News - November 2006

• Vacancy Exclusion’s Exception for Building “Under Construction” Applies to Renovations and Additions
• D&O Policy Does Not Cover Liability Arising From Organization’s Alleged Default on Bonds
• D&O Insurers Not Entitled to Summary Judgment Where Factual Issues Exist About Whether Insureds’ Settlement With Claimants Was Purely “Restitutionary”

< Return to News page

Top of Page

Vacancy Exclusion’s Exception for Building "Under Construction" Applies to Renovations and Additions

The California Supreme Court has ruled that when a vacancy exclusion is subject to an exception for a building “under construction,” the exception applies not only to new construction but to renovations and additions, provided the work requires the substantial and continuous presence of workers at the site. (TRB Investments, Inc. v. Fireman’s Fund Insurance Company (2006) 2006 WL 3257848)

Facts

TRB Investments, Inc. purchased a tenant-occupied commercial building, and insured the building through Fireman’s Fund. Upon termination of the lease, the tenant vacated the building.

Several months after the initial tenant vacated the building, TRB entered into a lease with a new tenant. The new lease agreement provided that, before the new tenant moved into to the building, TRB would make various renovations. Thus, TRB hired a general contractor, who began the renovations.

Over a period of two weeks, subcontractors worked on the building’s electrical system and air conditioning system. During a weekend, when no work was underway, a water heater failed, causing extensive water damage to the building.

The policy contained an exclusion that eliminated coverage for certain kinds of damage (including water damage) if the building had been “vacant” for more than 60 days prior to the loss. The policy defined a building as “vacant” if it did not contain enough business personal property to conduct customary operations. It was undisputed that, at the time of the loss, the building did not contain enough business personal property to conduct customary operations.

The exclusion also contained an exception that provided that a building “under construction” was not vacant. TRB asserted the building was “under construction” because of the renovations and that, therefore, the exception to the exclusion applied. Fireman’s Fund disagreed, and denied TRB’s claim. TRB sued Fireman’s Fund, but Fireman’s Fund prevailed in the trial court and in the California Court of Appeal. However, the California Supreme Court reversed.

Holding

According to the Supreme Court, the purpose of a vacancy exclusion is to prevent vandalism and to ensure prompt discovery of other types of damage. Thus, the Court held an exception for a building “under construction” applies not only to construction of a new structure, but to renovations of or additions to an existing structure, provided the work requires the substantial and continuing presence of workers at the premises. If a construction project results in the continuous and substantial presence of workers on the property, then the underlying justifications for the vacancy exclusion no longer exist.

Comment

There is a split in authority among other courts around the country, with some finding that a building undergoing renovation is “under construction,” and some finding a building undergoing renovation is not “under construction.” The California Supreme Court’s holding makes it clear that, irrespective of whether the work is characterized as new construction, renovations or additions, the critical issue is whether the work requires the substantial and continuing presence of workers at the premises.

Top of Page

D&O Policy Does Not Cover Liability Arising From Organization’s Alleged Default on Bonds

The California Court of Appeal has held that a directors and officers policy did not cover a nonprofit organization’s directors for liability arising from the organization’s alleged default on municipal bonds. (Medill v. Westport Ins. Corp. (2006) 143 Cal.App.4th 819)                                     

  Facts

Heritage Housing Development, Inc. (Heritage) was a nonprofit organization which raised money through municipal bonds in order to finance the acquisition and operation of healthcare facilities. After Heritage defaulted on the bond payments, the bondholders filed a securities class action against Heritage and several of its directors. The class alleged that Heritage, as private issuer of the bonds, was obligated to repay the principal, interest and any premium on the bonds. The class further alleged that Heritage and its directors mismanaged the bonds by running a “Ponzi” scheme whereby proceeds from subsequent bond offerings were used to mask cash shortfalls from prior offerings. The class asserted causes of action for violations of securities laws, breach of fiduciary duty, negligence and misrepresentation.

Heritage’s directors tendered defense of the action to Westport Insurance Corporation (Westport), which had issued a “Nonprofit Organization Liability Policy” to Heritage. Westport denied coverage for three reasons: (1) the policy’s definition of “loss” excluded coverage for claims arising out of breach of contract; (2) the policy excluded coverage for claims arising out of the issuance or endorsement of bonds; and (3) the policy excluded coverage for claims arising out of the failure to pay on financial instruments.

The directors sued Westport for breach of contract and bad faith arising from Westport’s refusal to defend in the underlying bond litigation. The trial court entered summary judgment in favor of Westport, and the directors appealed.

