In Quanta Specialty Lines Insurance Co. v. Investors Capital Corp., No. 10-0219-cv, 2010 WL 4608763 (2d Cir. Nov. 16, 2010), the Second Circuit affirmed a troubling decision of the United States District Court for the Southern District of New York, No. 06 Civ. 4624 (PKL), 2009 WL 4884096 (S.D.N.Y. Dec. 17, 2009). The district court found, and the Second Circuit confirmed, that a professional liability policy did not cover defense and indemnity costs incurred by the insured securities broker in arbitrations in which the plaintiffs alleged they had been sold unregistered securities, because the insured had notice of the claims at the inception of the claims-made policy period. The Quanta court based its conclusion that the insured had notice almost entirely on the insured’s receipt of a letter, several months before the policy went into effect, complaining that an investor had purchased unregistered securities from the insured. The insured’s investigation demonstrated almost immediately that the allegations in the letter were factually incorrect, causing the investor to withdraw her demand. The court nonetheless found the letter sufficient to put the insured on notice of similar legitimate claims first presented by the arbitration plaintiffs nearly a year later, leaving the insured without coverage for the arbitrations.
Plaintiff Quanta Specialty Lines Insurance Co. (“Quanta”) issued two consecutive claims-made professional liability policies to Investors Capital Corporation (“ICC”), a securities broker. The policy periods ran from December 31, 2004 to December 31, 2006.
On June 9, 2004—before the Quanta policies went into effect—an investigator from the North Carolina Division of Securities contacted ICC, requesting information about Joseph Jones, who had worked for ICC from April 1998 to December 2001. The investigator spoke with an ICC lawyer on the telephone and sent a follow-up letter to the lawyer requesting additional information about an investor, Patricia Whitehead’s, IRA account. On September 13, 2004, the Division of Securities issued a summary cease and desist order to Jones, prohibiting him from selling BAB Productions securities, which were unregistered securities. The summary order was not served on ICC. The Securities Division issued a final cease and desist order against Jones on November 10, 2004. ICC did not inform Quanta of the Securities Division investigation until April 2006.
Also notably—and again before the Quanta policy became effective—on October 21, 2004, ICC received a letter (the “Alston letter”) from a lawyer representing another ICC investor, Patricia Alston. The letter enclosed a copy of the Securities Division’s summary order against Jones, complained that Jones had also sold BAB securities to Alston, and requested that ICC provide reimbursement. During the next few weeks, ICC’s legal department investigated the allegations set forth in the letter and found that Alston in fact had never invested in BAB securities. ICC advised Alston’s lawyer, who said the letter could be disregarded and that no suit would be filed. Although a lawyer in ICC’s legal department initially logged the Alston letter as a matter that should be reported to ICC’s insurers, ICC did not inform Quanta of the Alston letter.
In August 2005 and April 2006, two groups of investors initiated NASD arbitration proceedings against ICC, alleging that Jones had sold them BAB securities. ICC promptly reported the arbitrations to Quanta, which defended ICC under a reservation of rights and filed a declaratory action seeking a judgment that Quanta was not required to defend or indemnify ICC in the arbitrations.
The district court, ruling on cross motions for summary judgment and applying New York law, found Quanta was not required to provide coverage for the arbitrations. First, the court found that the 2004 Alston letter and the two arbitrations were a single “Claim,” as defined in the policy, made when ICC received the Alston letter in 2004, before the Quanta policy went into effect on December 31, 2004. Under the terms of the policy, that Claim would be deemed to arise on the earlier date, when the letter was received. Second, when the policy period began, the court found that ICC, based on the North Carolina Securities Division investigation, the summary order against Jones, and the allegations of the Alston letter, had knowledge or a reasonable basis upon which to anticipate that a “Wrongful Act” as defined in the policy could result in a claim in the policy period. Because ICC had notice of the claim on the inception date, coverage was not available.
The district court first found that the October 2004 Alston letter set forth a Claim as defined in the Quanta policy, even though the letter was withdrawn after ICC’s investigation revealed that the letter’s allegations were incorrect. The policy provided that a Claim was “a demand received by any Insureds for Damages (including pleadings received in a civil litigation or arbitration) for an actual or alleged Wrongful Act,” but not “any proceeding commenced by a governmental or quasi-governmental official or agency.” Thus, the parties agreed that the Securities Division investigation was not a Claim. The Alston letter, however, was a Claim because it was a demand for damages, in the form of a request that ICC reimburse Alston’s expenditures, and alleged a Wrongful Act, “a negligent act or omission. . . . committed by an Insured,” by asserting that ICC, the Insured, negligently supervised Jones. Although the allegations in the letter ultimately proved to be untrue, the court found that the definition of a Claim encompassed “alleged” Wrongful Acts as well as “actual” ones. Moreover, ICC had listed the Alston letter on a log of potential claims, without indicating that it did not need to be reported to the company’s insurers.
The Quanta policy specified that “[a]ll Claims based upon or arising out [of] the same Wrongful Act or Interrelated Wrongful Acts shall be considered a single Claim and each such single Claim shall be deemed to have been made . . . when the earliest Claim . . . was first made.” The district court found the Alston letter and the two arbitrations for which ICC sought coverage all related to ICC’s alleged failure to supervise Jones’ sale of the BAB securities and therefore would be deemed to be a single claim first made before the policy’s inception date. According to the court, there was a “sufficient factual nexus,” as required by the case law, between Alston’s allegations that Jones sold BAB securities to her while he was affiliated with ICC, and the arbitration plaintiffs’ allegations that they purchased BAB securities as a result of ICC’s failure to supervise Jones’ activities.
The Quanta policy further provided that coverage was only available if, as of the December 31, 2004 inception date of the policy, “no Insured had knowledge or reasonable basis upon which to anticipate that the Wrongful Act or any Interrelated Wrongful Act could result in a Claim.” Several exclusions similarly prohibited coverage from being applied to claims of which the Insured had notice as of the inception date. The district court found that even if the Alston letter and arbitrations were not a single claim predating the policy period, the Alston letter provided ICC with notice before the policy period began. Based on the Securities Division investigation, the allegations of the Alston letter, the Securities Division’s summary order submitted with the letter, and ICC’s logging the letter as a matter to be reported to its carriers, a reasonable person would anticipate that a claim might be filed based on similar allegations. The ultimate withdrawal of the Alston letter was of no consequence. Under the circumstances, ICC could not reasonably claim that it had no knowledge that BAB was ever sold through ICC as of the end of 2004.
In November 2010, the Second Circuit affirmed the district court’s decision with little discussion, stating only that “[s]pecifically, we agree with the District Court that ‘as of the . . . inception date of the original policy, ICC had knowledge or a reasonable basis upon which to anticipate that a wrongful act or interrelated wrongful act could result in a claim.’”
The Second Circuit's decision visits an extreme prejudice to the insured, and seemingly extends a policyholder's notice obligation to an infinite set of circumstances. However, the holding cannot be ignored. Now, more than ever, a policyholder must give notice of anything that even resembles a claim at policy inception and renewal. We know that certain policyholders are hesitant to disclose facts that they do not consider "claims," for fear that disclosure may result in increased premiums or the refusal to provide certain types of coverage. The Quanta holding makes clear that the insured makes that decision at its peril. Insureds must err on the side of providing notice.