On January 16, 2019, the United States First Circuit Court of Appeals affirmed a decision of the federal district court sitting in Boston that ordered the Scottsdale Insurance Company to pay its $3 million liability limit on a Business and Management Indemnity Policy after refusing to defend its insured, Wellesley Advisors Funds (“Wellesley”).
The decision, Scottsdale Insurance Company v. Timothy L. Byrne, as Co-Chairman of the Board of Trustees for the Plumbers and Pipefitters Local 51 Pension and Annuity Funds et al., (the Fund) held Scottsdale owed the full policy limit after wrongfully denying defense coverage to its insured and subsequently not showing the allocation of damages between covered and uncovered claims.
The loss to the Pipefitters Pension Fund
On November 10, 2014, the Fund filed suit against Wellesley in the United States District Court for the District of Massachusetts. The Fund claimed that, in 2005, they invested $5 million with Wellesley, which Wellesley subsequently used to “invest in various real estate parcels….” Specifically, the complaint avers that Wellesley purchased on behalf of the Fund:
- “The Stone House,” a hotel in Little Compton, Rhode Island;
- a residential condominium called “Eastbourne Lodge” in Newport, Rhode Island;
- and a housing development in North Attleboro, Massachusetts.
The Fund’s complaint stated Wellesley entered into several mortgages on The Stone House for renovating the property. According to the Fund, the revenues from The Stone House’s hotel operation to its “‘fee’ for managing the property for [t]he Funds.” Wellesley failed to make required periodic payments on The Stone House mortgages, and the mortgagee sued for more than $5.6 million to enforce the mortgages against The Stone House.
The Fund averred that Wellesley “squandered the entire [$5 million] investment,” and that “[t]he properties were either lost to foreclosure or written down to a zero value because of taxes or mortgages owed.”
The two counts of the Fund’s complaint against Wellesley alleged negligence and violations of ERISA, respectively. The first count alleged Wellesley overleveraged the properties in excess of their value, failed to pay property taxes and retained the income from The Stone House and the two other investment properties for its own use. The second count, based on Wellesley having fiduciary duties to the Fund under ERISA, claimed the retention of revenues from The Stone House indulged in actionable “self-dealing and mismanagement of [the properties.]”
Scottsdale’s refusal to defend and Wellesley’s receiver’s assignment of rights to the Fund
Scottsdale had issued to Wellesley a Business and Management Indemnity Policy (“policy”) with coverage from November 15, 2013, to December 15, 2014, on a claims-made and reported basis. The policy had a liability limit of $3 million. The policy also named the realty fund managed by Wellesley as an insured by an endorsement.
The main insuring agreement of the policy provided:
[Scottsdale] shall pay the Loss of the [Wellesley] which [Wellesley] becomes legally obligated to pay by reason of a [Claim first] made against [Wellesley] during the Policy Period…and reported to [Scottsdale]…for any Wrongful Act taking place prior to the end of the Policy Period.
The policy’s defined the capitalized terms in the insuring agreement as:
- “a civil proceeding against any Insured seeking monetary damages or non-monetary or injunctive relief….” (“Claim”).
- “damages, judgments, settlements, pre-judgment or post-judgment interest awarded by a court, and Costs, Charges, and Expenses incurred by” the entities covered under the Policy. (“Loss”); and,
- “any actual or alleged error, omission, misleading statement, misstatement, neglect, breach of duty or act allegedly committed or attempted by” the insured entities. (“Wrongful Act”).
Wellesley duly notified Scottsdale of the Funds’ lawsuit. Scottsdale. Scottsdale refused to either defend or indemnify Wellesley as to the Funds’ claims.
On December 1, 2014, the Plymouth Superior Court appointed a receiver for the Wellesley’s realty fund involved in the Fund’s federal lawsuit. The receiver sought and obtained a stay of the Fund’s suit to investigate the affairs of the realty fund and the Scottsdale denial of coverage.
In July 2015, the Fund and the receiver entered into an agreement approved by the Plymouth Superior Court for the receiver to assign Wellesley’s rights to the Fund against Scottsdale for its denial of coverage. The approved order also allowed the receiver to let the Wellesley realty fund default on the Fund’s federal suit and not oppose the entry of judgment in favor of the Fund.
