In a July 23, 2010 opinion in Massachusetts Mutual Life Insurance Co., et al., v. Certain Underwriters at Lloyd’s of London, et al., C.A. No. 4791-VCL (July 23, 2010), read opinion here, the Court of Chancery, following Massachusetts law, denied certain defendant insurance carriers’ motion to dismiss a complaint which seeks, among other things, an equitable apportionment between the Primary Bond Underwriters and the directors’ and officers’ insurers of defense costs incurred in underlying litigation, a declaratory judgment that defendants must indemnify plaintiffs for any judgments or settlements in the underlying litigation, and specific performance requiring contemporaneous payment of defense costs as they are incurred by plaintiffs.

This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.

The Underlying Litigation

On December 11, 2008, Bernard L. Madoff, chairman of the market-making firm Bernard L. Madoff Investment Securities LLC (“BMIS”), disclosed his Ponzi scheme. Plaintiff Tremont Group Holdings, Inc. was the second largest “feeder fund” into BMIS, allegedly investing approximately $3.1 billion through one or more of the Broad Market Funds at the time that BMIS was exposed as a fraud. Subsequently, approximately thirty-six lawsuits and demands were filed against Tremont, related entities and certain of their directors and officers by persons and entities whose money had been invested in BMIS through Tremont’s Broad Market Funds, alleging misrepresentation, breach of fiduciary duty, mismanagement, and a failure to supervise in connection with their investments with BMIS.

The Insurance Coverage at Issue

The plaintiffs claim coverage under two insurance towers. The first tower consists of a primary fidelity bond (the “Primary Bond”) and excess bonds that generally follow form to the primary bond (the “Bond Tower”). The second tower consists of a primary directors and officers’ liability insurance policy (the “D&O Policy”) and excess policies that generally follow form to the primary D&O Policy (the “D&O Tower”). One group of defendants comprises the underwriters who issued the bonds in the Bond Tower (the “Bond Underwriters”). A second group of defendants comprises the insurers who issued the policies in the D&O Tower (the “D&O Insurers”).

The Bond Underwriters moved to dismiss the Complaint contending that it fails to state a claim under the Primary Bond, which is a fidelity bond. A fidelity bond is a specialized two-party agreement “whereby one for consideration agrees to indemnify the insured against loss arising from want of integrity, fidelity, or honesty of employees or other persons holding positions of trust.” The Bond Underwriters claim that there was an exclusion in the Primary Bond that was applicable to the facts in this matter and as a result, coverage was precluded. In particular, they refer to Rider Number 6 which provides that, “notwithstanding anything contained herein, this Bond specifically excludes any loss arising directly or indirectly from independent brokers, except when acting in collusion with any other Employee” (the “Independent Broker Exclusion”). The Bond Underwriters argue that Madoff conducted his illegal activities through BMIS, a registered broker-dealer for which Madoff was the sole principal. Because BMIS was independent of the insureds, the Bond Underwriters argue the Independent Broker Exclusion applies.

The plaintiffs argue that the Independent Broker Exclusion was the result of specific bargaining between the insureds and the Bond Underwriters. According to the insureds, the term “Independent Broker” does not refer to stockbrokers or broker-dealers like BMIS, but rather to participants in a particular distribution channel for life insurance company products. MassMutual sells its insurance products through a network comprised of two types of agents: “career agents” under contract to MassMutual who primarily sell MassMutual products, and “independent brokers” who are authorized to sell MassMutual products but who routinely also sell other companies’ products. According to the Insureds, the Independent Broker Exclusion differentiates between the two channels and excludes the latter group from coverage. If the Independent Broker Exclusion were intended to encompass stockbrokers, as the Bond Underwriters argued, the Court stated that “then it might have used that term. Conversely, if ‘Independent Broker’ were read to extend to stockbrokers, then the Independent Broker Exclusion would eliminate coverage that the Primary Bond otherwise extends expressly to ‘stockbrokers.’”

The Court noted that “[a]lthough the Bond Underwriters’ position may ultimately prevail, it is not the only reasonable reading. At this stage of the case, the Independent Broker Exclusion does not mandate dismissal. The term ‘Independent Broker’ is not defined in the Primary Bond. It does not appear in Standard Form No. 24.” In contrast to other provisions, the parties did not cite “industry materials or cases suggesting that the Independent Broker Exclusion is a form exclusion or standardized term.”

In the 48-page opinion, the Court also discusses a number of other claims raised by the Bond Underwriters including how the complaint states a claim for coverage under the Fidelity clause of the Primary Bond. In the end, the Court determined that because this was a motion to dismiss, it was not permitted to choose between two reasonable interpretations. As a result, the Court denied the Bond Underwriters’ motion.