Interpretation Mischief at the Fifth Circuit?

A recent opinion by the Fifth Circuit Court of Appeals serves as yet another reminder that the job description of anyone drafting a contract includes guarding against overreaching by a court.

The case in question is Flagship Credit Corp. v. Indian Harbor Ins. Co., 2012 WL 2299484 (5th Cir. June 15, 2012) (copy here). A finance company that was sued in a class action sought a declaratory judgment that it was entitled to indemnity under an insurance policy. The district court granted summary judgment to the insurance company; the Fifth Circuit reversed.

Here’s an abbreviated version of the facts:

One Glynn Hartt initiated a class action lawsuit alleging that Flagship Credit Corporation, which provides automobile financing in Texas, had failed to provide class members with adequate notice of default as required by the Texas Business and Commerce Code. Statutory minimum damages under the code were sought.

Flagship asked Indian Harbor Insurance Company to indemnify it in the class action suit. Indian Harbor agreed, reserving the right to deny coverage for any amount that did not constitute “loss” under the policy. The policy stated the “loss” excluded, among other things, “fines, penalties or taxes imposed by law.”

After Flagship and Hartt reached a settlement agreement, Indian Harbor refused to indemnify Flagship on the grounds that the settlement was a penalty.

Flagship sued Indian Harbor, arguing that the statutory minimum damages paid in settling the Hartt suit were covered losses. Concluding that the damages were “penalties” under the policy, the district court granted Indian Harbor’s motion for summary judgment.

In reversing, the Fifth Circuit accepted Flagship’s argument that because “penalties” occurs between “fines” and “taxes,” the rule of construction know as noscitur a sociis supports the interpretation that the entire clause concerns payments made to the government.

I don’t find that argument compelling. Sure, fines and taxes are paid to government authorities, but the statute in question contemplates payment to someone other than a government authority; if those payments constitute a penalty, why should adjoining words be used to narrow the meaning of “penalties”? (I’m aware that the court may have decided that it wanted to decide in favor of Flagship.)

As always, the only question that really interests me is, What Should the Drafter Have Done?™ If you plan on using strings of words, consider whether application of an arbitrary rule of construction could create mischief. If the drafter had wanted “penalties” to convey the broader meaning, they should have added something along the lines of “whether paid to a governmental authority or any other person.” Given the endless litigation involving insurance policies, I’d have thought that by now insurance companies would have tied up loose ends of that sort.

By the way, the parties had accepted that not only “taxes” but also “fines” and “penalties” were modified by “imposed by law,” so a fight over syntactic ambiguity was averted. But the drafter should have seen that too lurking as an issue and done something about it.

About the author

Ken Adams is the leading authority on how to say clearly whatever you want to say in a contract. He’s author of A Manual of Style for Contract Drafting, and he offers online and in-person training around the world. He’s also chief content officer of LegalSifter, Inc., a company that combines artificial intelligence and expertise to assist with review of contracts.