C L A I M D E N I E D April 2004 A publication of the Lowenstein - - PDF document

C L A I M

D E N I E D

April 2004

A publication of the Lowenstein Sandler Insurance Law Practice Group

A

s the first quarter of 2004 comes to a close, we thought it would be worthwhile to lead off this year’s first issue of Claim Denied with an overview of the hottest insurance issues of 2003 and a sum- mary of the interesting new cover- age disputes that are on the horizon for 2004. Last year represented a hybrid of the “bread and butter” environ- mental/ product liability claims that have fueled insurance disputes for the past twenty years and a new crop of D&O, bankruptcy, technol-

• gy, and broker liability claims. We

continue to see a steady stream of traditional environmental claims involving groundwater contamina- tion and/or off-site soil contamina- tion allegedly emanating from our client’s facilities. Despite the well- developed state of New Jersey envi- ronmental insurance law, a surpris- ing number of medium-sized and smaller companies have yet to receive the benefits of their policies. If reports of thousands of new NJDEP natural resource damage claims are true, environmental insurance will again move to center stage. In 2003, we also saw a sharp up-tick

• f coverage disputes involving
• asbestos. As many of the asbestos

manufacturers have fallen into bank- ruptcy, many new companies, such as lumber dealers, plumbing supply wholesalers, electricians, and a host

• f other family-owned businesses, are

falling prey to asbestos claims. Sadly, many asbestos insurance battles must now be fought in bankruptcy court, as defendants cannot reach cost- sharing agreements quickly enough with their insurers to stave off insol- vency. Moreover, new waves of mass tort product liability continue to appear. Like asbestos, silica claims and claims involving CCA, a wood preservative, present a myriad of insurance issues

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

Current State of Insurance Coverage Landscape

By: Robert D. Chesler, Esq. and Lynda A. Bennett, Esq.

Inside

NO DUTY TO DEFEND AOL IN DEFECTIVE SOFTWARE SUIT — BANKRUPTCY COURT REJECTS RESCISSION ATTEMPT AND MAINTAINS DIRECTORS AND OFFICERS ACCESS TO D&O POLICY — PROTECTING YOUR RIGHTS WHEN YOUR INSURER BECOMES INSOLVENT

including allocation, missing policies, the right to obtain coverage under

• ther people’s insurance, whether

insurer liability should be determined

• n a joint and several or pro rata

basis, whether individual claims pre- sent one or multiple occurrences, and countless others. T wenty years ago, insurance lawyers believed that it would only take a year or two to resolve all of the coverage issues. Instead, issues continue to multiply and gain in complexity. In terms of new liabilities, claims aris- ing from Directors and Officers liabil- ity coverage led the way for 2003. Insurers reacted to massive corporate scandals by disclaiming insurance coverage and frequently seeking to rescind the policies. Many compa- nies that had regarded the D&O pol- icy as a safety net found that it was full of holes. This in turn resulted in a new emphasis on underwriting to make certain that companies had the best possible provisions on key issues such as severability, the insured v. insured exclusion, and the insurer’s defense obligation. Intellectual property, Internet and technology-based claims also rose to the forefront in 2003. Traditional insurance policies dealt with bricks, not bytes. These policies frequently apply to physical damage, leading insurers to deny coverage for claims

• f lost data. Insurers have also dras-

tically cut back on advertising injury insurance, reducing or eliminating coverage for intellectual property and websites. Many, if not most, tech and e-commerce companies do not have the insurance coverage that they need. As the above examples illustrate, the business of insurance has become increasingly complex. The general liability policy has become ‘unbun- dled’, and a company may now need to purchase several kinds of insur- ance, such as employment, environ- mental and technology. Most of the new policies are claims-made, bring- ing notice issues to the fore. Many insurers are writing more restrictive policy provisions. The insurance broker’s job has become harder, and we have seen a resulting increase in broker liability claims. As we begin 2004, two new interest- ing groups of claims are emerging as “hot” insurance coverage disputes. First, corporate restructuring deals involving spin-off transactions have given rise to big ticket D&O cover- age disputes. In several instances, policyholders have been denied enti- ty coverage for lawsuits involving corporate spin-offs because the insur- er claims that no “securities transac- tion” took place in the context of the spin-off transaction. Second, the California Supreme Court has held that a successor corporation does not necessarily inherit the predecessor’s insurance rights if there was an asset instead of a stock transaction. Analysis of insurance will play a larg- er role in the calculations of corpo- rate lawyers. As the above coverage battles press

