First Circuit On Insurance for Loss of Use

Loss of Use

Zalma on Insurance in Top 50

The First Circuit Court of Appeal was called upon to resolve an insurance coverage dispute concerning the scope of a “loss of use” provision in Vicor Corporation v. Vigilant Insurance Company; Federal Insurance, No. Nos. 09-1470, (1st Cir. 03/16/2012). The appeal arose from wireless communication network outages in 2003. The outages were traced to the failure of a component part, known as a power converter, manufactured by appellee/cross-appellant Vicor Corporation and sold to Ericsson Wireless Communications, which incorporated the power converter into radio base stations (“RBS”) critical to Ericsson’s customers’ wireless networks. In May 2004, as a result of the network failures, Ericsson sued Vicor in California state court. They settled this suit (“the Ericsson litigation”) in 2007 for $50 million. Vigilant Insurance Company and Federal Insurance Company, two of Vicor’s liability insurers, paid $13 million of the settlement. Vicor contributed the remaining $37 million.

Vicor subsequently sued seeking indemnification from its insurers for the $37 million of its own funds that it paid to Ericsson. In addition to Federal and Vigilant, Vicor also sued an excess carrier, appellant/cross-appellee Continental Casualty Company (collectively “the insurers”). After eight days of trial, a jury awarded Vicor $17.3 million. The district court granted the insurers partial post-trial relief, reducing the verdict by $4 million and entering judgment for Vicor in the amount of $13.3 million plus interest. All parties filed timely appeals and cross-appeals raising multiple issues.

Facts

Vicor is a manufacturer of electronic equipment. The Vicor power converters at issue in this litigation break down input power supplies into power levels needed by various other component parts. Ericsson’s business includes the design, manufacture and sale of electronic equipment, including radio base stations, which are used to set up and operate cellular telephone towers and networks. Ericsson purchased Vicor power converters for use in Ericsson RBSs, which Ericsson sold to wireless communication providers worldwide. Trial testimony suggested that power converters that Vicor had sold to Ericsson began failing in October 2002 and that Vicor became aware in May 2003 that some of these failures were related to a manufacturing change in a component computer chip. In October 2003, severe outages occurred.

As a result of the network outages triggered by the RBS failures, Ericsson provided compensation to two of its customers. The record reflects that Ericsson paid approximately $9.3 million to one and spent $5 to $6 million to repair the Vicor products provided $3.3 million in free equipment.

In May 2004, Ericsson sued Vicor on several theories of liability, including breach of contract, breach of warranty, negligence, unfair competition, misrepresentation and fraud. In a February 7, 2007 memo, Vicor’s defense counsel summarized Ericsson’s damage claim, as set forth in its interrogatory answers. The claim totaled approximately $1.1 billion.

Vicor and Ericsson successfully resolved their differences through mediation, settling the Ericsson litigation for $50 million.

Vicor’s Lawsuit

After settling with Ericsson, Vicor filed this action against the insurers in Massachusetts federal district court, seeking reimbursement of the $37 million it had paid to Ericsson. Vicor sought a declaratory judgment that its payments were covered losses under the policies, as well as seeking damages for breach of contract.

The Insurance Policies

As relevant to this litigation, Vigilant issued two primary general liability policies to Vicor. Each policy was subject to general liability limits of $1 million per occurrence and $2 million aggregate. In addition to the general liability coverage, the Vigilant policies insured against Information and Network Technology Errors or Omissions (“E&O coverage”), providing liability coverage for “financial injury” caused by a “wrongful act,” as defined by the policy. The E&O coverage was subject to a $10 million policy limit.

Federal issued two excess and umbrella general liability policies that contained a general liability limit of $20 million per occurrence and in the aggregate.

Continental issued an excess liability policy with an $8 million limit to Vicor covering October 1, 2003 to October 1, 2004. The Continental policy is excess to the coverage provided by the Vigilant and Federal policies covering the same time period. As an excess policy, the Continental policy only provides coverage if a covered loss during the policy period exceeds the combined Vigilant-Federal limit.

Trial

The crux of the dispute in this case concerns the policy language addressing coverage for “loss of use of property that is not physically injured.” Of the money contributed by Vigilant and Federal to the Ericsson settlement, $3.14 million was considered to be for “physical injury to tangible property.” Vicor claimed at trial that the insurers owed it the remaining $37 million because

The insurers’ position is that repair costs, including emergency response costs, do not constitute loss of use damages.

