Premium finance and other lending institutions which have established lending programs in Delaware may sleep better at night now that the federal court there has determined that a life insurer cannot seek to both rescind the policy and retain the premiums, a tactic that many life insurers have been trying to employ recently. Moreover, the court held that it is not sufficient for a life insurer seeking to rescind a policy on insurable interest grounds to merely allege that the insured intended to sell the policy after issuance. In order to satisfy its pleading standards, the insurer must identify a specific third party with whom the insured had agreed in advance of policy issuance. See Sun Life Assur. Co. of Canada v. Berck, No. 09-cv-498-SLR, 2010 WL 2607247 (D. Del. Jun. 29, 2010); The Lincoln National Life Ins. Co. v. Snyder, No. 09-cv-888-SLR, 2010 WL 2787453 (D. Del. Jul. 15, 2010).

The Berck and Snyder decisions, dealing with issues of first impression in Delaware, are very significant because many premium finance lenders established facilities for life insurance transactions in Delaware in the mid-2000s when the economy appeared to be good and while life insurers and their agents were promoting the sale of policies to wealthy seniors. Many life insurers have subsequently commenced lawsuits seeking to rescind such policies and retain the premiums, which made up the collateral for the premium finance loans, arguing that the policies were issued as a result of sham STOLI transactions, in violation of insurable interest laws.

The courts across the country have issued conflicting opinions over the last few years, some allowing insurers to simply allege that the insured intended to sell the policy at the time he/she applied for it and allowing insurers to make claims to retain the premiums paid for the policies to offset certain costs and expenses, including commissions paid by the insurers to their agents in connection with the sale of the policies, in conjunction with their claims to rescind the policies. The perverse result in these situations is that the innocent lenders, not the insureds and agents who are alleged to have been the masterminds of the fraudulent STOLI schemes, are the ones who risk bearing the loss at the end of the day.

The Berck decision clarified that, under Delaware law, in accordance with other better-reasoned federal decisions (see, e.g., Sun Life Assur. Co. of Canada v. Paulson, No. 07-cv-3877, 2008 WL 451054 (D. Minn. Feb. 15, 2004) (construing Minnesota law)), an insurer must identify the stranger with whom the insured allegedly entered into an agreement prior to policy issuance "in order to indicate, at a minimum, the existence of bilateral intent." Since the insurer's complaint in Berck failed in this regard, its amended complaint was dismissed with leave to re-plead. In Snyder, the court determined that the insurer's insurable interest violation allegations contained enough detail to withstand the trustee's motion to dismiss.

In addressing the issue of whether a life insurer could seek to both rescind the policy and retain the premiums paid, both Berck and Snyder, adhering to well-settled principles of equity, held that if an insurer rescinds a policy, it must return the parties to the status quo by returning the premiums. Since this was the holding in both Berck (holding that the insurable interest violation allegations were insufficient) and Snyder (holding that the insurable interest violation allegations were sufficient), it is apparent that this is the rule in Delaware irrespective of whether the life insurer has properly alleged an insurable interest violation. Such should minimize a lender's loss if it, unknowingly and unfortunately, financed a sham STOLI transaction.

While both Berck and Snyder noted that a party who has allegedly been defrauded into entering into an agreement can seek damages for fraud, they further noted that "[i]n an equitable action such as this, plaintiff cannot have it both ways." Berck and Snyder recognized an additional problem with permitting the insurers to retain the premiums under such circumstances: "If an insurance company could retain premiums while also obtaining rescission of a policy, it would have the undesirable effect of incentivizing insurance companies to bring rescission suits as late as possible, as they continue to collect premiums at no actual risk."

Arent Fox is defending the trustee in the Berck case. For more information, please contact Jule Rousseau, James Westerlind, or Eric Biderman.