Legal Spotlight: October 15, 2014
Legal Fees Must Be Returned
In the early 1990s, the O’Quinn law firm began representing women in a class-action lawsuit against breast-implant manufacturers.
As litigation continued, the firm began to allocate the general expenses associated with the lawsuits by deducting 1.5 percent of each woman’s gross recovery, even though the contingent fee contracts did not provide for such a deduction and clients were not informed of the deduction.
In 1999, a group of former breast-implant clients filed suit against the firm, alleging they were improperly charged those expenses. A similar lawsuit was filed by other former clients in 2002, and it was later incorporated into the 1999 litigation.
National Union Fire Insurance Co., which had issued a primary Lawyer’s Professional Liability policy, agreed to provide the firm with a defense, subject to a reservation of rights, and in 2001, the U.S. District Court for the Southern District of Texas, Houston Division, upheld the firm’s right to a defense, but stayed the indemnity issue. The case was later closed.
The dispute entered arbitration, which ruled in 2007 that the law firm was liable for $41.5 million for breach of contract, attorneys’ fees and interest, as well as forfeiture of $25 million of its $263.4 million fee for the underlying breast-implant litigation. The firm later settled the final award for $46.5 million in 2009.
The firm also settled with a group of insurers that had issued an excess professional liability policy in separate actions, except for Lexington Insurance Co., which was sued by O’Quinn seeking indemnification up to the limit of liability.
Lexington asked the court to dismiss the case, arguing that the policy excluded losses that consisted of fines; penalties; sanctions; reimbursement of legal fees, costs, or expenses; or “matters which may be deemed uninsurable under the law,” which includes “the restoration of an ill-gotten gain,” according to court documents.
The insurer also argued that O’Quinn’s “improper billing practices” were not professional legal services, noting that the policy covers “only those acts which use the inherent skills typified by that professional, not all acts associated with the profession.”
The court agreed that the billing practices do not require specialized legal knowledge and that the law firm had received a “profit or advantage to which [it] was not legally entitled.” It dismissed the case.
Scorecard: The insurer did not need to pay up to the limits of its excess policy liability limits for the $46.5 million in damages and fees paid by the law firm.
Takeaway: Billing practices were not covered by the “professional legal services” policy issued by the insurer.
Millions Provided in D&O Coverage
Faced with six lawsuits seeking more than $1 billion in damages from the now-bankrupt MF Global Holdings, which is accused of improperly accessing customer money to cover trading losses, executives of the company sought defense coverage from D&O and E&O policies.
In April 2012, the U.S. Bankruptcy Court in the Southern District of New York set a “soft cap” of $30 million for insureds to use for defense. In May 2013, the insureds requested additional funds and eventually the court agreed to increase the cap to $43.8 million.
Later, the insureds asked the court to focus just on the D&O primary and excess policies, and eliminate the cap altogether. They argued the D&O proceeds should not be subject to bankruptcy court oversight or limitation.
And even though the judge found the amount of money spent so far for defense was “staggering, even before the first deposition has been taken,” he agreed with that position.
In September, Judge Martin Glenn withheld only $2.5 million for self-retention and $13.06 million that is the amount of a possible claim against the D&O policies if it pays the indemnification of former CEO Jon Corzine, Bradley Abelow, former president, and ex-CFO Henri Steenkamp. That decision provides up to an additional $200 million in coverage.
Scorecard: Former executives of MF Global were given access to an additional $200 million for defense of stockholder lawsuits.
Takeaway: Insurance policies that provide exclusive coverage to directors and officers are not part of the estate for bankruptcy purposes.
Lawsuit Fires Blanks
Marion E. “Bud” Wells, the sole shareholder of SSO, a retail firearm and security safety store, and Rex McClanahan agreed in 2007 to be owners of BGS, which used to be known as Bud’s Gun Shop in Paris, Ky.
All of its employees, including employee Matthew Denninghoff, were asked to execute noncompete agreements.
About that time, Wells began to liquidate his interest in SSO via a stock purchase agreement with Earley M. Johnson II. As part of the transaction, SSO assigned the federal and state trademark rights in the Bud’s Gun Shop name to Wells, who licensed the rights back to SSO.
For a time, BGS and SSO shared a building, but in January 2009, BGS relocated to Lexington, Ky., opening its own retail store. SSO continued to supply product and fulfill orders for it, however, until April 2010.
