The decision in this case has been confirmed by the Court of Appeal. To access the Court of Appeal judgment, click here

DMC Category Rating: Confirmed

This case note is based on an Article in the May 2005 Edition of the ‘Bulletin’, published by the Marine and Insurance teams at the international firm of lawyers, DLA Piper Rudnick Gray Cary. DLA Piper is an International Contributor to this website

Background
On 6 July 1994, the bulk carrier North Star was damaged by an explosion caused by a device located about 1 metre below the water line. Substantial quantities of seawater entered the engine room and damaged the machinery to such an extent that the costs of repair were likely to exceed the vessel's value, which, at the time of the incident, was about US$1.4 million.

The vessel was owned by North Star Shipping Ltd, a one-ship company managed by Kent Trading Corporation. Kent was beneficially owned by two brothers, H and M Petrakakos. The vessel's war risk cover was for US$4 million and incorporated the Institute War clauses dated 1.10.83. If the explosion was caused by an explosive device put in place either by terrorists or by some other outsider in order to cause malicious damage, it would fall within the insured perils.

The owners claimed under the war risks policy for a constructive total loss. Insurers, however, maintained that the loss was not covered because the explosion had been deliberately caused or procured by the owners. The position of the device indicated it could only have been placed by someone who had access to and was familiar with the ship. There was nothing to indicate that the explosion was caused by a terrorist or anyone acting from a political motive, but there was plenty of evidence to suggest that the owners were in desperate financial circumstances.

At the time of the explosion, the sale of the North Star for US$1.4 million was in jeopardy because the owners were having problems putting the vessel though a special survey. The deal gave the buyer the option of buying at a reduced price of US$1.1 million without the survey, but also the option to cancel on 10 July 1994. If the buyer cancelled (which by 6 July seemed highly likely), US$1.85 million it had already advanced to the owners would immediately become repayable. In the meantime, the most profitable ship in the owners' four-vessel fleet had been held under arrest for months in connection with a dispute with a previous business partner and another vessel had suffered a serious fire in mid-June.

It was also clear that the owners had been unable to meet their insurance premium payments for some time. The fleet's hull and machinery cover under a previous policy had been cancelled by insurers with effect from March 1994. New insurers were found, but by the end of June, premiums of over US$200,000 were outstanding. On 5 July 1994, the day before the explosion, the owners remitted US$10,350 towards these arrears, specifically requesting that US$5,350 of this sum be used to pay the outstanding war risk premium.

Complicity
The standard of proof of complicity is the balance of probabilities, but the court must feel a high level of confidence that the allegation is true, or must conclude that it is highly improbable that the allegation of complicity is not true (The Grecia Express [2002] 1 Lloyd's Rep 669).

The owner of a vessel may be shown to have had a motive for causing the loss, but in many cases this, on its own, will not be enough to establish a fraudulent claim. The physical circumstances of the loss have to be an essential part of the evidence. Evidence of the owner's previous or subsequent dishonesty, whether or not relating to insurance claims, is a matter to which at least some weight can be attached, but how much will depend on the nature and degree of the dishonesty.

Weighing up the evidence in this case, Mr Justice Colman concluded that the owners had been complicit in the loss of the vessel. In particular, he took account of the physical circumstances of the explosion (specifically, the location of the explosive device), the character and demeanour of the owners when they gave evidence at court, their commercial and financial circumstances and their conduct following the explosion.

Non-disclosure of material facts
Insurers also relied on non-disclosure of material facts to avoid the contract ab initio. They claimed that, before the war risks policy was entered into, the owners failed to disclose:

• Four separate pending criminal proceedings in the Greek courts: H Petrakakos was named (amongst others) as a defendant in all four actions, M Petrakakos in one;
• Civil proceedings in Panama against the Kent Group companies involving allegations of fraudulent trading;
• That the vessel's insured value at US$4 million was excessive;
• That the previous year's hull and machinery insurance had been cancelled for non-payment of premium; and
• That the owners were in a serious financial position.

The Greek proceedings concerned allegations of financial fraud involving an investment scheme, whereby individuals would invest sums of money on the promise of obtaining a guaranteed minimum repayment. At the date of placement, all four proceedings were progressing, although in two of them it had not yet been decided whether there would be a prosecution. In relation to one of the actions, solicitors acting for H Petrakakos had obtained a letter from the Serious Fraud Office in London stating that it regarded "Mr Petrakakos" as a victim of a fraud perpetrated by others and that it hoped he would give evidence on behalf of the Crown at the trial of those others on related charges of fraudulent trading.

The civil proceedings in Panama arose out of the dispute with a previous business partner and had resulted in the owners' most profitable vessel being arrested for nearly a year, contributing to their financial problems. It was alleged that Kent, controlled by H Petrakakos, had fraudulently endorsed an insurance policy relating to another vessel to the claimant without disclosing it had already been endorsed to a bank.

Moral hazard
Allegations of criminality or misconduct against a person seeking insurance cover are discloseable, even if the proposer knows they are groundless, because such allegations, whether made in criminal or civil proceedings, call into question the commercial integrity of the insured (CTI v Oceanus [1982] 2 Lloyd's Rep 178).