• n, and new ones develop, the

Insurance Practice Group

• f

Lowenstein Sandler remains poised to serve as your insurance advocate. T

• remain abreast of all of the latest

developments in insurance, be sure to visit our Insurance Outpost at www.insurance-lowenstein.com, where we regularly post highlights of leading insurance decisions, articles concerning key issues and trends in insurance, and a calendar of all of our up-coming insurance events and

• seminars. Of course, you may also

contact Robert Chesler (rchesler@lowenstein.com)

• r

Lynda Bennett (lbennett@lowen- stein.com) directly if you have an immediate insurance need.

NO DUTY TO DEFEND AOL IN DEFECTIVE SOFTWARE SUIT

By David Malekan, Esq. A divided panel of the United States Court of Appeals for the Fourth Circuit has held that America

Many companies that had regarded the D&O policy as a safety net found that it was full of holes.

Online, Inc.’s (“AOL ”) insurer does not have a duty to defend the com- pany against lawsuits alleging that “bugs” in AOL software caused dam- age to consumers’ computers. America Online, Inc. v. St. Paul Mercury Ins. Co., Nos. 02-2018 and 02-2084, 2003 WL 22346351 (4th

• Cir. Oct. 15, 2003).

The underlying plaintiffs alleged that AOL ’s Version 5.0 Internet access software, released in 1999, was rushed to market, resulting in sub- stantial bugs and incompatibility with numerous applications and

• perating systems. Included were

allegations that Version 5.0 caused system instability, disabled non-AOL Internet connection and e-mail pro- grams, and altered files belonging to

• ther programs on users’ systems,

particularly operating system files. According to many of the underlying plaintiffs, the only reported remedy was to reinstall the Windows operat- ing system, which may have involved the more extreme step of first refor- matting the hard drives on their per- sonal computers. AOL tendered defense of the class- action suits to its insurer, St. Paul, which denied coverage. AOL then sued, seeking coverage under two distinct definitions of “property dam- age” in its commercial general liabili- ty policy: (1) physical damage to tan- gible property of others, and (2) loss

• f use of tangible property of others

that is not physically damaged. The district court granted summary judg- ment to St. Paul, and the Court of Appeals affirmed. The Fourth Circuit held that no cov- erage existed under the first defini- tion of “property damage” because the underlying plaintiffs had only alleged damage to software, which the court did not consider “tangible.” The court distinguished between “data or instructions and the physical machines that give them meaning[,]” and reasoned that corruption of soft- ware does not equate to physical damage to the hardware. At worst, the court held, the hardware was “reconfigured” by the defect, and the remedy – while costly – did not require replacement of the hardware; rather, it required reinstallation of non-defective software. As to the second definition of prop- erty damage, based on “loss of use,” the court held that coverage was barred by an “impaired property”

• exclusion. This exclusion pertained

to “property damage to impaired property, or to property [not] physi- cally damaged,” resulting from the insured’s “faulty or dangerous prod- ucts

• r

completed work….” “Impaired property,” in turn, was defined as “tangible property capable

• f being restored to use by nothing

more than: an adjustment, repair, replacement, or removal of [the insured’s] products or completed work….” The court concluded that the exclusion places a limitation on the coverage of consequential dam- ages, restricting coverage to loss of use of other persons’ properties that are physically damaged. The dissent adopted AOL ’s argument that plaintiffs’ claims clearly alleged property damage because they assert- ed that the defective software caused a change in the physical structure of the computer, rendering it inoperable. The AOL decision is among the most recent in a disturbing trend of cases allowing insurers to successfully avoid large, expensive technology-based claims by drawing a distinction between damage to “software” and damage to the “hardware” that pro- vides the means for the software to

• perate. In essence, if the AOL

court’s opinion carries the day, policy- holders will be at the mercy of the plaintiffs that sue them to artfully draft a complaint that alleges physical damage to the computer terminal in

• rder to obtain insurance protection.

