Courts use choice-of-law analysis to avoid denying coverage

Recently, California and Delaware courts have applied choice-of-law analyses to coverage disputes seemingly to avoid denials of coverage. In Pitzer College v. Indian Harbor Ins. Co., the California Supreme Court held a choice-of-law provision was potentially unenforceable because it violated “fundamental public policy.” In Pfizer Inc. v. Arch Ins. Co. the Delaware Superior Court held Delaware law applied to insurance contracts that did not contain choice-of-law provisions, even though New York law arguably applied.

The outcomes in Pfizer and Pitzer may have been different had the insurers initiated litigation in the forums specified in the contracts. Insurers should be mindful of these decisions and include clear choice-of-law provisions in policies. If a coverage dispute does arise, insurers should be proactive so as to avoid unfavorable forums.

The Pitzer Decision

In Pitzer, California’s Supreme Court held that:

• California’s notice-prejudice rule is a fundamental public policy in the insurance context; and
• The notice-prejudice rule applies to consent provisions in first-party, but not third-party, liability policies.

The Indian Harbor policy required Pitzer to provide notice of pollution conditions and obtain Indian Harbor’s consent before incurring expenses or beginning remediation due to a pollution condition. The policy also provided that New York law governed all matters under the policy.

Pitzer discovered a hazard on its campus during a project and retained contractors to perform remediation work. Pitzer tendered its claim and provided notice of the work to Indian Harbor only after it was completed. Indian Harbor denied coverage pursuant to the notice and consent provisions.

Pitzer sued Indian Harbor for breach of contract. Indian Harbor moved for summary judgment, arguing it had no obligation to indemnify Pitzer because Pitzer violated the policy’s notice and consent provisions. Indian Harbor also argued that under New York law, Pitzer’s failure to provide timely notice warranted denial of coverage.

The federal district court granted Indian Harbor’s motion, holding in part the policy called for the application of New York Law. It also held while a state’s fundamental public policy can override a choice-of-law provision, Pitzer failed to establish California’s notice-prejudice rule applied.

Pitzer appealed, and the U.S. Court of Appeals for the Ninth Circuit sent the case to the California Supreme Court on the question of whether California’s notice-prejudice rule is a fundamental policy for choice-of-law analysis.

California Supreme Court’s ruling

California’s notice-prejudice rule requires insurers to prove an insured’s late notice of a claim substantially prejudices the ability to investigate and negotiate payment for a claim. Substantial prejudice will excuse the insurer from its obligations unless the insurer had actual or constructive knowledge of a claim. Insurers must show actual prejudice.

Whether California’s notice-prejudice is a fundamental rule of public policy was an issue of first impression. California’s rules have been found to be fundamental public policies when they:

1. Cannot be contractually waived,
2. Protect against otherwise inequitable results, and
3. Promote the public interest.

The California Supreme Court held California’s notice-prejudice rule satisfied these factors. In the context of first-party liability coverage, the opinion said, courts have widely recognized that enforcement of notice provisions permits insurers to “reap the benefits flowing from the forfeiture of the insurance policy” despite a lack of prejudice.

It also explained because an insurer’s right to control the defense and settlement of claims is paramount in the third-party context, courts have generally refused to find the notice-prejudice rule applicable to consent provisions in third-party policies.

Pitzer and Indian Harbor disputed whether the policy provided first-party or third-party coverage, and the Ninth Circuit did not certify the issue to the California Supreme Court. Accordingly, it was left to the Ninth Circuit to decide whether the policy provided first-party or third-party coverage.

Pfizer decision

Pfizer involved a coverage dispute between Pfizer and defendants Arch Insurance Company and U.S. Specialty Insurance Company (collectively “defendants”) on the issue of whether coverage for a class-action settlement in one lawsuit was barred by a related wrongful acts exclusion because of another class-action settlement.

The court, applying Delaware law, held litigation exclusions in defendants’ directors and officers (D&O) policies did not exclude coverage because the lawsuits were not “fundamentally identical.” Had New York law applied, defendants would have only been required to show the lawsuits shared a “sufficient factual nexus,” a lower burden than Delaware’s “fundamentally identical” standard.

