Fall, 1999
CLAIMS LAW UPDATE
MATERIAL
MISREPRESENTATION:
ARE THE COURTS CHANGING COURSE?
[Ref: Recognizing Fraud, Paras. 1.22]
So you thought you understood the legal standard for the materiality of a misrepresentation in the claims process? AEI students who have taken Recognizing Fraud will be familiar with the well-settled rule that a post-loss misrepresentation need not actually mislead the insurer in order to be material. As a federal Court of Appeals held in Fine v. Bellefonte Underwriters Ins. Co., 725 F2d 179 (2nd Cir. 1984), the insurer need only establish that the misrepresentation concerned some- thing that, at the time, was “relevant and germane to the insurer’s investigation as it was then proceeding.” Well, the Supreme Court of Nevada has news for you. That court’s recent decision in Powers v. USAA, 962 P2d 596 (Nev. 1998), was such a radical departure from the traditional analysis of materiality that a large part of the insurance industry, and a host of banking and business interests, tried to persuade the court to reconsider and reverse itself. The petition for reconsideration was denied on April 2, 1999. What could possibly have caused such an uproar?
THE PERILS OF THE SEA
The perils of the sea are many, but calm water is not one of them. So, when William Powers’ boat, the Mikimbi, sank in calm waters on April 28, 1987, his insurer, USAA, suspected fraud. In a sworn proof of loss submitted in June, the insured said that the main exhaust hose from the inboard engine had “deteriorated” and “failed” near the point where the hose passes through the hull (known as a “thru-hull”). A gate valve at the thru-hull was stuck open and could not be closed. A resulting “siphon effect” allowed seawater to enter the boat, ultimately causing it to sink. When USAA decided to raise the sunken boat, the insured changed his story. In an Examination Under Oath in October, 1987, he testified that the other end of the exhaust hose had become detached from the engine, allowing water to enter the boat through the hose. He cut the hose near the thru-hull and stuffed rags into the opening in the hull. Then, for reasons he could not explain, the insured reattached the hose, now dangling loose at both ends, to the engine. When the rags repeatedly fell out of the opening in the hull, the insured abandoned the boat.
Powers would seem to be a classic case of material misrepresentation and false swearing. In his Proof of Loss, the insured swore that the hose had deteriorated and failed. In his Examination Under Oath, he swore that he had cut the hose in an attempt to save the boat. One of these statements had to be false, and when the boat was raised, it was clear that the hose had not “deteriorated” but had been cut. The insured himself admitted that he initially “simplified” his story because he feared that USAA would deny his claim if he explained that he had deliberately cut the hose. At the time the Proof of Loss was submitted, USAA was investigating whether the insured had deliberately sunk the boat. Whether the exhaust hose deteriorated by itself or was cut by the insured certainly was “relevant and germane to the insurer’s investigation” at that time, even if it subsequently turned out that the condition of that end of the hose did not cause the boat to sink, an issue that never was conclusively determined.
USAA’s denial of the claim was based on a policy provision that voided the policy for “false swearing, concealment or misrepresentation of any material fact.” An open-and-shut case for material misrepresentation? The trial court didn’t think so, since it refused to find the misrepresentation material as a matter of law and allowed the jury to decide the issue, apparently over USAA’s objection. The jury found that the misre- presentation was not material and awarded damages (including punitive damages) to Powers based on breach of contract, bad faith, and breach of fiduciary duties. The Supreme Court of Nevada found sufficient evidence in the record to support the jury’s findings, and affirmed. In doing so, the court relied on two points. First, since the carrier suspected fraud from the outset, “USAA’s investigation of Powers would not have proceeded differently had he stated in May 1987 that he had cut the exhaust hose.” Second, “The condition of the hose at the thru-hull (i.e., cut or deteriorated) was not a relevant factor in the sinking of the boat.” Was this analysis consistent with what we all thought was settled law on materiality?
