The D & O Diary

As Alison Frankel recently reported in her On the Case blog (here), the insider trading charges to which former Morgan Stanley hedge fund manager Joseph “Chip” Skowron pled guilty cost the company a lot of money. And, as demonstrated in the lawsuit the company recently filed against Skowron, Morgan Stanley wants its money back – the company wants not only the almost $5 million of legal fees it paid on Skowron’s behalf, but also the more than $32 million in compensation the company paid Skowron, and even the $32 million the company paid to resolve the SEC’s case against Skowron.

An action of this type is unusual, as Frankel’s blog post well documents. (This particular case is also procedurally unusual and complex, as Frankel also shows). But Morgan Stanley’s efforts to recoup all of its costs from Skowron triggered a question to me from several readers on a parallel topic: that is, when can a D&O insurer recoup amounts it has paid out after an insured has pled guilty or  when circumstances otherwise establish that there is no coverage for amounts the insurer has paid?

The recoupment question most often comes up in the insurance context with respect to attorneys’ fees. D&O insurers generally take the position that when they pay defense fees under their policy, they are merely advancing defense fees subject to an ultimate determination on whether or not the amounts are actually covered under the policy, and that in the event of a determination of noncoverage they are entitled to be reimbursed for the amount they had advanced.

The carrier’s position in this respect may be particularly understandable when it is paying defense fees under the policy’s corporate reimbursement coverage (usually referred to as Side B coverage); in those circumstances, the insurance is providing a funding mechanism for the insured company’s own indemnification obligations. Just as the insured company would typically have the obligation only to advance defense expenses subject to a right of recoupment if it is determined that the indemnitee is not entitled to indemnification, the carrier’s payment on the insured company’s behalf also represents advancement subject to recoupment.

But even when the carrier’s is paying defense fees under another insuring agreement (whether it is the individual protection coverage under Side A or the entity coverage under Side C), the carrier will contend that at the outset of a claim a definitive coverage determination is not possible and so the insurer is merely advancing defense costs until it is possible to make the determination.

Just the same, it is relatively rare for a D&O insurer to try to recoup defense fees it pays. That is largely because it is pretty unusual in the context of a D&O claim for there to be final factual determinations, because most D&O claims settle long before the factual determinations are made. (Indeed, among the many reasons that securities suit rarely go to trial is the defendants’ concern that an adverse verdict would not only result in a finding of liability against them, but could also result in the loss of their insurance coverage.)

There is another practical reason that it is relatively rare for D&O insurers to attempt to recoup defense fees it has paid; that is, by the time an individual or company grinds all the way through a serious D&O claim, the person or company is usually broke. There is not much left for the insurer to go after. It is the very rare case where it is going to be enough left for it to be worth the insurer’s expense and time to try to recoup amounts paid out.

There is of course another reason why it is rare for D&O insurers to seek recoupment; in general, it is not a public relations move for insurance companies to go around suing the persons they insure.

Nevertheless, over the years there have been a certain number of cases where the D&O insurer has attempted to recoup defense expenses. The law in this area is not entirely uniform. In some jurisdictions, the courts have held that, if at the outset of a claim the carrier has reserved the right to seek recoupment in the event of a determination of noncoverage, the carrier has the right to seek to recoup defense costs incurred in connection with claims that are not covered under the policy. Court that follow this approach reason that allowing the insurer to recoup the defense costs where a timely reservation of rights was issued promotes the policy of ensuring that defenses are afforded even in questionable cases. Other courts following this line have reasoned that it would be inequitable for the insured to retain the benefits of the defense without repayment where there was no coverage under the policy.

On the other hand, other courts have held that the policy itself must specific address the carrier’s right to seek recoupment and that the mere fact that the carrier has reserved its rights to seek recoupment is not sufficient to create a right that is not otherwise found the policy.

A more interesting question, and one that comes up even less frequently than the question of the insurer’s right to recoup defense expenses, is the insurer’s right to recoup amounts paid as damages or in settlements. An insurer has the right of subrogation, that is, the right to proceed against a third party that caused the loss, to recoup the amount of that loss. Most D&O policies contain subrogation provisions, but even in the absence of an explicit subrogation provision, the carriers will contend that they have rights of equitable subrogation entitling them to go against the persons that caused the loss.

The subrogation provisions of many D&O policies often specifically address the question of when the D&O insurer may subrogate against an insured person under the policy. In most modern D&O insurance policies, the clause will specify that the insurer can exercise the right of subrogation against an insured person if the person from whom recovery is sought has been convicted of a deliberate criminal act or has been determined by adjudication to have committed a deliberate fraudulent act. However, because so many D&O claims settle, these preconditions for a subrogated recovery against an insured person are rarely met.

But the subrogation provisions and rights only address the conditions on the carrier’s right to assert a claim in the right of the party on whose behalf the carrier paid the claim. The carrier’s own right to recover amounts it paid for which it later appears there is no coverage arguably is a different question. (It is an interesting thought-problem to contemplate whether a carrier seeking recoupment of amounts paid pursuant to a settlement or judgment is proceeding by way of subrogation or in its own right; in the D&O context it may well depend on the insuring agreement pursuant to which the payment was made. If the payment was made pursuant to the corporate reimbursement coverage then the recoupment action would appear to represent subrogation; if the payment was made pursuant to either the individual protection or entity liability coverage parts, then it might be argued that the carrier’s recoupment rights are direct, not by way of subrogation.)

Although some D&O policies do contain provisions specifying that the carrier may seek recoupment of amounts advanced as defense expenses in the event of a determination of noncoverage, it is relatively unusual for these provisions to address the carrier’s right to recoupment of amounts other than defense expenses. In the absence of specific contractual provisions addressing the issue, the carrier would be obliged to rely on equitable arguments – that is, that it would be inequitable for the carrier to have to bear costs it was not contractually obligated to undertake and that rightfully should be borne by the person whose conduct caused the loss.

I know of various instances where carriers have sought to recoup amounts paid as defense expenses, but I cannot recall an instance where a carrier sought to recoup amounts it paid by way of judgments or settlements -- but that isn’t to say that it never happens; in fact, I expect that it has happened, and I would be very interested if readers aware of any occasions where this has happened could share their recollections with other readers by using the comment feature on this blog.

I will say that it is interesting how a particular situation, like Morgan Stanley’s new lawsuit against Skowron, can set off a whole cascade of thoughts and associations. My thanks to the several readers who contacted me with their thoughts and questions about the Morgan Stanley lawsuit.