Legal roundup: recent energy insurance cases

28 March 2018

US COURT OF APPEAL
Establishes New Test to Determine When an Oilfield Services Contract is Maritime

Previously, the United States Court of Appeals for the Fifth Circuit issued an opinion that affirmed the district court’s decision that a master services contract and an oral work order to provide flow-back services was a maritime contract. In applying maritime law as opposed to Louisiana state law that would have invalidated the contract’s indemnity provision by virtue of the Louisiana Oilfield Indemnity Act, (LOIA) the Fifth Circuit examined the contract using the multifactor tort-based test.

In a concurring opinion, two circuit Judges urged the Fifth Circuit to hear the case ‘en banc’ to abandon the previous test and to simplify the test for determining whether a contract is maritime [In law, an en banc session (French for ‘in bench’) is a session in which a case is heard before all the judges of a court (before the entire bench) rather than by a panel of judges selected from them]. The Fifth Circuit agreed and ordered that the case be heard by all members of the court.

The Fifth Circuit issued its en banc unanimous opinion that abandoned the previous factors in favour of a simpler, more straightforward two-pronged contract-based test following the principles set forth in the United States Supreme Court being:

1. Is the contract one to provide services to facilitate the drilling or production of oil and gas on navigable waters?

2. If the answer to the first inquiry is “yes,” does the contract provide or do the parties expect that a vessel will play a substantial role in the completion of the contract? If so, then the contract is maritime in nature.

In applying this new test, the Fifth Circuit noted that the oral work order required the contractor to perform downhole work on a gas well that could only be accessed by a platform. During the work, the crew encountered an unexpected problem requiring the use of a vessel and crane to resolve the problem. The Fifth Circuit reasoned that use of the vessel to lift the equipment was an insubstantial part of the job and not work that the parties expected to be performed. So, the Fifth Circuit held that the master services contract was non-maritime. As a result, Louisiana law per the LOIA barred the crane barge owner’s indemnity claim against the contractor.

Limit of liability in a reinsurance does not cap all obligations including defense costs of the insurers unless the original is capped

The New York Court of Appeals recently looked at whether a prior case law imposed either a rule of construction, or a strong presumption, that a per occurrence liability cap in a reinsurance contract limits the total reinsurance available under the contract to the amount of the cap regardless of whether the underlying policy is understood to cover expenses such as, for instance, defense costs?

In prior case law the court interpreted the limitations clause in a facultative reinsurance certificate to operate an expense inclusive cap. However, some courts have interpreted the prior case ruling to mean that third-party defense costs incurred by a cedent are unambiguously or presumptively subject to the amount of the stated liability limits in such certificates.

However the Appeals Court rejected that the prior case ruling established such a per se rule on expense inclusive caps. It distinguished the issues presented in the prior case and the case in question, with the former addressing whether the reinsurance contract at issue’s limitations clause established a cap for both liability costs and expenses or merely liability costs. Specifically, the court noted the prior case read the limitations clause in context of the entirety of the reinsurance contract in line with general principles of contract construction.

Additionally, the court distinguished the prior case on the fact that the expenses incurred were in litigation between the insurer and its policyholder, not costs (such as third-party defense costs) the insurer was obligated to pay pursuant to the terms of the underlying contract itself. Thus, the court concluded that the prior case did not address whether similar limitation clauses would require reinsurers to cover third-party defense costs in excess of those limits.

The court held definitively that the prior case did not supersede the ordinary rules of contract interpretation that otherwise apply to reinsurance contracts. Thus, under the Court of Appeals holding, New York law does not impose a rule nor a presumption that a liability limitation clause automatically caps all obligations, including defense costs and other expenses, owed by a reinsurer without regard for the specific provisions in the reinsurance contract.

A Missouri district court held a mandatory arbitration provision was unenforceable in an insurance coverage dispute
An electrician was injured on the job and won an uncontested judgement in state court against his power company employer. His employer was insured by Liberty Mutual and had excess insurance through AEGIS. The plaintiffs in the present case sued both insurers and alleged they should have been additional insureds under both policies and their coverage claims were wrongly denied. AEGIS moved to stay the proceedings and compel arbitration pursuant to a mandatory arbitration provision in its excess insurance policy. The various parties disputed which state’s law applied. The court ultimately denied the motion, holding the mandatory arbitration provision was unenforceable.

First, the court concluded the arbitration clause was unenforceable as it contravened Missouri public policy. Missouri choice of law rules allow for the application of another state’s law as long as the law “is not contrary to a fundamental policy of Missouri.” Application of North Dakota law (as advocated for by AEGIS) or any other state’s law that would enforce the arbitration provision was inappropriate as it would contravene Missouri law prohibiting mandatory arbitration clauses in insurance contracts.

