Nichols v. American Home Assurance Co., [1990] 1 S.C.R. 801

American Home Assurance Co. and The Law Society of Upper Canada Appellants

v.

Alan John Nichols Respondent

indexed as: nichols v. american home assurance co.

File No.: 21438.

1990: January 29; 1990: April 12.

Present: Dickson C.J. and Wilson, La Forest, L'Heureux‑Dubé, Gonthier, Cory and McLachlin JJ.

on appeal from the court of appeal for ontario

Insurance ‑‑ Liability insurance ‑‑ Duty to defend ‑‑ Action against insured alleging fraud ‑‑ Policy not applying to fraudulent acts ‑‑ Whether insurer under a duty to defend insured ‑‑ Whether obligation to defend governed by pleadings or by facts as they emerge at trial.

An action alleging fraud was commenced by a Bank against the respondent, a lawyer and member of the appellant Law Society. The respondent gave notice of the suit to the appellant insurance company, which had issued a liability policy to the Law Society on behalf of its members. The policy required the insurer to defend any suit against an insured seeking damages which were or might be payable under the terms of the policy, even if any of the allegations of the suit were groundless, false or fraudulent. The insurer denied any obligation to defend the respondent in view of the exclusion clause, which provided that the policy did not apply to fraudulent acts or omissions of an insured. The Bank later discontinued its action, and costs were awarded to the respondent on a party‑and‑party scale. The respondent claimed the balance of his costs from the insurer, which refused to pay. The respondent brought an action against the insurer seeking a declaration that he was entitled to a defence under the policy and an order that the insurer pay the unrecovered balance of the cost of his defence. The trial judge granted the relief claimed. The Court of Appeal upheld this judgment.

Held: The appeal should be allowed.

Under the policy, the insurer was under no duty to defend the insured. The duty to defend imposed by the defence clause is unambiguously restricted to claims for damages which fall within the scope of the policy. Since the only damages sought against the insured in this case were on account of fraudulent acts or omissions, and such damages are not payable under the policy, the defence clause did not apply. The duty to defend, while broader than the duty to indemnify, is not so broad that it arises with respect to allegations which are clearly beyond the scope of the policy.

The Court of Appeal erred in attempting to make the exclusion clause directly applicable to the duty to defend, and then concluding that since the exclusion does not refer to allegations as opposed to acts and omissions, allegations of fraud are not excluded from the duty to defend. The exclusion clause refers to actual acts or omissions because it is primarily concerned with the duty to indemnify. The scope of the duty to indemnify, in turn, triggers the application of the defence clause, which limits the duty to defend to claims for damages which are or may be payable under the policy. The duty to defend, unlike the duty to indemnify, is triggered not by actual acts or omissions, but by allegations, applying "even if any of the allegations of the suit are groundless, false or fraudulent".

General principles relating to the construction of insurance contracts support the conclusion that the duty to defend arises only where the pleadings raise claims which would be payable under the agreement to indemnify in the insurance contract. It is not necessary to prove that the obligation to indemnify will in fact arise in order to trigger the duty to defend; the mere possibility that a claim within the policy may succeed suffices. Finally, to hold that the insurer is required to defend claims regardless of how far outside the scope of the policy they might be would give rise to practical difficulties. It raises policy questions of whether others in the insurance pool should be taxed with providing defences for matters outside the purview of the policy, and might result in conflicts of interest.

Cases Cited

Disapproved: Conner v. Transamerica Insurance Co., 496 P.2d 770 (1972); referred to: Bacon v. McBride (1984), 1984 CanLII 692 (BC SC), 6 D.L.R. (4th) 96; Opron Maritimes Construction Ltd. v. Canadian Indemnity Co. (1986), 1986 CanLII 89 (NB CA), 19 C.C.L.I. 168, leave to appeal refused, [1987] 1 S.C.R. xi; Prudential Life Insurance Co. v. Manitoba Public Insurance Corp. (1976), 1976 CanLII 1099 (MB CA), 67 D.L.R. (3d) 521; Dobish v. Garies (1985), 1985 CanLII 1338 (AB QB), 15 C.C.L.I. 69; Thames Steel Construction Ltd. v. Northern Assurance Co., [1989] I.L.R. 1‑2399; Vancouver General Hospital v. Scottish & York Insurance Co. (1987), 1987 CanLII 2601 (BC SC), 15 B.C.L.R. (2d) 178.

