American Pepper Supply Co. v. Federal Insurance

SUPREME COURT OF ARIZONA
En Banc

AMERICAN PEPPER SUPPLY COMPANY, ) Arizona Supreme Court
) No. CV-03-0290-PR
Plaintiff-Appellant, )
Cross-Appellee, ) Court of Appeals
) Division One
v. ) No. 1 CA-CV 00-0549
)
FEDERAL INSURANCE COMPANY, ) Maricopa County
) Superior Court
Defendant-Appellee, ) No. CV 98-004028
Cross-Appellant. )
_________________________________ ) O P I N I O N

Appeal from the Superior Court in Maricopa County
The Honorable Barry C. Schneider, Judge

REVERSED AND REMANDED

Court of Appeals, Division One
Memorandum Decision (filed Jul. 24, 2003)

REVIEW DISMISSED

Opinion of the Court of Appeals, Division One
205 Ariz. 465, 72 P.3d 1284 (App. 2003)

VACATED IN PART

HERMAN, GOLDSTEIN & FORSYTH, P.C. Phoenix
by Keith B. Forsyth
and Evan S. Goldstein
Attorneys for Plaintiff-Appellant, Cross-Appellee

SANDERS & PARKS, P.C. Phoenix
by Robert J. Bruno
and Mark R. Gilling
Attorneys for Defendant-Appellee, Cross-Appellant

HUMPHREY & PETERSEN, P.C. Phoenix
by Andrew J. Petersen
Attorneys for Amicus Curiae
The Arizona Association of Defense Counsel
B E R C H, Justice

¶1 We granted review to determine the appropriate burden

for proving an insurer’s policy defense of concealment or

misrepresentation. We have jurisdiction pursuant to Article 6,

Section 5(3) of the Arizona Constitution, and Arizona Revised

Statutes (“A.R.S.”) section 12-120.24 (2003).

BACKGROUND

¶2 On Tuesday, August 27, 1996, American Pepper Supply

Company reported to its insurer, Federal Insurance Company, a

theft of equipment left outside its building during the

preceding weekend. Within three weeks of American Pepper’s

initial report of the loss, Federal’s investigation revealed

facts and inconsistencies that rendered American Pepper’s claim

“suspicious”: (1) the equipment, which American Pepper claimed

had a replacement value of more than $87,000, was left in an

unfenced and unguarded area; (2) the equipment stolen was no

longer used in American Pepper’s business; (3) there were

inconsistencies between American Pepper’s initial reports and

later reports to both the insurance company and the police as to

the equipment reportedly stolen;1 (4) American Pepper wanted to

settle the claim quickly for two-thirds of the value of the

equipment; and (5) American Pepper was not forthcoming regarding

1
For example, American Pepper initially reported that 600
galvanized steel meat hooks were stolen, but revised the number
and quality to 3000 stainless steal meat hooks.

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details of the acquisition of the equipment. Federal therefore

turned the claim over to its special investigation unit.

¶3 The investigation revealed that, contrary to American

Pepper’s initial reports that the equipment had been left on the

ground outside its building, employees had actually left the

equipment in a scrap metal salvage bin, which was discovered

empty on Monday, August 26. When confronted with the

discrepancy, American Pepper’s general manager claimed that the

equipment had been stolen out of the bin, and that the bin was

empty when National Metals, a metal recycler, picked up the bin

on Tuesday, the day American Pepper reported the claim to

Federal. But further investigation revealed that when National

Metals picked up the bin on Tuesday, it contained more than four

tons of material.

¶4 On November 19, 1997, Federal sent a letter formally

denying American Pepper’s claim on the grounds that the

investigation revealed “that [the equipment reported stolen] was

sold for scrap metal” and that American Pepper “concealed or

misrepresented material facts in the claim presentment process.”

Federal concluded that the claim was “not covered due to the

misrepresentation/concealment provisions of the policy and under

the law.”2 Despite the denial of coverage, Federal invited

2
The concealment or misrepresentation provision states that
“[t]his insurance is void if you or any other insured

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American Pepper to submit for review and consideration any

information “that has not been made available to us that would

have a bearing on [Federal’s coverage] decision.”

¶5 Rather than submitting further information, American

Pepper sued Federal, alleging breach of contract and bad faith.

American Pepper asserted that the equipment had been stolen and

that its employees had refilled the bin on Monday, after

American Pepper discovered the theft. Federal defended by

asserting that American Pepper had not suffered a compensable

loss and that American Pepper’s representatives had concealed or

misrepresented material facts concerning the theft of the

equipment, thereby precluding coverage pursuant to the

concealment or misrepresentation policy exclusion.

