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STEPHENS v. AMERICAN HOME ASSUR. CO.

January 27, 1993

DON W. STEPHENS, Commissioner of Insurance of the Commonwealth of Kentucky, in his capacity as Liquidator of Delta America Re Insurance Company, Plaintiff,
v.
AMERICAN HOME ASSURANCE COMPANY, et al., Defendants. DON W. STEPHENS, Commissioner of Insurance of the Commonwealth of Kentucky, in his capacity as Liquidator of Delta America Re Insurance Company, Plaintiff, v. AMERICAN RISK MANAGEMENT, INC., et al., Defendants. DON W. STEPHENS, Commissioner of Insurance of the Commonwealth of Kentucky, in his capacity as Liquidator of Delta America Re Insurance Company, Plaintiff, v. NATIONAL DISTILLERS AND CHEMICAL CORPORATION, et al., Defendants. DON W. STEPHENS, Commissioner of Insurance of the Commonwealth of Kentucky, in his capacity as Liquidator of Delta America Re Insurance Company, Plaintiff, v. AMERICAN INTERNATIONAL INSURANCE COMPANY, et al., Defendants.


MARTIN, JR.


The opinion of the court was delivered by: JOHN S. MARTIN, JR.

JOHN S. MARTIN, JR., DISTRICT JUDGE:

 Background

 Elkhorn Reinsurance Company ("Elkhorn") was incorporated in Kentucky on October 7, 1965, for the purpose of insuring the property and casualty risks of National Distillers and Chemical Corporation, now known as Quantum Chemical Corporation ("Distillers"). In 1972 Elkhorn expanded its business and began assuming reinsurance risks of unrelated third parties. Elkhorn's outside business consisted of reinsuring these primary insurers and ceding portions of risks it took on to secondary reinsurers, also known as "retrocessionaires."

 In 1985, Delta Re was declared insolvent. After a brief period of rehabilitation, the company was placed in liquidation proceedings on September 15, 1985. Don W. Stephens, in his capacity as liquidator (the "Liquidator"), has instituted these four actions, as well as others, in connection with the insolvency proceedings. The following is a brief summary of each action: *fn1"

 1. Stephens v. National Distillers & Chem. Corp., 91-Civ-2901

 (The "Distillers" case)

 The Liquidator seeks recovery from Distillers of dividends paid by Elkhorn from 1981 to 1983, claiming that Elkhorn's insolvency during that period renders such dividends illegal. Summary judgment was granted to the Liquidator on this claim by a Kentucky state court, which judgment is the subject of a motion here.

 The Liquidator also named certain retrocessionaires who reinsured Elkhorn/Delta Re before 1984 (the "Elkhorn Retrocessionaires"), seeking full coverage under the reinsurance contracts between them and the insolvent. The Elkhorn Retrocessionaires defend on the basis of fraud and seek rescission.

 2. Stephens v. American Risk Management, 89-Civ-2999

 (The "ARM" case)

 The Liquidator seeks coverage from certain retrocessionaires who signed reinsurance contracts with Delta Re in 1984 and 1985 ("Delta Re Retrocessionaires"). As in the Distillers case, the Delta Re Retrocessionaires defend on the basis of fraud and seek rescission. If such relief is granted, the Liquidator seek to hold liable, inter alia, persons who managed Delta Re after the sale ("Management Defendants"). These Management Defendants have impleaded Distillers and certain officials of the Kentucky Department of Insurance.

 3. Stephens v. American Home Assurance Co., 91-Civ-2898

 (The "American Home" case)

 The Liquidator seeks premiums from companies which ceded insurance risks to Delta Re in 1984 and 1985 (the "Delta Re Cedents"). As in the ARM case, the Delta Re Cedents claim fraud and seek rescission, and the Liquidator named Management Defendants in the alternative, who impleaded Distillers and Kentucky officials. The Kentucky officials, however, were dismissed by the Kentucky Federal District Court before it transferred this case here, which dismissal is contested.

 4. Stephens v. American International, 91-Civ-6245

 (The "American International" case)

 The Liquidator seeks premiums from ceding companies contracting with Elkhorn before 1984 (the "Elkhorn Cedents").

 The Second Circuit's recent opinion in Delta Holdings, Inc. v. National Distillers & Chem. Corp., 945 F.2d 1226 (2d Cir. 1991), cert. denied, 118 L. Ed. 2d 390, 112 S. Ct. 1671 (1992), provides further relevant background. There, Delta Holdings sued Distillers for rescission of the sale of Delta Re, claiming common law fraud and violation of securities laws, inter alia. The Second Circuit found that no fraud had been committed as to Delta Holdings, and reversed the district court's grant of rescission. Reference is made to that decision throughout this opinion, and familiarity with it is assumed.

