The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

As I discussed in a recent post (here), in a June 11, 2013 opinion, the New York Court of Appeals held that J.P Morgan (which had acquired Bear Stearns) is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from the alleged misconduct. The Court of Appeals opinion can be found here.

 

In the following guest post, Peter Gillon of the Pillsbury law firm offers his views about the Court of Appeals opinion in the J.P Morgan case, as well as about the decision’s implications. Readers are encouraged to add their comments on Peter’s guest post using the comment feature in this blog’s right hand column. I would like to thank Peter for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post. Here is Peter’s guest post:

 

In a case closely watched by industry observers, the New York Court of Appeals, in J.P. Morgan Securities v. Vigilant Insurance Company, No. 113 (NY, June 13, 2013), issued an important ruling in the field of Directors & Officers Liability Insurance, curtailing to some extent insurers’ ability to use a phantom exclusion to deny coverage. Insurers increasingly have argued that their policies do not cover damages that can be characterized as restitutionary in nature, even where the policy may be silent on the issue. The contention is based on two theories: (1) that notwithstanding contract language providing coverage, the policy is unenforceable in that respect because in some states coverage for damages in the form of restitution (or disgorgement of ill-gotten gains) is unenforceable as a matter of public policy; and (2) from an economic standpoint, when a policyholder returns monies it has obtained improperly, there is no basis for coverage because the policyholder has not incurred any “Loss.”

 

The New York high court called foul on this encroachment on policyholders’ contractual rights, holding that policyholder Bear Stearns was entitled to pursue its claim to coverage for a $160 million payment incurred as a result of settlement of an SEC enforcement proceeding, even though the agreement expressly characterized the payment as “disgorgement.” As the Court made clear, there is no public policy in the State of New York barring coverage for restitution or disgorgement; and the limited public policy exception to the enforceability of contracts for “intentionally harmful conduct” could not be sustained by insurers on the record before the court. (Slip Op. at 9-11). More important to policyholders, the Court also held that the bulk of the payment characterized in the settlement agreement as “disgorgement” was actually compensation for profits improperly received by Bear Stearns’ hedge fund customers, not the result of gain by Bear Stearns. Given that the “policy rationale for precluding indemnity for disgorgement – to prevent the unjust enrichment of the insured by allowing it to, in effect, retain the ill-gotten gains by transferring the loss to its carrier,” was not implicated because Bear Stearns was “not pursuing recoupment for the turnover of its own improperly acquired profits,” the Court denied insurers’ motion to dismiss. As Justice Smith put it during oral argument before the appellate court, “how can you disgorge something that you haven’t ‘gorged’?”

 

The ruling is critically important in that it curtails the use of the unwritten “restitution defense” by D&O insurers subject to New York law, unless the restitution payments at issue corresponded to benefits actually received by the insured. Under this test, the restitution defense would not apply to any claim, such as a claim for breach of fiduciary duties by directors or officers, where the individuals did not receive the benefit of a distribution or other transaction. Likewise, this matching test should limit use of the restitution defense in response to Side B claims (reimbursing a company for amounts paid as indemnity to individual directors or officers), where the company has paid restitution to a third party, but individual directors or officers did not actually benefit from the funds being disgorged.

 

Left unaddressed by the New York court, however, is one of the nagging issues in this area: whether the restitution defense requires the insurer to prove not only that the insured was the actual beneficiary of the amount being disgorged, but also that the gains were “ill-gotten.” In many cases, the recipient actually earned the amounts being disgorged, lawfully and properly, but is required to turn over its gains for technical legal reasons, regardless of fault. This may occur in a fraudulent transfer action brought by a bankruptcy trustee under Section 548 of the Bankruptcy Code (allowing avoidance of certain types of payments, such as severance payments to executives, made by an insolvent company less than two years prior to the bankruptcy petition date, in return for less than reasonably equivalent value). At least one court has held that in a fraudulent transfer action brought by a debtor company’s bankruptcy trustee against the company’s former CEO, the employee severance payment the CEO was ordered to disgorge did not constitute “Loss” within the meaning of the D&O policy. In re Transtexas Gas Corp., 597 F.3d 298, 310 (5th Cir. 2010)(“Payments fraudulent as to creditors that must therefore be repaid due to bankruptcy court order [are] a disgorgement of ill-gotten gains and a restitutionary payment.”). Other courts have rejected such an approach as an overbroad application of vague notions of public policy. In Federal Ins. Co. v. Continental Casualty Co., 2006 WL 3386625 (W.D. Pa. Nov. 22, 2006), a case arising from an action to recover alleged fraudulent transfers to former directors and officers under the Bankruptcy Code, the court refused to find that public policy rendered the preferential transfers uninsurable under state law. The court recognized that because liability in a fraudulent transfer action is strict, without regard to fault, “allowing the insured to collect under its insurance policy would not encourage others to intentionally engage in unlawful activity with the purpose of reaping a benefit from such activity through its insurance.” Id. at 23. The court observed that the insurance company already had a safeguard in place to prevent the insureds from reaping a windfall, namely, the Illegal Profit Exclusion. Id. Thus the court properly refused to second guess an expressly stated term of the policy based on public policy arguments. 

 

In light of the J.P. Morgan ruling, insurers and insureds alike are well advised to take a fresh look at their policy wordings. The expanding use of the restitution defense, and the inherent difficulty in applying policy language to contractual terms such as restitution and disgorgement, strongly suggest that policyholders should demand clearer policy language. On the negative side, a few policies now expressly exclude restitution and disgorgement from the definition of Loss, without defining those terms. Some policies are silent and some exclude from Loss any damages that are uninsurable as a matter of state law. From a policyholder’s standpoint, it makes good sense to insist on coverage for restitution/disgorgement to the fullest extent insurable under the law, absent final adjudication that the disgorgement was to remedy illegal profit or criminal conduct. Even in the unlikely event that a state’s “public policy” would prohibit enforcement of such contracts, an insurer can surely stipulate in its policy that it will not assert that restitutionary damages are uninsurable unless there is a final adjudication of illegal profit or conduct. It is already widely accepted wording in almost every D&O policy (usually in the definition of “Loss”) that the insurer will not assert that (restitutionary) damages imposed under Sections 11 or 13 of the Securities Act are uninsurable as a matter of law; so this recommendation is in no way a “stretch.” Given the decade of litigation over these issues, for insurers to continue to assert this phantom exclusion instead of setting forth a clear statement in their policies is the real violation of public policy.

 

© Peter M. Gillon 2013

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An insurer that breached its duty to defend may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him, according to a June 11, 2013 decision from the New York Court of Appeals. The Court of Appeals opinion can be found here.

 

A legal malpractice insurer had disclaimed a defense duty under its policy and a default judgment was entered against its insured. When the judgment creditor sought to enforce the judgment against the insurer, the insurer asserted coverage defenses based on policy exclusions other than it asserted in disclaiming its defense duty. The Court of Appeals ruled that the insurer that had denied its duty to defend could litigate only the validity of its disclaimer and could not rely on other policy exclusions to dispute its indemnification obligations.

 

Background

Goldan, LLC borrowed $2.83 million from two other companies. The loans were to be secured by mortgages. Goldan defaulted on the loans. The lenders then learned that the mortgages had not been recorded. The lenders sued Goldan and two of its principles, Mark Goldman and Jeffrey Daniels. The plaintiffs asserted a claim against Daniels for legal malpractice, alleging that Daniels had acted as the plaintiffs’ attorney with respect to the loan and that his failure to record the mortgages was “a departure from good and accepted legal practice.”

 

Daniels notified his legal malpractice carrier of the claim, which refused to provide either a defense or indemnity, stating that the allegations against Daniels “are not based on the rendering or failing to render legal services for others.”

 

The plaintiffs made a $450,000 settlement demand on Daniels (an amount well below the malpractice policy’s $2 million policy limit), which Daniels transmitted to the insurer. The insurer rejected the demand on the same ground on which it had denied coverage. Daniels then defaulted on the underlying claim and the plaintiffs obtained a default judgment against him in excess of the policy limit. Daniels assigned his rights under the malpractice policy to the plaintiffs, who then filed suit against the insurer for breach of contract and bad faith.

 

The insurer moved for summary judgment in reliance on two policy exclusions, the “insured’s status” exclusion (which precludes coverage for claims against an insured in his capacity as an officer, director or employee of a business enterprise) and on the “business enterprise” exclusion (precluding coverage for claims based on acts or omissions by any insured for any business enterprise in which the insured has a controlling interest). The plaintiffs cross-moved for summary judgment.

 

The trial court granted summary judgment for the plaintiffs on the breach of contract action, but granted the insurer’s motion for summary judgment on the bad faith claim. The intermediate court affirmed both rulings; the appellate court affirmed the breach of contract ruling on the grounds that the policy exclusions on which the insurer sought to rely were inapplicable. Two intermediate appellate judges dissented, arguing that there was an issue of fact whether the exclusions applied. The parties cross-appealed.

 

The June 11 Opinion

In a ten-page opinion written by Judge Robert S. Smith for a unanimous court, the Court of Appeals affirmed as to both claims, although with respect to the breach of contract issue, the Court of Appeals affirmed on different grounds than relied upon by the intermediate appellate court. The Court of Appeals did not reach the question of whether or not the exclusions on which the insurer relied precluded coverage here. Instead, the Court of Appeals held that when a liability insurer has breached its duty to defend its insured, the insurer may not later rely on policy exclusions to escape its duty to indemnify the insured for a judgment against him.

 

The Court of Appeals first confirmed that the insurer had a duty to defend the underlying claim. The Court of Appeals noted that the plaintiffs’ claim against Daniels “unmistakably pleads a claim for legal malpractice.” The allegations that Daniels had acted as the plaintiffs’ lawyers in the loan transaction were “unusual” and may even have been “groundless,” but that “does not allow” the insurer “to escape its duty to defend.” It might have been different “if the claim were collusive,” but the insurer did not assert collusion.

 

The Court then went on to hold that, having breached its duty to defend, the insurer could not rely on other grounds to contest a duty to indemnify its insured. The Court said that “an insurance company that has disclaimed its duty to defend may litigate only the validity of its disclaimer.” If, the Court said, “the disclaimer is found bad, the insurance company must indemnify its insured for the resulting judgment, even if policy exclusions would otherwise have negated the duty to indemnify.”

 

The Court justified this rule by saying that it “will give insurers an incentive to defend the cases they are bound by law to defend, and thus to give insureds the full benefit of their bargain.” The Court added that “it would be unfair to insureds, and would promote unnecessary and wasteful litigation, if an insurer, having wrongfully abandoned its insured’s defense, could then require the insured to litigate the effect of policy exclusions on the duty to indemnify.”

 

The Court did allow that “perhaps there are exceptions” to this rule. The Court noted that perhaps an insurer should not be barred from asserting that its insured injured the plaintiff intentionally. However, the Court noted, “no such public policy argument is available to [the insurer[ here.” Here, the insurer “having chosen to breach its duty to defend, cannot rely on policy exclusions to escape its duty to indemnify.”

 

Finally, the Court affirmed the lower court’s dismissal of the plaintiffs’ bad faith claims. Although the plaintiffs alleged that the insurer had failed to settle the underlying claim, the Court of Appeals noted that their claim was really not for a bad faith failure to settle, but for a bad faith failure to defend. The Court of Appeals said that “we need not decide …whether such an allegation could ever support a claim for damages in excess of the policy limit,” as “such a claim would require the insured to show, at a minimum, that the judgment against him would not have been entered if the insurer had defended the case,” which had not been alleged here.

 

Discussion

At the heart of the Court of Appeals decision seems to be a view that this insurer should have defended its insured.  The Court of Appeals clearly did not even consider the defense duty to be a close question. The underlying claims may have been both odd and groundless, but the insurer still had the obligation to defend its insured. (Not only that, but it seems pretty clear that the insurer would have been way better off if it had just defended its insured.) 

 

At first blush, this seems like a very adverse decision for insurers. But closer review suggests a reading that is a little less threatening for the insurers. One possible message from the Court of Appeals ruling is that this insurer was simply too terse when it denied it had an obligation to defend; it does seem that if the insurer had cited all of the alternative grounds on which it eventually sought to rely, it would have been able to rely on those grounds in contesting coverage. Certainly, going forward, any insurer denying the duty to defend under a liability insurance contract to which New York law applies will want to comprehensively state the basis on which it is denying a defense duty.

 

On the other hand, even if the insurer here had provided a more comprehensive basis for its rejection of the duty to defend, and thus preserved its right to rely on the two policy exclusions, it likely wouldn’t have helped the insurer in the end. A majority of the judges at the intermediate appellate court – the only court to consider the applicability of the exclusions on which the insurer sought to rely – concluded that the exclusions did not apply. Even though two judges dissented, the message seems to be that the insurer lacked a basis to disclaim a duty to defend. And so, again, the main message from this case seems to be that insurers should be very wary of disclaiming the duty to defend (rather than any arguable alternative message about taking greater care and being more comprehensive when disclaiming a defense duty).

 

Even if insurers consider the rule the Court of Appeals enunciated here to be harsh, the Court did provide one (small) escape hatch. The Court did acknowledge that there could be public policy exceptions to the preclusive rule it defined in this case. How broad this public policy exception might prove to be is unclear. However, I suspect there will be a host of cases in the future in which this exception will be better defined.

 

In a June 13, 2013 post on its Insurance Law Blog (here), a memo from the Traut Lieberman law firm states that the Court of Appeals decision "announced a new rule," and that previously "New York courts at both the state and federal level consistently rejected the notion that by having breached a duty to defend, an insurer is estopped from relying on coverage defenses for the purposes of contesting an indemnity obligation." The Court of Appeals decision "departs from this long-established jurisprudence."

 

FDIC Launches Another Failed Bank Lawsuit: On June 10, 2013, the FDIC as receiver for the failed Sun American Bank of Boca Raton, Florida, filed a lawsuit in the Southern District of Florida against seven former directors and officer of the bank. The FDIC’s complaint can be found here. The bank failed on March 5, 2010, well over three years ago, suggesting that the parties had previously reached some type of tolling agreement. The FDIC asserts claims against the defendants for negligence and gross negligence. The FDIC alleges that the defendants failed to use safe and sound banking practices and failed to adhere to prudent underwriting practices in approving a total of seven loans.

 

According to news reports about the FDIC’s lawsuit against the former bank directors and officers, this latest suit represents the seventh that the agency has filed in connection with a failed Florida bank. The FDIC has now filed a total of 66 lawsuits against former directors and officers of banks that failed during the current bank failure wave, including 22 so far during 2013.

 

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Among its many provisions, the Dodd-Frank created a new Federal Insurance Office within the U.S. Department of Treasury. The Act requires the FIO’s Director to provide a report each year to the President and to Congress “on the insurance industry and any other information deemed relevant by the Director or requested [by a Congressional] Committee.” The initial report was due in January 2012; like many of the regulatory actions required under the Dodd-Frank Act, the initial report was delayed. However, on June 12, 2013, the FIO finally released its first report, which can be found here. The Treasury Department’s June 12, 2013 press release about the report can be found here.

 

Though the report weighs in at a slim 53 pages (including endnotes), the report covers a lot of ground. It not only provides a financial overview of the U.S. insurance industry, but it also reviews, from the perspective of the U.S. insurance industry, the efforts that have been undertaken in the wake of the financial crisis to try to improve financial stability.

 

Among other things, the report notes that the U.S. insurance industry’s aggregate 2012  premiums totaled more than $1.1 trillion, or about 7 percent of U.S. gross domestic product. The industry directly employs 2.3 million people or 1.7 percent of the country’s nonfarm payrolls. (Those employment figures do not include the additional 2.3 million licensed insurance agents and brokers). The U.S. insurance industry also reports total assets of $7.3 trillion, of which $6.8 trillion represents invested assets.

 

The industry has shown recovery and improvement since the financial crisis. Both the Life and Health and the Property and Casualty sectors reported improved profitability in 2012. Moreover, at year-end 2012, reported surplus levels were at record highs for both the Life and Health and for the Property and Casualty sectors. At year end, the Life & Health sector reported surplus of about $329 billion and the Property and Casualty Sector reported surplus of about $597 billion.

 

Amidst all of these positive developments there are also some challenges – particularly the interest rate environment and the level of natural catastrophes.

 

 As the report notes, “despite near record net investment income in 2012, insurers’ investment yields remained low as a percentage of invested assets.” The low interest rates pose a “challenge for insurers seeking to balance investment risk and return.” The low interest rate environment poses a particular challenge for life insurers offering annuities with guaranteed benefits. The low interest rates also affects the present value of insurer contract obligations, particularly those of life insurers; as interest rates have decreased, the present value of future obligations have increased.

 

But though increased interest rates would produce improved investment returns, a sudden increase would involve other threats. Were interest rates to increase suddenly, interest rate levels would increase unrealized losses in insurer fixed income portfolios and could also prompt policyholders of interest bearing contracts to surrender the contracts for higher yield elsewhere.

 

Natural catastrophes also continue to pose a significant challenge to insurers. 2011 was the second costliest year on record for natural catastrophes in the United States, with insured losses estimated to be about $44.2 billion (the most significant losses were during 2005, the year of Hurricane Katrina and other hurricanes). The estimate for catastrophic losses during 2012 is about $43 billion, only slightly below 2011.

 

The body of the report contains several other items of interest, including several tables listing the largest insurers (by premium volume) within various industry sectors. The report also includes detailed financial information divided by sector, including aggregate information on the various sectors’ annual underwriting results. Among other things, the underwriting results information shows that during the catastrophe-driven years of 2011 and 2012, the Property and Casualty sector experienced underwriting losses. (The P&C industry combined ratio for 2011 was 108.3 and for 2012 was 103.3.)

 

My own observation about the interest rate environment is that it is directly affecting insurers’ underwriting behavior. Ordinarily, the expectation at a time when insurers are reporting record levels of surplus would be that there would be a great deal of competition in the marketplace, particularly on price. However, because the low interest rate environment means that investment income is under pressure, the insurers are forced to try to make their calendar year profitability from their underwriting operations. In order to try to produce an underwriting profit, the insurers are under pressure to try to increase pricing. The end result for insurance buyers is that they are facing pricing increases – particularly in the commercial insurance arena, where catastrophic losses in the P&C sector have meant consecutive years of underwriting losses.  

 

Natural catastrophes have been part of life throughout history. But as insured values increase and possibly as climate change produces more extreme weather events, the human (and therefore the insurance) impact from catastrophes has increased. It is far too early to tell how this year will turn out from a catastrophe perspective, but with the recent tornadoes in Oklahoma and with the Hurricane season just underway, we all have reason to be watchful and wary.

 

More About Insurance Coverage for Cyber Breaches: In a recent two-part series, Roberta D. Anderson of the K&L Gates law firm reviews the availability of insurance coverage to protect against losses arising from cyber breaches. The two installments can be found here and here.

 

The first installment provides background regarding the exposure and reviews the limitations associated with trying to obtain insurance coverage for cyber breaches under Commercial General Liability policies. The second installment goes on to discuss the limitations associated with trying to obtain insurance coverage for cyber breaches under property policies and other traditional insurance policies. The second installment then goes on to discuss the advent and development of purpose built cyber policies in the insurance marketplace. The article describes the first-party and third-party protection available under the cyber policies and the specific ways that the policies are designed to respond to various types of cyber incidents. The article reviews and compares various policies’ specific terms and conditions.

 

The two articles provide a quick but comprehensive overview of this emerging area of liability and insurance.

 

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In a June 11, 2013 opinion, the New York Court of Appeals held that Bear Stearns is not barred from seeking insurance coverage for a $160 million portion of an SEC enforcement action settlement labeled as “disgorgement,” where Bear Stearns’ customers rather than Bear Stearns itself profited from alleged misconduct.  The Court’s opinion reversed the ruling of an intermediate appellate court which had held that Bear Stearns could not seek insurance coverage for the settlement amount labeled as “disgorgement.” The opinion of the Court of Appeals can be found here.

 

Background

In 2006, the SEC notified Bear Stearns that the agency was investigating late trading and market timing activities units of Bear Stearns had undertaken for the benefit of clients of the company. The agency advised the company that it intended to seek injunctive relief and monetary sanctions of $720 million.

 

Bear Stearns ultimately made an offer of settlement and --without admitting or denying the agency “findings” – consented to the SEC’s entry of an Administrative Order, in which, among other things, Bear Stearns agree to pay a total of $215 million, of which $160 million was labeled “disgorgement” and $90 million as a penalty.

 

At the relevant time, Bear maintained a program of insurance that, according to the subsequent complaint, totaled $200 million. Bear Stearns sought to have the carriers in the program indemnify the company for the SEC settlement. However, the carriers claimed that because the $160 million payment was labeled “disgorgement” in the Administrative Order, it did not represent a covered loss under the insurance policies.

 

In 2009, J.P. Morgan (into which Bear Stearns merged in 2008) filed an action seeking a judicial declaration that the insurers were obliged to indemnify the company for the amount of the $160 million payment in excess of the $10 million self insured retention. The company argued that notwithstanding the Administrative Order’s reference to the amount as “disgorgement,” its payment to resolve the SEC investigation constituted compensatory damages and therefore represented a covered loss under the insurance program. The carriers moved to dismiss the company’s declaratory judgment action.

 

In a September 14, 2010 order (here), New York (New York County) Supreme Court Charles E. Ramos denied the carriers’ motion to dismiss. He held that the Administrative Order’s use of the term “disgorgement” did not conclusively establish that the settlement amounts were precluded from coverage.

 

In reaching this conclusion, he noted that the Administrative Order “does not contain an explicit finding that Bear Stearns directly obtained ill-gotten gains or profited by facilitating these trading practices,” and he found that the provision of the Order alone “do not establish as a matter of law that Bear Stearns seeks coverage for losses that include the disgorgement of improperly acquired funds." Judge Ramos rejected the insurers’ argument that they were entitled to dismissal.

 

As discussed here, in a December 13, 2011 opinion (here), the N.Y. Supreme Court, Appellate Division, First Department, reversed the lower court’s holding, granted the motions to dismiss and directed the entry of judgment in favor of the insurers. The appellate court concluded that the “SEC Order required disgorgement of funds gained through that illegal activity,” and that “the fact that the SEC did not itemize how it reached the agreed upon disgorgement figure does not raise an issue as to whether the disgorgement payment was in fact compensatory.”

 

The intermediate appellate court  further noted that in generating revenue of at least $16.9 million, “Bear Stearns knowingly and affirmatively facilitated an illegal scheme which generated hundreds of millions of dollars for collaborating parties and agreed to disgorge $160,000,000 in its offer of settlement.”  Bear Stearns appealed the intermediate appellate court’s ruling.

 

The June 11 Court of Appeals Decision

In a June 11 opinion written by Judge Victoria Graffeo for a unanimous court, the Court of Appeals reversed the intermediate appellate court and reinstated Bear Stearns’  complaint.

 

The insurers had argued that coverage for the “disgorgement” amount was precluded on two different coverage ground; first, that public policy prohibits insurance when an insured has engaged in conduct “with the intent to cause injury;” and second, that public policy prohibits insurance for disgorgement amounts.

 

The Court of Appeals first rejected the intentional injury argument, holding that though the SEC’s order recited that Bear Stearns has willfully violated federal securities laws, the Court of Appeals could not conclude that the public policy coverage preclusion applied. The SEC order, “while undoubtedly finding Bear Stearns’ numerous securities law violations to be willful, does not conclusively demonstrate that Bear Stearns also had the requisite intent to case harm.”

 

The Court of Appeals also rejected the insurers’ argument that public policy prohibits insurance for the “disgorgement” amounts. The Court of Appeals found that the SEC Order “does not establish that the $160 disgorgement payment was predicated on moneys that Bear Stearns itself improperly earned.” Rather, the order recites that Bear Stearns’ misconduct allowed its customers to profit.

 

The Court of Appeals found that the cases on which the insurers sought to rely in arguing that insurance coverage is precluded for disgorgement amounts linked the disgorgement payment to improperly acquired funds in the hands of the insured. The cases, the Court of Appeals said, “directly implicated the public policy rationale for precluding indemnity – to prevent the unjust enrichment of the insured by allowing it to, in effect retain the ill-gotten gains by transferring the loss to its carrier.” In this case, the Court said, “Bear Stearns alleges that it is not pursuing recoupment for the turnover of its own improperly acquired profits and, therefore, it would not be unjustly enriched by securing indemnity.”

 

The carriers, the Court of Appeals said, had not identified a single case where coverage was prohibited when the disgorgement payment was, at least according to Bear Stearns’ allegations, linked to gains that went to others.

 

The Court of Appeals also rejected the insurers’ argument that the improper profit exclusion precluded coverage for Bear Stearns’ claims. The Court said that because Bear Stearns alleged that its misconduct profited others, not itself, “the exclusion does not defeat coverage.”

 

Discussion

Bear Stearns faced an uphill battle trying to argue, that a portion of the SEC settlement expressly labeled as “disgorgement” is not precluded from coverage based on case law establishing that public policy bars insurance coverage for “disgorgement” amounts.

 

Nevertheless, Bear Stearns was able to successfully argue that because at least $140 million of the disgorgement amount represented its customers’ profits, not its own, the company was not seeking to retain its own ill-gotten gains. The Court of Appeals observation that the insurers were unable to cite a single case in which coverage had been precluded under these kinds of circumstances is interesting.

 

The Court of Appeal’s holding suggests that there may be circumstances in which an insured might seek insurance coverage for an amount labeled as “disgorgement,” at least where the insured itself did not profit from the improper conduct that was the basis of the disgorgement. However, this holding is only going to be useful for insured’s seeking coverage in a limited range of circumstances. The Court of Appeals opinion will be of no help to insureds seeking coverage for “disgorgement” under the more typical circumstances where the insured is alleged to have profited from the wrongful conduct that was the basis of the disgorgement.

 

Nevertheless, the Court of Appeals decision does provide at least one example where an insured was permitted to seek insurance coverage for amounts labeled as a “disgorgement.”  Insureds will undoubtedly seek to rely on this decision when trying to seek insurance coverage for disgorgement amounts and insurers undoubtedly will argue that the insured’s claim does not involved the kind of circumstances presented here.

 

It probably should be noted that the Court of Appeals did not rule that the insurers’ policies covered the disgorgement amount. The Court of Appeals held only that Bear Stearns was not, based on the allegations in its complaint, precluded from seeking insurance coverage. The parties must now return to the trial court, where there will be further proceedings to determine whether or not there is coverage under the policies for the “disgorgement” amount.

 

A June 11, 2013 Memorandum by the Troutman Sanders law firm discussing the Court of Appeals decision can be found here.

 

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The bankruptcy context is particularly ripe for D&O claims, and it also represents a particularly difficult claims context for D&O insurers. Anyone with any doubts about just how complicated bankruptcy claims can be will want to take a look at the settlement that the various concerned parties recently reached in the bankruptcy of defunct Florida homebuilder, TOUSA, Inc.

 

As discussed below, various D&O insurers will be paying a total of $67 million to settle claims that had been asserted against former directors and officers of TOUSA and related entities. According to the motion papers, the settlement agreement is part of a “grand bargain” to resolve claims among the various parties in adversary proceedings filed in the bankruptcy matter, as a part of larger efforts to facilitate the entry of a liquidation plan for the TOUSA bankruptcy estate. The parties’ June 4, 2013 settlement agreement can be found here. The parties’ June 6, 2013 motion for court approval of the settlement can be found here.

 

The $67 million aggregate settlement amount does not include additional funds that will be contributed by at least one other D&O insurer that reportedly will be entering a separate settlement agreement, and also does reflect an additional $8.5 million that two of the insurers involved have agreed to pay toward incurred but as yet unpaid defense expenses. One of TOUSA’s D&O insurers declined to participate in the settlement, and the settlement contemplates an assignment to the bankruptcy estate and to secured lenders committee of the debtors’ and the insured persons’ rights against the non-settling insurer. The settlement agreement is subject to bankruptcy court approval.

 

Background

On January 29, 2008, TOUSA and related entities filed a voluntary bankruptcy petition in the Southern District of Florida. In the years prior to the bankruptcy, related TOUSA entities had entered into a joint venture known as Transeastern JV to acquire another Florida homebuilder. In connection with the JV various TOUSA entities entered into certain debt financing agreements. The joint venture later failed.

 

On June 14, 2008, the unsecured creditors committee filed an adversary proceeding in the bankruptcy matter against a total of 19 former directors and officers of TOUSA and related entities. The committee alleged that the defendants had breached their fiduciary duties by failing to act in the best interests of the various TOUSA corporate entities and of the entities’ constituencies, including the creditors, and that certain of the defendant aided and abetted these breaches. During the course of ensuing proceedings, the individual defendants filed a total of six motions to dismiss the fiduciary duty claims, each of which was denied by the bankruptcy court.

 

The debtors and the individual defendants submitted the fiduciary duty matter as a claim to TOUSA’s D&O insurers. Certain of the insurers denied coverage for the claim. The debtors and the individuals filed an insurance coverage action as an adversary proceeding  in the bankruptcy matter seeking a judicial declaration of coverage  After the coverage action was commenced, the parties entered into an interim funding agreement that allowed for the payment of the defense fees of the individual defendants in the fiduciary duty action.

 

In addition, in December 2009 certain of the lenders involved in financing the failed Transeastern JV sent demand letters to the debtors and to the individual directors and officers asserting claims against them in connection with the various JV lending transactions. The debtors submitted these demands as claims to TOUSA’s D&O insurance carriers, for which several of the D&O insurers denied coverage.

 

In August 2010, the court ordered the parties to mediation. The list of participants in the mediation is long; it includes various creditors committees, the various debtor entities, the various entities that were involved in proving the joint financing of the failed JV, the individual defendants themselves, and as many as 12 D&O insurers.

 

The Settlement Agreement

It is some measure of the complexity of this matter and the number of moving parts that the mediation commenced in August 2010 only finally resulted in a settlement that could be submitted to the court in June 2013.

 

A total of ten of TOUSA’s D&O insurers participated in the settlement agreement submitted to the court. The ten participating insurers (and their respective contributions to the $67 million settlement and also toward additional defense expenses) are listed on page 11 of the settlement agreement. An eleventh insurer (apparently from Bermuda) reportedly will be entering a separate agreement in an amount that is not specified in the motion papers. A twelfth insurer (identified in footnote 1 on page 3 of the settlement agreement) declined to participate in the settlement, and one feature of the settlement is the debtors’ and the individual defendants’ assignment of their rights against this one non-settling insurer.

 

The list of the various parties and participants to this “grand bargain” settlement consumes more than two pages of the settlement agreement. As might be expected with a list of participants that long, the settlement agreement is complicated. As explained on page 9 of the motion for approval of the settlement, the $67 million settlement amount will be divided, with almost $48 million going to the unsecured creditors in connection with the breach of fiduciary duty claims; and a total of about $19 milliongoing to the various JV lenders, with this amount to be further divided among the lenders in differing amounts according to their respective interests. Presumably the separate settlement agreement with the Bermuda insurer will contribute additional amounts toward these various settlement funds.

 

Discussion

The settlement documents does not detail how TOUSA’s D&O insurance program was arranged, but the D&O insurers’ varying payment amounts specified in the settlement agreement suggests that the insurance was arranged as a tower and that the various insurers contributed toward the settlement according to their respective attachment point in the tower, with each succeeding insurer in the tower contributing a correspondingly smaller amount.

 

It is not clear from the settlement papers, but it appears that the insurance programs from more than one policy year may have been implicated here  (for example, the description of the complications involved with defense counsel payments suggests that there was a dispute between at least two carriers that might have been the primary carriers). Obviously, the involvement of more than one insurance tower and questions whether only one or both of the towers had been triggered represented a further complicating factor in trying to reach a settlement agreement.

 

Given the bankruptcy context, it seems probable that the insurance was funded as a loss under the D&O insurance policies’ Side A coverage (providing coverage for amounts that are not indemnified, whether due to insolvency or legal prohibition). This detail may have been relatively unimportant to the various “traditional” D&O insurers. But to the extent that any of the excess D&O insurers were providing only excess Side A insurance (or Excess Side A/DIC) insurance, this is a very important distinction, because if these losses were not Side A losses the Excess Side A insurers’ coverage would not have been triggered. From outward appearances (and it is always hard tell from the outside) at least some of the contributing D&O insurers were Excess Side A insurers. If that is the case, then this represents yet another recent example where the Excess Side A limits have been called upon to contribute toward a major D&O loss.

 

I can only imagine how difficult it was for the various parties to reach a settlement understanding in this case.Actually, that isn’t quite right – I really can’t imagine how they reached a settlement understanding.

 

With all of the competing claimants and the varying and competing interests, and the various insurers – many of them disputing whether there coverage was even involved owing to questions whether more than one tower of insurance was involved – trying come up with a framework for settlement, figuring out how much each insurer would contribute, and then deciding how the various contributions would be divided among the various claimants, had to have been an absolute nightmare. Just to add to the mix, there were further complications owing to the Bermuda insurer and to the one remaining excess insurer that declined to participate in the settlement. And throughout all of this, defense costs that would erode the amount of limits remaining for settlement were being incurred.

 

There is probably much more besides that could be said about this settlement, particularly by someone with an inside perspective (and I encourage anyone with a perspective on this settlement to add their comments to this post, using this blog’s comment feature if possible and posting anonymously if necessary).

 

The one last thing I will say is that this massive settlement is yet another example of a jumbo D&O settlement outside of the context of securities class action litigation. As I have noted numerous times in recent years on this site, the mix of corporate and securities litigation is changing, and while securities class action litigation remains important, it is now one of multiple sources of significant corporate and securities litigation. Increasingly, these other types of corporate and securities lawsuits are contributing significantly to the severity of losses in this arena. The number of jumbo D&O settlements that do not involve securities class action litigation continues to grow.

 

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On June 4, 2013, the Second Circuit, in an insurance coverage action involving the defunct Commodore International computer company, affirmed that excess D&O insurance is not triggered even if losses exceed the amount of the underlying insurance, where the underlying amounts have not been paid due to the insolvency of underlying insurers. The Second Circuit’s June 4, 2013 opinion can be found here.

 

The Second Circuit’s opinion is important because it represents the first time the Circuit has revisited its venerable and influential 1928 opinion in the Zeig v. Massachusetts Bonding & Insurance Co.

 

As I noted in my discussion of the district court’s decision (here), this is a tale haunted by the ghosts of several long-lost companies – not only the ghost of Commodore itself (the manufacturer of the classic Commodore 64 computer), but also the ghosts of Reliance Insurance Company, which went into regulatory liquidation in 2001, and of The Home Insurance Company, which went into liquidation in 2003. This case not only analyzes the requirements to trigger the obligations of excess insurers, but it also serves as an important reminder of the chaos that can follow when carriers become insolvent.

 

Background

Commodore filed for bankruptcy in 1994. In the bankruptcy proceeding, various claims were asserted against the company’s former directors. The individuals sought insurance protection for these claims from Commodore’s D&O insurers. Commodore had a D&O insurance program with total limits of $51 million, arranged in nine layers, consisting of a primary layer of $10 million and eight excess layers in varying amounts. Unfortunately for Commodore’s former directors, the first and fourth level excess layers were provided by Reliance and the third and sixth level excess layers were provided by The Home.

 

The primary D&O insurance was exhausted by payment of losses. However, due to Reliance’s insolvency, the individuals were unable to obtain insurance for losses that went into the next layers of insurance. The individuals sought to have the solvent excess insurers that provided the insurance layers above the insolvent carriers pay their defense expenses and other loss costs. These “next level” excess insurers filed an action seeking a judicial declaration that they had no obligation to “drop down” to fill the gaps created by the insolvent insurers, and also seeking a declaration that their excess insurance obligations had not been triggered because the underlying layers had not been exhausted by payment of loss. The individual directors contended that the excess insurers’ payment obligation had been triggered because their liabilities exceeded the amount of the underlying insurance.

 

The solvent excess insurers’ policies all contained a similar provision essentially providing that the payment obligation under the policies is triggered only “in the event of exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses.”

 

As discussed here, on September 28, 2011, Southern District of New York Judge Richard Sullivan granted the insurers’ motion for summary judgment. He ruled that the “next level” excess insurers had no obligation to drop down to fill the gaps caused by the insolvency of Reliance and of The Home. (Judge Sullivan’s ruling on the “drop down” issue was not appealed and was not before the Second Circuit). Judge Sullivan also concluded that the “next level” excess insurers obligations had not been triggered merely because the individuals’ liabilities exceeded the amount of the underlying insurance.

 

Judge Sullivan found that the “express language” in the excess insurers’ policies required exhaustion of the underlying limits by actual payment of loss in order to trigger coverage. He said that it is “clear from the plain language of the Excess Policies … that the excess coverage will not be triggered solely by the aggregation of Defendants’ covered losses. Rather the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”

 

Following further proceedings in the District Court, the individual directors appealed Judge Sullivan’s summary judgment ruling.

 

The June 4 Opinion

In June 4, 2013 Opinion written by Judge José Cabranes for a unanimous three-judge panel, the Second Circuit affirmed Judge Sullivan’s ruling. The appellate court said that “the plain language of the insurance policies supports the view of the insurer appellees.”

 

The individual directors had argued that the excess insurers’ payment obligation attached when defense or indemnity obligations reached the excess insurers’ respective attachment points. The Second Circuit said that “’obligations’ are not synonymous with ‘payments’ on those obligations,” adding that “to hold otherwise would make the ‘payment of’ language in these excess liability contracts superfluous.” The appellate court added that “because the plain language of the contracts specifies that the coverage obligation is not triggered until payments reach the respective attachment points, the District Court properly denied the Directors’ request for a declaration that coverage obligations are triggered once the Directors’ defense and indemnity obligations reach the relevant attachment point.”

 

Interestingly, the Second Circuit noted that the District Court had never actually said that the underlying insurers must make the payments before the excess insurers’ obligations were triggered. The appellate court noted that the District Court, echoing the excess policies’ themselves, “described the requirements in the passive voice and did not specify which party was obligated to make the requisite payments.” The District Court, the appellate court noted, “did not err in doing so,” as denying the directors’ request “did not require ruling on whether the underlying insurers, in particular, were required to made the payments; the Directors simply sought a declaration that the excess policies’ coverages are triggered once the respective attachment points were reached.”
 

 

The Second Circuit also rejected the individual directors attempt to rely on the Second Circuit’s 1928 Zeig opinion. (Zeig had held that an insured under a property insurance program could obtain the benefits of an excess policy where the insured’s loss exceeded the amount of the underlying insurance.) The appellate court did not overrule Zeig; rather, the Second Circuit distinguished Zeig.

 

First, the Second Circuit differentiated between the “context” in Zeig, in which the prior Court had been interpreting a first-party property policy, and the context in this this case, in which the Court was interpreting a third-party excess liability policy. The relevance of the question whether or not the amount of loss exceeded the amount of underlying insurance is clearly different in the context of a property policy than in the context of a third-party liability policy. The Second Circuit noted, quoting with approval from the Judge Sullivan’s opinion, that a third party liability insurer was within its right to require actual payment of the underlying amounts, so as to protect against collusive settlements.

 

Though the Second Circuit did not overrule Zeig, it did comment in a footnote that “though not relevant to our decision, it bears recalling that the freestanding federal common law that Zeig interpreted and applied no longer exists. See Erie R.R. Co. v. Tomkins, 304 U.S. 64 (1938), overruling Swift v. Tyson, 41 U.S. 1 (1842).”  

 

Discussion

If nothing else, this case serves as a reminder of the critical importance of carrier solvency. Carriers do not become insolvent frequently, but when they do, it is a mess. Here we are fully twelve years after Reliance went into liquidation (and nearly twenty years after Commodore went into bankruptcy) fighting about the problems caused when the carriers went bust. Unfortunately for the former Commodore directors, their insurance program had doubled down on the carriers that went insolvent; its insurance program included two layers of excess insurance each for both Reliance and The Home.

 

The Second Circuit’s holding that the excess insurers’ payment obligations were not triggered even though the individuals’ losses exceeded the amount of the underlying insurance is consistent with other recent decisions in which courts have interpreted the excess insurer’s trigger language to require exhaustion of the underlying insurance by the actual payment of loss (refer for example here and here).

 

Though the Second Circuit’s decision is consistent with other recent decisions on this topic, there are still a number of interesting things about this opinion. First of all, as noted above, this case apparently represents the first occasion on which the Second Circuit has revisited its venerable Zeig decision, a case on which policyholders have relied for years to try to compel their excess insurers to pay losses that exceeded the excess insurers’ layers.

 

The Second Circuit did not overturn Zeig, it merely distinguished the case. (For that matter, the Second Circuit didn’t even make clear which state’s law it was applying; in a footnote, the appellate court noted that the parties disputed whether Pennsylvania law or New York law applied, observing that “because there is no conflict between the relevant substantive law in these states however, we dispense with any choice of law analysis.”)

 

Just the same, I question whether or not Zeig remains good law after this decision in the Commodore case. As I noted above, the Second Circuit expressly noted that that “freestanding common law” that Zeig interpreted “no longer exists.” In light of this statement, I doubt whether Zeig represents reliable authority that could be cited and relied upon for the propositions it otherwise represents.

 

It is worth noting that for several years now, the D&O insurance marketplace has featured the availability of excess insurance policies with trigger language that allows the amount of the underlying limits of liability to be paid either by the insurer or the insured for the excess insurer’s payment obligation to be triggered. However, even if the policies of the solvent excess carriers in this case had included this modern language, the excess carriers’ payment obligations might not have been triggered; the clear suggestion of the Second Circuit’s analysis of the “payment of” language is that the underlying amounts had not been paid here, either by the insolvent insurers or by the insured persons -- which serves as a reminder that even the modern language does not solve every excess trigger problem.

 

It was interesting in the Second Circuit’s opinion that the appellate court expressly did not reach the question of whether the individual directors’ payment of the losses would have been sufficient to satisfy the “payment of” triggers of the excess policy. The Second Circuit’s commentary on this issue, and its analysis of the passive voice “payment of” language in the excess policy’s trigger, will give policyholders in coverage cases involving excess policies that lack the modern trigger a basis on which to argue for coverage. The policyholders could argue, if they have in fact themselves paid the underlying loss, that their payment of the loss satisfies the “payment of” trigger where the excess policy uses the passive voice and does not specify who must make the payment in order for the excess coverage to be triggered. 

 

Owing to the insolvency of Reliance and The Home, the individual directors here are left to face the underlying claims without the benefit of insurance. This dire circumstance provides a vivid illustration of the value of Excess Side A/DIC insurance, which by its terms would drop down and provide coverage in the event of the insolvency of an underlying insurer. Excess Side A/ DIC policies were available at the time that Commodore procured its D&O insurance, but the inclusion of these types of policies in a program of D&O insurance was not as common then as now. (The policies available then were more restrictive than those available today, as well.) If Commodore’s insurance program had included an Excess Side A/DIC policy, the individual defendants might have been able to rely on that policy to defend themselves despite the gaps caused by the insurers’ insolvency.

 

In any event, the time has finally come to draw a curtain on this production. At this point in a Shakespearean play, the stage directions would say: Exeunt stage left. And off into the night would troop the spirits of Commodore, Reliance and The Home – followed by the spirits of the several individual directors who have passed away while this seemingly interminable drama has dragged on. Among them would be the departing spirit of the late Alexander Haig, who during his mortal span of years was a Commodore director and who also served as Secretary of State under Ronald Reagan. He was not in fact “in control” during the tense hours after Reagan’s attempted assassination any more than he is now.

 

Special thanks to a loyal reader for sending me a copy of the Second Circuit’s opinion.

 

What is the Quickest Goal Ever Scored in a Soccer Game?:  I don't know for sure, but I doubt that there have been many goals scored faster than this goal by Enganamouit Gaelle Deborah, a striker for the FC Spartak women's soccer club in Russia. FC Spartak went on to defeat FC Pozarevac 7-0 in the championship game of the Serbian Women's League. Pay close attention, because if you blink you might miss the goal. 

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At times of trouble, D&O insurance can represent the last line of defense for corporate directors. For that reason, corporate board members rightfully are concerned about their insurance and want reassurance that their company’s policy will provide them the protection they will need. Unfortunately, directors don’t always know the questions to ask and only find out about problems after the claims have emerged.

 

In the following guest post, Paul Ferrillo and Ronit Berkovich of the Weil, Gotshal & Manges LLP law firm take a detailed look at the most important questions for directors and officers of troubled companies to ask about their D&O insurance. The authors address basic issues such as carrier and limits selection, as well as important questions about policy terms and conditions. This article was also published as a post on the Weil Bankruptcy Blog

 

I am grateful to Paul and Ronit for their willingness to post their article on this site. I welcome guest post submissions on topics of interest to this site’s readers. Please contact me directly if you are interested in publishing a guest post on this site.

 

Here is Paul and Ronit’s guest post:

 

We often get called into corporate calamities where “heavy water” is starting to overwhelm the bilge pump of the corporate yacht. Often in those situations good people like directors and officers, who are tasked with figuring out what to do to “save the ship,” must at the very same time try to figure out if they have enough directors and officers (“D&O”) liability insurance to weather the storm and protect them from the sharks.

 

Nautical allusions aside, trying to figure out if your D&O insurance is good enough when you are about to enter rough waters is not ideal for many reasons. First, it takes time to do so (and depending upon circumstances, there may be no time to tinker with the D&O coverage). Second, and more importantly, if there is a problem with your coverage, many carriers are reluctant to modify policy wording (to potentially “enhance” coverage) when a company is having financial difficulty because the carrier itself is worried about its own potential exposure to directors and officers claims (whether they might be lawsuits or regulatory investigations). To many less-forward thinking carriers, doubling down (in some respect, even if it serves to protect their insureds) sometimes makes no sense.

 

Finally, despite years of heavy claim activity and many large bankruptcies spurred by the financial crisis, we often still see the same problems with policies and towers of insurance. Why is that? We honestly cannot say. Sometimes corporations (and their boards) do not focus enough on D&O insurance issues because they are frankly too busy with other issues. Sometimes D&O insurance decisions are based not on “substance” issues, but on cost issues, which is generally not the right answer for many reasons. Furthermore, much of the literature dealing with D&O insurance tends not to be broadly disseminated to the folks who need the information most (like corporate directors and officers), and instead is left to the devices of risk managers and brokers who do not have much experience dealing with troubled company D&O issues.

 

Our goal in this piece is to place front and center the most important issues relating to “troubled company” D&O issues, so that directors and officers will understand what they need to know, and what to ask when questioning management on D&O coverage. These are not the only issues that should be addressed when considering the scope and breadth of D&O coverage, but certainly ones that should be at the top of any director’s and officer’s list. And truth be told, this advice should hold true for all companies and boards (not just troubled ones) because, as noted above, the best time to fix D&O issues is when the sailing is smooth, and not when the corporate yacht is about to sink.

