Opinion
No. C98-144 MJM
June 22, 1999.
ORDER
Introduction
This matter involves an insurance coverage dispute. The plaintiff, Cincinnati Insurance Company ("Cincinnati"), seeks a declaratory judgment under 28 U.S.C. § 2201 that it has neither a duty to defend nor a duty to indemnify Source Data Systems ("SDS") in its underlying litigation with Pineville Community Hospital Association ("Pineville") in Kentucky state court. In the underlying litigation, Pineville has brought contract and fraud claims against SDS, alleging that SDS misrepresented the "year 2000 compliance" of certain equipment and software it sold to Pineville. This court has diversity jurisdiction under 28 U.S.C. § 1332.
SDS moves to dismiss or stay this case pending resolution of the underlying litigation. (Doc. #26). SDS argues that this court has discretion to decline jurisdiction because Cincinnati seeks only a declaratory judgment, and that this court should dismiss or stay the action because many of the issues involved overlap with issues in the underlying state court litigation. Further, SDS argues that the duty to indemnify is not ripe because SDS has not been found liable in the underlying litigation. Cincinnati concedes that the duty to indemnify is not ripe, (Doc. #28 at 2), but argues that its duty to defend claim should be allowed to proceed because it can be adjudicated without interfering with the underlying litigation.
SDS has also submitted objections to an Order entered by Chief Magistrate Judge John A. Jarvey denying SDS's motion to stay discovery. (Doc. #36). In the Order, the magistrate judge directed SDS to answer Cincinnati's pending discovery by May 21, 1999, on the basis that the discovery requests "are not unduly burdensome and appear to be targeted at a determination of whether Cincinnati owes a duty to defend the underlying litigation." (Doc. #33). The magistrate judge concluded that SDS "has failed to demonstrate its entitlement to a protective order staying this litigation." (Doc. #33). However, the magistrate judge also stated that "usually, the duty to defend can be determined by examining the nature of the claims made in the underlying litigation together with any particular policy exclusions such as those for untimely notice of claim." (Doc. #33). At oral argument on May 17, 1999, this court orally stayed discovery until the resolution of SDS's pending motion to dismiss or stay.
Factual and Procedural Background
In the underlying litigation filed in Kentucky state court, Pineville alleged that in July 1995, SDS represented that certain equipment and software for Pineville's MEDNET system was "year 2000 compliant or would be made year 2000 compliant and that it would operate beyond 1999." (Compl. Ex. A at ¶¶ 5-6). Pineville alleged that SDS also represented that it "would remain available to fulfill its contractual obligations, including providing services and support for MEDNET so that it would remain operable beyond 1999." ( Id. ¶ 7). In November 1995, SDS sought and obtained Pineville's consent to assign its contractual rights and obligations to Keane. (Compl. Ex. A at ¶¶ 9-11). In exchange for Pineville's consent to the assignment, Keane allegedly represented that it would "continue the business of SDS," that it would "fulfill all obligations of SDS," and that the assignment would "have no significant impact" on Pineville. ( Id. ¶ 11). Despite these assurances, Pineville alleged it was required to purchase new equipment and software for more than $750,000 because SDS's equipment and software was not year 2000 compliant.
When Pineville filed suit against SDS and Keane, SDS tendered the defense of the lawsuit to Cincinnati. (Compl. ¶ 13). SDS also provided notice to Cincinnati that it believed it was entitled to indemnity coverage in the event that SDS is found liable. ( Id.). Cincinnati "accepted the tender of defense under a full reservation of its rights." ( Id.).
In this action, Cincinnati seeks a declaration that it does not owe SDS a duty to defend nor a duty to indemnify. Cincinnati issued two policies to SCI Financial Group ("SCI") which "recognized SDS as an additional insured." (Compl. ¶ 14). These policies took effect on September 30, 1991, and were renewed on September 30, 1994. ( Id. ¶¶ 14-15). On November 7, 1995, when SDS was sold to Keane, SDS was removed as an additional insured. ( Id. ¶ 15).
One policy — policy number CCP 044-46-91 — covered "damages because of `bodily injury' or `property damage'" which "is caused by an `occurrence'" and which "occurs during the policy period." (Compl. ¶¶ 16-17). This policy also included numerous exclusions, such as damages that were "expected or intended" by SDS and property damage in various circumstances. ( Id. ¶ 17).
