Solving the “Former Sub” Problem In Insurance Settlements

By Richard Milone on March 20, 2020

When settling long tail insurance claims involving product liability, toxic tort, or environmental claims, one of the most difficult challenges is how to handle the rights of the policyholder’s former subsidiaries.

A typical insurance settlement in a long tail exposure scenario involves insurance policies reaching back many years, often decades. It is common for the Named Insured, i.e., the party identified as the lead policyholder, to have bought or sold subsidiaries during the time when the insurance coverage being settled was in effect. This gives rise to what is known as the “former sub problem,” which occurs when a former subsidiary of the policyholder has its own liabilities that are potentially covered under the policies that are being settled and released. Those liabilities may, or may not, be related in some respect to the Named Insured’s own liabilities. They may be known or unknown. And frequently, the former subsidiary has no idea that its former parent’s insurance rights are being settled while the settlement is happening. Indeed, the former sub may not even realize that it is entitled to coverage under its prior parent’s insurance program until it sustains liabilities that prompt it to undertake an insurance review. This can happen years or decades after the settlement between its former parent and the insurer(s) has been completed.

Often when the Named Insured and its insurer are negotiating a settlement, the former subsidiary and its potential claims under the policy are forgotten altogether. This can be a costly mistake, causing challenging problems for all three parties — the Named Insured, the insurer, and the former subsidiary itself.

When a settlement is finalized but the potential rights of a former subsidiary are not taken into account, the scenario is likely to unfold as follows. The Named Insured probably will grant a broad release to the insurer, encompassing all conceivable claims under the policy. The definition of the “Releasing Parties” typically will include the Named Insured itself, plus all of its former, present, and future subsidiaries, affiliates, and related companies. For added protection, the insurer might insist that the settlement agreement refer to the deal as a “buyout” or “buy back” of the policy(ies) at issue, and sometimes will include language to the effect that the policies are eviscerated, eliminated, or wiped away, “as if they never existed.’ The insurer’s objective, obviously, is to close its books, pull down its reserve, and move on. If the Named Insured is satisfied that the payment is adequate to cover its own liabilities, it often will go along with the broad release demanded by the insurer. In this scenario, both parties to the settlement will go on their way, and consider the deal a success.

The problem arises when the former subsidiary appears years later, claiming that it is entitled to coverage under the same policy(ies) that were previously settled. Whether the former subsidiary’s claim to coverage is valid depends on several factors – the policy wording; the structure of the transaction by which it left the corporate family; and state law. These factors vary from case to case, but quite often former sub’s claims to rights under the supposedly “released” policies are legitimate. And, legitimate or not, they will require both the Named Insured and the insurer to call back old files and devote resources to claims that both parties thought had been resolved.

The former subsidiary will argue, correctly, that the Named Insured had no right to release claims that it did not own, and that a release granted by the Named Insured does not apply to independent parties who are not parties to the agreement, and received no consideration. Upon learning of the settlement, the former subsidiary could try to assert claims against both its former parent and the insurer under various legal theories, including breach of contract, tortious interference with contract, and unjust enrichment. If the former subsidiary finds evidence that one or both parties to the agreement knew or should have known of its existence, and deliberately excluded it from a settlement that purported to eliminate its rights, then claims for intentional torts such as fraud and insurer bad faith would likely be considered as well. Obviously, this is not a good situation for any of the three parties.

One court that recently addressed the issue ruled in favor of the former subsidiary. In Magnetek, Inc. v. The Travelers Indemnity Company, Case No. 17 C 3171 (July 11, 2019), the U.S. District Court for the Northern District of Illinois held that a settlement agreement and release by a corporate parent was not valid with respect to a subsidiary that left the corporate family years before. The court reasoned that one company had no authority to release rights belonging to a second company that it no longer controlled.

There are at least three ways to solve the former sub problem. Under any of these approaches, the parties must confront the issue directly and decide which party will bear the risk of a former subsidiary making a claim. As with any deal term, it is negotiable.

First, if the parties agree that the insurer will bear the risk of former subsidiaries someday making a claim, then the release can be structured so that such claims are no included. Typical language would limit the definition of the releasing parties to companies “controlled by the Named Insured” as of the date of the settlement. Resolving the issue in this manner deprives the insurer of finality, which is generally a settling insurer’s primary business objective. Thus, the settlement amount may need to be adjusted accordingly.

A second solution is to shift the risk to the policyholder in the form of an “indemnification” provision. Under such a term, the policyholder would agree to stand in the shoes of the insurer and pay for the defense costs and any liability of the insurer if a former sub claim should materialize. Policyholders of course are loathe to switch roles and become an “insurer’s insurer,” and would need to think carefully about taking on an indemnification responsibility. Again, the settlement price would need to reflect this potentially substantial burden on one party to the settlement. Generally speaking, the larger the settlement amount, the more realistic or reasonable it becomes for the policyholder to take on the risk of someday indemnifying its insurer.

Finally, another possible approach is to invite the former subsidiary to become a party to the settlement and give its own release to the insurer. The consideration paid to the former subsidiary would depend on the extent of the liability (or anticipated future liability) that the former subsidiary asserts is covered, or potentially covered, under the policy(ies) at issue. This is not an ideal scenario for any of the three parties. The former subsidiary may feel forced into a settlement at a time that suits other parties, but not itself, if its liabilities have not matured and it would prefer to keep the coverage available for the future. The insurer will not be happy about inviting a new party to make claims that had no present intention of its own to do so. And, the Named Insured will suspect (probably correctly) that every dollar paid to the former subsidiary is one less dollar that it can expect to be paid itself. But, at least this scenario is equally imperfect for all parties.

As with any issue in a complex commercial settlement, there is not a one size fits all solution, and often the former sub problem can be resolved as a trade off or in conjunction with other issues. But if not addressed in some fashion, the former sub problem is a ticking time bomb that the parties will wish they had considered and solved while negotiating their settlement.

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