Slip slidin’ away: The deterioration of the late notice defense

Through a series of opinions, courts seem to be gradually chipping away at insurer’s policy defenses based on late notice of claim or suit, or failure to forward suit papers. The new trend started when the Supreme Court held that a materiality requirement applied to another policy condition — the requirement that the insured obtain consent to settle — not subject to the regulation. Hernandez v. Gulf Group Lloyds, 875 S.W.2d 691 (Tex. 1994). While the materiality requirement sounds like textbook contract law on breach, the court then equated materiality to prejudice. The implication was that all breaches of conditions now require a showing of prejudice — a “no harm, no foul” rule for insureds that basically places the burden of proof on the insurer. The courts have now gone even further, ostensibly placing an affirmative requirement on insurers to notify insureds of suits and policy requirements to establish prejudice.

Crumbling underlying principles

The most recent case to test the limits is National Union Fire Ins. Co. v. Crocker, 446 F. 3d 347 (5th Cir. 2006), a Fifth Circuit opinion that resulted in certified questions to the Texas Supreme Court. While other cases erode the defenses based on conditions, the history of Crocker reflects a crumbling of the underlying principles.

In the underlying case, a nursing home resident brought suit against the nursing home and an employee asserting the employee, Morris, had injured her when opening a swinging door. Morris did not answer or defend, and the plaintiff obtained a default judgment for $1 million. The owner of the nursing home, Emeritus, was insured by National Union. Emeritus sought and was tendered a defense. Morris would have been entitled to coverage, as an employee, but never provided notice or suit papers and never requested a defense.

The District Court opinion acknowledges that Morris was required to notify National Union of the suit, provide copies of suit papers, and cooperate in the defense. It also notes that Morris provided plaintiff’s counsel with a recorded statement, but refused to respond to calls and letters from defense counsel for Emeritus. Morris’ deposition was taken, and he conferred with plaintiff’s counsel, but refused to confer with or accept assistance from defense counsel.

Ultimately, Emeritus obtained a take nothing judgment, but judgment was entered against Morris for $1 million, based on the default. Crocker then filed suit against National Union as a judgment creditor. National Union moved for summary judgment alleging, in part, that Morris had breached the policy conditions. Crocker argued that National Union had “actual notice” of the suit and service upon Morris, and had failed to defend. In the alternative, Crocker argued National Union had not established prejudice.

There is a long line of cases finding that failure to provide notice until after default is prejudice as a matter of law. The District Court acknowledged these cases but relied on Supreme Court dicta in a case denying coverage for prejudice and the few intermediate court cases some to find an exception for “actual knowledge.”

Even the finding of actual knowledge, however, is subject to scrutiny. The District Court found that National Union had knowledge that Morris had been sued, served, and had not answered, apparently based on pleadings in the case and knowledge available through defense counsel. But National Union was not a party, and forcing them to rely on counsel for another party appears to subvert the role of defense counsel, whose sole responsibility is to the insured. What if the circumstances make it undesirable for the named insured to share limits with an additional insured? Could he instruct counsel not to advise the insurer of facts that might provide “notice” for an additional insured? Does the insurer have a duty to scour pleadings to determine if there may be other insureds, and then notify them? If so — doesn’t it turn the “condition” on its head?

Other questionable holdings

While the treatment of notice is disconcerting, there are other questionable holdings. On reconsideration, the court rejected an argument that the policy was not issued in Texas, and therefore not subject to a prejudice requirement. The court held the existence of an insured facility in Texas implicated Texas law but also noted, in the alternative, that a prejudice requirement would apply regardless of the board order, relying on Hernandez. The court also found there was an actual and fully adversarial trial, satisfying the requirements of State Farm Fire Ins. Co. v. Gandy, 925 S.W.2d 696 (Tex. 1996), because Emeritus was present and defended itself, despite Morris’ default.

The Fifth Circuit, on appeal, noted that there were different purposes served by the notice requirement and the requirement that the insured provide suit papers, relying on Weaver v. Hartford Accid. & Indem. Co., 570 S.W.2d 367 (Tex. 1978) the court noted Weaver’s reasoning that a basic purpose of the suit paper requirement is to advise the insurer that it is expected to answer and defend. The court also noted that, under Weaver, Morris’ alleged ignorance of the insurance available to him was not a defense.

Nevertheless, the Fifth Circuit questioned the current state of the law, and ultimately certified questions to the Texas Supreme Court.

The three determinative issues the court identified are:

Whether the insurer has a duty to notify an ignorant additional insured of coverage; the extent of this duty, if it exists and the correlating extent of the additional insured’s duty to cooperate before he is informed; and whether proof of actual knowledge of service establishes, as a matter of law, the absence of prejudice.

Focus on insurer obligations

The styling of the questions reveals that the focus is on the insurer’s obligations and not the insureds’. The problems with this approach are myriad.

As discussed above, although an insurer may not direct defense counsel in matter related to coverage, it is apparently held to have constructive knowledge of facts known to defense counsel.

The Fifth Circuit’s survey of dicta in prior Supreme Court cases dealing with late notice or failure to forward suit papers — which repeatedly found no coverage where notice was after judgment — seems an attempt to reconstruct, rather than apply, the existing law.

Requiring an insurer to entreat its insured for notice also seems inconsistent with established law holding an insurer has no obligation to pay pre-tender defense costs, as there is no duty to defend prior to notice. Further, suggesting the insurer should take some affirmative action, even where no defense has been requested, ignores the possibility that some insureds may not wish to respond to a lawsuit, and may not desire an insurer to unwittingly subject them to the jurisdiction of a court. This should be a matter of no small concern to defense counsel.

And finally, the court never addresses the issue of how an attorney-client relationship can be formed with retained defense counsel, if there is no obligation of communication or cooperation on the part of the insured.

The Texas Supreme Court now has the opportunity to bring some much needed clarity and reason to these issues. While the Court should be fair in outlining the parameters of compliance, so that an insurer cannot capriciously deny coverage, it can also be hoped that the Court will recognize the policy provisions as conditions precedent, and put the burden of compliance back where it belongs.

Beth Bradley is a partner in the Dallas firm of Tollefson Bradley Ball & Mitchel LLP. Her practice is focused on coverage analysis and insurance disputes.