“Gilding the lily” or “telling lies with virtual impunity”? – the abolition of the fraudulent devices doctrine
In Versloot Dredging BV v HDI Gerling Industrie Versicherung AG and others (The DC Merwestone)1 the Supreme Court abolished the doctrine of fraudulent devices, holding by a majority of four to one that a collateral lie - an untruth told to support an otherwise valid claim - does not provide insurers with a defence to the claim.
The vessel suffered main engine damage following water ingress to the engine room. To support a claim on owners’ hull and machinery insurance, the vessel’s general manager, K, gave evidence that the master had reported a bilge alarm being triggered several hours before the casualty, but which was not investigated by the crew because the vessel was rolling in heavy weather. K subsequently admitted this was untrue. The underwriters argued that owners had made a fraudulent statement when presenting their claim, so that the claim was void.
At first instance2, Popplewell J found that K’s false statement was a “reckless untruth” told to support owners’ allegation of crew negligence, to head off any defence based on want of due diligence, and to improve the chances of a prompt settlement. Whilst K had genuinely believed at the time of his statement that it was a reasonable explanation of events, he was reckless as to whether he had in fact been told by the master that the bilge alarm had sounded.
Under the law as it then stood, an insured who made use of a fraudulent device such as a false document or statement in support of an otherwise genuine claim forfeited that claim. Following the obiter remarks of Mance LJ (as he then was) in The Aegon3, the lie would deny the insured of its claim where the lie was “material” in that it directly related to the claim and, if believed, would objectively yield a “not insignificant” improvement in the chances of winning at trial or obtaining a better settlement or quicker payment.
With some reluctance Popplewell J therefore dismissed the claim, which he found otherwise valid. He observed that to deprive owners of their €3.2 million claim as a result of K’s reckless untruth was a “disproportionately harsh sanction.”
The owners’ appeal to the Court of Appeal was dismissed, and the matter then came before the Supreme Court.
What is a collateral lie?
Lord Sumption (with whom Lords Clarke, Hughes and Toulson agreed) observed that there are three types of fraudulent claim4:
- where the entire claim is fabricated - in which case the insurer is under no obligation to pay the claim;
- where the claim is genuine but dishonestly exaggerated - again the insurer is not liable;
- where the claim is genuine but the insured gives dishonest information to support the claim, whether to improve its strength or with the aim of obtaining faster payment. This is a fraudulent device or a “collateral lie” - a lie which “turns out when the facts are found to have no relevance to the insured’s right to recover”. Such a lie might, the Supreme Court felt, be described in the vernacular as the insured “gilding the lily”5.
The Supreme Court’s judgment focused on the third category.
Collateral lies do not preclude recovery
Lord Sumption drew a distinction between claims which are fraudulently exaggerated, where “the insured’s dishonesty is calculated to get him something to which he is not entitled”, and a collateral lie, where “the insured is trying to obtain no more than the law regards as his entitlement and the lie is irrelevant to the existence or amount of that entitlement.”
In distinguishing between a fraudulent claim and a collateral lie, the question is whether, on the true facts, the lie goes to the recoverability of the claim. An insurer’s liability to pay a claim arises as soon as the insured suffers a loss covered under the policy. If the lie is told to support an otherwise unrecoverable claim, or to exaggerate the sum payable beyond what is due to the insured, it is fraudulent and the claim is forfeit. If, however, the lie is one which on the true facts is “immaterial” to the insured’s right to recover, because the insured is seeking to recover no more than what the law regards as the insured’s entitlement in any event, the insured’s claim will stand.
One justification for the remedy of forfeiture for a fraudulent claim is that the insured should not be permitted to make a “one way bet6”. However, that justification does not, in the majority’s view, apply to claims supported by a collateral lie, where “the insured gains nothing from the lie which he was not entitled to have anyway. Conversely the underwriter loses nothing if he meets a liability that he had anyway.”
Delivering a dissenting judgment, Lord Mance argued that to find that a lie told in support of a claim is “immaterial” simply because it later transpires that the claim was valid without it “seems a charter for untruth,” which leaves insureds to “tell lies with virtual impunity.” In his view, where collateral lies are deployed by an insured, it is almost always because the insured fears it has a questionable claim. Judging the validity or otherwise of the claim with the benefit of hindsight does not reflect that reality7.
The materiality of a collateral lie is to be judged with the benefit of hindsight8. The difficulty, from an insurer’s perspective, is that it may not be obvious when a lie is discovered whether it is “material”, so that the claim is forfeit, or collateral. That may not be known until the facts are found at trial.
The Supreme Court acknowledged that the insured’s mistruth might cause insurers to pursue irrelevant investigations or to decide not to make enquiries which had the truth been known would have been relevant. However, it was held that to permit insurers to decline an otherwise valid claim on that basis “would be a wholly disproportionate response9.” Instead, an insured who supports its valid claim with a collateral lie will face other sanctions10 including costs penalties. Lord Mance, however, was sceptical that the possibility of costs sanctions would, from the insured’s perspective, outweigh the perceived benefits of telling the lie at the time it was told11.