Based on the court-approved agreement of the Fund and the receiver Wellesley’s failure to defend the suit, the federal district court entered a default judgment in favor of the Fund against Wellesley for $5 million plus attorney fees and costs.
Scottsdale files a declaratory judgment against the Fund
In January 2016, the Fund demanded that Scottsdale pay Wellesley’s $3 million policy limit towards the $5 million default judgment.
Scottsdale’s maintained the same coverage position with the Fund that it had taken with Wellesley. There was no coverage under the policy because of several policy exclusions including:
- The Professional Services Exclusion which excluded any Claim “based upon, arising out of, attributable to, directly or indirectly resulting from, in consequence of, or in any way involving the rendering or failure to render Professional Services” Based on the policy’s definition of professional services, Scottsdale denied liability stating to the Fund, “the Lawsuit falls squarely within the scope of the Professional Services Exclusion.”
- The ERISA Exclusion which excluded any “Loss on account of any Claim for any actual or alleged violation of the responsibilities, obligations or duties imposed by ERISA…”
After the Fund refused to accede to Scottsdale’s view of coverage on Wellesley’s policy providing no coverage, Scottsdale filed for a declaratory judgment in the same federal court where the default judgment had entered.
Federal district court finds Scottsdale liable for Wellesley’s policy limit
In its suit, Scottsdale asked the federal district court to enter a declaratory judgment that the Fund had no rights under Wellesley’s policy. The Fund counterclaimed. After some discovery, Scottsdale and the Fund filed cross-motions for summary judgment.
Both Scottsdale and the Fund stated that there were no material facts in dispute and each claimed that they were entitled to judgment in their favor as a matter of law.
After hearing the arguments and reviewing the submissions of Scottsdale and the Fund, the judge denied Scottsdale’s motion for summary judgment and granted partial summary judgment to the Fund. The Judge found that the allegations raised in the original suit brought by the Fund against Wellesley were not “clearly excluded” from coverage under the policy and so Scottsdale had, at a minimum, a duty to defend Wellesley against those claims.
Based on Scottsdale’s failure to take up Wellesley’s legal defense in the Fund’s suit, the district court concluded that Scottsdale was liable to the Fund and entered judgment for the Fund in the amount of $3,038,081.10, consisting of the policy limit of $3 million plus post-judgment interest calculated at the statutory rate. Scottsdale timely appealed the district court’s judgment.
What the First Circuit Court of Appeals said
On appeal, Scottsdale argued that the district court erred in concluding that it had a duty to defend the Fund’s suit against Wellesley. Scottsdale pointed the appellate court to the Policy’s Professional Services and ERISA Exclusions, contending that each of those exclusions clearly applied to the claims asserted in the Fund’s lawsuit. To Scottsdale, each of these exclusions independently provided a basis for denying coverage.
In the alternative, Scottsdale argued that it was only liable for the costs of defending the Fund’s lawsuit—not the entire policy limit.
In addressing, Scottsdale argument that the policy exclusions allowed Scottsdale to have avoided defending the Fund, the Court stated certain basic principles of insurance law they would apply including:
- The “insurer’s duty to defend is independent of and broader than, its duty to indemnify,”
- insurers “owe a duty to defend [their insured] if the allegations in the underlying lawsuit are reasonably susceptible to an interpretation that they state a claim covered by [the] policy,”
- “An insurer has a duty to defend an insured when the allegations in a complaint are reasonably susceptible of an interpretation that states or roughly sketches a claim covered by the policy terms.”
- “For the duty of defense to arise, the underlying complaint need only show, through general allegations, a possibility that the liability claim falls within the insurance coverage.”
The Court then noted that where, as here, an insurer asserts that it is not obligated to defend due to some policy exclusion or exclusions, it bears the initial burden of demonstrating that the exclusion applies. In order to meet this burden the insurer has to show:
- “the facts alleged in the third-party complaint must establish that the exclusion applies to all potential liability as a matter of law.”
- “If even one of the counts in either of the complaints falls within the coverage provisions but outside any exclusion, [the insurer] would have a duty to defend the entire lawsuit.”
In determining, whether the exclusion applies, the Court also construes any ambiguities in the application of an exclusion against the insurer and in favor of the insured.
After stating these legal principles, the Court examined Scottsdale’s first argument to determine whether the policy’s professional services exclusion satisfied the legal criteria to avoid coverage.