Pfizer sought coverage from Defendants in relation to a lawsuit captioned Morabito et al. v. Pfizer, Inc., et al. The Morabito plaintiffs alleged securities violations against Pfizer in relation to representations and omissions it made regarding its drug, Celebrex. Pfizer ultimately settled the Morabito lawsuit, and the defendants denied coverage on the grounds that prior litigation, including Garber v. Pharmacia Corp., et al. triggered policy exclusions and endorsements. Garber, like Morabito, involved statements Pfizer made about Celebrex.

Pfizer sued defendants in the Delaware Superior Court, alleging breach of contract claims. The parties cross-moved for summary judgment, and defendants argued coverage for Morabito was excluded because it was a claim arising out of or attributable to Garber.

The Delaware Superior Court acknowledged Morabito and Garber were both class-action lawsuits related to Pfizer’s representations and omissions concerning Celebrex. However, the court drew a distinction about the associated health risks alleged in the lawsuits.

Pfizer’s excess D&O insurance followed form to its primary policy, issued by National Union Fire Insurance Co. of Pittsburgh, Pa. National Union’s policy contained an exclusion that excluded a loss based on similar or wrongful acts, and an endorsement that provided in part it would not be liable for any loss related to a related wrongful action alleged in Garber.

Arch’s D&O policy excluded claims for the Garber lawsuit and “Interrelated Wrongful Acts,” defined as “[W]rongful Acts that have as a common nexus any fact, circumstance, situation, event, transaction, cause or series of causally connected facts, circumstances, situations, events, transactions or causes.”

Delaware Superior Court’s analysis

Defendants’ D&O policies did not contain choice-of-law provisions. New York and Delaware law differed as to the interpretation of the interrelated acts exclusion at issue.

Under New York law, to establish claims are interrelated, an insurer must show the claims share a sufficient factual nexus, which exists when the claims arise from common facts and when the logically connected facts and circumstances demonstrate a factual nexus among the claims.

Under Delaware law, “relatedness” or “arising out of” policy language is interpreted as precluding coverage only when two underlying actions are fundamentally identical.

Delaware applies the “most significant relationship” test in its choice-of-law analysis, which includes consideration of:

1. the parties’ place of contracting;
2. where the contract was negotiated;
3. the place of performance;
4. the location of the subject matter of the contract; and
5. the place of incorporation and place of business of the parties.

The court recognized that:

1. Pfizer’s principal place of business was New York;
2. The policies were issued in New York;
3. Pfizer’s broker was located in New York;
4. The policies contained numerous New York endorsements; and
5. Morabito was instituted in New York.

The court held that, nevertheless, Delaware law applied.

It explained the application of Delaware law was consistent with the parties’ reasonable expectations at the time of contracting. The court noted the only mention of choice-of-law was found in an alternative dispute resolution provision that provided Delaware law applied in the event of arbitration. On that basis, the court determined the parties “probably expected” Delaware law to apply.

The court also held applying Delaware law accorded with the consistent application of Delaware law to D&O coverage disputes. When D&O coverage is at issue and the choice of law is between the headquarters or the state of incorporation, the latter has the most significant relationship. When considering the aforementioned factors to a corporate-wide insurance program, the inquiry should center on the insurance contracts and not the claims.

Upon the determination that Delaware law applied, the court held Garber and Morabito were not fundamentally identical, and the interrelated acts exclusions did not bar coverage.

Is this a trend?

The Pitzer and Pfizer decisions evidence what could be a trend of courts disregarding policy terms that are perceivably contrary to the forum’s policy. Insurers should consider including clear choice-of-law provisions in all policies. They should also consider initiating declaratory judgment actions in contracted-for forums to protect coverage terms and exclusions.

Michael L. Zigelman (mzigelman@kdvlaw.com) is a partner, chair of the general liability practice group and co-managing partner of the New York office at Kaufman Dolowich & Voluck LLP.

Aaron M. Cargain (acargain@kdvlaw.com) is an associate at Kaufman Dolowich & Voluck.

Related:

• Three trends increasing D&O insurance rates
• D&O concerns identified in Willis Towers Watson survey
• Increasing underwriting challenges in D&O insurance