The Supreme Court recognised that fraudulent insurance claims remain a serious problem for the London market and beyond. Research by the ABI12 suggests that the value of detected fraudulent claims exceeded £1 billion in 2014 and that undetected fraudulent claims cost the UK economy £2 billion that year. Against this background, the loss of the remedy of forfeiture for the use of a fraudulent device is perhaps surprising. However, the Court found that the policy of deterring fraudulent claims did not justify the loss of a valid claim supported by a collateral lie. For Lord Hughes, there is “plainly a difference of quality between the insured who deals fraudulently with his insurer in an attempt to gain something to which he is not entitled, and the insured who dishonestly gilds the lily with a lie or falsified evidence, but stands thereby to obtain nothing more than was his legal due.” The remedy of forfeiture in the latter situation “is simply too large a sledgehammer for the nut involved.”
As Lord Mance noted, insurers may respond to the abolition of the fraudulent devices rule by introducing clauses giving an express right to decline a claim supported by a collateral lie. It is understood that draft clauses to this effect are under consideration by the market. Whether insurers will be able to insist on the inclusion of such clauses in the current market remains to be seen.
In re Deepwater Horizon: A year and a half later
When the Supreme Court of Texas delivered its opinion in In re DeepwaterHorizon13 on February 13, 2015, commentators across the country pondered the impact of the opinion on the insurance industry. Many wondered whether the case would cause a sea change in the manner courts – at least Texas courts – interpret insurance policies. This article examines the impact In re Deepwater Horizon has had on insurance law in Texas. At the present time, results are mixed on Deepwater Horizon’s impact.
As a reminder, In re Deepwater Horizon raised the issue of what language is required to incorporate the limitations in an underlying contract referenced in an insurance policy. The insurance policy at issue named BP as an additional insured under the policy; however, the parties disputed whether BP’s coverage under the policy was determined strictly by the policy or whether it incorporated limitations in the underlying drilling contract. The insurance policies did not contain any explicit language limiting BP’s coverage as an additional insured. The Texas Supreme Court held that BP’s coverage under the policy was, in fact, defined by the drilling contract. The Court reasoned that there is no need for “magic words to incorporate a restriction from another contract into an insurance policy.” Since the drilling contract simply required BP to be named an additional insured “for liabilities assumed” under the contract, the Court reasoned that BP’s coverage under the insurance policy was also limited to the items listed in the drilling contract. There was a concern by many commentators that the Court’s ruling in In re Deepwater Horizon would lead to the overinclusion of limitations in outside contracts in insurance disputes.
Liberty Surplus Insurance Corporation v. Exxon Mobil Corporation suggests that courts have not interpreted In re Deepwater Horizon as requiring the wholesale adoption of limitations in underlying contracts.14 In Liberty Surplus Ins. Corp., the court rejected the insurer’s argument that the additional insured’s insurance coverage was limited by the underlying contract. In the underlying contract, the parties agreed that the additional insured would be insured “in connection with [the insured’s] performance of Services.” The court reasoned that there was explicit language in the insurance policy stating that the coverage extended “only with respect to liability arising out of [the insured’s] operations.” The court emphasized that mentioning an underlying contract is insufficient to incorporate the entirety of the underlying contract. Rather, “[t]he policy instead must clearly manifest the intent to include the extrinsic document as part of the policy.” Yet, some courts have extended the reach of In re Deepwater Horizon.
For example, in Ironshore Specialty Insurance Company v. AspenUnderwriting, Limited., the Fifth Circuit was confronted with a coverage dispute similar to In re Deepwater Horizon. In Ironshore Specialty Insurance Company, two companies—Endeavor and Basic— agreed to a master services agreement (MSA) whereby each agreed to be responsible for liability arising from claims brought by their respective employees and to obtain insurance coverage for at least $5 million.15 The excess insurer for Endeavor sued the excess insurer for Basic, alleging that Basic’s policy was not limited to $5 million. The insurance policy merely defined an insured as follows: “any person or entity to whom [the party] is obliged by a written ‘Insured Contract’ entered into before any relevant ‘Occurrence’ and/or ‘Claim’ to provide insurance such as is afforded by this Policy. . . .” Although the Court expressed doubts as to whether the policy’s brief reference to the MSA was sufficient to incorporate the limitations in the MSA, the Court ultimately held that In re Deepwater Horizon compelled it to hold that the limitations in the MSA were incorporated into the policy. Certainly, all courts have not interpreted the decision as making a significant change in the interpretation of insurance law. For instance, in Tetra Technologies, Inc. v. Vertex Services., LLC, a party argued that the court should reconsider its prior interpretation of insurance coverage in light of In re Deepwater Horizon.16 The Court held that it did “not read the Deepwater Horizon opinion as modifying or somehow rendering incorrect the methodology employed by this Court in its previous Order.”
As for those cases mirroring the facts of In re Deepwater Horizon, courts have thus far strictly adhered to the guidelines of the Supreme Court’s decision.17 In Miramar Petroleum, Inc. v. First Liberty Insurance Corporation, the court was faced with the question of whether an underlying drilling contract limited a party’s insurance obligations. Miramar contracted with Nicklos, and in the contract, Nicklos agreed to maintain insurance coverage for its liabilities under the contract. Similar to In re Deepwater Horizon, the insurance policy granted the party additional insured status “only to the extent required by a written agreement.” The court therefore held that the coverage under the policies was limited to the obligations the parties agreed to cover in the underlying contract.
As the above cases demonstrate, In re Deepwater Horizon has had an impact, albeit perhaps not the sea change some members of the legal field worried it may have (at least not yet). However, a few principles are clear from In re Deepwater Horizon and its progeny. When incorporating an underlying contract into an insurance policy, parties should include explicit language directing the court as to the extent to which the underlying contract should be incorporated. Absent such explicit language, parties lose control over the extent of coverage under the policy.