Investment Securities

Abstract

This survey piece is a discussion of Delaware Supreme Court's Estate of Malkin case on the contours of an adverse claim under UCC Article 8.

This year’s Investment Securities portion of the Uniform Commercial Code Survey examines a Delaware Supreme Court case that answers a certified question from the Eleventh Circuit. The case delves into the issue of what constitutes an adverse claim, based on compelling and relatively intricate facts involving a stranger-originated life insurance policy.

Contours of an Adverse Claim

In Wells Fargo Bank, N.A. v. Estate of Malkin, a stranger-originated life insurance (STOLI) policy that was void ab initio was nonetheless sold into the secondary market where it was held in Article 8’s indirect holding system. Following the death of the insured, but before the insurer discovered the policy’s unenforceability, the insurer paid its benefits to its then owner, and the estate of the insured sued the payee based on a state-created statutory right to that payout. The owner/payee asserted a defense to that lawsuit under the indirect holding system’s primary version of a bona fide purchaser rule, U.C.C. section 8-502, which protects against adverse claims to financial assets. The court held that the estate’s lawsuit was not an adverse claim.

The clearest way of setting forth the case’s complex facts is to begin with its Article 8 aspects. American General Life Insurance Company (AIG) was the issuer of a policy insuring the life of Phyllis M. Malkin, and in order to facilitate transfers of the policy AIG entered it into the indirect holding system, presumably with Depository Trust Company as clearing corporation, and with Wells Fargo Bank, N.A. as the first-tier securities intermediary. Wells Fargo in turn created a security entitlement in favor of Coventry Capital I LLC (Coventry), which as explained below had been a party to the initiation of the policy. Later, Coventry sold the policy to Berkshire Hathaway Life Insurance Company of Nebraska (Berkshire), as part of a package of 125 policies in all, with the purchase price of Malkin’s policy being about $322,000. Rephrasing this point about the sale more accurately in Article 8’s terms, Coventry and Berkshire arranged with Wells Fargo to extinguish Coventry’s security entitlement and to create a new security entitlement in favor of Berkshire. Berkshire thereby acquired a security entitlement to the policy and, under U.C.C. section 8-502, would ordinarily be entitled to that section’s “no action” protection against adverse claims as discussed below.

Berkshire, as beneficial owner of the policy, maintained it during Malkin’s life, by paying approximately $137,000 in premiums to AIG. Malkin died in 2014, some eight years after the policy’s issuance, and AIG paid the $4 million death benefit to Wells Fargo, which passed along those funds to its entitlement holder, Berkshire.

Following this payout, Malkin’s estate filed suit against Berkshire because, as now became evident, the policy had been a STOLI policy, initiated by parties having no insurable interest in Malkin’s life, and was therefore void ab initio under Delaware’s constitution and public policy. Malkin had had “life insurance capacity,” which is to say health good enough to support issuance of a policy, coupled with an absence of too many existing policies. An opportunistic broker had capitalized on this fact by offering Malkin the chance to “create dollars today” based on “a paper asset,” namely a life insurance policy to be issued and then sold on the secondary market. There would be no cost or risk to Malkin, because the early payments on the policy (totaling some $360,000) would be covered by a nonrecourse premium financing loan, in which the sole collateral would be the policy itself. (By the same token, later payments were likely to be covered by an eventual secondary market buyer, as indeed they were by Berkshire as noted above.) Malkin agreed, in exchange for an unspecified amount of incentive compensation. The broker arranged for LaSalle Bank and Coventry Capital I, LLC (Coventry), the bank’s lending program administrator, to pay the amount of the non-recourse loan to AIG, which in turn issued a $4 million policy naming a trust formed by Malkin as beneficiary. The non-recourse loan fell due in 2008, and Malkin’s trust duly surrendered the policy to Coventry in order to satisfy that debt. Overall, nothing of value other than the incentive compensation came to Malkin or to those with a stake in her well-being, nor was any financial outlay paid or promised by them.

Delaware statutes provide that if a life insurance policy is procured by a person who has no insurable interest in the insured person’s life, and if “the beneficiary, assignee or other payee” under such a policy receives the policy’s death benefits, then the insured person’s executor or administrator “may maintain an action to recover such benefits from the person so receiving them.” Malkin’s estate brought such an action against Berkshire.

A. Court’s Treatment of Potential U.C.C. § 8-502 Defense

With Wells Fargo having created a security entitlement to the death benefits in favor of Berkshire, Berkshire is generally entitled to U.C.C. section 8-502’s “no action” protection against adverse claims. Section 8-502 provides, “An action based on an adverse claim to a financial asset, whether framed in conversion, replevin, constructive trust, equitable lien, or other theory, may not be asserted against a person who acquires a security entitlement under Section 8-501 for value and without notice of the adverse claim.” Section 8-502 is one of Article 8’s versions of commercial law’s large and economically robust family of “bona fide purchaser” rules, having in common the policy goal of protecting the acquisition of property rights by parties that meet certain standards of innocence, ordinariness, and commercial importance.

The question in this case was whether section 8-502 protects Berkshire from the lawsuit by Malkin’s estate. The United States District Court for the Southern District of Florida ruled that it did not. The United States Court of Appeals for the Eleventh Circuit declined to rule on the merits and certified the question to the Delaware Supreme Court. The Delaware Supreme Court finally ruled that the section 8-502 defense was not available.

