Contract Interpretation

Tenth Circuit Affirms Tax Court’s Decision That Captive Insurance Arrangement Did Not Qualify for Tax Exemption

August 8, 2022 by Brendan Gooley

The Tenth Circuit Court of Appeals recently affirmed the tax court’s decision that a captive insurance arrangement that reinsured a number of other captive insurers did not qualify for a tax exemption.

Reserve Mechanical Corp. issued a number of insurance policies to Peak Mechanical Corp. Reserve and Peak had the same owners, and the arrangement was a form of captive insurance. The arrangement may have been an attempt to obtain tax benefits pursuant to a program that allowed both the deductibles and premiums to be exempt from taxation.

To attempt to qualify for that program, Reserve tried to ensure that at least 30% of its premiums came from companies not affiliated with it. It therefore arranged, among other things, through Capstone Associated Services Ltd. to reinsure a number of other captive insurers that worked with Capstone. Capstone also arranged for each captive insurer it worked with to assume a small percentage of risk from coinsuring thousands of vehicle service contracts.

The IRS concluded that this arrangement did not qualify for an exemption and assessed taxes.

The Tenth Circuit affirmed. It agreed with the IRS that Reserve had not satisfied its burden to demonstrate that its purported insurance transactions were truly arrangements for insurance. Although Reserve complied with some, but not all, of the formalities for insurance companies and went through some of the motions associated with pricing insurance premiums, the record reflected that no “experience, expertise, or studies supported the need for Peak to obtain the policies” and the “premiums for [certain] additional insurance were not supported by any study of similar commercially available policies or careful analysis of Peak’s risks of loss.”

With respect to the reinsurance agreements, the Tenth Circuit concluded that those agreements “did not create any meaningful risk for Reserve” and noted that “Reserve did not satisfy even the distribution threshold that Capstone set for it — obtaining 30% of its insurance premiums by insuring unaffiliated risks.”

Reserve Mechanical Corp. v. Commissioner of Internal Revenue, No. 18-9011 (10th Cir. May 13, 2022).

Ninth Circuit Confirms Arbitration Award Finding FAA Disallows Judicial Review of Whether Arbitrator’s Factual Findings “Are Supported by the Evidence in the Record”

August 3, 2022 by Kenneth Cesta

Plaintiff Annette Serna appealed from an order of the U.S. District Court for the Central District of California. Serna had brought wrongful termination and related claims against Northrop, including under California’s Fair Employment and Housing Act (FEHA), in the Superior Court of California, Los Angeles County. Northrop removed the matter to the U.S. District Court for the Central District of California and then moved to compel arbitration pursuant to Northrop’s 2010 arbitration policy, which explicitly covered “future” claims between Serna and Northrop. The district court compelled arbitration and stayed the action pending arbitration. The arbitrator dismissed Serna’s claims under FEHA, concluding that Serna was not a qualified individual under the statute. Thereafter, the district court denied Serna’s motion to vacate the arbitrator’s decision. The Ninth Circuit affirmed.

The Ninth Circuit concluded that the district court did not err when it compelled arbitration given that the 2010 policy expressly stated that “any claim, controversy, or dispute, past, present, or future” between Serna and Northrop would be subject to binding arbitration. The court rejected Serna’s argument that she was no longer bound by the 2010 policy because it was “superseded” by an updated policy in 2013, finding that nothing in the 2010 policy stated that a revised policy would nullify Serna’s agreement in 2010 to arbitrate all claims, including future claims arising out of her employment with Northrop. The Ninth Circuit also found that the district court did not err when it denied Serna’s request to vacate the arbitrator’s decision on the basis that Serna was not a qualified individual under FEHA, holding that the arbitrator’s factual findings on that issue are beyond the scope of judicial review allowed by the FAA. Finally, the court found that the arbitrator did not exhibit a “manifest disregard of the law,” concluding that the arbitrator did in fact identify the relevant legal standards and applied them, and noted that “because he did so, we may not second-guess his interpretation or application of the law.”

Serna v. Northrop Grumman Systems Corp., No. 21-55238 (9th Cir. July 12, 2022).

Third Circuit Confirms Arbitration Award Finding Award Was Consistent With Controlling Authority and Arbitrator Did Not Manifestly Disregard Parties’ Agreement

August 1, 2022 by Kenneth Cesta

Defendants Jeffrey M. Smith and Sarah A. Smith appealed from an order of the U.S. District Court for the District of the Virgin Islands. The district court denied the Smiths’ motion to vacate the arbitration award entered against them, concluding that the arbitrator made a good faith attempt to interpret and apply the agreement between the parties, which included the arbitration clause. The Third Circuit affirmed.