¶6 After being instructed by the trial court that Federal

had to prove the policy defense of concealment or

misrepresentation by “clear and convincing” evidence, the jury

found in favor of American Pepper and awarded $15,000. The

court of appeals affirmed, concluding that Federal’s defense was

comparable to a claim of fraud and thus should be proved by

clear and convincing evidence. Am. Pepper Supply Co. v. Fed.

Ins. Co., 205 Ariz. 465, 469-70, ¶ 18, 72 P.3d 1284, 1288-89

(App. 2003). We granted review to determine the appropriate

intentionally conceals or misrepresents any material fact or
circumstance relating to this insurance at any time.”

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burden by which an insurer must prove its policy defense of

concealment or misrepresentation.

DISCUSSION

¶7 Federal argues that the trial court erred by

instructing the jury that Federal had to prove its policy

defense of concealment or misrepresentation by clear and

convincing evidence rather than merely by a preponderance of the

evidence. To warrant reversal, the jury instruction must have

been not only erroneous, but “prejudicial to the substantial

rights of the appealing party.” Gemstar Ltd. v. Ernst & Young,

185 Ariz. 493, 504, 917 P.2d 222, 233 (1996) (quoting Walters v.

First Fed. Sav. & Loan Ass’n of Phoenix, 131 Ariz. 321, 326, 641

P.2d 235, 240 (1982)).

¶8 The appropriate burden of proof is a question of law,

which this court reviews de novo. See Nielson v. Patterson, 204

Ariz. 530, 531, ¶ 5, 65 P.3d 911, 912 (2003) (approving de novo

review of legal issues). Although a few jurisdictions require

that exclusions from coverage be proved by clear and convincing

evidence, the burden of proving insurance policy exclusionary

provisions is usually a “preponderance of the evidence.” Lee R.

Russ & Thomas F. Segalla, 17 Couch on Insurance § 254:14 (3d ed.

2003) [hereinafter “Couch”]; compare Rego v. Conn. Ins.

Placement Facility, 593 A.2d 491, 494-95 (Conn. 1991) (following

the majority of courts and commentators suggesting that insurers

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must prove policy defenses by a preponderance of the evidence),

with Am. Family Mut. Ins. Co. v. Schley, 978 F. Supp. 870, 874-

75 (E.D. Wis. 1997) (applying Wisconsin law, which requires that

an insurer prove the policy defense of misrepresentation “by

clear, satisfactory and convincing evidence”).

¶9 By requiring clear and convincing proof in this case,

the trial court and court of appeals adopted the minority

approach. In doing so, the court of appeals analogized

Federal’s defense to a charge of common-law fraud. Am. Pepper

Supply Co., 205 Ariz. at 469, ¶¶ 14, 16, 72 P.3d at 1288.

Observing that allegations of concealment or misrepresentation

implicitly charge the maker with “deceitful” conduct, the court

reasoned that such allegations may harm an individual’s

reputation in the same way that allegations of fraudulent

conduct do. Id. ¶ 15. The court of appeals therefore concluded

that it should require the defendant to meet the heavier burden

of proving clear and convincing evidence to help prevent

unwarranted harms to insureds’ reputations caused by insurance

policy defenses sounding in fraud. Id. ¶ 14 (citing Wells Fargo

Bank v. Ariz. Laborers, Teamsters & Cement Masons Local No. 395

Pension Trust Fund, 201 Ariz. 474, 498 n.24, ¶ 98, 38 P.3d 12,

36 n.24 (2002)).

¶10 Such reasoning comports with the notion that “[t]he

degree of proof should generally correspond to the elements

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required to be proved before the insurer escapes liability. The

closer the elements come to intentional wrongdoing, the stricter

the degree of proof is likely to be.” 17 Couch, supra ¶ 8, §

254:94 (second “Observation”).

¶11 Arizona has adopted this approach. As explained in

State v. Renforth, 155 Ariz. 385, 387, 746 P.2d 1315, 1317 (App.

1987), burdens of proof correlate positively with the

significance of the interests at stake. In a criminal case, for

example, the state must prove guilt beyond a reasonable doubt, a

heavy burden rooted in the belief that “it is far worse to

convict an innocent [person] than to let a guilty [person] go

free.” Id. (quoting In re Winship, 397 U.S. 358, 373 (1970)).

The clear and convincing burden imposed on fraud claims

similarly stems from the societal importance of an untarnished

reputation. Id. (citing Addington v. Texas, 441 U.S. 418, 424

(1979)). In a non-fraud civil case, however, an erroneous

verdict for either party is no less unjust for one party than it

would be if it were rendered for the opposing party. Id.

