The Second Circuit’s Ali Decision Supports Zeig on Exhaustion of Insurance

John A. Gibbons

John A. GibbonsThe Second Circuit’s June 4, 2013 decision in Ali v. Federal Insurance Co. addresses when and how a policyholder may recover from excess liability insurance policies for future liabilities when underlying insurers are insolvent. (Opinion linked here). A number of insurer-leaning commentators have cast the case as a rethinking of Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928), the seminal Second Circuit decision authored by Judge Augustus Hand, which first established the principle that policyholders could recover against excess insurance policies even if the policyholder did not collect the full limits of underlying insurance policies.  In Zeig, the Second Circuit rejected an excess insurer’s attempt to walk away from its insurance obligations simply because Mr. Zeig settled his claim against a separate insurance company. Zeig established the principle, recognized by numerous courts since, that a policyholder’s settlement with one insurer does not forfeit the policyholder’s rights against other insurers.

The characterization that the Second Circuit has now called Zeig’s common-sense, and widely recognized principle into question, however, seriously misreads the decision in Ali. To understand Ali—what it does and does not hold—requires an understanding of the issues that were actually ruled on by the district court and affirmed by the Second Circuit.

Contrary to the post-appeal commentary, Travelers Casualty and Surety Company of America (“Travelers”), one of the two insurers involved in the case, took the position on appeal that the district court’s ruling was consistent with Zeig—indeed, Travelers argued that Zeig was “entirely supportive of” the district court’s ruling. Brief on Behalf of Appellee Travelers at 39-40, (“Travelers Br.”) No. 11-5000, D.N. 72.  (Travelers’, and the other parties’, briefs are available online.)

The Second Circuit directly addressed confusion about the breadth of the district court’s order to ensure that there would be no confusion about its affirmance. Notwithstanding the clarity of the Second Circuit’s opinion, and the clear statements from Travelers that affirmance would be entirely consistent with Zeig, post-appeal commentary has attempted to manufacture conflicts between Ali and Zeig.

A more careful reading, however, reveals that Ali supports the central principle from Zeig. The Second Circuit’s reasoning is consistent with, and supports the well-reasoned line of cases that permit policyholders to recover excess coverage by exhausting underlying policies with amounts incurred by policyholders (without requiring actual payment by the underlying insurer). See, e.g., Trinity Homes LLC v. Ohio Cas. Ins. Co., 629 F.3d 653 (7th Cir. 2010); Maximus, Inc. v. Twin City Fire Ins. Co., 856 F. Supp. 2d 797 (E.D. Va. 2012).

Bankruptcy and Insurance Insolvencies

The Ali policyholders are the former directors and officers (“Ds&Os”) of Commodore International Limited (“Commodore”), maker of the Commodore PET and Commodore 64 (among other electronics), which filed for bankruptcy in 1994. Commodore purchased liability policies insuring the Ds&Os, including policies from Reliance Insurance Company and The Home Insurance Company, which filed for insolvency in 2000 and 2002, respectively. Federal Insurance Company (“Federal”) and Travelers, both of whom are still solvent, sold liability policies covering the Ds&Os that are excess of the insolvent Reliance and Home policies.

Ds&Os Sued in the Bahamas

The Ds&Os were sued in the Bahamas for $100 million in damages, which greatly exceeded the total amount of the Ds&Os’ remaining insurance coverage. At the time of the coverage litigation, the Ds&Os incurred approximately $14 million defending the suit, but no other “out-of-pocket” losses. The $10 million limit for the primary policy was exhausted by payment of defense costs. The Reliance and Home policies provided coverage for a number of the excess layers between the exhausted primary policy and the higher-level excess Federal and Travelers policies. The Ds&Os asked these higher-level excess insurers to “drop down” (i.e., pay in the place of the lower level insolvent Reliance and Home policies).

The Coverage Suit

Federal sued, asking the Southern District of New York to declare that the Federal excess policies were not required to “drop down” and begin paying for amounts that would otherwise have been paid by Reliance and Home had those insurers remained solvent. “Drop down” is the term generally used to refer to instances when an excess level insurer is asked to pay before the amount of lower level insurance coverage has been paid (“drop down” may be required by language in excess insurance policies).