Holding

The Court of Appeal affirmed the summary judgment in favor of Westport. First, the court held that the underlying claim did not fall within the policy’s insuring agreement because there was no “loss.” The policy defined “loss” so as to exclude “damages arising out of breach of any contract, whether oral, written or implied….” The court held that the plaintiffs in the underlying class action sought to recover damages based on Heritage’s failure to perform its contractual obligation to repay the bonds. Thus, the underlying bond litigation “arose out of” a breach of contract, even though the underlying plaintiffs did not specifically allege breach of contract in their complaint.

Second, the court held that coverage was barred by the exclusion for “issuance or endorsement of bonds….” The court noted that Heritage as the obligor on the bond was deemed to be the issuer of these securities pursuant to Securities and Exchange Commission rules. Thus, Heritage “engaged in the excluded activity of issuing bonds or securities.”

Third, the court held that coverage was barred by the exclusion for any loss arising out of “the failure to honor or pay on any financial instrument.” According to the court, any ambiguity in the term “financial instrument” could be resolved by construing the phrase in the context of the policy as a whole. The court concluded that the underlying class action litigation clearly “arose out of Heritage’s failure to pay on a “financial instruments,” namely, the bonds.

Comment

Top of Page

D&O Insurers Not Entitled to Summary Judgment Where Factual Issues Exist About Whether Insureds’ Settlement With Claimants Was Purely "Restitutionary"

The Ninth Circuit Court of Appeals has held that two D&O insurers were not entitled to summary judgment where factual issues existed as to whether their insureds’ settlement of a class action securities lawsuit was purely “restitutionary.” (Pan Pacific Retail Properties, Inc. v. Gulf Ins. Co. (9th Cir. (2006) 466 F.3d 867)

Facts

Western Properties Trust (Western) and Pan Pacific Retail Properties, Inc. (Pan Pacific) proposed a merger whereby all shares of Western would be acquired by Pan Pacific with consideration paid in Pan Pacific stock. In response, a Western shareholder brought a class action lawsuit alleging that directors and officers of both companies engaged in various misdeeds, including failing to negotiate the highest possible price for the Western shares.

Western tendered defense of the shareholder lawsuit to its directors and officers (D&O) insurer, Twin City Fire Insurance Company (Twin City), and Pan Pacific similarly tendered defense of the lawsuit to its D&O insurer, Gulf Insurance Company (Gulf). Twin City and Gulf both denied coverage on the grounds that the shareholder lawsuit only sought uninsurable “restitution” of increased consideration which Pan Pacific allegedly owed to Western’s shareholders as part of the merger. In addition, Twin City separately denied coverage on the ground that its insured, Western, had been indemnified by Pan Pacific as part of the merger and, therefore, Western had not suffered any insurable “loss.”

Ultimately, Pan Pacific paid just under $1 million settle the shareholder lawsuit. Pan Pacific and Western then filed a state court bad faith action against their respective D&O insurers, Gulf and Twin City, for refusing to pay any of the settlement and defense costs incurred in the underlying shareholder lawsuit. Gulf and Twin City removed the bad faith case to federal court and then filed motions for summary judgment, which the district court granted. Pan Pacific and Western appealed.

Holding

The Ninth Circuit Court of Appeals, applying California law, held that the district court had improperly granted summary judgment on the issue of whether Pan Pacific’s settlement with Western’s shareholders represented only uninsurable “restitution.” The appellate court agreed that the settlement of a claim alleging the purchase of stock under false pretenses and seeking only increased merger consideration is “restitutionary relief,” which is uninsurable. However, the appellate court also held that shareholders who challenge the actions of corporate participants in a merger may be able to recover increased merger consideration as well as other types of damages. Thus, the appellate court remanded to the district court to determine if the settlement Pan Pacific paid to Western’s shareholders represented only increased merger consideration (which is not insurable) or some other type of damages (which might be insurable).

The appellate court did affirm the summary judgment in favor of Twin City because its insured—Western—had been indemnified by Pan Pacific. According to the court, since Pan Pacific had fully indemnified Western under the merger agreement, Western had suffered no “loss” within the meaning of the Twin City policy.

Comment

The Ninth Circuit cited Level 3 Communications, Inc. v. Federal Insurance Co. (7th Cir. 2001) 272 F.3d 908 for the proposition that the settlement of a claim alleging the purchase of stock under false pretenses and seeking only increased merger consideration is uninsurable “restitutionary” relief. However, the Ninth Circuit held that shareholders challenging the actions of corporate participants in a merger are not limited to recovering only increased merger consideration, but rather, may be able to recover other forms of compensation.

Top of Page