 

Know Your Primary Carrier – Really Well

D&O insurance is frequently purchased in a “stack” or a “tower” of insurance, led by a primary carrier and multiple excess carriers. The excess policies are usually written in “follow form” nature, meaning they, in most cases, follow the terms and conditions of the primary carrier.

 

However, because neither insurance policy forms nor D&O carriers are fungible commodities, it is very important to understand who is the company’s primary D&O carrier, what coverage such carrier offers (either in its base form or by endorsement), and whether or not they “pay claims.” In many ways, the primary D&O carrier is like a critical vendor or business partner with whom the company cannot do without. In fact, the primary D&O carrier can sometimes be the most important business partner (and friend) a company and a director or officer can have. The hope is that when the seas are rough (like in an insolvency or restructuring scenario), the primary carrier will be there to respond to claims and ultimately protect the personal assets of the directors and officers involved – even in times where indemnification or advancement is unavailable or refused by the corporation.

 

A couple of points to consider:

 

1. What is the carrier’s claims handling and claims paying reputation? Is it business-friendly and coverage-neutral, or is the carrier known to try to find “outs” to coverage? Does the carrier have a free-standing claims department or does it farm out claims to coverage counsel? And if the company has multiple offices overseas, how does the D&O carrier handle cross-border claims or investigations? Through a bit of investigation, one can often learn from others (such as defense counsel or experienced D&O brokers) information that might indicate which way a carrier leans on these important questions. Obviously, the best carrier is one that will hang with the directors and officers even in the worst of times, and will not “run and hide” behind coverage defenses so it does not have to pay.

 

2. What is the carrier’s underwriting response to questions and potential modifications? What is the carrier’s responsiveness to requests to enhance coverage for the insured? These questions relate to the prior question. Directors, officers, and companies want a business partner in their primary carrier, not a “silent partner.” Many of the better carriers often will consider (and implement) policy changes even days or weeks before a bankruptcy filing to clarify policy language for the potential benefit of the insureds. Those are the types of carriers that a director or officer wants on his or her side.
Do You Have Enough Coverage?

 

This can be the most worrisome aspect to any director or officer caught up in a corporate storm. Unfortunately, this is also an area that is confusing because there are often no clear or “right” answers as to what limits should be purchased.

 

The most important thing a director or officer can do in this regard is ask many questions of management. Common sense suggests that for a $1 billion public company, $20 million of D&O insurance likely does not make sense. Similarly, for companies with substantial debt and perhaps not a lot of cash on hand, a low D&O limit also would not make sense. In addition to common sense, there are other available metrics directors and officers can consider. Very often, an experienced D&O broker can perform an exercise called benchmarking, which is designed to create an apples-to-apples comparison of the D&O insurance purchased by similarly situated companies. Thus, a company can look to a competitor in its space, or at its size, to determine what type and level of D&O insurance comparable companies have purchased. Finally, many larger companies with public debt or equity exposure can perform “mock” damages analyses to understand what a potential securities claim against them might look like from a damages and defense cost perspective. The variable here is that the cost of a simultaneous regulatory or criminal investigation, as discussed below, can vastly skew those amounts.

 

Can a company increase the limits of its D&O coverage midterm, or even after bad news surfaces? This is a question we often get. The answer is that it depends on the facts and the circumstances of the particular situation. Sometimes the circumstances a company faces are not so dire, and carriers will cooperate with the company’s desire to protect its directors and officers by agreeing to increase the limits of its tower (for a price, of course). Other times, the situation may be so severe that a request to increase limits will be politely declined. The later polite declination really proves our point. Directors and officers should ask questions up front regarding coverage amounts, and not wait until the corporate ship starts to keel over to request higher amounts. By then it might be too late.

 

Coverage for Regulatory and Criminal Investigations

Troubled companies often encounter a simultaneous regulatory (SEC/DOJ) or criminal investigation at the same time they are facing civil litigation. This is the potential “double whammy” of defense costs, which often can run into the millions depending on the situation. Thus, directors and officers need to know what sort of coverage their D&O insurance provides for such investigations because, to the extent such investigation constitutes covered loss under the D&O policy, every dollar spent on investigations will generally reduce the overall limits available to ultimately settle the underlying litigation.

 

The rules of the road are well established in this area. Directors and officers are generally covered under the company’s directors and officers insurance for regulatory and criminal investigations and inquiries. Corporations are generally not covered for their involvement in such situations, unless individual directors or officers are also simultaneously named in the investigation (these rules of the road are often different in the private equity space, which is beyond the scope of this article). Specialized policies in the D&O marketplace exist to cover regulatory and criminal investigation in those situations where only the company is named, though those policies are reported to be expensive. All other things being equal, a director or officer should ensure that he or she is covered for regulatory and criminal investigations and inquiries.

Why Does the Insured Versus Insured Clause (and Its Carve-outs) Really Matter?

The insured versus insured clause has been included in D&O policies for a long time. It finds its genesis in a carrier’s need to guard against collusive lawsuits brought by one insured (say, for instance, the company) against another insured (like a director or officer), solely designed to get to the proceeds of the company’s D&O policy.

 

Indeed, carriers may have valid reasons for not wanting to cover these types of lawsuits. But there are other types of potential “insured versus insured” lawsuits that should be covered (and thus “carved-out” of the insured versus insured exclusion) because they generally would not be collusive (and normally are just as hotly contested as suits brought by traditional third parties). Here is a list of certain types of lawsuits which we believe should be explicitly covered under the D&O policy (i.e., carved-out) to protect the interests of the directors and officers.

 

1. Shareholder derivative actions

2. Suits that generally arise in bankruptcy when bankruptcy-formed constituencies, such as creditors’ committees, bondholder committees, or equity committees bring an action derivatively on behalf of a bankrupt company for alleged breaches of fiduciary duty by the company’s directors and officers. Similarly, suits by trustees, liquidators and receivers against directors and officers should also be covered. As we have seen from very high-profile suits involving companies like The Tribune Company, Extended Stay, and BearingPoint, bankruptcy-formed constituencies and trustees have become much more aggressive and litigious over the years, and the threat of such suits simply cannot be ignored.

3. Whistleblower suits brought under the provisions of either Sarbanes-Oxley or Dodd-Frank.

 

What is Non-Rescindable Side A Coverage?

There are two general coverage sides to a D&O policy (leaving for another day the concept of outside director coverage). Coverage “Side A” is for non-indemnifiable loss, meaning loss for which a company cannot indemnify or is financially unable to indemnify. Under this side, the directors and officers are the insureds. Coverage “Side B,” on the other hand, is for indemnifiable loss. Under this side, the company is insured for securities claims.

 

Coverage Side A covers a range of different scenarios. For example, under Delaware law (where many corporations are incorporated), a company cannot indemnify its directors and officers for the settlement of a shareholder derivative action. And in bankruptcy, a company often will be unable to advance defense costs and to indemnify its directors and officers for claims. Indemnification claims by directors and officers against the company may be treated as unsecured claims that get pennies on the dollar, or may even be subordinated in certain circumstances.

 

As several of the noteworthy “financial fraud”-related bankruptcies have taught us, having “non-rescindable” Side A coverage is very important. “Non-rescindable” Side A coverage means what it says. Even in cases where a carrier may challenge as false statements made by a potentially complicit CEO or CFO in the company’s insurance application for D&O coverage (attaching to such application, for example, financial statements that later need to be restated), non-rescindable Side A coverage generally cannot be rescinded for any reason, which should allow the directors and officers to sleep better at night. Directors and officers should know that non-rescindable Side A coverage is generally standard in today’s D&O marketplace, and thus primary policies that do not have such coverage should be immediately updated.

 

What is Side A Excess Difference in Conditions Coverage (and Why Is It So Important)?

As noted above, having non-rescindable Side A D&O coverage is critically important. Having “Side A Excess Difference in Conditions” D&O coverage can be even more important. Why? This coverage reacts in two different, wonderful ways to protect directors and senior management.

 

First, it acts as “excess” Side A D&O insurance, meaning, in English, that it sits above the company’s traditional tower of insurance, and will pay Side A non-indemnifiable claims when the traditional tower is exhausted by either traditional indemnifiable claims or non-indemnifiable claims. Take, for example, a Company that has $50 million in traditional D&O coverage and $25 million of Side A Excess Difference on Conditions coverage, where $45 million of that insurance has already been exhausted by the settlement of a simultaneously commenced securities class action and SEC investigation. In such a case, the directors and officers would still have $30 million of Side A insurance to deal with, for example, the settlement of shareholder derivative litigation.

 

Second, most Side A Excess Difference in Conditions D&O Insurance has something called a “drop down” feature, meaning that if, for example, an underlying excess carrier refused to pay its limit of insurance for some coverage-related reason, the Side A Excess Difference in Condition carrier might have the contractual obligation to “drop down” and fill that layer. Thus, it is a critically important feature that potentially will help fill potential gaps in coverage. Also, note that most Side A Excess Difference in Conditions policies have very few exclusions (e.g., most do not have an insured versus insured exclusion), so they can be particularly helpful to directors and officers in navigating difficult claims.

 

What is the Priority of Payments Clause, and Why Is It Important?

A Priority of Payments clause specifies how a carrier should handle competing claims on a policy’s proceeds. For example, most Priority of Payments Clauses (some carriers call them “Order of Payments” clauses) specify that Side A claims get paid first, and then traditional Side B company reimbursement and indemnity claims get paid thereafter. Obviously, this approach is tremendously important to directors and officers who may need to defend themselves in securities class actions or bankruptcy-related or inspired litigation.

 

Some Priority of Payments clauses give the right to the company or a company officer (like a CEO or CFO) to “withhold” or “delay” payments made under Side B of a D&O policy until the time at which those payments are properly designated by the appropriate party. This type of discretion is potentially not a good thing. Why? Giving such potential discretion to the company or a company officer to withhold or direct payments under Side B of a D&O policy might be creatively viewed by some as giving the debtor in bankruptcy “a say” or “control” of the proceeds of the D&O policy, a situation that could be used by a creditor or other bankruptcy constituency to control or delay payments to the directors and officers under Side A of the Policy, again potentially leaving them without resources to pay their counsel. Years of experience counsels that carriers are very able to make policy reimbursement calls in bankruptcy settings, and the order of payments under a D&O policy should be left to them and not others.

 

Severability of the Application and Exclusions

The concept of “severability” is important in D&O policies for a simple reason: there are very often multiple insured persons under a D&O policy (often dozens), and it would be a bad thing if the wrongful, criminal, or even fraudulent conduct of one insured (say for instance a CFO who subsequently pleads guilty to “cooking the books”) could vitiate, void, or adversely affect coverage for the rest of the insureds under the policy. For this reason, most applications for D&O policies are fully severable (meaning statements made in the application by one insured person are generally not attributable to other directors and officers for the purpose of potentially rescinding coverage under the policy), and most “conduct exclusions” contained in D&O policies (like the fraud and criminal acts exclusion) are also fully severable as between insured persons, meaning one bad egg will not affect the coverage for the directors and management team.

 

Making a Better D&O “Mousetrap”

Admittedly, some of the above items are a bit difficult to understand conceptually for the non-insurance professional, and admittedly, directors and officers often have more pressing issues to deal with when trying to help their companies navigate through troubled waters. But as we have seen time and time again in our practice, very often D&O insurance becomes the lifeline for directors and officers when companies face trouble.

 

How can a director or officer stay on top of these issues in the most efficient manner possible? Here are a couple of suggestions:

 

(1) Ask the right questions to the right people, like the company’s risk manager, CFO, or general counsel, as to what is covered and what is not, and ask about the above issues to make sure you are comfortable that at least these points are properly covered. Again, common sense often prevails here, and if a director or officer does not like the answers he or she is getting, then corrective action should be demanded before it is too late to act.

 

(2) Make D&O insurance issues a board topic at least twice a year so that board members can stay abreast of coverage developments, options, and modifications.

 

(3) Make sure management sends out the company’s D&O program and tower of insurance at least once a year for a “tune-up.” In this area, coverage options often change, and better coverage can often be obtained so long as the right diagnosis is made by qualified persons such as an experienced D&O broker, or even sometimes, experienced outside counsel.

 

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One of the more interesting recent developments in the world of corporate and securities litigation was the $139 million settlement of the News Corp. shareholders derivative suit. Not only is this settlement apparently the largest ever cash settlement of a shareholders derivative suit, but the entire amount of the settlement is to be funded by the company’s D&O insurance. In the latest issue of InSights, which can be found here, I take a detailed look at the News Corp. settlement and discuss the settlement’s significance and possible implications.

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A recurring D&O insurance coverage issue is the question of whether or not the D&O insurance policy provides coverage for a plaintiffs’ fee award. The question often arises in the context of a settlement of a shareholders’ derivative suit that includes an agreement to pay the plaintiffs’ attorneys fees as part of the settlement. In many instances, the settling company’s D&O insurer will contest coverage for the plaintiffs’ attorneys’ fees.

 

In a May 28, 2013 Law 360 memorandum by Anthony Tatum and Shelby S. Guilbert, Jr. of the King & Spalding law firm entitled “Securing D&O for Attorneys’ Fees in Securities Cases” (here, subscription required), the authors present their views on this recurring coverage issue. The authors contend that “the plain language of most D&O policies, as well as the reported cases where this issue has been litigated, demonstrate that plaintiffs’ attorney’s fees should be covered.”

 

Carriers rely on several arguments when they contend that the plaintiffs’ fees are not covered under the policy. The principal argument on which they rely is that the plaintiffs’ attorneys’ fees portion of a derivative settlement represents a cost the company incurred in order to secure the benefits obtained for the company in the derivative lawsuit. The insurers argue that because the fees represent the cost of procuring a benefit for the company, they do not represent “damages” or otherwise represent covered “Loss” under the policy. Carriers will also sometimes argue further that under the “American rule,” each party to civil litigation bears its own costs, and so the agreement to pay the plaintiffs’ attorneys’ fees is a voluntary payment rather than a “Loss” to the company.

 

In their article, the authors argue that the typical D&O insurance policy has a very broad definition of Loss, typically including “damages, settlements, judgments and defense costs.” This broad definition typically contains no restriction or limitation removing plaintiffs’ attorneys’ fees from the definition of “Loss.” The authors assert that “when D&O insurers include broad definitions … but fail to specifically bar recovery of plaintiffs’ attorney’s fees, D&O policyholders have a compelling plain language argument that plaintiffs’ attorneys’ fees are covered loss.”

 

The authors argue further that, in addition to the policy language, “case law also generally supports the view that plaintiffs’ fees are covered loss.” The authors review at length the 2011 opinion of the First Department of New York’s Appellate Division in XL Specialty Insurance Co. v. Loral Space & Communications (here), in which the intermediate appellate court held that an insured’s payment of attorneys’ fees to plaintiffs’ counsel in a derivative lawsuit was covered loss, even though the lawsuit arguably benefitted the insured company. The authors also review two other decisions from other jurisdictions that the authors contend are “consistent” with the Loral case.

 

The authors conclude, with respect to the cases  they reviewed, that

 

The takeaway from all of these cases is that consistent with the plain language of most D&O policies, courts generally view plaintiffs’ attorneys’ fees as just another type of damages. Plaintiffs’ attorneys’ fees fall squarely within the scope of most D&O policies’ definitions of key terms like “loss,” “damages and “claim,” and unless a D&O policy specifically excludes coverage for plaintiffs’ attorneys’ fees, such fees should be covered.

 

Policyholders are unanimous in their agreement with the authors’ views of this issue. In my experience, policyholders are shocked to learn that the carriers would even try to contend that the plaintiffs’ attorneys’ fee portion of a derivative settlement would not be covered. Nevertheless, while I am generally on the policyholder side of these issues these days, I do think it is important to note that the questions surrounding these issues have not been quite as definitively resolved as the authors suggest in their memo.

 

Among other things, it is very important to note that while a majority of three judges in the Loral case did conclude that the plaintiffs’ attorneys’ fees were covered, the ruling was accompanied by a spirited dissent by two other judges who argued strenuously that the fees should not be covered under the policy. As I discussed in a prior post regarding the decision (here), the dissent said that in order for the derivative fee award to be covered, it would have to represent "an actual loss, not an expense or the cost of doing business." The dissent reasoned that in this case, Loral "did not sustain a loss but rather benefitted from the judgment."

 

A fee award a derivative suit, the dissent observed, represents "the equitable entitlement of the successful derivative plaintiff to recover the expenses of his/her attorneys’ fees from all the shareholders of the corporation on whose behalf the suit was brought." The dissent observed that "if not spreading the cost of attorneys’ fees sounds in unjust enrichment, the obvious corollary is that shifting the cost to shareholders as a group cannot be characterized as a loss."

 

At a minimum, the vigorous dissent in the Loral case shows that judicial views on this issue are hardly uniform, and in view of the close vote in the case at the intermediate appellate level, the state of the law on these issues arguably is not settled. The narrowness of split between the majority and the dissent on this issue suggests that this dispute is far from resolved. The underlying issue is likely to continue to be debated in other cases.

 

I have long wondered whether all would be better off if this issue were addressed in the policy, along the lines of the way the industry developed a policy solution to the contentious issue that Section 11 settlements were not covered under the Policy. The way the industry addressed that issue is that it became standard to include in public company D&O policies language stating that the insurer would not take the position that a settlement of a ’33 Act case was not covered under the Policy. Perhaps the industry will adopt a similar approach on this derivative lawsuit fee award issue.

 

In the meantime, while we await a solution to this issue in the policy, policyholders will continue to argue that amounts agreed to in payment of plaintiffs’ attorneys’ fees in derivative settlements represent covered loss under the policy.

 

I would be very interested in hearing from others on this issue, particularly readers on the insurer side of the aisle who may have a different perspective on this recurring issue.

 

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As I have previously noted (refer for example here), one of the most vexing issues in the D&O claims arena is the questions of whether or not two claims are or are not interrelated. If the two are interrelated, they are deemed a single claim for purposes of determining the claims made date. The outcome of this analysis often can mean the difference between the availability of coverage and non-coverage for one or both of the claims.

 

In a recent D&O insurance coverage dispute in the Western District of Washington, Judge Richard A. Jones wrestled with the relatedness question in the context of a qui tam claim that followed after an earlier anti-retaliation claim. Having determined that the subsequent qui tam claim “related back” to the prior anti-retaliation claim, and that the subsequent claim was deemed made at the time of the earlier claim, Judge Jones then had to determine whether the two claims were also a single claim for purposes of the application of a policy exclusion.

 

As discussed in his March 11, 2013 opinion (here), Judge Jones determined that the “single claim” deeming term operates only with respect to the policy’s claims made provisions, but did not operate with respect to the application of the policy’s exclusions. Judge Jones’s opinion is the subject of a May 15, 2013 memorandum from Matt Jacobs and Jan Larson of the Jenner & Block law firm (here).

 

Background

In April 2009, Richard Klein, the former CFO of Omeros Corporation, notified the company that he believed he had been terminated from the company in retaliation for internally reporting what he contended was the provision of falsified time records to the National Institute of Health (NIH) in connection with an NIH grant. In September 2009, Klein filed a lawsuit against Omeros alleging that he had been fired in violation of the anti-retaliation provisions of the False Claims Act.

 

Omeros submitted the anti-retaliation claim to its management liability insurer, which provided both EPL and D&O insurance to Omeros. Pursuant to a reservation of rights, the insurer defended Omeros against the Klein suit under the EPL coverage section. The insurer ultimately exhausted the $1 million limit of liability applicable to the EPL coverage in defense of the Klein claim.

 

In November 2010, Klein sought leave to amend his complaint to include a qui tam action on behalf of the United States, asserting that Omeros had violated the False Claims Act. Omeros submitted this amended claim to its management liability insurer. The insurer agreed to defend the amended claim, again under a reservation of rights, under the D&O liability portion of its coverage. The insurer then filed an action seeking a judicial declaration that it there is no coverage under its policy for the qui tam action. Omeros filed a counterclaim contending that the insurer had breached its duties under the policy, acted in bad faith, and violated the Washington Insurance Fair Conduct Act.

 

The insurer moved for partial summary judgment, arguing that because Klein did not file his qui tam claim until November 2010, and because the applicable policy expired in October 2009, the qui tam action was not a claim made during the policy period, and therefore was not covered under the policy. Omeros argued, in reliance on the policy’s Related Acts provisions and definitions, that the subsequent qui tam action related back to the prior anti-retaliation claim, that the subsequent claim is deemed made at the time of the earlier claim, and as a result of the operation of these provisions is deemed a claim made during the policy period.

 

The relevant provisions of the Policy provide that

 

All Claims based upon or arising out of the same Wrongful Act or any Related Wrongful Acts or one or more series of any similar, repeated or continuous Wrongful Acts or Related Wrongful Acts, shall be considered a single Claim. Each Claim shall be deemed to be first made at the earliest of the following times:

1. when the earliest Claim arising out of such Wrongful Act or Related Wrongful Act is first made; or

2. when notice pursuant to section VII.B above [relating to notice of facts “which may be reasonably expected to give rise to a Claim”] of a fact, circumstance, or situation giving rise to such a Claim is given.

 

The D&O Coverage section of the Policy defines “Related Wrongful Acts” as “Wrongful Acts” that re “logically or causally connected by reason of common fact, circumstance, situation, transaction, casualty, event or decision.”

 

The March 11 Opinion

In his March 11, 2013 Opinion, Judge Jones held that “the qui tam claim and the anti-retaliation claim Mr. Klein raise in his initial complaint are based on related wrongful acts.” Judge Jones noted that Klein had alleged in his initial complaint and in his qui tam claim that Omeros had made false reports to the NIH, and accordingly the two claims were logically connected. The insurer had argued that there were differences between the qui tam claim and the anti-retaliation claim; for example, the former seeks recoveries for wrongs done to the United States, while the later seeks a recovery solely from wrongs done to Klein. Judge Jones said that “the policy’s test for a related wrongful act is not whether there are differences, but whether or not there is any ‘common fact, circumstance, situation event or decision’ that logically connects the acts.”

 

Judge Jones added that Omeros’s alleged false reporting “is a common event that logically connects the anti-retaliation and qui tam claims.” The facts underlying both claims “are common facts.” Because the facts are related within the meaning of the policy, the policy requires the insurer “to treat separate claims based on those wrongful acts as if they had been made on the date of the earlier claim.”

 

The insurer, Judge Jones noted, also had a “backup argument.” The insurer argued that if the policy required the two claims to be treated as a “single claim,” and because that “single claim” would have to include Klein’s original anti-retaliation claim, the following exclusion in the D&O portion of the policy was therefore triggered with respect to the qui tam claim: “The Insurer shall not be liable to make any payment for Loss in connection with a Claim made against any Insured …based upon, arising out of, directly or indirectly resulting from, in consequence of, or in any way involving any past, present or future actual or potential employment relationship.”

 

Judge Jones concluded that although the policy deems interrelated claims a single claim for purposed of determining when a claim was made, “they are not a single claim for purposed of applying policy exclusions that are unrelated to the claim-made nature of the policy.” He added that “it is reasonable to construe exclusions that have nothing to do with the claims-made nature of the policy to apply individually to separate claims, even if the separate claims are considered a single claim for purposed of determining when they were made.”

 

Discussion

As I have frequently noted on this site, interrelatedness issues are among the most vexing that can arise under the D&O insurance policy. However, the insurer’s argument here that the anti-retaliation and qui tam claim were unrelated and therefore separate claims was always going to be an uphill battle. It is not just the Klein asserted the qui tam claim in an amended complaint in the same lawsuit in which he had asserted the anti-retaliation claim. It is also the fact that both claims depended on a core nucleus of underlying factually allegations based on his contention that the company had falsely reporting specific information to the NIH in connection with an NIH grant.

 

What is more interesting about this decision is Judge Jones’s exploration of the question of what it means that separate claims are “deemed a single claim.” The insurer argued that if the separate claims are a single claim for purposes of the determining the claims made date, then they must be a single claim for purposes of determining the application of policy exclusions. The problem with this argument is that the “deemer” clause deems separate claims to be a single claim for purposes of making the claims made date determination, not for all purposes under the policy.

 

The easiest way to see the problem with the insurer’s argument is to consider a situation in which Klein had filed both the anti-retaliation claim and the qui tam claim in his initial complaint during the policy period. In that circumstance, Omeros would reasonably expect that the insurer would provide coverage for both of the simultaneously made claims, with coverage for the anti-retaliation claim under the EPL coverage section and coverage for the qui tam claim under the D&O coverage section. The mere fact that the were separately made but deemed a single claim for purposes of the determining the claims made date should not change the availability of coverage under the policy.

 

It is always an interesting question whether or not two matters will be found to be sufficiently related to be deemed a single claim. In this case, the Court was asked to determine the extent of the implications if two separate claims were deemed a single claim for purposes of determining the claims made date. As Judge Jones determined, even if the separate claims are deemed a single claim for purposes of the claims made date determinations, the single-claim clause does not govern when applying policy exclusions unrelated to the claims-made nature of the policy.

 

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In a May 16, 2013 decision (here), Eastern District of Missouri Magistrate Judge Terry Adelman, applying Missouri law, determined that the failure of an insured under a management liability insurance policy to provide timely notice of claim precluded coverage under the policy, even in the absence of a showing of prejudice to the insurer.

 

Background       

On December 28, 2007, Secure Energy’s Board of Directors received a demand from Michael McMurtrey regarding commissions he allegedly was owed. On May 16, 2008, McMurtrey filed a lawsuit against Kenny Securities and against John Kenny, a director and founder of Secure Energy. On April 13, 2009, McMurtrey added Secure Energy as a defendant to the lawsuit. McMurtrey sought to recover $1.8 million in commissions and $2 million in punitive damages. McMurtrey alleged breach of contract, unjust enrichment, fraud, negligent misrepresentation, and conspiracy against Secure Energy. McMurtrey voluntarily dismissed his suit on June 25, 2009 but refilled it against the same defendants on July 8, 2009.

 

Secure Energy’s management liability insurance policy provided that the insured must provide notice of claim to the insurer as soon as practicable after becoming aware of the claim but no later than 60 days after the expiration of the policy. However, Secure Energy did not notify the insurer of the claim until May 4, 2011. According to the Magistrate Judge’s opinion, the reason for Secure Energy’s delay in providing notice was it was unsure whether it had a claim. However, the Magistrate Judge also noted that in 2009, the company’s insurance broker had advised the company that while there may be little or no coverage under the policy for the claim, the only way to determine coverage is to submit a claim.

 

The insurer rejected coverage for Secure Energy’s claim on the grounds of late notice. Secure Energy then filed an action seeking a judicial declaration that there was coverage for the claim under the policy. The insurer filed a motion for summary judgment arguing that coverage was precluded because Secure Energy had failed to provide timely notice. Secure Energy argued that coverage was not precluded because the insurer had suffered no prejudice from the untimely notice.

 

The May 16, 2013 Decision

In a short May 16 opinion, Magistrate Judge Adelman granted the insurer’s motion for summary judgment. Secure Energy had tried to argue that under Missouri law, an insurer cannot deny coverage for a claim based on late notice unless the insurer can demonstrate that the insured’s failure to comply with the notice provisions prejudiced the insurer. The insurer argued that under Missouri case law, in order to deny coverage on the basis of late notice, an insurer under a “claims made” policy need not demonstrate prejudice.

 

After reviewing the case law, Magistrate Judge Adelman observed that “the Missouri Supreme Court distinctly held that an insurer is not required to show prejudice in a ‘claims made’ policy. Several Missouri state and federal courts have followed this reasoning.” Magistrate Judge Adelman concluded that the insurer “is not required to demonstrate that it was prejudiced by Secure Energy’s failure to provide notice under the claims made policies. Secure Energy’s failure to give the requisite notice precludes it from coverage.”

 

Discussion         

Delayed notice is a recurring problem for policyholders seeking to obtain insurance coverage for claims. The reasons that the notice is delayed are innumerable. All too often, it will emerge that the reason the notice was delayed is that the policyholder did not think there was coverage or, as apparently was the case here, the policyholder did not think there was yet a claim. In other cases, the insured simply concluded that the claim was no big deal – only to find out later that it is a bigger problem than first appeared. Because I have seen these patterns so many times over the years, I have developed a simple rule – always give notice. No good comes from withholding notice. If you are asking the question whether or not you should give notice, then you should give notice.

 

But if policyholders sometimes hurt themselves by withholding notice, it can sometimes appear that some carriers in some instances seek to use the notice requirements as a coverage dodge. (Please note that in making this observation here, I am in no way commenting on the carrier’s behavior in the Secure Energy case.). For that reason, I am concerned when late notice can serve as a basis to deny coverage even in the absence of prejudice to the insurer. In fairness, the notice here was years late. The tardiness of the notice here is hard to excuse, particularly when two years prior to actually providing notice, the company had been advised by its broker to go ahead and give notice. But even here, the carrier does not appear to have prejudiced by the delay – or, at a minimum, did not claim to have been prejudiced by the delay.

 

The best way for companies to avoid problems with the notice requirement is to have processes to ensure that notice to the insurer is quickly provided after a claim has arisen. However, long experience has taught me that in the real world, the insurer is not always notified right away. The simple fact is that company management, particularly at some smaller companies, is focused on operational issues and is not always sophisticated about insurance issues. Courts evolved the “notice prejudice” rule in recognition of this practical reality.

 

I know that there are a number of jurisdictions where the courts have held that the “notice prejudice” rule is not applicable in the claims made context. I would argue that the “notice prejudice” rule has a place, even in the world of “claims made” policies. As I discussed in a prior post (here), some courts have applied the notice prejudice rule even in the claims made context (although, it should be noted, in that prior post, I noted some concerns with the court’s application of the rule in that specific case).

 

My concern is that without the application of the “notice prejudice” rule, the notice requirements can become a trap for the unsophisticated or uninformed insured and result in an inadvertent loss of the insured’s rights under the policy. I recognize that insurers want to be able to be involved in claims and don’t want to get caught up in murky questions about what may constitute “prejudice,” and therefore prefer a bright-line notice test. I would argue that the “notice prejudice” provides an appropriate balancing of interests. Obviously, the later a policyholder’s notice of claim is, the harder it would be for a policyholder to obtain coverage under the policy.  

 

I know my friends on the carrier side may have differing views, and in particular may well contend that the notice provisions serve important purposes that should not lightly be set aside. I invite readers to add their views using this blog’s comment feature in the right hand column.

 

BlackRobe Litigation Funding Firm Shuts Down: In recent posts (most recently here), I have noted with alarm the apparently proliferation of firms in the U.S. formed to provide litigation financing. The firms are in the business of providing funding for litigation as a form of investment. Among the many developments in this area that captured my attention was the 2011 formation of BlackRobe Capital Partners. The firm’s principals included Sean Coffey, a former partner at the Bernstein Litowitz plaintiffs’ securities firm, joined a year later by retired Simpson Thacher partner Michael Chepiga. As I noted at the time, the involvement of highly respected attorneys like Coffey and Chepiga added an entirely new dimension to the emerging litigation funding phenomenon.

 

Now comes the news that BlackRobe is closing down. As reported in a May 14, 2013 Wall Street Journal article (here), the firm’s founders are “walking away from the litigation-finance firm, citing internal disagreements and a failure to attract enough outside capital from investors.” Though the firm has made over $30 million in investments, “the firm wasn't able to raise a large discretionary pool of capital.”

 

It is hard to know how much significance to attach to BlackRobe’s demise. On the one hand, a significant factor contributing to the firm’s closure were philosophical differences among the firm’s founders. On the other hand, the firm was also having trouble raising capital, which could suggest an overall lack of investor support for the litigation funding project. However, representatives of several more established litigation funding firm are quoted in the Journal article to the effect that their firms have had no difficulty raising money. So it is possible that BlackRobe’s quick end reflects nothing more than the difficulty that startups face in an evolving industry.

 

Susan Beck’s May 16, 2012 Am Law Litigation Daily article about the BlackRobe firm’s demise (here), includes comments from several of the firm’s principals that seem to corroborate the conclusion that firm’s end was in large measure the result of company-specific factors, including in particular differences among the firm’s principals about how to run the firm.

 

Although the demise of the BlackRobe firm unquestionably is noteworthy, it may or may not say anything about the emergence of the litigation funding phenomenon. Certainly the firm’s difficulties raising capital suggest that it may be a difficult field for startups. Overall, it seems that litigation funding will continue to be a factor, notwithstanding BlackRobe’s demise.

 

Libor Claimants Face High Hurdles: As readers of this blog know, the civil claimants attempted to recover damages against the Libor benchmark rate-setting banks have found the going difficult. For example, most recently the claimants in the Libor scandal-related securities suit filed against Barclays had their action dismissed (about which refer here). A May 16, 2012 Law 360 by Michael Gass, Stuart Glass and Kevin Quigley of the Choate Hall law firm entitled “Libor Litigation Must Overcome Significant Obstacles” (here, subscription required) reviews the various adverse litigation developments the Libor scandal claimants have had to face and concludes that the claimants’ “obstacles to recovery are inherent and, perhaps, insurmountable.”

 

Special thanks to a loyal reader for sending along a link to the Choate Hall memo.

 

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The collapse of the venerable Dewey & LeBoeuf law firm is a cautionary tale from which observers have drawn many lessons, including cautions about the perils associated with large law firm mergers and the challenges associated with various forms of law firm partner compensation. The firm’s failure and the claims that have subsequently arisen against the firm’s former managers also highlight important  issues surrounding management liability  insurance for law firms.

 

As discussed here, the Dewey & LeBoeuf firm was the result of a 2007 merger between the Dewey Ballantine firm and the LeBoeuf Lamb Greene & MacRae firm. After encountering financial difficulties, the firm filed for bankruptcy in May 2012. A detailed description of the firm’s collapse can be found here.  In the bankruptcy proceedings, as part of the firm’s liquidation plan, about 400 former Dewey partners agreed to repay the firm’s bankruptcy estate a portion of the compensation they had earned during 2011 and 2012. The total value of the partner contribution plan is $71.5 million. This agreement allowed these former partners to avoid further claims from the estate.

 

However, the committee representing the firm’s unsecured creditors sought and obtained leave of the bankruptcy court to pursue separate claims against the firm’s former leaders – former firm Chairman Steven Davis, former executive director Stephen DiCarmine and former Chief Executive Officer Joel Sanders. (These three individuals were expressly excluded from the agreement embodies in the $71.5 partnership contribution plan.)  Late last year, representatives of the estate sent Davis a demand letter, accusing Davis of mismanagement. In papers filed with the court seeking leave to pursue claims against the three men, the estate’s representatives alleged that the three firm leaders had, among other things, “over-distributed the Firm’s available cash to select partners; abusively relied on guarantee agreements that bore no economic rationality; and concealed the firm’s true financial condition from its partners, employees and creditors.” 

 

On April 22, 2013, representatives of the estate filed a settlement agreement reflecting that Davis, the bankruptcy estate and the law firm’s primary D&O insurer had reached an agreement to settle the estates claims against Davis. A copy of the settlement agreement can be found here.  A copy of the motion to the bankruptcy court to approve the settlement can be found here. Among other things, Davis agreed to pay $511,145 to the estate and in addition the firm’s primary D&O insurer agreed to pay $19 million in settlement of the claims against him. Sara Randazzo’s April 23, 2013 Am Law Litigation Daily article about the settlement with Davis can be found here.

 

On May 2, 2013, DiCarmine and Sanders, who are not parties to the Davis settlement, filed limited objections to the proposed settlement. A copy of their objections, in which they asked the bankruptcy court to reject or modify the settlement, can be found here. Among other things, the two men objected that the $19 million insurance settlement would, together with the $6 million “soft cap” on defense fees, deplete the $25 million limit of liability of the primary policy, while additional claims remain or have been threatened against the two of them. The two men also object that the release contained in the settlement agreement not only releases the primary D&O insurer but, according to the two men, the law firm’s excess D&O insurers as well. (According to the Am Law Litigation Daily article linked above, the law firm carried a total of $50 million D&O insurance, provided by three different insurers that the article identifies.) . Tom Huddleston’s May 2, 2012 Am Law Litigation Daily article discussing the objections can be found here.

 

The outcome of the efforts of Davis and of the firm’s primary management liability insurer to settle the claims against him, as well as the impact of the objections, remains to be seen. While the situation still has further to go before it is fully resolved, the circumstances also present some important insurance implications.

 

First and foremost, these circumstances underscore the importance for law firms of a separate program of management liability insurance. Attorneys are well aware of their need to procure and maintain errors and omissions insurance – or what they typically think of as malpractice insurance. But while they understand their need to have insurance in the event of claims against them asserting that they erred in the delivery of client services, attorneys, or at least some of them, can be reluctant to accept their need to also maintain insurance protecting their firm’s managers against claims for wrongful acts committed in the management of their firm.

 

As these circumstances demonstrate, law firm managers face the possibility of potential claims for a wide variety of potential claimants. Indeed, law firm managers at least potentially face potential claims from the same general range of claimants as does any privately held business and therefore the need for management liability insurance is the same. At a minimum these circumstances provide a vivid illustration to use to explain to law firm manager trying to understand the kinds of claims that might be asserted against them.

 

Second, the size of the proposed settlement with Davis has important implications for law firms when they consider how much management liability insurance to buy.  By the same token, the multiplicity of claims that have been asserted against the former firm managers (which are detailed in the filing the objectors presented to the court) underscore the breadth of litigation that can arise against firm management. Many law firms do not need to be persuaded that they need to carry hefty limits of liability for their E&O insurance, but they may underestimate their needs when it comes to their management liability insurance. As a reader pointed out to me in a recent email exchange, many law firms carry significantly greater levels of E&O insurance than management liability  insurance. The scale of the claims involved here could encourage some law firms to consider increasing the limits of liability for their management liability insurance program.

 

Third, this situation also raises important considerations with respect to the terms and conditions of a law firm’s management liability insurance program. In November 2012, when the unsecured creditors’ committee first sought leave of the bankruptcy court to pursue claims against the three former firm leaders, one concern that was raised was whether the firm’s management liability  insurance would provide coverage for a claim of that type, as the creditors committee in effect would be asserting the law firm’s own claims against the individuals.

 

The concern was that these claims might run afoul of the policy preclusion of coverage for claims filed by one insured against another insured. The fact that the estate and Davis have reached a settlement agreement to be funded largely by management liability insurance suggests that this potential coverage issue was resolved. But the fact that this concern was raised does have important implications about the need to ensure that the insured vs. insured exclusion is revised to insure that it does not preclude coverage for claims brought by representatives of the bankruptcy estate, such as a bankruptcy trustee or creditors’ committee.

 

There are other insured vs. insured exclusion concerns potentially affecting coverage under a law firm management liability insurance policy. For example, one type of claim that frequently arises in the law firm context is a claim by a law firm partner not involved in firm management against the firm’s managers. The way a law firm’s management liability policy would respond to this type of claim is an important coverage consideration, as is the policy’s response to partnership and compensation issues.

 

Many observers have chosen to interpret the demise of the Dewey & LeBoeuf law firm as a sort of a morality tale about the wages of supposed greed and excess. While some may find enough from the law firm’s demise to support that kind of an interpretation, it would be unfortunate if those lessons were the only ones drawn from these events. Even if the law firm’s collapse is the result of the firm’s own peculiar set of circumstances, there are still important lessons for other law firms, even those that consider their circumstances to be different from those of the late lamented Dewey LeBoeuf firm. Among the lessons that every firm would do well to heed is the message about the importance of management liability insurance for law firm managers.

 

Special thanks to a loyal reader for sending me a copy of the objection to the Davis settlement.

 

FDIC Files Another Failed Bank Lawsuit: On April 30, 2013, the FDIC filed its latest lawsuit against former directors and officers of a failed bank. In a suit the agency filed in the Northern District of Illinois in its capacity as receiver of the failed Midwest Bank and Trust Company of Elmwood Park, Illinois, which failed on May 14, 2010, the FDIC asserts claims for gross negligence, negligence and breaches of fiduciary duty against 18 former directors and officers of the bank. A copy of the FDIC’s complaint can be found here. The American Banker’s May 2, 2013 article about the lawsuit can be found here.

 

In its complaint, the FDIC alleges that the Defendants “exhibited an extreme departure from the standard of care and want of even scant care in agreeing to lend $100 million to six uncreditwortthy borrowers and affiliated parties” without employing care and diligence to ensure that the borrowers were creditworthy or that the proposed projects were even feasible or would likely result in repayment of the loans. The alleged misconduct allegedly took place after regulators had warned the bank about its lending practices. The complaint further alleges that the defendants “disregarded prior experience, criticism and the Bank’s specific policy” in connection with $85 million in investments in certain preferred stock. Despite prior bad experience with similar investments, the defendants “pursued an uninformed gamble and held the stock until it had most of its value,” producing a loss for the bank that allegedly could have been avoided if the bank had followed its own announced policies and practices. In its complaint the FDIC seeks to recover over “$128 million in damages.”

 

With the filing of this latest complaint, the FDIC has now filed a total of 58 lawsuits against former directors and officers of failed banks, including fourteen so far this year. As I discussed here, it seems likely there will be more to come, as well. Special thanks to a loyal reader who sent me a copy of the Midway Bank complaint.

 

Mugging for the Camera: Following its cameo appearance during Advisen’s recent quarterly claims update webinar, one of The D&O Diary’s coffee mugs also made a guest appearance on Twitter, as captured below. To find out how you can get one of The D&O Diary coffee mugs, refer here.

 

 

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Disputes over notice of claim requirements usually involve questions about the timing or content of the notice. A recent notice dispute involving UnitedHealth Group raised neither questions of timing or content; rather, the dispute involved the question of “to whom” the notice must be sent. In an April 25, 2013 opinion (here), District of Minnesota Judge Patrick J. Schlitz, applying Minnesota law, held that in order to satisfy the notice of claim requirements in an excess  insurance policy, the notice had to be sent to the insurer's claims department as specified in the policy. Because the policyholder had failed to establish a genuine issue of fact whether the claims department had received the notice of claim, the Court granted summary judgment in favor of the excess insurer.

 

The dispute over the adequacy of notice arose in the context of a protracted and procedurally complicated action in which UnitedHealth is seeking insurance coverage from its insurers for a series of claims in which the company was involved between December 1998 and December 2000. The company’s primary insurance policy has been exhausted by payment of loss and the company has settled with five of its excess insurers. Four excess insurers remain as defendants.

 

In his April 25 order, Judge Schlitz considered a number of different motions in the continuing coverage litigation, including the motion for summary judgment of one of the remaining excess insurers, based on its assertion that it had not been provided notice of a claim known as the AMA claim. The AMA claim later settled for $350 million.

 

The notice provision in the excess insurer’s policy specified that:

 

It consideration of the premium charged, it is hereby understood and agreed that notice hereunder shall be given in writing to [the excess insurer], Financial Services Claims Department, 175 Water Street, New York, New York 10038 (herewritten the “Insurer”)

(a) The Company or the Insureds shall, as a condition precedent to the obligations of the Insurer under this policy give written notice to the Insurer as soon as practicable during the Policy Period, or during the Extended Reporting Period (if applicable), or [sic] any claim made against the Insureds.

 

According to the court’s opinion, the parties agreed that UnitedHealth had not provided written notice of claim sent to the specified address. UnitedHealth nevertheless argued that it had satisfied the notice requirements because it had “substantially complied” with the provisions. Judge Schlitz agreed with UnitedHealth that because Minnesota law “generally disfavors technical and narrow objections to the existence of coverage, especially when it comes to matters of notice,” substantial compliance is sufficient to satisfy a “to whom” notice requirement. But, he added, “substantial compliance requires notice that is substantial.”

 

Judge Schlitz disagreed with UnitedHealth that the “to whom” requirement is satisfied if the company “provides any kind of notice to any kind of agent” of the excess insurer.  He found that under the policy’s provisions, the notice requirement “has not been substantially complied with unless the Claims Department received notice of claim – somehow, from someone --- during the policy period.” He added that if an agent of the insurer becomes aware of a claim “but the agent does not work in the Claims Department and does not notify the Claims Department of the claim, then there has not been substantial compliance with the ‘to whom’ requirement.” Judge Schlitz reasoned in that regard that:

 

“Compiance” with a provision of an insurance policy should not be deemed “substantial” if doing so would defeat the very purpose of the provision. And the very purpose of a “to whom” requirement – its entire reason for existing – is to ensure that notice is provided not just to the insurance company, but to a particular part of the insurance company. A large insurance company has a legitimate reason to require that notice of claim be given to a particular person or department with the company, rather than to any of the company’s thousands of employees and agents scattered around the globe. Otherwise, there is a substantial danger that the “notice” will not be recognized as such and will not serve its function.

 

Judge Schlitz added that “The Court can conceive of no reason why an insurer … should not be able to protect itself by requiring that notice be given to a particular person or department. And enforcing such a requirement does not place an onerous burden on an insured – particularly an insured such as United, which is itself a huge and sophisticated insurance company, and which has no excuse for failing to send notice of the AMA claim to the Claims Department, as [the excess insurer’s] policy clearly required United to do.” He concluded that in order for UnitedHealth to show that it substantially complied with the notice requirement, it must show that notice of the AMA claim was received by the Claims Department during the policy period.

 

Judge Schlitz then reviewed the various ways in which UnitedHealth claimed that it had provided notice of the claim. UnitedHealth argued that the AMA claim had been noticed in a monthly loss run report that the company’s broker supplied to the excess insurer and that the loss run report also was attached to UnitedHealth’s renewal insurance application. However, while Judge Schlitz found that there is sufficient evidence from which a jury could find that someone at the excess insurer received the loss runs, there was no evidence that that the loss runs were provided to the claims department.

 

And while the AMA claim apparently was discussed at a meeting in connection with UnitedHealth’s  insurance renewal, there was no evidence that anyone from the excess insurer’s claims department had attended the meeting. Judge Schlitz specifically concluded that there was no evidence to suggest that the excess insurer’s claims department had received information about the AMA claims from the underwriting department.

 

Judge Schlitz also rejected UnitedHealth’s argument that because it had provided notice of claim to the primary insurer that is owned by the same insurance holding company as the excess insurer asserting the notice defense that the notice requirements had been satisfied.

 

Because UnitedHealth had “failed to show that there is a genuine issue of fact about whether the Claims Department received notice of the AMA claim during the policy period,” Judge Schlitz granted the excess insurer’s motion for summary judgment.

 

Discussion

Judge Schlitz’s conclusion that an insurance notice requirement is not satisfied unless it can be shown that notice has been given to the specific department identified in the notice provision is a cautionary tale for practitioners in this area. In the press of day to day business, it would be far too easy for a notice to be sent to the right company but to a person, location or address other than the one specified in the policy. The clear lesson is that everyone involved in the process of providing notice of claim to needs to help to ensure that notice is sent not just to the correct insurer but also to the correct location – and to the correct location for each of the insurers in an insurance program. The case also underscores the value of having processes to require and obtain acknowledgement of receipt of notice of claim as well.

