Flexsys America LP v XL Insurance Co Ltd [2009] EWHC 1115 (Comm)

Andrew Bartlett QC and Daniel Shapiro successfully represented XL against a claim by its insured for indemnity under the provisions of a drop down clause in a Master Policy. This is the first English decision as to the construction and effect of a drop down clause and the additional cover thereby provided by such clauses. The Court also considered whether there was no cover under the local policy (which was governed by Ohio Law) because of various deliberate act exclusions.

1. Flexsys America LP ("Flexsys") is a subsidiary company of Flexsys Holdings BV, a global concern based in Belgium. Flexsys manufactures, distributes and sells a chemical called 6PPD which has a variety of end uses and, in particular, is used in the manufacture of rubber tyres.

2. XL Insurance Co Ltd ("XL"), insured the Flexsys group pursuant to a Public and Products Liability Policy ("the Master Policy") governed by English law. The Master Policy is part of a global insurance programme under which, in addition, various local policies are issued in specific jurisdictions.

3. Flexsys was insured by XL Select (a US company related to XL) under a local Commercial Lines policy issued in the US state of Ohio ("the local policy") governed by Ohio law. Similarly to the Master Policy, the local policy provided a range of public and products liability cover.

4. Korea Kumho Petroleum Co Ltd ("KKPC") brought a claim against Flexsys on the basis that Flexsys, with others, engaged in an unlawful conspiracy to monopolize the US market for 6PPD and to hamper KKPC from competing fairly against it. Flexsys claimed indemnity from XL Select under the "Personal and Advertising Injury"cover provided by the local policy. In the event, XL Select reached a settlement ("the Settlement") with Flexsys which exhausted the local coverage which has a limit of $1M. The Master Policy limit of indemnity is $25M any one event. Flexsys was seeking to claim up to a further $25M of cover under the Master Policy pursuant to the provisions of a drop down clause in the Master Policy known as Memorandum E. Memorandum E of the Master Policy provides:

"Memoranda (each of which is subject otherwise to the terms of this Policy)Memorandum E: Drop Down ClauseIn the event of partial exhaustion of a local policy this Policy will pay in excess of the reduced underlying Limit of IndemnityIn 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"

5. Flexsys contended that the meaning of the second sentence is that Master Policy drops down to cover the current claim on all the terms of the local policy except for the local limit of $1M. Flexsys alleged that the limit of the Master Policy (but none of the other terms of the Master Policy) applies so as to provide a further $24M of cover on the terms of the local policy towards indemnifying the same claim by KKPC and the defence costs of KKPC's claim. Flexsys effectively contended that the Master Policy operates as an excess of loss cover in the event of exhaustion of the local policy by a single claim.

6. XL contended that on the true construction of the second sentence of Memorandum E, following the total exhaustion of the local policy, the Master Policy "drops down" to provide cover subject to the terms of the local policy in respect of a subsequent claim on the terms of the local policy in the same policy year. It does not provide further cover for the existing claim which exhausted the limits of the local policy. Although excess of loss cover is in general available under another of the Memoranda of the Master Policy (Memorandum C) no such cover is available where a claim is covered under the wider terms of the local policy but is irrecoverable under the terms of the Master Policy. (It was common ground that in the absence of Flexsys' construction of Memorandum E, under the terms of the Master Policy Flexsys would have no claim, because the relevant cover was in respect of legal liability for advertising injury arising out of Flexsys advertising its products or services and the claim brought by KKPC did not so arise.)

7. Tomlinson J found that XL's construction of Memorandum E is correct. In summary the drop down provision applies so as to provide additional cover under the Master Policy for subsequent claims following the partial or complete exhaustion of a local policy by a previous claim or claims. It is intended to prevent gaps in cover arising between the local and Master Policies after the payment of previous claims. It does not provide additional excess of loss cover in respect of the same claim that has exhausted the limits of the local policy.

8. Tomlinson J held that the precise operation of a drop down clause will be dependent upon its terms. On the terms of Memorandum E there was no dropped down cover for Flexsys' claim as,

