Fraudulent devices rule effectively abolished in UK shipping case

The Supreme Court of the United Kingdom has refined the scope of the fraudulent claims rule in Versloot Dredging BV v HDI Gerling Industrie Versicherung AG [2016] UKSC 45 by determining that the rule does not apply to collateral lies told by the insured to embellish their claim but which are otherwise immaterial to the insured’s right of recovery under the policy.
 

We have previously reported on the first instance decision of Popplewell J in the Commercial Court in our November 2013 article Court rejects insurance claim of ship owners because of "fraudulent device" used in making claim, and the Court of Appeal decision which confirmed the fraudulent device rule adopted at first instance in our November 2014 article Fraudulent devices rule confirmed in shipping case by England's Court of Appeal. The majority of the Supreme Court has now overturned the decision of the Court of Appeal and effectively abolished the fraudulent devices rule.

The insured claimants were the owners of the cargo vessel “DC MERWESTONE” which was incapacitated by a flood in her engine room which damaged the main engine beyond repair. 
 

The owners of the vessel made a claim for €3,241,310.60 under a marine insurance policy which extended to loss attributable to crew negligence (unless the owners were personally guilty of want of due diligence) and unseaworthiness (unless the owners were personally privy to it). The cause of the damage was found to be a combination of crew negligence, contractor’s negligence and unseaworthy pumps. However, the owners were not personally guilty of want of due diligence nor were they privy to the unseaworthiness. Accordingly, the loss was covered under the policy (at [59]), with the proximate cause being the perils of the sea (namely the fortuitous entry of sea water during the voyage).
 

The insured was asked by insurers to explain the ingress of water into the engine room and the pump’s failure to control it. Importantly, one of the owners’ directors asserted that the bilge alarm had sounded nine hours before water was seen under the floor plates of the engine room and that no action had been taken by the crew because it was attributed to the vessel rolling in heavy seas. This was a lie which was intended to reassure the insurers that the vessel was not unseaworthy and that its alarm systems were working satisfactorily. It was designed to divert the insurers’ focus from the state of the vessel and the possible privity of the owners to any unseaworthiness (which would have precluded cover under the policy) (at [62]).

It has been well established in English law that the fraudulent claims rule operates to bar the whole of an insured’s claim where that claim is either wholly invented or fraudulently exaggerated. The issue in the Supreme Court was whether the fraudulent claims rule extended to bar the insured’s claim where it had not invented or exaggerated the claim but had employed a fraudulent device, termed a collateral lie, to embellish or bolster a claim in circumstances where the underlying claim was nevertheless recoverable under the policy (at [51]).
 

The majority of the Supreme Court determined that the rule did not extend so far, overturning the decision of the Court of Appeal in this case and unsettling the principles applied by the Privy Council and recognised by the Supreme Court in subsequent cases: Stemson v AMP General Insurance (NZ) Ltd [2006] Lloyd’s Rep IR 852; Beacon Insurance Co Ltd v Maharaj Bookstore Ltd [2014] 4All ER 418; Summers v Fairclough Homes Ltd [2012] 1WLR 2004. The effect of the majority’s decision is that the fraudulent devices rule recognised in these cases has now been abolished.

In the leading judgment, Lord Sumption drew a distinction between a fraudulently exaggerated claim and a justified claim supported by collateral lies stating at [25] - [26]:
 

The position is different where the insured is trying to obtain no more than the law regards as his entitlement and the lie is irrelevant to the existence or amount of that entitlement. In this case the lie is dishonest, but the claim is not. The immateriality of the lie to the claim makes it not just possible but appropriate to distinguish them. I do not accept that a policy of deterrence justifies the application of the fraudulent claim rule in this situation.
 

Ultimately, Lord Sumption (with Lords Clarke, Hughes and Toulsen agreeing) determined that the extension of the fraudulent claims rule to collateral lies found to be irrelevant would be “disproportionately harsh to the insured” (at [36]).
 

Lord Sumption considered that a relevant collateral lie needed to be material to the claim in order for the fraudulent claims rule to apply and advanced a test for materiality assessed by reference to hindsight. Importantly, Lord Sumption considered that the materiality of a lie should be assessed by reference to the merits of the claim as determined by the Court rather than at the time when the lie was actually made and therefore differed (at [30]) from the view adopted by Lord Mance in Agapitos v Agnew (The ‘Aegeon’) [2003] QB 556. 