 

UnitedHealth’s apparent failure to provide the requisite notice of claim here is a little bit of a mystery. The claim was obviously very serious (or, at a minimum, it became very serious). It is clear from the Court’s opinion that the primary insurer on UnitedHealth’s insurance program was provided with the notice of claim required under its policy. It isn’t explained in the opinion how it came about the notice of claim had been sent to the prmary insurer (and apparentlyto other excess insurers as well) but not to the excess insurer involved in this motion. The court’s reference to the monthly loss runs is a reminder that UnitedHealth is a big, complex company that apparently became involved in a number of claims. The suggestion is that in the hubbub the notice of the AMA claim to this excess insurer somehow slipped through the cracks. Reading between the lines, there may also have been a confusion of or breakdown in responsibilities among the varaious process participants.

 

There is one aspect of this opinion that I find interesting. There is nothing in Judge Schlitz’s opinion to suggest that the excess insurer was prejudiced in any way by the absence of compliance with the policy’s notice provisions. At least as presented in the court’s opinion, it does not appear that the excess insurer argued that its interests had been prejudiced. The court was concerned only with the question whether or not the policyholder had satisfied the procedural requirements stated in the policy. There is no sense in the opinion of a consideration of a “no harm, no foul” point of view. .

 

The arguably harsh outcome of this dispute might be more comfortable if the analysis had been accompanied by some suggestion that UnitedHealth’s failure to satisfy the procedural requirements had somehow caused a problem for the excess insurer with reference to the AMA claim. Here’s my concern. Some  insurers try to enforce their policies’ notice requirements as if the implementation of the provions were a game of “Mother May I?” On some occasions, some insurers brandish supposed notice issues as if, as a result of the supposed notice defect, they have won the game because the policyholder failed to say “Mother May !?” D&O insurers are of course fully entitled to expect compliance with policy requirements. However, reasonable business considerations should temper the enforcement of the requirements.

 

Judge Schlitz commented that it was fair to strictly enforce the requirements of the notice provision against a large sophisticated company like UnitedHealth. Whether or not that is true, my concern is that the same analysis as he is applying to a big sophisticated company like UnitedHealth could also be applied to a company that isn’t as big or sophisticated.

 

In all fairness, however, it should be noted that isn’t a case where a notice of claim as such was sent to the wrong address or the wrong department. Notwithstanding UnitedHealth’s arguments, it looks as if for whatever reason, there really was not a notice of claim as such sent to any address or department. Without that, UnitedHealth was left to argue that various fragments of informatoin about the claim could be shown to have filtered through a complex pattern of interaction between the company and the excess insurer. That was aloways going to present some difficulties for UnitedHealth. The company was not in the best position it could have been in on these issues. 

 

As I said at the outset, this case is a cautionary tale for all of us working in this business. The lesson for all of us is to try to make sure that the notice of claim both goes to the specific address stated in the policy and that it goes to all of the insurers.

 

Ninth Circuit Reverses District Court Holding That E&O Insurance Policy Exclusion Precluded Coverage: On April 26, 2012, in a terse, unpublished four-page decision, a three judge panel of the Ninth Circuit reversed the district court’s dismissal of an insurance coverage action that Ticketmaster had filed against its error and omissions insurer. A copy of the Ninth Circuit’s opinion can be found here.

 

The errors and omissions insurance policy provided liability coverage for Ticketmaster for claims arising from the performance or the failure to perform professional services. The policy contained an exclusion, Exclusion E, specifying that the policy does not apply to any claim “based on or arising out of … any dispute involving fees, expenses or costs paid to or charged by the Insured.”

Ticketmaster was sued in a putative class action brought by ticketholders alleging that the company had made false representations regarding UPS delivery fees and order-processing charges for ticket events. Ticketmaster sought to have its E&O insurer defend it in the ticketholder claims. The insurer declined based on Exclusion E. Ticketmaster sued the insurer for breach of contract and bad faith. The district court granted the insurer’s motion for judgment on the pleading. Ticketmaster appealed.

 

In its April 26 opinion, the Ninth Circuit panel reversed the district court, holding that Exclusion E is “reasonably susceptible of at least two meanings, particularly in light of the Policy’s other 27 exclusions, and is thus ambiguous.” The appellate court identified the two possible meanings: “(i) Exclusion E may refer narrowly to a dispute regarding the monetary amount paid to or charged by Ticketmaster for uncontested services, or (ii) more generally, Exclusion E may refer to any dispute regarding a fee or charge for professional services, including a dispute regarding the relationship between services and the fees charged.”

 

The appellate court said that the E&O insurer had failed to carry its burden of showing that the second interpretation is the only reasonable one. The court noted that there are at least some allegations in the ticketholders’ action that do not involve the amount charged for uncontested services, such as the allegation that Ticketmaster performed no services in exchange for its order-processing charge. This allegation, the court said, did not dispute the amount charged but rather the relationship between any fee at all and the services provided. This dispute would be precluded by interpretation (ii) of Exclusion E but not interpretation (i).

 

The Ninth Circuit reversed the district court and reinstated the complaint, including Ticketmaster’s bad faith allegations.

 

FDIC Files Another Failed Bank Lawsuit and Two More Bank Fail: On April 26, 2013, the FDIC filed yet another lawsuit in its against the directors and officers of a failed bank. In its complaint (here), the FDIC, in its capacity as receiver of the failed Frontier Bank of Everett, Washington, has asserted claims for negligence, gross negligence and breach of fiduciary duty against twelve former directors and officers of the bank. The bank failed on April 20, 2010, so the FDIC filed its action just before the three-year statute of limitations expired.

 

The FDIC alleges that the defendants breached their duties to the bank by “causing the Bank to violate its own policies and prudent, safe and sound banking practices” in connection with the approval of at least eleven loans between March 2007 and April 2008. The FDIC sees to recover damages “in excess of $46 million.”  An April 26, 2013 Puget Sound Business Journal article regarding the FDIC’s new Frontier Bank lawsuit can be found here.

 

Not only did the FDIC file the lawsuit against the former Frontier Bank directors and officers, but the agency also took over as receiver of two more failed banks on Friday. The two banks are the Douglas County Bank of Douglasville, Georgia and the Parkway Bank of Lenior, North Carolina. Between January 1, 2013 and April 20, 2013, there were only five bank failures total,  but just in the last two weeks there have now been five more, for a total of ten so far during 2013. As I recently noted, though it has seemed as if the bank failure wave had just about played itself out, it now appears that there may yet be more bank failures yet to come.

 

With the failing of the latest lawsuit, the FDIC has now filed a total of 57 lawsuits against the former directors and officers of failed banks, including 13 so far this year alone. As I discussed here, it seems likely there will be more to come, as well.

 

Speakers’ Corner: On Tuesday, April 30, 2013, I will be participating in Advisen’s Quarterly D&O Claims Trends Webinar. In this free webinar, which will take place at 11:00 am EDT, I will be participating on a panel with Paul Ferrillo of the Weil Gotshal law firm, David Murray of AIG, and Jim Blinn of Advisen. The panel will discuss claims trends and developments during the first quarter of 2013. Registration information for the webinar can be found here.

 

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Insurance to provide coverage for breaches of representations or warranties in M&A transaction documents has been available in the marketplace for several years, but the specialty insurance product has not always been fully understood. More recently, interest in the product has grown and the product has improved, and so take-up for the product has increased as well.

 

In the following guest post, Joseph Verdesca and Paul Ferrillo of the Weil, Gotshal & Manges law firm take a close look at reps and warranties insurance and explain what M&A transaction participants need to know about the product.

 

I would like to thank Joseph and Paul for their willingness to publish their article on this site.. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly. Joseph and Paul’s guest post follows:

 

No less than two years ago, had one tried to initiate a conversation with a Private Equity Sponsor or an M&A lawyer regarding M&A "reps and warranties" insurance (i.e., insurance designed expressly to provide insurance coverage for the breach of a representation or a warranty contained in a Purchase and Sale Agreement, in addition to or as a replacement for a contractual indemnity), one might have gotten a shrug of the shoulders or a polite response to the effect of "let’s try to negotiate around the problem instead." Perhaps because it was misunderstood or perhaps because it had not yet hit its stride in terms of breadth of coverage, reps and warranties insurance was hardly ever used to close deals. Like Harry Potter, it was the poor stepchild often left in the closet.

 

Today that is no longer the case. One global insurance broker with whom we work notes that over $4 billion in reps and warranties insurance was bound worldwide last year, of which $1.4 billion thereof was bound in the US and $2.1 billion thereof was bound in the EU. Such broker’s US-based reps and warranties writings nearly doubled from 2011 and 2012. Reps and warranties insurance has become an important tool to close deals that might not otherwise get done. This article is meant to highlight how reps and warranties insurance may be of use to you in winning bids and finding means of closing deals in today’s challenging environment.

 

When Is Reps and Warranties Insurance Best Used?

Deal Size. Reps and warranties insurance is best suited to deals of a certain size range and type. Given the amount of limits that can be purchased in the marketplace for any particular deal, insurance pricing and the size of a typical escrow or indemnity requirement, the "sweet spot" for reps and warranties insurance are deals between $20 million and $1.5 billion. While reps and warranties insurance might have a role to play in larger or smaller deals, it can play a central role in facilitating transactions within this size range. The type of deal is relevant because it is much easier to obtain reps and warranties insurance when the business being acquired is privately owned rather than publicly held. In sum, insurance companies generally prefer to insure transactions where an identifiable seller (rather than a diverse stockholder base) is standing behind the representations of the target business.

 

Sell-Side Examples. For those finding themselves selling a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples

• Minimization of Seller Liability. A Private Equity or Venture Capital seller near the end of a Fund’s life wishes to limit post-closing indemnification liabilities on the sale of a portfolio company in order to safely distribute deal proceeds to the Limited Partners, but the buyer wants a high cap on potential indemnities or a long survival period for the reps at issue. Insurance could be the means to bridge this gap.

• Removal of Tax Contingency from Negotiations. A seller restructures itself immediately prior to the closing of a deal for tax purposes. During due diligence, both seller’s and buyer’s tax advisors agree the deal should be recognized as a tax-free reorganization. In the remote event that the IRS took a different position, the tax consequences to the buyer would be significant. The Seller wishes to retire with the proceeds from the deal, and does not want to provide an indemnity to the buyer for this potential risk. Insurance could serve to remove this risk from the scope of matters needing negotiation between the parties.

• Minimization of Successor Liability Risk. In an asset sale transaction where a portion of assets and liabilities remain with the seller, the buyer would have no control over the seller’s conduct post-closing and does not want to be subject to potential liabilities related to such excluded assets on a successor liability theory. If the seller is unwilling or unable to provide an indemnity for such matters, insurance could help the parties past this issue.

 

Buy-Side Examples. For those wishing to acquire a business or asset, situations that may warrant purchase of a reps and warranties policy for the transaction include the following examples:

• Bid Enhancement. A competitive auction process is being held by a seller of prime assets. A potential buyer wishes to distinguish his or her bid from others by arranging and agreeing to look to a reps and warranties insurance policy to take the place of an indemnity from the seller. Such a use of insurance could elevate the likelihood of the buyer winning the auction.

• Public M&A Indemnity. In a public M&A acquisition, the buyer could arrange for reps and warranties insurance to provide the indemnity that would not otherwise typically be available in light of the publicly held nature of the target.

• Distressed M&A Indemnity. Similarly, in a distressed M&A setting in which the buyer is concerned about the credit risk of the seller post-closing, the use of reps and warranties insurance would enable the buyer to be indemnified for breaches of reps and warranties in the acquisition agreement, while avoiding the seller’s credit risk.

 

What Should the Insurance Cover?

While each policy is unique, a reps and warranties policy generally covers "Loss" from “Claims” made by Buyer for any breach of, or an alleged inaccuracy in any of, the representations and warranties made by the Seller in the Purchase and Sale Agreement ("PSA"). Though a rep and warranty policy can be structured to cover very specific reps or warranties, coverage is generally afforded on a blanket basis for all reps and warranties. The definition of "Loss" in the policy should generally mimic the extent of the Indemnity negotiated in the PSA (which could include things like consequential or special damages). Loss can also include defense costs, fees, and expenses incurred by the Insured (for instance, the Seller) in defense of a Claim brought by a third party (for instance, the Buyer) arising out of alleged breach of a representation or warranty. Note that such policies almost always have a self-insured retention ("deductible") associated with them. The size of the retention can vary considerably from deal to deal, but usually in some fashion equates to the amount of the hold back negotiated.

 

What Should the Insurance Exclude?

Though the exclusions in a reps and warranties policy are not as numerous as those contained in a traditional directors and officers liability policy, they should do exist and be thoughtfully considered and negotiated. Reps and warranties policies do not cover known issues, such as issues discovered during due diligence or described in disclosure schedules. They also do not cover purchase price, net worth or similar adjustment provisions contained in the PSA. “Sell-Side” reps and warranty policies do not cover claims arising from the adjudicated fraud of the seller. Either buy side or sell side policies might have deal-specific exclusions where the carrier involved simply cannot get comfortable in insuring the particular representation or warranty at issue. Lastly, a rep and warranty policy would also generally not cover any breach of which any member of the deal team involved had actual knowledge prior to the inception of the policy or any material inaccuracy contained in the "No Claims Declaration" typically in connection with the issuance of the policy.

Cost of Coverage

Reps and warranties insurance is priced based on a number of factors, including most prominently the nature of the risk involved, the extent of the due diligence performed by the parties, and the relative size of the deductible. Reps and warranties insurance is currently generally priced as a percentage of the limits of coverage purchased. Nowadays, in the United States, a price range of 2.0% to 3.5% of the coverage limits is typical. Thus, a $20 million reps and warranties insurance policy on a moderately complicated deal might cost approximately $600,000. Who pays this premium is generally a function of the deal, and depends to some extent upon who is deriving the benefit from the insurance. If, for instance, a buyer-side policy is being purchased because a seller doesn’t want to deal with putting up an indemnity or hold-back, the premium would generally be the seller’s responsibility.

 

In order to facilitate the due diligence process (described below), many carriers require payment of an up-front underwriting fee. These fees can run from $25,000 to $50,000, and are used by the carrier typically to hire outside counsel to advise it during the underwriting process.

 

Deductible

Carriers typically determine the policy’s deductible according to the transaction value of the deal. In our experience, the current standard deductible ranges from 1% to 3% of the transaction value. The deductible will, however, vary from deal to deal based upon the risk involved. Buy-side policies alternatively tend to use the “hold-back” negotiated between the parties as a deductible.

 

Process to Get the Insurance in Place

The reps and warranties insurance market has evolved in response to prior concerns about the amount of time and effort necessary to put a policy in place. The carriers and brokers understand that, as with the deals themselves, the need for the insurance is typically on a very fast track.

 

Many of the large national insurance brokerages have specialized units that deal with reps and warranties insurance. These units, for the most part, are run not by “insurance people” but by former M&A lawyers who left private practice to become dedicated resources at the brokerages. They are fully familiar with the ins and outs of M&A and private equity transactions, and very little time is needed to get them up to speed. Though not all brokerages provide the same level and depth of resources, the right broker can become quickly integrated into the deal team and, importantly, will serve as an advocate with the insurance carriers.

 

Within 24 hours, a good broker will have you engaged with one of the handful of carriers that are known to service the reps and warranties insurance area. Be advised that not all carriers are created equally, and your broker should assist in advising as to selection of the best carriers for your purposes (including as to responsiveness, experience in corporate transactions, and reputation for proper claims payment decisions).

 

The best insurance carriers in this arena will typically provide a price and coverage quote (called a “Non-Binding Indication” or “NBIL”) within two or three days of the first conversation. Either in connection with the receipt of the NBIL or in a subsequent phone call, you should expect to receive a list of due diligence requests, and likely a request of the carrier for data room access (both the broker and carrier are accustomed to negotiating and executing a Non-Disclosure Agreement early in the process). The best carriers in this arena are, in our experience, capable of running a very efficient due diligence process and getting up to speed as a quick as possible regarding potential risks associated with the deals (e.g. intellectual property, environmental, etc.).

 

Within a week of receipt of the NBIL, the carrier, its counsel, the insured, its business people, its deal team members and its counsel (including sometimes the private equity sponsor) will typically discuss the due diligence done on the transaction, and answer questions of the insurance carrier to ensure the absence of any risks that might imperil the insurance transaction. Assuming the due diligence call goes well (and there might be follow up diligence calls as well on particular issues), the carrier involved will normally issue a draft insurance policy, which is normally then negotiated with the parties (assisted by the broker). A key issue will be “conforming” the insurance so that it matches what would otherwise have been provided by the PSA in the absence of the insurance (or otherwise serves the particular need for which it is being purchased). In negotiating such policy, focus will often be placed on defining the scope of losses included and excluded, the impact of knowledge qualifiers, the term of coverage, operational restrictions, subrogation provisions, and a host of additional issues beyond the scope of this article.

 

In Summary: Reps and warranties insurance (1) can be purchased quickly and efficiently, and won’t delay the deal, (2) can provide real coverage for troublesome aspects of a deal for which alternative solutions may not be readily available, and (3) can serve as a flexible tool to distinguish one’s offer in a competitive bidding situation. Teaming up with a well-experienced broker and insurance carrier is essential to making this happen. We have enjoyed the benefits of utilizing reps and warranties insurance into numerous transactions, and would be happy to share with you our thoughts in this arena in further detail.
 

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Lee Farkas, the criminally convicted former Chairman and majority shareholder of  the defunct Taylor Bean and Whitaker Mortgage Corporation, must repay the nearly $1 million in defense fees the company’s D&O insurer had advanced on his behalf, according to an April 11, 2013 Fourth Circuit opinion. The terse three-page appellate opinion adopts the ruling of the lower court, holding that Farkas’s criminal conviction triggered the D&O insurance policy’s “in fact” conduct exclusions which in turn triggered the insurer’s right to recoup the defense fees it had previously paid. The Fourth Circuit’s opinion can be found here, and the March 21, 2012 district court opinion, which the appellate court affirmed, can be found here.

 

Background

In June 2010, Farkas was indicted on multiple counts of committing and conspiring to commit bank, wire and securities fraud. On April 19, 2011, a jury found Farkas guilty of all 16 counts of fraud and conspiracy to commit fraud. As detailed here, Farkas was, among other things, alleged to have conspired with employees of the failed Colonial Bank to sell the bank approximately $400 million of mortgage assets that had no value. Taylor Bean was also alleged to have engaged in numerous other transactions with the bank that had no value. The bank’s collapse followed after the fraudulent scheme unraveled.

 

After he was indicted, Farkas sought to have his criminal defense fees paid by the company’s D&O insurer. With bankruptcy court approval, the D&O insurer advanced $928,977 toward Farkas’s defense. Farkas incurred significant additional defense expenses, and the carrier’s request for the bankruptcy court’s leave to pay those additional amounts was pending when the jury returned the guilty verdict. Following the verdict, the carrier informed Farkas that, as a result of the verdict and in reliance on the policy’s conduct exclusions, it would no longer fund Farkas’s defense costs, and it reserved its right to seek recoupment from Farkas of the amounts it had previously advanced.

 

Farkas filed an action in the Eastern District of Virginia seeking a judicial declaration that the jury verdict did not terminate the insurer’s defense obligation, and that in any event all of the fees he had incurred prior to the jury verdict must be paid. The D&O insurer filed a counterclaim seeking a judicial declaration that Farkas was not entitled to coverage under the policy and that Farkas was obligated to repay the amounts the insurer had previously advanced. The parties cross-moved for summary judgment. In her March 21, 2012 opinion, Eastern District of Virginia Judge Leonie Brinkema granted the insurer’s motion for summary judgment. Farkas appealed.

 

In arguing that as a result of the jury verdict coverage for Farkas’s criminal defense fees was precluded under the policy, the insurer relied on the policy exclusion specifying that “The Insurer shall not be liable to make any payment for Loss in connection with a Claim against an insured …arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.”

 

In seeking to have Farkas repay the amounts that it had advanced, the insurer relied on the language in the policy specifying that “advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss.”

 

The Fourth Circuit’s Opinion and the Ruling Below

On April 11, 2013, in a terse three-page per curium opinion, a three-judge panel of the Fourth Circuit affirmed the district court’s ruling. The appellate court said that “having carefully reviewed the briefs, record and appellate law, we affirm for the reasons stated by the district court in its thorough opinion.”

 

In her March 2012 opinion, Judge Brinkema had granted summary judgment for the D&O insurer, finding that the jury verdict in the criminal case represented an “in fact” finding that triggered the conduct exclusion; rejected Farkas’s argument that he was entitled to the payment of the defense costs incurred by not yet paid before the verdict was returned; ruled that the insurer was entitled to recoup from Farkas the defense cost amounts it has advanced prior to the verdict; and rejected Farkas’s argument that the district court should stay its ruling while Farkas’s criminal appeal was pending. (Farkas’s criminal conviction was in any event subsequently affirmed.)

 

In ruling that the jury verdict triggered the policy’s conduct exclusion, Judge Brinkema stated that “there can be no reasonable dispute that the jury verdict here is an objectively verified and pertinent factual finding.” She added that none of the courts that have held that an “in fact” wording in a policy exclusion requires a final adjudication had defined a final adjudication as an appeal. She concluded that “there is simply no support in the case law for plaintiff’s position that a jury verdict does not trigger the ‘in fact’ requirement in the exclusion.”

 

With respect to Farkas’s contention that the insurer should at least pay the defense costs he had incurred but that the insurer had not yet paid when the verdict was returned, Judge Brinkema said that Farkas’s argument “ignores the consequence of a particular claim being excluded.” Farkas’s conduct “was never actually covered under the Policy, and he was therefore never entitled to the monies advanced to him.” Pursuant to the policy language, the insurer, she found, “has the right to seek recoupment of any costs that it advanced before it determined that an exclusion applied.”

 

Discussion

The question of an insurer’s right to seek recoupment of advanced defense expenses is a recurring topic. As I have previously noted (here), although D&O insurers frequently assert their right to seek recoupment, it is still relatively rare for the insurers to actually do so. Among other reasons why the insurers rarely seek reimbursement is that it is relatively unusual for a D&O claim to proceed to the point that there has actually been a factual determination triggering an exclusion. Indeed, one of the many reasons why civil claims triggering D&O coverage frequently settle is that an insured defendant would risk a factual determination that might preclude policy coverage if the defendant were to press the case forward rather than settle.

 

This case’s criminal context obviously presents a different set of circumstances than does a civil case. A criminal defendant does not have the option of a pre-trial settlement that avoids a potentially coverage precluding outcome.

 

Just the same, the coverage outcome here is also due in part to an unusual feature of the policy at issue According to the court record, the D&O insurance policy at issue here was first issued to the Taylor Bean firm in 2008 and subsequently extended by endorsement. Even in 2008 it was standard for most D&O insurance policies to be issued with the “final adjudication” wording, rather than the “in fact” wording. With the final adjudication wording, the preclusive effect of the conduct exclusion does not apply under there has been a final judicial determination that the precluded conduct has occurred. The presence of the “in fact” exclusion language in the Taylor Bean policy is an anachronism that is unexpected and frankly a little bit surprising.

 

Because the policy had the “in fact” exclusionary language, Judge Brinkema had little trouble concluding that the jury verdict precluded coverage. Had the policy had the now-standard “final adjudication” language, the parties would then have had to argue about whether or not the criminal judgment against Farkas was “final” while his appeal was pending. I am well aware that there is extensive case law on the question whether or not a district court judgment if final and enforceable while an appeal is pending. But if the policy had contained the “final adjudication” language rather than the “in fact” language, Farkas might have had a better argument that the insurer was obligated to continue to advance his defense fees unless and until the conviction was affirmed.

 

It is worth noting that these circumstances demonstrate why the preferred exclusionary trigger is not just the “final adjudication” wording but rather the “final non-appealable adjudication” formulation. If the policy had the “non-appealable adjudication” wording, the insurer here would have been obligated not only to advance the amounts Farkas had incurred prior to the verdict but that the insurer had not yet paid, but also to continue to advance his defense expenses for his appeal. Farkas would have been able to continue to use his preferred counsel through his appeal (rather than, as Judge Brinkema noted, counsel appointed for him under the Criminal Justice Act). Farkas may well feel that the appeal might have turned out differently if he had been able to rely on his preferred counsel. I know for sure that if it were me, I would certainly want to be able to use my preferred counsel while appealing a criminal conviction.

 

The fact that Farkas had to rely on appointed counsel for his appeal suggests that he did not have resources of his own to rely on -- which begs the question of why the carrier went to the trouble to obtain an order requiring Farkas to repay the advanced amounts. I mentioned at the outset of this discussion that it is relatively rare for carriers to seek recoupment of advanced amounts, and among other reasons why it is rare is that often there is no point for the carrier to seek recoupment because usually by the time a serious D&O claim has concluded, the defendant is usually broke – which seems to be the case here, which in turn begs the question why the carrier even bothered to pursue a recoupment order.  It probably is worth noting in that regard that the D&O insurer did not initiate the coverage lawsuit here, Farkas did. The carrier only sought recoupment in its counterclaim, after Farkas had sued the insurer. Whether the carrier ultimately will recover anything under the recoupment order is a different question.

 

"Everything I Can See From Here": Two Men, a Dog, a Ball, and ....

 

Everything I Can See From Here from The Line on Vimeo.

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By now, many readers may have seen the 2012 Towers Watson D&O insurance survey, entitled “Directors and Officers Liability: 2012 Survey of Insurance Purchasing Trends,” which can be here. (I am only belatedly posting a link to the survey now owing to my travel schedule last week, when Towers Watson released the survey report).

 

As always, the survey report contains a number of interesting insights, including in particular the report’s conclusion that “the insurance marketplace for directors and officers liability is clearly firming, as evidenced by increased pricing experienced in many sectors.”

 

The report contains a number of other interesting insights about the current D&O insurance marketplace for both public and private/nonprofit entities, but readers will also want to note the precautionary comment in the report’s introduction, which state that “it is important that care is taken”  in drawing conclusions from the report owing to the fact that  "the majority of respondents were large organizations with total assets/revenues in excess of US$1 billion” and that “firms with assets/revenues under US$1 billion were not as well represented.”

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Many organizations purchase management liability insurance to provide liability and defense cost protection for their directors and officers. But the management liability insurance protects the individuals only for their actions undertaken in an “insured capacity.” The policies are not intended to not protect them for actions they undertake in a capacity other than as a director or officer of the organization. These issues proved to be determinative in the action to decide whether or not D&O insurance issued to Jerry Sandusky’s organization, The Second Mile, covered the legal fees Sandusky incurred defending criminal and civil allegations involving misconduct with children.

 

In a March 1, 2013 Memorandum Opinion, Middle District of Pennsylvania Chief Judge Yvette Kane held that because the alleged misconduct did not arise in Sandusky’s capacity as an employee or executive of The Second Mile, the organization’s management liability insurer had no obligation to provide him defense cost coverage. A copy of Judge Kane’s opinion can be found here. As I note below, I have some concerns about this ruling.

 

Background

Sandusky founded The Second Mile in 1977. From 1977 until Sandusky was criminally indicted for offenses against children. Sandusky served at times as a volunteer and at times as an executive-level employee of the organization. In November 2011, a grand jury returned a report charging Sandusky with multiple crimes involving children. Following a trial, Sandusky was convicted of a total of 45 charges involving offenses against children. Sandusky has appealed his criminal conviction. Sandusky has also been named as a defendant in a separate civil proceeding brought by one of his alleged victims.

 

Sandusky sought coverage for the attorneys’ fees incurred in both the criminal and civil matters from The Second Mile’s management liability insurer. Sandusky sought coverage under both the D&O and EPL portions of the policy. The insurer advanced Sandusky’s defense expenses subject to a reservation of its rights under the policy and initiated an action seeking a judicial declaration that it had no obligation to fund Sandusky’s defense expenses. The insurer filed a motion for judgment on the pleadings, arguing that it would be against Pennsylvania public policy to indemnify Sandusky for the child molestation charges against him. As discussed here, in a June 2012 order, Judge Kane agreed that it would be against Pennsylvania public policy for the insurer to indemnify Sandusky, she reserved the question of whether it would be against public policy for the insurer to provide Sandusky with a defense.

 

After Sandusky’s criminal conviction, the insurer moved for summary judgment, arguing that the acts alleged against Sandusky were not undertaken in an insured capacity. The policy defined the term “Insured Capacity” to mean “the position or capacity of an Insured Person that causes him to meet the definition of Insured Person.” Sandusky argued that the meaning of this provision is ambiguous and the further discovery was required to determine the extent of the coverage provided under the policy. 

 

The March 1 Opinion

In her March 1, 2013 memorandum opinion, Judge Kane granted the carrier’s motion for summary judgment. She found the policy language regarding “Insured Capacity” to be “unambiguous.” She said that in order to determine “whether the actions that form the basis of the claims against Defendant were performed in his capacity or role as an executive or employee of The Second Mile,” she must review the allegations against him. She then reviewed the various abuse allegations that had been alleged against Sandusky. Among other things, she noted that the alleged abuse was alleged to have taken place in a variety of locations, all away from The Second Mile’s facilities.

 

Based on this review, she concluded that “it is clear that Defendant Sandusky was not acting in his capacity as an employee or executive of The Second Mile in sexually abusing and molesting the victims named in the criminal and civil cases brought against him, and the Court so finds.” She added that Sandusky was not alleged to have engaged in the alleged misconduct “in furtherance of his duties for The Second Mile.” She noted that the fact that Sandusky met his victims through The Second Mile or even that he sexually abused victims “during the course of activities at” The Second Mile “does not change the fact that his sexual abuse of children was personal in nature and performed in his individual capacity.” Because Sandusky’s alleged conduct “was clearly personal in nature and not in furtherance of his duties for The Second Mile, he is owed no criminal defense under the Policy.”

 

Discussion

The nature of these allegations is so repugnant and the fact that Sandusky has been convicted criminally makes it hard to spend any time thinking about the issues here. I certainly have no interest in defending Sandusky or trying to prove that he has not been dealt with fairly here.

 

Nevertheless I do have concerns about this ruling. It is easier to see my concerns if we forget about Sandusky and imagine instead that a volunteer or employee of a nonprofit organization has been unfairly targeted by abuse allegations, perhaps as a particularly vindictive part of a smear campaign. Let us say for purposes of this hypothetical that the allegations, though false, are otherwise as heinous as those against Sandusky.

 

My concern is that under Judge Kane’s ruling, even this falsely accused individual could not look to his origination’s management liability insurer for a defense. Her ruling does not depend on Sandusky’s conviction. She expressly says that “Sandusky’s offenses against children –whether proven or alleged – were not conduct in his capacity as an employee or executive of the Second Mile.” The allegations alone are enough to determine coverage, because “sexual abuse of children” is “personal in nature” and is “performed in individual capacity.” She even said that this conclusion would apply “even if he sexually abused victims “’during the course of activities of Second Mile.’” 

 

If the mere fact that allegations of sexual abuse are personal and individual is enough to preclude coverage for Sandusky, then are mere allegations sufficient to preclude coverage even for a nonprofit official who is falsely accused as part of a smear campaign? Keep in mind, Kane is not interpreting a clause of a policy in which the insurer says “we won’t insure even allegations of sexual molestation.” She was interpreting a clause that talks about the capacity in which a person was sued and for which he or she got sued. In our smear campaign hypothetical, the only reason my hypothetical smear campaign individual was targeted was because they were an official of the nonprofit. Are we prepared to say that this falsely accused individual is under no circumstances entitled to a defense, simply because of the nature of the allegations?

 

I would be much more comfortable all the way around with this decision if it were based on the fact that Sandusky was actually convicted. Of course, given that his criminal case is still on appeal the judgment in the criminal case is not final, and so the insurer might not be able to preclude coverage on the basis of the criminal conviction for some time yet.

 

When Judge Kane says that her conclusion that Sandusky was not acting in an insured capacity applies even though he allegedly abused victims “during the course of activities of Second Mile,” that’s when I get uncomfortable with this result. It would be very easy to shrug this result off because of the terrible things for which Sandusky was convicted. But because Judge Kane’s conclusion does not depend on the conviction, this same result could apply to any nonprofit official, even one who is falsely accused and would otherwise be forced to defend him or herself against outrageous allegations without insurance and at their own expense. I am very uncomfortable with this whole subject matter, but I am also not entirely comfortable with this decision.

 

I invite readers to weigh in on this topic, particularly those who take a different point of view on this decision than I do. (I know I am setting myself up for a raft of messages about the need for separate sexual molestation coverage or the possible problems with the bodily injury exclusion in the typical D&O insurance policy, and perhaps other similar arguments as well. Please bear in mind that my concerns here are focused exclusively on Judge Kane’s reasoning in denying coverage, not on whether there may be other questions that might affect coverage or whether there are alternative insurance arrangements that might better address the sexual molestation exposure.)

 

Whistleblower Watch: In my annual year-end round up of D&O insurance and liability issues, I more or less said that I thought 2013 would be the year of the whistleblower, or at least the year in which the whistleblower bounty provisions of the Dodd Frank Act kick into high gear. Well, here we are into the third month of 2013, and there still haven’t been any more whistleblower bounty awards. So was I wrong? Maybe I was, but before you decide, you need to take a look at the list that Mary Jane Wilmoth has been compiling over at the Whistleblower Protection Blog.

 

As Wilmoth reports, the SEC posts Notices of Covered Action when a final judgment order, by itself or with prior orders and judgments in the same action, results in monetary sanctions over $1 million. Individuals who voluntarily provided the SEC original information that led to successful enforcement in the actions identified in the Notices are eligible to apply for whistleblower awards. Once the Notices are posted, individuals have 90 days to apply for an award. The blog post lists 22 actions in which Notices have been posted. The list is complete through February 8, 2013. From looking at the dates on which the Notices have been posted, the SEC is putting up Notices regularly. The pretty clear inference is that this list is going to get a lot longer very rapidly.

 

Obviously not all of the Notices will lead to whistleblower bounty awards. Indeed, many will not, as there may not be a qualifying individual. But it seems highly probable that there will be some awards, perhaps many. In other words, it still seems possible that 2013 will be the year in which whistleblower bounty provisions kick into high gear. Stay tuned.

 

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The modern public company D&O insurance policy provides coverage not only for the directors and officers of the company but also for the company itself – however, in the public company D&O insurance policy, the entity coverage applies only to securities claims, a limitation that sometimes leads to disputes whether or not a particular matter constitutes a securities claim.

 

A recent decision from the Central District of California took a look at whether the claims against a mortgage originator and securitizer involving the company’s issuance of mortgage-backed securities constituted a “Securities Claim” within the meaning of the company’s D&O insurance policy. In her February 26, 2013 order (here), Judge Josephine Tucker held that the claims were not “Securities Claims” within the meaning of the D&O policy and therefore that the insurer did not have a duty to advance defense costs.

 

Background

Until 2007, Impac Mortgage Holdings funded, sold and securitized residential mortgages. A unit of the company acquired mortgages that another company unit originated. The acquired mortgages were placed in a trust, which in turn issued certificates that were issued to an underwriter which then sold them to investors.

 

The coverage dispute relates to three separate claims that were asserted against Impac and its related entities. First, in April 2011, the Federal Home Loan Bank filed a state court complaint against Impac alleging unfair and deceptive acts as well as false and misleading statement in connection with the sale of the certificates. Second, in May 2011, Citigroup filed an action in the Central District of California against Impac, alleging violations of Sections 18 and 20 of the Securities Act of 1934, as well as negligent misrepresentation in connection with the Citigroup’ s purchase of certain other certificates. Finally, in April 2010, the Federal Reserve Bank of New York sent a letter to Impac referencing a dispute concerning priority of payments under four Impac securities offerings.

 

Impac submitted all three of these matters to its D&O insurer, seeking to have the insurer advance defense costs for all three matters and contending that all three arose out of Impac’s mortgage-backed securities business. The insurer denied coverage for all three claims and Impac filed an action against the D&O insurer, seeking a judicial declaration that the insurers ha a duty to advance defense costs. The parties cross-moved for summary judgment.

 

In pertinent part, the D&O insurance policy defined the term “Securities Claim” to mean a claim made against an insured:

 

(1) alleging a violation of any federal, state, local or foreign regulation, rule, or statute regulating securities …which is

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale of or offer or solicitation of an offer to purchase or sell any securities of an Organization;

 

The February 26 Ruling

In her February 26, 2012 order, Judge Tucker denied Impac’s motion for summary judgment and granted the D&O insurer’s summary judgment motion.

 

The D&O insurer had argued that the phrase “securities of the Organization” in the policy’s definition of the term “Securities Claim” referred to Impac’s own securities. Impac urged that the phrase had an additional meaning extending it to the mortgage-backed securities at issue in the underlying disputes. Impac argues that the term securities “of” the company encompasses securities that were possessed, connected or associated with the company.

 

With respect to Impac’s interpretation of the definition, Judge Tucker said:

 

The fact that it would be “semantically permissible” to interpret the Policies’ language as extending coverage to securities Impac bought, sold or was involved in the creation of is not sufficient to create coverage where none would otherwise exist. Rather the court must interpret the disputed language in context, w with regard to its intended function in the policy. Here, Impac has provided no admissible evidence that such an interpretation gives effect to the mutual intention of the parties. (Citations omitted)

 

Judge Tucker went on to note that Impac’s proposed interpretation “would require the phrase ‘securities of’ to carry multiple meaning within one policy definition.” She added that in the context of the full definition and policy, “the phrase ‘securities of’ makes sense only in reference to the securities of Impac itself.” She added that by ascribing multiple meaning so the phrase, “Impac’s construction would result in the provision of vastly broader coverage when the insured happens to engage in the business of securitizing mortgages and would cause a traditional D&O Policy for those particular companies to become a defacto E&O policy, i.e., a professional liability policy for entities.”

 

Judge Tucker also concluded that coverage was precluded by the D&O policy’s Error and Omissions Exclusion, precluding coverage for the company’s “performance of (or failure to perform) any professional services.” She noted in that regard that Impac had asserted against the co-defendant in the action – that is, Impac’s E&O insurer – that the underlying claims do arise out of the provision of professional services.

 

While she concluded that coverage was precluded under the D&O policy’s Errors and Omissions exclusion, Judge Tucker did rule in Impac’s favor ruling in a separate February 26, 2013 order (here) in Impac’s separate action against its E&O insurer. She held that that Impac’s securities transactions constituted professional services under the E&O policy. The parties had disputed whether the underlying claims, which related to Impac’s securitization of mortgages, arose out of Impac’s “performance of or failure to perform professional services for others.” The E&O policy defined Impac’s profession as “mortgage banker/mortgage broker.” Judge Tucker concluded that “the undisputed facts support the conclusion that the securitization was a central element in Impac’s mortgage banking/brokerage business.”

 

She also found that an exclusion cited by Lloyd’s was too ambiguous to warrant a denial of coverage. (The exclusion on which the E&O insurer had sought to rely excluded coverage for (1) “the depreciation (or the failure to appreciate) in value of any investment transaction” or (2) “any actual or alleged representation, advice, guarantee or warranty provided by or on behalf of an Insured with regard to the performance of any such investment.”)

 

Discussion

Like many coverage disputes, the dispute here over whether or not the claims at issue were or were not “Securities Claims” came down to an interpretation of the specific policy language at issue. But even without reference to the specific provisions in the policy, it would have represented an unexpected result for a company’s D&O insurance policy to pick up coverage for claims brought against it for its activities as a mortgage securitizer. As Judge Tucker correctly concluded, to do so would require the D&O insurance policy to provide coverage for the company’s delivery of professional services and would thereby convert the policy into an E&O insurance policy – when in fact the D&O policy carried an express exclusion of coverage for claims arising from the delivery of or the failure to deliver professional services.

 

In a Monday morning quarterbacking kind of a way, I find it irresistible to note that the extent of the policy’s coverage would have been clearer if the policy had not only generally excluded coverage for claims arising from the delivery of professional services but also expressly precluded from the definition of securities claim the company’s issuance of securities as part of its business as a mortgage securitizer.

 

While I don’t have a problem with Judge Tucker’s interpretation of the policy here, there are other gray areas that arise from time to time with respect to the extent of D&O insurance coverage for securities claims. There are claims that can arise when a company is hauled into a lawsuit alleging violations of the securities laws when the specific securities at issue may not be those of the insured company.

 

A couple of examples come to mind: say, for example, when the insured company has spun out one of its divisions as a stand alone, publicly traded entity, and the separate entities file claims not only against the new company but out of the predecessor firm as well. (For an example of this kind of claim, refer here). Another example is an aiding and abetting type lawsuit; say, for example, an insured company is alleged to have violated the securities laws by aiding another company misrepresent its financial condition (sure, private claimants can’t assert these kinds of claims under the federal securities laws, but the SEC can, and private claimants could assert their claims in reliance on state law liability theories). A D&O insurance policy limiting “Securities Claims” solely to claims relating to securities “of” the company arguably might preclude coverage for these claims. For that reason, I have preferred definitions of the term “Securities Claim” that extends coverage to any claim alleging a violation of the federal securities laws or state or local equivalents.

 

From the factual allegations in the Impac case, I can now see (from the carrier’s perspective), at least one flaw with a definition of the term “Securities Claim” that would extend coverage to any alleged violation of the securities laws. If Impac’s D&O policy had included this “any violation of the securities laws” formulation, the policy might well have picked up coverage for the claims against Impac arising from its mortgage securitization activities, which is a result I am certain that the D&O insurer did not intend here.

 

Recognition of this potential shortcoming to the “any violation of the securities laws” formulation suggests a need to devise a new formulation, one that would not hazard the kind of unintended result I noted in the preceding paragraph. My current thought is that perhaps the “any violation of the securities laws” formulation could include a provision expressly precluding coverage for the company’s issuance of securities other than its own securities.

 

This is the kind of topic that I think would benefit from a more thorough discussion. I welcome readers thoughts on this topic, under the heading – “toward a more perfect definition of the term ‘Securities Claim’.”

 

One final note for practitioners. In her analysis of the D&O policy, Judge Tucker correctly determines that traditional “duty to defend” case law and policy interpretation principles do not apply to a “duty to advance” D&O insurance policy. Those involved in litigating defense expense issues in the context of a D&O insurance policy may find her discussion of these issues useful.

 

A Stray Thought about Current Events: Pope Benedict has now moved on to his new life as Pope Emeritus. He undoubtedly hopes he can look forward to a life of quiet contemplation. Everyone here at The D&O Diary wishes him well. Whatever may lie ahead for him and for the Catholic Church, we can all be sure that Benedict will avoid the fate of one of his predecessors, Pope Formosus, who died in April 896 at the age of eighty-one after a five year papacy.

 

As described in Paul Collins’s recent book, The Birth of the West, a one-volume history of the nascent beginnings of modern Europe in the Tenth Century, following the death of Pope Formosus, his successor, Pope Stephen, convened what has become known as the “Cadaver Synod.” Ten months after Pope Formosus died, and under pressure from local magnates, Pope Stephen had his predecessor’s corpse exhumed, dressed in pontifical robes, and placed in a bishop’s chair to be tried for heresy. With troops surrounding the city, the terrified bishops called to pass judgment quickly found Formosus guilty of violating church law. All of his papal acts were declared void and his dead body, stripped of the papal robes, was reinterred as a layman in unconsecrated ground.

 

If Pope Stephen hoped this macabre ceremony would preserve peace, he was mistaken. Collins notes that “the Cadaver Synod marked the beginning of some of the worst internecine civil strife in the history of papal Rome.” All of this took place at a time when Europe was beset with recurring invasions from Vikings, Magyars and Saracens.

 

For those who are worried that the current Catholic Church faces challenges, well, things have been worse. Yet it was from this chaos that the rudiments of modern Europe slowly emerged. In any event, here’s hoping that the upcoming papal transition be smoother than some of those in the past have been.

 

Speaker’s Corner: On March 19, 2013, I will be speaking at a panel at the C5 Forum on D&O Liability Insurance in London. I will be participating on a panel entitled “The Impact of Increased Regulatory Oversight and Regulatory Investigations.” The panel will include my good friends Helga Munger of Munich Re, Cristiana Baez-Safa of XL and Ralf Rebetge of Chubb. The C5 Forum, which is excellent every year, includes a number of interesting sessions and an outstanding line up of speakers. Conference information, including registration instructions, can be found here. If you are planning on attending, I hope you will make a point of greeting me at the conference particularly if we have not previously met.

 

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After entity coverage began to be added to the D&O insurance policy a couple of decades ago, a recurring problem in the bankruptcy context was whether or not the D&O policy proceeds were property of the estate under Bankruptcy Code Section 541(a) and subject to the automatic stay under Bankruptcy Code Section 362. The question arose because the directors and officers of the bankrupt company wanted access to the insurance proceeds to fund defense expense or settlements, but the bankruptcy trustee wanted the proceeds preserved so they are available to satisfy the trustee's own claims, and so the trustee sought to subject payment of the proceeds to the bankruptcy stay.

 

As most practitioners who regularly deal with these issues know, the practical solution to these issues that seems to have been worked out is for the insured directors and officers to approach the bankruptcy court in order to try to obtain an order lifting the stay to allow the carrier to advance their costs of defense, usually subject to certain terms and conditions. These orders are often referred to as “comfort orders,” since they allow the carrier to advance the defense costs without running afoul of the bankruptcy court.

 

Though these procedures may be well known to those who have to deal with them frequently, they may be less familiar to others in the industry who are not as frequently involved in claims presenting these issues. Recent developments in a high-profile case provide a window into these procedures. Although these case developments are not unprecedented, they still provide a useful and perhaps even interesting insight into the way these processes work, particularly for those who may be less familiar with the processes.

 

As was well-publicized at the time, in November 2012, the Rhode Island economic development agency sued former major league baseball star Curt Schilling and several executives at Schilling’s defunct video gaming company, 38 Studios, in a civil action in Rhode Island Superior Court, alleging that Schilling and the other executives, as well as certain officials from the economic development agency, committed fraud in connection with the state’s approval of a $75 million loan guarantee supposedly provided to induce the company to relocate to Rhode Island from Massachusetts.

 

At the time the lawsuit was filed, Schilling’s company and certain related entities were in Chapter 7 bankruptcy proceedings in the District of Delaware bankruptcy court. The trustee in the bankruptcy proceeding contended that the proceeds of the company’s D&O policy were subject to the automatic stay in bankruptcy. Schilling and three other executives from his company filed a motion in the bankruptcy court seeking to have the automatic stay lifted in order to permit the advancement under the D&O policy of their costs incurred in connection with the defense of the Rhode Island lawsuit. The bankruptcy trustee filed limited objections.