Authors Cited

Couch, George James. Cyclopedia of Insurance Law, 2nd ed. By Ronald A. Anderson. Revised volume by Mark S. Rhodes. Rochester, N.Y.: Lawyers Co‑operative Publishing Co., 1982.

APPEAL from a judgment of the Ontario Court of Appeal (1989), 1989 CanLII 10407 (ON SC), 68 O.R. (2d) 1, 33 O.A.C. 142, 36 C.C.L.I. 204, [1989] I.L.R. 1‑2421, affirming an order of Hughes J. (1988), 1988 CanLII 4554 (ON SC), 63 O.R. (2d) 693, 30 C.C.L.I. 79, [1988] I.L.R. 1‑2282. Appeal allowed.

W. L. N. Somerville, Q.C., and Wendy Earle, for the appellants.

Janis P. Criger, for the respondent.

//McLachlin J.//

The judgment of the Court was delivered by

McLachlin J. -- The issue in this case is whether the insurer is under a duty to defend the insured. The question is whether on the policy of insurance here in question the obligation to defend is governed by the pleadings or by the facts as they emerge at trial.

The Facts

Mr. Nichols is a lawyer. The Bank of Montreal issued a writ against him and his partner, Servos, along with a number of corporations and other individuals. The statement of claim alleged that Messrs. Nichols and Servos had committed fraud on the Bank in assisting other defendants to transfer various real properties and charges.

Mr. Nichols gave notice of the suit to his liability insurer, the American Home Assurance Company, which had issued a policy to the Law Society on behalf of its members. The insurer responded by advising Nichols that it was denying any obligation to defend him, as well as indemnity coverage under the policy of insurance, which provided that the policy did not apply "to any dishonest, fraudulent, criminal or malicious act or omission of an Insured."

Sometime later, the Bank moved to discontinue its action against the law firm. Leave was granted and costs awarded to Mr. Nichols and Mr. Servos. Costs, however, were confined to the party and party scale, the judge noting that there were grounds for joining the law firm. In the result, Mr. Nichols was not fully indemnified for the cost of defending the law suit. He demanded that his insurer pay the balance of his costs.

The insurer refused to do so, maintaining that an obligation to defend did not arise under the policy in view of the fact that the only allegation against the law firm was that of fraud, coverage for which was excluded by the terms of the policy. Mr. Nichols brought an action against the insurer asking for a declaration that he was entitled to a defence under the policy and an order that the insurer pay the unrecovered balance of the cost of his defence.

The trial judge granted the relief claimed: (1988), 1988 CanLII 4554 (ON SC), 63 O.R. (2d) 693. In his view, on a proper construction of the policy and application of the contra proferens rule against the insurer, the insurer was required to provide a defence to the allegations of fraud.

The Court of Appeal affirmed this judgment: (1989), 1989 CanLII 10407 (ON SC), 68 O.R. (2d) 1. It noted, hypothetically, that were it not for the exclusionary clause the sums claimed would constitute damages, and that, had there been alternative pleadings in negligence, the insured would have been entitled to a defence. The Court went on to find, per McKinlay J.A., that the exclusionary clause did not state in an unambiguous way that neither indemnity nor defence coverage is available under the policy for alleged fraudulent acts. In her view, the true meaning of the policy was that "if an insured did not actually perform the alleged fraudulent acts, then the exclusion does not apply" (p. 7). Although earlier in her reasons McKinlay J.A. accepted the principle that the pleadings should govern the duty to defend ("on the wording of the policy itself the duty to defend arises only if the allegations are within the coverage" (p. 6)), in the result she appears to have held implicitly that it was not the allegations in the pleadings which determined if an obligation to defend arose, but rather the acts proved at trial. While McKinlay J.A. did not find the words of the policy ambiguous, she stated that if there were any ambiguity, it should be resolved in favour of the insured.

The Policy

The relevant provisions of the policy are as follows:

The American Home Assurance Company . . . agree . . .

