In order to try to resolve litigation pending against them, policyholders sometimes enter a settlement in which they agree to the entry of a consent judgment against them and to the assignment to the claimants of their rights under their insurance policy, subject to the claimants’ agreement not to execute the judgment against them. The question that often arises is whether, in light of the covenant not to execute, the policyholders have suffered a “Loss” as required to trigger policy coverage.
In a September 16, 2016 ruling in connection with a coverage dispute involving one of these types of settlement arrangements, Eastern District of New York Judge Arthur D. Spatt, applying New York law, rejected a D&O insurer’s argument that because of the assignees’ agreement not to execute on the consent judgment, the insured persons had suffered no “Loss.” The court’s determination of these questions raises some interesting issues. Judge Spratt’s September 16, 2016 opinion can be found here.
The coverage dispute arises from an earlier federal court lawsuit in which Intelligent Systems, LLC and several related parties sued certain former directors of Visual Management Systems, Inc. for negligence, common law fraud, securities fraud, and non-payment of promissory notes (the “Underlying Action”). The parties settled the Underlying Action pursuant to three separate stipulations settling the dispute. In the stipulations, the former VMS directors consented to judgments against them individually; the claimants agreed to “unconditionally forbear” the collection of the judgments against the Individual Insureds; and the VMS directors agreed to assign to the claimants their claims for indemnification under VMS’s D&O insurance policy. Each stipulation specified that “Nothing contained in the Stipulation shall constitute a waiver or release of the [claimants’] right to assert and claim or rights against [the D&O insurer].”
The claimants in the Underlying Action then filed a coverage lawsuit against VMS’s D&O insurer, in which the claimants asserted the rights under the policy that VMS had assigned, seeking to recover the amount of the consent judgment. The coverage action proceeded to trial. During the trial, the D&O insurer filed a Motion for Judgment as a Matter of Law (JMOL).
In its Motion, the insurer argued that because the settlement included an agreement that the judgment would not be enforced against the individual former directors of VMS, the individuals never suffered a “Loss” within the meaning of the Policy, there is no coverage under the policy for the judgment in the underlying action, and therefore that as assignees are not entitled to coverage the policy.
The plaintiffs in the coverage action argued that because the individual insureds never agreed to release the D&O insurer from liability under the policy, the judgments against the individuals does constitute a “Loss” under the policy, regardless of whether the assignees agreed to forebear collection of those judgments.
The Policy defined the term “Loss” to mean “The amounts which the Insureds become legally obligated to pay on account of a Claim, including damages, judgments, any award of pre-judgment or post-judgment interest, costs and fees awarded pursuant to judgments, settlement amounts and Costs, Charges, and Expenses, incurred by any of the Insureds.”
The September 16, 2016 Order
In his September 16, 2016 order, Judge Spatt denied the D&O insurer’s motion for judgment as a matter of law, and continued the matter for trial on remaining issues. Judge Spatt, applying New York law, found that the insurance policy covered the consent judgments and assignment of rights of the insured to the assignees, notwithstanding the assignees’ agreement not to execute the judgment against the individuals, due to the fact that the assignment did not release the D&O insurer from liability.
In reaching this conclusion, Judge Spratt cited several New York cases, as well as cases from other jurisdictions; he noted that the other jurisdictions’ courts have “recognized the right of assignees, such as the Plaintiffs, to pursue coverage on behalf of the insureds even when the assignment is coupled with a covenant not to execute the judgment against the insureds.”
Based on the cases Judge Spratt cited, he conclude that “New York courts and a majority of courts in other jurisdictions have held that an insurance company remains ‘legally obligated’ to pay a claim under a policy even where, as here, the claim was assigned to a third party, and the third party agreed not to execute a judgment against the insured’s personal assets.”
Judge Spratt emphasized that the settlement stipulations made clear that the settlement did not constitute a waiver of the underlying claimants to assert a claim or right of action against the D&O insurer. Without such a waiver, Judge Spratt said, the court “follows the majority of other courts that have confronted a similar issue” and held that the term “legally obligated to pay” encompasses the consent judgments against the Individual Insureds, “irrespective of the covenants not to enforce those judgments.” He concluded that the individual insureds did suffer a “Loss,” and that the assignees, standing in the shoes of the individual insureds, are entitled to seek coverage under the Policy for the judgments.
In reaching this conclusion, Judge Spatt distinguished the Eighth Circuit’s 2011 decision in U.S. Bank National Association v. Federal Insurance Company (here), in which the court had reached a contrary conclusion. Judge Spratt declined to follow the case because the definition of “Loss” at issue in that case contained a phrase not found at the policy at issue in the case before him, where the definition of “Loss” excluded “any amount not indemnified by the Insured Organization for which the Insured Person is absolved from payment by reason of any covenant, agreement or court order.”