Under the terms of the exclusion, Scottsdale contended that all of the allegations in the Fund’s complaint “arose out of” or “involved” “real estate development, property management, the purchase of real
property, or the arrangement of financing on real property,” all of which Scottsdale argued fell “within the plain meaning of the Professional Services Exclusion.”
The Court found however that Scottsdale had failed to account for all of the claims raised in the Fund’s suit.
Scottsdale had focused its denial on Wellesley’s activities stemming from Wellesley’s real estate activities involving developing, improving, or managing operations of The Stone House, and the properties in North Attleboro and Newport.
The Court agreed the Stone House activities likely fell with the exclusion. However, the Fund’s complaint did not have any allegations that clearly alleged excluded activities for the investment properties in North Attleboro or Newport. The Fund’s complaint only alleged that Wellesley invested in those parcels and that the properties were “lost to foreclosure or written down to a zero value because of tax or mortgages owed” and, Wellesley “engaged in self-dealing by retaining investment income from the properties for its own use.”
To the Court, these limited allegations precluded any meaningful evaluation of whether the loss of the Newport and North Attleboro properties was attributable to the excluded activities of Wellesley acting as a property manager, developer, investor, or otherwise.
The district court had found that “[a]t the very least; it is ambiguous whether in fact all of Wellesley’s purported misconduct stemmed from” Wellesley’s provision of professional services. Thus, the allegations concerning the Newport and North Attleboro properties are not clearly within the Professional Services Exclusion, and, where there is ambiguity, there is a duty to defend.”
The Appellate panel agreed with the district court judge, and stated, “We, therefore, conclude that Scottsdale failed to meet its burden of establishing that the Professional Services Exclusion applies to all claims of liability within the [Fund’s suit].
Based on this finding that Scottsdale had failed to show that the Professional services exclusion allowed Scottsdale to avoid defending the Fund, Scottsdale had to convince the Court that the ERISA exclusion applied to the negligence count of the Fund’s complaint as well as the ERISA count.
The Fund did not dispute Scottsdale’s claim the ERISA Exclusion barred coverage for the second count of the complaint that alleged Wellesley had breached fiduciary duties to the Fund under the ERISA statute. The issue for the Court was whether ERISA exclusion applied to the negligence count.
Under the ERISA statute, state common law claims are preempted by federal law. Scottsdale’s argument to the Court was that because the negligence and ERISA claims arose from the same set of facts, the negligence claim was therefore preempted by ERISA.
However, Scottsdale policy, the Court noted, did not explicitly remove “preempted” state law claims such as negligence from the Policy’s coverage. Although Scottsdale claimed the language in the ERISA exclusion excluding “similar provision of…state…common law” served this purpose, the Court disagreed whether such ambiguous language could extend to a common law action for negligence stated without a clear reference to ERISA-like fiduciary duties.
The Court concluded:
Scottsdale has the burden of demonstrating the exclusion’s application to the Underlying Action, and all ambiguities must be read against the insurer. Accordingly, we see no basis for excusing Scottsdale from its duty to defend based on the ERISA Exclusion.”
Ambiguity in the coverage exclusion required Scottsdale to allocate damages
Scottsdale’s final argument to the Court was that it should not be held liable for the full policy limit where it failed to defend the Fund’s suit, and the ERISA count was not covered.
The Court, however, applied the rule that where some of the claims fall within a policy’s coverage and others do not, “an insurer that breaches its duty to defend bears the burden of allocating a judgment against its insured between covered and noncovered claims
While Scottsdale argued that Wellesley engaged in self-dealing when it retained fees from the investment properties, the Court observed much of the Fund’s complaint focuses on the squandering of the Fund’ investment through, among other things, Wellesley negligently overleveraging and failing to pay taxes and service mortgages on the properties.
By failing to defend, Scottsdale became bound by the terms of the default judgment. Those were “conclusively establishe[d]” by the entry of default as to Scottsdale, and they offered, according to the Court, a theory of the Fund’ loss that is entirely separate from any improper gain by Wellesley.
The Court concluded affirming the judgment against Scottsdale because it “fails to demonstrate any grounds for allocating the judgment award between portions attributable to Wellesley’s improper gains and negligent losses. As such, we see no basis from which to relieve Scottsdale of its obligation to pay the policy limit.”