The Fourth Circuit Restricts the Meaning of Direct Actions for purposes of Diversity Jurisdiction and Limits the Application of a Virginia Statute Meant to Protect Claimants when a Policyholder Fails to Provide Notice of a Claim

Introduction

In late February 2019, the Fourth Circuit issued an opinion detrimental to claimants seeking policy benefits under a judgment-debtor’s insurance policy. Gateway Residences at Exch., LLC v. Illinois Union Ins. Co., — F.3d —-, No. 18-1491, 2019 WL 963238 (4th Cir. Feb. 28, 2019). A property developer, Gateway, suffered property damage when two generators caught fire during a test. Mechanical Design Group (“MDG”) designed and installed the generators. Gateway made a claim against MDG, but MDG failed to report the claim under its claims-made and reported errors and omissions liability policy.

After Gateway obtained a judgment against MDG, it tried to collect the judgment from MDG’s insurer (Chubb) in Virginia state court. The insurer removed the case to federal court. Gateway argued that the court should remand the case because it lacked subject matter jurisdiction. Under the diversity jurisdiction statute, an insurer takes on the citizenship of its insured when a claimant files a direct action. The trial court ruled that Gateway’s suit was not a direct action and refused to remand the case. The Fourth Circuit affirmed.

Gateway also argued Chubb waived its right to decline coverage, because it failed to provide timely notice of its coverage defenses to Gateway. A Virginia statute mandates that insurers inform claimants of coverage defenses against the policyholder within 45 days of discovery, or waive those defenses. The trial court noted that Chubb’s policy covered only claims made and reported during the policy period. Because MDG never reported the claim, the trial court ruled the policy was not triggered, and Chubb’s reporting obligation to Gateway never arose. The Fourth Circuit affirmed.

As explained below, the Fourth Circuit’s decision is flawed. Among other reasons, it misconstrued a statute designed to protect claimants when a policyholder fails to provide notice as required under a policy.

The Claim

Illinois Union Insurance Company (“Chubb”) insured MDG under a Contractors E&O (Professional) Liability policy (the “policy”). Gateway hired MDG to design and install two generators at a condominium complex in Alexandria, Virginia (the “Gateway”). When tested in August 2014, the generators caught fire and resulted in over $900,000 in damage to the property. Gateway demanded that MDG repair the damage shortly after the loss. MDG, however, went out of business in September 2014. MDG did not report the loss to Chubb, and the policy expired on February 1, 2015.

Gateway notified Chubb of its intent to sue MDG in September 2016 and sued MDG later the same month. Chubb sent a denial letter to MDG in October 2016, but did not inform Gateway of its coverage decision. Gateway obtained a default judgment against MDG and then sued Chubb in Virginia State Court to collect on the judgment against its insured.

Chubb removed the action to the Eastern District of Virginia. Gateway sought to remand the case on the theory that the court lacked subject matter jurisdiction, because the parties were not diverse. Gateway argued its suit against Chubb constituted a “direct action.” Under 28 U.S.C. § 1332(c)(1), in a direct action the insurer takes on the citizenship of the its insured. As MDG was a Virginia corporation, Gateway argued there was no diversity jurisdiction, and that the court should remand the suit. The trial court rejected Gateway’s argument and denied its motion.

The focus of the dispute was the application of Va. Code. Ann. § 38.2-2226. This statute requires a liability insurer to inform the claimant (or its counsel) of a breach by the insured of the policy’s terms or conditions. Id. The insurer must provide notice of the breach within 45 days of the breach or of the claim, whichever is later. Id. The failure to provide the required notice results in a waiver of the coverage defense against a suit brought by the claimant against the insurer.

The trial court granted Chubb’s motion for summary judgment. It reasoned that because the policy insured only those claims made and reported during the policy period, and MDG failed to report Gateway’s claim during the policy period, there was no longer a policy to breach at the time Gateway provided notice.

The Fourth Circuit’s Decision

Gateway appealed both the denial of the remand and the grant of summary judgment to Chubb. With respect to the remand, Gateway argued that several courts applying Virginia law had referred to actions to collect a judgment against an insurer as a “direct action.” While conceding this point, the Fourth Circuit observed that none of these cases interpreted the meaning of “direct action” as used in 28 U.S.C. § 1332(c)(1). Following decisions from other federal circuits, the court found that the term had a narrow meaning, being, “a suit in which the plaintiff sues a wrongdoer’s liability insurer without joining or first obtaining a judgment against the insured.” Id. at *2. The court determined that the intent of 28 U.S.C. § 1332(c)(1) was to address jurisdictional issues in states that allowed claimants to sue a defendant’s insurer without first obtaining a judgment against the defendant. Id. The court ruled that Gateway’s suit was not a “direct action,” and Chubb did not assume the Virginia citizenship of its insured. The court affirmed the order denying Gateway’s motion to remand.

