Sometimes courts get it right, both analytically and in the result. This was true in the landmark decision of the Texas Supreme Court in PAJ, Inc. v. Hanover Insurance Co. (Texas Jan. 11, 2008). In this case, the Texas court holds that “an insured’s failure to timely notify its insurer of a claim or suit does not defeat coverage if the insurer was not prejudiced by the delay.” While I agree with the holding, what may be more significant is the court’s adoption of the right analytical approach, specifically, considering the notice provision as covenant whose breach discharges the insurance company’s performance only where that breach constitutes a material breach of the contract.
The Texas Supreme Court sought to fashion a rule that avoided “draconian consequences for even de minimis deviations from the duties the policy places on insureds” (which is how it characterized the position of the dissent). Both the majority and the dissent embraced the principle that contractual provisions should be construed as covenants rather than conditions, owing to the fact that a breach of condition works a forfeiture. This principle applies even if a provision is in the “conditions” section of the policy. In PAJ, which I wrote about previously, the dispute between the majority and dissent centered on whether the particular provision should be considered to be a true condition or not.
Certainly, an unexcused breach of the obligation to provide timely notice is not sympathetic, and insurers have legitimate interests in knowing of the existence of claims against their insureds, in investigating claims while the evidence is fresh, and taking steps to safeguard their insureds’ interests and their own. The question in PAJ and other notice cases is whether it is best to set up a system that results in automatic forfeiture in all cases where notice is late or other “conditions” are violated. The Texas Supreme Court ruled that a “no harm, no foul” or “little harm, minor penalty” approach was fair to both sides. Accordingly, a policyholder that violates an obligation under the policy in general will be considered to have violated a covenant, not a condition. This was the holding also in the recent California appellate case of Belz v. Clarendon Am. Ins. Co. (Cal. App. Dec. 28, 2007), which while ostensibly focused on the question whether the particular clause at issue was a “no voluntary payments” or (merely) a “cooperation” clause adopts the equivalent framework considering material (prejudicial) versus immaterial breaches of policyholder duties.
Classifying a policy provision as a covenant does not mean that the insurer’s legitimate interests cannot be recognized. An immaterial breach of contract allows the non-breaching party a right to damages or set off; however, the non-breaching party is not allowed to suspend its promised performance completely. Put differently, to the extent the insurer can show that a policyholder’s breach of covenant in fact worked a harm to it in some way, the insurer is free to seek to prove the extent of that harm. If that harm is “immaterial” – that is, does not vitiate the entirety of the contract – then the insurer is able to set off its obligations (subject to the usual rules of proving damages). If the harm is material, then the insurer’s obligation to perform may be excused entirely. See generally Belz , slip op. at 15 (“‘To establish actual prejudice, the insurer must show a substantial likelihood that, with timely notice, and notwithstanding [any] denial of coverage or reservation of rights, it would have settled the claim for less or taken steps that would have reduced or eliminated the insured’s liability.’”) (citation omitted).
But it does not make sense to allow an insurer to keep the policyholder’s premium and refuse to perform when the policyholder’s late notice works no harm. Most policyholders do not have multiple claims under a single policy, and a strict forfeiture rule would create the situation that in the sole instance where the policyholder might achieve value from its insurance investment the insurer is excused from performing even though it has not in fact been harmed from late notice (all the while keeping the policyholder’s premium).
The confusion in the law has stemmed in part from the nomenclature adopted by courts in this area, where they have sought to protect insureds that or who gave “late” notice by requiring the insurer to show “prejudice” (or the policyholder to prove the absence of prejudice). But it makes no sense from a contract-law vantage point to characterize a provision as a condition but only to enforce it if the other party has been prejudiced from its nonperformance. The casual reference by courts to notice provisions as “conditions” and the adoption of the “notice/prejudice” rule itself has created confusion in the law.
The right approach is to presume that all contractual provisions setting forth policyholder duties are covenants, whose breach if immaterial entitles the innocent party to set off or if material entitles the innocent party to refuse performance. As the dissent in PAJ recognizes, “’[m]agic words are not controlling; labeling something a ‘condition precedent’ does not make it so.”
The right question is whether the specific language and the particular obligation is one whose performance should be completed before the other party’s obligation matures or is required at all. If an insurance company wishes to make notice a true condition precedent, it should make the contract provision absolutely clear that noncompliance will work a forfeiture. We see the equivalent of this in claims-made-and-reported policies which require that reporting of the claim (i.e., providing notice) occur during the policy period in order for the insuring agreement to be satisfied. As a leading English judge wrote in a key notice ruling there, “If insurers consider that they want or need such protection, they can and should try to express it in their insurance contracts and see if insureds and the broking market will accept it.” Friends Provident Life & Pensions Ltd. v. Sirius Int’l Ins.,  EWCA Civ. 601 (per Lord Mance).
PAJ was a split decision, 5 to 4, with strong majority and dissenting opinions. From the perspective of insurance law, it is a very positive development that the Texas justices all accepted the framework of determining whether notice was a condition or a covenant and if so the consequences of breach. Adopting the right framework not only produces correct results, as in PAJ, but also clarifies for insurers and insurance regulators how to approach revising the policy language to make clear – if intended – that punctilious compliance is requisite on pain of forfeiture. Were this made pellucid, then insurance regulators could step in to protect consumers or the marketplace could respond by pricing such policies commensurate with the traps they lay. Most important, insurers should say what is expected and what they require and make clear to purchasers the consequences of noncompliance (in plain, unambiguous language, and labeling something a “condition precedent” certainly fails on that score).
Regardless whether a particular jurisdiction is a “notice/prejudice” state, see Prince Georges Cty. v. Local Gov’t Ins. Trust (Md. 2004) at n.9 (classifying 38 states as “notice/prejudice” and discussing most others), policyholders in all circumstances should seek to involve their insurers as soon as practicable, and they timeously should consider whether claims against them potentially implicate coverage. As always, rather than arguing about conditions versus covenants and material versus immaterial breach, policyholders are advised to abide by the rule that notice is like voting in Chicago – do it early and often.