DUTY to DEFEND

The Innopex decision reads like a step-by-step guide for all parties involved in duty to defend cases. As you read the decision – or read about it – picture a judge at the next industry convention in a black robe, gold crest, and crimson sash delivering a message to claims professionals and underwriters alike. Innopex and its principals were sued by Gucci in New York State for allegedly selling “knock off” Gucci watches. They notified their insurer, Halifax Insurance Co. (now ING), of the claim, and requested that Halifax defend them.

Halifax retained counsel to provide an opinion on whether it was obligated to defend Innopex in the circumstances. The entire coverage opinion later came out on cross-examination. Coverage counsel “correctly pointed out” (in the words of the court) that the duty to defend is determined by the allegations pleaded in the underlying lawsuit read together with the coverage provided by the policy. The Supreme Court of Canada stated in Nichols vs. American Home Assurance Co. [1990] 1 S.C.R. 801 (S.C.C.) that if the pleadings allege facts, which if true, would require the insurer to indemnify the insured for the claim, then the insurer is obliged to provide a defense. Therefore the coverage counsel arrived at the conclusion that the allegations read with the pleadings did “unfortunately” give rise to a duty on the part of Halifax to defend Innopex in the Gucci litigation. He also notes that the costs of defending the litigation could be “potentially extraordinary”.

DEFINING POSITIONS

Coverage counsel recognized that Halifax would be ordered to defend Innopex under a conventional application of the rule set out in Nichols, so he recommended a “proactive” procedure that would allow Halifax to introduce facts to show that the allegations in the underlying litigation did not come within coverage under the Halifax policy. This procedure would allow Halifax to introduce affidavits and extrinsic evidence of “the true and undisputed facts” which might show the policy did not provide coverage to Innopex. On this basis Halifax might be able to avoid the obligation to defend.

Halifax accepted the advice of its coverage counsel and initiated an action for a declaration that it had no duty to defend Innopex in respect of the Gucci litigation. This action released a cascade of counter claims: claims by Innopex for punitive damages against Halifax, a motion by Halifax to dismiss the punitive damages claim, and two motions for summary judgment. The motions judge was faced with over three thousand pages of evidence, including transcripts of cross-examinations. In the meantime, Innopex had been fighting the litigation on two fronts.

Greer J. heard the motions for summary judgment and decided that Halifax did not have a duty to defend Innopex based on the exclusions in the policy. She did, however, order Halifax to pay the defense costs of Innopex to the date on which the hearings of the motions commenced. She also held that there was no factual basis to support the claim by Innopex for punitive damages based on the breach of Halifax’s duty of good faith.

TACTICAL MANEUVERING

The Court of Appeal reversed all of the finding and conclusions of the motions judge. As the Court of Appeal noted, Greer J. referred to the principles and the test that the court is to apply in deciding a duty to defend issue, as explained in Nichols, but she “failed to address the fundamental question of whether Halifax had a duty to defend on the basis of the pleadings in the underlying law suit when read along with the relevant provisions of the insurance policy”.

Contrary to the principles generally followed in Nichols, the motions judge applied the evidence generated by the summary judgment motions and made findings of fact relative to the Gucci claim. The court notes: “In fairness to the motion judge, this was the result of the tactic devised by [coverage counsel] to avoid the virtually certain finding of a duty to defend by recommending a procedure intended to manufacture a record which would disclose the ‘true facts’.”

The Court of Appeal then observed that “an insurer’s duty to defend can, and should, be decided without the consideration and application of extrinsic evidence bearing upon the underlying action…”. The duty to defend should be determined without holding a “trial within a trial” into the truth of the allegations in the underlying statement of claim. The Court of Appeal looked at the pleadings and the policy and determined that Halifax was under a duty to defend Innopex in the Gucci litigation. The court did not disregard the evidence entirely. It observed that the record contained evidence on which a trial judge could find liability and award punitive damages. The court allowed the Innopex counterclaim for punitive damages to proceed.

The court recognized that the duty to defend should be determined expeditiously as a preliminary matter to avoid the uncertainty faced by Innopex in this case: “When an insured person is sued for a claim that may fall within a risk that is insured, it is essential that he or she know at a very early stage whether or not the claim falls within the coverage, thereby creating a duty to defend, as it is necessary that prompt steps be taken to defend the lawsuit and to forestall judgment…”. In what appears to be an understatement the court adds, “the insurer’s procedure in this case did not result in either an early, or an economical resolution of the issue”.

WITHIN TRIALS

In the Innopex case, the Court of Appeal set out the road map for future applications of this type. It notes that applications to determine the duty to defend are “intended to be decided expeditiously. Invariably, such proceedings are decided by reading the claim or claims asserted in the statement of claim in the underlying action with the coverage provided by the insurance policy. If one or more of the claims in the underlying action fall within coverage, the insurer has a duty to defend the action on behalf of the insured. As the Supreme Court of Canada has observed, a duty to defend application should not be permitted to become a ‘trial within a trial’.”

In view of the Court of Appeal’s clear guidelines for applications to determine the duty to defend, counsel for insurers and insureds should take steps to have the issue decided expeditiously as a preliminary matter and avoid “trials within trials”. Neither party should attempt to “divert the court from deciding the real issue” in accordance with the rules set out in the Nichols and Innopex cases.

The apparent aim of the court in releasing the Innopex decision is to impose more certainty in the relationship between insurers and insureds in the context of duty to defend. The cost of that certainty may be higher defense costs being paid more often by insurers, including the “potentially extraordinary” defense costs anticipated by counsel in Innopex. It is conceivable that liability insurance premiums may have to be adjusted to reflect the increased costs.

On the other hand, the savings from unnecessary “trials within trials” may be sufficient to offset any increased defense costs. The quest for certainty in the law often produces more uncertainty, but because of this case the procedure for determining duty to defend is crystal clear.