To pay on behalf of the Insured all sums which the Insured shall become legally obligated to pay as damages because of any act or omission of the Insured . . . . and arising out of the performance or intended performance of professional services for others, or failure to perform such services as ought to have been performed, in the Insured's capacity as a lawyer . . . .

COVERAGE D -- DEFENSE, SETTLEMENT, SUPPLEMENTARY PAYMENTS:

With respect to such insurance as is afforded by this Policy, the Insurers shall in addition to the applicable Limit of Liability

(a)Defend any suit against the Insured . . . alleging such act or omission and seeking damages which are or may be payable under the terms of this Policy, even if any of the allegations of the suit are groundless, false or fraudulent . . . .

II. EXCLUSIONS

THIS POLICY DOES NOT APPLY:

(a)to any dishonest, fraudulent, criminal or malicious act or omission of an Insured, however, this exclusion does not apply to any Insured who is neither the author of the said act or omission, nor an accomplice . . . .

Analysis

Construction of the Policy

The appellants' argument may be summarized as follows. The defence clause imposes two conditions before the duty to defend arises. The clause reads as follows:

With respect to such insurance as is afforded by this Policy, the Insurers shall . . .

Defend any suit against the Insured . . . alleging such act or omission and seeking damages which are or may be payable under the terms of this Policy . . . . [Emphasis added.]

The two conditions are: (1) that the suit allege "such act or omission" (i.e. an act or omission described elsewhere in the policy); and (2) that the suit seek "damages which are or may be payable under" the policy. If the statement of claim is read as alleging facts on which there may be a cause of action in fraud, and nothing else, there are only two possibilities. Either the claim succeeds, in which case no damages are payable under the terms of this policy because of the exclusion clause, or the claim fails, in which case no damages are payable anyway. Therefore, it is argued, in no conceivable circumstance can the second of the two conditions be met. Put simply, the essence of this argument is that no duty to defend arose because the only damages claimed, damages for fraud, are not payable under the policy.

The respondent presents a more complex argument. The defence clause itself, it is noted, does not make any reference to allegations of fraud, but states that coverage applies to suits alleging "such act or omission". This must refer back to the basic indemnity clause, which provides as follows:

The American Home Assurance Company . . . agree . . .

To pay on behalf of the Insured all sums which the Insured shall become legally obligated to pay as damages because of any act or omission of the Insured . . . . and arising out of the performance or intended performance of professional services for others, or failure to perform such services as ought to have been performed, in the Insured's capacity as a lawyer . . . .

The suit is based on an act or omission arising out of services performed in the insured's capacity as a lawyer, so there is prima facie an obligation to indemnify, the respondent argues. This leaves the problem of the effect of the exclusion clause, which excludes application of the policy to "any dishonest, fraudulent, criminal or malicious act or omission of an Insured" and goes on to state that the "exclusion does not apply to any Insured who is neither the author of the said act or omission, nor an accomplice". The respondent argues that it is trite law that exclusions are to be construed restrictively, and that the burden of proving that an exclusion clause applies lies on the insurer. This exclusion makes no reference to allegations of fraud, but rather refers only to an act or omission, he emphasizes. Furthermore, the exclusion does not apply to any insured who is not the author of the said act or omission. As it has not been proved in this case that the insured committed a fraudulent act or omission, the exclusion does not apply in light of the above restrictive principles on the application of exclusion clauses, in the respondent's submission. The essence of the respondent's position is that because the exclusion clause does not specifically refer to allegations of fraud, it should be taken as applying only where actual acts of fraud are found. To put it another way, in the absence of a finding of actual fraud the exclusion does not apply and the duty to defend remains.

In my view the respondent's argument is overly complex and flawed. It depends on a finding of ambiguity in the contract. In my view, there is no ambiguity relating to the obligation to defend. That obligation is clear. It arises only where a suit is brought against the insured alleging an act or omission under the policy "and seeking damages which are or may be payable under the terms of this Policy". The question which must be asked is whether, in the case at bar, the Bank of Montreal's suit claimed damages which might be payable under the policy. The answer to this question must be negative. The only damages sought against the insured were on account of fraudulent acts or omissions. It is common ground that such damages are not payable under the policy. It follows that the Bank's claim was not for damages payable under the policy and that the defence clause does not apply.