 

On February 7, 2013, Bankruptcy Court Judge Mary Walruth granted the executives’ motion and entered an order (a copy of which can be found here) authorizing the D&O insurer to advance the executives defense costs, subject to certain conditions. First, the carrier was directed to provide the trustee and the trustee’s counsel no more than 45 days after the close of each calendar quarter a report stating the total amount disbursed under the policy; the amount disbursed during the quarter; the amount of fee and costs requests pending for which the carrier had not yet made disbursement; and the total amount of coverage remaining under the policy. The order specified that the trustee retained the right to try to seek to have the stay reinstated. The order also specifically stated that the order did not modify the parties’ various rights and obligations under the policy.

 

With the benefit of the order, Schilling and the other officials will now be able to rely on the D&O policy proceeds to fund their defense against the claims in the Rhode Island lawsuit. While there may be nothing remarkable about this now, for many years this relatively straightforward process was highly controversial and extensively litigated, as a result of disputes over the extent to which the policy and the policy proceeds were assets of the estate of the bankrupt company. Fortunately, the processes followed here are now better established. This case provides a good illustration of the way these things now work for those that may not be entirely familiar with these practices.

 

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On February 5, 2013, in a detailed opinion exploring the nuances of a D&O policy’s extended reporting period provisions, Western District of North Carolina Judge Henry Herlong Jr.  determined that the directors of the failed Bank of Ashville of Asheville, North Carolina timely provided their D&O insurer notice of the FDIC’s lawsuit against them as the failed bank’s receiver. Practitioners in the D&O arena will want to read this opinion, a copy of which can be found here, for its examination of the interactions between the policy’s “basic” 60-day extended reporting period and its 12-month “supplemental” extended reporting period.

 

Background

The Bank of Asheville failed on January 21, 2011. As discussed here, on December 29, 2011, the FDIC as the failed bank’s receiver filed a lawsuit in the Western District of North Carolina against seven former directors of the bank. On December 29, 2011, the directors provided the bank’s holding company’s D&O insurer with notice of the FDIC’s lawsuit.

 

The D&O policy provided coverage for the period November 3, 2007 through November 3, 2010. However, the policy contains a 60-day “basic” extended reporting period, allowing for the notice of claims 60 days beyond the policy’s expiration. The policy also provided for a 12-month “supplemental” extended reporting period that, by endorsement and upon payment of an extra premium charge, allows an additional 12 month reporting period. The “supplemental” extended reporting provision in the policy provided that “the supplemental Period starts when the Basic Extended Reporting Period …ends.” 

 

Through a process that the court’s opinion reviewed in detail, the bank purchased the 12-month supplemental extended reporting period prior to the expiration of the policy period. The endorsement the D&O insurer issued specified that the supplemental extended reporting period is “11-01-2010 – 11-01-2011.”

 

After the directors submitted notice of the FDIC lawsuit to the insurer, the insurer took the position that the notice was untimely. The directors filed an action seeking a declaratory judgment that the insurer is required to pay defense costs and any settlements or judgments in the FDIC’s lawsuit. The directors also alleged a claim for reformation of the policy. The parties filed cross-motions for summary judgment.

 

The February 5 Opinion

In his February 5 opinion, Judge Herlong granted the directors’ motion for summary judgment, holding that the directors had timely provided notice of the FDIC lawsuit to the insurer prior to the expiration of the extended reporting period.

 

The dispute that the court considered came down to the question whether the 12-month supplemental extended reporting period ran from the end of the policy period of the policy or from the end of the policy’s 60-day basic extended reporting period.

 

After a detailed review of the communications between the various parties involved in the acquisition of the supplemental extended reporting period, the court concluded that

 

Although the Policy provided a 60-day basic Extended Reporting Period automatically, [the D&O insurer] charged the Bank the maximum permitted under the Policy, a 200 percent premium, for the 12-months of Supplemental Extended Reporting Period coverage. However [the D&O insurer] erroneously used the dates November 3, 2010 to November 3, 2011. Thus under [the D&O insurer’s] argument, the Bank paid for 12 months and received only 10 months of additional extended reporting coverage. Based on the foregoing, the court finds that the starting and ending dates of the Endorsement conflict with the terms of the Policy and is ambiguous because it is subject to different interpretations regarding the 60-day Basic Extended Reporting Period and the 12-month Supplemental Extended Reporting Period.

 

The D&O insurer argued that all of the documents and communications, including in particular the endorsement showing a supplemental extended reporting period from November 3, 2010 to November 3, 2011, “support a finding that the intent of the parties was to eliminate the 60-day Basic Extended Reporting Period.”

 

Judge Herlong said that this “is an amazing argument, “ asking the question “Why would the Bank forfeit the 60-day Basic Extended Reporting Period when the Policy specifically provides that if the Bank purchases an extended reporting period of 12 months, the 12-month period begins when the 60-day Basic Extended Reporting Period ‘ends’?”

 

Judge Herlong concluded that “the evidence is clear that the Plaintiffs did not know or intend to forfeit the 60-day Basic Extended Reporting Period. To the contrary, the only inference that can be drawn from the evidence is that the Plaintiffs paid for 14-months of extended reporting coverage, which includes the 60-day Basic Extended Reporting Period and the 12-month Supplemental Extended Reporting Period.” Judge Herlong granted the directors request to reform the schedule of the endorsement to allow for notice during the period January 3, 2011 to January 3, 2012, as a result of which the directors’ notice to the insurer of the FDIC’s lawsuit was timely.

 

Discussion

Although this decision is fact intensive and is a reflection of the specific policy language involved, it nevertheless represents a cautionary tale that is worth heeding. D&O policies are complex contracts with a variety of parts that interact in myriad subtle ways. My review of the sequence of events here as well as a familiarity with the way that the transaction of the kind involved here are processed suggests to me that the parties really were not fully conscious of the possible complications arising from the interaction between the basic extended reporting period and the supplemental extended reporting period.

 

Once the dispute arose, the parties tried to argue over what had been intended, when in reality there had really been no intent, as the persons involved in the transaction may not have been conscious of the potential issue in the first place; the carrier provided a quote with and issued the supplemental extended reporting period endorsement with dates that did not take the 60-day basic extended reporting period into account. The bank and its representatives accepted the quote and placed the order for the supplemental extended reporting period without objecting that the specific period that the carrier proposed to provide did not take the 60-day basic extended reporting period into account. Accordingly, faced with a fundamentally ambiguous situation (but taking into account the policy’s provision that the supplemental extended reporting period starts when the basic extended reporting period ends), the court construed the situation in the directors’ favor.

 

I think anyone who has been involved in these kinds of situations can see how this happened. The policy allowed for a 12 month reporting period extension, the bank said it wanted a 12 month extension, and the carrier issued an endorsement that extended the reporting period 12 months. Because I can see how what happened here could happen, I am reluctant to try to draw conclusions too broadly, other than to say that this case does provide a lesson for us all on the need when modifying a policy to consider all of the ways that the proposed modification will affect the policy.  On a much simpler level, the case does provide an important illustration of the ways that the policy’s various extended reporting provisions interact. I want to make clear that in stating these conclusions here, I do not mean to suggest that I am finding fault with anyone’s actions. As I said, I can see how this situation came about.

 

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The past year included dramatic and important developments involving elections, tragedies and natural disasters. While there was nothing in the world of Directors and Officers Liability to match this drama, it was nevertheless an eventful year, with many significant developments. In the latest issue of InSIghts, which can be found here, I take a look at Top Ten D&O Stories of 2012.

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A distinctive feature of the current wave of FDIC failed bank litigation is the aura of déjà vu surrounding the suits. The resemblance of the current lawsuits to those filed during the S&L crisis is uncanny. And not only are the suits similar, but in many instances they even involve the same lawyers as last time around.

 

Just the same, any suggestion that the risks and exposures for financial institution directors and officers have not changed since the S&L crisis would be mistaken. The liability risks for FI Ds & OS have changed dramatically in recent years. In that earlier era, there was no Sarbanes Oxley Act and no Dodd-Frank Act, and there was no criminal money laundering liability. There was no Consumer Financial Protection Bureau or its requirements for compliance with consumer protection laws. There were no data privacy liability exposures of the type now emerging. Through these and a myriad of other legislative and judicial developments, the liability exposures of financial institution directors and officers have changed exponentially.

 

The individual directors and officers at financial institutions must navigate a difficult course in a treacherous environment. Fortunately for these individuals and their advisors, there is now a comprehensive resource to guide them. Samuel Rosenthal, a partner in the New York office of the Patton Boggs law firm, has written an exhaustive single-volume desk book  entitled Director and Officer Liability in Financial Institutions (here). Rosenthal’s 1045-page book is an indispensable reference for anyone who wants to understand and address the liability exposures of financial institution directors and officers.

 

Rosenthal’s book is built on a familiarity with the earlier litigation from the S&L crisis era as well as an awareness of the fraught circumstances now facing financial institution directors and officers following the subprime meltdown and ensuing credit crisis.

 

What makes this book so valuable is that it not only broadly organizes the traditional background regarding director and officer liability exposures but it also incorporates a thorough review of the new range of liability risks that have emerged as a result of legislative and judicial developments in recent years.

 

Thus for example, Rosenthal not only reviews the traditional civil liabilities facing financial institution directors and officers under the common law and federal statutory law, but also the myriad new criminal provisions to which FI Ds & OS are now subject, as well as the new potential consumer protection and privacy exposures they now face. Rosenthal brings many years of practical experience to this review; here is his perspective on the many recent changes:

 

This period over the last twenty-five years has witnessed a stunning trend in enforcement efforts has it has moved from traditional concepts dependent upom mens rea to one criminalizing conduct that might have been regarded – at best – to be a civil violation years ago. Directors and officers can be sued, barred from the industry or even jailed for conduct that years ago would have merited little or no attention from regulatory authorities and prosecutors.

 

In recognition of this new environment, Rosenthal’s book provides a detailed yet practical overview of the current state of governmental enforcement actions to which FI Ds&Os could be subject, including in particular a thorough summary of the recent civil actions and enforcement actions of the relevant federal agencies, as a way to afford insight into these agencies' current expectations and approach.

 

Finally the book provides a practical manual for directors and officers of financial institutions on how they can best try to defend themselves – from the investigative stage through ensuing civil and criminal proceedings. The defense overview section includes a separate chapter on the indispensable question of how the directors and officers can pay for their costs of defense. This section includes a critical review of the relevant indemnification and D&O insurance issues.

 

The one thing that is hard to capture in this short book review like this is how detailed and specific this book is. The book’s scope and depth are extraordinary. As I browsed the book’s lengthy table of contents, I found myself turning frequently to the interesting and perceptive discussion of a host of issues on which I am currently involved. In each case, the book’s treatment of the topic was thorough and helpful.

 

Just the same, the book is written with the directors and officers themselves in mind. The book is intended to inform them of their duties and exposures; of the steps that can take to try to mitigate their risks; and what they should do when claims arise. The book also aims for those who counsel financial institution directors and officers. The book will also be valuable for anyone involved in claims concerning FI Ds&Os, including regulators, claimants, defense counsel, and D&O insurance claims counsel.

 

In short, Rosenthal’s  book is a comprehensive, practical and helpful guide for financial institution directors and officers written by a knowledgeable and experienced practitioner. For anyone called upon to address liability and enforcement issues, having this book at hand will be like having a hotline to a skilled and trusted advisor. This book is an essential resource that everyone involved in D&O liability issues should have on their desks.

 

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As I have discussed in prior posts (refer here for example), one of the recurring D&O insurance coverage issues that has arisen in connection with the FDIC’s failed bank litigation is the question whether or not the FDIC’s claims as receiver for the failed bank against the bank’s former directors and officers trigger the D&O policy’s insured vs. insured exclusion. In a terse January 4, 2013 opinion (here), Northern District of Georgia Judge Robert L. Vining, Jr. held that, owing to the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion.

 

Background

Omni National Bank of Atlanta Georgia failed on March 27, 2009 (refer here). The FDIC was appointed as receiver for the failed bank. On March 16, 2012, the FDIC initiated a lawsuit in the Northern District of Georgia against ten former directors and officers of the bank, asserting claims against the defendants for negligence and gross negligence in connection with the approval of certain loans on low-income residential properties.

 

The bank’s D&O insurer initiated a separate declaratory judgment action seeking a declaration that there is no coverage under the bank’s D&O policy for the FDIC’s claims against the bank’s former directors and officers.

 

The D&O insurer filed a motion for summary judgment the declaratory judgment action, on three grounds: first: the carrier argued that because the FDIC as receiver “steps into the shoes” of the failed bank, the FDIC’s claim represents a claim “by, on behalf of, or at the behest of, the Company,” and therefore is precluded from coverage under the policy’s insured vs. insured exclusion; second, that the losses the FDIC seeks to recover do not fall within the policy’s definition of “loss,” which includes the so-called “loan loss carve-out”; and third that the policy does not in any event provide coverage for wrongful acts alleged against the former directors and officers that took place after the policy’s expiration.

 

The January 4 Opinion

In his January 4, 2013 opinion, Judge Vining denied the carrier’s motion for summary judgment with on the first two grounds, but granted summary judgment with respect to the alleged wrongful acts that took place after the policy’s expiration.

 

In rejecting the insurer’s argument that coverage is precluded by the policy’s insured vs. insured exclusion, Judge Vining said that “it is unclear whether the FDIC-R’s claims are ‘by ‘or ‘on behalf of’ the failed bank.” He added that “it is unclear what exactly is encompassed by the phrase ‘steps into the shoes.” These “ambiguities” arise, Judge Vining found, “in part because the FDIC-R differs from other receivers or conservators that might step into the shoes of a failed or insolvent bank.”

 

Judge Vining then reviewed the FDIC’s authority under FIREEA to recover losses, and the fact that in recovering losses the FDIC has authority to act on behalf of the bank’s depositors, creditors and shareholders.  Judge Vining noted that “the FDIC-R has multiple roles.” Accordingly, he concluded that “the FDIC-R has show that some ambiguity exists in the insured versus insured exclusion,” and he denied the carrier’s motion for summary judgment in reliance on the exclusion.

 

Judge Vining also rejected the carrier’s motion for summary judgment based on the argument that the financial losses the FDIC sought to recover did not constitute covered loss under the policy. Judge Vining found that “ambiguity exists in the definition of ‘loss’” because the “loan loss carve-out” does not “clearly exempt tortious claims” which is “the basis” for the FDIC’s claims in the underlying D&O liability action.

 

Discussion

Although D&O insurers have raised the insured vs. insured exclusion as a defense to coverage in connection with a number of FDIC failed bank claims, Judge Vining’s ruling in the Omni National Bank is so far as I am aware only the second ruling in connection with the current failed bank wave in which a court has made a ruling regarding the applicability of the insured v. insured exclusion to an action brought by the FDIC in its capacity as a receiver for a failed bank.

 

As discussed here, in October 2012, District of Puerto Rico Judge Gustavo Gelpi denied the D&O insurer’s motion to dismiss the coverage action the FDIC had brought against the carrier under Puerto Rico’s direct action statute. The D&O carrier involved had sought to dismiss the suit on the grounds that the D&O policy’s insured vs. insured exclusion precluded coverage for the FDIC’s claims in its capacity of the failed Westernbank against the bank’s former directors and officers. Judge Gelpi declined to dismiss the action, noting that the FDIC has authority under FIRREA to act “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

In both cases, the respective judges held that the carriers were not entitled to a determination as a matter of law that the exclusion precluded coverage. Both Judge Gelpi in the prior case and Judge Vining here determined that the Insured vs. Insured did not preclude coverage as a matter of law because the FDIC has the authority under FIRREA to act on behalf of a variety of different constituencies. The FDIC as well as individual directors and officers seeking coverage under their bank’s D&O insurance policies undoubtedly will seek to rely on these rulings in order to try to fight other carrier’s attempts to assert the Insured vs. Insured exclusion as a defense to coverage.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action.

 

The carriers will further argue that the policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

Though these rulings unquestionably are helpful for the FDIC and the individual directors and officers, it seems likely that these issues will continue to be litigated in other cases.

 

Special thanks to a loyal reader for providing me with a copy of Judge Vining’s January 4 Order.

 

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The year just finished included dramatic and important developments involving elections, tragedies and natural disasters. While there was nothing in the world of directors’ and officers’ liability to match this drama, it was nevertheless an eventful year in the world of D&O, with many significant developments. By way of review of the year’s events, here is The D&O Diary’s list of the Top Ten D&O stories of 2012.

 

1. Barclays and UBS Enter Massive Libor Scandal-Related Regulatory Settlements: The Libor scandal first began to unfold more than four years ago, but  with the dramatic announcements in late June 2012 of the imposition of fines and penalties of over $450 million against Barclays PLC, the scandal shifted into a higher gear. But as significant as were the Barclays settlements, the recent announcement by UBS that it had entered its own set of regulatory settlements totaling over $1.5 billion represented an even more substantial development.

 

In both sets of settlements, the banks involved admitted that their representatives had attempted to manipulate the Libor benchmark interest rates. UBS also admitted that its representatives had attempted to collude with third parties – including both interbank dealers and other Libor panel banks – to try to affect the benchmarks, at first to try to extract profits from its derivatives trading activities and later to try to affect public perception of the bank’s financial health during the peak of the credit crisis. The U.S. Commodities Futures Trading Commission expressly concluded that UBS had “succeeded” in manipulating Libor Yen benchmark rates. UBS’s Japanese unit pled guilty to one count of wire fraud.

 

Among the many implications from these developments is their possible impact on existing and future Libor scandal-related litigation. The revelations in the UBS regulatory settlements of collusive activity obviously will bolster the existing antitrust litigation that has been consolidated in Manhattan federal court. The sensational aspect of many of the factual revelations in connection with the UBS settlement may encourage other litigants to pursue claims, just as the revelations in the Barclays settlement encouraged other claimants to file suit. Among other suits that filed the Barclays settlement was the filing of a securities class action lawsuit in federal court in Manhattan. There is the possibility that UBS shareholders could also attempt to file a shareholder suit.

 

Another consideration in the wake of the UBS developments is the possibility of claims against the interbank dealers that allegedly participated in the Libor benchmark rate manipulation efforts. Up to this point, the universe of potential litigation targets seemed to be limited to the small handful of large banks on the Libor rate setting panels. With the suggestion that these third party interbank dealers participated in the allegedly manipulative conduct, for the first time there is a suggestion of the scope of litigation expanding beyond just the panel banks themselves.

 

It seems likely that there will be further regulatory settlements involving the panel banks in the months ahead. Among other features of the Barclays and UBS regulatory settlements that undoubtedly will capture the attention of the other banks is that, as massive as were the settlements that Barclays and UBS entered, both UBS and Barclays were the beneficiaries of credits for their cooperation with regulators. The unmistakable suggestion for the other banks is that they should step up their cooperative efforts with regulators as soon as possible or face the possibility of even more severe consequences. It does seem probable that by the time this scandal plays itself out, there will be many more regulatory settlements, some of which might make the Barclays and UBS settlements look modest.

 

As the other banks attempt to position themselves to reach regulatory settlements, there undoubtedly will be even further factual revelations, which in turn will further hearten prospective litigants and likely lead to either further or expanded litigation. However, there are a number of factors that should be kept in mind on the question of what the Libor-scandal litigation might mean for the D&O insurance industry.

 

First, many of the undoubtedly huge costs that are looming likely will not represent insured amounts. The regulatory fines and penalties will not be insured. The company investigative costs also are likely not covered. In addition, most of the antitrust litigation filed to date has named only corporate defendants. Under the typical D&O insurance policy, the companies themselves are only insured for securities claims. So the antitrust litigation, for example, would likely not be covered under the typical D&O insurance policy.

 

In addition, many of these large banks do not carry traditional D&O insurance or may only have restricted insurance. In some instances, the banks’ insurance may include a substantial coinsurance percentage or a massive self-insured retention. Other banks may only carry so-called Side A only insurance, which covers individual directors and officers only and is only available when the corporate entity is unable to indemnify the individuals due to insolvency or legal prohibition. Given that none of the potentially involved banks have failed, it seems unlikely that this Side A only coverage would be triggered.

 

2. As Bank Failures Wane, the FDIC Ramps Up the Failed Bank Litigation: The number of bank failures dropped significantly in 2012 compared with prior years. Only 51 financial institutions failed during 2012, the lowest annual number of bank closures since 2008, when there were 25 bank failures. By way of comparison, there were 92 bank failures in 2011 and 157 in 2010. Overall, there have been 468 bank failures since January 1, 2007. Of the 51 bank failures during 2012, only 20 came in the year’s second half, and only 12 came after August 1, 2012.

 

Though the bank failure pace clearly is declining, the pace of the FDIC’s filing of failed bank litigation is ramping up. With the addition of the December 17, 2012 filing of its lawsuit against the former CEO and six former directors of the failed Peoples First Community Bank of Panama City, Florida, the FDIC filed 25 failed bank D&O lawsuits during 2012 and a total of 43 altogether during the current wave of bank failures.

 

The signs are that the FDIC’s active pace of litigation filing activity will continue as we head into 2013. As Cornerstone Research noted in its recent report analyzing the FDIC’s failed bank litigation (refer here), the FDIC tends to file its failed bank lawsuits as the third year anniversary of the bank closure approaches, owing to the applicable three-year statute of limitations. The peak period of bank closures came in early 2010, suggesting that we will continue to see further failed bank litigation in 2013.

 

The Cornerstone Research report’s analysis shows that the FDIC has initiated D&O lawsuits in connection with nine percent of the banks that have failed since 2007. During the S&L crisis, the FDIC (and other federal banking regulators) filed D&O lawsuits in connection with 24% of all failed institutions. If the FDIC were to file D&O lawsuit in connection with 24% of all failed institutions this time around, that would imply that the FDIC would ultimately file about 112 lawsuits (based on the number of banks that have failed so far since 2007). The final number of FDIC lawsuits might well get into that range, as the FDIC’s most recent update on the number of authorized lawsuits indicates that the agency has authorized suits in connection with 89 institutions (or about 19% of the banks that have failed so far). The FDIC increased the number of authorized lawsuits each month during 2012, so the authorized number of suits could quickly reach as high as the implied 112 number of suits.

 

For whatever reason, the FDIC’s lawsuits against former directors and officers of failed banks have been disproportionately concentrated in Georgia. Of the 43 failed bank D&O lawsuits the FDIC has filed, 14 have involved Georgia banks, or just under one-third of all lawsuits. Nine out of the 25 D&O suits the FDIC filed in 2012, or about 36%, involved Georgia banks. At one level this is no surprise, as during the current bank failure wave there have been more bank failures in Georgia than in any other state. But the approximately 80 failed banks in Georgia represent only about 18 percent of the total number of bank failures, so the level of failed bank litigation in Georgia is disproportionately high. Of course there may be timing issues contributing to this and the disproportionately high level of lawsuits involving Georgia may even out as the FDIC continues to file new suits in 2013.

 

3. FDIC Wins $168.8 Million Jury Verdict Against Former IndyMac Officers: Even as the FDIC has continued to ramp up the number of lawsuits against former directors and officers of failed banks, the earliest suits the agency filed have been moving toward resolution. On December 7, 2012, in connection with the first D&O suit the agency filed as part of the current bank failure wave and in what may prove to be one of the most dramatic resolutions of any failed bank suit, a jury in the Central District of California entered a $168.8 million verdict  in the FDIC’s lawsuit against three former officers of the failed IndyMac bank.

 

The jury found that the defendants had been negligent and had breached their fiduciary duties with respect to each of the 23 loans at issue in this phase of the FDIC’s case against the three individuals. The just completed trial apparently represents only the first trial phase of this matter. There apparently will be a separate trial phase that will address the FDIC’s allegations as to scores of other loans as well as allegations with respect to the bank’s loan portfolio as a whole. The FDIC apparently is seeking total damages of more than $350 million.

 

While the jury verdict unquestionably represents a victory for the FDIC, the FDIC may face considerable challenges attempting to collect on it. As discussed at length here, in July 2012, Central District of California Judge Gary Klausner held in a related D&O insurance coverage case that all of the various lawsuits pertaining to Indy Mac’s collapse (including the case in which the jury verdict was just entered) were interrelated to the first-filed lawsuit, and thus triggered only the D&O insurance that was in force when the first suit was filed. Because all of the later-filed lawsuits related back to the first lawsuit, the later lawsuits – including the lawsuit in which the jury verdict was entered -- did not trigger a second $80 million insurance program that was in force when the later suits were filed. (Judge Klausner’s ruling is on appeal.) 

 

Reports are that defense expenses and other settlements have substantially depleted the first D& O insurance tower. In other words, unless Judge Klausner’s coverage ruling is reversed, there may be little or no remaining D&O insurance out of which the FDIC might try to recover on the jury verdict. However, as discussed on Alison Frankel’s On the Case blog (here), the FDIC hopes to be able to enforce against the D&O insurers the entire amounts of the judgments it obtains against the former IndyMac officers, even those amounts in excess of the policies’ limits of liability.

 

Regardless of whether or not the FDIC will ever be able to collect, the entry of the jury verdict in the IndyMac case represents a significant development. Indeed, in its recent report about FDIC failed bank D&O litigation, Cornerstone Research cited the FDIC’s success at the IndyMac trial as one reason we can expect to see the agency bring more failed bank D&O lawsuits in the months ahead. The jury verdict may also give pause to other failed bank directors and officers who were otherwise determined to fight FDIC claims. However, some commentators have questioned the relevance of the verdict to other FDIC suits outside of California.

 

In a related development a week after the jury entered the massive verdict against the three former IndyMac officers, Michael Perry, IndyMac’s former CEO, reached an agreement to settle the separate lawsuit that the FDIC had brought against him. In his settlement, Perry agreed to pay $1 million, plus an additional $11 million to be funded entirely by insurance. The settlement agreement provides that Perry has no liability for the insurance portion of the settlement and also provides for an assignment to the FDIC of all his rights against IndyMac’s D&O insurers.

 

4. Congress Enacts the Jumpstart Our Business Startups (JOBS) Act: On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). This legislation, which enjoyed strong bipartisan support in Congress, is intended to ease the IPO process for Emerging Growth Companies (EGCs) and facilitate capital-raising by reducing regulatory burdens and disclosure obligations. The Act also introduces changes that could impact the potential liability exposures of directors and officers of both public and private companies. These changes could have important D&O insurance implications.

 

As discussed at greater length here, the JOBS Act contains a number of IPO “on ramp” procedures designed to ease the process and burdens of the “going public” process for EGCs. For example, EGCs can elect to submit their IPO registration statement for SEC review on a confidential, nonpublic basis, although the registration statement must be publicly filed at least 21 days before the IPO roadshow.

 

Among the other features of Act that has attracted the most attention are its provisions allowing “crowdfunding.” Under these provisions, a company is permitted to raise up to $1 million during any 12-month period through an SEC-registered crowdfunding portal. The crowdfunding provisions have yet to go into effect. The SEC’s implementing regulations are due to be released in January 2013.

 

It remains to be seen how the JOBS Act’s changes will ultimately play out. Many of the Act’s provisions (such as, for example, the crowdfunding provisions) are subject to significant additional rulemaking. Even before the JOBS Act was enacted, the SEC was already straining under rulemaking obligations imposed by the Dodd-Frank Act. As the SEC is far behind on many rulemakings required by the Dodd-Frank Act, the sheer weight of the agency’s obligations, as well as post-election changes in the agency’s leadership, could mean delays for the rulemakings required under the JOBS Act.

 

Though the reduced compliance and disclosure requirements for EGCs reduces costs and affords these companies certain advantages, that does not necessarily mean that D&O insurance underwriters will regard ECGs as having less risk. To the contrary, the reduced compliance and disclosure requirements may well raise underwriters’ concerns that EGCs represent a riskier class of business.

 

In addition, some of the Act’s provisions could increase potential liabilities under certain circumstances. For example, Section 302(c) of the Act expressly imposes liability on issuers and their directors and officers for material misrepresentations and omissions made to investors in connection with a crowdfunding offering. The crowdfunding provisions may blur the clarity between private and public companies. The crowdfunding provisions expressly contemplate that a private company would be able to engage in crowdfunding financing activities without otherwise assuming public company reporting obligations. Yet, at the same time, that same private company will be required to make certain disclosure filings with the SEC in connection with the crowdfunding offering; and could also potentially incur liability under Section 302(c) of the JOBS Act.

 

Many private company D&O insurance policies contain securities offering exclusions.  The wordings of this exclusion vary widely among different policies, and some wordings could be sufficiently broad to preclude coverage for crowdfunding activities. In addition, some private company D&O insurers have already introduced exclusions expressly precluding coverage for claims arising from crowdfunding.  As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must assess the impact of changes introduced by this broad, new legislation. It may be some time before all of the Act’s implications and ramifications can be identified and understood.

 

5. Credit Crisis Suit Continue to Produce Massive Settlements: The subprime and credit crisis related litigation wave that began all the way back in 2007 continues to grind though the court system, and during 2012 several of the remaining cases resulted in massive securities class action lawsuit settlements The first of these was the $275 million Bear Stearns settlement, which was announced in June 2012. That was followed within a few weeks by the $590 million Citigroup settlement, announced in late August 2012.

 

Then in late September 2012, the parties to the pending BofA/Merrill Lynch settlement announced a $2.43 billion settlement, the largest settlement so far of any of the subprime and credit crisis related lawsuits. The BofA/ Merrill settlement is not only the eighth largest securities class action lawsuit settlement ever (refer here for the Stanford Law School Class Action Clearinghouse’s list of the top ten largest securities suit settlements), but according a September 28, 2012 press release from the Ohio Attorney General (whose office represented several Ohio pension funds that were among the lead plaintiffs in the case), it is the fourth largest settlement funded by a single defendant for violations of the federal securities laws, and it is largest securities class settlement ever resolving a Section 14(a) case (alleging misrepresentations in connection with the a proxy solicitation). According to the Ohio AG, the settlement is also the largest securities class action settlement where there were no criminal charges against company executives.

 

With the entry of these large settlements and of several additional smaller settlements during the year, the various settlements in the many securities class action lawsuits filed as part of the subprime and credit crisis related litigation wave now total $8.092 billion. The average credit crisis securities suit settlement is $139.5 million; however, if the three largest settlements are removed from the equation, the average drops to $80.87 million. Not all of these settlement amounts were funded by D&O insurance but D&O insurance did find a significant part of many of these settlements, including many of the smaller settlements. Moreover, many of the subprime and credit crisis securities class action lawsuits continue to grind through the system, and defense costs continue to accumulate and the prospect for even further settlement costs loom

 

Even as the credit crisis itself continues to recede into the past, litigation continues to accumulate -- although the litigation is evolving. That is, many of the most recently filed lawsuits, alleging either misrepresentations in offering documents relating to mortgage-backed securities or put-back rights asserted by issuers that purchased mortgages from lending institutions, are being asserted as individual actions. These latest suits seem to ensure that credit crisis related litigation will continue for years to come.

 

6. Securities Class Action Opt-Outs Return With a Vengeance: One of the more interesting story lines in the securities class action litigation arena in recent years has been the emergence of substantial class action opt-out litigation, whereby various claimants representing significant shareholder ownership interests select out of the class suit and separately pursue their own claims – and settlements. The class action opt-out litigation emerged as a significant phenomenon in the litigation arising out of the era of corporate scandals a decade ago. After attracting a great deal of attention and concern at the time, the phenomenon seemingly faded into the background -- that is, until several large public pension funds and mutual fund families opted out of the $624 million Countrywide subprime-related securities lawsuit settlement, about which I previously commented here.

 

Now, more than a year after the high-profile Countrywide opt-out suit, significant class action opt-outs appear to be becoming a regular part of the larger securities class action litigation. Even the $590 million settlement in the Citigroup subprime-related securities class action lawsuit, as massive as it is, has been accompanied by a significant number of class action opt-outs.

 

As discussed in Nate Raymond’s December 13, 2012 On the Case blog post (here), several significant institutional investors have elected to opt out of Citigroup settlement and are pursuing their own separate actions. The article, which notes that “opt-outs have become a regular feature fixture in any big securities class action,” reports that a total of 134 investors have chosen to opt out of the Citigroup settlement, including some institutional investors that had filed separate individual actions as long as two years ago.

 

Similarly, a significant number of institutional investors opted out of the Pfizer securities class action litigation pertaining to the company’s disclosures about the safety of its Celebrex and Bextra pain medication. In their November 15, 2012 complaint (here), seven public pension funds (including CalPERS and CalSTRS) and dozens of mutual funds from four separate mutual fund families have filed a separate lawsuit against the company and five of its individual directors and officers.

 

Why are the opt-out claimants selecting out of the class actions? The answer is that the institutional investor opt-out claimants think the can do better for themselves by proceeding separately. In a November 15, 2012 Am Law Litigation Daily article (here), counsel for the Pfizer securities litigation opt-out claimants is quoted as saying, among other things, that in other opt-out claims that his firm has filed in connection with other pending securities class action lawsuits, the firm has resolved the opt-outs claims for “multiples” of what they would have recovered as class claimants. In addition, based on counsel’s remarks in the news article, there has been a level of significant opt-out activity in recent years that has been going on beyond the radar screen -- indeed, the plaintiffs’ firm filing the Pfizer opt-out complaint reportedly has been involved in 14 additional opt-out suits just in the first nine months of 2012.

 

The comments in the Am Law Litigation Daily article suggest that institutional investors’ interest in opt-out litigation is growing, largely due to the growing perception that their recoveries will be increased by proceeding outside of the class. The opt-out claimants also avoid the cumbersome process and delays involved in the class settlement process. Mutual funds, which traditionally have not been involved in opt out litigation, have become more interested and involved in opting out. The article quotes Columbia Law Professor John Coffee as saying that “the trend is toward opting out.”

 

For many years, class action lawsuits have been a favored whipping boy for conservative commentators. But for all of the ills that class actions can sometimes involve, the prospect of a litigation process in which mass group claims are fragmented and can only be resolved in a piecemeal fashion hardly represents an improvement. Given the apparently increasing institutional investor interest in pursuing claims separate from the larger investor class, we could very quickly be getting to the point where resolution of class litigation is only one part of a multistep process.

 

7. Securities Suit Filings, Settlements and Dismissals Decline During 2012: Largely as a result of a slowdown in new filings during the fourth quarter, 2012 securities class action lawsuit filings were below the levels of recent years and well below historical averages. There were 156 new securities class action lawsuit filings during 2012, down from 188 in 2011 and well below the 1996-2011 annual average of 193.

 

The drop in 2012 filings is largely due to the decline in filings during the year’s fourth quarter. There were 45, 45 and 41 filings during the first, second and third quarters, respectively. However, in the fourth quarter there were only 25 new securities class action lawsuit filings. The 66 new filings during the second half of 2012 represented the lowest filing level for any half-yearly period since the first half of 2007. (I detailed in a recent post the differences in counting methodology that may explain how my tally differs from other published securities class action lawsuit counts.)

 

In addition, not only did the number of new lawsuit filings decline in 2012 (at least according to my tally), the number of cases resolved during 2012 through dismissal or settlement also plummeted, according to a recent study from NERA Economic Consulting.  (The NERA report considers the time of settlement as the date on which settlement is approved, so some high profile settlements that were announced in 2012 are not reflected in NERA’s analysis. The NERA report count of dismissals includes dismissals that are not yet final, such as dismissals without prejudice.)

 

According to the NERA report, the 92 settlements projected to be approved in 2012 is the lowest number of annual approved settlements since 1996 and 25% lower than 2011. The 60 dismissals NERA projected for 2012 represent the lowest dismissal level since 1998. The 2012 dismissal total is 50% lower than 2011. The total of 152 cases that resolved (settled or dismissed) during 2012 is also the lowest level since 1996. The NERA report notes that part of the reason for the decline in case resolutions may simply be that there were fewer cases pending and therefore available to be resolved as 2012 began, when there were the lowest level of pending securities cases since 2000. The report also speculates that the slowdown in the number of settlements and dismissals may also be due to “other changes in the legal environment.”

 

While the number of settlements may have declined, adjusted average and median settlements are up. The average securities class action settlement in 2012 was $36 million, compared to a 2005-2011 average of $42.1 million. But if the calculation excludes settlements over $1 billion, the IPO laddering cases and the merger objection cases, the 2012 average of $36 million compares to an adjusted average for the 2005-2011 period of $32 million. The median settlement in 2012 was $11.1 million, which is the largest ever annual median since 1996, making 2012 only the second year since 1996 that the median has exceeded $10 million.

 

8. The Mix of Corporate and Securities Litigation Continues to Change: For many years, the default topic when the question of corporate and securities litigation came up was securities class action litigation. However, in more recent years, a broader range of lawsuits has been relevant to the discussion. This diversification phenomenon got started in the middle part of the last decade with the wave of options backdating lawsuits, many of which were filed as shareholders’ derivative suits rather than as securities class action lawsuits. Another more recent manifestation of this development has been the onslaught of merger objection litigation, as a result of which nearly every merger transaction these days now involves litigation.

 

It seems clear that as the opportunities for plaintiffs’ attorneys to participate in traditional securities class action litigation have diminished, the plaintiffs’ attorneys are casting about, seeking ways to diversity their product line. The opt-out litigation noted above seems to be one manifestation of this effort, along with the merger objection litigation.

 

During the past year, yet another development of the plaintiffs’ lawyers’ efforts to diversity was the development of a new form of litigation involving executive compensation. This new wave of executive comp suits, in which the plaintiff’s seek to enjoin upcoming shareholder votes on compensation or employee share plans on the grounds of inadequate or insufficient disclosure, have resulted in some success – at least for the plaintiffs’ lawyers involved. These new kinds of executive compensation–related lawsuits possibly may be “gaining steam,” according to a recent law firm study.

 

A November 19, 2010 memo from the Pillsbury law firm entitled “Plaintiffs’ Firms Gaining Steam in New Wave Say-on-Pay Lawsuits” (here) reviews the history of say-on-pay litigation that has followed in the wake of the Dodd Frank Act’s requirements for an advisory shareholder vote on executive compensation. The memo shows that of the at least 43 companies that experienced negative say-on-pay votes in 2011, at least 15 were hit with shareholder suits alleging, among other things, that the companies’ directors and officers had violated their fiduciary duties in connection with executive compensation. However, as is well-documented in the law firm memo, these suits have not fared well in the courts; ten of the eleven of the 2011 suits that have reached the motion to dismiss stage have resulted in dismissals.

 

Faced with this poor track record on the 2011 say-on-pay suits, plaintiffs’ lawyers filed fewer of these kinds of suits in 2012 against companies that experienced negative votes. However, as the law firm memo explains, one plaintiffs’ firm has now “orchestrated a new strategy to hold companies liable: suits to enjoin the shareholder vote because the proxy statement failed to provide adequate disclosure concerning executive compensation proposals.” According to the memo, there have been at least 18 of these new types of suits, with nine of them having been filed just in the month preceding the memo’s publication.

 

As detailed in Nate Raymond’s November 30, 2012 Reuters story entitled “Lawyers gain from ‘say-on-pay’ suits targeting U.S. firms” (here), these new style have met with some success. According to the article, at least six of these suits “have resulted in settlements in which the companies have agreed to give the shareholders more information on the pay of the executives.” These settlements have also “resulted in fees of up to $625,000 to the lawyers who brought the cases.” The article also notes, however, that while the settlements have provided additional disclosures and legal fees for the firm that has filed almost all of these suits, “they have netted no cash for shareholders.”

 

These new suits share certain characteristics with the M&A-related lawsuits. That is, they are filed at a time when the defendant company is under time pressure that motivates the company to settle quickly rather than deal with the lawsuit. Just as in the merger context, where the company wants to move the transaction forward and doesn’t want the lawsuit holding things up, companies facing these new style say-on-pay lawsuits, facing an imminent shareholder vote, are pressured to reach a quick settlement rather than risking a delay in the shareholder vote.

 

Both the kinds of say-on-pay lawsuits filed in 2011 and the new style version of the suits that are hot now are symptoms of a larger phenomenon, which is the attempt by some parts of the plaintiffs’ securities bar to diversify their product line. The pressure on the plaintiffs’ firms to diversify will likely continue to lead to more lawyer-driven litigation of these kinds, including not only the varieties of lawsuits noted here but also perhaps other kinds of suits that will emerge in the months ahead.

 

9. Whistleblower Reports Surge, Threatening Further Enforcement Action and Bounty Payments Ahead: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would-be whistleblowers who hoped to cash in on the potentially rich rewards.

 

As it has turned out, the whistleblower bounty program has been slow to get started. The SEC finally awarded its first whistleblower bounty in 2012. As reflected in the SEC’s August 21, 2012 press release (here), the agency’s first whistleblower award for the relatively modest amount of $50,000. However, small amount of this single award should not be interpreted to suggest that the whistleblower program will not amount to much. To the contrary, the signs are that the whistleblower program seems likely to turn out to be very significant.

 

In November 2012, the SEC’s Office of the Whistleblower produced its annual report for the 2012 fiscal year on the Dodd-Frank whistleblower program. The report shows that during the 2012 fiscal year, the agency received 3,001 whistleblower tips. The agency received tips from all 50 states as well as from 49 countries outside the United States. The report details the events that must occur and the process that must be followed in order for a bounty award to be made. The prolonged process seems to ensure that some a significant amount of time is required between the time when a whistleblower submits a tip and a bounty award is made.

 

The agency’s report makes it clear that though there has only been one bounty award so far, many more lie ahead. Among other things, the report notes that during the past year there were 143 enforcement actions resulting in the imposition of sanctions in excess of the $1 million threshold for the award of sanction, and that Office of Whistleblower is continuing to review the award applications the Office received during the 2012 fiscal year. In other words, the likelihood is that there will be further awards in the year ahead – and the report notes that the value of the Fund out of which any future awards are to be made now exceeds $453 million.

 

It seems probable that as more awards are announced, interest in the whistleblower program will increase as well. Opportunistic plaintiffs’ lawyers casting about for alternatives to traditional securities litigation are already attempting to position themselves to take advantage of these anticipated developments. Many plaintiffs’ firms are advertising on the Internet and elsewhere seeking to assist whistleblowers to submit their tips to the agency and also to try to get the inside track on any civil litigation opportunities that might follow in the event that the SEC were to pursue an enforcement action based on the whistleblower’s tip. Among the more interesting examples of these efforts on plaintiffs’ lawyers’ part during recent months were the December 2012 publicity efforts of the plaintiffs’ firm representing whistleblower alleging that Deutsche Bank hid billions of dollars of losses on its derivatives portfolio during the peak of the credit crisis.

 

It seems that if 2012 was the year in which the Dodd-Frank whistleblower program finally got off the ground, 2013 will likely be the year when the program picks up serious momentum. It seems likely that in the year ahead that we will not only see increased enforcement activity as a result of whistleblowers’ tips, but that we will see increased numbers of whistleblowers’ bounty awards, as well as the possibility of increased private civil litigation following in the wake of the enforcement actions.

 

10. Rule 10b5-1 Trading Plans Under Scrutiny Once Again: When the SEC brought civil enforcement charges against former Countrywide Financial CEO Angelo Mozilo in June 2009, a critical part of the agency’s allegations was that Mozilo had manipulated his Rule 10b5-1 trading plans to permit him to reap vast profits in trading his shares in company stock while he was aware of increasingly serious problem in the company’s mortgage portfolio.

 

Among other things, the SEC alleged that pursuant to these plans and during the period November 2006 through August 2007, and shortly after he had circulated internal emails sharply critical of the company’s mortgage loan underwriting and the “toxic” mortgages in the company’s portfolio, Mozilo exercised over 51 million stock options and sold the underlying shares for total proceeds of over $139 million.

 

In October 2010, Mozilo agreed to settle the SEC’s enforcement action for a payment of $67.5 million dollars, including a $22.5 million penalty and a disgorgement of $45 million. The financial penalty was at the time (and I believe still is) the largest ever paid by a public company’s senior executive in an SEC settlement.

 

As if all of this were not enough to cast a cloud over Rule 10b5-1 trading plans, the trading plans are once again back in the news, and once again the news about the plans is negative. A front page November 28, 2012 Wall Street Journal article entitled “Executives’ Good Luck in Trading Own Stock” (here), reports on the newspaper’s analysis of thousands of trades by corporate executives in their company’s stock. Among other things, the newspaper reports on numerous instances where executives, trading in company shares pursuant to Rule 10b5-1 plans, managed to extract trading profits just before bad news sent share prices down or to capture gains with purchases executed just before unexpected good news.

 

It appears that the SEC reads the Journal. The agency has launched investigations in connection with trading activities at several of the companies mentioned in the Journal article. While not all of the trades under scrutiny involved Rule 10b5-1 trading plans, possible plan misuse seems to be at least one aspect of the investigation. Insider trading involving supposed tips about various companies has been a significant investigative focus for some time now (for example, as pertains to the various insider trading allegations involving Raj Rajaratnam and others), but these most recent allegations involve alleged improper trading by company insiders in their personal holdings of their company stock. The allegations and ensuing investigations seem likely to produce significant enforcement activity in the months ahead, as well as possible follow on private civil litigation.

 

There is no doubt that these various allegations involving insider trading plans have put the plans in a negative light. However, as discussed here, a well-designed and well-executed plan can still provide substantial liability protection by allowing insiders to trade in their holdings of company stock without incurring securities liability exposure. Notwithstanding these recent developments, a well-designed Rule 10b5-1 plan remains important securities litigation loss prevention

 

Blogging Year in Review: During 2012, the staff here at The D&O Diary tried to keep track of important developments in the world of directors and officers liability. While we strive to maintain our focus on topics within our central area of concern, from time to time we also try to diversify our mix of offerings. During the past year, we managed to work in other fare, such as interviews, book reviews and guest posts reflecting the perspectives of other industry commentators.

 

Though we enjoy diversifying the mix of offerings with these other kinds of articles, we must admit that we derive the greatest pleasure when we venture far off topic in our occasional travel blog posts. 2012 provided a rich variety of opportunities for travel blogging, including trips to London (with a special visit to the Lloyd’s Building), Dublin, Beijing, Hong Kong, Singapore, Munich and Berlin.

 

As much fun as it was to write the travel blogs, our favorite post of the year (and maybe of all time), was the July 2012 post about Summer and Time. If you have not yet read it, you can find the post here. Even if you don’t read the entire post, please take a look at the pictures and read the comments from other readers. Even if you have read it before, you may find it rewarding to read the post again, now that that the chilly winds of winter are blowing.

 

I have a lot of fun writing this blog. But I could never do it without the support and encouragement from readers. I would like to express my thanks here to the many readers who during the past year sent me case decisions, suggestions and document links. I get my best stuff from readers, and the willingness of readers to support my efforts helps to make this site a better resource for everyone. My thanks to everyone who has helped along the way, and to everyone that reads and supports this site.  And finally, I would also like to thank my colleagues at RT Pro Exec and RT Specialty for their support and encouragement I could never keep this going without their backing.