NEW YORK CITY FREEZE-OUT
For 15 years now, the leading case on the issue of materiality has been Fine v. Bellefonte Underwriters Ins. Co., 725 F2d 179 (2nd Cir. 1984). Landlord Fine had no use for the various artists, warehousers and other commercial tenants that occupied his newly-purchased buildings in New York City, since he planned to convert them to residential use. Unable to persuade a few stubborn tenants to leave, Fine decided to enlist Mother Nature in a mid-winter “freeze-out,” setting a thermostat so that the heating system would start up only when the outdoor temperature fell below freezing. Then, on a February night when the temperature hovered near zero, the remaining holdouts were burned out of the premises by a fire of unknown origin.
Naturally, Fine had the buildings insured against fire. During its investigation, the carrier found that the sprinkler system had failed to operate because, as one might expect, the water pipes froze. Surely Fine’s “freeze-out” policy couldn’t have contributed to this, since he testified under oath that the heat was set at 40ºF. In fact, however, the superintendent had set the heat at 30ºF (in violation of instructions to set it at 25ºF!). The carrier then denied Fine’s claim on grounds of false swearing. In Fine’s suit under the fire policy, the trial court, noting that the temperature on the night of the fire was so cold that the sprinkler system would have frozen even if the heat had been set at 40ºF, ruled that, “Since the Fine policy of freeze-out has not been proved to be the cause of the freeze-up, the false statements ... were not material.” The carrier, unamused, appealed.
The Court of Appeals reversed, ruling that, in order to be material, a misrepresentation need not relate to a subject that ultimately proves to be decisive or significant in the disposition of the claim. It need only relate to a subject that is “relevant and germane to the insurer’s investigation as it was then proceeding.” Materiality is “not to be judged by what the facts later turn out to have been.”
Fine’s insurer was exploring the possibility that the insured’s “freeze-out” strategy contributed to the failure of the sprinkler system, which the court described as “a plausible theory reasonably derived from the available factors.” The purpose of the EUO was to provide a means by which the insurer could evaluate that theory and determine the position it should take with respect to the claim, and Fine’s misrepresentation interfered with that process. In other words, whether the heat was set above or below freezing was, at the time, significant to the company in determining its course of action, and therefore was material. The fact that the heat setting did not contribute to the loss, and that the misrepresentation therefore would not have caused the insurer to pay the claim, was simply irrelevant. While Fine v. Bellefonte is binding only on federal courts in the Second Circuit (which consists of Connecticut, New York, and Vermont), it has been cited by numerous state and federal courts all over the country as the leading case on materiality in the claims process, and has not been reversed or overruled. So, the fact that Powers’ cutting of the exhaust hose may not have caused his boat to sink should also have been irrelevant. How did the court in Powers get around this?
THE CASE OF THE GAS CAN MAN
The court in Powers relied heavily on Pacific Indemnity Co. v. Golden, 985 F2d 51 (2nd Cir. 1993), which discussed Fine in reaching its own questionable conclusion on materiality. Golden involved a fire claim under a homeowners policy. The insured had stored large quantities of gasoline in garbage cans on the premises and, although the fire apparently was extinguished before these containers were ignited, the fire marshal’s initial report indicated that the fire had been set, probably with gasoline as an accelerant. At first, the insured said that he and a neighbor had brought the gas into the house some nine months before the fire, for use with a snowmobile. When witness statements established that the gas could not have been in the house at that time, the insured changed his story, admitting that he had lied and stating that he had brought the gas into the house during the month before the fire, intending to use it to poison his neighbor’s lawn.
The homeowners carrier denied Golden’s claim and filed an action for a declaratory judgment of non- liability. The carrier then made a motion for summary judgment based solely on misrepresentation, which was granted by the trial court. In reversing the summary judgment on appeal, the U.S. Court of Appeals for the 2nd Circuit (the same court that decided Fine) ruled that there was sufficient conflicting evidence to submit the issue of materiality to a jury, and remanded the case for trial. In other words, in the appellate court’s view, a reasonable jury could find that Golden’s misrepresenta- tion regarding the gasoline in his home was not relevant to the insurer’s investigation of a suspicious fire claim.
