

• Op. 03419, May 2, 2002, 2002 WL

827174 (N.Y.), the Plaintiff (“Con Edison”) sued its primary and excess insurers for defense and indemnification arising out of con- tamination at its former manufac- tured gas plant in Tarrytown, New

• York. Some of the upper-level

excess insurers moved to dismiss on the grounds of nonjusticiability. In deciding the motion, the trial court used a simple time-on-the-risk allocation method. It “took the highest projection of damages by Con Edison’s expert ($51 million), divided by the number of years named in the complaint (50), and…determined that policies that attach at levels above $1.1 million were nonjusticiable because they would not be reached even if Con Edison prevailed at trial.” Thus, the trial court granted the motion to dismiss as to those policies whose attachment points were in excess of that threshold. After losing at trial against the remaining insurers, Con Edison appealed on several grounds, including the trial court’s time-on- the-risk allocation methodology. Con Edison argued it should be permitted to pick and choose from among the applicable policy peri-

• ds, because each of the policies
• bligated each carrier to pay “all

sums which the insured shall be

• bligated to pay” for property dam-

age caused by an occurrence. Conversely, the carriers argued that the joint and several approach

ALLOCATION IN ENVIRONMENTAL INSURANCE: NEW YORK WEIGHS IN

By Alexander J. Anglim, Esq.

Environmental insurance coverage litigation is in some respects a relatively mature phe-

• nomenon. After more than twen-

ty years of vigorous advocacy on both sides, many of the key cover- age issues are now settled law in the majority of states. However, even where the insured’s entitle- ment to coverage is clear, other hotly contested issues remain. One such issue is allocation — namely, the issue of which policies must bear losses that trigger policies pur- chased over a period of several years or even decades. The two competing allocation rules are the “all sums” method (also known as “joint and several” or “pick and choose”) on one hand, and various pro-rata methods on the other. The all sums method expedites recovery by the insured; pro-rata methods typically impose on the insured the burden of seeking recovery of each insurer’s “fair” share of the total liability. New York is the latest state to have its highest court weigh in on this

• issue. Unfortunately for policy-

holders, the New York Court of Appeals has given its approval to the pro-rata approach. In Consolidated Edison Company of New York, Inc. v.

tion issues will continue to be liti- gated in New York and elsewhere. Therefore, as the Court aptly noted, this case clearly “is not the last word” on allocation methodol-

• gy in New York.

COURT SAYS NO TO AOL ON INSURANCE COVERAGE FOR DEFECTIVE SOFTWARE CLAIMS By Robert D. Chesler, Esq.

A court has held that America Online, Inc. is not entitled to insur- ance coverage for claims that soft- ware that it supplied to its cus- tomers damaged their computers. America Online, Inc. v. St. Paul Mercury Insurance Company, Civ. Action No. 01-1636-A (E.D.Va. June 20, 2002). The case arose out

• f a class action which AOL cus-

tomers had filed against AOL. In that class action, the customers had asserted that AOL had provided to its customers a defective software program to access the Internet. The plaintiffs alleged “that their computers have suffered damage and an impairment to the integrity

• r availability of data, software pro-

grams, operating systems, and infor- mation contained in their comput-

• er. . . [and] that the plaintiffs lost

the use of their computers and com- puter functionality . . .” Shortly after the class action suit was filed, AOL requested that its insurer, St. Paul, defend these claims under AOL’s general liabili- ty policy. St. Paul denied cover-

• age. AOL filed suit, and moved for

partial summary judgment on St. Paul’s duty to defend. The court found that coverage turned on the insurance policy’s definition of “property damage.” The policy defined property damage as “physi- cal damage to tangible property of

• thers, including all resulting loss
• f use of that property or loss of use
• f tangible property of others that

isn’t physically damaged.” The court first addressed whether physical damage to tangi- ble property had occurred. AOL argued that computer data, soft- ware and systems are tangible property because they are “capable

• f being realized,” a phrase that the

court did not explain. St. Paul argued that computer data and software systems are not tangible property because they could not be

• touched. The court looked to dic-

tionary definitions in order to ascertain the plain meaning of the word ‘tangible’, and concluded that ‘tangible’ “is something that is capable of being touched or per- ceptible to the senses.” While both sides cited to analogous cases, the court found the cases cited by

• St. Paul to be more persuasive. As

a result, the court found that “cov- was inconsistent with the policies’ requirement that the occurrence take place “during the policy peri-