The Smiths entered into an agreement, which included an arbitration provision, with plaintiff Bayside Construction LLC wherein Bayside was to perform repair work on the Smiths’ home located on St. Thomas, in the Virgin Islands. The Smiths declared Bayside in default for defects in the repair work but did not allow Bayside to cure the alleged defaults before declaring default, as required under the agreement. Bayside filed a demand for arbitration for amounts due and the Smiths filed a counterclaim for alleged overpayment for work performed. The arbitrator concluded that the Smiths had breached the agreement and entered an award in favor of Bayside, which included a modest reduction for “shoddy” work to the amount that Bayside had claimed.

The Smiths argued that the arbitrator “manifestly disregarded” Virgin Islands law and exceeded his powers by issuing an award to Bayside. The Third Circuit rejected the Smiths’ arguments and agreed with the district court’s finding that, while the arbitrator did not cite Virgin Islands law in the award, it was consistent with authority in the territory addressing both the “opportunity to cure” before terminating an agreement and the application of set-offs for defects in construction cases. The Third Circuit concluded it was “immaterial” that the arbitrator cited an arbitration rule rather than case law from the Virgin Islands in the award since the award would have been no different under Virgin Islands law. The Third Circuit also held that since the award was consistent with authority in the Virgin Islands, the arbitrator had not “manifestly disregarded” the law or the parties’ agreement, and did not exceed his powers.

Bayside Construction LLC v. Smith, No. 21-2716 (3d Cir. July 8, 2022).

Pennsylvania Federal Court Transfers Suit Against Applied Underwriters Per Forum-Selection Clause in Unfiled Reinsurance Agreement

July 20, 2022 by Benjamin Stearns

The Eastern District of Pennsylvania has transferred a lawsuit filed against Applied Underwriters Inc. and its subsidiaries to the District of Nebraska. The dispute involved a workers’ compensation insurance program issued by an Applied Underwriters subsidiary to Coyle Trucking Inc. Coyle alleged that the defendant companies misled it into believing that it had purchased a guaranteed cost policy when it had actually been sold a retrospective rating plan.

As part of the scheme, Coyle alleged that Applied’s subsidiary had “intentionally circumvented” Pennsylvania supervisory regulations by filing a guaranteed cost policy with the Pennsylvania insurance commissioner but then using two unfiled agreements to effectively convert the policy into a retrospective rating plan. According to Coyle, these unfiled agreements were a reinsurance treaty between one Applied subsidiary and another, and a reinsurance participation agreement. The agreement, which Coyle had entered into with one of the subsidiaries, included a forum-selection clause that required any dispute relating to the agreement to be brought in the District of Nebraska.

Coyle argued that the forum-selection clause was void because it was contained in an agreement pertaining to an insurance policy, and Pennsylvania law required such agreements to be filed and approved. Although the court noted that it “appears the [reinsurance participation agreement] should have been filed,” Coyle cited no Pennsylvania case that held that such a failure rendered the contract void. Coye cited several California cases that had so held, but those cases did not bind the Pennsylvania federal court. As such, the court found the forum-selection clause was valid and binding on the parties to the agreement. The court then applied the Third Circuit’s four-step test to determine whether to transfer the case because not all parties to the case were bound by the reinsurance participation agreement and the forum-selection clause. The court concluded that the case should be transferred to the District of Nebraska.

Coyle Trucking, Inc. v. Applied Underwriters, Inc., No. 2:19-cv-03164 (E.D. Pa. May 20, 2022).

Eighth Circuit Finds “Entire Contract” Challenge Must Be Decided by Arbitrator, Reverses Order Denying Motion to Compel Arbitration

July 8, 2022 by Alex Silverman

The Eighth Circuit Court of Appeals reversed and remanded a decision by the U.S. District Court for the District of Minnesota denying defendant SUNZ Insurance Co.’s motion to compel arbitration of crossclaims asserted by Payday Inc. The district court held without further analysis that it was “not convinced” whether Payday’s crossclaims fell within the scope of a valid arbitration clause. On appeal, the Eighth Circuit explained that Payday did not oppose SUNZ’s motion to compel on the ground that the arbitration clause itself was invalid; rather, it contended the contract containing the arbitration clause was superseded by a subsequent contract, thus purportedly voiding the arbitration clause. Citing the U.S. Supreme Court’s decision in Buckeye Check Cashing Inc. v. Cardegna, 546 U.S. 440 (2006), the Eighth Circuit held that a challenge to the validity of an entire contract is to be decided by an arbitrator in the first instance, whereas a challenge to the validity of an arbitration clause is to be decided by the court. Because Payday’s challenge was to the contract as a whole, not to the arbitration clause, the Eighth Circuit found the district court erred in denying SUNZ’s motion to compel arbitration.

Benchmark Insurance Co. v. SUNZ Insurance Co., No. 21-1679 (8th Cir. June 6, 2022).