The respondent seeks to meet this conclusion by arguing that damages might have been payable under the terms of the policy "if the acts alleged . . . are proven, but found to be negligent, rather than fraudulent, by a Trial Judge." This would be so if the statement of claim alleged negligence. However, it does not. Without an amendment to the pleadings, the Bank's claim could not give rise to damages payable under the policy.

The respondent also relies in this connection on the contention that the duty to defend is broader than and independent of the duty to indemnify. This is so, in the sense that the duty to defend arises where the claim alleges acts or omissions falling within the policy coverage, while the duty to indemnify arises only where such allegations are proven at trial. But it does not follow that the duty to defend is so broad that it arises with respect to allegations which are clearly beyond the scope of the policy.

I conclude that the duty to defend imposed by the defence clause is unambiguously restricted to claims for damages which fall within the scope of the policy. Since damages for fraud do not fall within the policy, one never arrives at the stage of inquiring as to whether there may be an ambiguity in the exclusion clause relevant to the duty to defend. I do not think it amiss, however, to set out my view of the relationship of the exclusion clause to the defence clause, for it is only in reading the policy as a whole that its true intention can be ascertained. As I read the policy, the exclusion clause is primarily concerned with the duty to indemnify. For this reason, it refers to actual acts or omissions, which are the precondition of the duty to indemnify. The scope of the duty to indemnify, in turn, triggers the application of the defence clause, through use of the phrase in the defence clause limiting the duty to claims for "damages which are or may be payable under the terms of this Policy." The duty to defend, unlike the duty to indemnify, is triggered not by actual acts or omissions, but by allegations, applying "even if any of the allegations of the suit are groundless, false or fraudulent." Thus the scope of the duty to defend is not conditioned directly by the exclusion clause, but only indirectly through that clause's definition of the scope of coverage. The error in the Court of Appeal's reasoning lies in attempting to make the exclusion clause directly applicable to the duty to defend, and then concluding that since the exclusion does not refer to allegations as opposed to acts and omissions, allegations of fraud are not excluded from the duty to defend.

I find no ambiguity in the exclusion clause. The policy does not provide indemnity for dishonest, fraudulent, criminal or malicious acts or omissions "of an Insured." The additional phrase in the exclusion clause making it inapplicable to cases where the insured is neither the author of nor an accomplice in the act or omission does not, in my view, mean what the respondent suggests it means -- namely that the exclusion for fraud applies only where actual fraud is established. Rather, it qualifies the phrase "act or omission of an Insured", making it clear that the exclusion is inapplicable where a dishonest, fraudulent, criminal or malicious act or omission may be legally attributed to an insured, but where the insured did not actually author or act as an accomplice in the commission of the fraud or other excluded act or omission. (It is on this ground that it is suggested Nichol's partner, Servos, was viewed as entitled to a separate defence. However, there appears to be no evidence on this matter.)

Thus far, I have proceeded only by reference to the actual wording of the policy. However, general principles relating to the construction of insurance contracts support the conclusion that the duty to defend arises only where the pleadings raise claims which would be payable under the agreement to indemnify in the insurance contract. Courts have frequently stated that "[t]he pleadings govern the duty to defend": Bacon v. McBride (1984), 1984 CanLII 692 (BC SC), 6 D.L.R. (4th) 96 (B.C.S.C.), at p. 99. Where it is clear from the pleadings that the suit falls outside of the coverage of the policy by reason of an exclusion clause, the duty to defend has been held not to arise: Opron Maritimes Construction Ltd. v. Canadian Indemnity Co. (1986), 1986 CanLII 89 (NB CA), 19 C.C.L.I. 168 (N.B.C.A.), leave to appeal refused by this Court, [1987] 1 S.C.R. xi.

At the same time, it is not necessary to prove that the obligation to indemnify will in fact arise in order to trigger the duty to defend. The mere possibility that a claim within the policy may succeed suffices. In this sense, as noted earlier, the duty to defend is broader than the duty to indemnify. O'Sullivan J.A. wrote in Prudential Life Insurance Co. v. Manitoba Public Insurance Corp. (1976), 1976 CanLII 1099 (MB CA), 67 D.L.R. (3d) 521 (Man. C.A.), at p. 524:

Furthermore, the duty to indemnify against the costs of an action and to defend does not depend on the judgment obtained in the action. The existence of the duty to defend depends on the nature of the claim made, not on the judgment that results from the claim. The duty to defend is normally much broader than the duty to indemnify against a judgment. [Emphasis added.]