 

I am looking forward to another year of blogging in 2013. I welcome readers’ thoughts and comments and in particular I welcome suggestions for how this site might be improved.

 

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An appellate court in New Zealand has “quashed” the controversial ruling of a  lower court ruling that former directors of the defunct Bridgecorp companies are not entitled to defense expense reimbursement under the companies’ D&O insurance policy where the companies’ liquidators have raised (but not yet proven) claims against them exceeding the policy’s limits of liability. The appellate court’s ruling ensures that the companies’ directors have access to the insurance to defend themselves against claims pending against them. A copy of the Court of Appeal of New Zealand’s December 20, 2012 judgment and opinion can be found here.

 

Background

The Bridgecorp liquidators, who have claims against the former Bridgecorp directors in connection with the companies’ collapse, have asserted a “charge” on the Bridgecorp companies’ D&O insurance policy under Section 9 of Law Reform Act of 1936. The liquidators allege that their claims exceed the policy’s limits of liability and that this “charge” gives them priority rights to the policy proceeds. The Bridgecorp directors initiated an action seeking a judicial declaration that the “charge” does not prevent the D&O insurer from meeting its contractual obligations under its policy to reimburse them for their defense expenses.

 

As discussed at length here, on September 15, 2011, New Zealand High Court (Auckland Registry) Justice Graham Lang ruled that the liquidators’ “charge” against the D&O insurance policy proceeds “prevents the directors from having access to the D&O policy to meet their defence costs.” Although Justice Lang acknowledged that this result is “harsh” and even “unsatisfactory,” he reasoned that Section 9 was designed to “keep the insurance fund intact” for the benefit of claimants and that this legislative purpose should not be defeated merely because coverage for both defense costs and indemnity were combined in a single policy.

 

The Bridgecorp directors appealed Justice Lang’s ruling. The appellate court combined their appeal with the application of the directors and officers of the Feltex Carpets. The Feltex officials had been sued in a group action by Feltex shareholders alleging that the Feltex defendants had made misrepresentations in connection with the company’s 2004 IPO. The Feltex directors sought a judicial declaration that they were entitled to have their defense expenses reimbursed under the Feltex D&O policy. Their application to have their petition combined with the Bridgecorp directors’ appeal was  granted. Even though the December 20, 2012 opinion of the Court of Appeal addresses only the Bridgecorp case, the Court’s judgment applies to both cases.

 

The Court of Appeal’s Ruling

In its December 20, 2012 opinion, a three-Justice panel of the Court of Appeal of New Zealand allowed the directors’ appeal and quashed Justice Lang’s lower court ruling. The Court of Appeal overturned the Justice Lang’s ruling on two ground: first, that the Section 9 “charge” does not apply to insurance funds payable with respect to defense costs, even where the defense cost coverage is combined with third-party liability coverage in a policy with a single limit of liability; and second, that Section 9 is not intended to “rewrite or interfere with contractual rights as to cover and reimbursement.”

 

In ruling that the Section 9 does not apply to the D&O policy’s defense cost coverage, the Court of Appeal noted that the policy provides coverage for “two distinct kinds of losses” that operate “independently.” The court reasoned that if the two coverages had been set up in separate policies, Section 9 could not have applied to the defense cost policy, and that the combination of the two coverages into a single policy should not affect the analysis. The court also reasoned that “it is irrelevant” that the policy proceeds would be depleted by payment of defense costs, as that is that is “the necessary consequence of the policy’s structure.”

 

The Court of Appeal also noted that the practical effect of Justice Lang’e ruling was to deny the directors of their contractual rights to defense cost reimbursement. The Court noted that a “charge” under Section 9 is “subject to the terms of the contract of insurance as they stand at the time the charge descends” and it “cannot operate to interfere with or suspend the performance of mutual contractual rights and obligations relating to another liability.” The Section 9 charge cannot deprive the directors of their rights to defense cost protection under the D&O policy.

 

Discussion

There were many troublesome aspects to Justice Lang’s decision, not least of which was that it operated to deprive the insuredsof one of the most important aspects of the policy’s protection at the time they needed it most. The Court of Appeal’s ruling ensures that the directors and officers of Bridgecorp (and of Feltex Carpets) will have access to the proceeds of their companies’ D&O insurance policies to defend the claims pending against them. Justice Lang himself noted that the need for this type of defense cost protection was among the most important reasons companies procure D&O insurance, yet his ruling, had it stood, would have frustrated this most  basic purpose of the policy.

 

Had the Court of Appeals affirmed Justice Lang’s decision, the New Zealand insurance marketplace would have had to have evolved an insurance solution ensuring that the D&O policy’s defense cost protection could not be stymied by a Section 9 charge. The marketplace would have had to come up with some structure separating defense cost coverage from indemnity coverage. While the marketplace certainly could have developed such a structure, it could have added complexity and cost to the insurance equation. . (I am aware that some insurers had already been offering alternatives designed to try to address this concern.)

 

More importantly, the need for a New Zealand insureds to have access to customized insurance solutions would have added further complexity to the already difficult equation of trying to provide insurance solutions that operate consistently and predictably across the globe. As I noted in my discussion of Justice Lang’s earlier ruling, D&O insurers are already struggling to provide insurance products that apply globally and operate locally. Those struggles will continue, but the Court of Appeal’s decision in the Bridgecorp case removes at least one factor that had even further complicated the efforts to provide global D&O insurance protection.

 

A December 20, 2012 New Zealand Herald article discussing the Court of Appeal’s ruling can be found here. Special thanks to a loyal reader for providing me with a link to the Court of Appeal’s ruling.

 

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In a December 6, 2012 opinion (here), a New York state court judge applying New York law has denied a D&O insurer’s motion seeking a summary judgment determination that its policy’s “professional services” exclusion precluded coverage for attorneys’ fees that the Andy Warhol Foundation incurred in defending claims brought by art owners disgruntled by the Foundation’s determination that Warhol had not painted the owners’ paintings.

 

Background

The Foundation is charged with protecting the legacy of the painter, Andy Warhol. The primary purpose of an affiliated entity, The Andy Warhol Art Authentication Board, is to review pieces of artwork submitted t it to determine whether or not they were created by Warhol.. (The related entities are collectively referred to in this post as the Foundation.).

 

 In 2007, an art owner filed a class action lawsuit against the Foundation and related entities on behalf of all persons who had sought authentication from the Foundation that art they owned had been painted by Warhol. A separate art owner later filed an individual action against the Foundation. The claimants, who included persons whose artwork had been determined not to have been created by Warhol, asserted claims of fraud, violations of the Lanham Act and violation of the Sherman Act. After extensive litigation, the claimants ultimately withdrew their claims.  

 

The Foundation sought coverage for its defense fees from the insurer that had issued the organization a $10 million D&O policy and a $2 million E&O policy. The insurer initially denied coverage under both policies, but ultimately wound up paying the full limit of $2 million under the E&O policy. The Foundation sought to recover the remaining balance of its defense costs ($4.6 million plus interest) under the D&O policy. The insurer refused to pay and the Foundation filed suit.

 

The insurer filed a motion for summary judgment in the coverage action, arguing, among other things, that coverage for the remaining defense fees was precluded under the D&O policy’s “professional services” exclusion, which provides that:

 

In consideration of the premium paid, it is hereby agreed that the Company shall not be liable to make any payment for “loss” or “defense cost” in connection with any “claim” made against the “Insured” based upon, arising out of, directly or indirectly resulting from or in consequence of, or in any way involving:

1. The furnishing or the failure to furnish professional services by an attorney, architect, engineer,, accountant, real estate agent, financial consultant, securities dealer, veterinarian or insurance agent or broker.

2. The furnishing or failure to furnish professional services by an [sic] physician, dentist, psychologist, anesthesiologist, nurse, nurse anesthetist, nurse practitioner, nurse midwife, x-ray therapist, radiologist, chiropodist, chiropractor, optometrist, or other medical or mental health professional.

3. A “professional incident” as defined herein. “Professional incident” means any actual or alleged negligent:

a) act;

b) error; or

c} omission

in the actual rendering of services to others including, counseling services, in your capacity as [sic] social services organization. Professional services include the furnishing of food, beverages, medications or appliances in connection therewith.

 

The insurer argued that the Foundation’s authentication services constitute “professional services,” precluding coverage for the defense fees. The insurer also argued that the Foundation fits within the category of a “social services” organization under Section 3 of the exclusion.

 

The Court’s Order

In his December 6, 2012 Decision and Order, Justice Peter Sherwood of the New York (New York County) Supreme Court, applying New York law, denied the D&O insurer’s motion for summary judgment. With respect to the professional services exclusion, Justice Sherwood found that the insurer could not carry its “heavy burden” of proving that the exclusion applies, noting that “the Exclusion lists specific occupations that involve specialized training and skill. Authentication services are not listed.” Justice Sherwood further noted that examples supplied in the exclusion “do not relate in any way to art authentication services.” Because the exclusion is “at best ambiguous,”  it must be construed in the policyholder’s favor,  Justice Sherwood denied the insurer’s motion for summary judgment.

 

Discussion

Although Justice Sherwood denied the insurer’s motion for summary judgment, he did not enter summary judgment in Foundation’s favor. Indeed, the docket cover sheet attached to the decision and order indicates that the ruling is a “non-final disposition.” It is unclear whether or not there are other bases on which the insurer is contesting coverage that were not addressed in its summary judgment motion or what other issues may remain for trial.

 

That said, Judge Sherwood’s ruling represents a serious set back for the insurer in this case. There is a peculiar irony in the court’s determination that the professional services exclusion did not preclude coverage yet at the same time the carrier (ultimately) acknowledged coverage for the claim under itsE&O policy. The general expectation between these kinds of policy’s is that a professional liability claim would be covered by one or the other of the two policy’s but not both; indeed, the general purposeof the professional services exclusion is to ensure that the D&O insurer does not pick up coverage for claims that properly belong under an E&O policy.

 

The problem for the insurer is not that the authentication services didn’t involve the delivery of a kind of professional service. Indeed, I think most people would agree that the art authentication services are professional services, as commonly understood. However that does not mean that the authentication services represent professional services within the meaning of the D&O policy’s exclusion. To make that determination, the actual language used in the policy must control. And that’s clearly where the insurer got in trouble here.

 

The exclusionary language used would seem to have little to do with circumstances of the Foundation’s operations. There is no general catch-all language, either -- or at least no language obviously intended to provide a catch-all provision. There is no doubt that had the insurer used language better matched to the Foundation’s activities and circumstances that the exclusion might have operated to preclude coverage. Any underwriting manager responsible for policy issuance quality control will want to take a close look at what happened here and draw some obvious lessons about the steps necessary to ensure that the policy as issued reflects the terms and conditions required to meet the risks accepted.

 

Lisa Scuchman’s December 10, 2012 Am Law Litigation Daily article about Judge Sherwood’s summary judgment ruling can be found here.

 

More About that $168.8 Million Verdict in the IndyMac Case: Readers interested in the massive $168.8 million jury verdict entered last Friday on behalf of the FDIC in its capacity as receiver of the failed IndyMac bank against thee banks former directors and officers will want to take a look at Alison Frankel’s December 11, 2012 post on her On the Case blog (here). As I noted in my discussion about the verdict, the FDIC’s strategy in the case is to try to recover under a second $80 million tower of D&O insurance. The agency’s strategy was dealt a major setback earlier this year, in the form of a ruling in a separate proceeding that all of the IndyMac lawsuits relate back to a prior claim and therefore trigger only a single, virtually depleted $80 million tower. That coverage determination is now on appeal. Frankel’s post does an a good job summarizing the FDIC’s strategy as well as its procedural maneuvering with respect to the second $80 million tower. The FDIC apparently hopes not only to be able to argue that the second $80 million tower is triggered, but that the D&O carriers are liable for  amounts awarded in excess of the $80 million as well.

 

Readers may also be interested in taking a look at the Alston & Bird law firm’s memo about the verdict as well. The firm’s December 11, 2012 memo argues that the verdict is of limited relevance outside of California or in any jurisdiction in which a corporate officer cannot be held liable for mere negligence. The law firm, which represents former directors and officers in a host of the FDIC’s failed bank cases, contends that in many of the cases that the FDIC has filed, “the FDIC will be required to demonstrate that the former bank officers and directors committed gross negligence, which is far more difficult to prove than simple negligence or breach of fiduciary duty.”

 

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Every fall, I assemble a list of the current hot topics in the world of Directors and Officers (D&O) Liability Insurance. While the past 12 months have not seen as many headline-grabbing D&O related events as in some past years, the issues that are currently unfolding have had a significant impact on the marketplace. In the latest issue of InSights (here), I take a look at what to watch now in the world of D&O. Readers of this blog will be particularly interested in the first entry of the article, discussing the question of whether the marketplace for D&O insurance is firming.

 

A prior version of the latest InSights article appeared in expanded form on this site, here.

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An employer’s management liability insurance policy does not provide coverage for employees’ claims that – contrary to statutory requirements -- the employer collected and failed to remit gratuities, because amounts owing due to a preexisting statutory duty do not represent covered loss, according to a recent decision of a Massachusetts federal court applying Massachusetts law. The September 10, 2012 decision can be found here. The decision is the subject of a November 26, 2012 post on the InsureReinsure.com blog, here.

 

Background

The Kittansett Club is a golf club in Marion, Massachusetts. According to the allegations in the underlying complaint, the club typically adds an 18% gratuity to food and beverage bills. A lawsuit filed on behalf of servers and bartenders at the club alleged that the club did not remit the gratuities to the servers at the club, but rather retained the gratuities or distributed them to management, in violation of a Massachusetts statute requiring employers imposing service charge or tip to remit the amounts to the service staff. The claimants also alleged breach of an implied contract, interference with contractual relations and unjust enrichment. The claimants sought restitution, injunctive relief, liquidated damages and attorneys’ fees. The club ultimately settled the servers’ claims.

 

The club submitted the servers’ complaint as a claim under its management liability insurance policy. The policy included both a directors and officers liability coverage part and an employment practices liability part. The club’s insurer denied coverage for the claim, arguing that the damages the claimants sought to recover did not arise from an alleged wrongful act but rather from a pre-existing statutory duty. When the insurer denied coverage for the claim, the club initiated a coverage action against the insurer in Massachusetts state court. The insurer removed the action to federal court, and the parties cross moved for summary judgment.

 

The September 10 Ruling

In her September 10, 2012 Memorandum and Order, Judge Denise J. Casper granted the insurer’s motion for summary judgment. In considering the insurer’s position, Judge Casper reviewed a number of cases -- including in particular the Fourth Circuit’s February 2012 opinion in Republic Franklin Insurance Co. v. Albemarle County School Board -- standing for the proposition that amounts owing as a result of a statutory obligation do not represent covered “loss” under a liability insurance policy. Judge Casper quoted the Fourth Circuit’s decision as saying that the case authorities on which it relied.

 

stand for the proposition that a judgment ordering an insured to pay money that the insured was already obligated to pay, either by contract or statue, is not a ‘loss’ covered under an insurance policy that requires that the loss be caused by a ‘wrongful act.’ The alleged ‘loss’ in such cases arises from the contract or the statute itself, not from the failure to abide by it.

 

Judge Casper held that the right of restitution for gratuities the club’s servers asserted “arose not from the wrongful act, but the Insureds’ pre-existing duty” under the Massachusetts statute requiring employers collecting tips or service fees to remit those amounts to the service staff.

 

The claimants in the underlying claim sought not only payment of the unpaid gratuities but also statutory treble damages, attorneys’ fees and costs. The insurer argued that these amounts were also outside the definition of loss because they represented penalties for which the policy did not provide coverage. Judge Casper concluded that these other amounts were compensatory in nature, and therefore not excluded as penalties that could be covered under the policy – “if no exclusion applied.”

 

The insurer further argued that the policy’s Earned Wages exclusion operated to preclude these other amounts, and Judge Casper agreed. The exclusion provides that there is no coverage under the policy “for any Claim related to, arising out of, based upon, or attributable to the refusal, failure or inability of any Insured(s) to pay Earned Wages.” The policy defines “Earned Wages” to mean “wages or overtime pay for services rendered.” Judge Casper concluded that “the usual and ordinary meaning of wages in this context would include gratuities.” Therefore, she concluded, “the Exclusions excluding coverage for any claims arising out of an insured’s failure to pay Earned Wages unambiguously applies in this case and the Insureds are not entitled to coverage under the Policy.”

 

Discussion

At one level, Judge Casper’s decision is no surprise. As Judge Casper herself noted, after concluding that the alleged misconduct in the underlying complaint constituted a “wrongful act” within the meaning of the policy, that fact does not, she said, “allow the Insureds to ignore their statutory obligations by shifting costs to their insurer.” Insured companies cannot, Judge Casper seems to be saying, withhold compensation from their employees and then shift the bill for the unpaid amounts to their insurer.

 

The “no loss” argument on which the insurer relied is based on increasingly well-established case authority; as the InsureReinsure.com blog notes, Judge Casper’s decision “joins a series of cases” including the Fourth Circuit’s decision in the Republic Franklin case) holding that “when an Insured is only being forced to return that which it never had a legal right either to receive or retain, insurance is not available.”

 

The more troublesome aspect of this decision relates to the fact that the claimants in the underlying claim sought further relief beyond just the remittance of the unpaid gratuities; they sought amounts that Judge Casper expressly found to be compensatory in nature. In addition, the golf club itself incurred expenses defending against the claimants’ claims, yet all of these amounts were found to be precluded from coverage under the policy’s Earned Wages exclusion.

 

This latter part of Judge Casper’s opinion illustrates how broadly these types of wage claim exclusions can sweep. If nothing else, Judge Casper’s ruling in this case is a reminder to insurance practitioners to review these exclusions to determine whether or not they would apply more broadly than intended. The exclusionary language of the type on which the insurer relied in this case typically is found in an exclusion referred to as the FLSA exclusion or the wage and hour exclusion, designed to preclude coverage primarily for alleged overtime and minimum wage violations. As this case shows, these exclusions can be worded so as to sweep far beyond just overtime and minimum wage claims.

 

Finally, it is worth noting that at least some contemporary management liability policies include some sublimited defense cost coverage for FLSA and wage and hour claims. From the face of Judge Casper’s opinion it does not appear that this policy provided this type of sublimited defense cost protection. This case does however provide a reminder that the sublimited defense cost protection afforded in these types of coverage extensions should be worded broadly enough to extend defense cost protection, for example, to all of the “Earned Wage” violations otherwise precluded from coverage under this policy.

 

One Pound Fish: Here at The D&O Diary, we consider it our duty to constantly scan the horizon in search of important trends of which our readers should be aware. It is in that spirit that we have embedded below the “One Pound Fish” song video, which, with nearly 4 million YouTube views, has gone totally viral. The video features a Pakistani fishmonger in London named Mohamad Shahi Nazir singining a Punjabi folk tune. Background about the video -- including the song's lyrics -- can be found here. I will leave it to others to try to explain the complex combination of circumstances that can come together to make, well, for example, a “One Pound Fish” song video, into an Internet phenomenon. Just remember, you saw it here first.  I have to say, you gotta love this guy. (The video starts a little slowly, the song starts about 30 seconds into the video.)

 

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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.

 

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Many professional liability insurance policies contain an exclusion that, though referred to as the antitrust exclusion, precludes coverage for a much broader array of claims than just claims alleging violation of the antitrust laws. A recent decision by the First Circuit, interpreting an Errors and Omissions insurance policy and applying Massachusetts law, in which the court found that the policy’s antitrust exclusion precluded coverage for a variety of different claims against the insured, underscores how broadly the preclusive effect of the antitrust exclusion can sweep. A copy of the First Circuit’s September 2, 2012 opinion can be found here.

 

Background

The Saint Consulting Group is a consulting company that advises its clients in land use disputes. The firm had developed what the First Circuit called a “niche practice” in representing grocery store chains hoping to block or delay the opening of Wal-Mart stores. The firm was hired by a grocery store chain to try to block two Wal-Mart stores in the Chicago area. The developers who were trying to organize the Wal-Mart development filed suit against Saint, alleging in an amended complaint that the Saint’s activities violated the Sherman Antitrust Act. The developers’ complaint also alleged violations of RICO and tortious interference with prospective business advantage.

 

The court dismissed the developers’ complaint, holding that the developers’ claims were precluded by the Noerr-Pennington doctrine (about which see more below). The developers’ have sought leave to file an amended complaint. The developer’s motion to amend apparently remains pending.

 

Saint submitted the lawsuit to its E&O carrier, which denied coverage for the claim in reliance on the E&O policy’s antitrust exclusion. The antitrust exclusion provides that the policy does not apply

 

to any claim based upon or arising out of any actual or alleged price fixing; restraint of trade, monopolization, or unfair trade practices, including actual or alleged violation of the Sherman Anti-Trust Act, the Clayton Act, or similar provisions [of] any state, federal or local statutory law or common law anywhere in the world.

 

Saint filed a coverage lawsuit against the carrier in Massachusetts state court, alleging breach of contract as well as related claims. The carrier removed the case to federal district court, where the judge granted the carrier’s motion to dismiss Saint’s lawsuit, holding that Saint’s claims were expressly excluded by the antitrust exclusion. Saint Appealed.

 

The September 2 Decision

In a September 2, 2012 opinion written by Judge Michael Boudin for a unanimous three-judge panel, the First Circuit affirmed the district court’s dismissal of Saint’s lawsuit.  The Court opened its analysis by stating that “the underpinning” of the developers’ complaint was that Saint and its client were “engaged in a campaign designed to frustrate feared competition from Wal-Mart.” The Court then reviewed the antitrust exclusion, which the court concluded clearly barred coverage for the developers’ claims based on the Sherman Act.

 

The “far more interesting question,” the Court noted, is whether the antitrust exclusion also reached the other counts in the developers’ complaint that relied on the same facts but “are not limited to and do not expressly identify their target as restraints of trade.” The Court concluded that it did, noting that the exclusion “extends by its terms to any claim ‘based upon or arising out of’ any actual or alleged … restraint of trade.” Under Massachusetts case authority, this “arising out of language” sweeps broadly enough to preclude coverage “even though the statute or tort is denominated in different terms.”

 

The court added that “it can hardly be disputed that the factual allegations” of the developers’ amended complaint “allege a conspiracy to forestall competition through misuse of legal proceedings and through deception.” Even the counts in the developers’ complaint that are not described as antitrust claims “depend centrally on the alleged existence of such a scheme.”

 

Saint tried to argue that the antitrust exclusion should not apply because the court in the underlying claim had concluded that Saint’s activities were protected from liability under all of the developers’ legal theories by the Noerr-Pennington doctrine. (The doctrine holds that liability under the antitrust laws cannot be imposed for activities aimed at legislatures, even where the activities’ motives and effects are to forestall competition). The First Circuit rejected this argument, noting that “the exclusion does not depend on whether a successful defense can be advanced: it excludes meritless claims quite as much as ones that may prove successful.”

 

Saint’s had another argument related to the Noerr-Pennington doctrine. It argued out that Noerr-Pennington activities comprise a large part of their business. Saint argued that if claims based on Noerr-Pennington activities were precluded from coverage that coverage under the policy would be illusory. The First Circuit paraphrased, with approval, the holding of the district court that the Saint had not alleged that the E&O carrier made explicit representations that its policy would cover without exclusions all of Saint’s core activities, adding that “that Saint may have expected more protections than it got suggests mainly that it may not have read carefully the policy it purchased.”

 

Discussion

Many professional liability insurance policies, at least in their base form, contain antitrust exclusions. Indeed, many of the leading carriers’ private company D&O insurance policies have antitrust exclusions. These exclusions are often referred to, as I have in this blog post and as the First Circuit did in its opinion, in shorthand form, as antitrust exclusions. But as the First Circuit’s opinion shows, these exclusions can have a broadly preclusive effect far beyond claims explicitly denominated as antitrust claims.

 

In certain respects, it is of course no surprise that the exclusion sweeps beyond just claims denominated as antitrust claims, since the exclusion does expressly refer to other types of claims, including in particular claims for “restraint of trade.” It is noteworthy in that respect that the First Circuit’s broad interpretation of the “arising out of” that the exclusion’s preclusive effect is not merely limited to claims for or denominated as “restraint of trade” but to any related claims regardless of how denominated based on the allegations.

 

Many professional liability carriers have an antitrust exclusion in the base policy forms. Typically, E&O insurers will not agree to remove or modify this exclusion. However, in at least some circumstances, private company D&O insurers will agree to remove this exclusion, or at least to modify it to provide sublimited coverage or defense cost coverage.

 

As this case shows, the antitrust exclusion can have a broadly preclusive effect, not just to antitrust claims, and not even to restraint of trade claims, but other claims not denominated as such that “arise out of” those types of alleged violations. Given this broadly preclusive effect, private company D&O insurance policyholders and their advisers should have a strong bias in favor of policies that do not contain this exclusion, and where coverage is available without the exclusion, should have a strong preference for policies lacking the exclusion.

 

The significance of this fact – that there should be a strong preference for policies without antitrust exclusions – is often underappreciated because of the way the exclusion is referred to; that is, as an antitrust exclusion. Denominated that way, it sounds like it only refers to alleged violation of the antitrust laws, which many smaller businesses (rightly or wrongly) do not consider to be a significant risk for them. But on its face the exclusion applies to much more than just antitrust claims, and as the First Circuit’s decision in this case shows, the exclusion’s preclusive effect can sweep very broadly – so broadly in fact that the insured felt that if the exclusion really does sweep as broadly as the carrier here contended, that coverage under its policy was “illusory.”

 

Make no mistake, in certain types of claims, the antitrust exclusion can represent a significant diminution of coverage, and so the preference for policies without antitrust exclusions, particularly private company D&O policies should not be overlooked. The availability of this type of critical policy revision upon request underscores the importance for insurance buyers of having an experienced and informed insurance advisor involved in their insurance purchases, to ensure that all opportunities for coverage improvement are fully explored.

 

I will say that I find one statement by the appellate court particularly harsh; I refer to the Court’s statement that if Saint “expected more coverage than it got suggests mainly that it may not have read carefully the policy it purchased.” To me, this statement suggests the appellate believes that its coverage conclusion was facially obvious from the words in the exclusion.

 

Perhaps it is obvious to the appellate court that the exclusion would be broadly applied to a wide variety of claims regardless of how denominated. In my experience, most clients are outraged to find out how broadly some carriers will attempt to construe policy exclusions. That doesn’t mean that these clients don’t read their policies carefully, it means that they have broad expectations of coverage. Those expectations are embodied in certain principles of insurance policy construction, such as, for example, that policy exclusions will be interpreted narrowly and that the burden is on the carrier to show that an exclusion applies. I think it is entirely reasonable that an insurance buyer might expect that an insurance policy it purchased would provide coverage for what it considers to be its core business practices. The appellate court may have disagreed and reached a different conclusion, but to me that hardly justifies saying that the insured company’s expectation of coverage was simply a reflection of a failure to read the policy; it was, rather, a failure to appreciate that a court would read the policy differently. (All of that said, I recognize that the court’s statement really was a reflection of the court’s impatience with Saint’s lawyers’ arguments on appeal rather than any comment on Saint itself.)

 

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Next Tuesday, the country will elect its President for the next four years. Exactly one week later, Congress will return to take up a critical piece of deferred business that could dramatically affect the country for the next four years and even beyond, regardless of who wins the Presidential election.

 

In a culmination of circumstances that collectively embody the current dysfunctional political climate in Washington, the country faces what has been called a “fiscal cliff.” Unless Congress is able to implement some remedial steps, after December 31 a host of temporary tax cuts will expire and a series of dramatic spending cuts will kick in. If Congress does not act, the changes could have a significant impact on the country’s economy. The impacts could also have serious negative implications for a wide variety of businesses and industries.

 

In this post, I first take a look at the details of the impending “fiscal cliff.” I then review the range of alterative paths that events might take and consider the possible implications for affected industries and companies. I conclude with an appraisal of the business risks these possibilities might present. As discussed below, the potential consequences could include, among other things, at least the possibility of a heightened litigation risk.

 

What is the “Fiscal Cliff”?

The phrase the “fiscal cliff” refers to a likely budget crisis and to a corresponding projected slowdown in the economy if specific laws are allowed to expire or to go into effect at the beginning of 2013. The changes include tax increases that will go into effect due to the expiration of the Tax Relief, Unemployment Reauthorization and Job Creation Act of 2010, which had among other things extended the Bush-era tax cuts. The expiration of the tax cuts would result in an increase in all income tax rates, as well as the rates on estate and capital gains taxes. In addition, the alternative minimum tax will revert to 2000 tax year levels; federal unemployment benefits will expire; and the 2% federal payroll tax reduction will terminate.

 

The changes also include the automatic spending cuts (“sequestrations”) mandated by the Budget Control Act of 2011, because the Congressional budget “supercommittee” created by the legislation failed to agree on a deficit reduction plan. Annual cuts of $109 billion per year will go into effect, with over half of the cuts coming from defense spending.

 

Just to complicate matters further, the federal government will likely hit its current debt level limit in early 2013, which could introduce yet another destabilizing budget issue that Congress must address at or about the same time.

 

As detailed in an October 9, 2012 post on the New York Times Economix Blog (here), if the changes go into effect, “almost everyone who pays taxes will see a hit to take-home pay in the first paycheck in January.” The White House estimates that a family of four with an income of $50,000 to $85,000 would pay an additional $2,200 in taxes during the 2013 tax year.

 

The spending cuts will also have an enormous impact. The Bipartisan Policy Center is predicting that the cuts alone could cost one million jobs in 2013 and 2014. The Congressional Budget Office predicts that economic growth would decline by 2.9 percent during 2013. There is a real risk that the country would experience a “double-dip” recession. I note parenthetically that most of the discussion about the possible effects if the U.S. goes over the fiscal cliff is focused exclusively on the consequences for the U.S. There undoubtedly will also be consequences for the global economy as well, at a time when a host of other economic factors already threaten to undermine the still-fragile recovery from the credit crisis.

 

To be sure, there is some reason to believe that while the increased taxes and budget cuts could have serious short-run negative effects, the longer run effects could produce not only significantly reduced deficits (as much as $7.1 trillion reduction in the national debt over the next ten years, versus a $10-11 trillion increase if current policies are extended for the next ten years), but also the reduced deficit and debt could lead to higher long-term growth prospects. Indeed, because of the significant long-term problems associated with the country’s current and growing debt level, if Congress merely extends current policies, growing interest costs will become an increasingly significant drag on the country’s economy.

 

There are those who believe that perhaps the country would be better off taking the “strong medicine” associated with the tax increases and across the board spending cuts (more about which below). However, automatic spending cuts, no matter how effective as a way to reduce the deficit, do not necessarily represent good policy, or really policy of any kind. To cite but one example, even if cuts to defense spending are a good idea, cuts affecting our military capabilities should only occur in a careful and considered way, not simply by lopping off a huge slice of the defense budget. As serious as are the problems associated with the deficit, defense budget cuts can’t be administered without knowing whether or not they could compromise national security. 

 

On an even more immediate level, if Americans were to see their take home pay slashed dramatically simply due to Congress’s failure to act, there would be a political firestorm of epic proportions. The political backlash could be even further intensified if Congressional inaction results in economic constriction and massive job losses.

 

The Congressional Alternatives

There is enormous pressure for Congress to act. Indeed, the conventional view is that the consequences of inaction are so severe that Congress will almost certainly do something, even if it is just to kick the can down the road for a few more months. The problem for the country and for Congress is that the picture is scrambled. The current budget issue will soon become an economic and financial problem but at the present moment, at least for the members of Congress who will have to address the issue, the situation represents a political problem. It is not just the uncertainty due to a Presidential election that remains extremely close. Many Congressional and Senate races also are also close, and the outcomes of a number of individual races could have an impact. Margins of victory and shifting majorities could also come into play. The Congressional body that will have to address these issues before year end will be composed of an as yet indeterminate number of lame duck politicians whose motivations and interests could be effected by next week’s elections. Add to this volatile political mix the possibility of a lame duck President, as well.

 

There are a variety of other factors that could further complicate Congressional efforts to confront these issues. Perhaps the most significant is the scarcity of working days between November 13 and year end. There is not much time for Congress to grapple with issues that are both complicated and controversial. In addition, notwithstanding the serious threat that the looming budget crisis presents, there will inevitably be a certain number of Congressmen who, with an eye to the 2014 elections, are willing to provoke a crisis in order to be able to try to pin the blame on the other party.

 

In addition, there are serious commentators and observers who believe that the best thing for the county would be for the automatic tax increases and budget cuts to go into effect. As discussed in an October 26, 2012 Washington Post article (here), those who subscribe to this view (who are known as “cliff divers”) believe that only the exigencies of the crisis will put enough pressure on Congress to reach a “grand bargain” that represents a comprehensive and considered approach to the country’s deficit and debt problems. These commentators also believe that if Congress rushes to act in the little time remaining, a short-term sub-par deal could result, that, once in place, would make it harder for Congress to find the will to grapple with the fundamental issues.

 

One additional consideration that must be taken into account in assessing whether or not Congress will act is the obvious fact that merely because the country faces a looming economic crisis does not mean that Congress will find a way to do something. The reason the country is approaching the fiscal cliff in the first place  is because of the adversarial parties’ past failures to work together and the willingness on the part of some to engage in political brinksmanship. The forces that have produced past stalemates could take the country right off the cliff. All it takes for the country to go off the fiscal cliff is a little bit of political gridlock --  which happens to be the specialty of this particular Congress.

 

What This Means for Business

There are a host of problems that could arise quickly in the new year if Congress does not act before year end. But the looming crisis is already having an impact. As detailed in an October 25, 2012 Washington Post article entitled “Fiscal Cliff Already Hampering U.S. Economy” (here), companies “are bracing for the fallout by laying off workers, letting jobs go vacant and postponing major purchases.” According to the article, Department of Commerce data show that business investment stalled in September. Some companies have already begun laying off workers as a cost-containment effort in anticipation of further downturn next year.

 

These problems will quickly accelerate if Congress fails to act to avert the tax increases and spending cuts. Among other things, the impact will quickly be felt in the defense industry, where the sequestrations could quickly result in layoffs. The budge cuts could also have a significant impact on the many small businesses that depend on government contracts. The potential problems for many other industries may be more difficult to discern now, but the impacts could be diverse and wide-spread. For example, there are predictions that there could be significant adverse impacts on the commercial real estate sector as vacancy rates climb. Manufacturing, which only recently has begun to rebound from the ill effects of the credit crisis, could also be affected. A sharp increase in taxes would likely produce a sharp downturn in consumer spending, particularly for discretionary and luxury products. Even the purchase of consumer staples (such as appliances and furnishings) could face a sharp decline.

 

At a minimum, businesses face a climate of uncertainty. With uncertainty, comes risk. In light of this uncertainty and risk, some advisors are cautioning companies to be sure to incorporate precautionary disclosure in the public statements as a way to forewarn investors about the potentially harmful impacts that could arise if Congress fails to act.

 

For example, in their October 23, 2012 memorandum entitled “The ‘Fiscal Cliff’: Look Before You Leap Into the Securities Litigation Trap” (here) the Choate, Hall & Stewart law firm advises companies to “assess their exposure to the fiscal cliff” and if the risks are sufficient to “factor the relevant trends and uncertainties” into the earnings guidance, as well as into their public filings and statements to investors, particularly during the current quarterly reporting season.

 

It is worth emphasizing the reasons the law firm is advising that companies take these steps; the memo notes that in light of the potential consequences for companies from the budget crisis, the companies can be sure that the plaintiffs’ lawyers “will be on the lookout for targets of ‘stock drop’ securities fraud class action litigation.” Companies that suffer adverse impacts from the looming crisis could face allegations that resulting stock price declines are the result of a company’s misrepresentations with respect to, or failure to adequately disclose, these risks. The memo observes that “a company that warns with sufficient detail that its forecasts are subject to uncertainty because of the fiscal cliff events may both discourage litigation before it starts and have a better chance of prevailing should it be targeted nonetheless.”

 

Discussion

Congress and the county are approaching a dangerous crossroad. Though Congress can defer the day of reckoning temporarily by (again) kicking the can down the road, the ultimate showdown can only be postponed, and only then for a short time. Sooner or later Congress will have to confront the problems associated with the growing cumulative deficit and enormous debt. The country’s best interests would be served if Congress were to be able to reach the so-called “grand bargain” that addresses both revenue and spending concerns and puts the country on a long-term path towards meaningful debt reduction.  Whether a sharply divided Congress (representing a sharply divided electorate) can reach this type of agreement could prove to be a very tough proposition. 

 

In the meantime, both households and businesses face an environment of uncertainty and attendant risk. Businesses already face difficult choices about what steps to take in order to be prepared for the possibility that Congress might fail to act. The risks companies face take a number of forms, but among the risks is the increased litigation exposure that can arise when companies’ fortunes take a sudden negative turn. As we saw during the credit crisis, adverse economic circumstances can beget a huge increase in litigation.  In light of these risks, companies would be well advised to follow the recommended course of precautionary disclosure outlined in the law firm memo linked above.

 

D&O underwriters also face a difficult task in this environment. The question whether or not to adjust underwriting and risk selection in the current atmosphere will be challenging, as it unclear whether or not there really be any kind of crisis that could produce adverse claims events. It is will be equally challenging to try to anticipate which companies – or even which kinds of companies --- will be most adversely affected if there really is a crisis. As if that were not enough, events will be moving fast over the next few weeks, much faster than the usual efforts to adjust underwriting practices and policies require.

 

Among the questions the D&O underwriters will have to consider is whether or not to begin taking a more cautious approach to the industries that will most obviously be affected if Congress fails to act, and if so, which industries to target. The underwriters will also have to consider how to scrutinize company disclosures in order to determine whether or not a particular company has been sufficiently precautionary. And the D&O underwriters will also have to adjust their positions as events unfold.

 

It will be interesting to see the outcome of next week’s election. I have to say, as an Ohio resident, this election can’t end soon enough. The around-the- clock political ad bombardment to which Ohio has been subjected is more than anyone should have to bear. But while it will be great to finally come to the end of this year’s electoral season and it will be interesting to see how the voting unfolds, there will be little break after the election is over. Regardless of who wins, there will be some serious issues for this country’s political leaders to face, right away.

 

In closing, I want to quote Minneapolis Star-Tribune Columnist D.J. Tice (here): “The smart way to resolve the debt crisis” will require a little more from Americans and their representatives. It will “require that Americans broadly stop telling themselves that only somebody else is responsible for the country’s budget mess, that only somebody else needs to pay higher taxes, and that only programs somebody else values need to be cut. It would require that politicians start telling the truth, and that voters reward them for it.” Tice’s position is absolutely correct. Unfortunately, he may also have identified the precise reasons why the crisis may not be averted.

 

Cliff Notes: Perhaps because of the vivid imagery involved in the characterization of the looming budget crisis as a “fiscal cliff,” the prospect of the country plunging off the budgetary precipice has inspired a number of cinematic allusions. The most evocative is the reference to the cliff divers’ approach as representing a prescription with a certain “Thelma and Louise” quality – desperate and doomed.

 

If Congress were to fail to act and the country were to race off the fiscal cliff, I think the experience for many Americans will be much like that of Wiley Coyote, shortly after chasing the Roadrunner off of a cliff – like the cartoon character, our legs will pump empty space briefly, and then, after a sudden and startling recognition that we are hanging in mid-air, we will plunge into the abyss.

 

And a Congressional debate in which some voices will contend that the best course for the country is to hurtle off the cliff will resemble the quarrel that Butch Cassidy and the Sundance Kid had as they argued about whether to try to escape their pursuers by jumping off a cliff into a raging torrent below:

 

Butch Cassidy (played by Paul Newman): Alright. I'll jump first.

Sundance Kid (played by Robert Redford): No.

Butch Cassidy: Then you jump first.

Sundance Kid: No, I said.

Butch Cassidy: What's the matter with you?

Sundance Kid: I can't swim.

Butch Cassidy: Are you crazy? The fall will probably kill you.

 

For those who don’t remember the movie, the two do jump off the cliff and they manage to survive the fall. However, they don’t escape their pursuers and they ultimately are taken down in an epic gun battle.

 

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One of the critical issues in building a D&O insurance program is the question of how to structure the insurance. Among the more complex issues is how to divide the program between “traditional” D&O insurance coverage and Excess Side A DIC insurance (which in effect provides catastrophic protection for individual directors and officers in certain defined circumstances). A more basic issue is how to “layer” the program between primary and excess insurers, and how much capacity each of these layers should have in the overall program.

 

The question of how to layer a D&O insurance program is certainly not new, but it remains a vital question and a source of continuing scrutiny and debate, because the way that an insurance program is structured can potentially have a significant impact in the event of a claim.

 

In the latest issue of InSights, I take a detailed look at the problems and challenges associated with D&O insurance layering and also suggest a few ways these problems and challenges can be reduced, or at least managed. The InSights article can be found here.

 

Worth Noting: Readers interested in developments regarding the duties of directors outside of the United States will want to take a look at the October 16, 2012 article from Mark Bestwetherick of the Clyde & Co. law firm entitled “Directors’ Duties and the Increasing Requirement for D&O Insurance in the UAE” (here). The article takes a look at pending changes to the UAE company law and the potential impact on the changes to director indemnification and insurance.

 

The World’s Worst Typos (In Pictures): Read ‘em and weep. Find them here.

 

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A significant side-effect from the current bank failure wave has been the FDIC’s assertion of claims against the former directors and officers of many of the failed banks. The FDIC’s claims have in turn raised significant questions of insurance coverage under many of the failed banks’ D&O insurance policies. As discussed in a prior post (here), one of the significant coverage issues that has come up is whether or not the claims of the FDIC, which it is asserting in its capacity as receiver for the failed banks, are precluded under the Insured vs. Insured exclusion found in most D&O insurance policies. (The Insured vs. Insured Exclusion is sometimes referred to as the I v I exclusion.)

 

In what is as far as I know the first decision on this issue as part of the coverage litigation arising out the current bank failure wave, the federal court in Puerto Rico has ruled that the I v I exclusion in the D&O insurance program of the failed Westernbank of Mayaguez, Puerto Rico does not preclude coverage for the FDIC’s claims against the failed bank’s former directors and officers. A copy of the court’s October 23, 2012 decision can be found here.

 

Regulators closed Westernbank on April 30, 2010, which according to the FDIC cost the insurance fund $4.25 billion. In October 2011, certain of the former Westernbank directors and officers had sued the bank's primary D&O insurer in state court in Puerto Rico (about which refer here). The FDIC as receiver for Westernbank moved to intervene in the state court action, and on December 30, 2011, removed the state court action to the District of Puerto Rico. On January 20, 2012, the FDIC filed its amended complaint in intervention, in which it named as defendants certain additional directors and officers,  and, in reliance on Puerto Rico’s direct action statute, the D&O insurers in the bank's D&O insurance program. A copy of the FDIC's amended complaint can be found here.

 

In its complaint, the FDIC, as Westernbank’s receiver, seeks recovery of over $176 million in damages from the former bank’s directors and officers as well as their conjugal partners, based on twenty-one alleged grossly negligent commercial real estate, construction and asset-based loans approved and administered from January 28, 2004 through November 19, 2009. In its complaint in intervention in the directors and officers coverage action against the bank’s D&O insurers, the FDIC seeks a judicial declaration that its claims against the directors and officers are covered under the policies. All of the defendants moved to dismiss the respective claims against them.

 

In his October 23 opinion and order, Judge Gustavo Gelpi denied all of the motions to dismiss. His rulings with respect to the D&O insurers’ motions to dismiss the coverage actions against them appear on pages 16 and following in the October 23 opinion.

 

The D&O insurers had moved to dismiss the coverage actions that had been filed against them in reliance on the I v I exclusion in the primary insurance policy. The exclusion provides that “The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured …which is brought by, or on behalf of, an Organization or any Insured Person other than an Employee of an Organization, in any respect and whether or not collusive.” The insurers argued that as receiver for the failed Westernbank, the FDIC stood in the shoes of Westernbank, which is an insured under the policy, and therefore the FDIC’s claims against the failed bank’s directors and officers were precluded from coverage under the D&O insurance policies by operation of the I v I exclusion.

 

As Judge Gelpi noted in his opinion these same issues were raised and litigated in a number of cases during the S&L crisis two decades ago. And as Judge Gelpi also notes in his opinion, these prior courts had split on the question of whether or not a D&O insurance policy’s Insured vs. Insured Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver against a failed bank’s former directors and officers. In summarizing these cases, Judge Gelpi noted that the question of the applicability of the exclusion in this context “is ambiguous.”

 

Judge Gelpi then, “with these differences in mind,” turned to the “purposes of the exclusion, the complaint and the specific terms of the policy for guidance.” He noted that the “obvious purpose” of the exclusion is to protect against collusive law suits; however, he also noted that the exclusion itself on which the insurers sought to rely made the exclusion applicable to Insured vs. Insured claims “whether or not collusive.”

 

The question to which Judge Gelpi then turned is whether or not the FDIC’s claims against the former directors and officers of Westernbank were “brought by, on behalf of or in the right of, and Organization or any Insured Person.” Judge Gelpi noted that the policy defines the term “Organization” as the named entity, each subsidiary and debtors in bankruptcy proceedings. After citing these provisions, Judge Gelpi summarily concluded that “Accordingly, the court finds that the FDIC’s course of conduct does not run afoul of this provision.” In reliance on prior cases that had concluded that the I v I Exclusion “does not prelude the FDIC from seeking redress from the Insurers.” 

 

By way of further elaboration, Judge Gelpi noted that the FDIC is suing “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

Discussion

Judge Gelpi’s ruling in this case is a significant victory for the individual directors and officers who hoped to be able to rely on the D&O insurance policies in order to be able to defend themselves against the FDIC’s claims against them, as well as for the FDIC, which hopes to be able to recover the losses it claims from the D&O insurance policies.

 

As the first decision on this insurance coverage issue in connection with the current bank failure wave, Judge Gelpi’s ruling will also obviously be of great interest to other failed bank directors and officers who face FDIC claims and whose D&O insurance carriers have tried to deny coverage in reliance on their respective policies’ Insured vs. Insured Exclusions. But while Judge Gelpi’s decision unquestionably will be helpful to the directors and officers in the other cases, it is far from the final word on the subject.

 

For starters, the split of authority in the cases from S&L crisis era remains. As Judge Gelpi noted, the courts have gone both ways on these issues and the carriers undoubtedly will continue to attempt to rely on the cases holding that the Insured vs. Insured exclusion does preclude coverage for claims brought by the FDIC.