(quoting In re Winship, 397 U.S. at 372). For that reason,

civil claims generally need be established only by a

preponderance of the evidence.

¶12 American Pepper cites several cases in support of its

argument that a higher burden is appropriate when a defense

sounds in fraud. See Sunseri v. Katz, 53 Ariz. 234, 87 P.2d 797

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(1939) (addressing suit to rescind a deed because of incapacity

or fraud); Cole v. Town of Miami, 52 Ariz. 488, 83 P.2d 997

(1938) (addressing the Industrial Commission’s alleged

concealment of a worker’s health condition in a worker’s

compensation case); Kingsbury v. Christy, 21 Ariz. 559, 192 P.

1114 (1920) (addressing fraudulent transfers in a

debtor/creditor dispute); Hall v. Warren, 5 Ariz. 127, 48 P. 214

(1897) (same); Rhoads v. Harvey Publ’ns, Inc., 145 Ariz. 142,

700 P.2d 840 (App. 1984) (addressing a claim sounding in tort

resulting from an employment relationship); Pinnacle Peak

Developers v. TRW Inv. Corp., 129 Ariz. 385, 631 P.2d 540 (App.

1980) (addressing whether the parol evidence rule bars evidence

of fraud in the inducement); Universal Inv. Co. v. Sahara Motor

Inn, Inc., 127 Ariz. 213, 619 P.2d 485 (App. 1980) (addressing a

claim to rescind a real estate contract on the basis of

fraudulent concealment of a material defect); Douglas v.

Vancouver Plywood Co., 16 Ariz. App. 364, 493 P.2d 531 (1972)

(addressing formation of a real estate contract); Ulan v.

Richtars, 8 Ariz. App. 351, 446 P.2d 255 (1968) (addressing a

claim sounding in tort resulting from a real estate

transaction). But none of these cases analyzes the distinction

between the common law tort of fraud, for which a heavier burden

of proof is usually imposed, and explicit contractual

undertakings not to conceal or misrepresent, which are usually

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proved by a preponderance of the evidence. None therefore

provides a persuasive rationale for imposing the heavier burden

in the insurance context.

¶13 Although we agree that allegations of concealment or

misrepresentation, like allegations of fraud, may harm an

insured’s reputation, several countervailing concerns persuade

us that for insurance contract defenses, the preponderance of

the evidence standard properly balances the parties’ and

society’s interests. First is ease of application. Applying an

identical preponderance burden of proof for both the insured in

establishing coverage and the insurer in establishing a contract

defense will reduce juror confusion. This is especially true in

a case like this one, in which the insurer’s defense is simply

the flip-side of the plaintiff’s claim. A jury will more easily

comprehend that the plaintiff-insured must prove “theft” and the

defendant-insurer must prove “not theft” by the same legal

standard.

¶14 Applying the same burden of proof to all contract

defenses an insurer raises also simplifies the analyses for the

jury. An insurer will often pursue in the same case several

related policy exclusions, such as arson, dishonesty, and

concealment or misrepresentation. See, e.g., Rego, 593 A.2d at

491; Am. Family Mut. Ins. Co., 978 F. Supp. at 874-75, 877. The

distinction between “dishonesty” and “concealment or

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misrepresentation” seems elusive at best and certainly is not

one that supports the imposition of different burdens. Thus to

require different burdens to establish them is unwarranted.3 As

another court succinctly explained, to require different burdens

of proof for dishonesty, arson, and concealment or

misrepresentation is “illogical and impractical.” Rego, 593

A.2d at 494.

¶15 Second, we rely upon the inherent difference between

the common-law tort of fraud, which is traditionally required to

be established by clear and convincing evidence, and the

contract defenses of concealment and misrepresentation, which

most states require be proved by a preponderance of the

evidence. In the former, a plaintiff sues for his justifiable

reliance on a material misrepresentation by a defendant. In a

contract defense case, however, it is the plaintiff himself who

is charged with making the false statement — after having

contractually obligated himself not to make such statements.

3
The court of appeals suggested that imposing a lower burden
for concealment or misrepresentation would create an
inconsistency between the standard for determining “dishonesty”
and the standard for determining “concealment or
misrepresentation.” Am. Pepper Supply Co., 205 Ariz. at 469, ¶
17, 72 P.3d at 1288. Couch suggests, however, that dishonesty
exclusionary provisions are subject to a preponderance burden.
10 Couch, supra ¶ 8, § 149:56 (stating that generally all
affirmative defenses are subject to a preponderance of the
evidence burden). Because no dishonesty provision is at issue
in this case, we reserve for another day the determination of
the proper burden for proving that defense.

