                                                                                                                           Opinions of the United
1999 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


9-1-1999

Carey v. Employers Mut. Cas. Co.
Precedential or Non-Precedential:

Docket 98-7118




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Recommended Citation
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Filed September 1, 1999

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

No. 98-7118

ALAN CAREY; STEPHEN HOFFMAN; JACK LEIB, Appellants

v.

EMPLOYERS MUTUAL CASUALTY COMPANY

On Appeal from the United States District Court for the Middle District of
Pennsylvania (D.C. No.
97-cv-00349) District Judge: Hon. Sylvia H. Rambo

Argued December 15, 1998

Before: SLOVITER, COWEN and OBERDORFER,* Circuit Judges

(Filed: September 1, 1999)

Mark W. Voigt (Argued) Michael I. Levin & Associates Huntingdon Valley, PA
19006

Counsel for Appellants

_________________________________________________________________

*Hon. Louis F. Oberdorfer, United States Circuit Judge for the District of
Columbia, sitting by designation.

Timothy Costello (Argued) Marshall, Dennehey, Warner, Coleman & Goggin
Philadelphia, PA 19103

Counsel for Appellee

OPINION OF THE COURT

SLOVITER, Circuit Judge:

Plaintiffs Alan Carey, Stephen Hoffman, and Jack Leib (the "Supervisors"),
who filed this action for a
declaratory judgment against Employers Mutual Casualty Co. ("Employers
Mutual"), appeal the decision of
the District Court denying their motion for summary judgment and granting
summary judgment in favor of
Employers Mutual. Employers Mutual had issued an errors and omissions
insurance policy in favor of
Berwick Township, Pa. (the "Township"). Plaintiffs filed this action
seeking a determination that Employers
Mutual is obligated to defend and indemnify them from a surcharge filed
against them by the Audit
Committee of the Township.
I.

The parties stipulated to the material facts. Carey, Hoffman, and Leib
were supervisors for the Township
during 1993. In May of that year, the Township entered into a contract
with Berwick Enterprises, which
was constructing a golf course and contiguous residential tracts. The
Township agreed to design and
construct a sewage treatment system and a storage lagoon that would
connect to the golf course's irrigation
system. Additionally, the Township agreed to pay certain construction
costs associated with the irrigation
system. The contract specified that the Township agreed to pay $240,000,
but if the construction cost less
than that amount, the Township would receive the benefit. Berwick
Enterprises constructed the irrigation
system and billed the Township the $240,000 referenced in the contract.
After the system was installed, the
Township's engineer, Group Hanover, Inc., analyzed the project and
concluded that the excavation cost for
the irrigation system was only $84,466. However, the report cautioned that
the analysis did not take into
account a variety of other relevant expenses. As a result of the
engineer's estimate, the Supervisors
negotiated a compromise and settlement under which Berwick Enterprises
received $216,000. The
Township paid $65,000 in cash and the remainder by a promissory note for
$151,000, with interest at six
percent. Appellant Leib signed the promissory note on behalf of the
Township on January 24, 1994.

In March 1996, the Township's Audit Committee concluded that the
Supervisors had negligently overpaid
Berwick Enterprises $140,216.50, representing the excess of principal and
interest beyond the engineer's
estimate of the cost ($84,466), and entered a notice of surcharge of
$140,216.50, the difference between
the cost to the Township of $224,682.50 (the settlement figure of $216,000
and interest of $8,682.50 on
the note) and the engineer's estimate. The reasons set forth by the Audit
Committee for imposition of the
surcharge were that the Committee had not been provided with any detailed
invoice or other documentation
contradicting Group Hanover's valuation of the project, and that the
Township should have followed a public
bidding process for the project.

Pursuant to the applicable procedure, the Supervisors filed a notice of
appeal from the Audit Committee's
Report in the Court of Common Pleas of Adams County seeking relief from
the Audit Report and notice of
surcharge. They claimed, inter alia, that they had acted reasonably and in
good faith in compromising the
disputed claim and that the Audit Committee had not correctly accounted
for all the relevant costs incurred
by the contractor in connection with the irrigation project. That
litigation was stayed pending resolution of
this case.

