When ignorance is not bliss: recent appellate court guidance on deeming provisions in professional indemnity policies
On 25 June 2020, the New South Wales Court of Appeal handed down a decision that provides guidance on what is required to be established by an insured to trigger a “deeming provision” in a professional indemnity insurance policy.
The decision, DIF III – Global Co-Investment Fund L.P v DIF Capital Partners Limited  NSWCA 124, supports the view that the existence of loss suffered by third parties may not be sufficient to constitute a notifiable fact or circumstance in the absence of further information that suggests the loss arises out of the conduct of the insured.
On the advice of DIF Capital Partners Limited, formerly known as Babcock & Brown Direct Investment Fund Limited (B&B), in 2007, DIF III – Global Co-Investment Fund L.P (DIF III), by its controlling partner, DIF III GP Ltd, invested US$25,000,000 in Coinmach Services Corporation (Coinmach), a leading provider of outsourced laundry equipment services in the United States. The investment then collapsed in the midst of the global financial crisis. Ultimately, DIF III received US$1,338,805 in May 2013 and a further US$89,564 in August 2013 in respect of its investment.
B&B had in place professional indemnity (PI) policy of insurance for the period of 1 September 2008 to 1 September 2009 (PI policy).
Subject to its terms, the PI policy responded to claims that were “first made” between 1 September 2008 to 1 September 2009 (policy period). Allied to this, the PI policy included a deeming provision that provided that a claim would be “considered to be made” when the B&B’s management became “aware of any fact, circumstance or event which could reasonably be anticipated to give rise to a Claim at any future time” (Deeming Provision). This was subject to a condition precedent that provided that written notification of such facts, circumstances or event needed to be made at the earliest practical moment, and, at the latest, by 30 days after the expiry of the policy period. If such notice was given, then any subsequent legal proceedings for damages against B&B as a direct result of any matters notified would be considered to be made at the time the notice was first given.
In 2018, DIF III commenced Supreme Court of NSW proceedings against B&B, outlining a number of asserted causes of action, including an allegation that B&B had breached the terms of its agreement with DIF III that required it to “exercise all due diligence and vigilance in carrying out its functions, powers and duties” in relation to the investment in Coinmach. Specifically, it was alleged that B&B had failed to undertake any, or any proper, due diligence or other investigations that a reasonable and prudent investment manager in its position would have undertaken prior to making the recommendation for DIF III to participate in the Coinmach investment.
DIF III claimed that, but for this breach, proper due diligence would have been performed and that, ultimately, the investment would not have gone ahead. DIF III sought to recover the amount of its investment on a “no transaction” basis.
DIF III also sued, amongst others, B&B’s PI insurers pursuant to the cut-through provisions of the Civil Liability (Third Party Claims Against Insurers) Act 2017 (NSW). The PI insurers admitted that B&B had breached its agreement with DIF III, but denied that DIF III had suffered any loss or damage due to that breach. The PI insurers also denied that they were obliged to indemnify B&B under the PI Policy on the basis that B&B’s management had not become “aware of any fact, circumstance or event which could reasonably be anticipated to give rise to a Claim” against B&B at any time during the policy period, so as to trigger the Deeming Provision, with the consequence that they were not liable under the PI Policy in respect of DIF III’s claim.
The claim was not first made against B&B during the policy period. Further, no notification of any “fact, circumstance or event” that could reasonably be anticipated to give rise to proceedings against B&B had been made to the PI insurers before the proceeding was commenced in 2018, some 9 years after the expiry of the policy period.
Despite this, the PI insurers accepted that, if B&B could establish that its management had become aware of any “fact, circumstance or event which could reasonably be anticipated to give rise to a Claim at any future time” during the policy period, then the failure to provide written notification of the fact, circumstance or event within the time required by the condition precedent would not by itself entitle insurers to refuse to pay the claim, due to the remedial effect of section 54 of the Insurance Contracts Act 1984 (Cth) (section 54).
As such, the critical issue in the claim against the PI insurers was whether it could be established that B&B’s management had become aware of any such “fact, matter or event” within the relevant time period so as to trigger the Deeming Provision (with the assistance of section 54).
Awareness of B&B’s management
DIF III relied on three emails that came to the attention of a member of B&B’s management during the policy period to seek to establish the relevant knowledge. Two of the emails pre-dated the closure of the Coinmach investment the third post-dated it. Relevantly:
- The first email recorded views of a separate investor in Coinmach concerning the “distressed” position of the Coinmach investment. The view expressed was that the prospect of holding the investment on a long term basis in order to realise value through EBITDA (net earnings) growth was at that time “impossible”.
