Security Plans, Inc., f/k/a Creditor Services, Inc., Plaintiff-Appellant,
CUNA Mutual Insurance Society, Defendant-Appellee
Argued November 7, 2013
Appeal from a judgment of the United States District Court for the Western District of New York (David G. Larimer, Judge), granting summary judgment to the defendant as to the plaintiff's claims alleging breach of contract and violation of the implied covenant of good faith and fair dealing. The district court, in granting summary judgment as to the breach of contract claim, properly refused to admit parol evidence to alter the meaning of an unambiguous contractual provision. But we conclude that the district court erred in granting summary judgment to the defendant on the implied covenant claim without determining whether, in calculating payments owed to the plaintiff, the defendant exercised its discretion arbitrarily or irrationally. Because we conclude that the record at the summary judgment stage presents a material dispute on this question, the judgment of the district court is AFFIRMED in part, VACATED in part, and REMANDED.
JERAULD E. BRYDGES (Fred G. Aten Jr., on the brief), Harter, Secrest & Emery LLP, Rochester, New York, for Plaintiff-Appellant.
DREW J. COCHRANE (Jon Evenson, on the brief), Stafford Rosenbaum LLP, Madison, Wisconsin, and Jeffrey Harradine, Ward Greenberg Heller & Reidy LLP, Rochester, New York, for Defendant-Appellee.
Before: SACK, HALL, and LIVINGSTON, Circuit Judges.
Sack, Circuit Judge:
This appeal from a judgment of the United States District Court for the Western District of New York (David G. Larimer, Judge ) concerns the scope and effect of the implied covenant of good faith and fair dealing that, as a matter of law, accompanies contracts concluded under New
York law. Security Plans, a credit insurer, sold its business to CUNA Mutual in exchange for an upfront sum and a performance-based payment, which would be calculated using three years of returns on Security Plans' former business. After the requisite time period, CUNA Mutual determined that Security Plans was not entitled to any performance-based payment. Security Plans argues that CUNA Mutual committed a company-wide error in managing its insurance policies, which substantially reduced the payment calculation. CUNA Mutual's failure to control for this error, Security Plans argues, constituted an arbitrary and irrational exercise of contractually conferred discretion, violating the implied covenant of good faith and fair dealing.
Under New York law, all contracts that confer discretion include an implied promise that neither party will " act arbitrarily or irrationally" in exercising that discretion. Dalton v. Educ. Testing Serv., 87 N.Y.2d 384, 389, 663 N.E.2d 289, 291, 639 N.Y.S.2d 977 (1995). The district court acknowledged this principle. But the court rejected the plaintiff's implied covenant claim, concluding that the record at the summary judgment stage reflected no evidence that CUNA Mutual acted in bad faith or with wrongful intent. We conclude that, on the facts of this case, a question of fact remains as to whether the defendant acted arbitrarily in calculating the earnout amount. We therefore vacate the portion of the district court's decision concerning the implied covenant and remand for further proceedings. For the reasons set forth below, we affirm the portion of the district court's judgment that granted summary judgment to the defendant on a separate breach of contract claim.
Security Plans, Inc., formerly known as Creditor Services, Inc., is a corporation based in Mendon, New York, which until 2002 specialized in the sale of credit-related insurance products, primarily to credit unions. Security Plans' primary products were credit life and credit disability insurance, which promise to pay the outstanding balance on a loan in the event the borrower dies or becomes disabled. In 2002, Security Plans agreed to sell substantially all of its assets to CUNA Mutual Insurance Society, a company incorporated in Iowa, with its principal office in Madison, Wisconsin. The parties set in motion a plan to transfer Security Plans' insurance clients (its " book of business" ) to CUNA Mutual. The merger was completed on January 2, 2003.
The Merger Agreement and Earnout Formula
An Asset Purchase Agreement, dated May 31, 2002, set forth the terms of this merger. CUNA Mutual agreed to pay $3 million immediately plus an additional performance-based payment to be made three years after the merger was concluded for Security Plans' property and book of business. The deferred-payment component of this compensation package is commonly referred to as an " earnout."  Under this contract, the maximum possible earnout was $2.2 million.
CUNA Mutual also executed three-year employment agreements with each of the three Security Plans shareholders, in which the shareholders agreed to assist in transitioning the book of business. Each former Security Plans client would have to decide individually whether to accept CUNA Mutual as its new insurer, and the earnout was therefore designed to encourage the shareholders to convert as many clients as possible.
The basic formula for calculating the earnout is not in dispute. The performance of Security Plans' book of business would be calculated annually for three years after closing, and then another three years of performance would be projected based on the data from the third year. Two variables would largely determine the size of the earnout: a weighted average of total written premiums brought in by the acquired business, and a weighted average of the business's combined loss ratios. These two amounts would be used to calculate a preliminary total earnout, which would then be reduced by service fees and other reimbursements paid to credit unions. This reduced figure would represent the final payment.
The Asset Purchase Agreement also provided:
[Security Plans] acknowledges that [CUNA Mutual] is under no obligation to operate its business after Closing in a manner focused on maximizing the Earn-Out . . . and may operate the business in accordance with its best business judgment.
Asset Purchase Agreement ¶ 2.9(e).
This dispute concerns two factors that affected the calculation of the earnout. First, Security Plans contends, CUNA Mutual used incorrect figures to calculate loss ratios for these accounts, thereby leading to a lower earnout than that to which Security Plans was entitled. Second, Security Plans argues, CUNA Mutual imposed an excessive deduction relating to service fees paid to credit unions.
Loss Ratios and the Claim Reserves Issue
Insurers are required by accounting rules and by statute to carry claim reserves, which are kept in anticipation of future liabilities. Claim reserves are, for accounting purposes, considered to be a component of incurred claims. Increases in incurred claims ordinarily will, all other things being equal, increase a company's loss ratio. Higher loss ratios would reduce Security Plans' earnout.
The parties agree that the loss ratios recorded for Security Plans' book of business for 2003 through 2005--the relevant reporting period for the earnout--were " atypically high." Def.'s Statement of Facts Pursuant to Local R. 56.1, ¶ 30; accord Pl.'s Resp. Pursuant to Loc. R. 56.1(b), ¶ 30. Their unusually high loss ratios were largely attributable to the fact that, during the same period, CUNA Mutual was carrying abnormally high claim reserves on all of its business, including the Security Plans policies. CUNA Mutual began to release claim reserves in 2006 to ...