 Summary of Present Motions

 In the Distillers, ARM and American Home cases, the Liquidator moves to certify to the Kentucky Supreme Court the question of whether rescission is available as a remedy after an insurance company has gone into liquidation proceedings, pp. 6-11. Absent certification, the Liquidator moves for judgment on the pleadings against the Elkhorn and Delta Re Retrocessionaires and the Delta Re Cedents for a determination that rescission is not available, pp. 6-14.

 The Elkhorn Retrocessionaires move for summary judgment against the Liquidator in the Distillers case on their defenses of fraud and illegality to the claims against them, pp. 14-20. Distillers moves for summary judgment against the Elkhorn Retrocessionaires on their cross-claims against Distillers in the Distillers case, pp. 21-35, and also to vacate or reconsider the Kentucky state court summary judgment rendered against it in favor of the Liquidator, pp. 35-39.

 Some of the Elkhorn Cedents move to dismiss the claims filed against them by the Liquidator in the American International case, pp. 39-46. The Kentucky state official third-party defendants in the ARM case move for dismissal of the Management Defendants' claims against them, pp. 46-54, while the Management Defendants seek reconsideration of such dismissal in the American Home case, pp. 55-56.

 These motions will be considered seriatim.

 Liquidator's Motion for Certification/Judgment on the Pleadings

 In the Distillers, ARM, and American Home cases, The Liquidator moves to certify to the Kentucky Supreme Court the question of whether rescission and the defense of fraud are available after liquidation proceedings have been initiated, and in the alternative, for an order disallowing the retrocessionaires' and cedents' defenses of fraud and barring their claims of rescission as a matter of law.

 Defendants are retrocessionaires and cedents who engaged in reinsurance transactions with Elkhorn/Delta Re. The Liquidator is suing them for provision of coverage and payment of premiums, respectively, pursuant to various contracts. The defendants defend on the basis of fraud, and have counter-claimed for rescission. They claim that Elkhorn/Delta Re was insolvent as early as 1980, and its failure to disclose this and other facts material to the reinsurance contracts renders the contracts void and unenforceable.

 The Liquidator claims that such claims are barred as a matter of law. Contending that this matter is governed by Kentucky insurance insolvency laws, the Liquidator seeks to have certified to the Kentucky Supreme Court this question:

 Whether Kentucky's comprehensive scheme for marshalling and distributing the assets of insolvent insurers -- the Kentucky Insurers Rehabilitation and Liquidation Act -- displaces any common law right of rescission that might otherwise be available to a party who dealt with the insolvent?

 Failing that, the Liquidator moves for judgment on the pleadings as to whether rescission and the defense of fraud are available as a matter of law.

 Choice of Law

 A federal court, sitting in diversity, normally applies the conflict of law rules of the forum state. Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487, 61 S. Ct. 1020, 85 L. Ed. 1477 (1941); Arkwright-Boston Mfrs. Mut. Ins. Co. v. Calvert Fire Ins. Co., 887 F.2d 437, 439 (2d Cir. 1989). Likewise, where federal jurisdiction is derived from the Federal Sovereign Immunities Act the conflict of law rules of the forum state govern. Barkanic v. General Admin. of Civ. Aviation of the People's Republic of China, 923 F.2d 957, 959-61 (2d Cir. 1991). However, in a case that has been transferred pursuant to 28 U.S.C. § 1404(a), the court should apply the law of the transferor court's forum state. Van Dusen v. Barrack, 376 U.S. 612, 84 S. Ct. 805, 11 L. Ed. 2d 945 (1964); Spar, Inc. v. Information Resources, Inc., 956 F.2d 392, 395 (2d Cir. 1992); Shamley v. ITT Corp., 869 F.2d 167, 171 (2d Cir. 1989). Since the Distillers and American Home cases were originally filed in Kentucky and later transferred here, Kentucky's conflict of law rules apply under Van Dusen, even though New York is the forum state. On the other hand, the ARM case was filed in this district, requiring an application of New York conflict of laws.

 Kentucky courts apply a "most significant relationship" test to settle conflict of law questions. Breeding v. Massachusetts Indem. & Life Ins. Co., 633 S.W.2d 717 (Ky. 1982); Lewis v. American Family Ins. Group, 555 S.W.2d 579 (Ky. 1977). "'The modern test is which state has the most significant relationship to the transaction and the parties.'" Id. at 581-82, quoting Restatement (Second) of Conflict of Laws, § 188 (1971). "Justice, fairness and the best practical result may best be achieved by giving controlling effect to the law of the jurisdiction which, because of its relationship or contact with the occurrence or the parties, has the greatest concern with the specific issue raised in the litigation." Breeding, 633 S.W.2d at 719, citing Babcock v. Jackson, 12 N.Y.2d 473, 240 N.Y.S.2d 743, 749, 191 N.E.2d 279 (1963).