• d.” The Court of Appeals agreed

with the insurers’ position, and affirmed the trial court’s decision. It held that the “all sums” approach would negate the phrase “during the policy period” because Con Edison had not proven that the entire loss had occurred during any single policy period. The Court further found that “[p]roration of liability among the insurers acknowledges the fact that there is uncertainty as to what actually transpired during any particular policy period.” However, it is noteworthy that the Court of Appeals did not hold that time-on-the-risk was the

• nly acceptable allocation method-
• logy. To the contrary, it held sim-

ply that the trial court’s use of a time-on-the-risk approach in this particular case was not error. In that regard, the Court of Appeals noted that other courts have taken different approaches to the pro-rata

• method. For example, some courts

consider the ratio of each insurer’s coverage to the total coverage applicable to the loss, while other courts have prorated coverage based on the proportion of damages suffered during each applicable pol- icy period. The Court also noted that courts “differ on how to treat self-insured retentions, periods of no insurance, periods where no insurance is available and settled policies.” These and other alloca-

“...coverage turned on the insurance policy’s definition

• f “property damage.”

erage did not exist for the allega- tions concerning data, software programs, operating systems and information.” The court next examined the claim that the software caused loss

• f use of computers. The court eas-

ily recognized that the computer itself was physical property, and that the definition of property dam- age specifically included loss of use

• f physical property. However, the

court denied coverage on the basis

• f the “impaired property exclu-

sion.” This little known and even less understood exclusion, which had not previously been applied to software, is based on the concept of ‘impaired property’, defined as “tan- gible property, other than the insured’s products or completed work, that can be restored to use by nothing more than: (1) an adjust- ment, repair, replacement, or removal of the insured’s products or completed work which forms a part

• f it; or (2) the insured fulfilling the

terms of a contract or agreement.” The policy then excludes “property damage to impaired property, or to property which isn’t physically damaged, that results from: (1) the insured’s faulty or dangerous prod- ucts or completed work; or (2) a delay or failure in fulfilling the terms of a contract or agreement.” This is a standard exclusion in gen- eral liability policies. Essentially, this exclusion applies to a component that, when integrated into a system, results in the failure of the system to work, and which can be removed without physical damage to the system. Courts have employed this exclu- sion in various contexts, including computer components, but it is particularly apt with respect to our growing dependence on software. While AOL is a third party lia- bility case, its true significance lies in the court’s conclusion regarding damage to data, a type of claim that is as important in the context of a company’s claim against its proper- ty insurer for loss of its own proper- ty as it would be in the consumer class action against AOL. Three federal courts (including the AOL court) have now addressed the issue

• f insurance coverage for damage to
• r loss of data. The first court, in a

first-party context, found that data was physical property and therefore should be covered under a general liability policy. The two subse- quent decisions, both involving third party liability, found that data was not physical or tangible proper- ty and, accordingly, denied cover- age under general liability policies.

Lessons Learned

The lesson learned from these three cases is that companies must assume that their insurers will deny coverage for claims involving loss

• f data or system malfunction

under traditional property and lia- bility policies. Companies should review their exposures in this regard, and work with their insur- ance brokers and consultants to determine if either endorsements

• r new insurance products are

available to address these risks. A wide variety of new ‘cyber insur- ance’ policies are available. These range from very narrow niche poli- cies (e.g., applying solely to dam- ages from hackers), to broad multi- media policies that include both first and third party coverage. These policies are not standard- ized, and can be customized to meet a company’s individual needs. For more information regarding this

• r any other insurance coverage

issue, please contact Robert D. Chesler, Chair of the Insurance Law Practice Group, at 973.597.2328

• r

at rchesler @lowenstein.com, or you can visit

• ur Insurance Outpost website at

www.insurance-lowenstein.com.

...companies must assume that their insurers will deny coverage for claims involving loss of data or system mal- function under traditional property and liability policies.

J

Insurance Law Practice Group 65 Livingston Avenue Roseland, New Jersey 07068

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For more information on any insurance coverage matter, please contact Robert D. Chesler, Esq. at 973.597.2328

The Lowenstein Sandler Insurance Practice Group Credo

Insurance should provide security and peace of mind. In exchange for a premium payment, the policyholder externalizes risk. However, the relationship of trust between policyholder and insurer that once existed has

• vanished. The cavalry has turned and run, the umbrella lies in tatters and the good hands are a fist. All

too frequently, the insurer’s response to a valid request for coverage is ‘claim denied.’ We, in the Lowenstein Sandler Insurance Practice Group, still believe that insurance policies provide coverage. We will advise our clients of their rights, guide our clients down the tortuous paths of claims-handling, and partner with our clients to pursue coverage through litigation when necessary. We stand prepared to be your insurance advo- cate.