The other policy — policy number CCC 436-79-10 — covered "the 'ultimate net loss' for occurrences during the policy period in excess of the underlying insurance or for occurrences covered by this policy either excluded or not covered by underlying insurance[.]" ( Id. ¶ 18). This second policy also contained numerous exclusions for property damage in various circumstances. ( Id. ¶ 19).
Cincinnati alleges that "[t]he allegations of the Pineville First Amended Complaint affirmatively establish that [SDS is] not entitled to defense" because: the Pineville action alleges causes of action based on fraudulent conduct and breach of contract; it does not allege an `occurrence' as defined by the policies; it does not allege `property damage' as defined by the policies; it does not allege that any `occurrence' or `property damage' happened during the policy period as required by the policies; it does not seek recovery for sums paid `as damages' as required by the policies; it alleges a loss which was a known loss from the viewpoint of SDS; it alleges a loss which was not fortuitous from the viewpoint of SDS; it alleges a loss that was in progress; and SDS' efforts to invoke insurance coverage for the alleged loss are barred by principles of equity. (Compl. ¶ 20). In addition, Cincinnati alleges that "one or more coverage exclusions, singly or in combination, eliminate coverage with respect to the Pineville action." (Compl. ¶ 21).
After filing this lawsuit, Cincinnati served 31 requests for production of documents and 35 interrogatories related to SDS's organizational structure, the products and services SDS sold to Pineville, SDS's awareness of year 2000 risks and efforts to purchase insurance to cover year 2000 risks, SDS's understanding of certain terms in the insurance contract, and documents which SDS used or intended to use during the sale to Keane, this litigation, or the underlying litigation with Pineville. (Doc. # 23, Exs. 1-2). In addition, Cincinnati served subpoenas on SCI and Keane requiring the production of documents related to the products and services SDS sold to Pineville, the representations SDS made to Pineville, SDS's awareness of year 2000 risks, and SDS's efforts to purchase insurance to cover potential year 2000 liability. (Doc. #13).
Analysis
The Declaratory Judgment Act provides that "[i]n a case of actual controversy within its jurisdiction, . . . any court of the United States, upon the filing of an appropriate pleading, may declare the rights and other legal relations of any interested party seeking such declaration[.]" 28 U.S.C. § 2201 (emphasis added). The Supreme Court has held that § 2201 gives district courts broad discretion to stay or dismiss declaratory judgment actions. Wilton v. Seven Falls Co., 115 S. Ct. 2137, 2142-43 (1995); Prudential Ins. Co. of America v. Doe, 140 F.3d 785, 788-89 (8th Cir. 1998). "In the declaratory judgment context, the normal principle that federal courts should adjudicate claims within their jurisdiction yields to considerations of practicality and wise judicial administration." Wilton, 115 S. Ct. at 2143.
In Wilton, the Court found that the district court did not abuse its discretion by staying the declaratory judgment action "where parallel proceedings, presenting opportunity for ventilation of the same state law issues, were underway in state court." 115 S. Ct. at 2144. In addition, the Court reaffirmed the ongoing validity of Brillhart v. Excess Ins. Co., 316 U.S. 491 (1942), which listed several factors which could guide the decision whether to stay a declaratory judgment action, including "`whether the claims of all parties in interest can satisfactorily be adjudicated in [the state court] proceeding, whether necessary parties have been joined, whether such parties are amenable to process in that proceeding, etc.'" Id. at 2141 (quoting Brillhart, 316 U.S. at 495). The Court reasoned that staying federal declaratory judgment actions in favor of pending state court proceedings makes sense because, "at least where another suit involving the same parties and presenting opportunity for ventilation of the same state law issues is pending in state court, a district court might be indulging in `[g]ratuitous interference' [with the state proceedings] . . . if it permitted the federal declaratory action to proceed." Id.
The Supreme Court noted that "where the basis for declining to proceed is the pendency of a state proceeding, a stay will often be the preferable course, insofar as it assures that the federal action can proceed without risk of a time bar if the state case, for any reason, fails to resolve the matter in controversy." Wilton, 115 S. Ct. at 2143 n. 2; see also Fuller v. Ulland, 76 F.3d 957, 960-61 (8th Cir. 1996) ("`[S]o long as the possibility of return to federal court remains, a stay rather than dismissal is the preferred mode of abstention.'") (quoting International Ass'n of Enterpreneurs of America v. Angoff, 58 F.3d 1266, 1271 (8th Cir. 1995), cert. denied, 116 S. Ct. 774 (1996)).
