In the recent case of Ernst & Young v. Chartis, 2014 ONCA 78, the Ontario Court of Appeal considered claims for indemnity and bad faith under a trustee’s errors and omissions insurance policy. The Court of Appeal upheld the application of a dishonest acts exclusion, and overturned that portion of the underlying Order which would have allowed the appellant to bring an action for an alleged breach of the insurer’s duty of good faith.  The Court of Appeal found that the insurer’s duty of good faith was owed exclusively to the insured, and not to the appellant, notwithstanding that the appellant was the assignee of the underlying proceeds of insurance. The Court of Appeal did, however, state that the appellant could still have a remedy against the insurer, if it could prove that the insurer had deliberately attempted to “subvert the course of justice” in the course of the defence of the underlying liability action.

Facts

The Parties

The appellant, Ernst & Young (E&Y), acted as receiver of International Warranty Company Ltd. (“IWC”), which sold extended warranties to car buyers. The premiums paid by the car buyers were placed in trusts to secure the funds for future warranty payments by IWC. The trust agreements contemplated that IWC would only draw on the trust funds as needed to reimburse itself as warranty work was undertaken. At the end of five years, any balance in the applicable trust was to be turned over to IWC.   Central Guarantee Trust Company (“CGT”) became the trustee of the trusts.

In 1987, IWC stopped depositing some of the warranty premiums into the trusts. CGT withdrew money from the trusts and paid it to IWC for its own use. Then, CGT made a $1.5 million loan to IWC, which was promptly repaid out of trust funds paid to IWC. IWC went out of business in December 1987 and was placed in receivership.   At that time, there was about $18 million in the trusts. This was insufficient to fund IWC’s warranty obligations.

The trust instruments did not permit CGT as trustee to withdraw money from the trusts and pay it to IWC for purposes other than the payment of warranty claims. The withdrawals were justified by IWC to CGT on the basis that there was an “actuarially projected surplus” in the trusts. That is, it was anticipated that after the withdrawals there would be sufficient funds remaining in the trusts to honour all future warranty payments

The respondent Chartis was CGT’s insurer.  Chartis had issued a D&O policy to CGT (the “Policy”), including a specific Trust Department Errors and Omissions endorsement.

The Breach of Trust Action (Alberta)

E&Y was authorized to bring a claim against CGT (the Alberta Action). In 1993, E&Y obtained a Court Order in Ontario (the “Houlden Order”) which provided that “any proceeds from insurance coverage arising out of a judgment or a settlement of the [Alberta] Action belong to [E&Y]...”[1]

Chartis defended the Alberta Action on behalf of CGT. An initial decision[2] was set aside and a new trial was ordered in 2006.[3]  In 2010 the Court of Queen’s Bench of Alberta held that CGT had breached the trusts, and granted judgment in favour of E&Y against CGT for a total award of over $10 million.[4]

The Ontario Summary Judgment Motions

Chartis refused to pay the judgment arising from the Alberta Action, taking the position that the claim was excluded by the terms of the Policy. Coverage litigation in Ontario resulted, giving rise to summary judgment motions considered by the Court of Appeal.  Of a number of issues raised on the motions, the Court of Appeal considered two main issues: the application of Policy Exclusions relating to “dishonesty”; and whether the Houlden Order entitled E&Y to sue Chartis for breach of its duty of good faith.

Result

The Court of Appeal upheld the application of the dishonesty Exclusions on the facts of the case. However, it overturned the motion judge’s finding on the issue of the breach of good faith, and found that the Houlden Order did not assign to E&Y a cause of action for breach of the duty of good faith.

Reasoning

The Policy Exclusions

The Policy had Exclusions which limited the insurer’s liability to make payments for any claim “for or arising out of” dishonest acts or bad faith.[5]  In considering these Exclusions, the Court of Appeal referred to the general principles of interpretation of insurance policies as laid out in Reid Crowther & Partners Ltd. v. Simcoe & Erie General Insurance Co.[6] and reviewed case law considering the meaning of the word “dishonest” when applied to a trustee.[7]

The Court concluded that, inter alia, CGT had committed deliberate breaches of trust and had misappropriated funds for its own benefit. These findings of fact amply supported the conclusion that the acts were dishonest and fell within the dishonesty Exclusion. The Court did not agree with E&Y’s suggestion that the words “for or arising out of” in the Exclusion required a “continuous chain of causation” which was not met when the misappropriation occurred after the withdrawals.

Breach of the Duty of Good Faith[8]

E&Y submitted that by granting to it CGT’s “proceeds from insurance coverage”, the Houlden Order had the effect of assigning to E&Y CGT’s claim against Chartis for breach of the duty of good faith. The motions judge agreed.[9] The Court of Appeal, however, did not agree,  concluding that while Chartis owed CGT a duty of good faith in the defence of the Alberta Action, the Houlden Order did not assign the right to sue for a breach of that duty to E&Y, as the right to sue for a breach of the duty of good faith did not fall within the “proceeds of insurance” assigned under the Houlden Order.

The Duty of Good Faith Is Separate From the Duty to Compensate

A liability insurer owes a duty of good faith to its insured in the defence of a claim. Chartis owed this duty to CGT. However, the duty to act in good faith is separate from the duty to compensate for the loss covered by the policy. The duty to act in good faith gives rise to a separate and independent cause of action.[10] This is well-supported in the case law.[11]

Assignment of “Proceeds of Insurance” is not Assignment of the Insurance Contract

An assignment of the “proceeds of insurance” refers to a particular type of assignment which is distinguished from an assignment of the insurance contract itself. The Court wrote: “Assignment of the contract substitutes the assignee as the party to the contract. In contrast, assigning the ‘proceeds of insurance’ merely assigns the right to the monies payable under an insurance policy to the assignee.”[12] The Court therefore concluded that because “proceeds of insurance” does not include damages for breach of the independent contractual duty of good faith owed to an insured, E&Y did not obtain a cause of action for any breach of the duty of good faith Chartis owed to CGT.[13]

There Is No Independent Duty of Good Faith to Third Party Assignees

The Court adopted the motion judge’s rationale as to why Chartis did not owe a separate duty of good faith to E&Y in either action:   

An insurer owes no duty to a person asserting a claim against its insured. The claimant is a stranger to the relationship between the insurer and the insured and is not in privity of contract with them ... Recognizing such a duty would be completely unworkable in the context of an adversarial relationship, would create irreconcilable conflicts of interest and lead to a breakdown of the indemnity system.[14]

Alternative Routes to Recovery

The Court of Appeal was careful to state that its finding should not prevent E&Y from some form of recovery if Chartis had in fact “steered” the defence so as to avoid its insurance obligations, as suggested by E&Y.  The Court of Appeal suggested what in its view were some potential forms of relief, such as variation of the Houlden Order to include assignment of CGT’s cause of action for breach of the duty of good faith, a claim for abuse of process on the basis of collateral attack of a court order, abuse of the court’s process as actionable in tort, or an action for civil contempt for breach of the strict terms of a court order.[15]

Ultimately, the Court of Appeal ordered that E&Y should be given the opportunity to make submissions on the availability of alternative remedies.

Conclusion

The dispute between these two parties is far from over.  However, some clarity has now been provided with respect to how the issues between them may be dealt with moving forward. Most importantly the Ontario Court of Appeal has set some rational limits on the issue of to whom an insurer’s duty of good faith is owed, while at the same time encouraging that some form of remedy be available to address situations in which insurers may inappropriately attempt to influence outcomes of underlying litigation in which they are contractually bound to provide a defence.