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Does an insurer have a duty to defend in software audit cases?

Posted by Steve Vondran | Nov 30, 2016 | 0 Comments

The intersection of insurance “BAD FAITH” law and software audits!


Our law firm is licensed to practice law in California and Arizona.  We accept federal copyright infringement software audit cases nationwide.  This blog discusses a case out of Ohio.  Bear in mind our firm is not licensed to practice law in Ohio, and this is not legal advice or a substitute for legal advice.

If your company receives a software audit demand letter from any of the following companies this blog could be very important:

These companies, and their trade associations and IP lawyers are known to send letters that basically insinuate that your business is infringing their software and they give you a chance to engage in a so-called “voluntary audit” with the smell of litigation hanging in the air (the normally send you a demand to preserve evidence letter).  When this happens, you may want to pull our your corporate insurance policies, including general liability and Director's and Officers insurance (called D&O).  These policies, depending on how they are worded, MAY require the insurance company to defend you in the audit and possibly provide copyright counsel to assist you.   If the policy appears to cover the audit, companies would be wise to consider tendering the defense to their insurance carrier.  This blog discusses one case in Ohio where this happened and the insurance company refused to defend the company subject to the audit.

What is D&O insurance?

According to wikipedia:

“Directors and officers liability Insurance (often called “D&O”) is liability insurance payable to the directors and officers of a company, or to the organization(s) itself, as indemnification (reimbursement) for losses or advancement of defense costs in the event an insured suffers such a loss as a result of a legal action brought for alleged wrongful acts in their capacity as directors and officers. Such coverage can extend to defense costs arising out of criminal and regulatory investigations/trials as well; in fact, often civil and criminal actions are brought against directors/officers simultaneously. Intentional illegal acts, however, are typically not covered under D&O policies. It has become closely associated with broader management liability insurance, which covers liabilities of the corporation itself as well as the personal liabilities for the directors and officers of the corporation.”

When your company is involved in a compliance investigation and when things get contentious (usually over outrageous settlement demands that cannot possibly be met without bankrupting a company), the lawyers for the BSA or software vendor may then start trying to leverage the situation by claiming they will seek the “profits” of the company or go after the officers and directors for willful copyright infringement.  This is why it is important to at least check with your insurance carrier to see if possibly there is any coverage.

Eight Floor Promotions vs. The Cincinnati Insurance Co.

This case involved a company in Ohio that received the “love letter” (as we jokingly refer to it) and the letter is typical of those sent by the software alliance to small business owners.  The letter insinuated that the company had installed software without paying for it, and hinted that litigation would ensue if an audit was not performed.  The company considered this to be a legal claim and tendered the defense to their insurance carrier (which denied the duty to defend the claim).  Here are some snippets from the case:

“This case arises out of an insurance coverage dispute between Eighth Floor and Cincinnati Insurance. Eighth Floor is a Nevada limited liability company with its principle place of business in Celina, Ohio. It manufactures and sells sports awards and business gifts. It is managed by a few officers, some of whom also sit on its board of directors.  Eighth Floor's Operating Agreement provides that it will “indemnify and hold harmless” its officers and directors “in any “threatened claim, action or proceeding to which any officer or any [director] is [a] party or is threatened to be made a party by reason of its or his activities on behalf of [Eighth Floor].”

 “In 2010, Eighth Floor purchased an insurance policy from Cincinnati Insurance (“the Policy”). The Policy provided that Cincinnati Insurance would “pay on behalf of the ‘company' all ‘loss' which the ‘company' [was] required to pay as indemnification to the ‘individual insureds' resulting from any ‘claim' first made during the ‘policy period for a ‘wrongful act.'

“On May 11, 2011, Eighth Floor's Chief Executive Officer, Dave Willis, received the following letter from the Business Software Alliance (“the BSA”):

Dear Mr. Willis: This firm represents [the BSA] in connection with its investigation of possible instances of illegal duplication of certain software companies' proprietary software products. The BSA represents the interests of [17 software companies]. We recently have been advised that [Eighth Floor] has installed on its computers more copies of [22 software programs] than it is licensed to use. Unauthorized duplication of computer software products constitutes copyright infringement. The Copyright Act (17 U.S.C. § 101 et seq.) provides that copyright owners may recover actual damages or statutory damages. In cases where the infringement is willful statutory damages can reach $150,000 for each copyrighted product that has been infringed. The copyright owner can also seek attorneys [sic] fees.

To learn more about copyright infringement damages, go here to watch our VIDEO.  The BSA letter continued:

“However, [the] BSA member companies have determined that litigation may not be necessary in this case, especially as senior management may not have had an opportunity to investigate or consider the ramifications of using unlicensed software. The BSA member companies instead wish to resolve this matter amicably by providing Eighth Floor with an opportunity to conduct its own company-wide investigation.

To take advantage of this opportunity, Eighth Floor's investigation must include an audit of all of the software published by [the] BSA members (see above) on all of its computers and a review of the software licenses and proofs of purchase for those licenses. Please understand that while we are contacting you in an effort to avoid litigation, the BSA member companies are not waiving their right to litigate to protect their copyrights if this effort is not successful.