In a strong dissenting judgment, Lord Mance raised serious concerns regarding the abolishment of the fraudulent devices doctrine noting at [128]:
 

Abolishing the fraudulent devices rule means that claimants pursuing a bad exaggerated or questionable claim can tell lies with virtual impunity. The same logic governs fraudulent devices as it does fraudulent claims generally. It is as Lord Hobhause said in The Star Sea para 62:
 

"…simple. The fraudulent insured must not be allowed to think: if the fraud is successful then I will gain; if it is unsuccessful, I will lose nothing."
 

In short, on the approach advanced by the majority, the fraudulent device will advance the insurance recovery if undiscovered, and quite possibly lead to the recovery of a bad or exaggerated claim, and it will have no effect on any insurance recovery to which the assured may be entitled, even if it is discovered. …
 

Lord Mance also disagreed with the test for materiality advanced by Lord Sumption, considering that the materiality of the lie ought to be assessed in its context at the time when the fraudulent device was deployed and that to do otherwise "makes no sense" (at [130]).

In his leading judgment, Lord Sumption considered the case law in Australia, noting that the application of the fraudulent claims rule to valid claims had exhibited the same differences of opinion as the English cases. In this regard, Lord Sumption referred, at [21], to the differing conclusions reached in GRE Insurance Ltd v Ormsby [1982] 29 SASR 498 and Tiep Thi To v Australian Associated Motor Insurers Ltd [2001] VSCA 48. 
 

While these two cases illustrate a difference of opinion between the Full Court of South Australia in 1982 and the Victorian Court of Appeal in 2001, it is important to note that Ormsby predated the introduction of the consumer-focused section 56 of the Insurance Contracts Act 1984 (Cth) and that the principles in Tiep Thi To have generally been supported in subsequent cases in both Victoria and New South Wales: Walton v The Colonial Mutual Life Assurance Society Ltd [2004] 13 ANZ Insurance Cases 61-620 at [144]; Allianz Australia Insurance Ltd v Douralis & Ors [2008] VSCA 72; Insurance Manufacturers of Australia Pty Ltd v Heron [2006] 14 ANZ Ins Cas 61-669. Accordingly, until the matter is determined by the High Court of Australia, it is likely that the preference in most Australian jurisdictions will continue to be to follow the decision in Tiep Thi To: namely that under section 56 of the Insurance Contracts Act, the existence of an underlying valid claim does not render an insured's fraud irrelevant.
 

We note that section 56(2) of the Insurance Contracts Act touches on the notions of proportionality identified in the reasons of the majority decision in Versloot. That section provides that “if only a minimal or insignificant part of the claim is made fraudulently and non-payment of the remainder of the claim would be harsh and unfair” the Court may order the insurer to pay "such amount as is just and equitable in the circumstances.” In Buchanan JA’s analysis of the provision in Tiep Thi To, his Honour noted that it applied to a fraud relating to only part of a claim. He said further that where the fraud related to the entire sum claimed, the division contemplated by the subsection could not be achieved. Further, and importantly, section 56(3) specifically underlines the importance of deterring fraudulent conduct and allows the court to "have regard to any other relevant matter". This is consistent with the reasoning in Lord Mance's dissenting judgment in Versloot for extending the fraudulent claims rule to collateral lies.

The decision in Versloot has resulted in the removal of a significant deterrent to fraudulent claims in relation to marine insurance in the UK. It will also have more general application in the UK as although section 12 of the Insurance Act 2015 (UK) (which comes into effect from 12 August 2016) encompasses fraudulent claims, it has left open how it would apply to the fraudulent devices extension.
 

Adopting the suggestion by Lord Mance in Versloot, insurers may be well advised to consider including contractual terms which deal specifically with fraudulent devices used by an insured during the claims process.
 

While the Versloot decision will be relevant to the law of marine insurance in Australia, section 56 of the Insurance Contracts Act will continue to govern fraudulent claims in relation to non-marine insurance.