Daily Archives: April 21, 2011

New York’s Highest Court Requires Policyholder-Specific Choice-of-Law Analysis by Insurers in Liquidation

The New York Court of Appeals decision on April 5, in the Midland Insurance Company liquidation (In re Liquidation of Midland Insurance Company[1]) is an important affirmation of policyholder rights.

In this decision, New York’s highest court held that a policyholder is entitled to a claim and policy-specific choice of law analysis in the liquidation process, rejecting the Midland liquidator’s effort to make a blanket application of New York law to Midland’s 38,000 policyholders. The essential holding of the New York Court of Appeals, i.e., that insolvency does not alter an insurer’s obligations to its policyholders, is not itself remarkable. However, this holding by New York’s highest court will have broad implications because of New York’s status of the domicile of hundreds of insurance companies. And, because this decision is also consistent with the decision of the only other state supreme court to address this question, policyholders may more confidently assert an individualized choice-of-law position when prosecuting claims in insurance company liquidation proceedings.

In liquidation proceedings, policyholders typically are required to submit claims to the liquidator of the insurance company in liquidation, appointed by the state regulatory body of the state in which the insolvent insurer is chartered. An “allowed claim” or “recommended amount” in the liquidation process must typically be approved by a trial court in the state in which the insurance company in liquidation is chartered. This court also hears disputes when a policyholder disagrees with a determination by the liquidator. Frequently, liquidators seek to make a blanket application of the law of the state in which the liquidation is proceeding, not only for administrative reasons but also because the law of such jurisdiction is typically friendly to insurers. New York is a particularly apt example of such a jurisdiction.

Background

Midland Insurance Company is a New York-chartered multiline insurer.[2] When the New York State Insurance Department determined that Midland’s liabilities exceeded its assets in 1985, Midland was placed into liquidation pursuant to Article 74 of the New York Insurance Law (Article 74).[3] Pursuant to the liquidation order, the Superintendent of the Insurance Department (the Liquidator) took possession of Midland’s property and sold or otherwise disposed of it.[4] The Liquidator provided notice to persons with potential claims against Midland, including more than 38,000 known Midland insurance policyholders.[5]

Claimants in Midland were policyholders based in various states who submitted proofs of claim to the Liquidator seeking an allowed claim in the liquidation for various environmental and toxic tort liabilities.[6] The Liquidator determined that some of the policyholders’ claims should be disallowed, prompting the policyholders to file an objection with the New York Supreme Court.[7] A key aspect of the policyholders’ objections was the Liquidator’s unilateral decision to make a blanket application of New York law in making its disallowance decisions.[8] The New York Supreme Court disagreed with the Liquidator, concluding that the applicable substantive state law should be decided based on the “grouping of contacts” approach of the Restatement (Second) of Conflict of Laws, and that a choice-of-law determination must be made on a case-by-case basis.[9] Under the “grouping of contacts” analysis, “[i]n the context of liability insurance contracts, the jurisdiction with the most ‘significant relationship to the transaction and the parties’ will generally be the jurisdiction ‘which the parties understood was to be the principal location of the insured risk . . . unless with respect to the particular issue, some other [jurisdiction] has a more significant relationship.’”[10]

The New York Appellate Division reversed. It distinguished the policyholders’ insurance claims from claims against solvent insurers, reasoning that New York law must apply to the claims in a liquidation proceeding because of New York’s “paramount” interest in ensuring equitable distributions from an insolvent insurer’s estate.[11] The Appellate Division voiced concern that to do otherwise would create “subclasses” among the policyholders in violation of New York Insurance Law Section 7434(a).[12]

The Final Decision

On further appeal, the New York Court of Appeals found the Appellate Division’s decision to be in error, concluding that each policy in dispute should receive an individual choice-of-law analysis to determine which jurisdiction’s law should govern. The Court of Appeals reaffirmed that under New York law, the “center of gravity” or “grouping of contacts” approach applies to choice-of-law when an insolvent insurer is involved.