We therefore must insist that you contact us by May 31, 2011. At that time we will provide you with specific guidance on how to conduct your audit. In addition, please do not destroy or replace any copies of any of the computer software products published by the above-mentioned companies that are currently installed on Eighth Floor's computers. The software programs installed on Eighth Floor's computers are evidence and therefore must be preserved in case this matter does proceed to litigation. In the meantime, you should not attempt to enter into any negotiations with sales representatives of these companies to purchase computer software products prior to the resolution of this matter.

We look forward to your cooperation. Sincerely, Troutman Sanders LLP

The letter in essence could be construed as a litigation hold letter.  This is similar format to a letter that the BSA currently sends to business owners across the United States. As you can tell, when you read the letter an emptiness may come to your stomach for most business owners I deal with tell me the cannot sleep for days.  So this is a very real and stressful situation.  At any rate, the case continues:

“On May 26, 2011, Cincinnati Insurance denied coverage for losses incurred in connection with the audit request. It explained that the audit request did not constitute a “claim” under the Policy because it was neither a “written demand for monetary damages or non-monetary relief” nor a “civil proceeding commenced by filing a complaint or similar pleading.” It agreed, however, to treat the audit request as a “notice of circumstances” that may give rise to a claim covered under the Policy but warned that “based on the information currently known,” coverage for a future claim may be limited or precluded under one of the Policy's exclusions (namely the intellectual property infringement exclusion).”

Nevertheless, the company completed the audit and found unlicensed software and attempted to negotiate a settlement (click here to see the BSA response and demand letter in this case).  The company tendered the defense to the carrier at the outset of the case and after the monetary demand was made.  Both times, the insurance carrier denied a duty to defend (which is what ultimately caused the company to file the lawsuit).

The insurers duty to defend

In Montrose Chem. Corp. v. Superior Court, 6 Cal. 4th 287, 295, 861 P.2d 1153, 1157 (1993) the California court discussed this legal concept:

“The determination whether the insurer owes a duty to defend usually is made in the first instance by comparing the allegations of the complaint with the terms of the policy. Facts extrinsic to the complaint also give rise to a duty to defend when they reveal a possibility that the claim may be covered by the policy. As one Court of Appeal has put it, “for an insurer, the existence of a duty to defend turns not upon the ultimate adjudication of coverage under its policy of insurance, but upon those facts known by the insurer at the inception of a third party lawsuit. Hence, the duty ‘may exist even where coverage is in doubt and ultimately does not develop. The defense duty is a continuing one, arising on tender of defense and lasting until the underlying lawsuit is concluded or until it has been shown that there is no potential for coverage.”

Overview of the software audit process

To learn more about the software audit process watch our videos:

Part one

Part two 

Tendering the defense to your D& O insurance carrier

As noted above, if your company receives an audit investigation letter, you should consider tendering the defense to your insurance carrier.  Even if coverage is denied, once a formal demand is made for money, another attempt at tender should be made.  If the insurance carrier refuses to cover the claim, a “bad faith” insurance action may lie.

What is an intellectual property exclusion?

As noted in the case above, the insurance carrier did not want to cover the software audit due to a “intellectual property exclusion” in the policy.  Meaning, because the subject matter of the audit is alleged pirated software (a copyright infringement), the carrier claimed no duty to defend existed under the terms of the policy.  Here is one California case that discussed a similar provision:

The other controversial provision was an exclusion for suits involving intellectual property. The policy stated: “We won't cover injury or damage or medical expenses that result from any actual or alleged infringement or violation of any of the following rights or laws: • Copyright. • Patent. • Trade dress. • Trade name. • Trade secret. • Trademark. • Other intellectual property rights or laws. Nor will we cover any other injury or damage that's alleged in any claim or suit which also alleges any such infringement or violation. But we won't apply this exclusion to bodily injury or property damage that results from your products or your completed work. Nor will we apply this exclusion to advertising injury that results from the unauthorized use of any: • copyrighted advertising material; • trademarked slogan; or • trademarked title; of others in your advertising.” See S.B.C.C., Inc. v. St. Paul Fire & Marine Ins. Co., 186 Cal. App. 4th 383, 390–91, 112 Cal. Rptr. 3d 40, 46 (2010)

What is insurance bad faith?

One California case involving State Farm Insurance provided a really nice summary of bad faith insurance law in California.  This case noted:

“All insurance contracts include the implied covenant of good faith and fair dealing. See Shade Foods, Inc. v. Innovative Products Sales & Marketing, Inc., 78 Cal.App.4th 847, 879, 93 Cal.Rptr.2d 364 (2000). A “bad faith” claim against an insurer is based on a breach of the implied covenant of good faith and fair dealing, which exists to assure the insurer makes prompt payment of claims to the insured. Buxbaum v. Aetna Life & Casualty Co., 103 Cal.App.4th 434, 442, 126 Cal.Rptr.2d 682 (2002). “When benefits are due an insured, delayed payment based on inadequate or tardy investigations, oppressive conduct by claims adjusters seeking to reduce the amounts legitimately payable, and numerous other tactics may breach the implied covenant.  See Waller v. Truck Ins. Exchange, Inc., 11 Cal.4th 1, 36, 44 Cal.Rptr.2d 370, 900 P.2d 619 (1995). The duty of good faith and fair dealings requires “an insurer to give at least as much consideration to the interests of the insured as it gives to its own interests.” Wilson v. 21st Century Ins. Co., 42 Cal.4th 713, 720, 68 Cal.Rptr.3d 746, 171 P.3d 1082 (2007); Maslo v. Ameriprise Auto & Home Ins., 227 Cal.App.4th 626, 633, 173 Cal.Rptr.3d 854 (2014).