In that case it was unclear whether the insurer might be liable to indemnify under the policy, so the duty to defend was held to apply. In the court's view it would have been unjust for the insurers to be able to assert that "the claim is probably groundless, or will probably end up falling outside of the indemnity coverage. Since we have no proof that we owe an indemnity in this case, we take the position that we owe no duty to defend."

Other Canadian authority overwhelmingly supports the view that normally the duty to defend arises only with respect to claims which, if proven, would fall within the scope of coverage provided by the policy: see Dobish v. Garies (1985), 1985 CanLII 1338 (AB QB), 15 C.C.L.I. 69 (Alta. Q.B.); Thames Steel Construction Ltd. v. Northern Assurance Co., [1989] I.L.R. 1-2399 (Ont. C.A.); Vancouver General Hospital v. Scottish & York Insurance Co. (1987), 1987 CanLII 2601 (BC SC), 15 B.C.L.R. (2d) 178 (B.C.S.C.)

The same view generally prevails in the United States: see Couch on Insurance (2nd ed. 1982), vol. 14, para. 51:45, and authorities cited therein. Only Conner v. Transamerica Insurance Co., 496 P.2d 770 (Okla. 1972), was cited to contrary effect. There, as here, only fraud was alleged. The court held that "[i]t is certainly not consonant with the objects to be accomplished by a professional insurance policy to say that by its terms no protection is afforded the insured when groundless charges of fraud and dishonesty are alleged in a suit against him" (p. 775). It was held that because the defence clause did not explicitly preclude the obligation to defend groundless suits for fraud, the duty to defend applied to such cases.

I offer two observations with respect to the Conner case. First, the duty to defend suits for fraud, groundless or not, is, in my view, clearly excluded by the wording of the defence clause in this case. In so far as Conner was concerned with a similar clause, I would respectfully disagree with the conclusion in that case that the clause did not exclude such a duty. Secondly, the adoption of the course chosen in Conner would give rise to practical difficulties. The insurer would always be obliged to defend regardless of how far outside the scope of the policy the claims might be, subject only to the possibility of recovery back in the event the claim ultimately succeeded only on grounds outside the scope of the policy. This raises policy questions of whether others in the insurance pool should be taxed with providing defences for matters outside the purview of the policy. Moreover, conflicts of interest may result. The insurer's interest in defending a claim is related to the possibility that it may ultimately be called upon to indemnify the insured under the policy. It is in the insurer's interest that if liability is found, it be on a basis other than one falling under the policy. Requiring the insurer to defend claims which cannot fall within the policy puts the insurer in the position of having to defend claims which it is in its interest should succeed. The respondent suggested that this potential conflict could be avoided if the insured was able to retain his own lawyer, with the cost to be borne by the insurer. However, this would not end the difficulty. An insurer would be understandably reluctant to sign a "blank cheque", and cover whatever costs are borne by whatever lawyer is retained, no matter how expensive. Yet the insurer could not challenge any of these expenses without raising precisely the same conflict. For this reason, the practice is for the insurer to defend only those claims which potentially fall under the policy, while calling upon the insured to obtain independent counsel with respect to those which clearly fall outside its terms.

I conclude that considerations related to insurance law and practice, as well as the authorities, overwhelmingly support the view that the duty to defend should, unless the contract of insurance indicates otherwise, be confined to the defence of claims which may be argued to fall under the policy. That said, the widest latitude should be given to the allegations in the pleadings in determining whether they raise a claim within the policy.

Conclusion

I conclude that the policy by its wording confines the duty to defend to claims which potentially fall within the indemnity coverage of the policy. This conclusion is supported, in my view, by the decisions in which the question has been considered as well as by practical considerations arising from the relationship of the insurer to the insured and their respective obligations and interests.

I would allow the appeal and dismiss the respondent's application with costs throughout.

Appeal allowed with costs.

Solicitors for the appellants: Borden & Elliot, Toronto.

Solicitor for the respondent: Gerald Swaye, Hamilton.