 

A further reason that Judge Gelpi’s decision is unlikely to provide the final word on the subject is that other courts may not find the logic on which Judge Gelpi relied as compelling as he did. Judge Gelpi does not, for example, appear to have even considered the question of whether or not an action by the FDIC in its capacity as receiver of a failed bank (and therefore in effect, “standing in the shoes of the failed bank”) is an action “in the right of” the Organization, within the language and meaning of the exclusion. Other courts may consider it important in considering the exclusion’s potential applicability to address this issue expressly, as Judge Gelpi’s opinion does not. These other courts, in more careful consideration of this issue, might also conclude that the FDIC asserting claims as a failed bank’s receiver is asserting claims “in the right of” the failed bank and therefore that the exclusion applies.

 

In support of his conclusion, Judge Gelpi also considered it important that the FDIC was not only suing in its capacity as receiver, but was also suing on behalf of “depositors, account holders, and a depleted insurance fund.” Indeed, many of the courts that had ruled during the S&L crisis era that the Insured vs. Insured exclusion did not preclude coverage for claims by the FDIC had made their decisions in reliance on the same or similar observations about the FDIC’s claims.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action. The policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

All of which is a long way of saying that though the policyholders and the FDIC prevailed in this case, these issues are likely to continue to be litigated, and the split of cases we saw during the S&L crisis is likely to continue.

 

Very special thanks to the several readers who supplied me with copies of Judge Gulpi’s opinion.

 

Another Georgia Failed Bank Lawsuit: On October 23, 2012, the FDIC, as receiver for the failed United Security Bank of Sparta, Georgia filed its latest failed bank lawsuit. The complaint, which the FDIC filed in the Northern District of Georgia, can be found here.

 

United Security bank failed on November 6, 2009. The FDIC’s lawsuit as the bank’s receiver is filed against a single defendant, Pierce Neese, the bank’s former CEO and also a bank director. The FDIC’s complaint asserts claims of Negligence and Gross Negligence against Neese in connection with 16 loans made between November 10, 2005 and March 27, 2008, which the agency alleges caused damages to the bank of over $6.373 million.

 

An unusual feature of the FDIC’s complaint, and perhaps the explanation why there is only a singe defendant is the case, is the agency’s allegation that from 2002 until March 2006, Neese “was effectively the Bank’s senior credit officer and functioned as a ‘One-Man Bank.’” Even after the bank established itself as a three-person LLC at the direction of regulators, Neese “continued to function as the Bank’s ‘one-man’ LLC until the Bank failed. According to the complaint, the bank even had print advertisements stating, “Meet Our Loan Committee, Pierce Neese.” The FDIC alleges that by dominating and usurping the loan approval process, Neese rendered the usual lending controls ineffective.

 

The FDIC’s complaint against Neese is the latest that the FDIC has recently filed as banks that failed in 2009 approach the third year anniversary of their closure (about which refer here). The complaint is also is the 35^th lawsuit that the FDIC has filed as part of the current failed bank wave and the 17^th that the agency has filed so far in 2012. The FDIC’s lawsuit against Neese is also the tenth lawsuit the FDIC has filed in connection with a failed Georgia bank. Although Georgia has had more failed banks than any other state, the percentage of all failed bank lawsuit involving failed Georgia banks is even greater than the percentage of all bank failures involving Georgia banks. For now at least, it seems as if the regulators are focusing on Georgia more than other states.

 

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I am pleased to publish below a guest post from Rhonda Prussack, Executive Vice President and Product Manager, Fiduciary Liability, for Chartis, and her colleague at Chartis, Larry Fine, Global Head Professional Liability Claims, Financial Lines Claims. Rhonda’s and Larry’s guest post is written in response to a recent guest post on this blog about the scope of fiduciary liability insurance, written by Kim Melvin and John Howell of the Wiley Rein law firm. Kim and John’s prior guest post can be found here.

 

 

I would like to thank Rhonda and Larry for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Rhonda’s and Larry’s guest post:

 

In Ms. Melvin’s and Mr. Howell’s article on the IBM coverage denial decision posted here on September 19^th, several good points were made, notably that plan fiduciaries typically wear “two hats” – one as settlor (i.e. the party making a business decision about a plan – for instance to terminate benefits or amend the terms of a plan) and the other as plan fiduciary (i.e. the party implementing the plan changes). However, Ms. Melvin and Mr. Howell then concluded that policyholders should not expect or necessarily want their policies to cover settlor capacity matters, even for an insured that wears two hats.

 

 

The IBM Case

In the plan participant class action against IBM, the plaintiffs alleged that IBM’s conversion of a traditional pension plan to a cash balance pension plan violated ERISA.  An excess fiduciary liability carrier denied having any coverage obligations on the grounds that the underlying suit related to “settlor capacity” acts as opposed to “fiduciary” acts.    A federal district court (and more recently a circuit court of appeals) upheld the carrier’s denial. As the authors correctly asserted, these decisions did not create a gap in coverage.  Nevertheless, they exposed an existing gap which carriers have been handling differently.

 

Is the Defendant a Fiduciary?

The question of whether a defendant is a fiduciary at all, or whether they were acting as a fiduciary when performing the acts in question, is often the main disputed question in an ERISA suit. For many years, certain carriers were narrowly interpreting their policies for clients that wore two hats and taking coverage positions based on opinions on the underlying merits of cases and defenses raised therein.  These carriers have presented a Hobson’s choice in which successful defenses based on lack of fiduciary status have led to the threat of lost coverage.  More customer-focused carriers, concerned that insureds get the benefit of their bargain, have been interpreting their policies more broadly, and some are now clarifying by means of endorsements.

 

Coverage Denials Based on Settlor Capacity

Ms. Melvin and Mr. Howell also pointed out that lawsuits “involving purely settlor issues are rare,” although in our experience, many carriers commonly reserve the right to deny coverage on that basis.  Often the result of these two facts is that insureds have to either fight with their carrier concerning allocation, or live in fear of future efforts by the carrier to recoup what it has paid, especially if the insureds are successful in a “settlor act” defense.

 

Coverage Not Traditionally Limited to Individuals   

The authors also made the point that fiduciary liability insurance arose at least in part from the desire to protect individuals against the personal liability imposed under ERISA for breaches of fiduciary duty. However, despite the individual fiduciary coverage at its core, fiduciary liability insurance for commercial insureds has traditionally included coverage for the organization sponsoring the plans, as well as for the plans themselves - even when individual fiduciaries are not named in a suit.  Yes, individual plan fiduciaries should definitely be concerned about their exposures (and the fact that they are expressly excluded from D&O policies). To address that concern, the most cutting-edge policies provide ample protections for individuals, including advancement of defense costs when the corporate sponsor fails to do so. However, the reality is that fiduciary liability policies cannot compete in today’s market if they limit their protections solely or even primarily to individual fiduciaries.

 

Costs in Settlor Matters Can Be Significant

It is true, as the authors maintained, that fiduciary policies do not step in to pay “benefits” owed pursuant to a plan, so that the coverage for “settlor act” claims, which some carriers provide, will generally be limited to defense costs.  It should be noted, however, that defense costs alone in purported “settlor act” cases can be in the substantial 8-figure range.   It is clear that carrying sufficient fiduciary liability insurance is eminently prudent and turning down broad coverage is ill-advised, since the product is still relatively inexpensive and offers substantial protection to corporate bottom lines.

 

Insureds have a right to expect that their fiduciary liability policies will protect all Insureds (including the plan itself and the corporate sponsor) from the various types of suits alleging breaches of ERISA and similar laws. 

 

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I am pleased to publish below a guest post from my good friend Kimberly M. Melvin and her colleague John E. Howell, both of the Wiley Rein LLP law firm. Kim and John’s article discusses a recent decision from New York’s high court and its implications for the scope of coverage under a fiduciary liability insurance policy. This article was first published by Advisen.

 

I would like to thank Kim and John for their willingness to publish their article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Kim and John’s guest post:

 

The Employee Retirement Income Security Act (ERISA) virtually created the market for fiduciary liability insurance because it both expanded potential liabilities for fiduciaries of benefit plans and—crucially—extended liability to the personal assets of individual fiduciaries. The demand for fiduciary liability insurance largely grew out of a desire to protect fiduciaries from such personal liability. This insurance—focused on protecting individual fiduciaries—by design did not cover a plan sponsor’s non-fiduciary acts, such as making business decisions regarding its employee benefit plans. New York’s high court recently issued a decision that recognized and confirmed this basic limitation in Federal Insurance Co. v. International Business Machines Corp., 965 N.E.2d 934 (N.Y. 2012). 

 

Yet, commentators, carriers and insurance buyers alike continue to criticize the IBM decision as creating a new “gap” or marking a sea change in the scope of coverage. Such criticism does not hold up. The IBM decision is really nothing new. It reflects the traditional terms and function of fiduciary liability insurance—to protect fiduciaries. What’s more, the recent market trend toward expanding the scope of fiduciary liability coverage to plan sponsors may not ultimately serve the best interests of insurance buyers and the primary intended beneficiaries of the coverage—individual fiduciaries of employee benefit plans.

 

Settlor or Fiduciary: The Sponsor of an ERISA Plan May Wear Multiple Hats

A company that sponsors an employee benefits plan can “wear two hats: one as a fiduciary in administering or managing the plan for the benefit of participants and the other as employer in performing settlor functions such as establishing, funding, amending, and terminating the trust.”[1] A plan sponsor acts as a fiduciary when it exercises discretionary authority over the management of a plan or its assets or the administration of the plan. But when a plan sponsor makes business decisions regarding a plan, such as whether to create, fund or terminate a plan, it acts as a settlor, not a fiduciary. 

 

As a settlor, the plan sponsor may pursue the best interests of the company and its shareholders and is not subject to ERISA’s fiduciary duties. As a fiduciary, the sponsor’s overriding concern must be the best interests of the plan participants. Since ERISA does not impose breach of fiduciary duty liability on a plan sponsor acting as a settlor, it may be asked: why do these differing “hats” matter? Because a plan sponsor can—in rare cases—be liable under ERISA for non-fiduciary acts. For example, settlor acts like amending an ERISA plan may violate ERISA’s “anti-cutback” or anti-discrimination rules.

 

The IBM Decision: Fiduciary Liability Coverage for Liability as a Fiduciary

IBM was sued in a class action alleging age discrimination under ERISA in connection with amendments to IBM’s pension plan—a settlor function. IBM settled the litigation and then sought coverage from its fiduciary liability insurance carriers for the settlement. IBM’s first excess insurer, Federal Insurance Company, filed a lawsuit seeking a declaratory judgment that the settlement was not covered because the class action did not allege that IBM acted in a fiduciary capacity. The Federal policy afforded specified coverage in connection with a “Wrongful Act,” defined, in relevant part, as “any breach of the responsibilities, obligations or duties by an Insured which are imposed upon a fiduciary of a Benefit Program by [ERISA].” Because the class action undisputedly did not concern conduct by IBM in its fiduciary capacity under ERISA, Federal maintained that the class action did not involve a “Wrongful Act.” The Court of Appeals of New York agreed, finding that “[a] straightforward reading of . . . the ‘Wrongful Act‘ definition is that it covers violations of ERISA by an insured acting in its capacity as an ERISA fiduciary.”[2] Since “IBM was not acting as an ERISA fiduciary in taking the actions that gave rise to the allegations” in the class action, but instead was acting as a plan settlor, the New York high court held that there was no coverage for the settlement.[3]

 

Reactions to IBM: Separating Fact from Fiction

Despite its clear and straightforward holding, the IBM decision has generated unwarranted criticism from commentators, insurance carriers and insurance buyers:

 

The settlor capacity issue addressed by the IBM court is brand new, and now companies are suddenly left uninsured for something that always was covered.

 

The IBM decision does not create a so-called coverage gap. It recognizes the fundamental purpose of fiduciary liability insurance – to protect fiduciaries from liability for breaches of fiduciary duty under ERISA. Other courts uniformly have agreed that settlor liabilities are not covered by fiduciary liability insurance policies, and IBM cited no cases to the contrary. In fact, as the IBM court noted, IBM’s argument that the policy covered any violation of ERISA whether or not it implicated IBM’s fiduciary capacity, was “strained and implausible” and would expand fiduciary liability coverage to “almost every lawsuit imaginable” against a company that happened also to be an ERISA plan sponsor.[4] 

 

Claims often involve a settlor act where no breach of fiduciary duty is pled, and most fiduciary policies pick up such an exposure. 

 

ERISA plaintiffs can, in rare cases, sue a plan sponsor solely for acts in its settlor capacity. Typically, though, ERISA litigation concerns the plan sponsor’s acts as both a settlor and a fiduciary: for example, the sponsor’s amendment of a plan (a settlor function) and its disclosures about the amendment (a fiduciary function). Such a “mixed action” would trigger – at least – defense costs coverage. And under the policies at issue in IBM, such a mixed action likely would have been covered subject to other common coverage defenses. Virtually none of the fiduciary liability policies on the market would cover the rare case clearly involving only settlor allegations, because it would not allege a Wrongful Act necessary to trigger coverage. 

 

The primary carrier settled the claim with IBM and paid its entire policy limit toward defense costs and the settlement whereas the excess carrier took a different position and sued the insured.

 

In fact, the primary carrier did not acknowledge coverage for the underlying action or pay the full limits of the primary policy. Rather, the primary carrier advanced IBM’s defense costs subject to a reservation of rights and at all times disputed the availability of indemnity coverage. The primary carrier ultimately settled its coverage dispute with IBM in exchange for a payment that left over 30% of its policy limits untouched. 

 

The Landscape of Fiduciary Liability Insurance: Changing for the Better?

Even before the IBM decision, the fiduciary liability insurance marketplace has been moving toward providing limited coverage for settlor functions – limited to defense costs only or to particular types of settlor conduct. Whether such expansions of coverage will be beneficial for insurance buyers and viable in the long term for the carriers remains to be seen. It is not self-evident that such expansions will really benefit individual fiduciaries, whom the insurance was principally intended to protect. 

 

Costly investigations or litigation focused on settlor issues may drain or completely exhaust the insurance limits available to protect individual fiduciaries from personal liability. Limits adequacy therefore should be a paramount consideration for the insurance buyer in reviewing these newer policy forms. In addition, the settlor coverage afforded under these newer forms may frequently provide very little additional protection. First, claims involving purely settlor issues are rare and, as noted above, mixed cases likely would be covered already. Second, the additional coverage likely extends only to defense costs because the damages recoverable in pure settlor cases are likely to be benefits that would have been due but for the assertedly improper conduct. Such damages would be excluded from coverage by the policy’s “benefits due” exclusion or carved out from the definition of covered Loss. Thus, while insurance buyers often presume “the more coverage the better,” buyers should closely review these newer forms and consider the practical effects of the so-called extensions of coverage and the primary purpose of obtaining fiduciary liability insurance in the first place when selecting the appropriate coverage.

 

About the Authors

Kimberly M. Melvin is a partner in the Insurance Practice at Wiley Rein LLP in Washington, DC. She represents insurers in connection with coverage issues, including liability policies issued to directors and officers, financial institutions, mutual funds, investment advisors, Real Estate Investment Trusts (REITs), rating agencies, insurance companies, insurance brokers and lawyers. Ms. Melvin can be reached at 2.719.7403 or kmelvin@wileyrein.com.

 

John E. Howell is an associate in the Insurance Practice at Wiley Rein. He represents insurers in connection with coverage issues arising under directors and officers, financial institution, lawyers and other professional liability coverages. Mr. Howell can be reached at 202.719.7047 or jhowell@wileyrein.com.

* * *

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Two more courts have joined the growing line of cases holding that excess insurer’s payment obligations were not triggered where the policyholder funded part of the loss below the excess insurer’s limit.

 

First, on September 12, 2012, New York (New York County) Supreme Court Judge Melvin Schweitzer, applying New York law, ruled in favor of a top level excess insurer where the two underlying excess insurers had paid less then their full policy limits and Forest Laboratories, the policyholder, had funded the gap. A copy of Judge Schweitzer’s opinion can be found here.

 

Second, on September 17, 2012, the Sixth Circuit, applying Ohio law, affirmed the district court’s entry of summary judgment in favor of the excess insurer, holding that the excess insurer’s policy limit had not been triggered when the insured, Goodyear Tire and Rubber Company, had reached a compromise with the primary carrier in which the primary carrier had paid less than its full policy limit. The Sixth Circuit’s opinion can be found here.

 

The Forest Labs Case

Forest Laboratories had a $70 million D&O insurance tower, consisting of a primary $10 million layer and six excess layers of $10 million each. Forest Labs became involved in securities class action litigation, which it ultimately settled for $65 million. Defense and claims expense added several million dollars more of cost. Forest Labs’ primary insurer and the first three excess carriers paid their full policy limits. However the fourth and fifth level excess insurers reached compromises with the policyholder in which each paid only a part of its limit and Forest Labs “filled in the gaps.” Forest Labs then sought payment from the top level excess insurer.

 

The top level excess insurer contended that because of Forest Labs’ compromise with the underlying excess insurers, the payment obligations under its excess policy had not been triggered. In making this argument, the top level excess insurer relied on language in its policy specifying that it is obligated to pay only when the underlying coverage has been exhausted “solely as a result of actual payment of a Covered Claim pursuant to the terms conditions of the underlying insurance.” The top level excess insurer also sought to rely on exhaustion trigger language in one of the underlying excess policies, which the top level excess insurer argued was incorporated by reference into its excess policy.

 

Forest Labs relied on the venerable Second Circuit decision in Zeig v. Massachusetts Bonding & Insurance Company, arguing that the top level excess insurer’s policy language was ambiguous and therefore should not be interpreted to preclude coverage. In response to Forest Labs’ reliance on Zeig, the top level excess insurer relied on the growing list of cases in which  courts had found that excess insurer’s payment obligations had not been triggered where, like here, the policyholder had funded part of the underlying loss amounts out of pocket. Among other cases, the top level excess insurer relied on the Comerica case (about which refer here), the Qualcomm case (refer here), the Bally Total Fitness Case (here), and the J.P.Morgan case (refer here).

 

Judge Schweitzer said, referring to the many cases on which the top level insurer sought to rely, that “these examples,” along with the more specific trigger language in the underlying excess policies, “evince a clarity unfortunately missing from the [top level excess insurer’] policy language.” He added, however, that this “does not render [the top level excess insurer’s] policy ambiguous, as in Zeig.”

 

Citing the top level excess insurer’s policy language providing that its payment obligations are triggered only when the underlying insurance is exhausted “solely as a result of actual payment of a Covered Claim pursuant to the terms and conditions of the Underlying Insurance,” which Judge Schweitzer found is “not ambiguous,” Judge Schweitzer concluded that the top level excess insurer was obligated to pay “only after the insurance has been paid under the provisions of the underlying policies … which provisions necessarily include their term limits.” Thus, Judge Schweitzer added, the top level excess insurer “pays only after the underlying insurers pay up to their policy limits.”

 

Judge Schweitzer commented that while the top level excess insurer “certainly could have done a better job of drafting its policy, and has many examples of better language to refer to [sic] accomplish that, the language it chose still protects [the top level excess insurer] in the situation, as here where the underlying insurers never paid their full policy amounts, due to settlements with plaintiff.”

 

The Goodyear Case

In 2003, Goodyear, following a restatement of its previously released financial statements, became involved in securities class action litigation and related SEC investigation. The lawsuits ultimately were dismissed and the SEC terminated its investigation. Goodyear incurred about $30 million in legal and accounting costs in connection with these matters.

 

Goodyear carried $25 million in D&O insurance, consisting of a primary layer of $15 million and an excess layer of $10 million. The insurers disputed coverage for Goodyear’s $30 million in expenses, particularly the costs associated with the SEC investigation. Goodyear ultimately reached a compromise with the primary carrier, in which the primary carrier paid only $10 million of its $15 million limit. The excess carrier then contended that its payment obligations had not been triggered, relying on the language in its excess policy providing that “Coverage hereunder shall attach only after [the Underlying Insurer] shall have paid in legal currency the full amount of the [Underlying limit].”

 

The dispute over the excess insurer’s payment obligation ultimately wound up in litigation. The district court entered summary judgment in the excess insurer’s favor.

 

On September 17, 2012, in an opinion applying Ohio law and written by Judge Raymond Kethledge for a three-judge panel of the Sixth Circuit, affirmed the district court’s summary judgment grant. The Sixth Circuit’s opinion opens by observing that the parties’ dispute represents the “latest in a series of recent cases in which one corporation asks us to disregard the plain terms of an insurance agreement with another corporation.” (The Sixth Circuit opinion does not identify the other cases in the recent series to which it was referring.) The appellate court said that relevant provision in the excess carrier’s policy is “undisputedly clear and unambiguous.”

 

Goodyear had argued that, notwithstanding the provision, that the Court should enforce the excess insurer’s payment obligation, because of public policy favoring settlements and because the excess insurer had not been prejudiced by Goodyear’s compromise with the underlying insurer. The Sixth Circuit rejected both of these arguments.

 

In rejecting the public policy argument, the Sixth Circuit said that, by contrast to the uninsured motorist cases on which Goodyear relied, “what we have here, instead, is an insurance agreement into which sophisticated parties have freely entered,” adding that the Court “will enforce the agreement according to its terms.” 

 

In rejecting Goodyear’s argument that the excess insurer’s payment obligations should be enforced because Goodyear’s deal with the primary carrier had not prejudiced the excess carrier, the appellate court said that “this case does not concern a mere notice or cooperation requirement, which perhaps we could waive off without any harm to the insurer.” Rather, the court said, adding a note of supposed humor that I am sure Goodyear did not appreciate, “the provision at issue here is where the rubber hits the road,” adding that “the agreement’s Insuring Clause, under whose terms [the excess carrier] undisputedly did not agree to provide coverage that Goodyear now seeks.” Goodyear’s arguments, the Court concluded, are “meritless.”

 

Discussion

As I noted at the outset, and as the citations on which Forest Labs’ top level excess insurer relied demonstrate, there is a growing list of cases reaching the same conclusion that an excess D&O insurers payment obligations are not triggered where as here the underlying insurers paid less than their full policy limits and the policyholder funded the gap. The latest case in this line of cases can be found here.

 

There is a troubling aspect of this growing line of cases. If you take this line of cases as a whole, what you have are an awful lot of excess insurers walking away from their payment obligations. They agreed to take on the risk and they collected their premiums and in a disputed claims situation where losses clearly pierced their layer, they are successfully fighting off their payment obligations. This effort now apparently includes the possibility that an excess insurer can bootstrap the trigger language from an underlying insurance policy to avert its payment obligation.

 

To be sure, now that this growing line of cases has highlighted the issue, many insurance buyers are seeking, and many excess insurers are now granting, excess coverage trigger language that allows the amounts below the excess insurer’s attachment point to be funded by payment either by the underlying insurers or by the policyholder. With this type of alternative payment trigger language in place, excess insurers are much less likely to be able to avoid payment. However, the Forest Labs case underscores the fact that the language needs to be cleaned up all the way up the tower, to guard against the possibility that an upper level excess insurer might, like the top level excess insurer here, try to bootstrap trigger language from an underlying policy in order to try to avoid its payment obligation.

 

Nate Raymond has a good article on the On the Case blog, here, discussing the two decisions. Special thanks to a loyal reader for providing me with a copy of the Sizth Circuit opinion.

 

 

 

 

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I am pleased to publish below a guest post written by Paul A. Ferrillo of the Weil Gotshal and Manges law firm. Paul’s guest post identifies the liability exposures that IPO companies and their directors and officers face, and describes the insurance considerations the companies should address in confronting those exposures. Paul’s article was first printed in Westlaw Journal Corporate Officers & Directors Liability, a Thomson Reuters publication.

 

I would like to thank Paul for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Paul's guest post:

 

 

With a potentially improving economy and rebounding public markets, the idea of going public (a long-shelved consideration in the past few years) in an initial public offering (an “IPO”) has come back in vogue, both in the United States and abroad.  Going public, of course, can be a very good thing for a company, its directors, its initial investors (often venture capital firms or private equity firms), and its stockholders—if the stock does well. But sometimes the stock does not do well because the company misses earnings, or worse, finds some accounting problem that must be disclosed to investors. The price of “not doing well” is often more than just monetary—there could be mountains of lawsuits filed against the company and its directors and officers. These lawsuits can present unique problems for defendants, since the strict liability provisions of Section 11 of the 1933 Act (which govern liability with respect to the publication of alleged materially misleading statements in a company’s prospectus) are almost always implicated. That means, in sum, that any material misrepresentation, even negligently made (because scienter, or culpable knowledge, is not a requirement of a Section 11 claim), could form the basis of liability against a corporate director. Depending upon the severity of the problem and the resulting drop in the stock price, an IPO “failure” could also draw the attention of state and federal securities regulators and potentially the United States Attorneys office. Needless to say, securities class action litigations and investigations can cost millions or tens of millions to defend and settle.

 

 

The delicate balance between the “good” and the “bad” IPOs often ends up on the desk of a company’s risk manager.  Unfortunately, D&O insurance for IPOs is a very different product than other corporate insurance. Slips and falls, broken bones, workers compensation and fire losses are not the issue here. Instead, the personal assets of directors and the company’s most senior executives are at risk.  For this reason, leaving D&O insurance decisions for IPOs solely to risk managers is not advised.  Directors themselves need to understand the pitfalls and perils of poor decisions related to D&O insurance for IPOs. Directors need to understand the value that a sophisticated insurance broker brings to the D&O insurance purchasing decision.   This knowledge is especially important for directors in today’s environment where companies may be seeking to go public under the streamlined requirements for emerging growth companies as set forth in the Jumpstart Our Business Startups Act (“Jobs Act”) of 2012, which generally sets forth looser compliance and internal control requirements than under the Sarbanes Oxley Act of 2002. This article attempts to bring all of these issues together, in one place, for directors to understand what they need to know about D&O insurance (and related corporate insurances) when a company goes public.

 

 

How Much D&O Insurance to Buy?

 

Very often, after a director is recruited to sit on the board of a company going public, one of his first questions is “well, how much D&O insurance are you going to have?” Unfortunately, there is not one right answer to this question.  Some view it a “cost question.” Buying a lot of good D&O insurance costs money, and some companies don’t want to pay a lot for it, as they think it’s a “commodity.” Directors often take an opposite view.  They are on the firing line, and if there is not enough D&O insurance, they could be asked to write a personal check to the plaintiffs’ counsel to settle an action against them—a very unpalatable prospect. Finally, others view it as a question answered by reference to benchmarks—if the last company that did a $300 million IPO bought $20 million of D&O insurance, why shouldn’t we? 

 

 

All of these viewpoints have some ring of truth and make some sense. But the bottom line is that being uninsured is a very bad thing for everyone involved. So why not resolve to make a D&O IPO insurance purchase that makes better sense to all those potentially involved in the aftermath of a failed IPO? To do so, we recommend the following: First, ask your insurance broker for recommendations as to other similarly situated companies that went public in terms of what D&O limits they purchased. A sophisticated broker with experience in the public company D&O markets should have this information at his fingertips. Such benchmarking is a good start to get a ballpark figure of what limits to buy.  Second, an arguably better approach is a market capitalization analysis of potential stock drop scenarios, using generally-accepted settlement figures that are publicly-available. For instance, imagine that a company expects its market capitalization twelve months post-IPO to be $1 billion. And what if that company were to suffer a 40% stock drop as a result of the announcement of unexpected bad news? That would equate to a $400 market capitalization drop. Taking 10% of that number (10% being a “proxy” for the percent of shareholder losses that might be recoverable in a “medium” severity case) would equate to a potential settlement of $40 million (but note that in a Section 11 case with strict liability issues, the settlement percentage could arguably be higher!). Adding in attorney’s fees and the potential costs of an investigation might get you to a $50 million total per-claim loss. The $50 million number should be another data point to consider when evaluating a D&O limits purchase. Again, there is no “right” answer here. 

 

 

What Carriers to Use in “the Tower”

 

Years of experience defending securities class actions allow us to make some comments about the importance of good D&O insurance. D&O insurance is not a commodity. Not all D&O carriers are equal.  Not all D&O carriers have good reputations for handling and paying claims. Not all carriers will “step up to the plate” when its time to resolve the action. Directors should ask around (to other directors and other companies of boards they sit on) to understand which carriers are willing to pay claims and which are not. Good brokers will have this information too, if they are willing to share it with you. Lawyers who defend securities class action typically run into many carriers while mediating class actions, and may also have an opinion on which carriers are business-minded and stand behind their director clients. There is nothing worse that having a recalcitrant carrier at the settlement table that refuses to pay a claim. 

 

 

Portfolio Company IPO’s versus Spin-offs

 

Many times IPOs are a tool for private equity firms or hedge funds looking to exit or reduce an investment. Sometimes IPOs result from larger companies spinning off profitable subsidiaries into standalone public companies. Spin-offs present unique D&O challenges to consider in the D&O insurance purchasing decision: the potential for overlapping boards, the potential for not only a stock drop for the company going public, but for the parent as well under certain circumstances, counsel and privilege issues that might require multiple sets of defense counsel (which add to the cost of a litigation), and the selling shareholder liability of the ultimate parent who is selling its shares of the spin-off in the IPO.

 

 

Regardless of the challenges, one simple strategy for a director of the company going public is to insist that the company going public purchase enough D&O insurance to fully satisfy the company’s (and his) potential liability to shareholders.  Another question to ask is whether there will be any additional insureds on the policy (e.g. the private equity sponsor, or the ultimate parent who is spinning off the company going public) who may have other liability issues like potential selling shareholder liability.  If too many constituencies share from the same tower chances are that there may be not enough money left at the end of the day to effectuate a settlement of all outstanding litigations and investigations, especially in a Section 11 case.

 

 

Indemnifiable versus non-Indemnifiable Loss Coverage –Side A D&O Insurance

 

Part of any analysis of the purchase of D&O insurance is the purchase of Side A D&O coverage. “Side A” excess D&O coverage is for “non-indemnifiable loss,” i.e. loss incurred by a director for which a company cannot advance or indemnify, or is financially unable (because of an insolvency scenario) to advance or indemnify pursuant to its bylaws or certificate of incorporation. Side A coverage only exists for the benefit of the directors and officers—it would never cover the entity.

Though certainly a part of traditional D&O coverage, in the years after Enron and Worldcom, it has become standard to purchase separate Side A D&O coverage to cover the directors and officers with dedicated limits that are fully accessible in any insolvency situation. Though some would term this “bankruptcy-specific” D&O coverage, the need for Side A excess D&O insurance can come up in other ways. More specifically, under Delaware law, the settlement of a shareholder derivative action is “non-indemnifiable,” meaning the Company cannot fund such a settlement.  So having Side A coverage available for such a situation is a huge positive for a director. More specialized forms of Side A coverage also exist, like Side A “difference in conditions” coverage (which can, under certain circumstances, drop down and provide coverage in situations where an underlying carrier won’t pay), and “independent director” coverage (which expressly covers only independent directors) also exist. Directors and independent directors should insist on dedicated Side A limits as part of the overall IPO D&O structure.

 

 

Mandatory Advancement – Presumptive Indemnification Clauses

 

One of the new developments in the D&O marketplace over the last two years is mandatory advancement of defense costs under any circumstance. Previous to 2010 D&O carriers would generally advance defense costs from dollar one in insolvency settings, understanding that (1) in such a case a company “was unable to advance” defense costs within the retention, and (2) to not advance defense costs would potentially leave directors without adequate counsel, thus exposing them (and the carrier) to increased exposure. A soft market for D&O insurance, among other reasons, caused carriers to expand advancement of defense costs to situations where a company “simply refuses” to advance or pay a director’s defense costs, in addition to the insolvency scenario. That is a huge consideration when such defense costs could run into the hundreds of thousands of dollars. Further, presumptive indemnification language normally contained in D&O policies should be stricken or watered down so it does not conflict with the broad advancement of defense cost coverage now being offered in the D&O marketplace.

 

 

Definition of Loss Issues

 

A D&O policy is not particularly useful if it does not cover all claims-related payments and settlements concerning litigation commenced against directors and officers. A director should insist on the broadest definition of “loss” possible, which should include the payment of (1) all pre-claim investigation or inquiry costs, (2) all defense costs, judgments and settlements related to litigation and post-claim investigatory proceedings and litigation, (3) all expert costs, (4) any defense costs associated with bankruptcy-related investigations commenced by a trustee, receiver or creditors committee, and (5) all defense costs and settlements associated with claims against him under Sections 11, 12 and 15 of the 1933 Act. 

 

 

Bankruptcy Protections

 

Needless to say, the primary D&O policy should work in all settings, including bankruptcy settings. Directors should insist on broad “definition of claim” words to cover bankruptcy investigations, and a broad carve-out from the insured-versus-insured exclusion for derivative claims brought by creditors committee, bondholder committees or properly formed bankruptcy constituencies of the company. Finally, we recommend a simplified “order of payments” (or “priority of payments”) clause which does not leave any discretion to the company to withhold or direct payments under a D&O policy. 

 

 

Though our list of questions is long, it is certainly not exclusive of other D&O policy enhancements sophisticated brokers might also suggest for clients going public. A good broker can be an ally here, not a hindrance to the process. At the end of the day, however, it is up to the director himself to fully educate himself on the D&O coverage for any company for whom he or she is going to sit on the board. This is an area that is simply too important to overlook. Again, good D&O insurance often goes unnoticed. But poor D&O insurance often comes to light at the worst possible time for a director.

 

 

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Weil Gotshal & Manges Releases Latest Edition of "The 10b-5 Guide": In adddition to writing the above blog post, Paul Ferillo is also one of the co-authors, along with his colleagues Robert Carangelo, David Schwartz and Matthew Altemeier, all also of the Weil, Gotshal & Manges law firm, of the seventh edition of The 10b-5 Guide, which the firm released today. The  law firm's press release regarding the Guide can be found here and a link to the electronic version of the Guide can be found here. 

 

 

The Guide provides a comprehensive survhey of recent developments in the regarding 10b-5 actions, including in particular a complete overview of the decisions of the U.S. Supreme Court in the securities law arena during the 2010-11 term. The Guide is presented as a primer for corporate employees and securities ltigation practitioners and serves as a handbook to one of the SEC's most important rules.

 

 

The Guide is great resource and I highly recommend it for everyone. (Readers will note that I wrote the Foreward for this latest edition of the Guide.)

 

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In the August 2012 issue of Business Law Today, the ABA Business Law Section published an article entitled “Training for Tomorrow: Corporate Counsel Checklist for Supervising Creation/Renewal of D&O Protection Program” (here). The article describes the critical components of a comprehensive executive protection program. A detailed description of the article and an explanation of the process by which the ABA Business Section created and published the checklist can be found in a September 11, 2012 post by Kevin Brady on the Delaware Corporate and Commercial Litigation Blog

 

The ABA checklist and accompanying commentary emphasizes that there are multiple components of a comprehensive program to protect corporate directors and officers from potential financial and criminal liability. The first element, statutory exculpation, should be incorporated into the company’s certificate or articles of incorporation.

 

Three additional elements of the program described in the ABA article are:  the right to advancement of defense costs; relief from the duty to repay advances; and indemnity against settlement and judgments. All three of these elements should be address in the company’s corporate by-laws. As the article notes, the changing legal environment poses “significant hurdles” to “making sure that the entity’s by-laws actually provide the maximum rights to advancement and indemnity that the law permits. The article provides a short, useful checklist to be used in reviewing corporate by-laws in order to ensure that the provisions provide the recommended components of executive protection program. Readers of this blog will find this portion of the ABA article particularly useful.

 

The article also notes that D&O insurance is a critical component of a comprehensive executive protection program. The article also contains a D&O insurance checklist. The list contains many useful items. D&Oinsurance professionals will want to be familiar with the list, as it is possible that their clients, armed with checklist, might expect the insurance professionals to respond to each of the checklist items.

 

One item that should be added to the list is the critical importance of associating in the D&O insurance placement process an experienced and knowledgeable insurance professional that is qualified to negotiate policy terms and conditions and that is able to make informed recommendations about policy limits and structure. Corporate counsel that want to ensure that their company’s D&O insurance program is state of the marketplace will want to enlist the assistance of a D&O insurance professional that is out in the marketplace every day and that is fully informed about what is available in general and from each of the carriers.

 

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On September 7, 2012, the Delaware Supreme Court, applying California law, held that Intel’s excess insurer’s defense obligations were not triggered where Intel had settled with the underlying insurer for less than policy limits and had itself funded the defense fees above the settlement amount and below the underlying insurer’s policy limit. A copy of the Court’s opinion can be found here. (Hat tip to the Traub Lieberman Insurance Law Blog for the link to the Court’s opinion).

 

Intel carried a multilayer tower of general liability insurance, consisting of a primary layer of $5 million, a first excess layer of $50 million, and multiple layers above that. Intel became involved in antitrust class action litigation triggering the insurance tower. Intel subsequently became involved in insurance coverage litigation with the first level excess insurer, which the first level excess insurer settled with a payment to Intel of $27.5 million. Intel funded its own defense expenses above that amount.

 

When its payment of defense expenses exceeded the remaining amount of the first level excess carrier’s limit of liability, Intel contended that the second level excess carrier’s defense obligations had been triggered. The second level excess carrier contended that its payment obligations could only be triggered by payments by the underlying excess insurer and that Intel’s own payments did not trigger payment. The second level excess insurer (hereafter, the insurer) filed an action in Delaware Superior Court seeking a judicial declaration that its payment obligations had not been triggered. The Superior Court granted summary judgment for the excess insurer, and Intel appealed.

 

On appeal, Intel argued that its defense cost payments were sufficient to trigger the insurer’s payment obligation. In making this argument, Intel relied on Condition H, which is titled “When Damages Are Payable” and provides that policy coverage “will not apply unless and until the insured or the insured’s underlying insurance had been paid or is obligated to pay the full amount of the Underlying Limits.”

 

In arguing that its payment obligations had not been triggered notwithstanding Intel’s payment of the defense expenses, the insurer argued in reliance on an Endorsement that had been added to the policy and that provided in Paragraph C that “Nothing in this Endorsement shall obligate us to provide a duty to defend any claims or suit before the Underlying Insurance Limits … are exhausted by payment of judgments or settlements.” The insurer argued that notwithstanding Intel’s payment of defense expenses, the underlying limit had not been exhausted by “payment of judgments or settlements.”

 

In affirming the lower court’s entry of summary judgment, the Supreme Court, in an opinion written by Justice Henry duPont Ridgeley for a five-judge panel, found that “Intel’s reading of the [insurer’s] policy purports to do exactly what Paragraph C of the Endorsement forbids: obligate [the insurer] to provide a duty to defend before exhaustion of the underlying …policy by payment of judgments or settlements.” The Court added that “viewing the policy language as a whole, Intel’s reading is untenable.” The Delaware Court also called Intel’s interpretation “strained.”

 

The Court specifically found that Paragraph C “cannot be construed under California precedents to encompass an insured’s own payment of defense costs.” The term “judgments” refers, the Court found,“to a decision by some adjudicative body of the parties’ rights” and the term “settlements” refers to “some agreement between parties as to a dispute between them.” Defense costs paid by the insured “do not fall within the plain meaning of either term.”

 

The Delaware court also referred specifically to the California Intermediate Court of Appeals decision in the Qualcomm case (about which refer here), in which the court held that payments of amounts by the policyholder did not suffice to exhaust the underlying insurance and trigger the excess coverage.  Though noting that the Qualcomm case involved different policy language, “the implications of Qualcomm’s holding for this case are clear” – that is, that “plain policy language on exhaustion, such as that contained in Paragraph C, will control despite competing public policy concerns.”

 

The Delaware Court also concluded that because the “plain language of the policy control,” the venerable Zeig v. Massachusetts Bonding & Insurance Co. decision from the Second Circuit is “inapplicable.”

 

Discussion

This Delaware decision joins a growing line of cases concluding --based on the language at issue requiring payment by the underlying insurer -- that the policyholder’s payments do not suffice to trigger an excess insurer’s payment obligation. (Refer here for the most recent discussion of the growing line of cases).

 

It is worth emphasizing that these cases are strictly a reflection of the policy language at issue. The excess policies certainly could provide that payment by either the insurer or the insured would suffice to exhaust the underlying insurance amounts and to trigger the excess insurer’s payment obligation. Indeed, more recently, many excess D&O insurance carriers have agreed to modify their policies to recognize payment either by the underlying insurer or by the insured as a trigger to the excess insurer’s obligation.

One of the interesting things about this case is that Condition H, on which Intel relied, did in fact expressly allow for the amount of the underlying insurance to be paid either by the “insured or the insured’s underlying insurance.” The Delaware Court, interpreting this provision (which is captioned “When Damages Are Payable”), said that it provided only that “Intel’s payment of damages may trigger [the insurer’s] duty to indemnify” (emphasis added). The Court went on to say that “nothing in Paragraph C suggests that Intel’s direct payment of defense costs may trigger (the insurer’s] duty to defend” (emphasis added).

 

That is, because the payment on which Intel sought to rely in arguing that the insurer’s payment obligations had been triggered was the payment of defense expenses (not damages), and because INtel was seeking payment from the insurer of defense expense (not damages), Condition H was irrelevant and only Paragraph C applied.

 

It is worth noting that Paragraph C had been added by endorsement, and it is fair to say the relationship between the various provisions and amendments is complicated. As the Delaware court itself noted, the “interplay” between the provisions “is admittedly complex.”

 

Insurance policies are of course complicated contracts with a variety of operating provisions. These provisions interact in complex ways, and when base forms are amended by endorsement, the interactions can become even more complicated.

 

Without in any way meaning to suggest that the policy at issue in this case did not reflect the intent of the parties to the contract, this case is a good illustration of how important it is to make sure that all of the various policy provisions are appropriately structured to that the interaction of the various provisions results in the intended outcome. Which is reminder that it is mportant in connection with the policy placement process that policyholders enlist the assistance of knowledgeable, experienced insurance advisors who understand the coverage and understand how various provisions and amendments will interact even the event of a claim.

 

 Today’s Typo of the Day: This high school booster club banner has a rather unfortunate typo.

 

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In an August 27, 2012 post (here), I discussed Central District of California Judge James Selna’s August 21, 2012 decision in Petersen v. Columbia Casualty, and in particular Judge Selna’s consideration of the insurer defendant’s duty to advance under its liability policy. Following my publication of the post, I was contacted by Jeffrey Kiburtz of the Shapiro, Rodarte & Forman law firm. Jeff had a differing perspective on Judge Selna’s opinion and he suggested the possibility of a guest post on the topic, to which I readily agreed. Jeff’s guest post discussing Judge Selna’s opinion is set forth below.

 

I would like to thank Jeff for his willingness to set out his views as a guest post on this site. I welcome guest posts from responsible commentators on topics of interest to this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Jeff's guest post:

 

 

 

As a regular reader of Kevin’s blog, I always find it be well-written, informative and timely – it is truly a great resource and I am thankful to him for helping me stay up-to-date on a variety of management liability issues (as well as the opportunity to submit this guest blog). And while I also find myself in agreement with the majority of his substantive commentary, I felt compelled to provide a different perspective on the Petersen v. Columbia Casualty he discussed here. (For the record, I had no involvement in the Petersen case.)

 

 

As discussed in greater detail there, Petersen ostensibly addressed the standard for determining whether an insurer must advance defense costs under a non-duty to defend policy. For Kevin, “the court [in Petersen] correctly understood the insurer’s defense obligations and correctly declined to apply principles derived from duty to defend cases to the determination of the insurer’s obligations.” From my perspective, however, the court’s decision on the standard applicable to non-duty to defend policies did not expressly consider, and is in any event difficult to reconcile with, established Ninth Circuit precedent. (I’ll leave for others the issue of whether there is any actual conflict between our two stated perspectives.)

 

 

In refusing to apply duty to defend principles (most notably the principle that defense obligations are triggered by a “mere potential” for coverage) to the analysis of whether an insurer must advance defense costs, the court in Petersen appears to have relied nearly exclusively on Jeff Tracy, Inc. v. U.S. Specialty Ins. Co., 636 F. Supp. 2d 995 (C.D.Cal. 2009). Further, both Petersen and Jeff Tracy suggested that the only support for the insured’s “mere potential” argument was Gon v. First State Ins. Co. 871 F.2d 863 (9th Cir. 1989), which both courts distinguished as addressing the timing of when an insurer must begin to advance defense costs, not the method of determining whether such a duty exists in the first instance. Thus, in both Jeff Tracy and Petersen, the Central District concluded in one form or another that “the Ninth Circuit did not hold [in Gon] that the duty to defend or ‘potential for coverage’ standard still applied” to non-duty to defend policies. Jeff Tracy at 1003.

 

 

Now, admittedly, the specific reach of Gon (and a similar case, Okada v. MGIC Indem. Corp., 823 F.2d 276, 282 (9th Cir.1986)) is a little unclear, but the Ninth Circuit itself regards Gon and Okada as “circuit precedent requiring the advancement of defense costs for potentially covered claims.” Pan Pacific Retail Properties, Inc. v. Gulf Ins. Co., 471 F.3d 961, 970 (9th Cir. 2006). Moreover, although the court in Pan Pacific distinguished Gon and Okada on grounds that those cases are inapplicable when, as in Pan Pacific, the coverage action was brought after the conclusion of the underlying matter, the court made reasonably clear in a separate case that potentiality remains the test when contemporaneous advancement of defense costs is the issue. Unified Western Grocers, Inc. v. Twin City Fire Ins. Co., 457 F.3d 1106, 1112 (9th Cir. 2006).

 

 

Unified Western Grocers involved alleged fraudulent transfers in the context of a leveraged buyout. The insurer declined coverage on grounds that the underlying suit effectively constituted an action for restitution based on allegations of intentionally wrongful conduct. And, while the insured countered that the asserted breach of fiduciary duty was at least potentially covered, the insurer argued that the claim for breach of fiduciary duty and its related allegations were, in effect, inseparably intertwined with the non-covered, intentionally wrongful conduct and demand for restitution. Reversing the district court, the Ninth Circuit agreed with the insured, holding that the breach of fiduciary duty claim gave rise to a potential for coverage and the broad allegations of intentionally wrongful conduct did “not automatically subsume all allegations of a negligent character.” Id. at 1114.      

 

 

As most relevant to this discussion, the Ninth Circuit stated that “[i]n determining whether an unproven claim is covered by an applicable insurance policy, we are reluctant to frame coverage based on isolated allegations in an underlying complaint.” Id. at 1112 (citingGon and the seminal California duty to defend case Gray v. Zurich Ins. Co. (1966) 65 Cal.2d 263 for the proposition that “the third party complainant, who may overstate the claims against the insured, should not be the arbiter of the policy's coverage.”) Based on this, the court applied a potentiality test to the two coverage issues raised by the insurer (intentionally wrongful conduct and restitution), ultimately holding that there remained a possibility of covered liability based on the not-necessarily-intentional conduct alleged in connection with the breach of fiduciary claim and that the relief sought was not necessarily restricted to restitution.   

