Flexsys America LP v XL Insurance Company Limited
The insured, a company incorporated in Ohio, was part of a group of companies that manufactured, sold and distributed chemicals used in the manufacture of rubber products. It was covered by a local public and products liability policy and by a master policy issued by XL for the group as a whole.
In April 2006, a Korean company filed a complaint against the insured in the Californian District Court making various allegations of improper and illegal conduct. The complaint was struck out in December 2008, but an appeal has been lodged before the United States Court of Appeals.
The insured claimed indemnity under its local policy for costs incurred in defending the Californian proceedings, estimated at over $2 million. The local insurer settled the claim at $1 million, equivalent to the relevant policy limit.
The insured now claimed for the balance under the master policy and for a declaration that the policy would cover any potential liability to the Korean company.
The local policy, which was subject to the law of Ohio, included cover against legal liability to pay damages for "personal and advertising injury" up to a limit of $1million.
This was defined as (amongst other things) "oral or written publication, in any manner, of material that slanders or libels a person or organisation or disparages a person's or organisation's goods, products or services". It excluded knowing violation of the rights of another and the publication of material known to be false.
The policy provided that the insurer was under a duty to defend the insured against any claim seeking damages, but not against claims for personal and advertising injury to which the policy did not apply.
Under the master policy, the insurer promised to indemnify the insured against "legal liability for advertising injury arising out of advertising their products or services". The relevant limit of indemnity was $25 million any one event subject to an excess of £500,000 each claim.
Advertising injury was defined as "oral or written publication of material that slanders or libels a person or organisation or disparages a person's or organisation's products or services".
For insureds domiciled outside the UK, a "difference in limits" clause provided cover for losses exceeding the limit of indemnity of the local policy. A "difference in conditions" clause stated the master policy would respond when its terms were broader than the local policy to cover claims that were not recoverable under the local policy.
There was also a "drop down clause" which said:
"In the event of a partial exhaustion of a local policy, this policy will pay in excess of the reduced underlying limit of indemnity. In the event of total exhaustion of a local policy, this policy will continue in force as the underlying insurance subject to the terms exceptions and conditions of the particular local policy."
The master policy was governed by English law and did not impose a duty to defend on the insurer. Legal costs were covered, but subject to the insurer's prior written consent.
It was not disputed that, under the narrower terms of the master policy, the insured would not have a claim. But the insured argued that the drop down clause applied.
It said the clause was triggered because the relevant indemnity limit under the local policy had been exhausted. Under the clause, the master policy would drop down in place of the local policy, subject to the terms and conditions of the local policy but bringing with it the $25 million limit of indemnity.
The insurer denied the drop down clause operated when the underlying loss was not covered by the terms of the master policy. It also maintained there was no liability under the local policy, as the allegations made by the Korean company fell within the exclusions for knowing violation and falsity.
The judge agreed with the insurer.
The cover for "advertising injury" under the master policy was narrower than under the local policy and only covered advertising by the insured of its own products or services. It did not extend to the publication of any material disparaging the products or services of another.
The "differences in conditions" clause dealt with the situation where cover under the master policy was wider than the local policy, but not the other way round. From this, the judge inferred that ordinarily the master policy would not respond to a claim that fell outside its terms.
The insured's argument that the drop down clause nevertheless provided it with cover would bring about the "doubly surprising consequence" that the master policy would have to respond, not only to a claim that did not fall within its own terms, but also on terms more favourable than the local policy as regards the indemnity limit and incorporating a duty to defend.
In the absence of a single, universally applied form of words, each drop down clause must be construed individually. In this case, the judge interpreted the wording to mean that, where prior claims had resulted in either the partial or total exhaustion of the local policy, the clause would provide new cover from the ground up to meet subsequent claims, but this cover would be subject to the terms conditions and limits of the local policy.
Although he did not need to decide the issue, the judge also concluded that the underlying claim did not fall within the cover of the local policy.
Under Ohio law, insurers' duty to defend arises if allegations made against the policyholder arguably or potentially bring the claim within the cover. In this case, the complaint alleged a series of intentional acts forming part of a conspiracy to exclude the Korean company from the US market. Liability for such conduct was excluded by the terms of the local policy.
It is common in an international insurance programme for the master or global policy to pick up shortfalls in cover under the local policies by "differences in conditions" clauses. But, as this case illustrates, such clauses are usually tailored to the situation where cover under the local policy is narrower than under the master policy, not where the reverse is the case.
The judge deliberately avoided making any comments about drop downs generally, but the decision confirms that drop down clauses, which reinstate the cover provided by the local policy when local policy limits have been used up by prior claims, cannot operate independently as a wholesale extension of the master policy if the underlying claim falls outside the master policy's terms.