- The second email referred to an earlier email exchange in which certain interested parties had expressed the view that “the Coinmach deal should go ahead – although agreeing it being un-commercial – purely for the reason of collecting a substantial fee… and other satellite fund investors”.
- The third email attached a draft valuation of Coinmach as at 1 October 2009 undertaken by KPMG LLP, which concluded that Coinmach’s interest-bearing debt exceeded its enterprise value, with the consequence that the value of Coinmach’s equity was nil.
DIF III submitted that the three communications were to be considered together and that, in the context of the admission in the proceedings that B&B had breached its obligation to undertake appropriate due diligence, this was sufficient to prove knowledge of a fact, circumstance or event that gave rise to the claim made against B&B in the proceedings.
First Instance Decision
In relation to the insurance issue, Justice Ball found that these did not indicate the claim made in the proceedings, but instead referred in a general sense to the poor performance of the Coinmach investment performing badly. His Honour also found that the evidence did not establish that the emails were received by persons whose knowledge could be attributed to B&B for the purposes of the Deeming Provision.
As B&B had no knowledge of facts, circumstances or events that could reasonably be anticipated to give rise to the claim against B&B made in the proceedings, section 54 of the ICA had no work to do.
DIF III appealed.
Meagher JA (Bathurst CJ and Bell P agreeing) delivered reasons on the insurance issue, upholding Justice Ball’s decision.
His Honour held that the emails were not sufficient to prove on the balance of probabilities that B&B’s management was aware of any “fact, circumstance or event which could reasonably be anticipated to give rise to” the claim brought against B&B. His Honour stated that the second email “did not provide any basis for thinking a claim of some sort might be brought against” B&B. The first and third emails were said to concern Coinmach’s financial position in October and November 2008. In this regard, his Honour stated:
Whilst the fact of [Coinmach’s] financial position made it likely that there were persons or entities… who would suffer losses as a result of its failure, that was not of itself a matter which could reasonably be anticipated to give rise to a claim against [B&B]… there was nothing in any of those communications which suggested that DIF III or any other party had a basis for making a claim arising out of the conduct of [B&B] in relation to the… investment
In arriving at his view, his Honour considered some of the principles outlined by the England and Wales Court of Appeal in Euro Pools Plc v Royal & Sun Alliance Insurance Plc  EWCA Civ 808, relevantly being that:
- a deeming provision should be construed with a view to its commercial purpose, being to provide an extension of cover “for all claims in the future which flow from the notified circumstances”;
- a deeming provision that refers to circumstances that “may” give rise to claims sets a “deliberately undemanding test”;
- a notification need not be limited to particular events and may be to a “problem” described in general terms if that problem of itself may give rise to a claim. This is notwithstanding that the quantum and character of such claims, or the identity of claimants, may not be known at the date of notification; and
- the awareness of the insured does not mean that the insured needs to know or appreciate the cause, or all the causes, of the problems which have arisen, or the consequences, or the details of the consequences, which may flow from them.
His Honour also referred to the England and Wales Court of Appeal decision of HLB Kidsons (a firm) v Lloyd’s Underwriters  EWCA Civ 1206, in which Toulson LJ stated that the notifiable circumstance must be such that it “may reasonably be regarded in itself as a matter which may give rise to a claim”. In this case, the language of the Deeming Provision required it to be a circumstance that “could reasonably be anticipated to give rise to a claim”.
Where a claims made and notified policy contains a deeming provision, and there is a late notification of facts and circumstances, the remedial effect of section 54 creates practical difficulties for insurers in assessing and finalising exposures that might arise. This, together with the statutory right to notify facts/circumstances that might give rise to a claim during a policy period contained in section 40(3) of the Insurance Contracts Act, is why deeming provisions are becoming increasingly uncommon to find within claims made and notified policies in Australia.
This decision provides helpful guidance on how deeming provisions in professional indemnity insurance policies may be interpreted, specifically:
- that awareness by an insured that losses might be suffered by third parties may not be sufficient, in and of itself, to establish awareness of facts, circumstances or events that might give rise to a claim. Each claim will however be dependent on its precise facts, and the particular wording of the policy (and deeming provision) in question; and
- how forensic scrutiny must be applied to relevant information and material relied upon by an insured as establishing awareness of facts or circumstances at a particular point in time when assessing whether a late notified claim is covered.
It also provides some appellate court support for the application of the principles considered in Euro Pools Plc v Royal & Sun Alliance Insurance Plc relating to the construction of deeming provisions in Australia.