 

 

Further, lest one think that the Ninth Circuit missed that it was dealing with what appears to have been a pretty standard D&O policy that did not provide for a duty to defend, the court made clear that while “Gon and Gray involved interpretations of an insurer's duty to defend potentially covered claims” and are “not directly applicable to determining an insurer's duty to indemnify loss,” the determination that the district court’s decision below that there were “no covered claims as a matter of law . . . is closely analogous to the question of whether there is a potentially covered claim.” Id. at 1112 fn.8.  

 

 

Returning to Petersen, it is difficult to reconcile the court’s apparent rejection of any form of a potentiality test with the precedent discussed above, especially Unified Western Grocers. For example, like Unified Western Grocers and unlike Pan Pacific, coverage in Petersen was determined during the pendency of the underlying litigation. Further, while it appears that the court in Petersen implicitly distinguished Olympic Club v. Those Interested Underwriters at Lloyd's London, 991 F.2d 497 (9th Cir. 1993) (an earlier Ninth Circuit decision in which the court explicitly held that potentiality is the test for non-duty to defend policies) on grounds that the policy in Olympic Club did not expressly disclaim the insurer’s duty to defend, that would not be sufficient to distinguish Unified Western Grocers as the policy there plainly had no duty to defend. The Petersen court also appears to have distinguished Olympic Club on grounds that the policy in Petersen did not provide coverage for allegations of wrongful conduct, an assertion which does not appear factually accurate, as the definition of “Act” quoted in the Petersen decision encompassed allegations of wrongful conduct.  

 

 

The court in Petersen also appears to have been swayed by the presence of allocation provisions in the policy, which seems to suggest that the court viewed potentiality and allocation as mutually exclusive, i.e., that one cannot have a potentiality standard without also requiring the insurer to fund 100% of the defense of a mixed suit. Irrespective of the rationale, the policy’s allocation provisions would not in any event appear to be an adequate basis for distinguishing United Western Grocers, as the policy at issue there also contained an allocation provision. Lastly, while Unified Western Grocers did not mention the final policy attribute cited as militating against a potentiality standard in Petersen (i.e., that the policy required the insured to consult with the insurer before incurring defense costs), it is hard to imagine that factor being significant, especially since the “power of the purse” control that language provides the insurer makes the policy more akin to a duty to defend policy, arguably making it more appropriate to apply principles developed under duty to defend policies. 

 

 

It seems worth noting that the Petersen court’s decision on the standard applicable to determining whether an insurer must advance defense costs could be considered dicta, as it is not clear from the recited facts that application of a potentiality standard would have yielded a different result. Nevertheless, whether dealt with on that basis or otherwise, I would question the suggestion that Petersen (or Jeff Tracy for that matter) represents the law in California federal courts concerning the duty to advance defense costs. 

 

 

        

            

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I am pleased to publish below an article by my good friend Richard J. Bortnick (pictured left) concerning the directors’ and officers’ liability issues related to cyber security and data breaches. Rick is a Member of the Cozen O’Connor law firm and he is also the co-author of the CyberInquirer blog. This article first appeared as a chapter in the July 2012 publication Willis' Executive Risks - A Boardroom Guide 2012/2013. I would like to thank Rick for his willingness to publish the article here.

 

I welcome guest posts from responsible commentators on topics of interest to this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Rick's guest post: 

 

 

Cyber insurance has become a necessity. Every company that maintains, houses or moves sensitive information is at risk of a data breach, primarily due to the growth and increased sophistication of hackers, malicious software and, most recently, ‘hacktavists’. Even mere employee negligence can lead to a data breach. High-profile companies such as Sony can attest that cyber-intrusions can lead to hundreds of millions, if not billions, of dollars in legal exposure.

 

 

Equally troublesome, our expanding online society has introduced new financial risks and exposures that may not be covered under general and professional liability insurance products, including standard directors’ and officers’ (D&O) policies. As such, corporate directors and officers, and their risk-management professionals, must ensure that they buy appropriately tailored policies that provide protection against the rapidly expanding risks to which they could be vulnerable, both personally and professionally.

 

 

The risks and costs of a data breach

 

It has become known as the Year of the Breach: in 2011, companies of all sizes experienced malicious intrusions or employee negligence that affected their operations and/or businesses. For example, in April 2011, computer hacktavists unlawfully accessed the Sony PlayStation Network (PSN) and obtained the personal and financial information of roughly 77 million PSN users. Since then, Sony and its insurers likely have spent tens, if not hundreds, of millions of dollars to remedy and mitigate the resulting security and commercial crises — an amount that grows by the day as lawyers prosecute class action lawsuits on behalf of allegedly affected users whose personal and financial information was improperly accessed. 

 

 

Equally problematic for Sony, it has been sued by its commercial general liability (CGL) insurer, Zurich American, which is seeking to avoid coverage by arguing that its general liability policies do not and never were intended to cover data breaches.

The TJX Companies also fell victim to a cyber intrusion that security experts predict will have long-term costs of between US$4 billion and US$8 billion in fines, legal fees, notification expenses and brand impairment. In the TJX case, the retail group reported that 45.6 million credit and debit card numbers were stolen from one of its systems during the period July 2005 to January 2007. Of critical import, the January 2007 intrusion occurred after TJX already had knowledge of the initial breaches. 

 

 

Of course, big corporations are not the only entities that are vulnerable to hackers and hactavisits; indeed, half of all companies that have experienced data breaches have fewer than 1,000 employees. 

 

 

NetDiligence, a US company that specialises in assessing cyber risks and data breaches, released a study in June 2011 summarising its survey of data-breach insurance claims made between 2005 and 2010 in a variety of industries in the US (see the panels on the next three pages). Based on the claims payout data submitted for the study, the average cost for a data breach was US$2.4 million. Topping the list of the most frequently breached sectors were healthcare and financial services. 

 

 

Moreover, the study found that 95 per cent of the breaches were caused by one of three things: hackers, rogue employees and loss/theft of equipment. For the most part, the information stolen consisted of personal identification information (PII) — name, address, email address, telephone number, social security number and credit card information — or personal health information (PHI).

 

 

 

Similarly troubling, in 2011 nearly 23 million confidential records were exposed in the US as a result of over 419 reported security breaches, according to the non-profit Identity Theft Resource Center (ITRC).

 

 

These numbers are likely to hold steady; at the start of April 2012, the ITRC reported 105 breaches and roughly 4.5 million exposed records in the first three months of the year. In turn, the Ponemon Institute, a data-security research firm, reported that the average cost of a breach to US organisations in 2011 was US$5.5 million, and that the cost per compromised data record stood at $194. These substantial numbers include the attendant costs of retaining forensic experts, attorneys’ fees, customer-notification expenses, fraud monitoring, public relations support, business interruption, loss of customer goodwill, and third-party liability claims.

 

 

Many breaches result in reputational damage, leading to diminished future cash flows. While loss of goodwill is notoriously hard to quantify, its financial impact can be both long-term and substantial.

 

 

Cyber security regulations and compliance

 

SEC guidance

 

On October 13, 2011, in response to the “increasing dependence on digital technologies” and associated risks, the Division of Corporation Finance (DCF) of the US Securities and Exchange Commission (SEC) issued a ‘Disclosure Guidance’ that presents, for the first time, disclosure recommendations relating to cyber-security risks. It is worth noting the DCF’s own observation in the guidance that it “is not a rule, regulation, or statement of the Securities and Exchange Commission”. The DCF also emphasises that many of its ‘recommendations’ may already be encompassed within corporate disclosure obligations found elsewhere in various SEC regulations.

 

 

While the Disclosure Guidance is designed to be ‘advisory’, its practical implications establish the ‘recommendations’ as best practices and in essence render compliance essential, if not mandatory. To put it another way: non-compliance would be ill-advised. 

 

 

At the same time, the DCF counsels that “material information regarding cyber-security risks and cyber incidents” may need to be disclosed “in order to make other required disclosures, in light of the circumstances under which they are made, not misleading.” It cites Basic Inc v Levinson (1988) for the proposition that “information is considered material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision or if the information would significantly alter the total mix of information made available.”

 

 

Although the Disclosure Guidance is only directed at public companies under the SEC’s jurisdiction, it can be expected to have far-reaching implications for non-public companies and even individuals doing business with public companies.  

 

 

What does the disclosure guidance say?

 

It makes most sense to begin with what the Disclosure Guidance is not. The DCF makes it clear that it is not advising companies to make detailed disclosures of highly technical elements of their cyber-security programme or even the details of an actual cyber attack. Indeed, it is aware that “detailed disclosures could compromise cyber-security efforts — for example, by providing a ‘roadmap’ for those who seek to infiltrate a registrant’s network security — and we emphasize that disclosures of that nature are not required under the federal securities laws”. On the other hand, the DCF advises that companies should avoid offering “generic risk factor disclosure.”

It also highlights the point that existing disclosure obligations may warrant discussion of such risks — in many cases rendering cyber-security disclosures mandatory. For instance, Regulation S-K and Form 20-F of the Securities Act of 1933 require public companies to disclose “risk factors” that would be relevant to a prospective investor. Accordingly, the Disclosure Guidance counsels that companies “should disclose the risk of cyber incidents if these issues are among the most significant factors that make an investment in the company speculative or risky.”

 

 

The DCF further suggests that companies, in determining whether risk disclosure is required, should evaluate their cyber-security risks, taking account of previous incidents, the likelihood of future occurrences, the magnitude of those risks and the adequacy of preventive measures. Depending on the circumstances of individual companies, the DCF says that appropriate disclosures may include:

 

•             discussion of aspects of the company’s business or operations that give rise to material cyber-security risks and the potential costs and consequences

•             description of outsourced functions that have material cyber-security risks, and how the company is addressing those risks

•             description of cyber incidents experienced by the company that are individually or in the aggregate material, including the costs and other consequences

•             risks related to cyber incidents that may remain undetected for an extended period

•             description of relevant insurance coverage.

 

Beyond all of this, the DCF recommends the following (potentially required) disclosures that could implicate cyber issues.

 

 

Discussion and analysis of financial condition

 

The DCF recommends: “Registrants should address cyber-security risks and cyber incidents … if the costs or other consequences associated with one or more known incidents or the risk of potential incidents represent a material event, trend, or uncertainty that is reasonably likely to have a material effect … For example, if material intellectual property is stolen in a cyber attack … the registrant should describe the property that was stolen and the effect of the attack on its … operations, liquidity, and financial condition and whether the attack would cause reported financial information not to be indicative of future operating results or financial condition. If it is reasonably likely that the attack will lead to reduced revenues, an increase in cyber-security protection costs, including related to litigation, the registrant should discuss these possible outcomes, including the amount and duration of the expected costs, if material.”

 

 

Description of business

 

“If one or more cyber incidents materially affect a registrant’s products, services, relationships with customers or suppliers, or competitive conditions, the registrant should provide disclosure … In determining whether to include disclosure, registrants should consider the impact on each of their reportable segments. As an example, if a registrant has a new product in development and learns of a cyber incident that could materially impair its future viability, the registrant should discuss the incident and the potential impact to the extent material.”

 

 

Legal proceedings

 

“If a material pending legal proceeding to which a registrant or any of its subsidiaries is a party involves a cyber incident, the registrant may need to disclose information regarding this litigation …”

 

Financial statement disclosures

 

Noting that “cyber-security risks and cyber incidents may have a broad impact on a registrant’s financial statements”, the DCF sets out some of the costs and losses that may need to be disclosed in statements, depending on the nature and severity of the potential or actual incident:

 

•             the possibly substantial costs incurred in preventing cyber attacks

•             any incentives provided to customers to mitigate damages from a cyber incident and maintain the business relationship

•             losses, in the wake of cyber attacks, from asserted and unasserted claims, including those related to warranties, breach of contract, product recall and replacement, and indemnification of counterparty losses from their remediation efforts

•             potentially diminished future cash flows, therefore requiring consideration of impairment of certain assets including goodwill, intangible assets, trademarks and patents.

 

 

Disclosure controls and procedures

 

The DCF further notes that: “Registrants are required to disclose conclusions on the effectiveness of disclosure controls and procedures. To the extent cyber incidents pose a risk to a registrant’s ability to record, process, summarize, and report information that is required to be disclosed in Commission [SEC] filings, management should also consider whether there are any deficiencies in its disclosure controls and procedures that would render them ineffective.” 

 

 

In short, directors and officers must be attuned to the regulations to protect themselves against the impact of cyber risks and costs in the larger context of their company’s disclosure obligations to investors. Or, to put it another way, those who ignore the Disclosure Guidance do so at the risk of an action by the SEC or by shareholders if a cyber incident occurs.

 

 

Given the increased prevalence and effectiveness of cyber attacks and breaches, and in light of the Disclosure Guidance, it would be difficult to justify why proper protective measures — including sufficient cyber insurance   — were not put in place, and why the risks were not disclosed to the investing public.

 

 

A ‘not so hypothetical’ hypothetical

 

Consider the following case and contemplate whether the court may have reached a different result in light of the Disclosure Guidance. Heartland Payment Systems stores millions of credit and debit card numbers on an internal computer network to facilitate payment processing. In December 2007, hackers launched a Structured Query Language (SQL) attack on Heartland’s payroll management system. To its credit, Heartland was able to repel the attack before any personally identifiable information was stolen.

 

 

Regrettably, however, the company failed to detect malicious software (malware) that had been placed on the network by way of the SQL attack. This malware infected Heartland’s payment processing system, ultimately enabling the hackers to steal 130 million consumer credit and debit card numbers.

 

 

Heartland did not discover the malware until January 2009, at which time it notified government authorities and publicly disclosed the event. 

 

 

Over the course of the following month, Heartland’s stock price plunged in value. Shareholder class actions alleging securities fraud and material non-disclosures followed. 

 

 

In their complaint, the plaintiffs alleged that Heartland and its officers and directors had made material misrepresentations and omissions about the December 2007 SQL attack. For example, the plaintiffs alleged the following material misrepresentations:

 

•             At numerous times, defendants concealed the SQL attack in statements made during earnings conference calls and in 10-K (annual) reports

•             Defendants misrepresented the general state of Heartland’s data security because they were aware that Heartland’s network had been breached and yet they had not fully remedied the problem

•             Notwithstanding its knowledge of the SQL attack, the company failed to disclose that its information systems were extremely vulnerable (rather, it had stated that it took computer security very seriously).  

 

The plaintiffs claimed that Heartland and its directors and officers had violated Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 by failing to disclose material information related to a lack of security and known breaches of its information systems. As a result of the company’s material misrepresentations related to the security breach, the plaintiffs alleged, Heartland’s common stock lost around 80 per cent of its value.

 

 

As is common in security class action lawsuits, the Heartland defendants moved to dismiss the shareholders’ complaint on the basis that it failed to state a claim upon which relief could be granted, because it did not allege the existence of a material mis-statement or omission. In ruling on that motion (see In re Heartland Payment Systems Inc, 2009), the US District Court for the District of New Jersey found that the existence of unresolved network security issues did not, in itself, suggest that the company did not value data security or that it did not maintain a high level of security. The court further found that while knowledge of the 2007 SQL attack may have been material to the plaintiffs’ investment decisions, securities issuers have no general duty to disclose every material fact to investors.

 

 

In addition, the court found that the plaintiffs’ complaint failed to sufficiently plead the necessary elements of scienter, or knowledge of wrongdoing, as it did not allege that defendants knew or had reason to suspect that Heartland’s security systems were so deficient that it was false to say the company placed significant emphasis on maintaining a high level of security. Accordingly, the court granted the defendants’ motion to dismiss. 

 

 

Now, consider the language of the Disclosure Guidance in addressing the following, potentially required ‘risk factor’ disclosures: “A registrant may need to disclose known or threatened cyber incidents to place the discussion of cyber-security risks in context. For example, if a registrant experienced a material cyber attack in which malware was embedded in its systems and customer data was compromised, it likely would not be sufficient for the registrant to disclose that there is a risk that such an attack may occur. Instead, as part of a broader discussion of malware or other similar attacks that pose a particular risk, the registrant may need to discuss the occurrence of the specific attack and its known and potential costs and other consequences.”

 

 

In light of the express reference to ‘malware’, Heartland may have found it more difficult to argue that its failure to detect the malware embedded in its systems was reasonable and that its failure to disclose the extent of other potentially significant risks associated with a known cyber attack adequately satisfied the recommendations in the Disclosure Guidance. At a minimum, the fate of the defendants at the motion-to-dismiss stage may have been different, as the shareholder plaintiffs’ counsel would have been able to cite the company’s failure to abide by the Disclosure Guidance as being allegedly reckless and actionable. 

 

 

Additional theories of liability against officers and directors, and actions against non-public companies Securities Act violations, as alleged by the Heartland plaintiffs, are by far the most likely to be brought by shareholders alleging cyber-related material non-disclosures. However, plaintiffs who choose not to seek federal class-action status are free to assert claims based on state law theories of fraud, breach of fiduciary duty or negligence. Therefore, directors and officers should be aware that, in addition to Securities Act violations, state law remedies could support other types of action   especially against non-public or closely held companies faced with cyber/privacy liabilities. The DCF Disclosure Guidance further highlights that directors and officers continue to face exposure from the possibility of derivative suits.

 

 

The Disclosure Guidance: practical implications for non-public companies

 

Yes, the Disclosure Guidance only applies to public companies; but that doesn’t mean the recommended best practices do not affect private companies. 

 

 

A prudent public company subject to SEC reporting requirements will require its business partners, suppliers, vendors and others to provide it with parallel disclosures in order to avoid direct (or even vicarious) liability to those with whom it is in privity for those companies’ failings. Privately held entities also have business relationships with public corporations and so may find themselves required to perform the analyses and assessments suggested by the Disclosure Guidance, albeit indirectly, simply to maintain their competitive footing in the market. To illustrate, if you were a business client and your prospective public company associate provided you with all of its cyber-related disclosures, would you not insist upon similar disclosures from potential private company partners — irrespective of whether the Guidance applies to them?

 

 

As a private company submitting a business proposal to a prospective client who asks for such information, would you refuse? Of course not. The only practical solution is to evaluate your own cyber risks and exposures — and be in a position to address them. 

 

 

Why technology and cyber insurance has become a necessity

 

A typical CGL insurance policy defines ‘property damage’ as “physical injury to tangible property, including all resulting loss of use of that property”. Regrettably, many policyholders and brokers incorrectly assume that CGL policies extend to losses involving intangible property such as electronic data. This misconception is partially based on the intuition of policyholders and brokers that traditional policy forms should adapt to protect against evolving risks. While this belief may be understandable, it is not correct.

 

 

Beginning in 2001 (in other words, during the early emergence of electronic commerce), certain CGL policy forms added language that specifically excluded electronic data from their definitions of ‘property damage’. Additionally, professional liability policies often do not include coverage for the results of a cyber intrusion, and often contain exclusions when criminal acts are the cause of the loss. 

 

 

Even though a majority of cyber incidents may not be covered by traditional insurance products, 65 per cent of company respondents in a Carnegie Mellon University study indicated that their boards are not reviewing insurance coverage for cyber-related risks, notwithstanding that 86 per cent of respondents agreed that cyber and information-security risks pose at least a moderate danger to their organisation.

 

 

The study, published in March 2012, further found that boards and senior management are not engaging in key oversight activities such as setting policies and budgets to help protect against breaches and mitigate financial losses. Thus, although many corporate executives may appreciate the risks posed by cyber breaches, most do not follow up by taking steps to ensure that their companies purchase technology and cyber liability insurance. 

 

 

Technology insurance is analogous to traditional ‘tangible property’ insurance. It typically covers first-party loss such as business-interruption expense as well as the costs of a forensic expert, who would be retained to identify the cause of the technology breach, and other necessary expert consultants. In turn, cyber liability insurance provides third-party coverage that is designed to protect a company from legal claims brought by those whose personal information has been compromised.

 

 

Technology and cyber insurance can take many forms, with some insurers adding endorsements to a standard CGL policy that extend the coverage to technology and cyber risks. For example, Insurance Service Office (ISO) endorsements provide first-party coverage for loss of electronic data resulting from physical damage to tangible property. That, however, means companies may not be adequately protected against substantial risks if there is a different cause for the loss. Additionally, endorsements do not cover the crisis-management costs of lawyers, forensic experts, breach-notification letters etc.

 

 

Standalone technology and cyber insurance products are far more comprehensive and, typically, cost-effective. Although they may be marketed under various names, they generally cover similar risks and exposures. Covered losses in the first-party context include ‘data-breach expenses’, ‘cyber extortion’, ‘digital asset loss’ and ‘business-interruption loss’. However, as suggested by its name, first-party cyber insurance does not cover claims brought by third parties. Additionally, few products cover the expenses incurred to correct system problems and prevent future data breaches. 

 

 

In turn, third-party cyber insurance often fills in these gaps and may be referred to as ‘privacy liability insurance’, ‘network security liability insurance’ or ‘internet media liability insurance’. Despite the differing labels, each provides similar cover for third-party liability after a data breach, namely: ‘crisis-management expenses’, including notification costs, fraud monitoring, forensic investigations, public relations consultants and the costs of pursuing third parties responsible for the breach, ‘liability expenses’, including the costs of defending and settling lawsuits, and ‘regulatory expenses’, including the cost of compliance with SEC regulations.

 

 

Regardless of what form of insurance is purchased, companies and their insurance professionals must ensure that their policies are tailored to their own unique needs.

 

 

Why directors and officers’ insurance should supplement cyber insurance

 

In addition to purchasing tech/cyber insurance covering first-party and third-party exposure, both public and private companies should ensure that their D&O liability policies respond to cyber-related claims based on allegations of securities fraud, breach of fiduciary duty and alternative theories of liability. 

 

 

In the event of a data breach or a catastrophic first-party loss, it would not be surprising for shareholders’ counsel to file securities fraud and/or derivative suits against a company’s directors and officers alleging failure to properly disclose and manage risks and/or breach of fiduciary duty. Given the defence costs associated with such suits, even in the absence of liability exposure, it is essential to have a D&O policy that complements a cyber insurance policy. In this respect, a specialist insurance broker is not just helpful, it is a necessity.

 

 

Methods of preventing data breaches, and strategies in the event of an intrusion  

 

Ultimately, the responsibility for preventing cyber breaches falls on each individual company whose reputation is on the line. While government regulation may have advanced in addressing the problem of data breaches, it has been estimated that 85 to 90 per cent of a company’s assets are maintained on an electronic platform and susceptible to a tech/cyber crisis — and regulations alone cannot protect them. In some cases, they may be self-defeating, as the cost of regulatory compliance can consume much of a company’s ‘security’ budget. 

 

 

Of course, it is far less costly, from both a financial and reputational point of view, to prevent a cyber breach than to attempt after-the-fact mitigation of its negative effects.. This point is made clear by the 2012 ‘Data Protection & Breach Readiness Guide’, published by the Online Trust Alliance (OTA). The report advocates several ‘security best practices’ that could significantly reduce the likelihood of a tech/cyber loss. While the OTA provides 19 guidelines on ‘data governance and loss prevention’, four in particular bear mention. 

 

 

First, according to the OTA, companies should engage in data classification according to the level of the data’s sensitivity and tailor their software protection schemes accordingly. Next, the OTA advises that data minimisation can prevent a breach, as hackers cannot obtain information that is not kept on a system. Companies should review any sensitive information on their system and eliminate non-essential data that poses an unnecessary risk of data breach.

 

 

Third, companies should destroy data that is no longer in use. And fourth, the OTA suggests that companies provide employee awareness and readiness training to ensure that staff understand company policies on data collection and retention, and data-loss reporting procedures. 

 

 

In addition to taking steps to prevent an incident, organizations need to be ready to identify and deal with the results of any breach. They should have in place a data response team trained to respond to a breach in a co-ordinated and prompt fashion. This trained response team should include representatives from key groups within the company, including legal, information technology, information security, human resources, public relations and customer service. The data response team should have broad decision-making authority and be available 24/7. The initial goal of the group should be to evaluate systems and create plans and procedures to prevent and, if necessary, manage a tech/cyber incident.

 

 

Additionally, companies should determine the notification requirements that govern their industry. Since many state, federal and foreign regulations require prompt notification, it is important to work out in advance how the relevant individuals should be contacted, as it will significantly improve the company’s ability to mitigate consumer frustration and increase compliance. Should a breach occur, the response team and dedicated employees can move quickly to contain and repair the damage.

 

 

Conclusion

 

Although the DCF says the Disclosure Guidance is ‘advisory,’ it makes it equally clear that cyber-security risks may fall under existing SEC disclosure obligations in certain circumstances. Accordingly, a public company would be ill-advised to disregard the best practices provided by the DCF. 

 

 

The essential message is simple: if companies are aware of material cyber-security risks and/or incidents, and if disclosure of those risks or incidents would be material to investors, a company risks SEC action (not to mention shareholders’ and derivative actions) by failing to publicly disclose this information as part of its routine reporting requirements.    

 

 

Companies also should follow prudent security practices to reduce the likelihood of a data breach, and have a data response team ready to deal with and mitigate potential future damage in the event of a cyber incident. Perhaps most importantly, businesses should ensure that they have virtually seamless insurance coverage to deal with any such events. Just as our economy is evolving, so are the types of insurance available to meet a policyholder’s changing needs. 

 

 

Understanding the components of these new-age policies is critical, and executives should devote the time and resources needed to identify a specialist insurance broker who can assess a company’s vulnerabilities and ensure that it purchases the right products.

 

 

Data is a prized asset that warrants its own specific protection. Now is the time to ensure that your data and corporate executives are properly insured so that, when a cyber incident occurs tomorrow, your company and its directors and officers are not burdened with exorbitant costs and huge, uncovered potential exposures.

 

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Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

 

How Significant Will the Libor Scandal-Related Litigation Be?: The Libor scandal itself first began to unfold more than four years ago, following a series of articles in the Wall Street Journal. But with the dramatic announcements in late June of the imposition of fines and penalties of over $450 million against Barclays PLC, the scandal has shifted into a higher gear and has become one of the leading stories in financial papers around the world. At this point, it is apparent that the Libor scandal is going to be one of the hot topics for months and perhaps years to come. An overview of the scandal and of the key developments in recent months can be found here.

 

As is often the case when scandal breaks, the investigative and regulatory developments have been followed by litigation. As discussed here, some of the litigation began to emerge over a year ago, but with the Barclays regulatory settlements, there has been a raft of more recent litigation. Many of the lawsuits have raised antitrust allegations, but at least one of the recent lawsuits – one brought by Barclays shareholders – involves claims under the federal securities laws.

 

It does seem probable that by the time this scandal plays itself out, there will be many more regulatory settlements, some of which might make the Barclays settlements look like pocket change. A related question is whether the banks’ civil litigation exposures are going to be similarly enormous. It is clearly far too early to know for sure. But there are a number of factors that should be kept in mind on the question of what the Libor-scandal litigation might mean for the D&O insurance industry.

 

First, many of the undoubtedly huge costs that are looming likely will not represent insured amounts. The regulatory fines and penalties will not be insured. The company investigative costs also are likely not covered. In addition, most of the antitrust litigation filed to date has named only corporate defendants. Under the typical D&O insurance policy, the companies themselves are only insured for securities claims. So the antitrust litigation, for example, would likely not be covered under the typical D&O insurance policy.

 

In addition, many of these large banks do not carry traditional D&O insurance or may only have restricted insurance. In some instances, the banks’ insurance may include a substantial coinsurance percentage or a massive self-insured retention. Other banks may only carry so-called Side A only insurance, which covers individual directors and officers only and is only available when the corporate entity is unable to indemnify the individuals due to insolvency or legal prohibition. Given that none of the potentially involved banks have failed, it seems unlikely that this Side A only coverage would be triggered.

 

In the end, while the Libor scandal related follow-on litigation could be massive, the Libor scandal may not prove to be a significant event for the D&O insurance industry. Of course, developments could prove this analysis wrong. The plaintiff lawyers may come up with creative ways to expand the universe of defendants, or claimants may meet with unexpected success in asserting claims outside the U.S. If these kinds of things were to happen, then the Libor scandal could prove to be a more serious event for the D&O insurance industry. But as things stand, it does not appear that this scandal is, by itself, going to change the market.

 

What Will the Impact of the JOBS Act Be?: On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). As discussed at greater length here, the JOBS Act contains a number of IPO “on ramp” procedures designed to ease the process and burdens of the “going public process” for Emerging Growth Companies (EGCs). For example, EGCs can elect to submit their IPO registration statement for SEC review on a confidential, nonpublic basis, although the registration statement must be publicly filed at least 21 days before the IPO roadshow. Among the other features of Act that has attracted the most attention are the legislation’s provisions for “crowdfunding.” Under these provisions, a company is permitted to raise up to $1 million during any 12-month period through an SEC-registered crowdfunding portal

 

It was hoped that the legislation would encourage EGCs and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), at least so far the one thing the Act seems to have produced is “unintended consequences.”

 

By way of illustration, Zweig cites as an example of one company trying to take advantage of the JOBS Act’s streamlined IPO procedures and reduced reporting requirements the 132 year-old British football club, Manchester United. Zweig also refers to “blind pools” and “blank check” investment funds that are angling to take advantage of the JOBS Act’s provisions. Neither type of company is likely to contribute to job creation in the United States. Zweig also reports that at least seven Chinese companies are converting to JOBS Act reporting provisions, in order to be able to reduce the disclosures they are required to file; as Zweig points out, this is “no trivial matter since several other Chinese-based companies have recently been accused by U.S. regulators of filing misleading financial statements.”

 

The Act’s reduced reporting requirements are also producing some unintended consequences.  A number of commentators have noted that while these JOBS Act provisions may serve the laudable goal of easing the IPO process, these provision also introduce risks for investors. Nor are these remarks just coming from sideline commentators. Many of the most specific warnings are coming from the companies themselves.

 

In her May 15, 2012 CFO.com article entitled “A New Risk Factor: The JOBS Act” (here), Sarah Johnson reports that for many of the companies taking advantage of the JOBS Act IPO on-ramp provisions, the fact that the companies are relying in the JOBS Act “is itself a risk factor.” Her article notes that recently a number of companies “have warned investors in their prospectuses filed with the Securities and Exchange Commission that the JOBS Act’s breaks on SEC rules could actually be a turnoff.” By way of example, she quotes Cimarron Software’s recently filed S-1, in which the company states that “we cannot be certain if the reduced disclosure requirements applicable to emerging growth companies will make our common stock less attractive to investors.”

 

A common assumption about the new crowdfunding procedure is that it will be most beneficial to start-up companies. But at least according to a May 9, 2012 CFO.com article (here), due to the procedural burdens and costs associated with the JOBS Act’s crowdfunding provisions, crowdfunding is unlikely to be an attractive alternative for start-up companies.

 

According to the article, the crowdfunding provisions in the JOBS Act may be “too complex and onerous” and “not very cost-effective”   for an early-stage company. Among other things, entrepreneurs launching a new venture “may lack the financial acumen and robust business plans they’ll need to comply with the JOBS Act” and they also “may not have the cash to hire the accountants and lawyers they will need to navigate the law.”  In addition, as discussed here, many commentators are concerned that the potential for fraud on the crowd may outweigh the promise of new financing for legitimate startups. Among other reasons for these concerns is that with crowdfunding, “the risk of fraud increases because the pool of investors includes those who have no personal relationship with the business owner and who may be geographically remote from and thus unable to oversee the business itself.

 

From the perspective of the directors and officers of companies seeking to raise capital through crowdfunding, it is important to note that the crowdfunding activity entails its own liability exposures. The JOBS Act expressly incorporates provisions imposing liability on crowdfunding issuers for misrepresentations and omissions in the offerings, on terms similar to the existing provisions of Section 12 of the Securities Act of 1933. Under these provisions, a person who purchases securities issued under the crowdfunding exemption may bring an action based on any material misrepresentation or omission against the issuer, directors and executives for a full refund or damages.

 

It is also worth noteworthy that these crowdfunding provisions may blur the clarity of the division between private and public companies. The crowdfunding provisions seem to expressly contemplate that a private company would be able to engage in crowdfunding financing activities without assuming public company reporting obligations. Yet at the same time, that same private company will be required to make certain disclosure filings with the SEC in connection with the offering and could potentially incur liability under Section 302(c) of the JOBS Act

 

Private companies interested in taking advantage of the crowdfunding provisions once they become effective will want to review their D&O insurance policies’ public offering exclusions to determine whether or not these exclusions would preclude coverage for a crowdfunding liability action under Section 302(c) of the Jobs Act. The wordings of this exclusion vary widely among different policies, and some wordings could be sufficiently broad to preclude coverage.

 

Going forward, however, carriers may seek to adjust the wordings of these exclusions or other policy provisions in light of the crowdfunding liability exposure. Some carriers may try to take the position that crowdfunding liability is a kind of risk that they did not intend to cover in a private company D&O insurance policy. Indeed, some private company D&O Insurers have already introduced “Crowdfunding” endorsements designed to narrow or eliminate the carriers’ potential exposure to liability incurred in connection with crowdfunding activities.

 

As was the case with the Sarbanes-Oxley Act and the Dodd-Frank Act, the D&O insurance industry may face a long period where it must assess the impact of changes introduced by this broad, new legislation. It may be some time before all of the Act’s implications and ramifications can be identified and understood. It will be important for companies and their advisors to monitor these developments as they unfold

 

What Will Happen to the Pace of Banking Closures and FDIC Failed Bank Litigation Filings?: The pace of bank failures has slowed considerably during 2012. Year to date through August 31, 2012, there have been a total of 40 bank closures, compared to 74 during the period January 1, 2011 through August 31, 2011. Since January 1, 2008, 454 banks have failed, but during the month of August 2012 only a single bank failed. In addition, the number of banks the FDIC has ranked as problem institutions has also declined for five consecutive quarters.

 

But though both the number of bank failures and the number of problem institutions are declining, the FDIC’s most recent Quarterly Banking Profile shows that the FDIC still ranks over ten percent of the nation’s depository institutions as problem institutions. In other words, though the pace of bank failures may have slowed, there may be much further to go before the current banking crisis is completely behind us. 

 

As was the case during the S&L crisis two decades ago, the current wave of bank failures has also led to an influx of lawsuits brought by the FDIC, as receiver for the failed banks, against the banks’ former directors and officers. Through August 31, 2012, the FDIC had filed a total of 32 failed bank lawsuits, including 14 so far during 2012. The pace of the FDIC’s lawsuits filings has slowed considerably as the year has progressed. During the first four months of the year, the FDIC filed eleven lawsuits. However, between April 20, 2012 and August 31, 2012, the FDIC filed only three additional lawsuits. Indeed, since mid-July, the FDIC has not filed any additional failed bank lawsuits.

 

This apparent lull in lawsuit filings is surprising, for a couple of reasons. First, during the equivalent period three years prior to the apparent filing lull, there were a host of bank closures, over 50 in all. In light of the three year statute of limitations, one would have expected the last few months to have been a period of heightened filing activity.

 

The filing lull is even more surprising given that the FDIC itself has indicated that it has approved many more lawsuits than have actually been filed so far. As of August 14, 2012, the last date on which the FDIC updated its website, the agency indicated that his has now authorized suits involving 73 failed institutions; against 617 individuals for D&O liability. So far the agency has filed 32 suits involving 31 failed institutions, involving 268 individuals.

 

In view of the substantial gap between the number of authorized lawsuits and the number filed so far, it seems likely that the pace of failed bank lawsuit filings will pick back up at some point. But given the current lull, it does start to seem that perhaps there will not be as much overall failed bank litigation as had originally seemed likely. Even just a short time ago, some commentators had been predicting there might be a total of 86 FDIC lawsuits against the directors and officers of failed banks as part of the current bank failure wave. The final number may prove to be lower than projected.

 

Now That the First Dodd-Frank Whistleblower Bounty Has Been Paid, Will We See More Enforcement Actions and Follow-On Civil Litigation Based on Whistleblower Report?: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would be whistleblowers who hope to cash in on the potentially rich rewards.

 

We may now be closer to finding out whether or not these concerns were valid. As reflected in the SEC’s August 21, 2012 press release (here), the agency has now made its first whistleblower award for the relatively modest amount of $50,000. According to the press release, “the award represents 30 percent of the amount collected in an SEC enforcement action against the perpetrators of the scheme, the maximum percentage payout allowed by the whistleblower law.”

 

The press release also explains that the whistleblower’s assistance led to a court ordering more than $1 million in sanctions, of which approximately $150,000 has been collected thus far. The court is considering whether to issue a final judgment against other defendants in the matter. Any increase in the sanctions ordered and collected will increase payments to the whistleblower.

 

The recent award may be the first under the bounty program, but it is clear that there will be many more to come. The SEC’s August 21 press release quotes SEC Chairman Mary Schapiro as saying that “The whistleblower program is already becoming a success. We’re seeing high-quality tips that are saving our investigators substantial time and resources.” The press release also quotes the head of the SEC’s whistleblower office as saying that since the program was established in August 2011, about eight tips a day are flowing into the SEC, adding that “the fact that we made the first payment after just one year of operation shows that we are open for business and ready to pay people who bring us good, timely information.”

 

It seems obvious that whistleblowers, motivated by the bounty program, are coming forward to report securities law violations. It also seems probable that some (perhaps many) of the situations reported would not otherwise come to the attention of the SEC, and that with these reports the pace of enforcement activity will increase.

 

These developments have companies worried. As discussed in an August 29, 2012 CFO.com article (here), some companies are worried that because of the lure of the bounty award, company employees will bypass internal reporting mechanisms and go straight to the SEC. And not only is it a concern that more companies could find themselves having to deal with SEC enforcement activity, it is entirely possible that the enforcement activity will in turn lead to follow-on litigation in the form of shareholder derivative suits, and even in some cases increased securities class action litigation.

 

It is far too early to tell whether and to what extent any of these concerns actually will come to pass, especially since there has still only been just one whistleblower bounty award. Nevertheless, there definitely so seem to be reasons for companies to be concerned.

 

Will Congress Take Steps to Increase Corporate Officials’ Liability Exposures and Narrow Their Protection?: As if it were not enough that through the Dodd-Frank whistleblower provisions that Congress has enacted provisions to increase the likelihood of SEC enforcement action, a bill now pending in Congress could increase the size of the penalties the SEC can impose.

 

As discussed in greater detail here, on July 23, 2012, Democratic Rhode Island Senator Jack Reed and Republican Senator Charles Grassley introduced a bill titled The Stronger Enforcement of Civil Penalties Act of 2012 to increase the SEC’s civil monetary penalties authority and to directly link the size of those penalties to the scope of the harm and investor losses. The Senators’ joint July 23, 2012 press release about the Bill can be found here. The Bill has been referred to the Senate Committee on Banking, Housing, and Urban Affairs.

 

The Bill proposes to update the maximum money penalties the SEC can obtain from both individuals and from entities, and further provides that the penalties may be obtained both in enforcement actions filed in federal court and in the agency’s own administrative actions (currently the SEC must file a civil enforcement action in order to seek penalties).

 

The increased penalties proposed by the new Bill are scaled to the seriousness of the offense. For the most serious offenses (specified as the third tier violations involving fraud, deceit or manipulation) the per violation penalty for individuals may not exceed the greater of $1 million; three times the gross pecuniary gain; or the losses incurred by victims that result from the violation. The maximum per violation penalty the SEC can seek from entities is limited to the greater of $10 million; three times the gross pecuniary gain; or the losses incurred by victims.

 

For less serious violations, the maximum amount the SEC may seek is correspondingly lower. For individuals, the per violation penalty may not exceed the greater of $100,000 or the gross pecuniary gain as a result of the violation. The equivalent per violation limit for entities is the greater of $500,000 or the amount of the pecuniary gain. The maximum per violation penalty amount for violations not involving fraud or deceit is the greater of $10,000 for individuals or the amount of the pecuniary gain, and for entities, the greater of $100,000 of the amount of the pecuniary gain

 

The bill was submitted at the request of SEC Chairman Shapiro, enjoys bipartisan support, and represents policies that President Obama has advocated, so it seems likely to pass into law. The practical implication seems to be not just that the SEC will seek higher penalties, but will seek penalties more often, given the proposed new authority to seek penalties in administrative actions. With greater firepower at its disposal, the SEC may become even more active, and perhaps even more aggressive.

 

In a separate development, on May 30, 2012, Representative Barney Frank introduced a bill entitled the “Executive Compensation Clawback Full Enforcement Act” (here) that by its own terms is designed to “prohibit individuals from insurance against possible losses from having to repay illegally-received compensation or from having to repay civil penalties.” The proposed Act’s appears primarily addressed to the compensation clawback sections in the FDIC’s “orderly liquidation authority” in the Dodd-Frank Act. However, the proposed Act’s separate prohibition of insurance for “civil money penalties” appears to address the long-standing question of insurance for civil money penalties imposed on bank officials by the FDIC. Rep. Frank’s bill is discussed in greater detail here. The bill has been referred to the House Subcommittee on Financial Institutions and Consumer Credit.

 

From news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to certain compensation clawback insurance products that have been introduced into the marketplace. Frank himself is quoted as saying “"the creation of insurance policies to insulate financial executives from claw-backs is one more effort by some in the industry to perpetuate a lack of accountability.”

 

The proposed Act’s provisions also seem expressly designed to address the question of insurance for the FDIC’s imposition of “civil money penalties” against senior officials at depositary institutions. The question of insurability of civil money penalties is a long-standing one. As discussed in a prior guest post on this site, the FDIC has taken the position on an individual institution level basis that insurance protecting individual bank directors and officer from civil money penalties is prohibited. But while there was some discussion of and concern about these issues, the question of insurability of civil money penalties remained an uncertain issue (at least for the banks themselves, if not for the FDIC). However, if Rep. Frank’s bill becomes law, or at least of its provisions prohibiting insurance of civil money penalties becomes law, the question would obviously be resolved.

 

What Will Be the Impact of the Amgen Case, Now Pending Before the U.S. Supreme Court?: Over the course of the past several years, the U.S. Supreme Court has shown an unusual willingness to take up securities cases. During the upcoming term, the Court will once again be considering an important securities case. As discussed here, on June 11, 2012, the Court granted the petition of Amgen for a writ of certiorari in a securities lawsuit pending against the company. As a result, next term the Court will be addressing the question of whether securities plaintiffs must establish in their class certification petition that the alleged misrepresentation on which they rely was material.

 

In the Amgen case, the plaintiff had sued Amgen and certain of its directors and officers seeing damages under the federal securities laws based on alleged misrepresentations about the safety of certain of the company’s products. The plaintiff moved to certify a class of Amgen shareholders. The defendants opposed the motion, arguing that the plaintiff was not entitled to a class-wide presumption of reliance based on the fraud-on-the-market theory, because the plaintiff could not show that the alleged misrepresentations were material. To the contrary, the defendants argued that as a result of analyst reports and public documents, the market was aware of the information that the plaintiff alleged had been concealed. The district court rejected the defendants’ arguments and certified a plaintiff class, rulings that the Ninth Circuit affirmed.

 

Amgen then filed a petition to the Supreme Court for a writ of certiorari. In its petition, a copy of which can be found here, Amgen argued that there is an “irreconcilable conflict” in the federal judicial circuits on the question of whether or not a plaintiff must establish materiality at the class certification stage. According to the cert petition, the Second and Fifth Circuits have held that a plaintiff must prove materiality for class certification and that defendants may present evidence to rebut the applicability of the fraud-on-the-market theory at the class certification. The Seventh and Ninth Circuits, by contrast, hold that district courts are barred from considering materiality at the class certification stage.

 

The Third Circuit, according to the petition, has adopted an “intermediate approach” which holds that a plaintiff does not need to demonstrate materiality as part of an initial showing before class certification, but that defendants may rebut the applicability of the fraud-on-the market theory by disproving the materiality of the alleged misrepresentation.

 

In its cert petition, Amgen stressed the “in terrorem power of certification” in the securities litigation context, which often compels defendants to enter into massive settlements. The presence or absence of this kind of pressure will, Amgen argued, depend on the circuit in which the case was filed. In the Seventh and Ninth Circuits, the company argued, defendants “will frequently be forced by practical realities, to settle cases for enormous sums regardless of whether they have a meritorious materiality defense,” while in the Second and Fifth Circuits, the plaintiffs would have to establish materiality as a precondition to class certification, and in the Third Circuit, the defendants would have the opportunity to rebut any materiality showing.

 

As the Morrison & Foerster firm said in its June 11, 2012 memorandum about the Supreme Court's cert grant in the Amgen case,

 

A clear answer from the Supreme Court to these questions could have a significant impact on securities litigation. A decision that endorses the Ninth Circuit's approach could made securities litigation more costly for defendants, particularly in circuits where plaintiffs are presently required to prove materiality at class certification. Conversely, a decision rejecting the Ninth Circuit's approach could provide defendants an early opportunity to challenge the viability of class action claims.

 

In addition, there is the possibility here that the Supreme Court -- rather than narrowly interpreting the existing standard for the applicability of the fraud-on-the-market presumption -- does something more radical instead, like entirely redefining whether, when and how the fraud-on-the market presumption might apply. Indeed, this case presents the Court with its first clear chance to revisit the doctrine since it was first articulated nearly a quarter of a century ago.

 

In other words, the Roberts court has once again agreed to hear a case that at least potentially could have an enormous impact on the class action securities litigation exposures of public companies and their directors and officers. The case will be argued and decided during the Supreme Court term commencing in October.

 

How (and When) Will the Long-Running Credit Crisis Litigation Wave Finally Play Out?: The first of the subprime and credit crisis related securities suits was filed in February 2007. Over the course of the following years over 240 credit crisis securities class action lawsuits ultimately were filed, and during the past five years the cases have slowly been making there way through the system.

 

Many cases have been dismissed, and of the cases that have survived dismissal motions many have been settled. The latest case to settle was the high profile Citigroup case, which the parties announced on August 29, 2012 (here) had been settled for $590 million. A number of other cases have settled in recent months, including the Bear Stearns case, which settled earlier this summer for $275 million. My running tally of subprime and credit crisis-related securities suit resolutions, including settlements, can be accessed here.

 

The securities litigation related to the subprime meltdown and credit crisis has not produced any settlements on the scale of the mammoth, multi-billion dollar settlements in the era of corporate scandals a decade ago, but in the aggregate and on average, the credit crisis litigation has produced very significant settlement numbers. With these latest settlements, the aggregate amount of all of the subprime and credit crisis-related lawsuit settlements to date is about $5.5 billion. The average settlement is about $103.8 million, but if the three settlements over $500 million are taken out of the equation, the average drops to about $73.22 million.

 

The pace of settlements in these cases appears to have slowed somewhat during 2012 compared to a year ago. During 2011, 22 of the subprime meltdown and credit crisis securities suits settled, including sixteen between January 1, 2011 and August 31, 2011. However, during the same eight month period during 2012, only eleven cases settled.

