Second Circuit: Excess D&O Insurance Not Triggered When Underlying Carriers Are Insolvent, Even If Loss Exceeds Excess Attachment Point
On June 4, 2013, the Second Circuit, in an insurance coverage action involving the defunct Commodore International computer company, affirmed that excess D&O insurance is not triggered even if losses exceed the amount of the underlying insurance, where the underlying amounts have not been paid due to the insolvency of underlying insurers. The Second Circuit’s June 4, 2013 opinion can be found here.
The Second Circuit’s opinion is important because it represents the first time the Circuit has revisited its venerable and influential 1928 opinion in the Zeig v. Massachusetts Bonding & Insurance Co.
As I noted in my discussion of the district court’s decision (here), this is a tale haunted by the ghosts of several long-lost companies – not only the ghost of Commodore itself (the manufacturer of the classic Commodore 64 computer), but also the ghosts of Reliance Insurance Company, which went into regulatory liquidation in 2001, and of The Home Insurance Company, which went into liquidation in 2003. This case not only analyzes the requirements to trigger the obligations of excess insurers, but it also serves as an important reminder of the chaos that can follow when carriers become insolvent.
Commodore filed for bankruptcy in 1994. In the bankruptcy proceeding, various claims were asserted against the company’s former directors. The individuals sought insurance protection for these claims from Commodore’s D&O insurers. Commodore had a D&O insurance program with total limits of $51 million, arranged in nine layers, consisting of a primary layer of $10 million and eight excess layers in varying amounts. Unfortunately for Commodore’s former directors, the first and fourth level excess layers were provided by Reliance and the third and sixth level excess layers were provided by The Home.
The primary D&O insurance was exhausted by payment of losses. However, due to Reliance’s insolvency, the individuals were unable to obtain insurance for losses that went into the next layers of insurance. The individuals sought to have the solvent excess insurers that provided the insurance layers above the insolvent carriers pay their defense expenses and other loss costs. These “next level” excess insurers filed an action seeking a judicial declaration that they had no obligation to “drop down” to fill the gaps created by the insolvent insurers, and also seeking a declaration that their excess insurance obligations had not been triggered because the underlying layers had not been exhausted by payment of loss. The individual directors contended that the excess insurers’ payment obligation had been triggered because their liabilities exceeded the amount of the underlying insurance.
The solvent excess insurers’ policies all contained a similar provision essentially providing that the payment obligation under the policies is triggered only “in the event of exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses.”
As discussed here, on September 28, 2011, Southern District of New York Judge Richard Sullivan granted the insurers’ motion for summary judgment. He ruled that the “next level” excess insurers had no obligation to drop down to fill the gaps caused by the insolvency of Reliance and of The Home. (Judge Sullivan’s ruling on the “drop down” issue was not appealed and was not before the Second Circuit). Judge Sullivan also concluded that the “next level” excess insurers obligations had not been triggered merely because the individuals’ liabilities exceeded the amount of the underlying insurance.
Judge Sullivan found that the “express language” in the excess insurers’ policies required exhaustion of the underlying limits by actual payment of loss in order to trigger coverage. He said that it is “clear from the plain language of the Excess Policies … that the excess coverage will not be triggered solely by the aggregation of Defendants’ covered losses. Rather the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”
Following further proceedings in the District Court, the individual directors appealed Judge Sullivan’s summary judgment ruling.
The June 4 Opinion
In June 4, 2013 Opinion written by Judge José Cabranes for a unanimous three-judge panel, the Second Circuit affirmed Judge Sullivan’s ruling. The appellate court said that “the plain language of the insurance policies supports the view of the insurer appellees.”
The individual directors had argued that the excess insurers’ payment obligation attached when defense or indemnity obligations reached the excess insurers’ respective attachment points. The Second Circuit said that “’obligations’ are not synonymous with ‘payments’ on those obligations,” adding that “to hold otherwise would make the ‘payment of’ language in these excess liability contracts superfluous.” The appellate court added that “because the plain language of the contracts specifies that the coverage obligation is not triggered until payments reach the respective attachment points, the District Court properly denied the Directors’ request for a declaration that coverage obligations are triggered once the Directors’ defense and indemnity obligations reach the relevant attachment point.”
Interestingly, the Second Circuit noted that the District Court had never actually said that the underlying insurers must make the payments before the excess insurers’ obligations were triggered. The appellate court noted that the District Court, echoing the excess policies’ themselves, “described the requirements in the passive voice and did not specify which party was obligated to make the requisite payments.” The District Court, the appellate court noted, “did not err in doing so,” as denying the directors’ request “did not require ruling on whether the underlying insurers, in particular, were required to made the payments; the Directors simply sought a declaration that the excess policies’ coverages are triggered once the respective attachment points were reached.”
The Second Circuit also rejected the individual directors attempt to rely on the Second Circuit’s 1928 Zeig opinion. (Zeig had held that an insured under a property insurance program could obtain the benefits of an excess policy where the insured’s loss exceeded the amount of the underlying insurance.) The appellate court did not overrule Zeig; rather, the Second Circuit distinguished Zeig.
