UK: The Ongoing Duty of Good Faith – Time To Bring the Curtain Down?

Last Updated: 16 November 2001

K/S Merc-Scandia XXXXII v. Lloyd’s Underwriters (CA(Eng), transcript 31st July 2001)

The English Courts have long grappled with the concept of the existence and extent of a post-contractual duty of good faith in insurance contracts. The existence of the duty prior to the formation of the contract, both to disclose all matters material both to the hypothetical prudent underwriter and to the decision of the actual underwriter to accept the risk and not to make material misrepresentations is, of course, well established (see, for example, Pan-Atlantic v. Pine Top Insurance [1995] 1 A.C. 501), but the position generally after the contract is made has been less than clear. The problem for the courts has been that, because the duty of good faith, if it exists after the contract is made, is an extra-contractual duty and not an implied term (see Banque Keyser Ullman SA v. Skandia (UK) Insurance Co. Ltd. [1991] 2 A.C. 249), the only remedy open for breach of such duty is to avoid the policy, an extremely draconian measure, especially when the policy has been on foot for some time.

Instances where the courts have required what might be described as "good faith" on the part of parties to a contract of insurance in their actions after the contract is made include:

  • Not to make fraudulent claims (see, for example, Goulstone v. Royal Insurance Co. (1858) 1 F&F, 276; Britton v. Royal Insurance Co. (1866) 4 F&F, 905). This applies not just to wholly fraudulent acts, such as the insured person burning down the insured building in order to make the claim, but also fraudulent acts which taint an otherwise valid claim, such as the insured pretending that the contents of a building destroyed by an accidental fire were extremely valuable when in fact the building was empty. However, the law also recognises the commercial reality of making a claim, that an insurer, through his loss adjuster, will seek to adjust a claim downwards, and so the insured, whilst not permitted wilfully to exaggerate his claim, can legitimately put in a claim for a figure that he knows he is unlikely to obtain, as an initial bargaining position (see Orakpo v. Barclays Insurance Services [1995] LRLR 443).
  • To make full disclosure on a variation of the risk. However, the right of avoidance relates only to the variation and not to the original risk (see Iron Trades Mutual v. Cie de Seguros [1991] 1 LRLR 213). As the parties are altering the contractual terms, it would follow that full disclosure should be made only in relation to the alteration.
  • To make full disclosure on renewal. As a new contract is being negotiated, this can more properly be seen as an example of the pre-contractual duty of good faith.
  • When the insurer has the right to information, whether by an express or implied term of the policy, it has been said that there may a duty of good faith in the giving of the information (see, for example, Phoenix General Insurance Co. v. Halvanon Insurance Co. Ltd. [1985] 2 Lloyd’s Rep 559 and Alfred McAlpine Plc v. BAI (Run-Off) Ltd. [2000] 1 Lloyd’s Rep 437). However, such cases do not support the right of avoidance on the part of the insurers if the duty is breached, in absence of prejudice to the insurers in connection with their ultimate liability for the claim.

This whole issue was considered at length by the House of Lords in Manifest Shipping Co. Ltd, v. Uni-Polaris Insurance Co. (The ‘Star Sea’) [2001] 2 W.L.R. 170, in the context of a marine hull and machinery policy where the allegation made by the insurer was one of culpable non-disclosure on the part of the insured during the course of the claim, specifically during the course of litigation over the claim between the parties. The House of Lords held that any ongoing duty of good faith ended when the litigation commenced, and therefore the insured was entitled to conduct the litigation by the rules of the court (and claim privilege over certain reports), rather than being forced to continue to provide the insurer with full information (including therefore the reports) under the terms of the policy. (The editors of MacGillivray on Insurance Law submit that any such duty should determine once the claim has been rejected.)