The Supervisors sought coverage from Employers Mutual under the errors and
omissions (E&O) insurance
policy purchased by the Township, which was effective June 1995 to June
1996 and which covered claims
made for alleged wrongful acts after June 4, 1987. Employers Mutual denied
coverage on three separate
grounds: the policy specifically excluded from covered losses any "[f]ines
or penalties imposed by law," see
App. at 120; the policy excluded " `[w]rongful' acts involving . .
.[a]mounts actually or allegedly due under
the terms of a payment or performance contract," see App. at 121; and the
policy excluded "[a]ny claim
brought by any federal, state or local governmental regulatory body," see
App. at 122. The insurer also
contended that its defense and indemnification of the Supervisors would
violate public policy.

The Supervisors filed a declaratory judgment action in the Court of Common
Pleas of Adams County in
February 1997 alleging that they were entitled to defense and
indemnification under the insurance policy.
Employers Mutual, an Iowa corporation, removed the case to federal court
and answered, citing the three
exclusions from coverage referred to above. Both parties moved for summary
judgment. On January 28,
1998, the District Court granted Employers Mutual's motion, concluding
that the surcharge action was a fine
or penalty under the policy terms; the court consequently declined to
reach the other policy exclusions relied
on by Employers Mutual.

The supervisors filed a timely notice of appeal. We have jurisdiction
pursuant to 28 U.S.C. § 1291. Our
review is plenary. See Nationwide Mut. Fire Ins. Co. v. Pipher, 140 F.3d
222, 224 (3d Cir. 1998). The
parties agree that Pennsylvania law applies.

II.

An errors and omissions insurance policy is a form of professional
liability insurance designed to insure
certain classes of professionals from risks such as negligence. See Lee R.
Russ, Couch on Insurance §
131:38, at 131-49 to -50 (3d ed. 1997). In essence, an E&O policy is a
form of malpractice insurance.
National Ass'n of Realtors v. National Real Estate Ass'n, Inc., 894 F.2d
937, 938 (7th Cir. 1990);
Syndicate 420 at Lloyd's London v. Early Am. Ins. Co., 796 F.2d 821, 824
n.2 (5th Cir. 1986).

Other types of policies, such as those issued for corporate directors and
officers, which often contain E&O
provisions, commonly exclude coverage for fines and penalties. See 3
Rowland H. Long, The Law of
Liability Insurance § 12A.05[7][a][iii], at 12A-95 (1989).

The Supervisors urge that the policy language "[f]ine or penalty imposed
by law" is ambiguous and must be
construed against Employers Mutual as the drafter of the policy. See
Commonwealth of Pennsylvania, Dep't
of Transp. v. Semanderes, 109 Pa. Commw. 505, 511, 531 A.2d 815, 818
(Commw. Ct. 1987) ("When a
contract is ambiguous, it is undisputed that the rule of contra
proferentem requires the language to be
construed against the drafter . .. and in favor of the other party if the
latter's interpretation is reasonable.")
The District Court concluded that the issue is not whether the policy
itself is ambiguous, but rather whether
the surcharge is a fine or penalty and thereby excluded from coverage.

There are not many cases dealing with the scope of a fines and penalties
clause in an insurance contract.
Counsel for Employers Mutual stated that he had found none. Our research
has uncovered only a few, and
those are not direct analogs. The decisions often turn on the precise
language of the policy.

For example, in Page Wellcome, Professional Service Corp. v. Home
Insurance Co., 758 F. Supp. 1375
(D. Mont. 1991), aff'd, 993 F.2d 887 (9th Cir. 1993), Wellcome, an
attorney who was sanctioned by a
state trial court for giving a closing argument that violated the court's
in limine ruling, sought and was denied
coverage by his professional liability insurer on the ground that the
sanction was a "fine or penalty," which the
policy expressly excluded from the definition of covered "damages." The
federal district court agreed with
the insurer, holding that the policy was clear and unambiguous in its
prohibition of fines, which the court
defined as "the payment of money imposed upon a person for misconduct."
Id. at 1379-80. The court ruled
that because the sanction was imposed for misconduct, it constituted a
fine and the insurer had no duty to
indemnify or defend. Id. at 1380-81.