At some point before January 2010, Denninghoff — who quit that month without notice and began working for SSO — “deliberately erased” his work email and other contents but “secretly kept” BGS’s customer database, giving them to SSO, where his sister was a vice president, according to court documents.
SSO then opened a competing online firearms operation and sent mass promotional emails to BGS customers, according to court documents. BGS sued for misappropriation of trade secrets and breach of contract, among other charges.
SSO sought defense and indemnification under its commercial general liability policy with Liberty Corporate Capital Ltd. It claimed that BGS’s accusation that it stole customer information that was used for emails fell under the “advertising idea” section of the policy.
It also argued that trademark infringement claims constitute “property damage.”
Liberty Corporate Capital sought to dismiss the request for coverage, and the U.S. 6th Circuit Court of Appeals agreed.
Electronic data is not “tangible” property, and the use of customer database information did not involve advertising ideas, it ruled.
Scorecard: Liberty Corporate Capital did not have to indemnify or defend an insured accused of theft of trade secrets.
Takeaway: Because Kentucky law did not define “advertising idea,” it must be interpreted “according to the usage of the average man.”
Misclassification mistakes — two words that sound almost innocuous, but which could result in substantial fines and legal headaches for a company if they get things wrong.
Put simply, misclassification mistakes arise most often when a company misclassifies an employee as an independent contractor.
Such a misclassification can have a serious impact if that person is, for example, supposed to be covered by insurance. Moreover, it happens more often than many people think.
“Misclassification of employees as independent contractors continues to be rampant, especially in traditionally low-wage industries such as home health care and janitorial services, but also remains prevalent in higher-paying industries such as construction and trucking,” Debra Friedman, a member of the labor and employment practice Group at law firm Cozen O’Connor, told Risk & Insurance®.
A 2000 study by the U.S. Department of Labor (DOL) found that approximately 30 percent of companies misclassify workers. Some of them may simply be ignorant of the law (although ignorance offers no legal defense).
More often, though, companies deliberately misclassify workers to save money. This is because companies do not pay Social Security and Medicare taxes, unemployment insurance tax, or workers’ compensation insurance for independent contractors, nor do they provide independent contractors with employee benefits such as health insurance, pensions or 401(k) matches, and paid time off.
Significantly, these costs can represent 20 percent to 40 percent of an employee’s total compensation.
Also, said Friedman, “independent contractors, unlike employees, are not protected under federal or state minimum wage or overtime laws or anti-discrimination statutes, and do not have the right to bargain collectively and join unions or obtain job-protected leave.”
Stakes Are High
Some recent cases have shown a wide variety of companies and plaintiffs.
In July of this year, FedEx Ground drivers won summary judgment in their misclassification lawsuit brought against FedEx under the Massachusetts Independent Contractor Act, with the judge ruling the workers were, in fact, employees.
And in October 2013, the Penthouse Executive Club in New York reached an $8 million settlement with a group of adult dancers who had complained that they had been misclassified as independent contractors and had not been properly compensated as a result.
“Historically, misclassification mistakes have been a very big issue in the trucking industry, or especially if you are dealing with contractors,” said Eric Silverstein, senior vice president and leader of Lockton’s risk management team.
“As a result, the trucking industry has put together the blueprint for how to deal with this. If you’re providing insurance for an owner/operator fleet, or you’re dealing especially with subcontractors, then there needs to be a clear contract and an arms-length agreement. From a risk management perspective this can be a lot of work — it must be very clear who’s working under contract.”
According to Friedman, misclassification of employees has serious implications for companies, as they are at risk for investigations and lawsuits from both federal and state governments, as well as private lawsuits from individuals or classes of individuals.
“Federal and state governments have been losing billions of dollars each year due to misclassifications and therefore have been putting more resources into identifying and prosecuting misclassifications.” — Debra Friedman, labor and employment practice group, Cozen O’Connor
In addition to taxes and benefits (including the value of lost benefits), a company may be liable for penalties (such as fines, liquidated damages and/or punitive damages), costs, interest, and attorneys’ fees, she said.
Companies also may be required to post notices about their wrongdoing in their workplaces, and, in California — even on their company websites.
“Importantly, federal and state governments have been losing billions of dollars each year due to misclassifications and therefore have been putting more resources into identifying and prosecuting misclassifications,” said Friedman.
“In 2011, the U.S. Department of Labor and the IRS entered in a Memorandum of Understanding [MOU] to share information for the purpose of identifying and reducing misclassifications of workers. Since that time, at least 14 states also have entered into MOUs with the U.S. Department of Labor to share information and reduce the incidence of worker misclassifications.”