Although both Brillhart and Wilton involved federal declaratory judgment actions between parties to pending state court litigation, the Eighth Circuit has applied Brillhart and Wilton to cases brought by insurers against insureds to determine the duty to defend and the duty to indemnify, even where the insurer was not part of the pending state court litigation. See Canal Ins. Co. v. Ashmore, 126 F.3d 1083, 1087-88 (8th Cir. 1997); Century Indemnity Co. v. McGillacuty's, Inc., 820 F.2d 269, 270-71 (8th Cir. 1987) (per curiam).
In Ashmore, an occupant of a truck was injured in an accident. The occupant sued the truck company in Mississippi state court. The truck company's insurer sued in federal district court in Arkansas seeking a declaration that it did not owe the truck company a duty of defense or a duty to indemnify. The district court refused to consider disputed factual issues at issue in the pending state court litigation, and declared that the insurer had a duty to defend the company on the basis that "these factual issues give rise to a possibility that coverage exists." 126 F.3d at 1085. The Eighth Circuit found the district court did not abuse its discretion by refusing to determine the disputed factual issues, implicitly upholding the district court's determination that the insurer had a duty to defend the truck company. Id. at 1085, 1087-88.
Notwithstanding the disputed factual issues, the district court also addressed whether a policy exclusion for vehicle occupants applied. The district court found that it was not part of the insurance contract, and thus denied the insurer relief. On appeal, the Eighth Circuit found that the policy exclusion was part of the insurance contract, but that Arkansas public policy rendered the exclusion void for amounts up to $25,000 in damages. Id. at 1085-87.
Similarly, in McGillacuty's, the court upheld the district court's decision to dismiss a declaratory judgment action without prejudice. In McGillacuty's, the insured's primary insurer was insolvent, but his excess insurer was solvent. 820 F.2d at 270. Under Missouri state law, a state guaranty association was required to provide defense and limited coverage when an insurer was insolvent. The state guaranty association "agreed to provide a defense, but denied liability coverage" because it took the position that the excess insurer should step into the shoes of the insolvent primary insurer. Id. The excess insurer sued the insured, seeking a declaration that it did not provide primary coverage for the insured. The Eighth Circuit upheld the district court's decision not to exercise jurisdiction because (1) the insured's liability had not yet been determined and (2) the dispute was essentially about which insurer would provide coverage for whatever amount of damages, if any, were ultimately awarded. Id. at 270-71.
Because the state guaranty association agreed to provide the defense, the Eighth Circuit in McGillacutty's did not need to address whether the excess insurer had a duty to defend the insured. See id.
A. Duty to Indemnify
In this case, SDS seeks to dismiss or stay Cincinnati's claim for declaratory relief on both the duty to defend and the duty to indemnify. Because Cincinnati concedes that adjudication of the duty to indemnify is not ripe, (Doc. #28 at 2), and because McGillacuty's held that it is proper to wait for a determination of the insured's liability before adjudicating coverage, 820 F.2d at 270-71, this court will stay the proceedings as to Cincinnati's duty to indemnify pending the outcome of the underlying litigation in Kentucky state court. See generally National Elec. Mfrs. Ass'n v. Gulf Underwriters Ins. Co., 162 F.3d 821, 823 n. 1 (4th Cir. 1998) (declining to address duty to indemnify where "the parties agreed that the duty to indemnify issue was not ripe because [the insured] had not been held liable to pay damages in any underlying claim."); West Bend Mut. Ins. Co. v. Iowa Iron Works, 503 N.W.2d 596, 601 (Iowa 1993) (trial court "acted correctly and prudently in declining to address the indemnity question" where the underlying liability litigation was still pending); cf. Stine Seed Farm, Inc. v. Farm Bureau Mut. Ins. Co., 591 N.W.2d 17, 18 (Iowa 1999) ("It is expedient to first resolve whether there is a duty to defend because that duty is broader than the duty to indemnify."). Therefore, the motion to stay proceedings as to Cincinnati's request for a declaration that it has no duty to indemnify will be granted.B. Duty to Defend