BANKRUPTCY COURT REJECTS RESCISSION ATTEMPT AND MAINTAINS DIRECTORS AND OFFICERS ACCESS TO D&O POLICY

By Lynda A. Bennett, Esq. and Adam Cantor, Esq. The insurance coverage ramifica- tions of recent corporate scandals

continue to be resolved in the con- text of bankruptcy litigation. The latest decision stems from the Adelphia bankruptcy where: (a) cer- tain insurers attempted to void Adelphia’s D&O policies on grounds

• f fraud allegedly perpetrated by the

company’s founding directors; and (b) the bankruptcy estate and the individual named insureds continued to grapple over the rights to the insurance proceeds. The Adelphia court’s ruling on both issues was pri- marily designed to balance the best interests of the bankruptcy estate and the D’s and O’s.

Rejection of Insurer Rescission Action

Adelphia’s primary and excess insur- ers had filed a declaratory judgment action, outside of the bankruptcy proceeding, seeking to void and rescind the D&O policies because of certain directors’ suspected fraud. The insurers’ demand was oppres- sive, since rescission would effect not

• nly the allegedly criminal directors,

but also any “innocent” insureds and the company itself. Thus, the bank- ruptcy court stayed the insurers’ action on grounds that it threatened to frustrate any reorganization efforts that might be taken with respect to Adelphia or its subsidiaries. In par- ticular, the court noted that the loss

• f entity coverage as a funding source

to resolve pending liabilities would substantially impair Adelphia and its subsidiary companies’ ability to reor-

• ganize. The court also cited the

importance of having the ability to maintain and attract independent directors with the promise of ade- quate insurance protection as being crucial to any effort to reorganize a viable corporate entity. Accordingly, the insurers’ attempt to avoid their coverage obligations by rescinding the Adelphia policies failed.

D&O Coverage Must Protect Individuals First

Leaving the D&O coverage intact led the court to resolve the other signifi- cant insurance question that has repeatedly arisen in the context of the recent corporate scandals: Who “owns” the proceeds of a D&O policy in the bankruptcy setting? Federal courts are split on the issue. Some courts have held that the company

• wns only the D&O policy, not its

proceeds, because the policy was pur- chased for the benefit of the directors and officers. Other courts, however, have held that the debtor company has an interest in preserving policy proceeds because resolution of charges against the directors and offi- cers are often part of global settle- ments preceding reorganizations. In an earlier, related case, as a matter of first impression, the District Court for the Southern District of New Y

• rk

held that policy proceeds were not part of the estate, because Adelphia did not yet have interest in the pro- ceeds, i.e., the company had not yet committed itself to any payments that were indemnifiable under the policy. Seeking to strike a balance between that decision and its own interest in preserving the policies as viable assets for reorganization, the bank- ruptcy court held that while Adelphia’s directors and officers must be permitted access to the D&O coverage to fund their defense efforts, that right of access is not unlimited. As such, the court has established that each individual insured may tender bills, up to a maximum of $300,000 per month, to defend against the various pend- ing litigations, subject to a possible stay in the future if the court believes that the policy proceeds may be entirely consumed by those defense costs. The import of the Adelphia deci- sion is clear: insurance coverage remains at the center of resolving many of the headline-making cor- porate scandals. Although insurers have generally been unsuccessful in dodging their insurance obligations, a federal court has recently rescind- ed a D&O policy because of misrepresentations by the CFO who signed the application. Without doubt, coverage fights among insur-

Insurance coverage remains at the center of resolving many of the headline- making corporate scandals.

ers, directors and officers, and bankrupt companies will continue.