The Liquidator did not dispute the applicability of the rule to claims against solvent insurers, but argued that Article 74 creates an exception to the rule where the insurer has been adjudged insolvent and is in liquidation.[13] The Court of Appeals performed a thorough analysis of Article 74 and flatly rejected the Liquidator’s arguments. The court concluded that post-insolvency laws do not address choice-of-law issues or dictate any variation in common law choice-of-law principles when handling claims.[14] The court acknowledged that the policyholders’ claims against Midland derived from insurance policies that were issued prior to insolvency and reasoned that, because the “grouping of contacts” analysis would apply to claims submitted to an insurer, there was no reason that claims submitted to a liquidator after the insurer’s insolvency should be treated differently.[15] To the contrary, the court recognized that blanket application of New York law to all of the policies would conflict with the statutory mandate that the Liquidator determine the amount “justly owed” to the policyholders because the calculation of what is “justly owed” varies based on different jurisdictions’ methodologies of calculating the insured’s loss.[16] The Court of Appeals further dispensed with the Appellate Division’s concern that to allow individual law choice-of-law analyses would create prohibited “subclasses” of persons entitled to distributions from the liquidations.[17] The court held that the proscription against subclasses applies only to the treatment of claimants at the asset distribution phase, not at the claim allowance or valuation stage.[18]

Thus, through its analysis of the plain language of Article 74, the court concluded that the policyholders are “entitled to an evaluation of their claims by the Liquidator under the same common law choice-of-law principles that clearly applied to their claims prior to Midland’s insolvency.”[19]

Implications

The holding of Midland is consistent with the language of general liability policies and with existing law.[20]

The New York Court of Appeals approvingly cited a 2004 Missouri Supreme Court case that held that “the insurer’s insolvency did not change its coverage obligations” and that “insurer insolvency laws did not address choice-of-law and therefore Missouri’s pre-insolvency choice-of-law principles continued to govern the insurance policies at issue.”[21] With these two state supreme court decisions reaching the same result, policyholders prosecuting claims in insurer liquidation proceedings may confidently assert individualized choice-of-law positions, either on a policyholder-specific, claim-specific, or policy-specific basis, just as they would if they were litigating over coverage in a court of law.

Terminations For Convenience And Creedence Clearwater Revival: “Bad Moon Rising”

The U.S. won’t be able to avoid a crippling debt crisis as long as Congress refuses to include defense spending . . . in the mix of program cuts to reduce federal spending, the co-chairman of the presidential debt commission said Tuesday.   Army Times, March 8, 2011, available here

Terminations for the Government’s convenience developed as a tool to avoid enormous procurements upon completion of a war effort.  Because public policy counseled against proceeding with wartime contracts after an end to [Civil War] hostilities the government, under certain circumstances, began to terminate contracts and settle with the contractor for partial performance.  

Krygoski Constr. Co. v. United States, 94 F.3d 1537 (Fed. Cir. 1996)

It now is generally accepted that the federal budget must be reduced drastically, although just how drastically and where is still a matter for debate.  But public policy already has “counseled against proceeding” with certain procurements, and the process of terminating increasing numbers of contracts for the convenience of the government already may have begun in earnest, as indicated by the following developments:

  • On January 13, 2011, the Commandant of the Marine Corps recommended cancellation of the Marine Corps Expeditionary Fighting Vehicle (“EFV”) because its costs had become “too onerous.” He did so in the face of the outspoken opposition of many senior Marine generals who believed that without the EFV the Marines would “have to begin abandoning the [amphibious] mission that has long been at the core of their identity.”
  • On February 4, 2011, the White House web site boasted that it has reduced contract spending from an annual 12% increase between 2000 and 2008, to a FY 2010 reduction to “$535 billion versus $550 billion in the prior year.” To accomplish this feat, agencies have, among other things, “ended unnecessary or unaffordable contracts,including contracts for weapons systems, information technology, financial management, operations and maintenance, transportation and fuel.”  (emphasis in original). But the White House cautions that “[t]here is still much to be done to make sure every contracting dollar is well spent.”

This posting offers a brief review of the history and principles of the government’s right to terminate for convenience, including two recent decisions that illustrate just how minimal courts and Boards of Contract Appeals view the limits that exist on the Government’s authority to exercise that right.