The Ds&Os countered, asking the district court to order Federal and Travelers to pay once the total amount of the Ds&Os’ liability obligations reached the attachment point for the insurers’ higher-level excess policies. At the time of the coverage litigation, the Ds&Os had not incurred any liability obligations that would reach the higher-level excess policies—instead the Ds&Os asked for a declaration to cover prospective liability obligations and asked the district court to order the higher-level excess insurers to pay without first requiring the policyholders to pay the liabilities attributable to the insolvent Reliance and Home policies.

The district court granted Federal’s request, ordering that the Federal excess policies were not required to “drop down.”  The district court then denied the Ds&Os request for a declaration that prospective, inchoate liability obligations alone were sufficient to reach the attachment point of the higher-level excess policies. The Ds&Os only appealed that part of the district court’s order denying them access to the higher-level excess policies if the future liability obligations reached those policies’ attachment points. The Ds&Os did not appeal the “drop down” ruling.

Prospective Liability Obligations Are Not the Same as Liability Payments

The Second Circuit’s Ali opinion affirms the district court based primarily on the circuit court’s distinction between prospective liability obligations versus liability payments: “‘obligations’ are not synonymous with ‘payments’ on those obligations.” Op. at 11. The Second Circuit reasoned that language from the Federal and Travelers policies required “actual payment” of underlying insurance amounts, and the Ds&Os obligations without “actual payment” did not exhaust the limits of the underlying insolvent policies. Interpreting policy language concerning “exhaustion” by “payment” the Second Circuit concluded:

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 Director’s request for a declaration that coverage obligations are triggered once the Directors’ defense and indemnity obligations reach the relevant attachment point.

Op. at 11.

Payments from Underlying Insurers or Policyholders Exhaust
Insolvent Coverage and Lead to Recovery from Excess Insurers

The Second Circuit grappled with confusion in the appellate briefing about the breadth of the district court’s ruling. The Ds&Os read the district court’s order as requiring “actual payment” of the underlying insolvent policy limits by the insolvent insurers, Reliance and Home; very likely an impossibility that could force a forfeiture of coverage.

Travelers assured the Second Circuit and the Ds&Os on appeal that such a reading was incorrect: “Nowhere in the Decision does the district court hold that the underlying limits must be exhausted by payment of the Insolvent Carriers.” Travelers Br. at 36. Travelers further argued that “Travelers believes Zeig is entirely supportive of the district court’s Decision.” Travelers Br. at 40. Indeed, Travelers explained that, “[i]n Zeig this Court held that an insured’s settlement with an underlying carrier for an amount below the full limits of liability did not prejudice an excess carrier ‘so long as it was only called upon to pay such portion of the loss as was in excess of the limits of those [underlying] policies.’” Travelers Br. at 40 (citation omitted). Travelers further represented that once the Ds&Os, and/or the underlying insurance companies including Federal, wrote checks for amounts equal to the attachment point of Travelers excess policies then “the Ds&Os could look to Travelers” to pay. Travelers Br. at 41.

With this background and argument, the Second Circuit clarified the breadth and meaning of the district court’s (and its own) holding when it explained: “The District Court never held that the underlying insurers must make payments before the obligations under the relevant excess policies are triggered.” Op. at 11-12. The Second Circuit then provided the reasoning for its holding, which directly indicated that payment of the underlying insurance limits could be satisfied by payments from either the underlying insurers, the policyholders, or even perhaps another entity, so long as the payments are attributable to underlying policies.

The Second Circuit’s reasoning specifically referenced the “maintenance of underlying insurance” provisions, which policyholders frequently cite for the proposition that they are entitled to coverage even if the underlying insurer does not actually pay: “The District Court also appropriately noted that the relevant excess insurance policies contemplate continued coverage even if the Directors fail to maintain underlying insurance policies at all.” Op. at 12 n.15.

The Second Circuit also squarely addressed the oddity, some might say incongruity, of requiring actual payment from insolvent insurance companies: “[R]equiring nonoperational insurance companies to make payments as a condition precedent to the attachment would be odd, effectively relieving [Federal] and Travelers of their policy obligations, and leaving the Directors without coverage, on account of the insolvency of the underlying insurance providers.” Op. at 12 n.15. The Second Circuit seems to be clear in stating that it would not support such an odd, and inequitable, result.