  • The Master Policy (by Memorandum D) specifically provides cover from the ground up where the terms and conditions of the Master Policy are broader than the local policy. As there is no express provision in similar terms dealing with the converse case where the terms and conditions of the Master Policy are narrower than those of the local policy the ordinary inference is that the Master Policy will not respond in those circumstances.
  • XL's construction ensures that the same phrase "in the event of ... exhaustion of a local policy," is read with the same meaning in both sentences of Memorandum E.
  • XL's construction of Memorandum E is consistent with the two sentences of Memorandum E achieving broadly similar objectives, i.e. the avoidance of gaps in cover through the reinstatement of the local policy in respect of subsequent claims. It is also consistent with the Master Policy "dropping down", a process which involves the provision of cover by the Master Policy at a lower level or attachment point than is normal.
  • XL's construction has the advantage that it does not require the expression "subject to the terms, Exceptions and Conditions of the particular local Policy" to be read in the unnatural sense that it does not include the local limits of indemnity, whether specific or aggregate, which are as much terms and conditions of the local policy as are the other express provisions in the cover.
  • Flexsys' construction is odd in six respects. (i) Extension 10 of the Master Policy limiting cover for liability for advertising injury to that arising out of product advertising, is meaningless since in the event of a claim exhausting the local cover the Master Policy will drop down on the terms of the local policy. (ii) the Master Policy is responding to a claim which is not covered according to its terms. (iii) although responding on the terms of the local policy, the Master Policy is responding on terms more favourable than the local policy applies to a claim of that type, to which the local policy applies both a specific and a general aggregate limit of US$1 million in respect of a claim or claims brought by any one person or organisation. (iv) the construction achieves "duty to defend" cover up to a limit of indemnity of US$25 million out of a Master Policy which incorporates no reference to any such duty, specifically provides that there is cover only for defence costs incurred with insurers' consent, and does not cover the underlying claim. (v) On Flexsys' construction the cover which "continues in force" as the dropped down cover is subject to the limits of indemnity of the Master Policy although otherwise subject to the terms, conditions and exceptions of the local policy. If the dropped down cover is subject to the Master Policy limit of indemnity it is difficult to see why it is not also subject to the Master Policy excess, which regulates the point at which the limit begins to be eroded. However if this were so, the purpose of the drop down cover in providing cover from the ground up would be severely compromised, since subsequent claims would need to exceed the applicable Master Policy excess before cover is available. (vi) The reaching of an event based particular limit would not ordinarily be described as "total exhaustion of" a policy, whereas that was the effect of Flexsys' construction.

9. At paragraph 20 the Judge approved some general background statements about drop down clauses in global insurance programmes. He also referred to an IRMI paper on drop down clauses and noted that of the various examples of drop down clauses provided none would provide excess cover in respect of a single claim which itself exhausts the primary policy. All of the examples given posit exhaustion by prior claims. Although every drop down clause will depend on its own terms, the case provides guidance as to the proper construction of such clauses consistent with their commercial purpose.

10. As well as the main issue, the Judge also considered whether Flexsys was in fact entitled to an indemnity under the local policy pursuant to Ohio law. He found that there was no cover under the local policy in respect of product disparagement because such cover was qualified by Exclusions 2(a) and 2(b), which exclude from cover personal and advertising injury (a) caused by or at the direction of the insured with the knowledge that the act would violate the rights of another and inflict personal and advertising injury and (b) arising out of oral or written publication of material, if done by or at the direction of the insured with knowledge of its falsity.

11. The court has to look at the allegations in KKPC's complaint through the prism of Ohio law as it relates to the proper construction of the local policy for the purpose of determining the ambit of the coverage given. Under Ohio Supreme Court case law, when the allegations in a complaint filed against a policy holder arguably or potentially bring the claim within the indemnity coverage of the policy, the insurer is required to provide a defence of all claims, regardless of the outcome of the underlying action or the insurer's indemnity obligations to the insured. The duty to defend based on the allegations presented in the complaint is a broader duty than the duty to indemnify.

12. The approach in Ohio is that whilst "the duty to defend may arise from the complaint alone if the allegations in the complaint unequivocally bring the action within the policy coverage ... the duty to defend need not arise solely from the allegations in the complaint but may arise at a point subsequent to the filing of the complaint" - see City of Willoughby Hills v Cincinnati Insurance Co 9 Ohio St. 3d 177, 180 (1984). Notwithstanding the apparent width of this approach, and the fact that "the scope of the allegations may encompass matters well outside the four corners of the pleadings" - see again City of Willoughby Hills - there is no reluctance on the part of the courts of Ohio in plain and obvious cases to declare that the duty to defend is simply not made out. See Motorists' Mutual Insurance Company v. National Dairy Herd Improvement Association 141 Ohio App. 3d 269, 750 N.E. 2d 1169, a judgment of the Court of Appeals of Ohio, Tenth District.

13. Tomlinson J considered that this was a plain and obvious case where the duty to defend is simply not made out. KKPC's Complaint alleges a series of intentional acts forming part of a conspiracy to exclude KKPC from the US market. It is a litany of allegedly improper conduct, carried out intentionally and with a clear intent to injure. The whole thrust of KKPC's Complaint at every point is that Flexsys has pursued a deliberate and concerted course of conduct designed to keep KKPC out of the market and to that end has told deliberate untruths to the effect that KKPC was guilty of patent infringement. What is alleged is commercial intimidation to maintain market share in the face of competition. The notion that such conduct could be characterised as simply negligent or reckless is, in the Judge's view, absurd. Liability in respect of such conduct is plainly excluded from the ambit of the local policy cover.

14. Tomlinson J also considered that the fact that XL Select paid out the limit of indemnity in settlement of the claim by Flexsys. This was no deterrent from the conclusion that the duty to defend is not here made out. In Ohio an insurer can be liable in damages where it has denied coverage in circumstances characterised as bad faith. An insurer who is found not to have had reasonable justification for its understanding of the position is regarded as having acted in bad faith, and this failure can come about through incompetence, stupidity or mistake. The fact that in such circumstances XL Select chose to pay out a relatively modest limit of indemnity without admission of liability is not a particularly powerful indicator as to how an Ohio court would approach the matter.

Andrew Bartlett QC and Daniel Shapiro were instructed by David Philip of Kennedys Solicitors.

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