Next, the court concluded that even under a traditional choice of law analysis, the arbitration clause was still unenforceable. Missouri choice of law for insurance coverage disputes provides certain factors to consider in determining what law to apply, in the absence of effective choice of law by the parties. Here, the court found the insurance policy contained an effective choice of law provision where it stated construction in accordance with the laws of the jurisdiction in which the situation forming the basis for the controversy arose. The accident’s location in Kansas therefore dictated Kansas law governed. Because arbitration provisions in insurance contracts are unenforceable under Kansas law, the court reached the same conclusion it previously did that the provision was unenforceable.

Australian Court looked at the importance of causation when considering whether damage was “Accidental”
The insured commenced proceedings in the Federal Court of Australia against his insurer seeking indemnity under a policy of insurance for ‘accidental’ loss and damage to the starboard engine of his motor yacht.

The damage occurred one day after the insured vessel had been serviced. The vessel was operated for approximately five minutes before an alarm activated and the speed of both engines slowed down automatically to a ‘limp’ mode. Approximately eight minutes later, the starboard engine shut down completely and a subsequent mechanical inspection revealed extensive and irreparable damage.

A jointly-appointed expert referee considered that the damage was ‘a direct result’ of overheating and seizure of the engine due to loss of lube oil pressure, but also faulty design of the sealing arrangement between the lube oil cooler and the engine block.

The insurer declined indemnity on the basis that:

(a) the insured’s failure to read the vessel manual, know about the operation of alarms, recognise their significance and act reasonably means the damage was not ‘accidental’; or alternatively,

(b) certain exclusions in the policy were triggered including, amongst others, loss and damage arising from (i) faulty design; (ii) inherent defect; and (iii) structural design.

The Court accepted the insured’s evidence that, despite the vessel manual stating that the alarm would trigger a warning on an LCD screen that the engine oil pressure was low, no such warning was displayed. The insured’s evidence was that if it did, he would have turned off the  engine. The Court held that the insured was not aware of the risk of damage to the engine by continued operation, and therefore could not have chosen to take that risk. Accordingly, the damage was ‘accidental’ within the meaning of the policy.

However, the Court also found that, notwithstanding the insured’s failure to turn off the starboard engine as being a possible cause of the damage, the single proximate cause was the failure of the gasket due to its faulty design. Therefore, the damage was nevertheless excluded under the policy.

UK Supreme Court interprets the meaning of Rule F of the York-Antwerp Rules differently and more broadly than previous general average adjusting practice.
In January 2009 the chemical carrier “LONGCHAMP” was boarded by pirates in the Gulf of Aden and diverted to Somali waters. After weeks of negotiations, the vessel’s owners agreed to a ransom of USD 1.85 million, down from the original ransom demand of USD 6 million.

The Owner claimed in General Average the costs incurred during the period of negotiation – crew wages including risk bonus, food, supplies and bunkers. The expenses were claimed under Rule F of the York Antwerp Rules 1974 as expenses incurred in substitution for the higher cost of paying the initial ransom demand. The adjustment was disputed.

The High Court upheld the adjustment and held that the inclusion of the costs fell within Rule F. The Court of Appeal reversed this decision and Owners appealed to the Supreme Court. Under the York-Antwerp Rules Rule A, “there is a general average act, when, and only when, any extraordinary sacrifice or expenditure is intentionally and reasonably made or incurred for the common safety for the purpose of preserving from peril the property involved in a common maritime adventure.”

Rule F states, “any extra expense incurred in place of another expense which would have been allowable as general average shall be deemed to be general average and so allowed without regard to the saving, if any, to other interests, but only up to the amount of the general average expense avoided.”

The shipowner argued that the expenses incurred during the negotiation were incurred in place of another general  average expense namely the USD 4.15 million saved as a result of the negotiations with the pirates.

Cargo interests contended it would not have been reasonable to pay the original USD 6 million ransom demand so any such payment would not have been an expenditure “reasonably” incurred within the meaning of Rule A and therefore the original ransom demand would not qualify as an “expense which would have been allowable” under Rule F. Further, and following the Court of Appeal’s reasoning, the reduction in the ransom was not an alternative course of action so the expenses during the negotiation were not “incurred in place of another expense”.

On the first point the Supreme Court majority determined that it was not necessary to determine whether or not it would have been reasonable to pay the initial ransom as the reference in Rule F to an “expense which would have been allowable” is a reference to an expense “of a nature” which would have been allowable rather than the quantum of that expense.

On the second point the Supreme Court majority concluded that the language of Rule F does not require that the expenses be incurred in pursuing an “alternative course” but in any event held that in this case, negotiating the ransom was a different course of action to paying the initial demand.

This decision overturns decades of accepted average adjusting practice in applying Rule F. Prior to the decision, the generally accepted view was that a “hypothetical alternative had to be one which would be recognized by commercial interests as ‘reasonable’ in terms of being practicable and not a matter of artificial invention and also ‘reasonable’ as regards to quantum.”

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