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(Re)insurers Beware, COVID-19 Exposures Arising from Insolvencies

By Damon N. Vocke and Mark A. Bradford

As if COVID-19’s initial challenges related to claims, renewals, and exclusions, all while operating in a remote environment, were not enough, ceding and assuming companies face risk associated with their counterparties’ ability to survive the proverbial economic storm. This risk will only be heightened if other severe events develop in the near term including CAT losses or cyber occurrences. As business moves forward from and through the pandemic, insurance and reinsurance professionals need to pay attention to the solvency of counterparties, including captives and fronting carriers, in light of the stress that COVID-19 will impose on claims and investment portfolios.

Doing business with a counterparty operating in or near the zone of insolvency can unwittingly create risk, especially because the amounts associated with an insurance insolvency are often significant. E.g. Jo Ann Howard & Assocs., P.C. v. Cassity, 395 F. Supp. 3 1022, 1194 (E.D. Mo. 2019) (entering $102 million judgment in favor of receiver of insolvent insurance company following four week bench trial which followed appellate reversal of prior jury trial that had resulted in $390 million verdict in favor of receiver). In one instance, an insurer or reinsurer may face claims that it precipitated an insolvency as a result of not having timely honored claims. While in another, insurers and reinsurers, alike, may face accusations of disguised insolvency to perpetuate a counterparty and thereby further the solvent company’s own business interest to the detriment of the insolvent company’s creditors.

The term “zone of insolvency” is somewhat amorphous, and leading courts have struggled with a precise definition. Generally speaking, the term means a distressed company with a deteriorating fiscal condition, minimal reserves, marginal surplus, and little ability to invest in future operations. Think of a company who might not be able to obtain a loan from a commercial lender or a company whose reserves and financial position might cause a regulator heartburn during an examination. While insolvent counterparties are not easy to spot, and there is often at least some plausible deniability, claims and account executives may hear stories from their counterparts or senior personnel may have learned that a counterparty has taken a large hit or is fighting a bet the company series of claims.

Beyond claims that a transaction or course of conduct caused or disguised an insolvency, struggling companies create risk to the extent that state insurance codes and federal bankruptcy law allow receivers and trustee to void payments made within a certain time period, typically three months to a year depending upon the jurisdiction, preceding an order of liquidation or rehabilitation. Receivers sometimes have years to initiate proceedings to claw back payments such that a company who thought its books were settled could face claims down the road. Creditors similarly may have claims under state law to claw back payments. E.g. Gen. Fidelity Ins. Co. v. WFT, Inc., 837 S.E.2d 551, 556-57 (N.C. Ct. App. 2020) (affirming judgment in favor of creditor of dissolved company). If a counterparty transfers its assets, dissolves, or is placed into receivership, it makes sense to immediately evaluate what claims may be brought against the insolvent counterparty and how to make claims against the insolvent estate in any state receivership or federal bankruptcy proceedings, in the event one is opened, in addition to considering defensive posture.

Third-party liability claims can ensnare.

Aiding and abetting is a powerful and often utilized tool in a receiver’s, bankruptcy trustees’, or creditor’s kit. Counterparties, including reinsurers, and professional advisors such as actuaries, attorneys, accountants and consultants are prime targets for third-party liability claims even if their conduct or advice was not the reason for the insolvency. E.g. Stewart v. Wilmington Trust SP Servs., Inc., 112 A.3d 217, 320-21 (Del. Ch. 2015) (sustaining certain aiding and abetting claims brought by liquidator of captive insurer while dismissing others), aff’d 2015 WL 6672222 (Del. 2015). Liquidators and creditors may bring claims, either in concert or in competition with one another, targeting the going concerns who have the ability through their own funds or insurance coverage to satisfy a judgment.

Choice of law matters.

Some jurisdictions limit the duties owed to creditors or at least restrict direct claims, as opposed to derivative actions, by creditors. E.g., North Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101-02 (Del. 2007) (holding creditors could not assert direct action). However, other jurisdictions impose obligations before the moment of insolvency when the company was operating in the ill-defined and difficult to pinpoint “zone of insolvency”. For example, Vermont, which is one of the leading domiciles for captives with over 575 active captives and over $22 billion in annual gross written premium, imposes a duty to creditors “not only when the corporation is technically insolvent, but also when the corporation operates in the vicinity or zone of insolvency.” Gladstone v. Stuart Cinemas, Inc., 178 Vt. 104, 117 (Vt. 2005).

A counterparty may be domiciled in a jurisdiction other than where its personnel are located. It is a good idea to take stock of counterparties’ domiciles and form of organization, e.g. stock company, mutual, reciprocal, etc., including those operating domestic or foreign captives, and if necessary, to engage counsel to evaluate what duties may be owed and to whom.

Insolvency Can Create Competing Claims and Extended Statutes of Limitations.

