Cozen O’Connor: Washington Appellate Court Holds That Below-Limits Settlement Fails to Trigger Excess Policies [Global Insurance Alert]

Washington Appellate Court Holds That Below-Limits Settlement Fails to Trigger Excess Policies

Global Insurance Alert

November 25, 2013

On November 12, 2013, in Quellos Group LLC v. Federal Insurance Company, the Washington Court of Appeals affirmed summary judgment in favor of two excess professional liability insurers because the excess policies “require[d] exhaustion of the underlying liability limits by actual payment by the insurer before excess coverage is triggered ...” even though the insured “filled the gap” by paying the difference between the value of the settlement with the primary carrier and the primary policy's limits. This holding represents the latest in a growing line of cases finding that an insured cannot settle with an underlying insurer for less than policy limits, absorb the difference between the settlement value and the limits, and then trigger excess coverage.

Background

Quellos Group was an investment management company based in Seattle. Its CEO, Jeffrey Greenstein, and its director and attorney, Charles Wilk, created and implemented a tax shelter strategy, known as POINT, for investors. POINT utilized two offshore shell corporations and a paper portfolio of more than $9 billion in stocks to generate apparent capital losses for POINT transactions. Quellos Group then charged its investors based upon the value of the transaction's tax loss. The more money the investor “lost” in the POINT transaction, the more money Quellos Group charged. Six clients used the POINT tax shelter between 2000 and 2002.

POINT began to unravel for the Quellos Group in 2005, beginning with an IRS audit of the tax returns of the six clients utilizing the POINT tax shelter. The IRS denied the clients’ claimed tax benefits. The clients first threatened and then filed lawsuits against Quellos Group, which were settled for a total of $35 million. Quellos Group also incurred $45 million in defense costs and other costs for various government proceedings.

Ultimately, POINT resulted in a Senate investigation. The U.S. Attorney’s office indicted Greenstein and Wilk on multiple charges, including conspiracy to defraud the IRS, tax evasion, counseling false tax returns, wire fraud and conspiracy to launder monetary instruments. The California Franchise Tax Board assessed penalties against Quellos Group. In 2010, Greenstein and Wilk pled guilty to conspiracy to defraud the IRS of approximately $240 million in taxes.

Quellos Group’s Insurance Coverage Claims

In 2004, Quellos Group purchased a claims-made investment management policy with a $10 million liability limit, subject to a $2.5 million self-insured retention from AISLIC. Federal Insurance Company issued a policy excess of the AISLIC policy, with $10 million limits. Indian Harbor also issued an excess policy with $20 million limits, excess of the Federal and AISLIC policies.

Quellos Group sought reimbursement from these policies for the POINT settlements, as well as the costs incurred in connection with the government investigations. AISLIC determined that Quellos Group was entitled to approximately $5 million of the policy’s $10 million limit. Federal and Indian Harbor declined to pay, and reserved rights because the underlying limits had not been exhausted. As a result, in 2010, Quellos Group filed a breach of contract and declaratory judgment action against its insurers. In 2011, AISLIC and Quellos Group entered a settlement, pursuant to which AISLIC still paid only approximately $5 million of its $10 million limits under the 2004-2005 policy. In an effort to trigger its excess policies for this policy period, Quellos Group then agreed to “fill the gap” between the $5 million settlement and the $10 million AISLIC limit by paying the additional $5 million itself.

Exhaustion of Underlying Limits Is the Defining Characteristic of Excess Coverage

In response, Federal and Indian Harbor filed a motion for summary judgment asserting that their excess policies were not triggered because Quellos Group failed to exhaust the limits of the underlying AISLIC primary policy. In response, Quellos Group argued that the excess policies’ exhaustion provisions violated Washington’s public policy favoring settlements. Quellos Group also argued that the exhaustion requirement is a “condition to coverage,” and that the insurers could not establish that the alleged breach of the exhaustion provision was either material or prejudicial because it “filled the gap” between the settlement value and the underlying policy limits. The trial court rejected both of Quellos Group’s arguments and granted summary judgment in favor of Federal and Indian Harbor.

On appeal, the Washington Court of Appeals analyzed the exhaustion provisions in each of the excess policies. In relevant part, the Federal excess policy provided that “[c]overage hereunder shall attach only after the insurers of the Underlying Insurance shall have paid in legal currency the full amount of the Underlying Limit for such Policy Period.” (emphasis added) The exhaustion provision in the Indian Harbor excess policy similarly stated that coverage attached “only after all of the Underlying Insurance has been exhausted by the actual payment of loss by the applicable insurers thereunder ....” (emphasis added) The court of appeals held that the unambiguous language of both provisions “compels the conclusion that excess coverage was not triggered” by Qeullos Group’s gap filling.

Additionally, the appellate court affirmed the trial court’s rejection of Quellos Group’s novel suggestion that the excess policies’ exhaustion requirement is a condition akin to notice or cooperation, necessitating proof of prejudice. The court held that “[u]se of the language ‘only after’ in the insuring clause in the policies does not mean that the requirement that the insurer must pay the full amount of the underlying policy limits before the excess insurer is obliged to provide coverage is a condition.” According to the court, the language ‘only after’ reflects the distinguishing characteristic and function of an excess insurance policy,” i.e., that it is not triggered until the underlying insurer has paid the full amount of its limits for loss.

Clear and Unambiguous Policy Language Trumps Public Policy in Favor of Settlements

Quellos Group also confirms that unambiguous policy language will trump an insured’s argument premised on public policy in favor of settlements. In making this argument, Quellos Group relied on certain cases, including the 2nd Circuit’s 1928 decision in Zeig v. Massachusetts Bonding and Insurance Company, to support the proposition that public policy should prevail over the clear and unambiguous language in the exhaustion provisions. In Zeig, though the insured settled with its primary carrier for less than policy limits, the insured was permitted to trigger the excess policy because the exhaustion provision did not specify that the full amount of the underlying policy needed to be paid in cash by the underlying insurer before the excess policy was triggered. In Quellos, the court of appeals distinguished Zeig on the basis that the provisions in the Federal and Indian Harbor policies were unambiguous. The court, however, did not cite or discuss the 2nd Circuit’s recent decision in Ali v. Federal Insurance Company, which limited Zeig to first-party insurance, rather than third-party liability coverage like that in Quellos. Ali also noted that Zeig was based on a now-defunct notion of federal common law.

Conclusion

The Quellos decision is noteworthy as another appellate decision enforcing unambiguous policy language requiring full payment of the underlying limits by the underlying insurer to trigger excess coverage and rejecting gap-filling efforts by policyholders. It is, therefore, an extension of a growing line of similar decisions in a state that had not previously addressed the issue. Quellos is also noteworthy because of its rejection of the policyholder’s argument that the attachment language was a condition that required the insurers to prove prejudice. Instead, the court held the language expressed the “distinguishing characteristic and function” of excess insurance. Quellos provides, therefore, a highly positive development furthering the predictability of when excess policies will be triggered.


Authors

Thomas M. Jones

Vice Chair, Global Insurance Department

tjones@cozen.com

(206) 224-1242

Angelo G. Savino

Chair, Professional Liability Practice Group

asavino@cozen.com

(212) 908-1248

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To discuss any questions you may have regarding the issues discussed in this Alert, or how they may apply to your particular circumstances, please contact Thomas Jones at tjones@cozen.com or (206) 224-1242 or Angelo Savino at asavino@cozen.com or (212) 908-1248.