In light of the presence of numerous fraud indicators in Golden, (the recently-upgraded fire alarm failed to function, the insured had tried to sell the house and had recently increased his insurance coverage, and there were two mortgages on the property), arson by the insured was, like the freeze-out theory in Fine, “a plausible theory reasonably derived from the available factors.” Whether the gas had been on the premises for nearly a year or was brought in shortly before the fire would seem to have been relevant to the insurer’s investigation of a potential arson defense. If the gas was brought in shortly before the fire rather than nine months before, isn’t it is more likely that it was brought in with the intention of feeding the fire and assuring the total destruction of the house?
The appellate court didn’t see it that way. While acknowledging that the misrepresentations in Fine were material because they affected the insurer’s investigation of “a theory that could result in its denial of coverage,” the court simply ignored the fact that the same was true in Golden. The better view would seem to be that of the trial court, which stated, with admirable clarity and common sense, that “when a home is destroyed by fire, and the Fire Marshall initially suspects gasoline was used to fuel the fire, then any statements regarding the origin of gasoline found on the premises must be material to an insurer’s investigation.”
A CAFETERIA APPROACH TO LEGAL ANALYSIS
How did we get from Fine v. Bellefonte to decisions such as Golden and Powers? It seems that these courts, rather than overrule Fine or decline to follow it, simply took a cafeteria approach, choosing the language they liked from Fine, altering it slightly to support their rulings, and leaving key passages from the court’s opinion on the shelf. Specifically, the court in Fine held that:
False sworn answers are material if they might have affected the attitude and action of the insurer. They are equally material if they may be said to have been calculated either to discourage, mislead or deflect the company’s investigation in any area that might seem to the company, at that time, a relevant or productive area to investigate.
The key phrases in this passage are italicized here for emphasis, because they seem to be the very phrases that the Golden and Powers courts chose to ignore. In Golden, the court stated that:
Pacific has failed thus far to show that ... its investigation would have proceeded differently had Golden initially given his true reason for storing the gasoline at his house. The interviews conducted by Pacific following the December 12, 1988 interview of Golden merely revealed that the gasoline was not present as early as February, 1988. Thus, there is insufficient evidence in the record to determine whether Golden’s misrepresentations either affectedPacific’s “attitude and action” or discouraged, misled or deflectedits investigation ...”
Similarly, the court in Powers stated that:
To be deemed a material misrepresentation, it must be shown that the insurer’s investigation would have proceeded differently had the insured told the truth.
Since USAA “was suspicious of Powers’ claim from the outset due to the fact that the Mikimbi sank in calm waters,” the court continued:
In the instant case, there was ample evidence upon which the jury could have concluded that USAA’s investigation of Powers would not have proceeded differently had he stated in May 1987 that he had cut the exhaust hose.
The subtle change from Fine should now be obvious. Under Golden and Powers, it is not enough that the insured’s misrepresentation “might have” affected the insurer’s investigation or “may be said to have been calculated” to mislead or deflect the investigation. To be material, the misrepresentation must actually change the way the insurer conducts its investigation. In Fine, however, the court never even suggested that the insured’s misrepresentation actually caused his insurer’s investigation to proceed differently, and certainly didn’t require such proof as an element of materiality. Nevertheless, the court continued to rely on the fact that “USAA would have done nothing different in its investigation had it known the hose was cut rather than ‘deteriorated.’ ” While this may be true, the misrepre- sentation clearly was calculated to deflect the investigation. As the court itself noted, “Powers admitted that he had misrepresented the detachment of the hose because he was worried that USAA would summarily deny his claim.”
As noted above, the court in Powers also relied on the absence of any finding that the insured’s act of cutting the exhaust hose caused the boat to sink. Some six months after the sinking, the insured stated for the first time that the exhaust hose had been dislodged from the engine, allowing water to enter the boat. Noting that the boat’s designer had testified that this, rather than the cutting of the hose, had caused the boat to sink, the court found that the insured’s misrepresentation was “not reasonably relevant to USAA’s investigation” because “the condition of the hose at the thru-hull (i.e., cut or deteriorated) was not a relevant factor in the sinking of the boat.”