The availability of the section 8-502 defense to Berkshire is squarely a policy question, presenting a collision between two legislative policy goals. Underlying section 8-502 is the commercial law goal just mentioned of protecting good-faith purchasers in the indirect holding system; while underlying the insurable interest statute is the goal of preventing the payoff of disinterested and hence unlawful wagers on human life. On the merits of this policy quandary, it is almost surely most sensible for the insurable interest statute’s policy to prevail, notably because the commercial law goal can be roughly approximated by diligence of the parties as discussed below.

Although the Delaware Supreme Court did vindicate the insurable interest statute’s policy, the court did so by taking refuge in disappointingly textualist arguments about Article 8. It held that the action by Malkin’s estate was not an “adverse claim.” That term is defined as “a claim that a claimant has a property interest in a financial asset and that it is a violation of the rights of the claimant for another person to hold, transfer, or deal with the financial asset.”

The court’s first textualist argument focused on the definition’s reference to a “property interest” and asserted that “[n]obody can have a ‘property interest’ in a STOLI policy or its proceeds [ . . . ] because, as this Court held in Price Dawe, such policies are ‘nullities’—invalid human-life wagers that never come into legal existence.” This assertion has two different infirmities. First, when a STOLI policy is paid out, the fact that the policy never came into existence becomes beside the point, because the simple fact is that the payee has the paid-out funds, which certainly are in existence and are the subject of countless commercial law property disputes every day. And second (building on the first), the text of the adverse claim definition does not depend on a “property interest” but rather on “a claim that a claimant has a property interest.” Thus what section 8-502 protects against is a plaintiff ’s claim of a property interest (whether or not the plaintiff even actually has a property interest), and Malkin’s estate obviously had such a claim, conferred expressly by the insurable interest statute. Not only does the null nature of the STOLI policy (as opposed to its payout) not negate that claim; it is the claim’s entire reason for being.

The court’s other textualist argument was that “because STOLI policies are void ab initio, when an investor receives their proceeds it does not commit ‘a violation of the rights of the claimant’ [within the meaning of section 8-102(a)(1)] but rather a violation of Article II, Section 17 of Delaware Constitution and of the State’s public policy.” It is hard to make any sense of this argument. Violations of rights can obviously be grounded in several sources at once, particularly when the sources to which the court points (the Constitution and public policy) are the very basis for the legislative source against which the defendant asserts its defense (Malkin’s estate’s section 2704(b) action). Second (and harking back to the court’s first textualist misstep above), section 8-102(a)(1)’s definition of adverse claim does not in fact refer simply to “a violation of the rights of the claimant” but rather to “a claim that . . . it is a violation of the rights of the claimant,” which is exactly the claim that Malkin’s estate’s lawsuit makes. Part of text is always the associated textual context, and in fact the words “text” and “context” derive from roots meaning “woven together.”

In another type of argument, the court invoked Official Comment 1 to section 8-502, which points out that “[a] security entitlement is a complex bundle of rights. This section does not deal with the question of what rights are in the bundle.” The rights in the bundle, the court then reiterated, were void ab initio, and “the securitization of a STOLI policy and a later transfer of the security entitlement under the UCC does not bring the void policy back to life.” True enough; but a further aspect of this “complex bundle of rights” is that the payout on the void policy results in the asset credited to the securities account no longer being the policy itself. Rather, the rights credited to the account become the cash from the payout. This cash has its own life, independent in some ways from any absence of life of the policy itself, as section 2704(b) makes clear.

Finally, it is notable that the court did briefly advert to questions of legislative intent. “We cannot find any basis in the text of the Delaware UCC to conclude that the General Assembly intended to violate the Delaware Constitution’s general prohibition of wagering or alter the State’s longstanding prohibition of STOLI policies.” It is surely true that the legislative history of Delaware’s Article 8 makes no reference to those particulars. But the potential use of Article 8 as a structure for transferring and holding interests in life insurance policies may very well not have been evident to its drafters or to Delaware legislators of the time. Regardless of this historical posture, section 8-502 is deliberately drafted extremely broadly, affording entitlement holders protection against adverse claims “whether framed in conversion, replevin, constructive trust, equitable lien, or other theory.” Moreover, the Prefatory Note adopted in 1994 as part of Article 8’s official text includes a section headed “Whatever else they have or may devise,” stating that “[r]apid innovation is perhaps the only constant characteristic of the securities and financial markets,” and that Article 8 is “intended to be sufficiently flexible to accommodate new developments.”

B. Conclusion

Despite the flaws in its reasoning, the outcome of the case is almost surely correct. On the facts of this case, Berkshire sought to protect itself from the issues presented by requiring a representation from Coventry about the non-STOLI nature of the 125 policies. By extension, future parties in Berkshire’s position can better protect themselves by not permitting such a representation to include a knowledge carve-out, and/or by further probing the assets.

The court does cabin its holding with thoughtful gestures in the direction of section 8-502’s importance. “In answering the certified questions, we stress that, although the Delaware UCC defenses implicated in this case do not apply in the sui generis context of a Section 2704(b) action to recover the proceeds of a STOLI policy, our reasoning does not affect their validity in other contexts.” However, gestures such as these do not eliminate the uncertainty that can affect parties to future transactions, even those not involving life insurance policies at all. The court’s shaky reasoning leaves us with a precedent that can lead to other rulings, not having the same level of intuitively or practically correct outcome.

Overall, the Eleventh Circuit was adroit in certifying this question to the Delaware Supreme Court, and it is beneficial to have such an authoritative state court pronouncement on a matter so central to Article 8. This authoritativeness is partially undermined, however, by its apparently sound result being founded on shaky textualist grounds rather than on a more direct grappling with the policy dilemma presented by the competing statutes.