A Duty to Defend.

Recent court cases have expanded insurers' responsibility to defend against claims for the misappropriation of trade secrets, in some instances.

Assume that an insured has been sued for the misappropriation of a competitor's trade secrets. The plaintiff's complaint alleges that the insured hired a key employee away from a competitor to help design a better product for the insured, improve the insured's manufacturing processes or overhaul the insured's marketing strategies. The complaint further alleges that the employee in question stole the former employer's trade secrets pertaining to those design processes, manufacturing processes and/or marketing strategies.

The insured's counsel has tendered the defense to the insurer under the "advertising injury" section of the insured's comprehensive general liability policy. In reviewing the policy, the insurer sees that as with the typical comprehensive general liability policy, advertising injury is defined as, among other things, "an injury other than bodily injury or property damage arising out of the misappropriation of advertising ideas or style of doing business."

Unfortunately, as with many comprehensive general liability policies, the policy in question does not define the terms "advertising ideas" or "style of doing business." Thus, the critical question becomes, "Does the insurer have a duty to provide a defense to the insured in this case?" If the insurer guesses wrong, and such a duty exists, the consequences can be severe.

Breach of Duty

Although there has been limited coverage afforded for copyright or trademark infringement under the advertising injury coverage section of standard comprehensive general liability policies, claims for the misappropriation of trade secrets usually have been denied by insurance companies as outside the scope of coverage. But one case out of the 9th U.S. Circuit Court of Appeals has significantly broadened the insurer's duty to defend such claims.

In Sentex Systems Inc. vs. Hartford Accident & Indemnity Co., Electronic Security Systems Inc. sued its competitor, Sentex, and one of its employees, who had been a key employee for Electronic Security Systems. Electronic Security Systems alleged that Sentex Systems, which designs and manufactures telephone-entry security systems for buildings and gated communities, had induced its former employee, Paul Columbo, to breach the noncompete agreement he had signed with Electronic Security Systems. The complaint further alleged that Sentex, through Columbo, had stolen Electronic Security Systems' trade secrets, including its customer lists, marketing techniques and other inside and confidential information. Sentex and Columbo then allegedly used the information to solicit Electronic Security Systems' customers.

Sentex, both after Electronic Security Systems filed the complaint and later after discovery, asked Hartford to defend the lawsuit pursuant to the "advertising injury" section of its comprehensive general liability policy. Hartford refused. Sentex subsequently settled the case with Electronic Security Systems for $35,000 and then sued Hartford for breaching its duty to defend. As part of its defense in the case, Hartford argued that it had no duty to defend Sentex because misappropriating advertising ideas involves only situations where there has been a theft of text, words or form of an actual advertisement and that condition had not been satisfied.

However, the 9th U.S. Circuit Court of Appeals disagreed and held that a much broader interpretation should apply because the relevant portion of the policy at issue used the word "ideas." The court further held that for purposes of the duty to defend, the insured need not show that it used the plaintiffs advertising ideas directly in written sales materials. According to the court's opinion:

"In this day and age, advertising cannot be limited to written sales material, and the concept of marketing includes a wide variety of direct and indirect advertising strategies. It is significant that [Electronic Security Systems'] claims for misappropriation of trade secrets relate to marketing and sales and not to secrets relating to the manufacture and production of security systems...While we may agree with Hartford that the mere misappropriation of customer mailing lists, standing alone, may not bring a complaint within the scope of possible coverage for 'advertising injury' as 'misappropriation of advertising ideas,' it is clear that the scope of [Electronic Security Systems'] lawsuit was much broader. We thus agree that Hartford breached its duty to defend under these policies."

Proceed With Caution

Even after the Sentex decision, all is not lost for the insurer. Another critical question remains: Was there a causal connection, or nexus, between the alleged misappropriation and the advertising injury as required by the policy? In Sentex, the answer was yes. Electronic Security Systems' president testified that the information at issue was used to market Sentex's products in a variety of ways. Thus, Hartford had a duty to defend.

The critical point for the insurer to keep in mind is that the duty to defend is much broader than the duty to provide coverage (or indemnify) for the loss in question. Many insurers make the mistake of focusing on the latter vs. the former in their coverage analysis. Even where there is only a potential for coverage, a duty to defend is owed to the insured. In 1993, a court found in Montrose Chemical Corp. vs. Superior Court "the duty may exist even where coverage is in doubt and ultimately does not develop." In other words, the insured need only show that the underlying claim may fall within the policy coverage; "the insurer must prove that it cannot."

It is risky for an insurer to rely on only the express allegations contained in the plaintiff's complaint as a reason for refusing to provide a defense. It is not uncommon for insurers to take the position that there is no possibility for coverage as the complaint is presently framed (or pleaded) by the plaintiff. For example, in a typical trade-secret misappropriation case, an insurer may take the position that the plaintiff did not allege a misappropriation of advertising ideas in the course of the insured's advertising activities. But in many states, the insured is not limited by the words and allegations of the complaint. As stated by one court in the 1996 case CNA Casualty vs. Seaboard Surety Co., the duty to defend "is not measured by the technical legal cause of action pleaded in the underlying third-party complaint, but rather by the potential for liability under the policy's coverage as revealed by the facts alleged in the complaint or otherwise known to the insurer."

In the decision in Gray vs. Zurich Insurance Co., it was stated that "the duty to defend [is] fixed by the facts which the insurer learns from the complaint, the insured, or other sources. An insurer, therefore, bears a duty to defend its insured whenever it ascertains facts which give rise to the potential of liability under the policy." Moreover, an insurer must conduct an adequate investigation and attempt to ascertain such facts. Insurers that fail to do so may be barred from denying coverage, as stated in Stalberg vs. Western Title Insurance Co.

Policy Exclusions

The obligation to defend an insured in a trade-secret misappropriation lawsuit is something that an insurer should never take lightly. Any insurer who attempts to avoid providing a defense without conducting an adequate investigation on the grounds that coverage is "highly unlikely" or "doubtful" is asking for trouble and setting itself up for a bad-faith lawsuit. Moreover, in light of the Sentex decision, there is yet another lesson to be learned: With court decisions broadening the insurer's responsibility for defending claims for intellectual property violations, prudent insurers should add an endorsement to comprehensive general liability policies that specifically exclude claims beyond the copyright- and trademark-infringement claims associated with advertising activity exposure. At a minimum, insurers should seriously consider adding to their comprehensive general liability policies an exclusion clause that reads something like this: "This insurance and policy does not apply to any liability arising ou t of or directly or indirectly related to the actual or alleged publication or written or oral statements of any type or form which is alleged as an infringement, violation or defense of any trade secrets rights or laws."

Chris Carr is an assistant professor of law and public policy in the College of Business at California Polytechnic State University, San Luis Obispo, Calif. Jack Morton and Jerry Furniss are professors of business law in the School of Business Administration at the University of Montana, Missoula, Mont.