To establish a bad faith claim against an insurer, the insured must show that:

( 1) benefits due under the policy were withheld; and ( 2) the reason for withholding the benefits was unreasonable or without proper cause. See Bravo v. United States Life Ins. Co., 701 F.Supp.2d 1145, 1159 (E.D.Cal.2010); Wilson, 42 Cal.4th at 723, 68 Cal.Rptr.3d 746, 171 P.3d 1082; Progressive West Ins. Co. *974 v. Superior Ct., 135 Cal.App.4th 263, 278, 37 Cal.Rptr.3d 434 (2005). However, “an insurer denying or delaying the payment of policy benefits due to the existence of a genuine dispute with its insured as to the existence of coverage liability or the amount of the insured's coverage claim is not liable in bad faith even though it might be liable for breach of contract.” Wilson, 42 Cal.4th at 723, 68 Cal.Rptr.3d 746, 171 P.3d 1082; Jordan v. Allstate Ins. Co., 148 Cal.App.4th 1062, 1073, 56 Cal.Rptr.3d 312 (2007); Chateau Chamberay Homeowners Assn. v. Associated Internat. Ins. Co., 90 Cal.App.4th 335, 349, 108 Cal.Rptr.2d 776 (2001). “ A genuine dispute exists only where the insurer's position is maintained in good faith and on reasonable grounds.” Wilson, 42 Cal.4th at 723, 68 Cal.Rptr.3d 746, 171 P.3d 1082; Maslo, 227 Cal.App.4th at 636, 173 Cal.Rptr.3d 854. “ The genuine dispute rule does not relieve an insurer from its obligation to thoroughly and fairly investigate, process and evaluate the insured's claim.” Wilson, 42 Cal.4th at 723, 68 Cal.Rptr.3d 746, 171 P.3d 1082; Maslo, 227 Cal.App.4th at 636, 173 Cal.Rptr.3d 854. The “genuine dispute” doctrine will not apply when the insurer engages in a biased investigation. See Pyramid Techs., Inc. v. Hartford Cas. Ins. Co., 752 F.3d 807, 823 (9th Cir.2014); Guebara v. Allstate Ins. Co., 237 F.3d 987, 996 (9th Cir.2001); Chateau Chamberay, 90 Cal.App.4th at 348–49, 108 Cal.Rptr.2d 776. “The ‘genuine dispute' doctrine may be applied where the insurer denies a claim based on the opinions of experts.” Chateau Chamberay, 90 Cal.App.4th at 347, 108 Cal.Rptr.2d 776; Fraley v. Allstate Ins. Co., 81 Cal.App.4th 1282, 1292, 97 Cal.Rptr.2d 386 (2000). “The reasonableness of the insurer's decisions and actions must be evaluated as of the time that the decisions were made,” and not in the light of subsequent events. Jordan, 148 Cal.App.4th at 1073, 56 Cal.Rptr.3d 312.  See  Chierfue Her v. State Farm Ins. Co., 92 F. Supp. 3d 957, 973–74 (E.D. Cal. 2015)  If you feel like your insurance company is denying you coverage and representation for a software audit, call us to speak with an insurance bad faith lawyer.  We have successfully recovered for clients in various insurance related cases.

Contact us if you received an audit demand letter

We can help review your insurance policy to see if you have any grounds to demand that your insurance carrier (ex. general liability, or directors and officers insurance) should require that the insurance company appoint a lawyer to oversee your internal software audit and help negotiate the settlement.  If you are looking for software cumis counsel, we can also potentially help.  Call us to discuss your legal rights at (877) 276-5084.

About the Author

Steve Vondran

Thank you for viewing our blogs, videos and podcasts. As noted, all information on this website is Attorney Advertising. Decisions to hire an attorney should never be based on advertising alone. Any past results discussed herein do not guarantee or predict any future results. All blogs are written by Steve Vondran, Esq. unless otherwise indicated. Our firm handles a wide variety of intellectual property and entertainment law cases from music and video law, Youtube disputes, DMCA litigation, copyright infringement cases involving software licensing disputes (ex. BSA, SIIA, Siemens, Autodesk, Vero, CNC, VB Conversion and others), torrent internet file-sharing (Strike 3 and Malibu Media), California right of publicity, TV Signal Piracy, and many other types of IP, piracy, technology, and social media disputes. Call us at (877) 276-5084. AZ Bar Lic. #025911 CA. Bar Lic. #232337


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