Generally speaking, insurance companies are excluded from federal bankruptcy and are rehabilitated or liquidated under the auspice of state receivership statutes. This can create a patchwork of potential laws and competing liquidating authorities each laying claim to assets or claims. For example, an insolvent counterparty may have as its parent a non-insurance holding company, or in the case of a captive a non-insurance insured, who would be liquidated under the bankruptcy code and one or more operating entities that write insurance or reinsurance and that would each be subject to liquidation in their state of domicile. In re First Assured Warranty Corp., 383 B.R. 502, 521 (Bankr. D. Colo. 2008) (holding that bankruptcy court had jurisdiction over non-insurance affiliate) (“domestic insurance companies are ineligible for bankruptcy relief.”) In these types of competing claimant situations, it is important to observe contractual formalities and obtain releases from all potentially interested parties if possible. See Stephens v. Nat’l Distillers & Chem. Corp., 70 F.3d 10, 12 (2d Cir. 1995) (vacating and remanding for additional proceedings regarding claim by liquidator of reinsurer against non-insurance holding company for return of dividend payments).

Receivership can also extend the time in which a counterparty’s liquidator can assert claims. Fla. Stat. §631.042 (tolling and extending statute of limitations as to claims by receiver of insolvent insurance company); In re Diamond Benefits Life Ins. Co., 907 P.2d 63, 67 (Ariz. 1995) (holding that insurance receiver pursuing claim for conversion of company funds was exempt from statute of limitations). It may also allow a receiver to void arbitration and forum selection provisions. Taylor v. Ernst & Young, L.L.P., 958 N.E.2d 1203, 1211 (Ohio 2011) (holding that insurance liquidator was not bound by insolvent company’s arbitration agreement). This means that a company whose counterparty goes into rehabilitation or liquidation may face claims years beyond what may have been anticipated or reserved and may do so in a forum that was not anticipated at the time of contracting. Against this background, it may be well worth exploring options with liquidators early in the receivership process such as a commutation or a loss portfolio transfer and wrapping such transactions with a general release so as to avoid later claims or issues.

Tips and takeaways.

Medical professional liability, nursing home, business interruption, and director and officer coverage, among other lines, may see increased claim activity as losses develop in relation to crisis and pandemic planning and management and as claims develop against insureds who provide professional or other services to persons inflicted with the novel coronavirus. However, companies principally writing in other lines are not immune to investment losses and credit risk and can be a source of potential counterparty liability.

While each counterparty potentially in the zone of insolvency presents a unique set of circumstances, there are general tips that apply universally:

  • Document in writing the arm’s length nature of the relationship and any transactions;
  • Make certain to disclose any transactions to regulators that are required to be disclosed and obtain regulatory approval or written buy-in, if possible;
  • Avoid deals that seem too good to be true or deals that seem to unduly advantage a counterparty’s insiders at the potential expense of the company or its creditors.

Proposed Illinois Data Transparency and Privacy Act Referred to State Senate Judiciary Committee

On February 27, 2020, the Illinois State Senate referred SB2330, which if enacted would create the Data Transparency and Privacy Act (the “Proposed Act”), to its Judiciary Committee. The Proposed Act would apply to “businesses”, including insurers, intermediaries, and other third-party service providers, who collect or disclose the personal information of 50,000 or more persons, Illinois households, or a combination thereof or who derive 50% or more of their business’s annual revenue from the sale of personal information. As currently drafted, SB2330 may apply to insurers and other affiliates who write a limited number of policies in Illinois but meet the statutory thresholds through business written outside of Illinois. While the Proposed Act contains a carve-out for personal information collected, processed, sold, or disclosed under the Gramm-Leach-Bliley Act, SB2330 may still have applicability to many insurers and reinsurers admitted to write business in Illinois and may also be of particular note to surplus lines carriers from both an enterprise and an underwriting perspective.

Under SB2330, Illinois consumers, including policyholders who meet the statutory definitions, would have several broad rights concerning personal information: (1) the right to transparency, (2) the right to know, and (3) the right to opt out, correct, and delete. SB2330, 101st Gen. Assemb., Reg. Sess., §§15, 20, 25 (Ill. 2020). Businesses who meet the statutory definition would be required to establish a procedure for collecting consumers’ requests and also for authenticating the consumer making each request. Id. at §30(a). The Proposed Act would mandate a response to a consumer’s request within 45 days. Id. at §30(e). Each impacted business would be required to post links on its website and mobile applications for the purpose of processing consumer requests. Id. at §30(b).

A violation of the Proposed Act would be statutorily deemed an unlawful practice under the Consumer Fraud and Deceptive Business Practices Act. Id. at §40(b). Whether such a finding is constitutionally permissible is something which may need to be tested if the Proposed Act is enacted depending upon regulatory guidance and interpretation. The Illinois Attorney General would be tasked with enforcement of the Proposed Act in terms of alleged violations of the Illinois Consumer Fraud and Deceptive Business Practices Act. Id. Consumers would also have a right of action in the event of “an unauthorized access and exfiltration, theft, or disclosure as a result of the business’ violation of the duty to implement and maintain reasonable security procedures and practices . . . .” Id. at §40(a).