The ‘Star Sea’ did not, however, provide conclusive assistance as to the extent to which the duty of good faith applied generally after the conclusion of the contract. In KS/Merc-Scandia, the Court of Appeal of England & Wales undertook a further review of the position in the light of a contract of liability which insured ship repairers in Trinidad. As is common in liability policies, the policy under review required the insured to give prompt notice to the insurers of circumstances which may give rise to a claim and to keep the insurers fully advised thereafter, and gave insurers the right to take conduct of the defence of claims. The policy also included a provision in the following terms:

"If the insured shall make any claim knowing the same to be false and fraudulent, as regards amount or otherwise, the policy shall become void and all claims hereunder shall be forfeited."

The facts upon which the insurers based their defence to liability in relation to the claim arose during the course of litigation between the insured and the claimant ship owners. The Managing Director and Chairman of the insured forged a letter dealing with the authority of officers of the insured to discuss the claim, in the context of an application contesting the jurisdiction of the English courts. The forgery was discovered almost immediately, but insurers instructed separate solicitors to protect their interests and withdrew their consent to legal costs being incurred in the defence of the claim. Soon thereafter, insurers purported to avoid the policy. The claimant ship owners succeeded against the insured at trial and, having wound up the insured, claimed from the insurers under the Third Parties (Rights Against Insurers) Act 1930, which is mirrored in Hong Kong by an Ordinance of the same name. At trial, the claimant shipowners succeeded.

Before the Court of Appeal, the insurers argued that:

  • the duty of good faith applied in general terms throughout the contract, breach of which and, certainly, any fraudulent conduct, entitled insurers to avoid; there was never an occasion on which the insured could act in bad faith without risking avoidance.
  • if the duty only applied in some circumstances (and not generally) after the contract was made, then it applied on this occasion, since the giving of information to insurers must be such an occasion.
  • the breach of the obligation to keep the insurers advised was so serious that they were justified in refusing to pay the claim (this was not, of course, a defence of breach of duty of good faith, but was one based on a breach of the express terms of the policy; i.e. a contractual defence).

The contractual defence

Giving the judgment of the Court of Appeal, Longmore LJ decided to deal first with the contractual defence. The express term relating to fraudulent claims (set out above) could not be relied upon by insurers, because no claim arose under the policy until such time as the liability of the insured to the claimant ship owners had been established, and the events relied upon occurred before that date (relying on Post Office v. Norwich Union [1967] 2 Q.B. 363 and Bradley v. Eagle Star [1989] A.C. 957). Instead, insurers relied on a (fraudulent) breach of the express obligation to keep them fully advised.

Such clause, however, could be breached by the insured innocently, negligently and recklessly, as well as fraudulently. The effect of the breach depended on whether the clause constituted a warranty (the breach of which, however trivial, could allow the insurers to repudiate the contract), a condition (the breach of which could only give rise to a claim in damages) or an innominate term (the effect of a breach of which depended on nature and gravity of the breach itself). Insurers, relying on Alfred McAlpine Plc v. BAI (Run-Off) Ltd. [2000] 1 Lloyd’s Rep. 437 (CA (Eng)), argued that there was a fourth category of clause in insurance cases, namely a term the breach of which was so serious as would entitle underwriters to reject the claim without repudiating the contract as a whole. The Court of Appeal rejected this defence on the basis that there was no serious consequence to the insurers from the insured’s fraudulent conduct. Thus, the clause was not a warranty, nor was it a condition, but there was no finding as to what precisely the clause was.

The good faith defence

Insurers submitted that, in the light of the House of Lords decision in The ‘Star Sea’, the only application of the duty of good faith post contract was to cases of dishonesty, but that in such cases the duty was breached whatever the act of dishonesty and its consequences. The claimant ship owners, standing in the shoes of the insured, argued that the duty should only apply to instances analogous to the pre-contractual situation (i.e. where there was a subsequent change to the contract) and to fraudulent claims.