Over the insurers’ objections, the district court ruled that three of Vicor’s specific damage claims could go to the jury under the loss of use rubric: emergency repair costs in the amount of $5 to $6 million; the $9.5 million settlement between Cricket and Ericsson; $3.3 million in the delivery of emergency equipment to China Unicom.

The jury returned a verdict the day after it was instructed awarding Vicor $8 million in loss of use damages for the 2002-2003 policy period, and $9.3 million for the 2003-2004 policy period.

Discussion

The insurers argue that the district court erred by including emergency response costs within the definition of loss of use damages. The insurers’ position is premised on the idea that loss of use damages are subject to an implied temporal limitation that confines coverage to damages incurred due to the inability to use the failed equipment until it is replaced or repaired. In other words, because repair costs represent the cost of ending the loss of use period, such costs are not themselves damages for loss of use.

As recognized by the district court, the archetypal example of loss of use damages comes in the context of a damaged automobile. Simply put, the cost to rent a replacement vehicle while the damaged vehicle is being repaired would represent loss of use damages; the actual cost of repairs would not.

In this case, the “emergency repairs” allowed by the district court are not loss of use damages. It is not enough to demonstrate, as Vicor attempts to do, that there was a “loss of use” of certain property (the power converters or the wireless networks) and that Vicor subsequently paid damages. The claimed damages must be tied to the actual period during which the use of the non-physically injured property was lost and to the loss of use itself, in the context of a damaged vehicle loss of use damages compensates plaintiff for the finite period in which the vehicle is simply unavailable for use.

The goal of liability insurance is to protect the insured from claims of injury or damage to others, but not to insure against economic loss sustained by the insured due to repairing or replacing its own defective work or products. The instruction presented to the jury by the trial judge used the example of replacing a defective power converter with a new one as a non-covered “repair,” it then went on to carve out an “emergency repairs” exception to the proscription on indemnity for general repair costs.

The First Circuit concluded that the district court’s jury instruction referencing “emergency repairs” was erroneous. Given that the emergency repair costs were pursuant to the jury instructions a centerpiece of the putative loss of use damages considered by the jury, the error was prejudicial, and therefore it had no choice but to vacate the judgment and require a new trial.

The First Circuit instructed the trial court that, on remand, the district court should fashion jury instructions making clear that classic loss of use damages (such as lost profits or the rental value of substitute property) that are incurred while repairs are pending may be recovered by an insured, but the actual costs of repairs may not. The district court also may, and probably should, instruct the jury regarding the duty to mitigate loss of use damages and may explain that the costs of reasonable mitigation measures are recoverable, provided that the mitigation measures are distinguishable from ordinary repairs and result in a net savings.

The Weakness of the Settlement

Although Vicor and Ericsson settled the underlying suit for $50 million in March 2007, they created no formal allocation of the payments between covered and uncovered claims. As a result the insurers were required to rely upon their independent investigation. Based on that investigation the primary insurers Vigilant and Federal determined that the failure of the Vicor power converters caused slightly more than $3 million in third-party property damage that would be covered under the general liability policies. They also paid the remaining $9.7 million remaining on the technology liability coverage. Vicor agreed to supply $37 million to fulfill the terms of the settlement.

Privilege

The parties argued mightily pre-trial over the attorney client privilege and the work product protection. The First Circuit noted that Massachusetts recognizes an exception to the attorney client privilege that renders the privilege inapplicable to disputes between clients. Therefore, when a lawyer represents multiple clients having a common interest, communications between the lawyer and any one or more of the clients are privileged as to outsiders, but not to the multiple clients represented.

As a result, when an attorney has been retained to represent both insured and insurer in a third party action, communications by either party will not be privileged even if their interests later diverge. Communications between an insured and its attorney connected with the defense of underlying litigation are normally not privileged vis-a-vis the insurers in subsequent litigation.

An attorney retained by an insurer to represent the insured as the attorney for both and the fact that the insurers tendered the underlying defense pursuant to a reservation of rights does not defeat any claim of a common interest. It is undisputed that the primary insurers paid defense counsel and partially funded the settlement with Ericsson. The trial record reflected multiple letters, reports and other communications between underlying defense counsel and the insurers regarding such matters as liability assessment, strategic litigation planning and calculations of potential damage outcomes. All were marked as “privileged and confidential,” and the parties agree they were privileged as to third-parties, such as Ericsson.

