On January 11, 2008, a closely divided Texas Supreme Court rejected the “no prejudice” rule for late notice and held that “an insured’s failure to timely notify its insurer of a claim or suit does not defeat coverage if the insurer was not prejudiced by delay.” PAJ, Inc. v. The Hanover Insurance Company, Case No. 05-0849.

The case involved a commercial general liability policy that provided coverage on an occurrence basis for, among other things, liability arising from “advertising injury.” The policy’s notice provision required that the insured notify the insurer of any claim or suit brought against it “as soon as practicable.”

In November 1998, the insured received a demand from one of its competitors that it stop marketing a particular product. A month later, the competitor filed suit against the insured for copyright infringement. Initially believing that the policy was not implicated by the dispute, the insured did not notify the insurer of the suit until four to six months after it was filed. The insurer subsequently denied coverage based on the insured’s failure to provide timely notice of the claim.

In the coverage litigation that followed, the parties stipulated that the insured failed to provide notice as soon as practicable and that the insurer was not prejudiced by the untimely notice. Based on these undisputed facts, the trial court granted summary judgment in favor of the insurer and held that the insurer, as a matter of law, was not required to demonstrate prejudice to avoid coverage under the policy. The court of appeals affirmed, concluding that because the policy provision at issue was a “condition precedent,” as opposed to “merely a covenant,” a showing of prejudice was not required.

On review, the Supreme Court determined that whether prompt notice is a condition precedent or a covenant does not matter. Rather, the insurer’s coverage obligation turns on whether the insured’s breach of the policy provision is a material one. In this connection, the Court noted the “fundamental principle of contract law” that “a material breach by one contracting party excuses performance by the other party, and an immaterial breach does not.” Accordingly, the Court concluded that, because “only a material breach of the timely notice provision will excuse [the insurer’s] performance under the policy,” late notice will not defeat coverage absent proof that the insurer was prejudiced by the delay.

In reaching its conclusion, the Court asserted that, with respect to occurrence-based policies, notice is “not an essential part of the bargained-for exchange” because, unlike situations involving claims-made policies, notice is not the event that triggers coverage. In this connection, the Court recognized the distinction drawn by the United States Court of Appeals for the Fifth Circuit between occurrence-based policies and claims-made policies, requiring proof of prejudice in the case of the former, but not the latter.

Although the Court noted the distinction drawn by the Fifth Circuit, it did not specify whether its holding was limited to occurrence-based policies, or whether the holding was intended to impose a prejudice requirement in the context of claims-made policies as well. The same day that the Court issued its opinion in PAJ, however, it also granted the petition for review in Prodigy Communications, Inc. v. Agricultural Excess & Surplus Insurance, Co., Case No. 06-0598 (which had been pending for more than a year), and accepted a request for certification from the Fifth Circuit in Financial Industries Corporation v. XL Specialty Insurance Company, Case No. 07-1059. Because both of these cases explicitly address the prejudice requirement in the context of claims-made policies, the Court will have the opportunity to determine whether a different rule should apply.