Judge Spatt concluded that he would not present the “Loss” issue to the jury for decision, but continued the trial for jury’s determination of remaining issues.
Although not relevant to Judge Spratt’s September 16 ruling, readers may be interested to know that on September 21, 2016, the jury entered a verdict in favor the D&O insurer. As reflected in the jury verdict form (here), the jury concluded that one of the plaintiffs in the underlying case had been a director or officer of the insured company, as a result of which the policy’s insured vs. insured exclusion applied and coverage under the policy was precluded. So while the insurer loss this motion, it ultimately won the trial.
Based on my experiences earlier in my career representing insurers in coverage disputes involving these kinds of settlement arrangements, I am not a big fan of these kinds of deals. During my years representing the carriers, I saw settlements of this type that appeared collusive and calculated to try to “set up” the insurer. These kinds of settlement arrangements can involve excesses, particularly in connection with the calculation of the amount of the consent judgments, and for that reason I think courts ought to proceed cautiously in validating these kinds of deals.
A particular concern, and the issue that was before the court here, is the question of whether a policyholder that has entered a consent judgment but has the benefit of a covenant not to execute has suffered a “Loss” under the policy.
Looking at the text from the opinions on which Judge Spatt relied in addressing this question, it could be argued that these cases, while confirming that a covenant not to execute does not release a liability insurer, do not address the question of whether or not the policyholder has actually suffered a “Loss” within the meaning of the policy.
Judge Spratt relied on and cited the cases as standing for the proposition that “an insurance company remains ‘legally obligated to pay’ a claim under a policy where, as here, the claim was assigned to a third party, and the third party agreed not to execute the judgment against the insured’s personal assets.” The problem with analysis is that it arguably does not answer the question that the policy’s definition of “Loss” requires the court to answer.
The question the policy requires to be asked is whether the insured is legally obligated to pay specified amounts, not whether the insurer is legally obligated to pay; indeed, the question of whether the insured is legally obligated to pay is logically and analytically prior to and determinative of the question of whether the insurer is legally obligated to pay.
With respect to the question of whether or not the individual insureds here were “legally obligated to pay” the consent judgments here, it is worth noting that the insurer cited a recent federal appellate case specifically holding that a policyholder with the benefit of a covenant not to execute is not legally obligated to pay the judgment amount and therefore has not suffered a “Loss.” The case is Jones v. Southern Marine & Aviation Underwriters, Inc., a 1989 Fifth Circuit case (here). However, rather than addressing the merits of that holding, Judge Spatt simply said that it was contrary to the weight of the other authority he considered.
Setting to one side the merits of the actual question that Judge Spatt was asked to decide, and also setting to one side the concerns I about these kinds of concerns I noted above, I have to acknowledge here a pragmatic lesson I have learned to appreciate based on my more recent experience representing policyholders.
I have lived long enough to learn that sometimes policyholders may feel they have little choice but to enter these kinds of arrangements. Where the insurer has denied coverage for their claim, policyholders may well conclude that there is no other way for them to extricate themselves from a claim other than to enter one of these types of settlement arrangements. Because I have seen enough situations where the policyholders may feel a settlement arrangement of this type is the only way to bring the litigation against them to an end, I have to admit that I would hate to see the courts cut off this avenue for policyholders, notwithstanding the concerns I noted above.
I know that carriers dealing with these kinds of arrangements often feel hard done by. For reasons I alluded to above, I understand the carriers’ concerns. I can see the arguments on either side of these issues.
Perhaps the solution for the carriers can be found in the language that was included in the definition of “Loss” that was at issue in the Eighth Circuit decision on which the D&O insurer had attempted to rely here. That is, if the carriers want to try to cut off their exposure to these kinds of arrangements, the carriers could incorporate in their definitions of “Loss” the language at issue in the Eight Circuit case, to the effect that “Loss” does not include “any amount not indemnified by the Insured Organization for which the Insured Person is absolved from payment by reason of any covenant, agreement or court order.”
To be sure, I am not encouraging carriers to include this language, and in fact in my current role as an insurance broker if I were presented with a proposed policy that included this language, I would ask to have it removed or attempt to find another carrier whose policy did not include this language. I doubt that in a competitive marketplace many carriers would succeed in adding this language to their definitions of “Loss.”
What I am saying is that insurers have the option to add this type of language, and in the absence of this language, I think it could be argued that the carriers should not be heard to argue that their policyholders have suffered no loss because they entered a consent judgment subject to a covenant not to execute.
I have tried to walk through all of the issues that these kinds of settlement arrangements present. I freely acknowledge that parts of my analysis may be inconsistent with other portions of the analysis, and that the analysis as a whole may not entirely cohere. In the end, I was drawn to more of a pragmatic conclusion rather than an analytically consistent conclusion. I know that these types of arrangements are often controversial and that many readers may have strong views on these issues. I invite readers to add their thoughts and observations using the comment feature at the end of the post.