 "New York courts apply an 'interest analysis' to choice of law issues involving contractual disputes, see Intercontinental Planning, Ltd. v. Daystrom, Inc., 24 N.Y.2d 372, 300 N.Y.S.2d 817, 248 N.E.2d 576 (1969); see also Hutner v. Greene, 734 F.2d 896, 899 (2d Cir. 1984), and, therefore, 'the law of the jurisdiction having the greatest interest in the litigation will be applied.' Daystrom, 24 N.Y.2d at 382, 300 N.Y.S.2d at 825, 248 N.E.2d at 582." Arkwright-Boston, 887 F.2d at 439 (choice of law in reinsurance contract dispute).

 It is clear that New York has the most significant relationship to, and the greatest interest in, the present issue. All retrocession agreements were solicited, negotiated, executed, and performed in New York and the intermediary, Paul Napolitan, Inc., is located in New York.

 The Kentucky Court of Appeals, in the context of a personal jurisdiction issue, characterized the relationship of the State of Kentucky to some of these transactions as follows:

 [Delta]'s principal offices, records and personnel were removed to New York City [in 1983] and all business was conducted from that location. The record before us reflects that even though Delta did business both foreign and domestic, there is no absolutely no indication that it was engaged in any activity in the Commonwealth until it became insolvent, or, in other words, ceased doing active business.

 Sullivan Payne Co. v. McCarty, 1990 Ky. App. LEXIS 165, No. 86-CA-2998-MR, slip op. at 2 (Ky. Ct. App. 1990). While this opinion expressly reserved judgment on conflict of law issues, it clearly indicated the lack of a relationship between Kentucky and the transactions relevant to this motion.

 The only relationship Kentucky bears to this entire litigation relates to the insolvency proceedings. Because Delta Re is a Kentucky corporation, Kentucky's liquidation statutes govern Delta Re's insolvency proceedings. Thus, Kentucky has a significant relationship to and interest in all issues arising from the insolvency.

 However, the defense of fraud in the inducement and the equitable rescission of a contract due to fraud are declarations that the contract was void ab initio. Christiania Gen. Ins. Corp. v. Great Am. Ins. Co., 979 F.2d 268, 278 (2d Cir. 1992); Eastern Dist. Piece Dye Works, Inc. v. Travelers Ins. Co., 234 N.Y. 441, 138 N.E. 401 (1923). The validity of a contract must be determined by reference to the laws of the state that has the most significant relationship with and greatest interest in its formation, rather than the state in which its enforcement is sought. If there were no valid contracts in the first place, the Liquidator could hardly attempt to enforce them regardless of authority granted by Kentucky's statutes. Since Kentucky had no relationship, significant or otherwise, with the formation of the contracts, and New York's relationship is overwhelming, Kentucky conflict of law rules dictate that New York substantive law applies to whether the defense of fraud and the remedy of rescission are available in the Distillers and American Home cases. Likewise, since New York has the greatest interest in a determination of the validity of the contracts, New York conflict of laws rules dictate that New York substantive law applies in the ARM case.

 Certification

 Because New York law governs these issues, the motion for certification to the Kentucky Supreme Court is denied.

 Availability of Rescission After Insolvency

 As the Second Circuit observed in Christiania Gen. Ins. Corp. v. Great Am. Ins. Co., 979 F.2d 268 (2d Cir. 1992):

 The relationship between a reinsurer and a reinsured is one of utmost good faith, requiring the reinsurer to disclose to the reinsured all facts that materially affect the risk of which it is aware and of which the reinsurer itself has no reason to be aware. In certain cases, the description of items covered under the original policy may be so imprecise as to warrant rescission of the contract because the reinsurer was not adequately apprised of the risk.

 979 F.2d at 278 (citations omitted).

 It is clear that, were it not for the insolvency of Delta Re, rescission and the defense of fraud would be available. Sumitomo Marine & Fire Ins. Co. v. Cologne Reinsur. Co. of Am., 75 N.Y.2d 295, 303, 552 N.Y.S.2d 891, 895, 552 N.E.2d 139 (1990); New York Bowery Fire Ins. Co. v. New York Fire Ins. Co., 17 Wend. 359 (N.Y. 1837); Royal Indem. Co. v. Preferred Acc. Ins. Co., 243 A.D. 297, 276 N.Y.S. 313 (1st Dept. 1934), aff'd, 268 N.Y. 566, 198 N.E. 407 (1935). Indeed, the Liquidator has conceded this point. Thus, the question becomes whether the insolvency of Delta Re renders the remedy of rescission and/or the defense of fraud unavailable as a matter of New York law.