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Indeed most insurance contracts affirmatively require insureds

to deal fairly and in good faith with the insurer. In short,

the societal concerns that support the imposition of the clear

and convincing burden in common-law fraud cases do not support

the imposition of the same burden with respect to contract

defenses.

¶16 Third, applying the preponderance of the evidence

burden to a concealment or misrepresentation defense comports

with sound reason and is supported by major commentators in the

field. See, e.g., 22A Appleman, Insurance Law and Practice §

14062 (J. Appleman ed. 1979) (proposing a jury instruction for

fraud in the context of insurance litigation using a

preponderance of the evidence burden of proof); 10 Couch, supra

¶ 8, § 149:56 (stating that generally all affirmative defenses

are subject to a preponderance of the evidence burden). Indeed,

our own court of appeals has held that the defense of arson,

which by its nature may impute fraudulent representations to the

insured, must be proved only by a preponderance of the evidence.

Godwin v. Farmers Ins. Co. of Am., 129 Ariz. 416, 418-20, 631

P.2d 571, 573-75 (App. 1981).

¶17 Finally, although it is a minor consideration, we note

that adopting the preponderance burden puts Arizona in the solid

mainstream of jurisdictions that have decided this issue. See

Rego, 593 A.2d at 494-95 (following the majority of courts and

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commentators suggesting that insurers must prove policy defenses

by a preponderance of the evidence); accord 17 Couch, supra ¶ 8,

§ 254:14. Although joining the majority is not, by itself,

reason for adopting a preponderance burden of proof, there is

value in applying a uniform and consistent standard to

commercial transactions.

¶18 We recognize that important interests motivate both

insureds and insurers: insureds wish to recover for legitimate

claims and insurers wish to avoid paying invalid ones. While we

do not want to encourage insureds to submit fraudulent claims,

we also do not want to make it easier for insurers to reject

valid claims. The tort of bad faith, however, protects the

insured’s interests against abuse in the latter case. Given

these legitimate interests and the remedy in place for abuse by

insurers, we conclude that an equally applied preponderance

burden is appropriate to properly balance the competing

concerns.

¶19 Although plaintiffs worry that insurers will escape

payment too easily, we do not see that application of the

preponderance burden of proof has resulted in harmful

consequences when applied to related contract defenses. In

Godwin, 129 Ariz. at 418-20, 631 P.2d at 573-75, for example,

the court of appeals applied the preponderance burden to the

contract defense of arson, which, like the defense of

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concealment or misrepresentation, often involves the insured’s

concealment or misrepresentation of the true cause of the fire.

In the nearly quarter century since that decision, we have seen

no evidence that the application of the preponderance standard

has led to a flood of denied claims or an onslaught of

litigation.

¶20 Therefore, because we find that the integrity of jury

deliberations outweighs the negligible potential for

reputational harms and the equities are appropriately balanced

by an equal burden, we conclude that the trial court erred by

instructing the jury that Federal had to prove the contract

defense of concealment or misrepresentation by clear and

convincing evidence. The burden of proving a concealment or

misrepresentation exclusion is met by convincing a jury, by a

preponderance of the evidence, that the insured has materially

misrepresented its claim or concealed evidence that would permit

a fair resolution of its claim.

¶21 Having concluded that the jury instruction requiring

proof of the contract defense by clear and convincing evidence

was erroneous, we must now determine whether that error

prejudiced Federal’s substantial interests. See Gemstar Ltd.,

185 Ariz. at 504, 917 P.2d at 231. In this case, the jury found

that American Pepper established its breach of contract claim by

a preponderance of the evidence, but did not find that Federal

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proved concealment or misrepresentation by clear and convincing

evidence. We cannot say that the jury might not have found

concealment or misrepresentation by a preponderance of the

evidence had it been properly instructed. For that reason we

conclude that the erroneous jury instruction did prejudice

Federal and a new trial is therefore required.

CONCLUSION

¶22 The proper burden of proof applicable to a policy

defense of concealment or misrepresentation is proof by a

preponderance of the evidence. We therefore reverse the

judgment on the breach of contract claim and vacate that portion

of the court of appeals opinion addressing the burden of proof.

We further remand American Pepper’s breach of contract claim to

the trial court for a new trial.4

__________________________________
Rebecca White Berch, Justice
CONCURRING:

_________________________________________
Charles E. Jones, Chief Justice

_________________________________________
Ruth V. McGregor, Vice Chief Justice

_________________________________________
Michael D. Ryan, Justice

_________________________________________
Andrew D. Hurwitz, Justice

4
The court of appeals opinion addressed another issue that
was not the subject of this petition for review.

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