Plaintiffs cannot have it both ways. They cannot make use of the benefit of the common interest exception to avoid waiver of the attorney-client privilege as to third parties and simultaneously assert the privilege against the parties with whom they share a common interest.” Accordingly, the First Circuit concluded that the district court erred, and Vicor cannot rely on the attorney-client privilege to shield all communications between it and underlying defense counsel.

Resolution of the work-product privilege issue required less discussion. In the context of coverage litigation, it is a touchstone of such a claim that Vicor must demonstrate that its attorneys prepared the putatively shielded documents in anticipation of a lawsuit with the insurers. In this case, events provide fairly clear lines of demarcation. Documents produced while the insurers were providing a defense are unlikely to be protected; those produced during the periods when the insurers denied coverage – or refused to provide indemnity – are likely to be protected.

The fact that both the insured and insurer are deemed to be clients does not mean that all communications are excepted from the applicable privileges, or that the insurers are necessarily entitled to the entire defense file, as they claim. From the current record, however, the First Circuit was unable to make the necessary judgments about which materials are subject to disclosure. It concluded that the district court abused its discretion in denying the insurers’ motion to compel in its entirety, and upon remand, should tailor a discovery order consistent with this opinion, should the parties not be able to reach substantial agreement on their own. See Fed. R. Civ. P. 37(a)(1) (requiring parties to confer regarding discovery disputes or attempt to do so prior to filing motion to compel).

ZALMA OPINIONS

Although this case dealt with large sums of money with the parties represented by well respected and competent counsel, the dispute that resulted in the trial, disputed jury instructions, and prejudice requiring reversal and new trial because the parties, at the time they settled the underlying case, failed to allocate the $50 million settlement to avoid this suit.  Had the parties done the appropriate allocation of damages at the mediation they would have totally avoided the lawsuit that resulted in this appeal.

Perhaps if, after the reservation of rights, independent counsel was demanded and appointed by Vicor, as insured, and separate monitoring counsel, by the insurers, they would have both been independently represented at the medication, the settlement funds would have been allocated, and an agreement reached not only with the underlying plaintiff, Erickson, but also between the insurers and Vicor. Clearly, the settlement of a claim for more than $1 billion settled for $50 million was such a good deal that Vicor was willing to put up $37 million of its own money. If it intended to recover that $37 million from its insurers in this subsequent suit it should have set the suit up by properly allocating the payment. If Ericson was willing to accept the $50 million it meant nothing to it how the payment was allocated.

© 2012 – Barry Zalma

Barry Zalma, Esq., CFE, is a California attorney, insurance consultant and expert witness specializing in insurance coverage, insurance claims handling, insurance bad faith and insurance fraud. Mr. Zalma serves as a consultant and expert, almost equally, for insurers and policyholders.

He founded Zalma Insurance Consultants in 2001 and serves as its senior consultant. He recently published the e-books, “Zalma on Diminution in Value Damages – 2012,”“Zalma on Insurance,” “Heads I Win, Tails You Lose — 2011,” “Zalma on Rescission in California,” “Arson for Profit,” “Insurance Fraud,” and others that are available at www.zalma.com/zalmabooks.htm.

Mr. Zalma can also be seen on World Risk and Insurance News’ web based television program “Who Got Caught” with copies available at his website at http://www.zalma.com.

About Barry Zalma

Barry Zalma, Esq., CFE, is a California attorney who limits his practice to consultation regarding insurance coverage, insurance claims handling, insurance bad faith and fraud and acting as a mediator or arbitrator on insurance disputes. Mr. Zalma serves as a consultant and expert almost equally for insurers and policyholders. He founded Zalma Insurance Consultants in 2001 and serves as its only consultant. He recently published the e-books, "Zalma on Insurance Fraud - 2013;" "Zalma on Rescission in California - 2013"; "Random Thoughts on Insurance" containing posts from this blog; "Zalma on Insurance;" "Murder and Insurance Don't Mix;" “Heads I Win, Tails You Lose — 2011,” “Zalma on Diminution in Value Damages,” “Arson for Profit” and “Zalma on California Claims Regulations,” which are all available at http://www.zalma.com/zalmabooks.htm. Contact the author or access his free "Zalma's Insurance Fraud Letter" at http://www.zalma.com/ZIFL-CURRENT.htm or write to him at zalma@zalma.com.
This entry was posted in Zalma on Insurance. Bookmark the permalink.

Leave a Reply