SAN FRANCISCO—A 6th Circuit case decided last year demonstrates how positions taken by insureds in prior litigation can impact or foreclose coverage in subsequent disputes with insurers. In KVG Properties Inc. v. Westfield Ins. Co., KVG was unaware that its tenant was operating a cannabis growing operation, says Shanti Eagle of Farella Braun + Martel LLP.

Although Michigan allowed for limited legal marijuana cultivation, there was no evidence the tenant was in compliance with local law. After a DEA investigation resulted in a search warrant, KVG had the tenant evicted from the property. KVG then sought recovery from Westfield under its property policy for extensive damage done to the property by the tenant, including torn-out walls and damage to the HVAC, ductwork and roofing, GlobeSt.com learns.

“Westfield denied the claim, relying on the 'dishonest or criminal acts' exclusion, among others,” Eagle tells GlobeSt.com. “That exclusion extended to activity by someone to whom the insured had entrusted the property. The district court found coverage was excluded, and granted summary judgment for Westfield. KVG appealed and the 6th Circuit upheld the lower court's decision. The appellate court found that the damage to the insured's property as a result of unauthorized modifications was within the broad coverage grant of the policy. However, the panel held that the exclusion applied to preclude any recovery by KVG.”

Eagle said KVG argued that the criminal acts exclusion should not eliminate coverage because cultivating marijuana was legal under Michigan law under some circumstances and it was Westfield's burden to prove the exclusion applied. However, the appellate court pointed out that, in addition to the criminal investigation, which tended to indicate the tenants were not in compliance with Michigan law, KVG had itself characterized the tenant's activity as illegal in its complaint in the eviction proceedings. Therefore, the court found it was unnecessary to address the federalism issue, and ruled that the exclusion barred coverage.

“In doing so, however, the court implied that under different facts, the federalism argument would be a compelling one, stating that it would be hesitant to find a legal grow operation excluded to be 'criminal' activity based on an insurer's argument of federal illegality,” Eagle tells GlobeSt.com. “This is consistent with an increasing trend among federal courts willing to consider the legality of cannabis under state law in interpreting policies' exclusionary language.”

In a footnote, the 6th Circuit also questioned whether the exclusion should apply where the criminal act was committed by someone who had procured the entrustment of the property under false pretenses, as was the case in the Michigan operation. However, because the parties did not raise this argument, the court did not address it, she says.

“Future insureds dealing with this exclusion should consider the 'making false pretenses argument',” Eagle tells GlobeSt.com. “The right to obtain an immediate eviction in this case ultimately cost KVG a half a million dollars in property damage it could have otherwise recovered from insurance. This case demonstrates why it can be advantageous to evaluate a claim with an eye to coverage early on and avoid taking positions or making admissions—whether in pleadings, discovery responses or elsewhere—that could unwittingly impact a future dispute over coverage.”

A little preventative care can go a long way and this lesson carries over to all types of claims, Eagle points out. Understanding coverage from the outset can shape the way a case is litigated, whether as a plaintiff or a defendant, and should be taken into account at strategic decision points, starting with the initial pleadings.

Californians voted in 2016 to approve Prop. 64 making marijuana legal for adult usage. Dispensaries opened to the public on Jan. 1, 2018, setting off what some have estimated to be an industry of more than $6 billion in annual sales. This makes 10 states where recreational marijuana is legal and 33 states where medical usage is legal.

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Prior Litigation Can Impact Coverage in Future Disputes

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