The IRS also has an employment tax initiative in place to audit more than 6,000 employers, selected at random, with the objective of finding and correcting worker misclassifications.
Friedman pointed out that this increased government focus is resulting in millions of dollars in back wages and penalties.
In May 2013, for example, the DOL obtained a consent judgment against Bowlin Group LLC and Bowlin Services LLC, providers of infrastructure solutions, for more than $1 million in back wages and damages covering 196 employees.
Seventy-seven of the workers had been misclassified as independent contractors.
“On the state level, New York should serve as a cautionary tale,” Friedman added. “In 2013 alone, New York identified almost 24,000 instances of employee misclassification, uncovered more than $300 million in unreported wages and assessed nearly $12.2 million in unemployment insurance contributions.”
Other states also are getting increasingly tough on misclassification.
Massachusetts announced that in 2013, it collected more than $15 million in back taxes, unpaid wages, unemployment insurance contributions, fines and penalties related to employer fraud and misclassification. Earlier this year, a California state labor board ordered a logistics company to pay more than $2.2 million in back pay to seven drivers it misclassified as independent contractors.
With such high financial stakes it makes sense to avoid making these mistakes in the first place.
“Employers should keep in mind that whether an individual can work for their company as an independent contractor is not the employer’s decision,” said Sheryl Jaffee Halpern, labor and employment attorney at law firm Much Shelist. “It’s the government’s decision. The challenge is that the tests used by the IRS and the U.S. Department of Labor are not identical. And the agency responsible for administering unemployment benefits in the worker’s home state may apply yet a different test — which in many states is more stringent than the IRS’ and Department of Labor’s tests.”
Employers should become familiar with these tests, she said, and then use the relevant factors to assess on an individual basis whether a worker can properly be classified as an independent contractor.
That classification should come at the outset of the business relationship, Friedman said. Generally, she said, independent contractors have specialized skills that are not focused on the company’s core business functions. If in doubt, classify the worker as an employee or consider working through a workforce management or staffing company and have them make the classification determination.
“Employers should keep in mind that whether an individual can work for their company as an independent contractor is not the employer’s decision. It’s the government’s decision.” — Sheryl Jaffee Halpern, labor and employment attorney, Much Shelist
If such a mistake is made — and identified quickly — then what should a company do?
“Naturally, it’s best not to use the ostrich approach if a mistake has been made,” said Halpern. “That said, because reclassifying a worker can have unintended consequences, we recommend that an employer work with their legal counsel to devise the best strategy for correcting the mistake in a way that does not create additional exposure.”
Friedman said companies have various options for correcting misclassifications.
“If a company is acting on its own, a key consideration is whether to address the classification mistake retroactively by voluntarily paying back taxes or taking other remedial actions.
“Any decision on how to handle the mistake retroactively has risks of opening the door to employee claims and/or government investigations,” said Friedman.
If a company decides to voluntarily pay back taxes, it may want to consider working with the IRS, and possibly any applicable state governments.
Since 2011, the IRS has had a Voluntary Classification Settlement Program that is available to companies that voluntarily seek to reclassify independent contractors as employees and that are not under audit for misclassification by the DOL or a state agency, or under an employment audit by the IRS.
Under this program, companies have significantly reduced federal payroll tax liability, and no interest or penalties are assessed.
While this program clearly has some benefits for addressing misclassifications, Friedman said, companies may be exposed to lawsuits for unpaid wages (minimum wage and overtime) and benefits, as well as fines and penalties under other federal and/or state laws.
There may be companies that believe a misclassification mistake is not all that important.
But the growing number of firms that have been forced to pay substantial fines would loudly disagree.
A Renaissance In U.S. Energy
America’s energy resurgence is one of the biggest economic game-changers in modern global history. Current technologies are extracting more oil and gas from shale, oil sands and beneath the ocean floor.
Domestic manufacturers once clamoring for more affordable fuels now have them. Breaking from its past role as a hungry energy importer, the U.S. is moving toward potentially becoming a major energy exporter.
“As the surge in domestic energy production becomes a game-changer, it’s time to change the game when it comes to both midstream and downstream energy risk management and risk transfer,” said Rob Rokicki, a New York-based senior vice president with Liberty International Underwriters (LIU) with 25 years of experience underwriting energy property risks around the globe.
Given the domino effect, whereby critical issues impact each other, today’s businesses and insurers can no longer look at challenges in isolation one issue at a time. A holistic, collaborative and integrated approach to minimizing risk and improving outcomes is called for instead.