The Government’s termination right is unilateral; it is not “balanced by a comparable right or advantage to the contractor.”

As the Federal Circuit explained in Krygoski, the concept of termination for convenience first appeared at the end of the Civil War. Krygoski Constr. Co. v. United States, 94 F.3d 1537, 1541 (Fed. Cir. 1996) (citations omitted).  It since has evolved into a powerful and mandatory contractual provision that gives the government the right to terminate a contract “in whole or . . . in part . . . [without cause] if . . . termination is in the Government’s interest.”  FAR 52.249-2 Termination for Convenience of the Government (Fixed Price) (May 2004).  The clause limits contractor recovery to reasonable costs of preparing the termination settlement proposal, costs actually incurred in performance of the contract work, plus a reasonable profit on those costs, thereby relieving the government of the obligation of paying anticipatory profits (i.e., breach damages) on the work that, but for the termination, the contractor would have performed.  See Dairy Sales Corp. v. United States, 219 Ct. Cl. 431, 593 F.2d 1002 (1979). Moreover, if the government can show that the contractor would have incurred a loss on a fixed price contract had it been completed, then (i) profit will not be allowed even on the work performed and (ii) the costs of performance recovered will be reduced in an amount proportionate to the projected loss. FAR 49.203(a); Systems & Computer Info., Inc., ASBCA No. 18458, 78-1 BCA ¶ 12,946.  These provisions give the government a broad and indeed unique right not “balanced by a comparable right or advantage to the contractor.”  District of Columbia v. OFREGO, 700 A.2d 185, 199 (D.C. 1997), citing John Cibinic, Jr., & Ralph C. Nash, Jr., Administration Of Government Contracts, 1073-1075 (3d ed. 1995).

The Government’s right to terminate for convenience is extremely difficult to overturn.

The government’s right to terminate a contract for convenience generally has been viewed as virtually bullet-proof.  For many years the contractor was required to present “well nigh irrefragable proof” of bad faith or abuse of discretion on the part of the contracting officer to justify a finding of breach.  Kalvar Corp. v. United States, 211 Ct. Cl. 192, 543 F.2d 1298 (1976), cert. denied, 434 U.S. 830 (1977). Then, for a brief period, it was believed that the government must show some change in circumstances between contract award and termination to justify exercise of its right or risk a determination that its termination was undertaken in bad faith.  Torncello v. United States, 231 Ct. Cl. 20, 681 F.2d 756 (1982). But the Federal Circuit severely limited Torncello in 1996 by ruling in Krygoski that Torncello’s changed circumstances doctrine could no longer apply in light of the Competition in Contracting Act, which “permits a lenient convenience termination standard.” For example, a contracting officer may discover that the specifications “inadequately describe the contract work” and “may therefore need to terminate [the] contract for the Government’s convenience to further full and open competition.” The court did note that “the Government’s authority to invoke a termination for convenience has . . . retained limits,” i.e., the government can not act in bad faith by, for example, entering into a contract with no intention of performing it or terminating a contract “simply to acquire a better bargain from another source.” Krygoski, 94 F.3d at 1541,1543.  More recent cases have established that bad faith must be proved by “clear and convincing” evidence, including a showing that the contracting officer was motivated by malice towards the contractor, which can be demonstrated by showing, among other things, “a specific intent to injure” or a “conspiracy . . . to get rid of” the contractor.  Am-Pro Protective Agency, Inc. v. United States, 281 F.3d 1234, 1241 (Fed. Cir. 2002) (citations omitted). The bar to overturning a T for C, plainly, is extraordinarily high.

The Government can terminate for convenience even if it has prior knowledge of facts indicating that it might want to terminate the contract for convenience in the future. 

