California Insurance - Insurer Has No Duty To Defend Lawsuit Where, Despite The Legal Theories Asserted, The Claims Arise Out Of Non-Covered Activities
Cary Medill et al., v. Westport Insurance Corporation, No. B177005 (Cal. Ct. App., October 4, 2006).
California’s Second Appellate District court of Appeal affirmed summary judgment in favor of Westport Insurance Corporation that its Nonprofit Organization Liability Policy did not obligate it to defend claims arising out
of its insured’s mismanagement of bond offerings and related breaches of contract. Representing Westport both at the trial level and on appeal were Ross, Dixon & Bell’s Jennifer Mathis (argued) and Daniel
Streeter. Lewis K. Loss of Thompson, Loss & Judge, LLP was co-counsel for Westport.
The insured nonprofit organization, Heritage Housing Development, Inc. (“Heritage”), raised money through municipal bonds for the purpose of financing the acquisition and operation of healthcare facilities. After
Heritage defaulted on the bond payments, Heritage’s officers and directors were named as defendants in a securities class action brought by the bond investors. The class alleged that Heritage mismanaged the bonds by
running an elaborate “Ponzi” scheme where proceeds from subsequent bond offerings were used to mask cash shortfalls from prior offerings and that these transfers violated the bond agreements. The class brought
causes of action for, among other things, violations of securities laws, breach of fiduciary duty, and negligence based on the directors and officers’ alleged failure to properly oversee the legitimacy and feasibility of the
plans under each of the bond offerings, for alleged misrepresentations in the bond offering documents and for violating the terms of the bond indentures.
Westport Insurance Corporation issued a “Nonprofit Organization Liability Policy” to Heritage, under which Heritage’s directors and officers sought coverage for the bond litigation. The policy excluded
from its definition of “Loss” damages “arising out of” breach of contract. The policy also excluded loss “arising out of … any ‘insured’s’ issuance or endorsement
of …bonds” or “failure to honor or pay on any financial instrument or credit given for continued patronage or use of any ‘insured’s’ services or products.” When
Westport denied coverage for the bond litigation based on these policy provisions, several of Heritage’s directors sued for bad faith, breach of contract and declaratory relief in Los Angeles County Superior Court. Westport
agreed to defend the insureds under a reservation of rights until the court determined the coverage issues.
The trial court granted Westport ’s motion for summary judgment, agreeing that all of the claims asserted against Heritage’s directors and officers arose from its breaches of contract, issuance of bonds, and failure
to pay those bonds.
In a lengthy published decision, the Court of Appeal affirmed. The court rejected the insureds’ argument that because none of the insureds themselves allegedly breached any contract, the “breach of contract”
exclusion should not apply. The court reasoned that the policy’s definition of Loss excluded damages “arising out of” breaches of contract, and that both the policy and California law give a broad
definition to the phrase “arising out of.” Because the underlying litigation would not have existed without the bond contracts, all of the claims in the lawsuit – even tort claims – were excluded
from coverage.
The court next rebuffed the argument that, because none of the appellants – i.e., the directors and officers – issued any bonds, the “bond issuance” exclusion should not apply. The court found
this fact was irrelevant, noting that under California law, the exclusion precluded conduct where any insured (here, Heritage and the Heritage entities) engaged in the excluded activity of issuing or endorsing bonds.
For similar reasons, the court rejected the insureds’ arguments regarding the application of the “failure to pay” exclusion. Even though none of the directors and officers allegedly failed to pay a debt,
the underlying litigation was entirely premised on Heritage’s failure to pay on the bonds, which excluded coverage for all insureds.
The court next discussed – and rejected – the insureds’ “concurrent proximate cause” analysis. The insureds argued that under the reasoning of the California Supreme Court’s decision
in State Farm Mut. Auto. Ins. Co. v. Partridge, 10 Cal.3d 94 (1973), there must be coverage under the policy because the insureds’ negligence was an independent proximate cause of the loss to the class. The
Court refused to apply Partridge, finding that insureds’ alleged negligence did not exist independent of the policy’s other excluded risks. According to the Court, none of the loss allegedly caused by
the insureds would have occurred without Heritage’s breaches of contract, defaults on its bond obligations, or the issuance of the bonds in the first place.
Last, the court dispelled the notion that if there was no coverage for the insureds’ negligence in connection with the bond litigation, the policy’s coverage was illusory. The court noted that the insured’s
business was operating healthcare facilities, not issuing bonds, and accordingly not every lawsuit that conceivably could be brought against the insureds would necessarily arise out of excluded activities. The court observed,
for example, that the policy specifically covered claims against the insureds involving wrongful employment practices. Further, not every claim alleging negligence necessarily triggers a defense obligation. Rather, coverage
depends on the nature of the risk covered. According to the court, there was nothing in the Westport policy to suggest that it intended to act as guarantor for hundreds of millions of dollars of unpaid contractual obligations
in connection with the bonds.