On June 4, 2013, the federal Second Circuit Court of Appeals issued an important decision addressing when underlying insurance will be deemed exhausted for purposes of the attachment of higher layers of excess insurance.  In doing do, the court sharply limited an influential 1928 precedent, Zeig v. Massachusetts Bonding & Insurance Co., 23 F.2d 665 (2d Cir. 1928).  Zeig, written by Judge Augustus Hand, is often cited as the leading case standing for the proposition that, if an excess policy ambiguously defines “exhaustion,” settlement with an underlying insurer will constitute exhaustion of the underlying policy for purposes of the attachment of the excess coverage.

The new decision, Mehdi Ali v. Federal Insurance Co., 719 F.3d 83 (2d Cir. 2013), involved a single tower of D & O insurance that had been issued to a now bankrupt computer company (Commodore).  Two of the insurers in the tower were themselves in liquidation and unable to pay claims.  Commodore’s former directors, defendants in numerous post-bankruptcy lawsuits, sought a declaration that the obligations of their excess insurers were triggered once the total amount of their defense and/or indemnity obligations exceeded the limits of the underlying policies.  The District Court denied the directors’ motion for partial summary judgment, ruling that the excess policies did not attach until there was actual payment of the underlying losses.  Judgment was entered pursuant to a stipulated dismissal.  The Second Circuit, in an opinion by Judge José Cabranes, affirmed.

The Second Circuit reasoned that the plain language of the excess policies required full payment of the underlying losses as a condition precedent to the attachment of coverage under the excess policies.  Those policies provided, with slight variations, that coverage “shall attach only after [the] Underlying Insurance has been exhausted by payment of claims,” and that “exhaustion” occurs “solely as a result of payment of loses thereunder.”

Much of the opinion was devoted to distinguishing Zeig.  Zeig had involved a claim against an excess burglary insurance policy.  The plaintiff had three underlying policies with total limits of $15,000.  After the plaintiff suffered a loss owing to an alleged burglary, he settled with the three underlying policies for $6,000, and then sought to recover against the excess insurer. The excess policy stated that it would apply “only after all other insurance herein referred to shall have been exhausted in the payment of claims to the full amount of the expressed limits.”  Judge Hand refused to read this language literally, as requiring actual cash payment as a condition precedent to recovery under the excess policy.  Instead, he treated claims as “paid” if they were “settled and discharged,” and allowed the plaintiff to recover on the excess policy to the extent that the loss was greater than the stated limits of the underlying insurance.

In Mehdi Ali, the Second Circuit limited Zeig to first-party insurance rather than excess liability insurance.  As Judge Cabranes reasoned, in the first-party context, the loss will normally be fixed before any settlement with the primary insurers.  In the liability insurance context, however, the underlying claim and the primary insurance coverage may be settled simultaneously, giving rise to the possibility of settlement manipulation to the detriment of the excess insurers.  A settlement could equally be manipulated in a situation with an insolvent primary.  In a footnote, Judge Cabranes added an observation that Zeig had been decided under pre-Erie general federal common law.  Mehdi Ali, in contrast, was decided under New York and/or Pennsylvania law (they were assumed to be equivalent).

Zeig is apparently no longer good law with respect to liability insurance in the Second Circuit. Mehdi Ali does not go as far as have other recent decisions that have criticized Zeig, however.  Judge Cabranes strongly implies that the underlying insurers themselves need not be the ones to pay the policy limits, and that some other party, such as the directors, could make the requisite payments and validly trigger the excess insurance.  The courts in Comerica v. Zurich American Insurance Co., 498 F.Supp.2d 1019 (E.D. Mich. 2007), Qualcomm v. Certain Underwriters at Lloyd’s, London, 161 Cal.App.4th 184 (Cal. App. 2008), Citigroup v. Federal Insurance Co., 649 F.3d 367 (5th Cir. 2011), and JP Morgan Chase & Co. v. Indian Harbor Insurance Co., 947 N.Y.S.2d 17 (N.Y. App. Div. 2012) went further, holding that only full payment of the primary policy limits by the primary insurer itself would be sufficient to trigger the excess policies.  These decisions, however, arose in the context of below-limits primary policy settlements, rather than insolvencies of the primary policies.