First, the Second Circuit differentiated between the “context” in Zeig, in which the prior Court had been interpreting a first-party property policy, and the context in this this case, in which the Court was interpreting a third-party excess liability policy. The relevance of the question whether or not the amount of loss exceeded the amount of underlying insurance is clearly different in the context of a property policy than in the context of a third-party liability policy. The Second Circuit noted, quoting with approval from the Judge Sullivan’s opinion, that a third party liability insurer was within its right to require actual payment of the underlying amounts, so as to protect against collusive settlements.
Though the Second Circuit did not overrule Zeig, it did comment in a footnote that “though not relevant to our decision, it bears recalling that the freestanding federal common law that Zeig interpreted and applied no longer exists. See Erie R.R. Co. v. Tomkins, 304 U.S. 64 (1938), overruling Swift v. Tyson, 41 U.S. 1 (1842).”
If nothing else, this case serves as a reminder of the critical importance of carrier solvency. Carriers do not become insolvent frequently, but when they do, it is a mess. Here we are fully twelve years after Reliance went into liquidation (and nearly twenty years after Commodore went into bankruptcy) fighting about the problems caused when the carriers went bust. Unfortunately for the former Commodore directors, their insurance program had doubled down on the carriers that went insolvent; its insurance program included two layers of excess insurance each for both Reliance and The Home.
The Second Circuit’s holding that the excess insurers’ payment obligations were not triggered even though the individuals’ losses exceeded the amount of the underlying insurance is consistent with other recent decisions in which courts have interpreted the excess insurer’s trigger language to require exhaustion of the underlying insurance by the actual payment of loss (refer for example here and here).
Though the Second Circuit’s decision is consistent with other recent decisions on this topic, there are still a number of interesting things about this opinion. First of all, as noted above, this case apparently represents the first occasion on which the Second Circuit has revisited its venerable Zeig decision, a case on which policyholders have relied for years to try to compel their excess insurers to pay losses that exceeded the excess insurers’ layers.
The Second Circuit did not overturn Zeig, it merely distinguished the case. (For that matter, the Second Circuit didn’t even make clear which state’s law it was applying; in a footnote, the appellate court noted that the parties disputed whether Pennsylvania law or New York law applied, observing that “because there is no conflict between the relevant substantive law in these states however, we dispense with any choice of law analysis.”)
Just the same, I question whether or not Zeig remains good law after this decision in the Commodore case. As I noted above, the Second Circuit expressly noted that that “freestanding common law” that Zeig interpreted “no longer exists.” In light of this statement, I doubt whether Zeig represents reliable authority that could be cited and relied upon for the propositions it otherwise represents.
It is worth noting that for several years now, the D&O insurance marketplace has featured the availability of excess insurance policies with trigger language that allows the amount of the underlying limits of liability to be paid either by the insurer or the insured for the excess insurer’s payment obligation to be triggered. However, even if the policies of the solvent excess carriers in this case had included this modern language, the excess carriers’ payment obligations might not have been triggered; the clear suggestion of the Second Circuit’s analysis of the “payment of” language is that the underlying amounts had not been paid here, either by the insolvent insurers or by the insured persons -- which serves as a reminder that even the modern language does not solve every excess trigger problem.
It was interesting in the Second Circuit’s opinion that the appellate court expressly did not reach the question of whether the individual directors’ payment of the losses would have been sufficient to satisfy the “payment of” triggers of the excess policy. The Second Circuit’s commentary on this issue, and its analysis of the passive voice “payment of” language in the excess policy’s trigger, will give policyholders in coverage cases involving excess policies that lack the modern trigger a basis on which to argue for coverage. The policyholders could argue, if they have in fact themselves paid the underlying loss, that their payment of the loss satisfies the “payment of” trigger where the excess policy uses the passive voice and does not specify who must make the payment in order for the excess coverage to be triggered.
Owing to the insolvency of Reliance and The Home, the individual directors here are left to face the underlying claims without the benefit of insurance. This dire circumstance provides a vivid illustration of the value of Excess Side A/DIC insurance, which by its terms would drop down and provide coverage in the event of the insolvency of an underlying insurer. Excess Side A/ DIC policies were available at the time that Commodore procured its D&O insurance, but the inclusion of these types of policies in a program of D&O insurance was not as common then as now. (The policies available then were more restrictive than those available today, as well.) If Commodore’s insurance program had included an Excess Side A/DIC policy, the individual defendants might have been able to rely on that policy to defend themselves despite the gaps caused by the insurers’ insolvency.
In any event, the time has finally come to draw a curtain on this production. At this point in a Shakespearean play, the stage directions would say: Exeunt stage left. And off into the night would troop the spirits of Commodore, Reliance and The Home – followed by the spirits of the several individual directors who have passed away while this seemingly interminable drama has dragged on. Among them would be the departing spirit of the late Alexander Haig, who during his mortal span of years was a Commodore director and who also served as Secretary of State under Ronald Reagan. He was not in fact “in control” during the tense hours after Reagan’s attempted assassination any more than he is now.
Special thanks to a loyal reader for sending me a copy of the Second Circuit’s opinion.
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