Even though it concedes that the duty to indemnify is not ripe, Cincinnati argues that its claim regarding the duty to defend should be allowed to proceed because the court's decision on that issue would not interfere with the underlying litigation pending in Kentucky state court and because declaratory relief by this court is the only way by which Cincinnati can avoid the defense costs associated with the underlying litigation. SDS responds that if Cincinnati believed it did not have a duty to defend, it could have brought a motion for summary judgment based solely on the pleadings and the insurance contract; according to SDS, the fact that Cincinnati has served discovery shows that there is a duty to defend because it shows there are disputed factual issues.Under Iowa law, "[t]he duty to defend arises `whenever there is potential or possible liability to indemnify the insured based on the facts appearing at the outset of the case.'" A.Y. McDonald Indus., Inc. v. INA, 475 N.W.2d 607, 627 (Iowa 1991) (emphasis added) (citing First Newton Nat'l Bank v. General Cas. Co., 426 N.W.2d 618, 623 (Iowa 1988)). To decide whether there is a duty to defend, a court should examine the petition to "decide whether the facts alleged `bring the claim within the liability covered by the policy.'" Stine Seed Farm, 591 N.W.2d at 18 (emphasis omitted) (citing Chipokas v. Travelers Indem. Co., 267 N.W.2d 393, 395 (Iowa 1978)). "In other words, the duty to defend rests solely on whether the petition contains any allegations that arguably or potentially bring the action within the policy coverage." A.Y. McDonald Indus., 475 N.W.2d at 627 (citing 7C J. Appelman, Insurance Law Practice § 4684, at 83-85 (Berdal ed. 1979)). Even where the record ultimately shows that an insurer has no duty to indemnify, the insurer may still be liable for failing to defend if the facts which "appeared at the outset of the case" showed that the insurer had such a duty. A.Y. McDonald Indus. v. INA, 842 F. Supp. 1166, 1177 (N.D. Iowa 1993). However, "no duty to defend exists where it clearly appears there is no duty to indemnify." West Bend Mutual, 503 N.W.2d at 601.
The court concludes that Cincinnati is entitled to contest the duty to defend in this declaratory judgment as long as the litigation does not interfere with factual determinations that will be made by the Kentucky state court. Because Cincinnati is currently providing a defense, this claim is clearly ripe for adjudication. The duty to defend, as a practical matter, is often resolved while the underlying litigation is still pending. E.g., West Bend Mutual, 503 N.W.2d at 599-601 (applying policy exclusions and insuring clauses in light of the allegations by the plaintiff in the underlying litigation in reviewing summary judgment in favor of insured on duty to defend issue). As SDS points out, Cincinnati could bring a summary judgment motion based on the pleadings and the terms of the insurance policy without interfering with the underlying litigation in Kentucky state court. (Doc. #30 at 3). Therefore, the court will not stay Cincinnati's claim for declaratory relief to the extent Cincinnati seeks a declaration that it does not owe SDS the duty to defend the underlying litigation in Kentucky state court.
C. Discovery
Having denied the motion to stay on the duty to defend issue, the court will now address whether Cincinnati should be allowed to pursue discovery on that claim. As quoted above, Iowa law provides that "the duty to defend rests solely on whether the petition contains any allegations that arguably or potentially bring the action within the policy coverage." A.Y. McDonald Indus., 475 N.W.2d at 627. Thus, it appears to the court that Cincinnati should be able to bring a dispositive motion based on Pineville's petition in Kentucky state court and the applicable language of the insurance policies at issue.
Nonetheless, Cincinnati argues that many cases recognize the usefulness of evidence outside the initial petition and the insurance contract in deciding whether an insurer has a duty to defend. Therefore, Cincinnati argues, it is entitled to discovery to prove that it has no duty to defend. In support of its argument, Cincinnati cites McAndrews v. Farm Bureau Mut. Ins. Co., 349 N.W.2d 117 (Iowa 1984), in which the court stated that the duty to defend inquiry "must sometimes be expanded beyond the petition" to include "`any other admissible and relevant facts in the record.'" Id. at 119 (emphasis omitted) (quoting Central Bearings Co. v. Wolverine Ins., 179 N.W.2d 443, 445 (Iowa 1970)). As the Iowa Supreme Court explained, allowing additional evidence beyond the petition and the insurance contract may be necessary because "the draftsman of a pleading against the insured is not ordinarily interested in the question of coverage which later arises between insurer and insured." New Hampshire Ins. Co. v. Christy, 200 N.W.2d 834, 838 (Iowa 1972)).
