In recent posts (here and here), I have discussed the issues surrounding coverage under D&O insurance policies for investigative costs and special litigation committee expenses. In response to these posts, readers Jeff Kiburtz and Cindy Forman of the Santa Monica law firm of Shapiro Rodarte & Forman have submitted the following guest blog post. This guest post of course reflects the views of the post’s authors, and not necessarily those of the author of The D&O Diary. Cindy and Jeff’s guest post is as follows:  

 

Having recently ended an unusual week straight of rain in normally sunny Los Angeles, the saying "when it rains it pours" comes to mind. This phrase aptly describes the situation in which many companies find themselves when revelations of accounting irregularities or other alleged misconduct surface – first there is a story in the press, then a letter indicating the SEC opened an informal investigation, next a DOJ subpoena, and, sometime during this period, the company’s stock drops and a shareholder makes a demand for an investigation or forgoes the demand and files a derivative suit.

 

The response to this downpour is immediate and expensive. Typically, at least three sets of law firms are retained – one to handle the government investigations and private litigation, a second to conduct an internal investigation and report to a special committee established by the company, and a third, which usually consists of several different firms, to defend the implicated directors and officers.

 

Recognizing the potential to spend large amounts of money very quickly, in-house counsel and the company’s outside lawyers move to create a division of labor between the various firms to coordinate the overall effort. Central projects such as the review, coding and scanning for privilege of all of the documents potentially relevant to the underlying issue are assigned to a specific firm, frequently the internal investigation counsel. Work specific or unique to the various groups is, however, done by the respective group’s own counsel.

 

Although each firm represents the unique interests of their clients, and potential or actual conflicts are therefore implicit, in many circumstances the various interests are largely aligned and the attorneys can and do work together for the mutual benefit of all. If, for example, the company needs to respond to a DOJ document subpoena, there is no reason their theoretically diverging interests should prevent the company’s defense counsel from tapping into the document review work done by the internal investigation counsel to locate responsive documents.

 

The single greatest beneficiary of this collaboration is the company, which in many circumstances is required to pay the bill for all of the various lawyers. We would think that, by extension, the company’s D&O insurers would also see and appreciate the extent to which collaboration between the various groups reduces the overall legal spend. It seems, however, that many D&O insurers are quite restrained in their enthusiasm, often declining coverage for various categories of fees incurred by the company under numerous theories. One fee category that is almost uniformly declined is fees incurred by internal investigation counsel, which, perhaps coincidentally, also happens to be the largest single line-item in many situations.

 

When declining coverage for internal investigation fees, insurers often argue that because the definition of "Claim" does not specifically reference internal investigations, fees incurred by internal investigation counsel were not incurred "in connection with a Claim." Insurers also argue that the internal investigation counsel represents only the special committee, which typically is not one of the enumerated categories of "Insureds" under most D&O policies. A related argument is that internal investigation counsel is supposed to be neutral and objective, such that their work cannot be described as defensive in nature and, therefore, cannot be considered "defense costs."

 

Most policyholders regard these arguments as formalistic and compartmentalized, divorced from the business realities of these "when it rains it pours" situations. For one, the carriers do not give adequate consideration to the fact that much of the internal investigation work (e.g., construction of an electronic document database and obtaining witness statements) is relevant and necessary to defending any securities claim or government investigation, and would need to be performed even in the absence of any internal investigation. In this sense, the insurer’s objection is one of form not substance, as the nature of the substantive work is less relevant to the insurer than the designation of the firm who handled that work (e.g., document review conducted by defense counsel is admittedly covered, but that same work is allegedly not covered merely because it was performed by internal investigation counsel).

 

Further, the insurers’ arguments tend to disregard the direct and obvious connection between the allegations of and investigation into potential wrongdoing and the coordinated effort taken and paid for by the company to investigate and respond in an appropriate manner. When the allegations surface, all of the attorneys involved, whether they represent the company, the special committee or the individual insureds. need to review documents and interview witnesses to determine the relevant underlying facts that impact their respective clients’ interests. It often is not until much later, if at all, that facts surface which demonstrate that the various parties’ interests are in fact adverse. That the information gained during the earlier investigation phases might be used by the special committee in a manner inconsistent with coverage (e.g., advising the board to pursue litigation against directors and officers) does not justify a wholesale declination of all fees incurred by the special committee.

 

A few of these issues came up in the recent MBIA v. Federal Ins. Co. coverage action Kevin has addressed (here and here), where the court seemed not to have been overly warm to the legal principles underlying the insurer’s arguments.

 

 

Federal argued that the firm which handled the internal investigation, Dickstein Shapiro, represented only the special committee, not the company or any of the other insureds. Although the court dismissed this argument on a factual basis (finding that Dickstein made an appearance on behalf of the company in the securities litigation), it also noted that, independent of this fact, the special committee was comprised of members of the board of directors who were expressly charged with acting in the best interest of the company and who "could readily reach independent decisions without being independent of [the company]." While this portion of the opinion could have been more clear, the court’s decision cuts against both the notion that special committees are necessarily separate "entities" from the company and that their required independence precludes characterizing as "defense costs" the work done on their behalf.

 

Another aspect of the court’s decision in MBIA is also worth noting. Insurers frequently argue that internal investigation counsel’s work was not performed "in connection with a Claim," but rather was performed "in connection with" something other than a "Claim," e.g., an internal investigation. This argument makes relevant the causal nexus implied by the "in connection with" language. Policyholders often argue that the implied nexus in this non-exclusionary term is very broad, something akin to an incidental or minimal causal connection; for example, the fees are covered if they bear some reasonable relationship to a covered claim. In our experience, insurers appear reluctant to characterize the allegedly required nexus, but by implication seem to suggest something like predominant causation; for example, the fees are covered only if the predominant reason for doing the work was to defend against the covered claim. While it does not appear that the parties in the MBIA case briefed this issue, by finding coverage for the internal investigation fees related to the derivative suits the court arguably recognized that "in connection with" implies only a minimal causal connection in this context.

 

The insurance bar is likely concerned by the MBIA decision, as it could have widespread implications. It will be interesting to see whether Federal seeks appellate review or whether insurers in the future will simply seek to downplay the significance of a district court decision and attempt to confine it to the facts before the court. 

 

The D&O Diary would like to thank Cindy and Jeff again for their submission of this guest post. The D&O Diary accepts appropriate guest posts from responsible commentators on topics relevant to this blog. My goal in hosting guest posts is to encourage discussion of important topics and to facilitate the exchange of contrasting points of view. Readers who are interested in submitting guest posts should feel free to let me know using the "Contact" function on this blog.