Where an allegation is made but not resolved at the time of placement, the fact that the allegation is unfounded does not mean it is not material (The Grecia Express [2002] 1 Lloyd's Rep 669). In Brotherton v Aseguradora Colseguros SA (No.2) [2003] 1 Lloyd's Rep 746, Lord Justice Mance commented that, in such circumstances, issues of materiality and inducement would be decided taking into account the likelihood that, if there had been full disclosure, the insured would also have disclosed any evidence he had to prove his innocence.

The owners argued that the allegations were not material, relying on the evidence of their expert witness, Mr Posgate, who took the view that moral hazard considerations played only a peripheral role in war risk insurance and had little practical significance. In his view, the scope of a war risks cover was sufficiently narrow as to make the risk of fraudulent claims very remote.

Mr Justice Colman accepted that the scope of war risk cover was such that, by comparison with hull and machinery cover, there were fewer opportunities for faking an insured loss, but, nevertheless, the potential for fraud was not negligible. The owner might, for instance, conceal the fact that the vessel was trading in a war zone in order to avoid the additional premium. In his view, there was no logical basis for differentiating the two types of cover when considering issues of moral hazard.

In this case, he concluded that the court proceedings in both Greece and Panama were material and discloseable. There was no doubt that the information would have influenced the decision of a prudent underwriter. Even if there was evidence to suggest the insured was innocent (such as the SFO letter) this could not diminish the materiality of the allegations. In any case, the SFO letter would have made no difference as it did not affect the pending Greek proceedings and had no connection at all to the allegations made in Panama.

Inducement
The non-disclosure of the allegations was material, but did it induce the actual underwriters to accept the risk on the terms they did? The evidence showed clearly that it did.

Underwriters in the London market usually expect to evaluate a risk with some rapidity and give a fairly immediate response to the broker. The idea that the SFO letter would have been enough to allay the serious concerns they would have had over the allegations, or even that underwriters would have taken the time to make any further investigation, was simply not realistic. In the case of war risks insurance, where the premium is typically very small, no underwriter would want to take on a risk if there was any lingering doubt as to the commercial probity of the insured.

Excessive value
It was not disputed that the vessel's market value was between US$1.12 and US$1.4 million, depending on whether it could be sold with a completed special survey. The insured value, however, was stated to be US$4 million.

In order to show that an insured value is excessive, it has to be shown to be far in excess of a "disparity consistent with prudent ship management". An owner who genuinely and reasonably believes his vessel ought to be insured for a particular value does not have to disclose the true market value. Only if the disparity cannot be justified on reasonable commercial grounds must it be disclosed (The Grecia Express).

The owners said that they reasonably believed the vessel should be insured for US$4million. The figure had been carried over from the year before and took into account US$3 million which had been spent on repairs when the vessel was bought in 1989, as well as future charter earnings.

The judge thought it was not unreasonable for an owner to set the insured value at a level reflecting his earlier capital investment as well as future net revenues. A disparity with market value which roughly reflected those components would not normally be treated as material. In this case, an insured value of US$3 million would not necessarily fall outside the range of what was consistent with prudent ship management. But the additional US$1 million was excessive.

Taken alongside the contemporaneous sale of the vessel for US$1.4 million (or US$1.1 million at the reduced price) this was a material fact that should have been disclosed. On the question of inducement, however, the judge was not persuaded that underwriters would have refused the risk on the grounds of overvaluation alone, but, in conjunction with the other undisclosed material, it at least contributed to the decision to accept the risk.

Non-payment of premiums
Insurers claimed that the fact that the previous year's hull and machinery insurance for the Kent fleet had been cancelled for non-payment of premium was discloseable, as was the owners' dire financial situation.

In the Martin P [2004] 1 Lloyd's Rep 389, it was held that late or non-payment of premium under a previous policy was not, in itself, material to the risk under a marine hull and machinery policy and so need not be disclosed. The court took the view that the insurers were adequately protected by section 53(1) of the Marine Insurance Act 1906 (which provides that the broker is directly responsible to underwriters for the payment of premium) and by a broker's cancellation clause and a premium warranty clause in the policy.

Mr Justice Colman agreed that, in most cases, the risk that premium might not be paid in time, or at all, would not affect the magnitude of the insured risk nor, normally, would it be relevant to moral hazard because underwriters can exercise their right of recourse against the broker under section 53(1). But this did not mean that premium payment defaults were incapable of being material. In some cases it was possible that the non-disclosure would have affected the terms in which the underwriter accepted the risk, even with the benefit of section 53(1). He may, for instance, have required a premium warranty clause to be added.

As for the owners' financial problems, the question whether or not these were material depended on their severity and the risk that they would become tempted to make a fraudulent claim. In this case, the payment defaults and the policy cancellation were all part and parcel of the owners' very serious financial situation. When taken together with the other non-disclosures about the pending proceedings and the over-valuation, they were material and discloseable because of their relevance to moral hazard.