On appeal, the Ninth Circuit certified the question to the Montana Supreme
Court. See Wellcome v. Home
Ins. Co., 849 P.2d 190, 191 (Mont. 1993). The Montana Supreme Court
rejected Wellcome's argument
that the term"fine" is limited to criminal statutes and that sanctions are
neither fines, penalties, nor any other
type of punishment. The Court referred to Black's Law Dictionary in
holding that a fine is a pecuniary
punishment, and that this meaning is clear and well understood. Wellcome,
849 P.2d at 193. It thus
concluded that the policy excluded coverage for Wellcome because the
sanction imposed on him was a
punitive fine or penalty. Id. at 194; see also Dixon v. Home Indem. Co.,
426 S.E.2d 381, 382-83 (Ga. Ct.
App. 1993) (holding that term "sanctions" in exclusion for fines,
statutory penalties, and sanctions prevents
coverage for award of attorneys fees imposed to deter filing of frivolous
lawsuit).

The issue of the scope of a policy exclusion of coverage for fines or
penalties also may arise when coverage
is sought for the payment of punitive damages.1 See Long, supra, §
12B.05[1], at 12B-92. For example, in
Collins & Aikman Corp. v. Hartford Accident & Indemnity Co., 436 S.E.2d
243 (N.C. 1993), a trucking
company, which maintained an umbrella/excess liability policy for damages
arising from its operations, was
held liable for $2.5 million in compensatory and $4 million in punitive
damages following a serious accident.
The parties settled for $4.2 million. The insurer refused to cover the
punitive damages, on the ground that the
policy stated that " `damages' do not include fines or penalties." Id. at
246. The court rejected this argument,
holding that the term "penalty" in the policy exclusion was at least
ambiguous and, therefore, it must be
interpreted against the insurer who wrote the policy. The court thought
"[i]t takes some construing of the
word `penalty' to hold that it includes punitive damages," and declined to
so hold. Id. at 247.

Finally, some cases address the scope of a fines or
_________________________________________________________________

1. Generally, courts are divided on the public policy question whether an
insurer may indemnify punitive
damages. See Long, supra, § 12A.05[7][a][iii], at 12A-96 to -97; see also
Barry R. Ostrager & Thomas R.
Newman, Handbook on Insurance Coverage Disputes ch. 14 (9th ed. 1998).
penalties exclusion as it
applies to coverage for various administratively imposed sanctions. In
that situation, the courts usually have
looked to the nature of the sanction in determining whether the policy
excludes coverage. For example, in
St. Paul Fire & Marine Ins. Co. v. Briggs, 464 N.W.2d 535 (Minn. Ct. App.
1991), the Internal Revenue
Service (IRS) sought to recover the employer's unpaid withholding taxes
from two officers personally. The
relevant Internal Revenue Code ("IRC") provision made the individuals
liable for a "penalty equal to the total
amount of the tax evaded, or not collected, or not accounted for and paid
over." Id. at 537 (quoting 26
U.S.C.§ 6672 (1989)).

The insurer had issued a directors' and officers' liability policy
covering negligence, errors, omissions, and
breaches of duty, but excluding fines and penalties or other losses deemed
uninsurable by law. The insurer
argued that the tax assessments were excluded penalties. The Minnesota
court disagreed, holding that the §
6672 liability was not a penalty within the language of the policy
exclusion. In so holding, it relied on several
federal court decisions that ruled that, despite the "penalty" language of
the Code provision, the assessment
was not penal in nature, i.e., the penalty was not punitive. Nonetheless,
the court in Briggs concluded that
"insurance coverage for nonpayment of taxes would be contrary to public
policy," id. at 539, and held the
insurer had no duty to defend or indemnify.