As of March 4, 2020, the Proposed Act has not been scheduled for hearing and has only received a single reading, in a single chamber of the General Assembly. The Illinois Constitution mandates that each bill shall be read by title on at least three different days in each house. ILL. CONST. art. IV, §8(d). It is unclear whether the Proposed Act will meet a similar fate as previous data privacy legislation proposed in recent Illinois sessions. As the Proposed Act has an effective date of July 1, 2021, as currently drafted, it is unclear whether data privacy is something that might have legs in the regular session or something that could be resurrected in the veto session following this November’s election. Either way, SB2330 and similar proposed legislation in other States are of note particularly for insurers who write in multiple jurisdictions and may face an obligation to comply with data privacy laws, each with their own nuance, across multiple jurisdictions.

In Its October-2018 Term, the Supreme Court of the United States Will Address Whether the Court or a Panel of Arbitrators Decides Applicability of the Federal Arbitration Act Where the Parties Have Delegated Questions of Arbitrability to the Arbitrators

On February 26, 2018, the Supreme Court of the United States granted certiorari in Oliveira v. New Prime, Inc., 857 F.3d 7 (1st Cir. 2017), cert. granted, 2018 WL 1037577 (U.S. Feb. 26, 2018) (No. 17-340), and added the case to its October-2018 Term. The Court will resolve a circuit split which has developed among the First, Eighth, and Ninth Circuits, in addition to division among lower federal and state courts, regarding gateway questions of arbitrability under the Section 1 definitions and exemptions of the FAA. More specifically, the Court will again address efforts by lower courts to avoid the broad mandate under the FAA in favor of the enforcement of arbitration agreements in the context of an arbitration agreement containing an express class waiver provision.

The FAA applies to “[a] written provision in any maritime transaction or a contract evidencing a transaction involving commerce to settle by arbitration . . . .” 9 U.S.C. §2 (emphasis added). At issue in New Prime (and the circuit split before SCOTUS), is the intersection of the FAA’s definition of commerce which provides for various exceptions including one for “any other class of workers engaged in foreign or interstate commerce”, 9 U.S.C. §1, and the Supreme Court’s directive that “[a]n agreement to arbitrate a gateway issue is simply an additional, antecedent agreement the party seeking arbitration asks the federal court to enforce”. Rent-A-Center, West, Inc. v. Jackson, 561 U.S. 63, 70 (2010). Couched broadly, the question before the Supreme Court is whether a party who wishes to avoid an agreement to arbitrate questions of arbitrability can do so by presenting the dispute as one of statutory interpretation under the FAA. In other words, how broad is the mandate of Rent-A-Center. Such a question may hold similarities to the age old quandary which came first, the chicken or the egg.

Legal questions concerning the enforcement of arbitration agreements and initial questions of arbitrability under the FAA remain points of heated contention. One of the benefits of arbitration is a streamlined process where discovery (and its attendant costs) can be moderated and controlled before a panel of subject matter experts who bring reinsurance, insurance, or other expertise to the dispute at hand. Those efficiencies are much more difficult to realize if courts engage in lengthy proceedings, including discovery and the weighing of evidence, to determine gateway factual questions about arbitrability where the parties contracted to submit questions of arbitrability, i.e. the arbitrator’s jurisdiction among other issues, to the arbitrators.

The Illinois Duty to Defend: Litigation Insurance against Groundless Suits Even When Extrinsic Facts Known to Both Insurer and Insured Would Otherwise Abrogate Coverage

On January 13, 2015, the Illinois Appellate Court issued its opinion in Illinois Tool Works, Inc. v. Travelers Casualty and Surety Co., 2015 IL App. (1st) 132350 (1st Dist. 2015), wherein the court held the insurer had a duty to defend its insured against numerous vaguely pleaded toxic tort complaints. The central issue in Illinois Tool Works was whether facts extrinsic to the underlying complaint, known to both the insurer and insured, can abrogate the duty to defend. The Illinois Appellate Court held that undisputed extrinsic facts not pleaded in the underlying complaint cannot relieve an insurer of its duty to defend unless and until proven in the underlying action. Continue reading The Illinois Duty to Defend: Litigation Insurance against Groundless Suits Even When Extrinsic Facts Known to Both Insurer and Insured Would Otherwise Abrogate Coverage

Duane Morris Chicago Office Adds Trial Partners Tomas M. Thompson and Mark A. Bradford

Duane Morris LLP is pleased to announce that Tomas M. Thompson and Mark A. Bradford have joined the firm’s Trial Practice Group as partners in the firm’s Chicago office. Thompson and Bradford, who join from DLA Piper, follow the addition in the firm’s Chicago office of partners Mark D. Belongia and Lisa T. Scruggs, associate David B. Shafer and associate Brian L. Dougherty.

Continue reading Duane Morris Chicago Office Adds Trial Partners Tomas M. Thompson and Mark A. Bradford