In Ali v. Federal Insurance Company, ___ F.3d ___, 2013 WL 2396046 (2d Cir. June 4, 2013), the United States Court of Appeals for the Second Circuit, applying both New York and Pennsylvania law, held that coverage under excess directors and officers (“D&O”) liability insurance policies was not triggered because the policies’ plain language required that the underlying insurance policies be exhausted “solely as a result of payment of losses,” which had not occurred. Accordingly, the Second Circuit affirmed the district court’s judgment dismissing a claim that the excess policies were triggered merely by the accrual of liability—and not actual payment by the underlying policies—to reach the attachment points of the excess policies.

Commodore International Limited (“Commodore”), a computer technology company, filed for bankruptcy in 1994. Id. at *1. By the time of its bankruptcy filing, Commodore had purchased a $50 million tower of D&O coverage. Id. at *1 n.2. Federal Insurance Company (“Federal”) provided the second and fifth layers of excess coverage for a combined total of $10 million in policy limits, and Travelers Casualty and Surety Company of America (“Travelers”) provided the seventh layer with a policy limit of $10 million. Id. The insurers that provided the first, third, fourth, and sixth layers of excess coverage in the tower are insolvent. Id. at *1.

Anticipating that the former directors and officers (the “Directors”) of the company would file claims for coverage relating to a lawsuit against them filed in the Bahamas, Federal filed a coverage action against the Directors in the Southern District of New York seeking a declaration that it was not required to “drop down” to cover liability that would have been otherwise covered by the insolvent excess insurers. Id. The Directors filed a counterclaim against Federal and a third-party claim against Travelers (collectively, the “Excess Insurers”) seeking a declaration that the Excess Insurers’ “coverage obligations are triggered once the total amount of [the Directors’] defense and/or indemnity obligations exceeds the limits of any insurance policies underlying their respective policies, regardless of whether such amounts have actually been paid by those underlying insurance companies.” Id. at *2 (emphasis and alterations retained, quotation marks omitted). The Excess Insurers filed a motion for judgment on the pleadings on their claim regarding the drop-down issue, and the Directors filed a motion for partial summary judgment on their claims regarding the trigger issue. Id. at *1-2.

The district court granted the Excess Insurers’ motion for judgment on the pleadings on the drop-down issue because the plain language of the excess policies did not require the Excess Insurers to automatically drop down to provide coverage that should have been provided by the underlying, now insolvent, insurers. See Fed. Ins. Co. v. Estate of Gould, 2011 WL 4552381, at *3-5 (S.D.N.Y. Sept. 28, 2011). The court also confirmed that no such obligation was created by applicable law. Although the parties disputed whether New York or Pennsylvania law applied, the court did not decide the issue because it concluded that “both New York and Pennsylvania law clearly provide that an excess insurer is not required to fill gaps in coverage created by the insolvency of an underlying insurer.” Id. at *4.

The district court likewise denied the Directors’ motion for partial summary judgment against the Excess Insurers on the trigger issue. In so ruling, the court noted that the plain language of the excess policies conditioned the trigger of the excess policies on “the exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses thereunder.” Id. at *7 (quotation marks omitted).

Subsequently, the district court, at the parties’ request, dismissed with prejudice all remaining claims and third-party claims. The Directors appealed the trigger issue—but not the drop-down issue—to the Second Circuit. Ali, 2013 WL 2396046, at *2.

Affirming the district court’s judgment, the Second Circuit emphasized that a holding “that these excess liability coverage obligations are triggered when ‘defense and/or indemnity obligations’ reach the attachment point . . . would make the ‘payment of’ language in the[] excess liability contracts superfluous.” Id. at *5. Therefore, the Second Circuit agreed with the district court that the plain language of the excess policies required actual payment of the underlying limits as a “clear condition precedent to the attachment of the Excess Policies.” Id. (quotation marks omitted).

In response to the Directors’ argument that the district court’s opinion effectively required actual payment by the insolvent insurers in order for the underlying policies to be exhausted, the Second Circuit pointed out that the district court “never held that the underlying insurers must make payments before the obligations under the relevant excess policies are triggered.” Id. (emphasis retained). Although the Second Circuit found that resolution of this issue was unnecessary, it noted that “requiring nonoperational insurance companies to make payments as a condition precedent to the attachment would be odd” and would “effectively reliev[e] [the Excess Carriers] of their policy obligations.” Id. at *6 n.15.

The Second Circuit also rejected the Directors’ reliance on Zeig v. Massachusetts Bonding & Insurance Company, 23 F.2d 665 (2d Cir. 1928), a decision that broadly construed the term “payment” to include amounts that are compromised by settlement. In Zeig, the policyholder had purchased burglary insurance totaling $15,000 in coverage, plus an excess policy that attached after the primary coverage was “exhausted in the payment of claims to the full amount of the expressed limits.” Id. at 666. As a result of a burglary, the policyholder filed claims for $15,000 with the primary insurers but settled those claims for $6,000. Id. The policyholder also filed a claim under the excess policy for losses in excess of $15,000. Id. The excess insurer argued that its policy was not triggered because the policyholder needed to collect the entire $15,000 in order to exhaust the primary policies. Id. The Zeig court found that requiring actual payment of the $15,000 would serve “no rational interest” of the excess insurer, “so long as it was only called upon to pay such portion of the loss as was in excess of the limits” of the primary policies. Id. Therefore, the Zeig court broadly construed the term “payment” in the excess policy as meaning a cash payment or “the satisfaction of a claim by compromise, or in other ways.” Id.

The Directors in Ali argued that Zeig controlled. However, the Second Circuit found “nothing . . . inherently errant or unusual about interpreting an exhaustion clause in an excess liability insurance policy differently than a similarly written clause in a first-party property insurance policy.” Ali, 2013 WL 2396046, at *6 (emphasis retained). The court distinguished Zeig and related decisions on the ground that “[i]n those cases, the insured suffered out-of-pocket losses . . . for which the insured sought indemnification,” whereas “[t]he Directors’ requested relief . . . focuses on their obligations to pay third parties.” Id. at *7 (emphasis retained). This distinction created an incentive—not present in Zeig—for the Directors “to structure inflated settlements with their adversaries . . . that would have the same effect as requiring the Excess Insurers to drop down and assume coverage in place of the insolvent carriers.” Id. (quotation marks omitted). The Second Circuit agreed with the district court that the Excess Insurers in Ali “have a clear, bargained-for interest” in deterring the possibility of such settlement manipulation by requiring actual payment up to the attachment points of the excess policies. Id. Accordingly, the court concluded that “[i]n this context, the plain meaning of ‘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.” Id.

The Ali decision is important because it confirms that the plain meaning of policy language requiring exhaustion of underlying policies through “payment of losses” will be enforced so that actual payment, and not merely policyholder liability, is required to trigger the excess policies.