An Iowa court looked differently at excise taxes under IRC § 4975(a) that
the IRS imposed on the insureds
for their improper dealings with an ERISA pension plan. See Hofco, Inc. v.
National Union Fire Ins. Co.,
482 N.W.2d 397 (Iowa 1992). The insurance policy covered loss because of
any breach of fiduciary duty,
but excluded fines and penalties from the term "loss." The court concluded
that the policy did not cover the
five-percent excise tax imposed by the IRS. The court held that "penalty,"
though undefined, was not
ambiguous, relying on Black's Law Dictionary for the meaning of penalty as
money that the law exacts as
punishment for either doing a prohibited act or not doing a required act.
Reviewing the cases and legislative
history of the excise tax at issue, the court concluded that"the excise
tax statute was passed to shift the
sanction for a violation of the prohibited transaction provision from the
trust or plan to the parties." Id. at
402. It reasoned that the purpose of the excise tax was (1) to prohibit
certain conduct, not to raise revenue;
(2) to impose the tax on the specific individuals involved in the
prohibited transaction; and (3) to curb the
prohibited conduct through pecuniary punishment. Id. at 403. Therefore, it
held that the tax was a penalty
rather than a tax, and the policy provided no coverage.

In summary, the available case law suggests that an exclusion for fines
and penalties, where those terms are
undefined in the policy, allows an insurer to deny coverage when the item
to be covered is punitive, rather
than merely compensatory. Supporting this conclusion is the fact that "a
significant number of states" prohibit
insurance for fines and penalties that are penal, rather than remedial or
compensatory, in nature. See
Ostrager & Newman, supra, § 10.03[d], at 551. Moreover, there are cases
holding that punitive fines and
penalties are not insurable as"damages." See, e.g., City of Fort Pierre v.
United Fire & Cas. Co., 463
N.W.2d 845, 849 (S.D. 1990) (holding that civil penalties for Clean Water
Act violation were punitive and
uninsurable as a matter of public policy). But see Weeks v. St. Paul Fire
& Marine Ins. Co., 673 A.2d 772
(N.H. 1996) (observing that, where insurer has failed to expressly exclude
fines and penalties, court would
not relieve insurer of obligation to pay compensatory surcharge that was
arguably punitive in nature).

With this background, we turn to consider whether the surcharge noticed by
the Township is punitive in
nature and hence a fine or penalty excluded from coverage by Employers
Mutual's policy.

III.

We focus on the nature of the surcharge provision. Because there are no
Pennsylvania Supreme Court cases
on point, we are left to predict whether that court would interpret the
surcharge at issue as a punitive fine or
penalty. See Borman v. Raymark Indus., Inc., 960 F.2d 327, 331 (3d Cir.
1992). Pennsylvania law directs
township auditors to:

surcharge any elected or appointed officer for the amount of any loss to
the township caused in whole or in
part by the officer's act or omission in violation of law or beyond the
scope of the officer's authority. If the
auditors find an absence of intent to violate the law or exceed the scope
of authority. . . the surcharge
imposed shall be limited to the difference between the costs actually
incurred by the township and the costs
that would have been incurred had legal means and authorized procedures
been employed. Provisions of this
section which limit the amount of surcharge do not apply to cases
involving fraud or collusion on the part of
the officers or to any penalty issuing to the benefit of or payable to the
Commonwealth.

53 Pa. Stat. Ann. § 65907(a) (emphasis added).

The only reported Pennsylvania case to address the nature of a surcharge
is In re Appeal from Report of
Audit of South Union Township for 1975, 47 Pa. Cmwlth. 1, 407 A.2d 906
(Commw. Ct. 1979). There,
the Board of Auditors appealed the dismissal by the Court of Common Pleas
of Fayette County of the
surcharges filed against two township supervisors covering, inter alia,
amounts paid to the supervisors as
compensation for use of their automobiles, amounts paid to township
employees to be used for
hospitalization insurance premiums, and back wages paid to employees
pursuant to an arbitration. The
Commonwealth Court sustained the trial court's dismissal of the
surcharges, primarily because the
supervisors had not abused their discretion in making the payments.
Significantly, in at least two instances,
the appellate court sustained the dismissal of the surcharges because it
had not been shown that the township
sustained a financial loss, thereby signifying that the purpose of the
surcharge is to compensate for loss
suffered. Id. at 3-5, 7, 407 A.2d at 908-10. That compensatory purpose is
further reflected in the reason
the court gave in holding the trial court erred in refusing to call one
supervisor to testify on the ground that it
would violate his right against self-incrimination. The Commonwealth
Court, although finding the error
harmless, held that the proceeding was civil, not quasi-criminal, and
observed that "the function of the
surcharge is remedial and not punitive, i.e., it is designed to reimburse
the government for losses resulting
from some misconduct of its officials." Id. at 8, 407 A.2d at 910.