PROTECTING YOUR RIGHTS WHEN YOUR INSURER BECOMES INSOLVENT

By Lynda A. Bennett, Esq. Notwithstanding recent reports that the economy is beginning to rebound, there has been a sharp rise

• f insurers experiencing financial dif-
• ficulties. Indeed, within the last six

months alone: Best’s Insurance has down-graded Royal Sun Alliance and Atlantic Mutual Insurance Companies; the Home Insurance Company has been placed in liquida- tion; and rumors continue to swirl about the financial health of Kemper and the London Market. Reliance Insurance Company was placed in liquidation in May 2001. KWELM,

• ne of the largest groups of insolvent

London companies, is quickly mov- ing toward establishing a September 2004 “bar date” by which all claims must be tendered and run off pro- ceedings will commence to distribute KWELM’s remaining assets. In the face of this grim solvency pic- ture, there are a few things that you can and should do to preserve and/or maximize your coverage rights. First, determine whether your coverage program is placed with any of the tee- tering insurers and instruct your bro- ker to secure replacement coverage as soon as possible. Second, to the extent you have coverage with an insolvent insurer, carefully evaluate whether you have any claims, or even potential claims, which you should immediately tender to the Liquidator assigned to oversee the run off of the insurance company. Third, examine whether you have coverage under any insurance policy issued to others with whom you have a contractual relationship, rights under an indemnity agreement, or any other vehicle that may fill the

• gap. Fourth, consider retaining cov-

erage counsel to evaluate and pursue coverage for any pending or immi- nent claims from the appropriate guaranty funds. While every state has adopted some form of the uniform Property Liability Insurance Guaranty Association model statute, there are sticky legal nuances that must be resolved such as: (a) is there a prior- ity of payment provision that may establish another state as the appro- priate venue for your claim; (b) is there a “residence” qualification to trigger your right to make a claim; (c) are there specific limits to the state’s statute that may preclude recovery for large corporations; and (d) is there a mechanism for determining whether multiple lawsuits, such as asbestos or silica, should be treated as separate “covered claims” for purpos- es of the statutory cap on recovery or whether the statutory cap applies in the aggregate to the liability present- ed by the claims as a whole? Finally, if your company has coverage placed with an insolvent insurer, you should prepare Management that the company may have to absorb the costs associated with coverage gaps left by the insolvent. While a few courts have required solvent insurers sitting above insolvent insurance to “drop down” to fill the gaps, most courts have saddled policyholders with the burden of absorbing gaps in

• coverage. Depending on the size of

the coverage gaps and the insurers creating those gaps, you may also have to consider whether your bro- ker bears any responsibility for the company’s insolvency predicament. 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 Lynda A. Bennett, member of the Insurance Law Practice Group, at 973-597-2386 or at lbennett@lowenstein.com. Or visit the Insurance Outpost website at www.insurance-lowenstein.com.

Consider retaining coverage counsel to evaluate and pursue coverage for any pending or imminent claims from the appropriate guaranty funds.

J

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

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www.insurance-lowenstein.com

Publications

• “When Coverage Does Not

Meet Expectations,” New Jersey Law Journal, Robert D. Chesler, Esq. and Lynda A. Bennett, Esq., April 14, 2003

• “Absolute Pollution Confusion,”

New Jersey Law Journal, Robert D. Chesler, Esq. and Kristina D. Pasko, Esq., November 17, 2003 Past Events

• 2004 American Bar

Association Insurance Coverage Litigation Committee CLE Seminar

• Natural Resource Damages:

What It Means to New Jersey Businesses

• Trigger & Allocation:

Insurance Law in the Age of NRD and Asbestos Recent Outpost Legal Highlights

• NJ Appellate Division Finds

Coverage Under Missing Policy Based on Stipulation

• Homeowners Policy Does Not

Cover Professional Plumbing Services

• NJ Appellate Division

Expands Insurer Liability Beyond Policy Limits