The Institute in the Courts: Supreme Court of Delaware Adopts Sections of Contracts 2d

In Geronta Funding v. Brighthouse Life Insurance Company, 2022 WL 3654872 (Del. Aug. 25, 2022), the Supreme Court of Delaware adopted the “fault-based analysis” framed by Restatement of the Law Second, Contracts §§ 197 to 199 for considering “questions specific to insurance policies declared void ab initio as against public policy for lack of an insurable interest as the correct test” to determine whether insurance premiums paid to insurers should be returned.

The case arose in 2018 when the policy owner, which had purchased the policy as part of a bulk sale of life-insurance policies, discovered that the individual insured under the policy was fictitious. After the owner informed the insurer of the fraud, the insurer brought a declaratory action against the owner, arguing that it was entitled to retain all premiums that the owner and its predecessors paid because the policy was void ab initio; the owner counterclaimed to recover the premiums it paid to the insurer. After a bench trial, the trial court entered judgment in part for the owner, finding that the owner was only entitled to premiums it paid after it made the insurer aware that the insured individual was fictitious.

The Supreme Court of Delaware affirmed in part, reversed in part, and remanded to the trial court to determine whether the parties had inquiry notice of “facts tending to suggest the void nature of the policy,” using the framework set forth by Restatement of the Law Second, Contracts §§ 197 to 199. The court observed that the trial court correctly looked to § 198 in analyzing which party was more at fault to determine whether the owner was entitled to a return of premiums paid to the insurer, but that it erred in finding that the owner was more at fault, because it failed to consider whether the parties had inquiry notice of the suspicious nature of the insured individual.

The court explained that, as a general rule, contracts that were void for violating public policy did not entitle either party to any form of restitution, but the Restatement provided exceptions to that rule by focusing primarily on the respective fault of the parties. Under § 197, a party in such a void contract could be entitled to restitution if denial of restitution would cause disproportionate forfeiture. Meanwhile, under § 199, a party could be entitled to restitution if that party did not engage in serious misconduct and withdrew from the transaction before an improper purpose was achieved, or if denial of restitution would leave property that was the subject of the contract in the hands of a party whose control would violate public policy.

In this case, the court focused on § 198, under which a party could be entitled to restitution if it was excusably ignorant of facts and legislation in the absence of which the contract would have been enforceable, or the party was not equally at fault with the other party. Factors the court looked to in determining whether a party was excusably ignorant included whether “the facts surrounding the policy put or should have put” a party on notice that something was amiss, whether the party “failed to notice red flags,” and whether a party’s expertise in relevant insurance fields “should have caused it to know or suspect that there was a substantial risk that the policy it purchased was void.” The court acknowledged the trial court’s conclusion that the insurer did not have actual knowledge of the lack of insurable interest until it was informed by the owner, but pointed out that § 198 also required factual findings as to whether the insurer had inquiry notice of the lack of insurable interest during the time it was paid insurance premiums. According to the court, certain “stipulated facts or factual findings . . . could support a finding that [the insurer] was on inquiry notice of facts tending to suggest that the policy was void,” such as the insurer’s internal communications noticing that that the insurance policy had suspicious-activity flags, and press releases from state prosecutors stating that the insured individual’s purported son had pleaded guilty to insurance fraud and theft by deception after he submitted false applications for life-insurance policies on behalf of the same fictitious insured individual.

In making its decision to adopt §§ 197 to 199, the court observed that Delaware case law lacked a more nuanced resolution to the parties’ dispute than the extreme solutions found in common law of either leaving the parties in their current state or rescinding the insurance policy and returning all premiums. According to the court, adopting §§ 197 to 199 not only would place Delaware “in line with the majority of jurisdictions,” but, more importantly, would also be “more consistent with public policy considerations” governing insurance policies. The court explained that it “should take care to discourage” insurance policies that were void against public policy for lack of an insurable interest, and, while automatic return of premiums “discourage[d] insurance companies from hiding the invalidity of a policy for as long as possible in order to continue collecting premiums,” doing so would encourage “investors to continue purchasing life insurance policies without investigation into whether those policies [were] unenforceable policies . . . .” The court reasoned that the Restatement’s approach would incentivize “insurers to speak up when the circumstances suggest[ed] that a policy [was] void for lack of an insurable interest because they [would] not be able to retain premiums if they stay[ed] silent after being put on inquiry notice,” and ensured that all players along the chain of insurance policies would behave in good faith.