In the case before us on appeal, the District Court, focusing on the
question whether the Audit Committee's
surcharge constituted a penalty, analogized this surcharge to the one
imposed in trusts and estates law
forfiduciaries who are negligent in their duties. In support of this
analogy, the District Court observed that,
under Pennsylvania law, a public official acts as afiduciary in holding
public funds. See Columbia Cas. Co. v.
Westmoreland County, 365 Pa. 271, 274, 74 A.2d 86, 88 (1950).

In the trusts and estates context, the Pennsylvania Supreme Court has
held,

Surcharge is the penalty for failure to exercise common prudence, common
skill and common caution in the
performance of the fiduciary's duty and is imposed to compensate
beneficiaries for loss caused by the
fiduciary's want of due care.

In re Miller's Estate, 345 Pa. 91, 93, 26 A.2d 320, 321 (1942) (emphasis
added); accord In re Trust of
Munro v. Commonwealth Nat'l Bank, 373 Pa. Super. 448, 452, 541 A.2d 756,
758 (Super. Ct. 1988). By
the plain terms of this definition, the Pennsylvania courts construe
thefiduciary's surcharge to be
compensatory, even though it is also considered a penalty. Based in part
on this analogy, in conjunction with
the precedent describing the surcharge as remedial rather than punitive,
and the statute that authorizes
surcharges "for the amount of any loss to the township caused by the
officer's act," we conclude that the
surcharge is not punitive but remedial.

Of course, Employers Mutual could have expressly excluded surcharges from
coverage under its E&O
policy, but it failed to do so. Therefore, the Supervisors argue, the
policy is at best ambiguous as to the
exclusion of the surcharge.

"A provision of a contract of insurance is ambiguous if reasonably
intelligent persons, considering it in the
context of the whole policy, would differ regarding its meaning." State
Farm Mut. Auto. Ins. Co. v. Moore,
375 Pa. Super. 470, 475-76, 544 A.2d 1017, 1019 (Super. Ct. 1988) (quoting
Musisko v. Equitable Life
Assurance Soc., 344 Pa. Super. 101, 106, 496 A.2d 28, 31 (Super. Ct.
1985)). Looking at this policy as a
whole, we agree that the policy drafted by Employers Mutual is ambiguous
regarding coverage for this
surcharge because it is susceptible to more than one interpretation
regarding what it covers.

Significantly, the policy does not define the terms "fine" or "penalty"
anywhere. As the precedents discussed
earlier demonstrate, a fines or penalties exclusion may be raised in a
wide variety of situations not all of
which are clearly excluded under this language.

Pennsylvania law, like that of many states, provides:

[W]here the language of a policy prepared by an insurer is either
ambiguous, obscure, uncertain or
susceptible to more than one construction, courts will construe the
language most strongly against the insurer
and accept the construction most favorable to the insured.

D'Allessandro v. Durham Life Ins. Co., 503 Pa. 33, 37, 467 A.2d 1303, 1305
(1983) (citing Ehrlich v.
U.S. Fidelity & Guar. Co., 356 Pa. 417, 423, 51 A.2d 794, 797 (1947)).
Consequently, we hold that the
fines and penalties exclusion in the E&O policy here does not
unambiguously exclude the surcharge imposed
by the Audit Committee, and the District Court erred in granting summary
judgment for Employers Mutual.

In reaching this conclusion, we do not hold that Employers Mutual must
defend or indemnify the
Supervisors. The insurance company raised two other exclusions that the
District Court did not address. On
remand, the District Court may consider those alternative exclusions.

IV.
For the reasons set forth, we will reverse and remand to the District
Court for further proceedings consistent
with this opinion. A True Copy: Teste:

Clerk of the United States Court of Appeals for the Third Circuit 12

FOOTNOTES