 The general rule is that a liquidator of an insurance company "stands in the shoes" of the insolvent, gaining no greater rights than the insolvent had. Bohlinger v. Zanger, 306 N.Y. 228, 117 N.E.2d 338 (1954); Corcoran v. National Union Fire Ins. Co., 143 A.D.2d 309, 532 N.Y.S.2d 376 (1st Dept. 1988). Thus, absent specific law to the contrary, "the reinsurers are free to assert any affirmative defenses, such as fraud, that they may have had against the [insolvent company]." In re Union Indem. Co., No. 41292-85, slip op. at 12 (N.Y. Sup. Ct. October 28, 1992).

 The New York Court of Appeals has held that the defense of set-off survives insolvency proceedings, despite the argument that the debts were not mutual because the liquidator was a different legal entity from the insolvent company. In re Midland Ins. Co., 79 N.Y.2d 253, 582 N.Y.S.2d 58, 590 N.E.2d 1186 (1992). In so holding, the court said:

 Liquidation cannot place the liquidator in a better position than the insolvent company he takes over, authorizing him to demand that which the company would not have been entitled to prior to liquidation. Defendant concedes that before Midland was adjudged insolvent Kemper Re had the right to set off the treaty premiums against the amount owed under the Playtex contract. Those rights were not altered merely because a liquidation order was entered.

 582 N.Y.S.2d at 64 (citations omitted). While Midland was an interpretation of a statutory defense of set-off, see N.Y. Ins. Law § 7427, as opposed to the common law defense of fraud or remedy of rescission, the analysis of the Court of Appeals is distinctly relevant to the instant issue.

 Indeed, Midland has been the basis for a New York Supreme Court's ruling on the precise issue before this Court. See Union Indemnity. There, although finding the affirmative relief of rescission barred by an injunction previously issued by the court, the court held that the defense of fraud was available to a reinsurer whose contractual obligations the liquidator sought to enforce. Citing Midland, the Supreme Court ruled that "the reinsurers are free to assert any affirmative defenses, such as fraud, that they might have had against [the insolvent company]." Id., slip op. at 12.

 The New York Court of Appeals has also recently held that an insured's contractual right to notification of cancellation of coverage survives a declaration of insolvency. In re Transit Casualty Co., 79 N.Y.2d 13, 580 N.Y.S.2d 140, 588 N.E.2d 38, cert. denied, 113 S. Ct. 199, 121 L. Ed. 2d 141 (1992). Ruling that "nothing in the [Uniform Insurer's Liquidation] Act obligates states subscribing to its terms to abandon statutory or decisional law requiring notice of cancellation to be sent to policyholders before an insurance contract is cancelled," the Court of Appeals found that the contractual right of notification, having vested prior to liquidation proceedings, was not extinguished by them. 79 N.Y.2d at 20, 580 N.Y.S.2d at 144.

 Thus, New York courts have been strongly supportive of preserving rights which existed prior to liquidation proceedings. As illustrated by Union Indemnity, the defense of fraud and the remedy of rescission for fraudulent inducement are included in this protection. While no determination is made at this time as to the merits, it is clear they are not rendered unavailable as a matter of New York law by the mere fact of insolvency proceedings. *fn2"

 Retrocessionaires' Summary Judgment Motion

 Retrocessionaires in the Distillers case move for summary judgment on their defense of fraud based on material misstatements and/or omissions made by Elkhorn, and on their defense of illegality based on Delta Re's insolvency at the time of contracting.

 Background

 The insolvency of Delta Re, and the failure to discover it quickly, stemmed primarily from the difficulty in calculating and monitoring the accuracy of loss reserves carried by insurance companies. While a complete discussion of these problems and their relation to Delta Re is contained in the second Circuit Delta Holdings opinion, 945 F.2d 1226 at 1228-40, a brief explanation of some of these factors is required to put these motions in context.

 Because future claims will be a drain on an insurer's resources, insurance companies are required to carry "loss reserves" as liabilities. These loss reserves are intended to estimate the value of claims which will be paid on policies which the company is carrying. Loss reserves consist of both "case reserves" and "incurred-but-not-reported reserves", or "IBNR" reserves. Case reserves are reserves established upon the filing of a claim; since not every claim will be ...


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