Insurer Wins State's First Ever Reservation of Rights Recoupment in Bacteria Exclusion Case

By Jennifer C. Sheehan, Esq.

In Berkley National Insurance Company v. Granite Telecommunications, LLC and Atlantic Newport Realty, LLC, 2022 WL 3021107 (D. Mass 2022), the United States District Court ruled that an insurer who defended a claim under a reservation of rights was entitled to be reimbursed for legal fees and costs incurred in defending and settling a suit on behalf of its insured.

Defendant Granite leased offices from Atlantic Newport Realty and was the named insured on a Commercial Lines Policy issued by Berkley.  The policy provided that Berkley would pay those sums “that the insured becomes legally obligated to pay as damages because of ‘bodily injury’ or ‘property damage,’” and had the right and duty to defend the insured against any suit seeking those damages, but had no duty to defend the insured from a suit seeking damages to which the policy did not apply.  The policy excluded coverage for damages for bodily injury that “would not have occurred, in whole or in part, but for the actual, alleged or threatened inhalation of, contact with, exposure to, existence of, or presence of, any ‘fungi’ or bacteria on or within a building or structure,” or that arose “out of the actual, alleged or threatened discharge, dispersal, seepage, migration, release or escape of ‘pollutants.’”  The coverage included the cost to settle suits.

The bodily injury in at issue occurred when sewage backed up from the building’s drains into a workspace in Granite’s company café.  A chef working in the café was exposed to bacteria as a result of the sewage back up, which in turn resulted in a foot infection requiring extensive medical treatment.  A lawsuit followed, and Berkley initially denied coverage based upon the aforementioned exclusions.  However, Granite threatened Berkley with a c. 176D claim, and Berkley thereafter agreed to defend Granite “as a show of goodwill,” but to do so under a reservation of rights based on the aforementioned bacteria and pollution exclusions in the policy.  Berkley’s reservation of rights expressly stated that it reserved its right to bring a declaratory judgment action on the question of its defense duty.  Berkley did in fact bring such an action while the case was pending.

The suit was then mediated; during the course of the mediation, evidence was presented that the subject injury was the direct result of the chef’s exposure to the sewage and bacteria.  The case settled at mediation, and Berkley proposed to Granite that they split the settlement payment.  Granite rejected the proposal, again citing to c. 176D.  Berkley paid the settlement in full, but advised Granite that it was doing so under a full reservation of rights to recover the payment as part of the ongoing declaratory judgment action. 

The court in the declaratory judgment case considered how an insurer’s duties to defend and indemnify are viewed in the context of a settlement.  With regard to the duty to indemnify, it must be “ascertained through the lens of the settlement,” including what claims were settled and why the money was paid.  “The only question should be how the parties to the settlement viewed the relative merits of the plaintiff’s claims at the time of settlement.”  In applying these tenets to the chef’s suit, the court found that there was no dispute that his injuries were caused by exposure to the bacteria in the sewage that backed up into his workspace, and that the settlement reached at the mediation was intended to compensate him for his foot injuries.  As such, “there could be no plainer example of the type of case to which the [bacteria and/or pollution exclusions were] meant to apply.”  As such, there was no duty to indemnify.

As to the duty to defend, the court reviewed the chef’s lawsuit, and determined that the “only losses conceivably lying within the scope of the allegations [in the chef’s complaint] are those that resulted from his exposure to bacteria in the overflow of the raw sewage.”  Thus, Berkley had no duty to defend Granite and Atlantic Newport, or to settle the claim.

Against this backdrop, the court reviewed Berkley’s claim for reimbursement.  Berkley sought reimbursement under the principle of equitable restitution, which requires a person who has been unjustly enriched at the expense of another to repay the injured party.  This remedy requires that the defendant received a benefit (which in this case was not disputed), and that such benefit was unjust, which turns on the reasonable expectations of the parties.

In this case, the court concluded that the defendants “should reasonably have expected that Berkley would seek reimbursement … pursuant to its explicit reservation of rights.”  The court also noted with disapproval the defendants’ threats to sue Berkley under c. 176D if it did not defend them and fund the settlement, and held that it would be unjust for them to retain the benefits of Berkley’s coverage of the suit and settlement, given that Berkley had no duty to defend or indemnify and was forced to do both.

What this ruling means for insurers

This decision is the first in Massachusetts which permits an insurer to recover defense and settlement costs from an insured when the insurer has defended under a reservation of rights and there is no coverage for the claim.  The court essentially took the concept of unjust enrichment, which has long been followed in Massachusetts, and applied in the context of an insurer who defends an insured under a reservation of rights.  Previously, Massachusetts appellate courts had only permitted insurers to recoup payments made to insureds when the payment at issue was “erroneous.” 

However, it should be noted that this case does not overturn or void the “erroneous payment” requirement for reimbursement.  This case was in federal court, and while based on Massachusetts law, it simply interprets that law, and does not change it.  As such, it is not clear at this time whether this case represents a new remedy for insurers or is an anomaly.

Regardless, it underscores the importance of detailed reservation-of-rights letters, and of reiterating said reservations, and the implications of the reservations (e.g., filing declaratory judgment actions) during the claim, suit, and/or settlement process. 


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