Rescission of Policies Permitted When Insureds Misrepresent Claims Experience in Renewal Application

 Prepared by Dana Hentges Sheridan, Esq. of of Tressler LLP

Concealment of a counterfeiting scheme in the renewal application amounted to a material misrepresentation, thus warranting rescission as the loss was not, in the California federal court’s view, fortuitous under either the first issued policy or the renewal policy. The Upper Deck Company, et. al. v. Endurance American Specialty Insurance Company, 2011 U.S. Dist. LEXIS 148668.
In early 2010, the Upper Deck Company and the Upper Deck Company, Inc. (collectively, “Upper Deck”) commenced a coverage action against Endurance American Specialty Insurance Company (“Endurance”) in San Diego Superior Court for breach of contract, breach of the implied covenant of good faith and fair dealing, and declaratory relief. Endurance removed the action to federal court based upon diversity jurisdiction. In the federal action, Endurance filed an answer and counterclaim seeking a declaration of no coverage and rescission of the policies at issue.
Upper Deck manufactured, marketed and distributed sports and memorabilia trading cards. It contracted with Konami Digital Entertainment (“Konami”) for exclusive U.S. distribution rights to Yu-Gi-Oh! cards. Unbeknownst to Konami, and without its permission, Upper Deck also contracted with other entities, including Vintage Sports Cards, Inc. (“Vintage”), to facilitate the printing of about 600,000 counterfeit cards. Konami discovered the counterfeit operation and in or about October 2008 secured a court order enjoining certain of the manufacturing and distribution entities, including Vintage, from making and distributing the cards.
In the fall of 2008, Konami seized the counterfeit cards and shortly thereafter filed litigation against Vintage and other entities that had manufactured the cards for Upper Deck. Upper Deck was not named as a defendant to the litigation until December 11, 2008, when Konami amended its Complaint to add it as a party. Konami also demanded that Upper Deck cease its counterfeiting activities and comply with the preliminary injunction issued by the District Court. Upper Deck was not a party to the action when the order on injunctive relief was issued, but the order extended to all “persons, firms or corporations in active concert or participation” with Vintage. In any event, Upper Deck was aware of the injunctive proceeding from the outset, even if it was not directly named in the District Court action until after the order on injunctive relief had issued.
On December 23, 2009, the District Court granted dispositive motions in favor of Konami and against Upper Deck on the following causes of action: Violations of the Federal Trademark Counterfeiting and Infringement laws; Unfair Competition in Violation of Federal Law; State Unfair Competition, and Common Law Trademark Infringement. The rest of the case was set for trial, but the parties ultimately settled the case.
At issue in the coverage action were two Endurance E&O policies issued to Upper Deck. The policies were issued on a claims made and reported basis. The first policy covered the period of December 10, 2007 to December 10, 2008, while the renewal covered the term of December 10, 2008 to December 10, 2009.
In or about December 2008, when it was brought into the litigation, Upper Deck tendered the suit to Endurance, who accepted the defense under a reservation of rights. Prior to the case settling, Endurance paid about $1.2 million in defense costs under one policy. On the first day of trial, Upper Deck and Konami settled the action for an undisclosed amount in excess of the policy limits. Upper Deck did not provide notice to Endurance of the settlement. Ultimately, Endurance refused to contribute the remaining policy limits under either policy toward defense costs or settlement, and coverage litigation ensued.
Among other coverage defenses asserted, Endurance sought to rescind the 2007 and 2008 Policies because Upper Deck misrepresented and concealed material information pertaining to the first proceeding in injunctive relief. Basically, when it applied for the renewal coverage (the 2008 Policy), it failed to disclose that there was an order for injunctive relief to which it would be bound. In a series of questions, the renewal application asked Upper Deck to identify whether it was aware of any “alleged deficiencies, errors or omissions in work performed by Upper Deck that had not been previously reported to Endurance.” Upper Deck did not respond to these questions. The 2008 Policy also contained the following exclusionary language (in the application itself):
NOTE: It is agreed that any claim or lawsuit against the Applicant, or any principal, partner, managing member, director, officer, or employee of the Applicant, or other proposed insured, arising from any fact, circumstance, act, error or omission disclosed or required to be disclosed in response to Questions 16, 17, 18, 19, and /or 20 is hereby expressly excluded from coverage under the proposed policy.
The Court ultimately found that Upper Deck had concealed material information from Endurance in its renewal application when it did not notify Endurance of the order in injunctive relief. Pursuant to Cal. Ins. Code §331, “[c]oncealment, whether intentional or unintentional, entitles the injured party to rescind insurance.” Concealment is defined as “[n]eglect to communicate that which a party knows, and ought to communicate.” Cal. Ins. Code §330. In California, summary judgment on a rescission claim may only be granted where “the false negative answers and omissions of [the applicant] were material to [the insurer’s] decision to provide insurance coverage.” And under our Insurance Code §334, “materiality is to be determined not by the event, but solely by the probable and reasonable influence of the facts upon the party to whom the communication is due, in forming his estimate of the disadvantages of the proposed contract, or in making his inquiries.” The test is subjective in the sense that “the critical question is the effect truthful answers would have had on [the particular insurer], not on some ‘average reasonable’ insurer.”
The Court found that, at the latest on October 30, 2008, Upper Deck learned that it, and all parties acting in concert with Vintage, had been preliminarily enjoined by the District Court in the Konami action from engaging in any counterfeiting and distribution related activities. While the Upper Deck entities were not joined or named as parties in the Konami action until December 11, 2008, they were under the jurisdiction of the District Court as the injunction extended to “all persons, firms and corporations in active concert or participation” with Vintage, and Upper Deck had actual knowledge of the injunction. Thus, Upper Deck knew of the existence of the Konami action and the disposition in injunctive relief when it was applying for renewal coverage, and it was obligated to disclose such information to Endurance.
The Court stated, “[t]here is no doubt that the information related to intentional counterfeiting is material to the decision of Endurance to issue the contract of insurance to Upper Deck in the first instance. . . The court concludes, from the evidentiary record identified by the parties, that no reasonable person could disagree that had Upper Deck disclosed its long-term scheme to willfully violate the intellectual property rights of Konami, Endurance would not have issued the contracts of insurance at issue.” 
The Court also noted the relevancy and application of the fortuity doctrine, when assessing the equity of rescission as a remedy. Here, the evidentiary record in the underlying District Court action established that the Upper Deck entities intentionally and willfully engaged in a scheme to violate the intellectual property rights of Konami for financial gain. In this regard, the Court stated that, “[t]he evidentiary record demonstrates that Upper Deck controlled the risk of loss as it proceeded with its counterfeiting activities…” The Court held:

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