Of course, the jury was never asked what caused the boat to sink. They were asked to decide only whether Powers’ misrepresentation was material. His theory that the boat sank because the exhaust hose came loose from the engine manifold, and not because he cut it at the thru-hull, would seem to run aground on the inconvenient fact that, when the boat was raised, the hose was still attached to the engine. Now we know why Powers was forced into the unfathomable contention that, after cutting one end of the hose at the thru-hull, he then reattached the opposite end of the dangling hose to the engine before fleeing the sinking boat. The court ruled that a reasonable jury could accept this theory, and if it did, it would render the insured’s misrepresentation regarding the “deteriorated” hose immaterial. This conclusion obviously leaves the following language from Fine on the cafeteria shelf:
[A] misrepresentation will be considered material if a reasonable insurance company, in determining its course of action, would attach importance to the fact misrepresented.
It thus appears that materiality of false statements is not determined by whether or not the false answers deal with a subject later determined to be unimportant because the fire and loss were caused by factors other than those with which the statements dealt.
Applying these principles to the insurer’s investigation of a “freeze-up” theory in Fine, the court ruled:
The questions were material to that investigation. It is irrelevant whether Bellefonte was ultimately able to muster sufficient evidence to prove its theory at trial.
Thus, the fact that Fine’s sprinkler system would have failed, and his buildings would have burned to the ground, even if he had set the heat at 40ºF was simply irrelevant. The temperature setting was, at the time, a relevant area for the insurer to look at, and Fine’s misrepresentation was material even though it was “later determined to be unimportant.”
Similarly, the fact that Golden’s house would have sustained the same fire damage even if he had brought the gas onto the premises nine months before the fire, rather than one month before, should have been irrelevant. If the gas was brought into the home only one month before the fire, it is more likely that the insured intended to use it to start or feed the fire. Thus, the subject of the insured’s misrepresentation was, at the time, a relevant subject for his homeowners carrier to examine even though those particular containers of gas were not involved in the fire. And, whether Powers’ exhaust hose was cut deliberately or “deteriorated” certainly was a relevant subject of inquiry in the investigation of the sinking of the boat, even if one accepts (as the majority opinion apparently does) the questionable proposition that the condition of the hose had nothing to do with the sinking.
CONCLUSION
Under Golden and Powers, a misrepresentation in the claims process is not material, and provides no basis for denial of the claim, unless it (1) actually influences the direction of the insurer’s investigation, or (2) concerns something that actually caused the loss. Consider how this might affect the actions of a “guilty” insured. Let’s say you’re Mr. Powers and you really did sink the boat by cutting the exhaust hose. Do you have anything to lose by lying? If the insurer buys your story and pays the claim, well, what they don’t know won’t hurt them. If they raise the boat and discover the truth, the lie will not have altered the course of the investigation. You can point out that the boat went down in calm water (a dissenting justice also made reference to “deep financial and domestic trouble”), so the carrier was suspicious from the start. They were going to raise the boat anyway, and your lie didn’t change a thing. If the carrier can’t prove that cutting the hose actually caused the sinking, your lie isn’t material, and you get paid. And if they do prove it? You’re not getting paid anyway, so your lie didn’t hurt you. Under Fine, the lie is material as a matter of law, and the same case would be dismissed by a judge, perhaps on a motion for summary judgment.
But what if the insured truly is innocent? That is, what if Powers really did find the exhaust hose detached from the engine, try to close the gate valve, cut the hose at the thru-hull, and try to re-attach the other end to the engine before abandoning ship? Anyone who finds himself in that kind of a bind should follow this advice: DON’T LIE. The story may be a tough sell, but it will have much more credibility if the carrier’s investigation does not reveal any glaring inconsistencies between the story and the facts.
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