Commentators that seek to create a conflict between Ali and Zeig, thus, simply misread the Second Circuit’s decision. The Second Circuit distinguished the “drop down” and “legal obligations versus legal liabilities” issues in Ali from the entirely distinct exhaustion from “out-of-pocket” losses issue addressed in Zeig and its progeny: “In [the Zeig line of] cases, the [policyholder] suffered out-of-pocket losses (for instance, through the loss of property, or through liability payments to a third party) for which the [policyholder] sought indemnification. The Directors’ requested relief, by contrast, focuses on their obligations to pay third parties.” Op. at 14.

The Second Circuit’s reference to the continuation of excess coverage under “maintenance of underlying insurance” provisions, its comments about the oddity of requiring payments from insolvent insurers, and its recognition that “out-of-pocket” losses exhaust insurance policies, all support a policyholder’s right to recover excess insurance based on the payment of underlying limits by the underlying insurer or the policyholder, or even another entity. This principle represents the better reasoned view, and is more consistent with the policy language and favorable to policyholders.

Ali’s “Actual” Significance

At most, Ali is an extended anti-“drop down” ruling (again, absent specific “drop down” policy language). The reasoning behind the district court’s ruling and Second Circuit’s affirmance can be found in both courts’ expressed concern about creating a rule that would encourage policyholders’ to accept liability obligations that would not require actual payment by the policyholder or any other underlying insurer as a means of accessing higher-level excess insurance policies. The district court and Second Circuit worried that tying recovery of excess insurance to prospective liability obligations, without “actual payments,” could be used to effectively impose “drop down”:

If [the Directors] were able to trigger the Excess Policies simply by virtue of their aggregated [but unpaid] losses, they might be tempted to structure inflated settlements with their adversaries in the Bahamas Litigation that would have the same effect as requiring the Excess Insurers to drop down and assume coverage in place of the insolvent carriers.

 Op. at 14. The Second Circuit’s final sentences highlighted the limited scope of the holding and significance of Ali:

[T]he excess insurers here had good reason to require actual payment up to the attachment points of the relevant policies, thus deterring the possibility of settlement manipulation.  In this context, the plain meaning of the phrase “payment of losses” refers to the actual payment of losses suffered by the Directors—not the mere accrual of losses in the form of liability.

Op. at 15.

The concern about tempting the Ds&Os into “inflated settlements” also highlights the limited record that the district court and Second Circuit considered. The courts did not consider judgments or actual liability settlements that created immediate liability obligations for the policyholders. It is unclear how the courts would analyze actual judgments or reasonable, already-existing settlements—for example, settlements approved by a bankruptcy court or otherwise established as reasonable. Court judgments and reasonable settlements (court-approved or not) do not raise concerns for the “possibility of settlement manipulation,” and thus the reasoning for Ali’s distinction between liability obligation and liability payment evaporates. In the distinguishable context of an immediate legal obligation to pay a judgment or reasonable settlement, the Second Circuit and underlying courts may conclude that such reasonable settlements impose liabilities that satisfy the attachment point requirements of excess policies.

In addition, when policyholders present covered settlements or judgment, any solvent underlying insurer’s failure to pay is a breach, and the excess insurers should not be able to premise their-own refusal to pay (another breach) on the underlying insurer’s breach. Also, the policyholder and the other settling parties would have immediate rights against the insolvent estates to satisfy the insolvent policy limits. The case does not address situations in which the policyholders are insolvent, and thus unable to pay, which is separately governed by the distinct line of cases holding that the insolvency of the policyholder does not eliminate insurers’ obligations. Instead, Ali only addresses a request for a declaration of rights in the context of prospective, inchoate liability obligations, and appears limited to that fact pattern.

The district court and the Second Circuit did not forever relieve the excess insurers of the obligation to pay the Ds&Os liabilities. To the contrary, the courts only ruled that the excess recovery would not be ordered now. If the Ds&Os’ liabilities become immediately payable and reach the excess attachment points, then according to the decision (and Travelers representations), the excess insurers should be ready to pay.

For other policyholders, the case raises strategic issues that counsel should consider when seeking to resolve losses that implicate multiple layers of insurance coverage. The case also offers both opportunities and caution for policyholders to address.

Based on the Second Circuit’s reasoning, and the statements of the insurers involved in the appeal, the rumors of Zeig’s demise have been greatly exaggerated. The principles embodied by Zeig, and the well-reasoned body of case law that has developed since, are supported by the Second Circuit and remain full of vitality.

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