Commercial landlord KVG Properties Inc. has appealed a district court summary judgment ruling dismissing its claims under a first-party property policy issued by Westfield Insurance Company, arguing that the district court improperly rejected its claim because KVG’s tenants’ use of the property for marijuana growing operations was illegal under federal law. The appeal underscores the growing divide between state and federal marijuana laws and raises several important insurance coverage issues that will likely continue in the future.
KVG leased commercial office space to several tenants in Novi, Michigan. In October 2015, the Drug Enforcement Agency raided the rental units in connection with an investigation into marijuana growing operations. Following the raid, KVG evicted the tenants and filed a property damage claim with its insurer, Westfield, for the tenants’ vandalism to the leased spaces, which included removing walls, cutting holes in the roof, adding HVAC ductwork, adding gas lines, and modifying heat and humidity levels in the leased spaces.
In denying coverage for the claim, Westfield cited three exclusions: (1) the illegal and dishonest acts exclusion; (2) the inadequate maintenance exclusion; and (3) the humidity and moisture exclusion. In the ensuing coverage lawsuit, the federal district court granted summary judgment in Westfield’s favor, concluding in part that “[t]he tenants’ use of the units to grow marijuana was illegal or at the very least dishonest.” The district court also held that Westfield properly denied KVG’s claim under the humidity and moisture exclusion due to uncontroverted evidence from Westfield’s engineer that the units were exposed to prolonged moisture levels for one year or more.
KVG’s claim raises several important marijuana-related coverage issues.
First, KVG’s appeal to the Sixth Circuit highlights that the district court’s opinion was based solely on the illegality of marijuana under federal law, notwithstanding the fact that cultivating medical marijuana is not a crime under Michigan law and no federal charges were filed as a result of the DEA’s raid. The KVG decision is one of several recent insurance coverage cases involving marijuana that highlight the divergent state and federal drug laws and how they can lead to inconsistent and conflicting decisions.
Courts universally hold that when an insurer relies on an exclusion to deny coverage, the burden is on the insurer to show that the exclusion clearly and unambiguously applies to the claimed loss, and any ambiguities in the policy will be construed in favor of coverage. Can an insurer invoke an illegal acts exclusion where activities are not illegal under applicable state law? Presumably, a direct conflict in the law regarding illegality of an act should present enough uncertainty to prevent triggering an illegal acts exclusion.
Furthermore, does the analysis change when the insurer is not only aware of allegedly illegal activities, but also applies the exclusion to operations in a state that has enacted legislation specifically legalizing such operations? As we have previously discussed on this blog, admitted insurers have already begun issuing marijuana-specific first- and third-party insurance coverage, specifically targeting marijuana businesses. Insurers certainly have the ability to issue conduct-specific exclusions to address the conflict between state and federal law.
KVG raises this issue on appeal, arguing that Westfield cannot invoke a generalized illegal acts exclusion to bar coverage for an act that may not have been illegal under state law. This problem is compounded by the fact that even though marijuana is illegal under federal law, federal authorities rarely enforce such laws, as evidenced by the lack of any federal charges against KVG’s tenants. At a minimum, such provisions are ambiguous and should be construed in favor of coverage.
Second, KVG’s insurance claim presents several other issues that will almost certainly arise in future dealings with marijuana operations, regardless of whether the operations are legal or illegal under relevant state law. With respect to potential coverage under first-party property policies, tenants leasing commercial space for marijuana growing operations may need to retrofit older properties to handle increased energy and heat requirements, which often requires significant renovations and use of moisture-producing equipment. Unauthorized renovations or increased humidity may trigger common exclusions in property policies, as they did in the KVG case. Note, however, that the particular exclusion at issue in the KVG case was different in that it applied not only to acts by KVG, but also to acts by anyone to whom KVG “entrusted” its property. Policyholders should be aware that intentional or dishonest acts exclusions with this “entrustment” language are much broader than similar exclusions in other types of policies.
With respect to third-party liability policies, marijuana operations also present potential exposure from retailers, customers, and related entities in the event that the manufacturing, storage, transportation, or sale of marijuana products results in personal injury or other loss. Policyholders should consider these issues when placing new coverage or on renewal to prevent coverage gaps and maximize insurance recovery in the event of a claim.
The KVG case serves as a preview of insurance coverage disputes that are likely to continue in the future due to conflicting state and federal laws and the intersection of marijuana operations with landlord-tenant, professional services, and other business relationships. Stay tuned for further updates as we continue to monitor this developing area of law.