In McHugh v. DLT Solutions, Inc., 618 F.3d 1375 (Fed. Cir. 2010), the CAFC reviewed and reversed a decision of the Armed Services Board of Contract Appeals (“ASBCA”) holding that (i) the government had breached a “non-substitution clause” stating that the government agreed not to replace the software it was purchasing “for a period of one . . . year” after the contract expires or is terminated” so that (ii) the government’s termination of the contract for convenience was a breach of contract which together made the government liable for “expectation damages.” After the contractor delivered the software, the procuring agency realized that its platform was inadequate to support the software and the agency with approval responsibility refused to approve its use.  The procuring agency continued to use its existing software, with upgrades, and terminated the contract for convenience of the government.  In reversing the Board’s holding, the Federal Circuit noted that the Board had “specifically found that [the agency] terminated the contract because its platform was inadequate and it could not obtain approval of the oversight agency, and held that “in light of . . . changed circumstances . . . the government was justified in utilizing the termination for convenience clause in terminating the contract . . . .” But the Court took special care to emphasize that use of the clause was justified “even if the agency had prior knowledge that it might not be successful in deploying the contracted for software,” citing Caldwell v. Santmyer, Inc. v. Glickman, 55 F.3d. 1578, 1583 (Fed. Cir. 1995) (Court refused to overturn a termination for convenience where the government has awarded the contract in good faith but, “at the same time, has knowledge of facts supposedly putting it on notice that, at some future date, it may be appropriate to terminate the contract for convenience”);McHugh, 618 F.3d at 1378.

However, the Government may not terminate simply to get a better price for performing needed work.

In Sigal Constr. Corp. v. Gen. Servs. Admin., CBCA, No. 508, 10-1 BCA ¶ 34,442 (May 13, 2010), the solicitation required a lump sum bid price for base contract work and fixed unit prices for certain restoration work items, the latter accompanied by estimated quantities “for the purpose of estimating offers.” The contractor’s post-award survey of  the quantities for the restoration work revealed that actual quantities for certain of the bid units were substantially in excess of the estimated quantities for those units. Several months after learning how much the actual quantities exceeded the estimated quantities in the solicitation, the GSA requested and received a lower unit price quote from another contractor to perform the work on a number of the affected bid units and suspended the contractor’s work on those units.  The contractor submitted a certified claim for breach damages, including lost profits for itself and its subcontractors.  Id. at 169,969.  The Contracting Officer denied the claim, arguing that the work in question was not part of the contract specifications in the first place and, in any event, GSA had authority to reduce the scope of work either under the Changes or Termination for Convenience clause.  The Board rejected GSA’s interpretation of the specifications and found the agency had committed a breach of contract, stating in part:

One of the few limitations on the Government’s right to terminate for convenience is that the Government may not terminate simply to get a better price for performing needed work.

Id. at 169,971.

The Government’s actual understanding of its requirements at time of award and termination are key facts in determining the propriety of a termination for convenience.

Sigal Construction and McHugh illustrate the narrow contours of the fact patterns that will support a successful challenge to a T for C:

  1. A termination likely will not be overturned merely because the contractor shows the government should have known it might later terminate the contract for convenience.
  2. But – a termination for convenience can be overturned if the contractor can show the government acted in bad faith because it awarded the contract with no intention of performing it.
  3. And – a termination for convenience can be overturned on the ground of bad faith if the contractor can show that, at the time of termination, the government understood the work was still required, but terminated solely to obtain a better price from another contractor.

Conclusion

Against the foregoing background, contractors may wish to take the following steps to protect themselves from unwarranted terminations for convenience:

  • When responding to solicitations, make reasonable efforts to assure that the specifications accurately describe the government’s requirements.
  • When the government reduces the scope of work of your contract, take all practicable steps to confirm that the government’s reasons for doing so reflect its present understanding of its actual requirements, and that the reduction does not reflect an effort to obtain a lower price from another source.

While these steps will not ensure protection, they certainly will reduce the risks.

Federal Circuit Decision in In re Tanaka

On April 15, the Federal Circuit reversed the BPAI decision and remanded the matter for further proceedings in accordance with the opinion.  The Federal Circuit held  that a patent owner that retains original patent claims and adds new narrower claims in a reissue application does indeed present a type of error correctable by reissue under 35 U.S.C. § 251.  