However, none of the cases to which Cincinnati cites holds that discovery is allowed on a declaratory judgment claim by an insurer on the duty to defend, and the court has not been able to find any Iowa cases so holding. Having reviewed the cases, the court believes that a stay of the pending discovery is appropriate under the facts and circumstances of this case.
In Christy, the court used an example which showed how allowing additional evidence beyond the petition may be necessary to protect the rights of insurers. In the example, an insured was sued for negligent operation of an automobile, but the vehicle was not identified in the petition. 200 N.W.2d at 838 (citation omitted). As a matter of fact, however, the insured owned two vehicles, only one of which was covered by the insurer. Id. The Iowa Supreme Court stated that if the alleged negligent operation of the automobile involved the non-insured vehicle, there would be no duty to defend. Id.
In Christy, the court held that the "general rule" under which courts look only at the allegations in the petition "does not deal with the special situation where there is a conflict between the alleged facts and the actual facts as known to the insurer." Id. (quotation omitted). Thus, an insurer has a right to use "known" facts to avoid the duty to defend. Id. Clearly, if the insurer knows facts which defeat the duty to defend, an insurer may move for summary judgment on the basis of affidavits or otherwise seek an expedited ruling on the issue.
The tougher question is where the insurer does not know the relevant facts, but believes that the facts known by the insured would defeat the duty to defend. This appears to be the situation in this case. Naturally, the insurer would want to use discovery to establish the facts for purposes of bringing a summary judgment motion. It would certainly be unfair to allow an insured to mislead an insurer about the facts in order to obtain a defense when the insurance contract would not otherwise provide a defense. Therefore, the court cannot accept a blanket rule against discovery in a duty to defend case.
However, any discovery must be carefully limited to the facts as the insured knew them at the outset of the case. Cf. Old Republic Ins. Co. v. Chuhak Tecson, P.C., 84 F.3d 998, 1002-03 (7th Cir. 1996) (Posner, J.) (applying Illinois law, the court found "strict limits on the scope of pretrial discovery" in declaratory judgment actions by insurers against insureds because of the need to protect insureds from being forced to litigate multiple lawsuits simultaneously and because pretrial discovery by an insurer may produce evidence damaging to the insured in the underlying litigation). Even an insured's good faith version of events, which later is rejected by the jury, must be accepted as true for purposes of determining whether the insurer has a duty to defend. McAndrews, 349 N.W.2d at 119 (in deciding the duty to defend, the court had to accept as true the insured's allegation at the outset of the case that he hit the plaintiff in the underlying litigation in self-defense, even though the plaintiff alleged, and the jury later found, that the insured committed an intentional tort).
Therefore, the court concludes that any discovery to which Cincinnati is entitled should be carefully limited to ascertain the facts known at the outset of the underlying litigation that are likely to answer the duty to defend question. Upon the court's review of Cincinnati's discovery requests in this case, it is clear that Cincinnati's discovery has not been tailored to elicit responses that answer the duty to defend question based on facts known at the time Pineville filed its complaint in Kentucky state court. Thus, the court will continue the stay of Cincinnati's pending discovery requests. However, if Cincinnati decides that it needs limited discovery in order to bring a motion for summary judgment on the duty to defend, Cincinnati is free to bring a motion before the court to allow such discovery.
If Cincinnati decides to bring such a motion, Cincinnati should explain how the discovery it seeks is relevant to the duty to defend question (i.e., Cincinnati should identify what part of the underlying state court petition and the insurance contract it is trying to explain with the requested discovery).
ORDER
For the foregoing reasons, the defendant Source Data System's motion to dismiss or stay the proceedings (Doc. #26) is GRANTED IN PART and DENIED IN PART. The proceedings related to the plaintiff Cincinnati Insurance's claim that it does not owe the defendants a duty of indemnification are STAYED pending the resolution of Pineville Community Hospital Association, Inc. v. Keane, Inc., No. 98-CI-00302, in Bell Circuit Court in the Commonwealth of Kentucky. Source Data System's motion is DENIED in all other respects.The defendant Source Data System's objection to the magistrate's order and motion to stay discovery (Doc. #36) is SUSTAINED. Discovery in the proceedings related to Cincinnati Insurance's claim that it does not owe the defendant Source Data Systems a duty to defend is STAYED, except for any discovery conducted consistent with this Order.