Why a Policyholder Must Fulfill all Conditions before Filing Suit

Failure to Submit to EUO Abates Lawsuit

Almost every first party policy contains a provision requiring the insured to produce relevant documents and submit to an examination under oath (EUO) and to do so before filing suit. Similar conditions have been enforced since the early Nineteenth Century.

In AXO Staff Leasing, LLC v. Zurich American Insurance Company, McCeeadie & McCreadie, Inc., Lassiter Ware Insurance, Case No. A-19-CV-00002-LY, United States District Court Western District of Texas Austin Division (September 16, 2019) Zurich sought to abate the lawsuit and compel AXO’s president to appear for and testify at EUO.

THE INSURANCE DISPUTE

In an insurance coverage dispute between insurer Zurich American Insurance Company (“Zurich”) and named insured AXO Staff Leasing, LLC (“AXO”). AXO is a Texas limited liability company that was in the business of providing “temporary and permanent staffing for companies, processing payroll, withholding income taxes, and managing other similar human resources functions as requested” from 2010 through 2017.

FACTS

The President of AXO, was notified by the Internal Revenue Service Criminal Investigation Division that AXO’s Chief Financial Officer, John Herzer, was under criminal investigation. The IRS claimed that AXO had failed to file quarterly tax returns and pay payroll taxes from 2010 to 2017. AXO alleged in its suit that after the President, Marchant, confronted Herzer regarding the IRS criminal investigation, Herzer confessed that “instead of paying over the taxes owed by AXO, he had embezzled the money for personal use.” AXO promptly terminated Herzer.

AXO notified Zurich of the embezzlement and filed a Proof of Loss with Zurich, alleging that AXO “was the victim of its Chief Financial Officer’s ‘dishonest acts,’ which resulted in at least $3.6 million in losses through embezzlement, and has become liable for at least $4.9 million in penalties and interest for the CFO’s willful non-payment of payroll taxes (and the underlying tax, at least $9.7 million, remains unpaid).”

Zurich reserved its rights in writing summarizing the terms of the Policy and raising questions as to whether Herzer was an “Employee” as defined in the Policy. Zurich noted that the Policy “expressly provides that “Employee” does not include: “(i) any broker, factor, commission merchant, consignee, contractor or other agent or representative of the same general character, or (ii) any natural person who is authorized by you to sign your checks or make withdrawals from your bank accounts without the countersignature of another natural person similarly authorized by you.”

Zurich formally requested the Examination under Oath of AXO, by and through Mr. Marchant, as provided for in the Policy. AXO responded to the Reservation of Rights Letter disputing the coverage issues and contending that Herzer met the definition of employee. AXO eventually informed Zurich that it had completed its forensic accounting and delivered its report to Zurich contending that Herzer embezzled $4,730,702 from AXO.

Zurich’s attorney responded to AXO’s letter stating that Zurich would like to proceed with the examination under oath, but only after all of the following have been accomplished:

Matthew Curtis and RGL Forensics have concluded their work in this matter and issued their report to Zurich.

On behalf of AXO, you have provided me with the documents relating to the issue of whether Mr. Herzer was authorized to sign AXO’s checks or make withdrawals from its bank accounts without the countersignature of another natural person similarly authorized by AXO.

On behalf of AXO, you have also provided AXO’s documents evidencing the draws paid to Mr. Marchant and to Mr. Herzer between 2009 and 2016, including any documents reflecting approval of these draws and how they were recorded on the company’s books and records.

AXO has amended or supplemented its Proof of Loss to update its claimed losses.

AXO responded to the letter and provided Zurich with the Amended Proof of Loss, but failed to fully comply with all of Zurich’s requests.

AXO then sued Zurich, alleging breach of contract, unfair settlement practices, and a violation of the Texas DTPA although it had failed to fulfill the EUO condition and cooperation condition. Zurich responded and filed a Motion to Compel Examination under Oath and Abate this Lawsuit, arguing that AXO failed to comply with the conditions precedent contained in the Policy before filing suit.

LEGAL STANDARDS

The decision to abate (stop the litigation) an action is largely a matter of judicial discretion, which must be exercised in light of the policy against unnecessary dilatory motions.

Texas law provides that insurance policies are construed according to common principles governing the construction of contracts, and the interpretation of an insurance policy is a question of law for a court to determine. Construing insurance policies where the language is plain and unambiguous, courts must enforce the contract as made by the parties, and cannot make a new contract for them, nor change that which they have made under the guise of construction.

ANALYSIS

Zurich argues that AXO has failed to comply with the conditions precedent contained in the Policy before filing this insurance coverage lawsuit by failing to

submit to an examination under oath (“EUO”), and

provide Zurich with all “pertinent records” before filing this lawsuit.

In particular, Zurich complained that AXO refused to provide information regarding whether Mr. Herzer had authority to sign checks or make withdrawals without the countersignature of another person similarly authorized by AXO – a key element in determining whether Mr. Herzer was an ’employee’ of AXO, as defined by the Policy.

In addition to a condition requiring attendance at examination under oath the Policy further contains a “Legal Action Against Us” clause that provides that the insured “may not bring any legal action against us involving loss unless you have complied with all the terms of this insurance.”

The Court concluded that AXO failed to comply with the terms of the Cooperation Clause because it did not submit to an EUO and give Zurich a signed statement of AXO’s answers as required by the Policy.

It is well established under Texas law that cooperation clauses and insurance policy provisions requiring an insured to submit to an examination under oath as conditions precedent to sustaining a suit on the policy are valid. In addition, “Suit Against Us” clauses are also valid conditions precedent to liability under insurance policies. Courts have found such clauses “clear and unambiguous” in entitling the insurer to have the conditions precedent followed before the insured is entitled to file suit under the Policy.

AXO did not dispute that Marchant never submitted to an EUO and failed to produce “for our examination all pertinent records” requested by Zurich before filing this lawsuit.

Because AXO failed to comply with the Cooperation Clause, it has failed to comply with the conditions precedent in the Policy before filing this lawsuit. Where an insured fails to comply with a condition precedent requiring the insured to submit to an examination under oath, the remedy is abatement of the case.

Because AXO failed to comply with the Cooperation Clause in this case, the case must be abated and AXO must submit documents and testify at EUO before the suit may proceed.

ZALMA OPINION

AXO, perhaps because it was driven out of business by Herzer’s criminal conduct, failed to fulfill the policy conditions and hoped to bludgeon Zurich into paying almost $5 million by filing a premature law suit. The effort failed when the USDC read the policy and required the insured to fulfill the conditions precedent so that the insurer would be allowed to have sufficient facts to determine if it owed indemnity to AXO. Insurers should never be sued for breach of contract and bad faith before the insured has complied with the conditions precedent. One might speculate that the failure to submit to an EUO was because the insured knew, if the testimony was honest, Zurich would establish that Herzer did not fit the definition of “employee” and the claim would fail.