With respect to the grant of summary judgment to Chubb, the court emphasized that Va. Code. Ann. § 38.2-2226 required notice to the claimant when the insured breached the terms and conditions of the policy and therefore created a coverage defense. The court concluded that MDG did not breach a condition of coverage, so that there was no coverage defense. Instead, it reasoned that the policy had expired in February 2015, so “there was no ‘breach’ because, after February 2015, there was no policy to be breached. Gateway Residences, 2019 WL 963238, at *5. Although Gateway first made a claim during the policy period, the policy required notice to the carrier of that claim during the policy period. Because MDG never triggered coverage, the court concluded that Chubb had no obligation under § 38.2-2226. The court characterized Gateway’s claim as being outside the scope of the policy’s coverage. The court ruled that a denial based on the “scope of coverage” was not a “defense” under § 38.2-2226, so that Chubb was not obligated to provide notice of the denial to Gateway. Because Chubb had no obligation to provide notice, it did not waive any defenses to coverage. Id.

Comment

With respect to the court’s finding that a suit by a judgment creditor is not a “direct action” for purposes of diversity, it is unfortunate that the Fourth Circuit ignored prior precedent. The decision is consistent with other the law from other circuits, however. Accordingly, most insurers will be able to freely remove collection actions brought by claimants to federal court.

With respect to the court’s analysis of § 38.2-2226, there is much to criticize. First, the court entirely missed the purpose of the Virginia statute. The statute is intended to protect claimants in the event a policyholder fails to provide timely notice of a claim. See Liberty Mut. Ins. Co. v. Safeco Ins. Co. of America, 288 S.E.2d 469, 474 (Va. 1982). By its terms, the statute applies to “liability policies” and does not distinguish between occurrence-based policies and claims-made policies. Virginia enacted the statute in 1986, after claims-made policies had become prevalent, and the Commonwealth has revised the statute twice since its enactment. Presented with opportunities to limit the scope of the statute to occurrence-based policies, the legislature declined to do so. Clearly, the Virginia legislature intended the clause to apply to claims-made policies. This Fourth Circuit’s decision denies claimants protections afforded to them under Virginia law.

The court’s conclusion that Gateway’s claim fell outside the policy’s “scope of coverage,” and therefore was not a “defense” under § 38.2-2226, is a misunderstanding of Virginia law and the policy. The policy’s “scope of coverage” is professional loss that has resulted from wrongful acts in the performance of the insured’s professional services. The allegation that MDG committed errors in the design and installation of the generators appears to fall squarely into the scope of the policy’s coverage.

The timely reporting of a claim is a condition precedent to coverage, not the scope of coverage. Although notice during the policy period is part of the insuring agreement, MDG’s E&O policy also provided in its terms and conditions that timely notice was a “condition precedent.” Opening Brief of Appellant, Gateway Residences at Exchange, LLC, v. Ill. Union Ins. Co. 2018 WL 3440460, at *10 (4th Cir. 2019) (No. 18-1491). Virginia law has long treated timely notice as a condition of precedent to coverage. See State Farm Mut. Auto. Ins. Co. v. Porter, 272 S.E.2d 196, 200 (Va. 1980).

Further, the court misinterpreted when the breach occurred. The court stated, there was no ‘breach’ because, after February 2015, there was no policy to be breached. Gateway Residences, 2019 WL 963238, at *5. The breach occurred, however, during the policy period, when MDG failed to tender Gateway’s claim to Chubb. Accordingly, the court relied on flawed reasoning in concluding that there was no policy to breach. In sum, the Fourth Circuit ignored the purpose of the statute, confused the scope of coverage with conditions precedent for coverage and therefore failed to apply § 38.2–2226 as intended.

A few practical lessons may be drawn from the decision. First, if a contractor has committed an error, the property owner should consider tendering a notice of claim to the contractor’s insurer. Many insurance policies do not require the notice of claim come from the insured. If a contractor goes out of business, providing notice on behalf of the contractor is even more imperative.

Insurers, however, sometimes require notice to a specific person or address. The failure to meet these specific requirements may afford the insurer a coverage defense. Thus we suggest owners obtain copies of their contractor’s insurance policies. The advantage is two-fold. First, it allows the owner to verify the contractor has complied with the insurance requirements of the contract. Second, in the event of a claim, it allows the owner to evaluate the contractor’s coverage and provide notice to the insurers in compliance with the policy’s notice clause. We appreciate not all contractors will be willing to provide their insurance policies to an owner. Nevertheless, when an owner has sufficient leverage to demand this concession, this is a condition worth considering.