The Federal Circuit relied on precedent from the CCPA decided in 1963:

Nearly a half century ago, our predecessor court, the Court of Customs and Patent Appeals, clearly stated that adding dependent claims as a hedge against possible invalidity of original claims “is a proper reason for asking that a reissue be granted.”  In re Handel, 312 F.2d 943, 946 n.2 (CCPA 1963). The basis for the reissue application in Handel was nearly identical to that in this case. The patentee had mistakenly failed to include narrow claims that he had a right to claim and later sought reissue to obtain those narrower claims without proposing to cancel any broader claims encompassing the claims sought to be added. The proposed reissue claims differed from the existing claims simply by the inclusion of additional limitations.

Judge Giles S. Rich wrote the Handel decision reversing the Board’s rejection of the reissue application. He explained that the reissue claims involved subject matter disclosed in the specification and thus were properly directed to “the invention disclosed in the original patent.” Id. at 944. In a footnote, Judge Rich remarked that “[t]he term ‘inoperative’ has been construed to mean inoperative adequately to protect the invention, which may be due to failure of the solicitor to understand the invention.” Id. at 945 n.2 (quoting McGrady, Patent Office Practice 309 (4th ed. 1959)). . . .  Thus “[t]he narrower appealed claims are simply a hedge against possible invalidity of the original claims should the prior use be proved, which is a proper reason for asking that a reissue be granted.” Id.

The Federal Circuit cited other precedent, such as an earlier case favoring the claiming of species in reissue.  The Federal Circuit also invoked the use of narrower claims to clarify the meaning of the issued broader claims by reliance on the doctrine of claim differentiation:

This court, however, has recognized that “each claim is a separate statement of the patented invention.”  Pall Corp. v. Micron Separations, Inc., 66 F.3d 1211, 1220 (Fed. Cir. 1995). And each claim of a patent has a purpose that is separate and distinct from the remaining claims. Claims of narrower scope can be useful to clarify the meaning of broader, independent claims under the doctrine of claim differentiation. Phillips v. AWH Corp., 415 F.3d 1303, 1314 (Fed. Cir. 2005). And dependent claims are also less vulnerable to validity attacks given their more narrow subject matter. Thus, the omission of a narrower claim from a patent can render a patent partly inoperative by failing to protect the disclosed invention to the full extent allowed by law.

The Federal Circuit dismissed concerns that the public would be disadvantaged by subsequent addition of narrower claims, since that was already addressed by the equitable intervening rights statute (35 U.S.C. § 252).Judge Dyk dissented with the majority.  He opined that none of the cited cases squarely addressed the issue at hand.  Judge Dyk relied on the Supreme Court decision in Gage v. Herring, 107 U.S. 640 (1883) to find support for the Patent Office’s position that if the original claims are maintained, there is no adequate error for a reissue application:

The applicants here attempt to do virtually the same thing as in Gage. By retaining the original claims without alteration or amendment, the applicants have admitted that there was no error in the original patent. The fact that no error is being corrected here, as in Gage, makes reissue unavailable in this case. 

Judge Dyk’s dissent also found that the present case lacked proper surrender of the original patent:

Here, the addition of the dependent claims has no impact on the applicants’ rights under the original patent. The original claims were not changed, and the addition of new claims has no effect on the applicants’ rights under the original claims. The applicants effectively attempt to retain their rights under original patent while securing a second patent which covers the subject matter of the dependent claims.

This is, moreover, directly contrary to another aspect of the reissue statue, which requires “surrender of [the original] patent.” 35 U.S.C. § 251. As a condition of reissue, § 251 requires that the applicant relinquish any claim to the original patent—”the patentee has no rights except such as grow out of the reissued patent.” Eby v. King, 158 U.S. 366, 373 (1895). Here, the applicants surrender nothing; they attempt to retain their rights under the original patent in their entirety.

Regardless of whether you agree with the majority or the dissent, this decision does provide the patent owner another avenue of correction of patent rights and an attempt to maintain a claim of past damages via preservation of the original patent claims.  To avoid past damages, the burden is on the defendant to prove invalidity of any original claims that may be infringed and to show “substantive amendment“ of the originally claimed subject matter in any newly added narrower claims that might survive invalidity and yet still at least arguably be infringed.