Aging Infrastructure, Aging Personnel
The irony of the domestic energy surge is that just as the industry is poised to capitalize on the bonanza, its infrastructure is in serious need of improvement. Ten years ago, the domestic refining industry was declining, with much of the industry moving overseas. That decline was exacerbated by the Great Recession, meaning even less investment went into the domestic energy infrastructure, which is now facing a sudden upsurge in the volume of gas and oil it’s being called on to handle and process.
“We are in a renaissance for energy’s midstream and downstream business leading us to a critical point that no one predicted,” Rokicki said. “Plants that were once stranded assets have become diamonds based on their location. Plus, there was not a lot of new talent coming into the industry during that fallow period.”
In fact, according to a 2014 Manpower Inc. study, an aging workforce along with a lack of new talent and skills coming in is one of the largest threats facing the energy sector today. Other estimates show that during the next decade, approximately 50 percent of those working in the energy industry will be retiring. “So risk managers can now add concerns about an aging workforce to concerns about the aging infrastructure,” he said.
Increasing Frequency of Severity
Current financial factors have also contributed to a marked increase in frequency of severity losses in both the midstream and downstream energy sector. The costs associated with upgrades, debottlenecking and replacement of equipment, have increased significantly,” Rokicki said. For example, a small loss 10 years ago in the $1 million to $5 million ranges, is now increasing rapidly and could readily develop into a $20 million to $30 million loss.
Man-made disasters, such as fires and explosions that are linked to aging infrastructure and the decrease in experienced staff due to the aging workforce, play a big part. The location of energy midstream and downstream facilities has added to the underwriting risk.
“When you look at energy plants, they tend to be located around rivers, near ports, or near a harbor. These assets are susceptible to flood and storm surge exposure from a natural catastrophe standpoint. We are seeing greater concentrations of assets located in areas that are highly exposed to natural catastrophe perils,” Rokicki explained.
“A hurricane thirty years ago would affect fewer installations then a storm does today. This increases aggregation and the magnitude for potential loss.”
On its own, the domestic energy bonanza presents complex risk management challenges.
However, gradual changes to insurance coverage for both midstream and downstream energy have complicated the situation further. Broadening coverage over the decades by downstream energy carriers has led to greater uncertainty in adjusting claims.
A combination of the downturn in domestic energy production, the recession and soft insurance market cycles meant greatly increased competition from carriers and resulted in the writing of untested policy language.
In effect, the industry went from an environment of tested policy language and structure to vague and ambiguous policy language.
Keep in mind that no one carrier has the capacity to underwrite a $3 billion oil refinery. Each insurance program has many carriers that subscribe and share the risk, with each carrier potentially participating on differential terms.
“Achieving clarity in the policy language is getting very complicated and potentially detrimental,” Rokicki said.
Back to Basics
Has the time come for a reset?
Rokicki proposes getting back to basics with both midstream and downstream energy risk management and risk transfer.
He recommends that the insured, the broker, and the carrier’s underwriter, engineer and claims executive sit down and make sure they are all on the same page about coverage terms and conditions.
It’s something the industry used to do and got away from, but needs to get back to.
“Having a claims person involved with policy wording before a loss is of the utmost importance,” Rokicki said, “because that claims executive can best explain to the insured what they can expect from policy coverage prior to any loss, eliminating the frustration of interpreting today’s policy wording.”
As well, having an engineer and underwriter working on the team with dual accountability and responsibility can be invaluable, often leading to innovative coverage solutions for clients as a result of close collaboration.
According to Rokicki, the best time to have this collaborative discussion is at the mid-point in a policy year. For a property policy that runs from July 1 through June 30, for example, the meeting should happen in December or January. If underwriters try to discuss policy-wording concerns during the renewal period on their own, the process tends to get overshadowed by the negotiations centered around premiums.
After a loss occurs is not the best time to find out everyone was thinking differently about the coverage,” he said.
Changes in both the energy and insurance markets require a new approach to minimizing risk. A more holistic, less siloed approach is called for in today’s climate. Carriers need to conduct more complex analysis across multiple measures and have in-depth conversations with brokers and insureds to create a better understanding and collectively develop the best solutions. LIU’s integrated business approach utilizing underwriters, engineers and claims executives provides a solid platform for realizing success in this new and ever-changing energy environment.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty International Underwriters. The editorial staff of Risk & Insurance had no role in its preparation.