Scottsdale Insurance Company v. McGrath

Background

Scottsdale Insurance Company insured Watershed Ventures, LLC under a Business and Management Indemnity Policy. The policy provided directors-and-officers and company coverage for Watershed, its subsidiaries, and covered directors and officers. The policy defined an “Insured” to include the company and its directors and officers.

Rocky Aspen, LLC was formed by Rocky Aspen Management 2014, LLC, a wholly owned Watershed subsidiary, and AH DB Kitchen Investors LLC. Each held a 50 percent interest under Rocky Aspen’s operating agreement. AH DB’s sole member was Aristone Hospitality LLC, whose sole member was Patrick McGrath. McGrath was also the sole member of Castlegrace Equity Investors, LLC.

McGrath was appointed as AH DB’s co-manager of Rocky Aspen. The operating agreement gave the co-managers authority over Rocky Aspen’s management and operations. It also provided that, if specified funding or other events occurred, AH DB would forfeit its voting units and the Watershed member would have the sole right to appoint, remove, and replace co-managers.

AH DB did not meet its funding obligations by the March 25, 2015 deadline. Under the operating agreement, the option-triggering events therefore occurred, AH DB forfeited its voting units, and the Watershed option became exercisable. On January 5, 2016, Rocky Aspen Management 2014 exercised the option and purported to remove McGrath as co-manager. Rocky Aspen later filed for Chapter 7 bankruptcy. The bankruptcy trustee brought proceedings against Castlegrace, AH DB, and McGrath concerning two alleged monetary transfers connected to loans.

McGrath and AH DB tendered the trustee’s demand to Scottsdale. Scottsdale took the position that McGrath was not insured under the policy and reserved its rights. Scottsdale then filed this action seeking declarations concerning McGrath’s insured status, whether the trustee’s demand alleged covered wrongful acts, whether a subsidiary exclusion applied, and whether notice was timely. McGrath asserted counterclaims, including claims for a declaration that he was insured, bad-faith breach of the insurance contract, and breach of the duty to defend. He also asserted third-party claims against Watershed and an equitable-lien claim.

Motion and Issue

Scottsdale moved for summary judgment under Federal Rule of Civil Procedure 56 on its declaratory-judgment claims and McGrath’s counterclaims. The parties did not dispute the material facts. The motion presented a legal question: when did Rocky Aspen become a “Subsidiary” under the Watershed policy?

The policy’s definition covered an entity in which the parent company, directly or indirectly, owned more than 50 percent of the outstanding securities representing the present right to vote for managers or directors. It also covered a joint-venture entity in which the parent company or a qualifying subsidiary owned exactly 50 percent and solely controlled the joint venture’s management and operations under a written agreement.

Scottsdale argued that Rocky Aspen became a subsidiary only when the Watershed option was exercised on January 5, 2016. It contended that, before then, Rocky Aspen remained a 50-50 joint venture in which Watershed did not solely control management because McGrath remained a co-manager. McGrath argued that Rocky Aspen became a subsidiary when the option-triggering events occurred in March 2015, because AH DB forfeited its voting units and Watershed gained sole power to appoint and remove managers.

Court’s Analysis

Judge Liman held that Rocky Aspen satisfied the policy’s first subsidiary definition after the Watershed option was triggered, both before and after the option was exercised. The policy used the broad phrase “any entity,” and the court concluded that this language included a limited liability company formed through a joint venture.

The court reasoned that, when AH DB forfeited its voting units, Rocky Aspen Management 2014 obtained the sole power to appoint and remove Rocky Aspen’s managers. Because Rocky Aspen Management 2014 was a Watershed subsidiary, Watershed indirectly controlled more than 50 percent of the outstanding securities representing the present right to vote for Rocky Aspen’s managers. The court also concluded that the forfeited units were no longer outstanding and that the remaining voting rights were held through Watershed’s subsidiary.

The court rejected Scottsdale’s argument that Rocky Aspen’s voting units were not “securities” under the investment-contract test associated with Securities and Exchange Commission v. W.J. Howey Co. The court explained that the policy’s use of “securities” was broader and could include voting interests separated from economic interests. It also noted that Scottsdale’s interpretation would exclude other commonly recognized parent-subsidiary arrangements, including a parent’s control of a limited liability company.

The court further rejected Scottsdale’s argument that Rocky Aspen’s formation as a joint venture prevented it from qualifying as an “any entity” under the first definition. The court read the first and second parts of the definition together: the first applied to any entity that was majority-owned by a parent, while the second addressed equally owned joint ventures in which one member had contractual sole control of management and operations.

The court did not accept McGrath’s alternative argument that Rocky Aspen also satisfied the second, joint-venture definition before the option was exercised. That provision required sole control of management and operations, not merely effective control or the power to remove a manager. While Watershed could remove McGrath, McGrath remained a co-manager until he was removed and could participate in Rocky Aspen’s management. Watershed therefore did not solely control management and operations during that period. The court also concluded that the operating agreement’s deadlock provision did not establish sole control.

Disposition

The court held that Rocky Aspen was a policy subsidiary when the Watershed option-triggering events occurred. Scottsdale’s argument that McGrath was not an insured during the relevant period therefore failed on the theory presented in the motion. The court denied Scottsdale’s motion for summary judgment and directed the clerk to close the motion. The opinion did not enter a final ruling on every coverage or counterclaim issue, and it stated that discovery was scheduled to continue.