Longmore LJ held that, if there were a duty of good faith subsisting post contract, the right to avoid for breach must be subject to at least the same requirements as for breach pre-contract (i.e. materiality to the prudent underwriter and inducement to the actual underwriter), and therefore that the act of the insured which is relied on by the insurer must be causally relevant to the insurer’s ultimate liability or, at least, to some defence of the insurer, before the insurer is entitled to avoid the policy. Thus, in this case, the insurers must have been seriously prejudiced by the fraud before the policy could be avoided.

He also held, however, that there were two difficulties with the submissions made on the part of the claimant ship owners. The first was that the situations analogous to the pre-contractual position were rather examples of it and the position in relation to fraudulent claims was unclear as to whether it derived from a breach of a post contractual duty of good faith and therefore allowed avoidance, or from some other source which lead to the "forfeiture of the benefit of the policy". The second difficulty was to fit within the submission the cases where lack of good faith post contract only sounded in damages or other common law contractual remedies.

Longmore LJ held that it was not open to the Court of Appeal to decide that the duty had no application post contract, or that it only applied in the two instances put forward by the claimant ship owners. Longmore LJ held instead that it was only appropriate to invoke the remedy of avoidance in a post-contractual context in situations analogous to the situations where the insurer has the right to terminate for breach, i.e. in situations where the fraud was material in that it would have an effect on the insurer’s ultimate liability (as in Royal Boskalis Westminster N.V. v. Mountain [1997] LRLR 523) and the gravity of the fraud or its consequences were such as to allow the insurers to terminate the contract (by accepting repudiation). Thus, the right to avoid the contract was aligned with the right to terminate it.

Applying this analysis to the facts, obviously, since he had decided there was no right to terminate, Longmore LJ held that there was no right to avoid, and thus upheld the judgment at first instance for the claimant ship owners.

Comment

With the greatest respect to the learned Lord Justice, I believe that this analysis is flawed. I believe that the correct analysis is that there is no post-contractual duty of good faith except in situations where the contract is being altered, whether by extension, amendment, addition of insured parties etc., which are better seen as examples of the operation of the pre-contractual duty.

As to the duty not to make fraudulent claims, this "duty" can be explained on the grounds of public policy, that a fraudster should not benefit from his own fraud. As such, there is no need for a post-contractual duty of good faith to operate.

As to the duty to provide information to the insurer in relation to claims, whether this is an express or implied term of the contract, it is perhaps a better view that the insurer has only common law remedies for breach of these express or implied terms (as is apparent from the cases), and the cases which refer to ‘good faith’ in this respect set out the scope of the contractual obligations to provide information to which they give rise (i.e. not to make material non-disclosure or misrepresentation), rather than establish that such obligations are part of a continuing duty of good faith, with all the ramifications for the insured which arise if the duty actually exists and is breached.

The flaw in the reasoning, I believe, is evident from the following passage from Longmore LJ’s judgment:

"It is often observed that the right of avoidance is disproportionate… If the right to avoid in a post-contract context is exercisable only when the right to terminate for breach has arisen, the disproportionate effect of the remedy will be considerably less and the extra advantages given to insurers when they exercise a right of avoidance (e.g. non-liability for earlier claims) will be less offensive than they otherwise would be."

Again, with respect, in a situation where there is no right to avoid in relation to a breach of a pre-contractual duty of good faith, the ability to avoid for breach of a post-contractual duty (rather than to terminate the policy going forward) will often be wholly disproportionate, especially in the context of contracts which run for a long period and under which it is accepted from the outset that there will be a number of claims even on a best case scenario. The better approach, I believe, is to do away finally with the concept of the duty post contract and allow insurers to rely on the perfectly adequate protection afforded by the express and implied terms of the contract, the common law public policy considerations in relation to fraudulent conduct, and the obligations of good faith which arise on amendment and renewal.

Gareth Thomas, Partner

(These views are personal to the author, who is a co-author of Halsbury’s Laws of Hong Kong – Vol. 15(1): Insurance)

 

 

"© Herbert Smith 2002

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