On July 15, 2014, the Sixth Circuit Court of Appeals tagged an excess insurer with responsibility for paying $8 million in underlying defense costs after the primary insurer was determined to have wrongfully refused to take on the duty to defend. IMG Worldwide, Inc., et al. v. Westchester Fire Ins. Co., Nos. 13-3832, 13-3837, 2014 WL 3409044 (6th Cir. Jul. 15, 2014). The ruling serves as a cautionary warning to excess insurers that they may not sit idly by, comforted by the notion that they are insulated under a follow-form policy from owing a defense obligation merely because the underlying primary insurer has denied coverage.

Background

The IMG case was brought to determine whether an excess insurer, Westchester Fire Insurance Company ("Westchester"), was obligated to reimburse its insureds, IMG Worldwide, Inc. and IMG Academies, LLP (collectively, "IMG"), for a settlement payment they made, and defense costs they incurred, in connection with the lawsuit Gastaldi, et al. v. Sunvest Communities USA, LLC, et al., Case No. 08-62076-CIV (S.D. Fla. 2009) (the "Gastaldi case"). The Gastaldi case stemmed from the failure of a real estate development project in Orlando, Florida. The plaintiffs alleged that co-developers had sold them undeveloped properties with the promise that they would be upgraded and developed into high end condominiums. IMG was a consultant on the project, and also licensed the use of its name and logo in marketing materials.

IMG sought coverage from its commercial general liability insurers, including primary insurer Great Divide Insurance Company ("Great Divide"), and Westchester. The Westchester policy provided coverage up to $25 million in limits, excess of $1 million in coverage provided under the Great Divide policy, for liability resulting from each "occurrence" that causes "property damage." Both carriers denied coverage and refused to provide a defense to IMG.

IMG ultimately settled the Gastaldi case for nearly $5 million, after having incurred defense costs of over $8 million dollars. Following the settlement, IMG continued to seek coverage from both Great Divide and Westchester for indemnity and reimbursement of the settlement amount, and reimbursement of defense costs. Great Divide eventually agreed to settle with IMG, with Great Divide paying $1,250,000, exhausting the $1 million per occurrence limit of its policy, and providing $250,000 toward the defense costs. In exchange, IMG released Great Divide from any and all claims based upon or arising out of the Gastaldi case and Great Divide's handling of claims for coverage in connection with that lawsuit. Unlike Great Divide, Westchester continued to deny coverage and refused to settle, leading to the IMG coverage suit.

At trial in the coverage suit, Westchester took the position that the damages sought by the Gastaldi plaintiffs were not "property damage," and that there was no "occurrence." The jury disagreed, finding that Westchester was liable for breaching its duty to indemnify IMG, and awarding damages to IMG in the amount of $3,900,000 for the Gastaldi settlement. The court retained the question of whether Westchester was also liable for reimbursement of IMG's defense costs over and above the $250,000 contributed by Great Divide in its settlement with IMG. The U.S. District Court for the Northern District of Ohio ruled that Westchester was not required to reimburse IMG for its defense costs, reasoning that Westchester's obligations: (1) expired when IMG settled with Great Divide; and (2) were conditioned on its retention of subrogation rights allowing it to recover payments from another insurer. IMG Worldwide, Inc., et al. v. Westchester Fire Ins. Co., 945 F. Supp. 2d 873 (N.D. Ohio 2013). IMG appealed.

The Appellate Decision

The Sixth Circuit's analysis began by dismissing the parties' arguments about whether Westchester was a "true" excess insurer or "coincidental" excess insurer, and whether Westchester was obligated to provide "drop down" coverage, which the Court deemed legal red herrings. It then directed its attention to the language of the policies. As is customary, Great Divide, as primary insurer, was charged under its policy with the duty to defend IMG against any suit seeking covered damages. However, the Westchester policy provided that Westchester must undertake the duty to defend under certain circumstances:

[Westchester] will have the right and duty to defend the insured against any 'suit' seeking damages for ... 'property damage' when the 'underlying insurance' [Great Divide] does not provide coverage....

The Court stated that Westchester's obligations under this provision turn on what it means to "provide coverage," and, more specifically, whether any underlying insurance that provides for coverage, but nevertheless improperly denies coverage, "provides coverage" under the terms of the policy. It held that the term "provides" could reasonably mean either "provide for" or "undertakes to deliver," the latter of which would trigger Westchester's defense obligation when Great Divide wrongly denied coverage. Since the language was susceptible to more than one meaning, the Court found the policy language ambiguous, and construed the language against Westchester (the drafter). Consequently, because the Gastaldi case was a suit seeking damages for "property damage," and Great Divide did not undertake to deliver coverage, the Court found that Westchester had a duty to defend IMG after Great Divide wrongfully denied coverage.

A second provision of the Westchester policy was held to independently support the finding that Westchester owed a duty to cover IMG's defense costs: "[i]f no other insurer defends, [Westchester] will undertake to do so, but [Westchester] will be entitled to the insured's rights against all those other insurers." The Court noted that, at the time the Gastaldi case was brought, and IMG requested coverage from Westchester, "no other insurer" had defended IMG. Accordingly, Westchester was found to have breached the policy when it refused to provide a defense despite IMG's specific demand after Great Divide refused to provide a defense.

A final blow was dealt to Westchester on the issue of damages. Westchester argued that all of the approximately $8 million in defense costs should be set off, since Great Divide was contractually obligated to pay for the full amount of IMG's defense costs, and IMG released Great Divide of that obligation. The Court rejected the argument, stating that applying a credit or set-off would not be appropriate under the circumstances. It then noted that Westchester was repeatedly given a full and fair opportunity to defend IMG or seek a judicial declaration of its rights, suggesting that its refusal to do so was not excused by IMG's subsequent settlement with Great Divide. Accordingly, Westchester was liable to pay $7,996,655.57 plus pre-judgment interest to IMG.

Summary

If it is any consolation to Westchester, the harsh result is somewhat softened by the Court's express recognition that Westchester can still seek reimbursement from Great Divide under various equitable principles, including equitable contribution and subrogation, and that such claims have been adequately preserved. In any event, excess insurers must now be more mindful of the legal grounds upon which the primary insurer relies in denying coverage, and would be best served by performing independent examinations of the primary policy upon the insured's initial tender of defense. If, after such analysis, there is any question as to the excess insurer's defense obligations, the excess insurer should seek a judicial declaration of its rights in order to adequately safeguard its interests. In addition, underwriters are now on notice of the perils of continuing to incorporate the "Westchester language" into excess policies, and should take precautionary measures to avoid the obligations imposed upon excess insurers by the IMG ruling.