 

Though the pace of settlements may have slowed, that does not necessary we are reaching the conclusion of this aggregate litigation event. Many cases continue to work their way through the system, and some of the highest profile cases are yet to be resolved, including the BofA/Merrill Lynch merger case, the AIG case, and the Citigroup bondholders’ case. As these cases and others work themselves out, they will continue to weigh on the results of the affected D&O insurers. It will be some time yet before we can calculate the final tally on the subprime and credit crisis litigation wave.

 

Will the Many Other Scandals Roiling the Financial Industry Lead to Additional Claims?: The Libor-scandal is far from the only financial scandal in which the financial industry had become mired recently. Unfortunately, a host of other scandals involving the industry have also emerged or expanded over the summer. These recent scandals may also lead to claims, and some cases already has.

 

First, there’s the money laundering scandal. In July, the U.S. Senate released a report alleged that over the last decade HSBC failed to implement anti-money-laundering protections and evaded Treasury sanctions against Iran, Myanmar, and others. The Senate report says HSBC facilitated the flow of billions of dollars between Mexico and the U.S. despite warnings drug money was involved, and provided cash to banks with ties to terrorist groups. The report also faulted the government’s Office of the Comptroller of the Currency for taking virtually no action against the bank despite being aware of problems for years. In late July, HSBC said that HSBC said that it had set aside $700 million to cover the potential fines, settlements and other expenses related to the money-laundering inquiry.

 

Second, in early August, the New York Department of Financial Services raised allegations that Standard Chartered had disregarded Treasury sanctions by allowing transactions with Iranian banks worth as much as $250 billion to pass through its New York office and that the bank had deliberately obscured the country of origin. On August 14, 2012, the New York regulator announced that Standard Chartered had agreed to a civil penalty of $340 million to resolve the charges. Investigations into the bank by other authorities including the Department of Justice and the Office of Foreign Assets Control continue. The Standard Chartered settlement followed the June 2012 announcement of the Office of Foreign Assets control that ING had agreed to pay a settlement of $619 million to settle allegations that the company had violated U.S. sanctions.

 

Third, a host of regulators are investigating the losses J.P Morgan suffered as a result of derivatives trades in the company’s London office that went seriously awry. At last report, the company’s losses from the trades (which were known in the financial markets as the “London Whale” trade) be as much as $5.8 billion.

 

Beyond these headline grabbing scandals, there have also been a host of smaller scale scandals involving the financial services industry, including Wells Fargo’s $173 million settlement with the Department of Justice of allegations that the company engaged in discriminatory residential home mortgage lending practices; Capitol One’s $210 million settlement with the Consumer Financial Protection Bureau of  allegations that the credit-card issuer pressured customers into buying consumer-credit-protection products such as identity-theft-monitoring services; and Capitol One’s $12 million settlement with the Department of Justice that the company had violated certain statutory protections for veterans, among other things, through wrongful foreclosures.

 

Indeed, this past summer so many scandals involving the financial services industry that you needed a scorecard just to keep track of them all.

 

Litigation has already followed in the wake of at least some of these scandals. As discussed here, following the initial disclosure of J.P. Morgan’s losses from the London Whale trades, shareholders filed a securities class action lawsuit against the company and certain of its directors and officers, alleging that the company’s statements regarding its trading practices and internal controls were misleading. In addition, following Standard Chartered’s settlement with the New York regulator, families of the victim’s of the 1983 bombing of the Marine barracks in Beirut sued the bank seeking compensation for its concealment of its Iran-linked transactions.

 

Investigations in connection with some of these various scandals are continuing. It remains to be seen whether as further details and developments emerge there will be further follow-on civil litigation. The sheer number of scandals seems to suggest the likelihood that there will be further lawsuits. There certainly does seem to be limit to the capacity of the financial industry to produce scandals.

 

What are the Implications of All of This for the D&O Insurance Marketplace?: After several years in which D&O insurance purchasers have enjoyed declining premiums and expanding coverage, the marketplace seems to have reached an inflection point. At a minimum, almost all of the private company management liability carriers are attempting to increase premium or otherwise add coverage restrictions to their renewals.   Based on current trends, most private company insurance buyers can expect to see increases of from 5% to 10 % (and in some cases, more) at their next renewal, with financially troubled companies and companies with adverse claims histories potentially seeing even larger increases.

 

The public company D&O insurance marketplace has also shifted recently. Economic turmoil and increased governmental regulation and enforcement activity continue to pose a challenging environment for companies and their directors and officers. At the same time, merger objection suits and other negative claims trends have led some carriers to complain of premium inadequacy. Public company D&O carriers in some case are attempting to increase in premium and retention levels. Companies that are likeliest to see upward pressure on their insurance premiums are those that have an adverse claims history or are experiencing financial challenges. Although the carriers for many kinds of companies may be pushing to increase premiums, companies in the following industries are likelier to experience premium pressure: financial services, including commercial banking; extractive natural resources; life sciences; and technology.

 

Some carriers are also attempting to add coverage restrictions, at least in some cases. Among other restrictive provisions that some carriers are seeking in at least some cases are:  separate retentions for mergers and acquisitions activity; separate retentions or other restrictive provisions relating to “crowdfunding”; and in private company management liability policies that have an employment practices coverage section providing sublimited defense cost coverage for wage and hour claims, a reduction in the sublimit.

 

Though the market environment clearly has shifted in recent months, we are not in a true “hard market.” The insurance marketplace continues to be characterized by significant levels of insurance capacity. Given the current high capacity levels, it is possible that competitive forces could undermine many of the market changes noted above. The current, more disciplined underwriting climate could either represent a transition to a sustained period of higher insurance prices and more restrictive terms, or it could merely be a temporary phase before softer market conditions resume. For the present, however, insurance buyers should be prepared for the possibility that they will see premium increases at their next renewal.

 

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Labor Day has come and gone. The kids are back in school. The air is cooler and the nights are longer. There’s a definite autumnal feeling in the air. It is time to get back to work. Fortunately, The D&O Diary kept its eye on things over the summer. So if you are feeling the need to get caught up on what happened while you were out, don’t worry, we’ve got you covered. Here is a quick summary of what you missed on The D&O Diary while you were away.

 

Libor Scandal Surges, Litigation Emerges: The unfolding scandal moved into the headlines of business pages around the world in late June after Barclays agreed to over $450 million in regulatory fines and penalties. Inevitably, litigation has followed; indeed, it had begun to accumulate well before the Barclays settlements were announced.  An overview of the scandal itself  can be found here, and the details of the follow-on  litigation can be found here, here and here. Although many of the lawsuits filed so far have been based on antitrust claims, there has been at least one securities class action lawsuit filed as well, involving Barclays and its former CEO and its former Chairman (about which refer here). The scandal clearly has further to run, and there will likely be further litigation as well. As Stanford Law Professor Joe Grundfest put it, “the Libor-litigation industry is clearly a sector to watch for years to come.”

 

Mid-Year Securities Litigation Studies Released: All of the leading statistical services have issued their respective studies of securities class action lawsuit filings for the first six months of 2012. My post about the Cornerstone Research study can be found here; the NERA Economic Consulting study, here; and the Advisen study can be found here. My own analysis of the first half filings can be found here.

 

Key Insurance Coverage Decisions: In a case that addressed one of the perennial D&O insurance coverage issues, on June 27, 2012 Central District of California Judge R. Gary Klausner ruled that subsequent lawsuits related to the collapse of IndyMac bank were interrelated with an earlier suit and therefore there is no coverage under a second tower of D&O insurance for the subsequent claims. A discussion of the case and the interrelatedness issue can be found here.

 

In a different case, on June 29, 2012, the Seventh Circuit, applying Illinois law, held that when the defendants in a lawsuit include both persons who are insureds under the defendant company’s D&O policy and persons are not insureds, the policy’s Insured vs. Insured exclusion does not preclude coverage for the entire lawsuit, but only the portion attributable to the claims brought against the non-insured person defendants. The extent of coverage available when the defendants include both insured persons and non-insureds is to be determined by the policy’s allocation provisions. A discussion of the Seventh Circuit’s opinion can be found here.

 

In the latest of what is now a lengthening line of cases, on June 12, 2012, the New York Supreme Court, Appellate Division, First Department, applying Illinois law, ruled in a coverage case brought by JPMorgan Chase that owing to settlements reached with underlying carriers in a professional liability insurance program, the excess insurers in the program have no payment obligation because conditions precedent to coverage under the excess carriers’ policies had not been met. The New York case and the earlier line of cases are discussed here.

 

And as discussed here, in a decision that gives broad effect to a D&O insurance policy’s contractual liability exclusion, on August 17, 2012, Middle District of Pennsylvania Judge William Nealon granted the insurer’s motion for summary judgment, holding under Pennsylvania law that the insurer had no obligation to defend or indemnify the policyholder for negligent and fraudulent misrepresentation claims in the underlying action.

 

Finally, In an August 21, 2012 opinion, Central District of California Judge James V. Selna, applying California law, rejected the insured’s efforts to have the malpractice insurer’s duty to advance obligations determined under duty to defend principles. The court concluded that the insurer did not have the duty to advance the insured’s defense expenses incurred in a dispute between the insured and his former law firm. Judge Selna’s opinion is discussed here.

 

The FDIC’s Pace of Failed Bank of Lawsuit Filing Slows: As I noted when the FDIC filed two new failed bank lawsuits in mid-July, those two new lawsuits represented the first lawsuits the agency had filed in two months. Although it seemed at the time as if the two new suits might represent an end to the lull, in time following the July filing of the two lawsuits, the FDIC has not filed any further new failed bank lawsuits. Indeed, between April 20, 2012 and today, the FDIC has filed only three lawsuits, after filing eleven in the first four months of the year.

 

This apparent slowdown in FDIC failed bank lawsuit filings during the last four months is all the more surprising given that during the equivalent period three years prior well over 50 banks closed. In addition, according to its website, the agency has authorized so many more lawsuits than it has filed – and it has been increasing the number of authorized lawsuits each month. In the latest update to its website on August 14, 2012, the agency indicated that his has now authorized suits involving 73 failed institutions; against 617 individuals for D&O liability (those figures represented an increase from the prior month’s numbers of with 68 failed institutions against 576 individuals). So far the agency has filed 32 suits involving 31 failed institutions, involving 268 individuals.

 

Courts Wrestle With Business Judgment Rule and the Scope of Potential Failed Bank Director and Officer Liability: When the FDIC has initiated litigation against the former directors and officers of a failed bank, in many instances, the FDIC has included in its complaint a claim against the individual defendants for ordinary negligence. However, in several instances, individual defendants have successfully argued that their conduct is protected by the business judgment rule and accordingly, that they cannot be held liable for ordinary negligence.

 

The most significant holding is the August 14, 2012 decision in the Northern District of Georgia in the Haven Trust case, in which Judge Steve C. Jones dismissed the claims against both the director and officer defendants, because of his determination that under Georgia law the directors’ and officers’ conduct is protected by the business judgment rule. The Haven Trust case is discussed here. Earlier in August, a judge in the Middle District of Florida, ruled in the FDIC’s failed bank lawsuit relating to the failed Florida Community Bank of Immokalee, Florida, that under Florida law directors cannot be held liable for ordinary negligence, as discussed here. The ruling in that case did not reach the question of whether or not officers can be held liable for ordinary negligence under Florida law.

 

However, as California attorney Jon Joseph wrote in his April 11, 2012 guest post on this blog (here), courts applying California law on the issue and considering whether corporate officers as well as directors can rely on the business judgment rule have split on the issue. Most recently, on June 7, 2012, Eastern District of California Judge Lawrence O’Neill held that the defendant officers cannot rely on the statutorily codified business judgment rule under California Corporations Code Section 309, because the statute by its terms refers only to officers not directors Judge O’Neill’s ruling is discussed here (second item).

 

Keynote Addresses at the Stanford Directors’ College: Once again this summer, I participated in the annual Stanford Directors’ College, held at Stanford Law School in Palo Alto, California. Though I was there as a faculty member, I also attended in my capacity as a blogger, and I reported on the keynote address of NASDAQ CEO Robert Greifeld and the keynote addresses of venture capitalists Marc Andreessen and Ben Horowitz here. I separately reported on the keynote addresses of Delaware Chancellor Leo Strine and Netflix CEO Reed Hastings here.

 

Interview with Professional Liability Insurance Industry Leader: On June 21, 2012, I published my interview of my good friend and industry colleague David Bell. David announced earlier this year that he was leaving Bermuda to return to Montana, where he was taking up a position as President and Chief Operating Officer of ALPS Corporation. The interview not only covers David’s reasons for making the move, but also reflects his thoughts about the industry and about life.

 

U.S. Supreme Court Grants Cert in the Amgen Case:  As discussed here, on June 11, 2012, the U.S. Supreme Court agreed to hear an appeal of a securities class action lawsuit in the Amgen v Connecticut Retirement Plans case. The Supreme Court will address a significant split in the Circuits on the question whether securities plaintiffs must establish in their class certification petition that the alleged misrepresentation on which they rely was material.  The case, which will be argued and presumably decided during the upcoming Supreme Court term, may also give the Court the opportunity to take a look at the fraud on the market theory as well.

 

Chinese Cases Face Pleading Obstacles, Settle Modestly: A number of the securities suits filed against U.S.-listed Chinese companies have survived motions to dismiss. First, the Second Circuit revived the suit against China North Petroleum Holdings, which the district court had dismissed. And on August 8, 2012, Southern District of New York Judge Katherine Forrest denied the motion to dismiss the securities class action lawsuit that had been filed against China Automotive Holdings. A copy of Judge Forrest’s opinion can be found here. And as discussed here, on August 24, 2012, Southern District of New York Judge George Daniels denied in part the company’s motion to dismiss in the Duoyuan Global Water and two of its officers.

 

Not all of the suits against the Chinese companies have fared as well. For example, on August 1, 2012, Southern District of Florida Judge Marcia Cook, in the securities class action lawsuit involving Jiangbo Pharmaceuticals, granted the motions to dismiss of the company’s CFO, Elsa Sung, and of its auditor. The dismissals are without prejudice. A copy of her opinion can be found here.  

 

The claimants that have managed to get their suits against U.S.-listed Chinese companies all the way to the settlement stage have found that they often are forced to accept only modest settlements, often because the Chinese companies carry only very modest levels of D&O insurance (about which refer here).

 

Congressional Bill Would Increase SEC’s Penalty Authority: As discussed here, on July 23, 2012, Democratic Rhode Island Senator Jack Reed and Republican Senator Charles Grassley introduced a bill titled The Stronger Enforcement of Civil Penalties Act of 2012 to increase the SEC’s civil monetary penalties authority and to directly link the size of those penalties to the scope of the harm and investor losses. The Senators’ joint July 23, 2012 press release about the Bill can be found here.

 

And Finally: It may be that everyone here at The D&O Diary has attention deficit disorder. From time to time, we do seem to have trouble staying on topic. For example, my reflections on Time and Summer probably distracted me a lot more than anything else I posted this summer. I confess that I like the Time and Summer post (which can be found here) better than anything I have written for this site. Some day I will have the courage to explain why I wrote it, but not yet. If you have not yet read it, please take a moment and at least look at the pictures and read the many readers’ comments. The post’s concluding message seems apt even as summer draws to a close.

 

Anyway, I think my favorite off-topic foray of the summer was when I posted the new Matt is Dancing video. The Where the Hell is Matt 2012 video is embedded below. The video opens with a short commercial (sorry) but stick with it, the video is so much fun. Cue it up and prepare to smile.

 

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There is a host of well established legal principles that govern insurers’ defense obligation under the standard liability insurance policy where the insurer has the duty to defend the insureds. But many professional liability insurance policies are not written on with the duty on the insurer to defend (which is usually described as a “duty to defend” basis). Because many professionals want to control their own defense, liability insurance for these professionals often provides that the insured professionals will defend themselves, with the obligation on the insurer to advance defense expenses as they are incurred, subject to all of the policy’s terms and conditions.

 

Because the defense obligations under the more traditional duty to defend coverage are well established and are more familiar to many courts, the courts all too often attempt to resolve issues arising under duty to advance policies by referring to principles developed with regard to duty to defend policies.

 

A recent Central District of California decision in a dispute arising under a legal malpractice policy takes an interesting look at these issues. In an August 21, 2012 opinion (here), Judge James V. Selna, applying California law, rejected the insured’s arguments to have the malpractice insurer’s duty to advance obligations determined under duty to defend principles, and applying the more stringent principles  the court determined to be applicable to the insurer’s duty to advance, the court concluded that the insurer did not have the duty to advance the insured’s defense expenses he incurred in a dispute between the insured and his former law firm.

 

Background

Between May 2007 and March 2008, Gregory Glenn Petersen was an attorney with and shareholder of the Jackson, DeMarco, Tidius & Peckenpaugh law firm (JDTP). Before, during and after the time Petersen was with JDTP, he represented the San Diego Police Officers’ Association (SPDOA), as well as several individual police officers in litigation related to employment benefits and labor negotiations. The SPDOA and the individual officers later terminated Petersen as their counsel, and subsequently brought a legal malpractice action against, inter alia, JDTP and Petersen.

 

JDTP’s professional liability insurer paid all of JDTP’s and Petersen’s defense costs incurred in excess of the policy’s $150,000 retention. JDTP paid the retention amount. The malpractice action ended in a settlement that the insurer funded under the policy.

 

Thereafter, JDTP served an arbitration demand on Petersen, in which, as amended, JDTP sought to recover its payment of the $150,000 retention, as well as about $100,000 in fees the firm allegedly incurred in dealing with Petersen’s departure from JDTP and in connection with the malpractice cases. Petersen submitted the arbitration dispute as a claim under JDTP’s professional liability insurance policy, seeking to have the insurer fund his defense and indemnify him. The insurer denied coverage for the dispute and Petersen filed an action for declaratory judgment against the insurer and for damages. In his declaratory judgment claim, Petersen sought a judicial declaration that the insurer has an immediate duty to advance his expenses incurred in defending against the JDTP arbitration claim. The parties filed cross-motions for summary judgment.

 

Among other things, JDTP’s professional liability insurance policy provides that “the Assureds and not the Company have the duty to defend Claims” (the “Company” being a reference to the insurance company), providing further that, subject to the policy’s other terms and conditions, “the Company on behalf of the Assureds shall Advance Claim Expenses … in excess of the applicable RETENTION, if any, before the final disposition of a Claim against the Assureds.”

 

The August 21 Opinion

In seeking a judicial declaration that the insurer must advance his defense expenses, Petersen argued in reliance on principles established under duty to defend policies that “to prevail on his claims he need only show a possibility that there is a covered claim.” He reasoned that “the duty to advance claims expenses is sufficiently analogous to the duty to defend that the same standard should apply.” The insurer argued that the “possibility of coverage” standard and other rules of law governing a policy with a duty to defend do not apply to a policy containing only a duty to advance claims expenses.

 

The court reviewed several cases on which the parties relied, determining first that the courts have indeed differentiated the duty to advance claims expenses from the duty to defend. Judge Selna also reviewed a decision on which Petersen sought to rely arising out of the WorldCom securities litigation and under New York law. Judge Selna discounted that case because it arose under New York law rather than California law, and concluded in any event that it was not persuasive of Petersen’s position.

 

After considering the cases applying California law and arising under policies providing for a duty to advance defense expenses rather than a duty to defend, Judge Selna turned to the policy in dispute. He noted to the “policy provides for the claims expenses to be advanced subject to several conditions”, including the insured’s obligation to obtain the insurer’s consent to reasonable attorneys’ fees and to settlements; as well as subject to the policy’s allocation provisions. Combined with the policy’s “explicit disclaimer of any duty to defend,” Judge Selna found that the policy “is not consistent with the broader duty to defend.”

 

Accordingly, Judge Selna determined that he “will not apply any legal rule … based on a duty to defend policy to the present case” and concluded that Petersen had the burden of establishing “that the underlying claims are within the basic scope of coverage.”

 

Judge Selna then proceeded to determination that the claims presented within JDTP’s arbitration demand were within the policy’s scope of coverage, he ruled that “the uncontroverted facts show beyond a genuine issue of material fact that the arbitration asserted against Peterson does not require the Insurers to advance claims expenses because he is not covered by the Policy.” Judge Selna granted the insurer’s motion for summary judgment and denied Petersen’s  cross-motion.

 

Discussion

In my current professional role as a representative of policyholders’ interests, I often read cases these days rooting for the policyholders. But for a large part of my career, I represented insurers’ interests, both as an advocate and as an advisor. I recall all too well from those days representing insurers how vexing it was when courts were insufficiently precise in their understanding of insurer’s policy obligations. I found it particularly confounding when courts would blur the lines and apply principles applicable to the duty to defend policies in the determination of insurer’s obligations under duty to advance policies.

 

Even though these days I root for policyholders’ interests when reading case decisions,in the end, what I really want is for coverage disputes to be resolved based on a correct judicial understanding of the parties’ respective obligations under the insurance policy. In this case, the court correctly understood the insurer’s defense obligations and correctly declined to apply principles derived from duty to defend cases to the determination of the insurer’s obligations.

 

In the long haul, all parties’ interests will be served if coverage disputes are resolved based upon a correct judicial understanding of the parties’ policy obligations. In particular, all parties’ interests will be served if courts do not inappropriately seek to determine carriers’ obligations under a duty to advance policy applying principles determined in connection with duty to defend policies.

 

One thing that should be clear from all of this is the basic point that insurers’ obligations under a duty to advance policy are different from insurers’ obligations under duty to defend policies. In some situations, policyholders have a choice of which kind of defense provisions to have in their policies (this is particularly true in the private company D&O insurance context).

 

It is critically important when the policyholder is choosing which kind of defense arrangement to have in its policy for the policyholder to be fully informed about the differences in the kinds of defense arrangements. There are advantages and disadvantages to each type of arrangement; being able to understand and explain these differences requires an informed understanding of the claims process and how the difference defense arrangements might affect future claims. This is one more reason why it is particularly important to have an experienced and knowledgeable advisor involved in the professional liability insurance placement process.

 

Special thanks to a loyal reader for providing me with a copy of the August 21 opinion.

 

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In a decision that gives broad effect to a D&O insurance policy’s contractual liability exclusion, on August 17, 2012, Middle District of Pennsylvania Judge William Nealon granted the insurer’s motion for summary judgment, holding under Pennsylvania law that the insurer had no obligation to defend or indemnify the policyholder in the underlying action. A copy of Judge Nealon’s opinion can be found here.

 

Background

In 2004 and 2005, Uni-Marts sold a group of convenience stores in Pennsylvania. The buyers later contended that Uni-Marts had made misrepresentations and omissions about costs and expenses to induce prospective buyers. The buyers initiated a lawsuit in Pennsylvania state court against UniMarts (referred to as the Alliance Action). The complaint in the Alliance Action contained five causes of action against Uni-Marts: 1) fraud in the inducement; 2) negligent misrepresentation; 3) breach of the Fuel Supply Agreement;4) breach of the Purchase Agreement; and 5) breach of the Right of First Refusal Agreement. The Alliance Action ultimately settled for Uni-Marts’ agreement to pay the buyers $2 million and $25,000 in settlement administration costs, as well Uni-Marts’ agreement to certain changes in the contracts.

 

Uni-Marts sought coverage under its D&O insurance policy for its costs of defending the Alliance Action as well as for the cash amounts of the settlement. The D&O insurer denied coverage relying among other things on the policy’s contract exclusion, which provided that no coverage will be available “based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion … shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement.” The carrier filed an action in federal court seeking a judicial declaration that coverage was precluded. The parties filed cross-motions for summary judgment.

 

The August 17 Holding

There was no dispute that count three through five in the Alliance Action were based on Uni-Marts’ alleged liability under a written contract. The parties disputed whether or not coverage was precluded by the policy’s contractual liability exclusion for the negligent misrepresentation and fraud in the inducement counts in the Alliance Action. Uni-Marts argued that the two tort claims arise out of pre-contractual conduct and stand alone from the contract claims.

 

Judge Nealon held, “giving plain meaning to the unambiguous language of the contract exclusion,” that the fraudulent inducement and negligent misrepresentation claims “certainly are ‘based upon, arising out of, or in consequence of any actual or alleged liability’ under the contracts.” The tort claims, Judge Nealon found, “arise from the same essential facts and circumstances from those which underlie the breach of contract claims.” 

 

Of particular importance to Judge Nealon in reaching this conclusion is the fact that “the financial information relied upon by the class plaintiffs [in the Alliance Action] was incorporated into the Purchase Agreements.” Judge Nealon interpreted the plaintiffs in the underlying action as having alleged that the specific financial representations on which the plaintiffs relied as having been incorporated into the Representations, Warranties and Covenants section of the Purchase Agreement. Based on this determination, he concluded that “the fraud in the inducement and negligent misrepresentation claims are based upon, arise from, or are in consequence of Uni-Marts’ liability under the agreements.”

 

Judge Nealon also went on to make a “but for” analysis with respect to the fraudulent inducement and negligent misrepresentation claims, asking “would the store owners’ fraud in the inducement and negligent misrepresentation claims exist even in the absence of the contracts and breach thereof. The answer to that question is no. Had the class plaintiffs not entered into the contracts and had Uni-Mart no breached the contracts, there would be no independent tort claims” because “the injuries suffered by the class plaintiffs would not have occurred had there been no contracts and no breach thereof.”

 

Judge Nealon concluded by noting that requiring the insurer “to cover this loss, which its essence is derived from a business agreement gone bad, would be greatly expanding the coverage of the D&O policy beyond that which is called for by the plain language.”

 

Discussion

For many readers, this case my present something of a surprise outcome. Certainly, claims for fraudulent inducement and negligent misrepresentation arguably represent the very kinds of things for which policyholders purchase D&O insurance. However, the outcome of this case can be understood as a reflection of two factors that interacted in this situation: the exclusion’s broad preamble, and Judge Nealon’s determination that the financial misrepresentations had been incorporated into the agreement.

 

In a prior post about the contractual liability exclusion generally, I have noted how extensively a contract exclusion with the broad “based upon, arising out of” preamble can sweep. While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the broad preamble. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy. In general, courts have applied a broadly preclusive interpretation to exclusions with the broad preamble language.

 

However, not every decision has swept so broadly as to preclude coverage for the types of tort claims asserted here; in particular, Judge Nealon was forced to try to distinguish a relatively recent Western District of Pennsylvania decision in which the court, under very similar circumstances, found that misrepresentation claims were not precluded from coverage. The way that Judge Nealon distinguished the prior case and reached the conclusion that the exclusion here precluded coverage was through his determination that all of the financial misrepresentations on which the plaintiffs relied had been incorporated into the Purchase Agreement. I suspect that not every reader will be persuaded by this analytic legerdemain. But this determination is in any event a distinct characteristic of this decision that may allow it to be distinguished in any future cases involving both breach of contract and misrepresentation claims.

 

The troublesome thing about the breadth of the preclusionary effect given here to the contractual liability exclusion is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insureds could find themselves without coverge for claims of a kind that might well have assumed would be covered, but because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion are precluded from coverage.

 

The real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental to the outcome (setting aside of course the concerns about Judge Nealon’s determination that the financial representations had been incorporated into the Purchase Agreement).

 

Many carriers will insist on using the broad preamble for the contractual liability exclusion and will refuse to use the narrower “for” preamble language. However, given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose to try to apply the exclusion to preclude a wide swath of claims.

 

I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims alleging a different variety of wrongful conduct.

 

SEC Awards First Whistleblower Bounty: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would be whistleblowers who hope to cash in on the potentially rich rewards.

 

However, if the SEC’s first award under this program is any indication, some whistleblowers may decide to curb their enthusiasm. As reflected in the SEC’s August 21, 2012 press release (here), the agency has now made its first whistleblower award for the relatively modest amount of $50,000. According to the press release, “the award represents 30 percent of the amount collected in an SEC enforcement action against the perpetrators of the scheme, the maximum percentage payout allowed by the whistleblower law.”

 

The press release also explains that the whistleblower’s assistance led to a court ordering more than $1 million in sanctions, of which approximately $150,000 has been collected thus far. The court is considering whether to issue a final judgment against other defendants in the matter. Any increase in the sanctions ordered and collected will increase payments to the whistleblower.

 

There undoubtedly will be other awards, some of which undoubtedly will be larger. But for the first example, this modest award itself is unlikely provide much encouragement to prospective whistleblowers.

 

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On August 1, 2011, in a 2-1 decision characterized by a testy but interesting exchange between the majority and the dissent, the Sixth Circuit held that a fidelity policy provided coverage for nearly one million dollars a bank employee stole from client brokerage accounts. For those who (like me) are not regularly involved in fidelity claims, the two opinions provide an interesting opportunity to consider the purpose and operation of fidelity coverage and how it relates to general liability policies. The Sixth Circuit’s decision can be found here.

 

Background

First Defiance Financial Corporation is a bank holding company. Jeffrey Hunt was a “dual employee” for First Defiance, providing investment advisory services to First Defiance customers and also trading securities for Online Brokerage Services. The clients’ assets were held in individual accounts at a third institution, National Financial Services. These client accounts were accessible only by First Defiance’s investment advisors, which acted as the “exclusive agent” on the clients’ behalf.

 

In April 2007, First Defiance learned that Hunt had transferred a total of about $859,000 from nineteen client accounts to his own bank account. First Defiance ultimately repaid the clients for their losses, including lost interest and unrealized client income. The total amount of First Defiance paid to the customers was about $930,000.

 

First Defiance provided a proof of loss to its fidelity insurer for the amount of its payment to the clients. The fidelity policy provides insurance against “[l]oss resulting directly from dishonest or fraudulent acts committed by an Employee, acting alone or in collusions with others.” In its Covered Property provision, the policy specifies that the policy covers “loss of Property (1) owned by the Insured, (2) held by the Insured in any capacity, or (3) owned and held by someone else under circumstances which make the Insured responsible for the Property prior to the occurrence of the loss.” 

 

The fidelity insurer denied First Defiance’s claim for the loss, and First Defiance initiated a coverage lawsuit against the fidelity insurer. The district court entered summary judgment for First Defiance, holding that First Defiance’s loss was covered under the policy. The fidelity insurer appealed the coverage ruling. The parties also cross-appealed the district court’s calculation of the amount that the fidelity insurer owed. I do not discuss in this post the issues relating to the calculation of the insurer’s obligations.

 

The August 1 Opinions

In a majority opinion written by Judge Jeffrey Sutton for a divided Court, the Sixth Circuit affirmed the district court, holding that the fidelity policy covers First Defiance’s losses. Judge Deborah Cook dissented, writing a separate opinion that is well worth reading.

 

The crux of the majority’s opinion is its conclusion that the money in the client brokerage accounts represented Covered Property within the meaning of the fidelity policy. In reaching this conclusion, the majority determined that money in the brokerage accounts was “held under circumstances that made the insured responsible for the property” and that that responsibility arose “prior to the occurrence of the loss.”

 

The fidelity insurer had argued that First Defiance’s responsibility did not arise prior to the loss, and that First Defiance could have incurred liability only after Hunt stole the money, giving rise at most to a potential tort claim against the bank.

 

The majority rejected this argument, concluding that the definition refers to “responsibility” before the loss, not to liability, and that “the fiduciary relationship” between First Defiance and its clients “pre-dates the theft” making First Defiance “responsible for transactions undertaken with a client’s money from the moment the fiduciary relationship was formed.” The majority added that the bank’s responsibility “need not be established by a tort verdict, which necessarily cannot happen before the theft; it can be established by the terms of the account between the bank and the client and the fiduciary duties that spring from them.”

 

In her dissenting opinion that relies on policy drafting history and the purposes of the relevant language in the fidelity policy, Judge Cook characterizes the majority opinion’s policy interpretation as “simplistic.” Judge Cook asserts that “neither the policy language nor the history of fidelity coverage supports the majority’s view that the customer accounts constituted First Defiance’s ‘Covered Property.’”

 

Judge Cook focused specifically on the language in the definition of Covered Property requiring that the employer’s responsibility must vest “prior to the occurrence of the loss.” Judge Cook reviewed how this language had been added to the policy form to clarify that “a fidelity bond, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.” The provision, Judge Cook said, adds a “temporal element” requiring that “the insured’s responsibility for the stolen property must arise prior to the loss, not by virtue of vicarious liability.” First Defiance could have but did not assume responsibility for the risk of theft prior to loss “by placing [a] guarantee in its investment agreements with its customers.”

 

In an irritable response to the dissent, the majority opinion reiterates that First Defiance was “responsible” for money in the customer accounts at the time the accounts were opened, “long before –prior to—the loss of some money in those accounts cause by Hunt’s theft.” The majority opinion emphasizes that the policy does not require that the insured entity’s contract expressly state that insured entity undertakes responsibility for theft from customer accounts, but instead the policy requires only that “the ‘circumstances’ of the relationship must make the insured ‘responsible for the money before the theft.” In a dismissive characterization of the dissent’s position on this issue, the majority opinion adds the concluding comment that this question has been “Asked and answered.”

 

Discussion

The critical issue here is the question of when First Defiance became responsible for the theft. Was it responsible for the theft from the moment the client accounts were created, or was it responsible only after the theft had taken place, on the basis of vicarious liability?

 

The question matters, because the answer to the question determines whether or not this loss properly belongs under a first-party policy like the fidelity policy at issue here, or more properly belongs under a third-party liability policy like a general liability policy.

 

Without presuming to suggest the right answer to this question, I will say that I found the dissenting opinion’s review of the history of the relevant language in the fidelity policy to be instructive. At least based on the sources referenced in the dissenting opinion, it seems that the language at issue here was added to the policy in order to clarify that the fidelity policy, unlike a general liability policy, provides no coverage for an employer’s vicarious liability for employee torts.

 

However, that observation does not alone answer the question of when the bank became responsible for the employee theft. On the one hand, I tend to agree that to agree with the majority’s common sense reasoning that the customer would certainly assume that the bank would be responsible for an employee theft from the customer’s account, and I also agree with the majority that as a practical matter its highly unlikely that there would be a written expression of this assumption in the bank’s agreement with the customer.

 

On the other hand, I tend to agree with the dissent that the expectation that the bank would be responsible for the employee’s theft simply reflects a general assumption that an employer is responsible for employee misconduct. If, for example, First Defiance had not voluntarily reimbursed the customers for their loss as a result of the theft and the customers had been forced to sue the bank, the customers would have, one way or the other, based their claims against the bank on some version of vicarious liability.

 

Framing the question in terms of that hypothetical lawsuit also seems to suggest that – even though the bank voluntarily made the customers whole – the payment to the customers was  as a result of a third party liability claim.

 

All of that said, I would have a hard time subscribing to the dissent’s view of this case if the end result was that there was no insurance at all for this loss. I would be more comfortable altogether with the dissent’s position if I were sure that if the loss were not covered under the fidelity policy, it would be picked up under another policy. I would not be comfortable at all with the dissent’s position if it would result in the loss falling into a crease between policies. In particular, I would want to know whether or not the typical general liability policy would have in fact picked up this loss.  Of particular concern is the possibility that a liability policy might preclude this loss because it was the result of an intentional act.

 

It would seem that, in a world in which there is little certainty, the safe thing for an insured organization to do in a situation like this is to submit a claim under both the fidelity and liability policies.

 

I am very interested to know the thoughts and reactions of readers who work more frequently with fidelity policies. I would like to know what others think of the majority’s position on these issues and also the dissenting opinion as well. I am also curious to know about what readers may think about the possibility that the possible coverage for this claim under a general liability policy. I encourage readers to post their comments to this post using the comment feature in the right hand column.

 

For those readers interested in a good quick introduction to fidelity coverage I recommend the Much Shelist law firm’s November 1, 2011 memo entitled “The ABCs of Fidelity Bonds: What Policyholders Need to Know” (here).

 

SEC, The Jury Has a Message for You: Many readers many be aware that on July 31, 2012, a civil jury in federal court in Manhattan acquitted Citigroup employee Brian Stoker on allegations that he had misled investors in connection with $1 billion of collateralized debt obligations. In a highly unorthodox accompaniment to the verdict form, the jury included a message to the SEC that “"This verdict should not deter the SEC from continuing to investigate the financial industry, to review current regulations, and modify existing regulations as necessary." 

 

In his August 3, 2012 New York Times article entitled “Jury Gets Encouragement from Jury That Ruled Against It” (here), Peter Lattman reports, based on his interview of one of the jurors, how the note came about. As Lattman points out, the note seems to reflect common discontent that persons in the financial industry who were responsible for the excesses that contributed to the credit crisis have not been brought to account. As Alison Frankel notes in an August 2, 2012 post on her On the Case blog (here), for the SEC, the jury’s note “has to read like one more reminder that the public is still waiting for corporate accountability.”

 

In her August 1, 2012 Summary Judgment column on the Am Law Litigation Daily (here), Susan Beck has an interview with the foreman of the jury that heard Stoker’s case. From the foreman’s comments, it seems clear that the jury thought that while there was wrongdoing it was more in the form of collective wrongdoing of the company itself rather than that of one lower level individual. Beck quotes the foreman as saying that  "He did not act in some kind of vacuum where his behavior was not tolerated or encouraged by his bosses. . .To try to hang all this on Stoker didn't work."

 

Frankel’s column has an interesting analysis of how the acquittal in the SEC’s case against Stoker may affect the long running saga of the SEC’s settlement of its enforcement action against Citigroup in connection with the CDO transaction. As noted here, Judge Jed Rakoff has rejected the settlement and refused to stay the case. More recently, the Second Circuit stayed the case pending an appeal of Rakoff’s rejection of the settlement, in an opinion that strongly suggested that Rakoff was wrong on the merits. Frankel suggests, among other things, that in the upcoming appellate arguments, the SEC may rely on the acquittal to show that the agency was wise to settle its case with Citigroup rather than test evidence that might not have withstood muster. On the other hand, the special counsel representing Judge Rakoff in the appeal may be able to argue (perhaps in reliance on the jurors’ comments in press reports) that the jury verdict actually reflected the jurors’ belief that there was misconduct among higher ups at Citigroup, and so Rakoff was right to reject the settlement.

 

There definitely is something about this case where every single thing that happens is interesting and worthy of commentary. It will in any event be interesting to see how the appeal regarding the erstwhile settlement unfolds. The appellate case is due to be argued in late September.

 

The Unintended Consequences of the JOBS Act: When Congress passed the Jumpstart our Businesses Startups (JOBS) Act earlier this year (about which refer here), it was hoped that the legislation would encourage “Emerging Growth Companies” and facilitate job creation. However, as discussed in Jason Zweig’s August 4, 2012 Wall Street Journal article entitled “When Laws Twist Markets” (here), things are playing out a little different than expected. As Zweig puts it “No matter how Congress monkeys with the laws, one always remains in force: the law of unintended consequences.”

 

By way of illustration, Zweig cites as an example of one company trying to take advantage of the JOBS Act’s streamlined IPO procedures and reduced reporting requirements the 132 year-old British football club, Manchester United, which hopes to launch its $300 million IPO next week. Zweig also refers to “blind pools” and “blank check” investment funds that are angling to take advantage of the JOBS Act’s provisions. Neither type of company is likely to contribute to job creation in the United States. Zweig also reports that at least seven Chinese companies are converting to JOBS Act reporting provisions, in order to be able to reduce the disclosures they are required to file; as Zweig points out, this is “no trivial matter since several other Chinese-based companies have recently been accused by U.S. regulators of filing misleading financial statements.”

 

As I have previously noted (here), a company’s status as an “Emerging Growth Company” arguably is for some companies itself a risk factor of which the company’s investors should be warned, particularly those companies taking advantage of the JOBS Act’s relaxed reporting requirements.

 

It should be noted that none of the comments above about the JOBS Act have anything to do with what may be the Act’s most distinctive feature, its allowance for online “Crowdfunding.” As I discussed here, the Act’s crowdfunding provisions were intended to facilitate fundraising for start-ups, but for many reasons, “crowdfunding is unlikely to be an attractive alternative for start-up companies.”

 

So far at least, it would seem the JOBS Act has produced only unintended consequences.

 

My New All-Time Favorite Headline: The headline for the lead article in the August 4, 2012 Detroit Free Press, regarding legal controversy surrounding Michigan’s emergency management law for financially troubled municipalities, reads simply “CHAOS” in four-inch high letters. (An online version of the article, sans the headline under which the story appeared in the print edition, can be found here.)

 

Given the financial condition of many of Michigan’s municipalities, and indeed given the ongoing developments around the world, the Free Press might well consider using that same headline every day. And newspapers everywhere else, too.

 

And Finally: I am an enthusiastic (if intermittent) fan of European football, particularly English Premier League football. Owing to this interest, I downloaded onto my iPad the Fan Chants app, which has recordings and lyrics of soccer fan chants from around the world. Some of the chants are rude and even profane, but overall the chants are highly entertaining. They can also be highly addictive; for example, since writing the paragraph above referring to Manchester United, I have been sitting here silently chanting to myself “Oh Man-ches-ter (Oh Man-ches-ter) is won-der-ful (is won-der-ful)…”

 

In contemplation of all of this, it somehow seemed appropriate to share this video clip of Sheffield United fans singing the “Greasy Chip Butty Song.” (A Chip Butty apparently is a sandwich consisting of French fries on buttered bread.) Here are the lyrics for those who can’t make out the words in the video:

 

You Fill Up My Senses,

Like A Gallon Of Magnet,

Like A Packet Of Woodbines,

Like A Good Pinch Of Snuff,

Like A Night Out In Sheffield,

Like A Greasy Chip Butty,

Like Sheffield United,

Come Fill Me Again,

Na Na Na Na Na...OOOOHH! 

 

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In a June 29, 2012 opinion (here), the Seventh Circuit, applying Illinois law, held that when the defendants in a lawsuit include both persons who are insureds under the defendant company’s D&O policy and persons are not insureds, the policy’s Insured vs. Insured exclusion does not preclude coverage for the entire lawsuit, but only the portion attributable to the claims brought by the non-insured person defendants. The extent of coverage available when the defendants include both insured persons and non-insureds is to be determined by the policy’s allocation provisions.

 

Background

The underlying claim (referred to as the “Miller action”) involves a lawsuit brought by five individuals against Strategic Capital Bancorp, Inc. (SCBI) and two of its officers. In their suit, the plaintiffs asserted claims for fraud, civil conspiracy for alleged violations of the Illinois Consumer Fraud and Deceptive Business Practices Act. Three of the plaintiffs in the Miller action are former SCBI directors and therefore qualify as “Insureds” under the SCBI D&O policy. The other two Miller action plaintiffs are not Insureds under the policy.

 

The SCBI D&O policy includes an exclusion (of a type found in most D&O policies, and usually referred to as an “Insured vs. Insured” exclusion) precluding coverage for “Loss on account of any Claim made against any Insured: …brought or maintained by or on behalf of any Insured or Company in any capacity.” The Policy also contained an allocation provision, specifying that when loss from a Claim incudes both “covered and uncovered matters” the amount “shall be allocated” between covered Loss and uncovered loss based upon the relative legal exposures of the parties to the covered and uncovered matters.”

 

SCBI submitted the Miller action as a claim under its D&O policy. The carrier denied coverage for the claim in reliance on the Insured vs. Insured exclusion. Coverage litigation ensued. The District Court ruled in favor of the carrier, holding that the “plain language” of the exclusion precludes coverage for civil proceedings “brought or maintained by any Insured.” SCBI appealed.

 

The June 29 Opinion

In an opinion written by Judge David Hamilton for a three judge panel, the Seventh Circuit affirmed in part and reversed in part the holding of the district court. The appellate court affirmed the district court to the extent the lower court had held that coverage under the policy for the claims brought by the three former directors was precluded by the Insured vs. Insured exclusion, but reversed the district court to the extent that the lower court had held that the exclusion also precluded coverage for the claims brought by the plaintiffs who were not Insureds. The Seventh Circuit, In reliance on its 1999 decision in the Level 3 Communications, Inc. v. Federal Insurance Co.  case (here)– which the Court said was “practically indistinguishable“ from this case -- held that there was coverage under the policy for the claims brought by the non-insureds, and that defense costs and any indemnity amounts would have to be allocated between covered Loss and uncovered loss using the policy’s allocation provisions.

 

In the Level 3 case, the Seventh Circuit had also addressed the question of the application of an Insured vs. Insured exclusion in a D&O policy to a claim that ultimately included both insured and noninsured claimants. Initially, the claimants in the underlying case had only consisted of non-insureds. However, six months after the underlying lawsuit had been commenced, an insured person joined as a plaintiff. The Seventh Circuit held in the Level 3 case that in that situation “the insurance contract requires allocation of covered and noncovered losses rather than barring all recovery because of the presence of an insured on the plaintiff’s side of the case.”

 

The D&O insurer in this case attempted to distinguish the Level 3 case based on two factual differences: timing and “majority rule.”   The carrier first argued that in the Level 3 case, the insured plaintiff did not join the underlying suit until six months after it was filed. The Seventh Circuit said that its ruling in Level 3 had not depended on the timing, and so rejected this attempt to distinguish the earlier case.

 

Second, the carrier argued, in reliance on what the appellate court described as a “counting noses” approach that coverage in a mixed claimant case like this should be based o n the number of insured plaintiffs or proportion of damages claimed by insured plaintiffs. The court said that this “proposed additional requirement for a majority of non-insureds claimants or dollars has no basis in the …policy language.”

 

The appellate court also noted that the carrier attempted to rely on the Eleventh Circuit’s 2005 opinion in the Sphinx International v. National Union Fire Insurance Co. case (here), which also involved a claim brought both by insured persons and noninsureds. In that case, a former director initiated a securities suit and then published a nationwide notice soliciting other shareholders to join the suit. The former director then amended his complaint to add the additional plaintiffs.  The Eleventh Circuit held that coverage was precluded for the entire suit based upon the company’s D&O policy’s Insured vs. Insured exclusion., which precluded coverage for loss arising from a Claim brought “By or at the behest of … any DIRECTOR or OFFICER … unless such claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of any DIRECTOR OR OFFICER of the company.” The Eleventh Circuit had held that the director plaintiff had actively solicited the other plaintiffs, and therefore the exclusion precluded coverage for the entire claim.

 

The Seventh Circuit found the Sphinx decision to be distinguishable by its fact, including in particular with regard to the policy language involved in that case. The Seventh Circuit also noted that Sphinx itself had distinguished the Level 3 case because the policy language in the earlier case was “too dissimilar” to the language at issue in Sphinx “to be decisive.”

 

Discussion

One of the reasons carriers include Insured vs. Insured exclusions in their policies is that, in addition to avoiding collusive suits, the carriers don’t want to pick up coverage for corporate infighting. Internecine battles can be vexatious and often are not susceptible to resolution on a rational business basis. Given this justification for the inclusion of an Insured vs. Insured exclusion in the policy, I can see how the carriers would take the position that if any one of the plaintiffs is an insured person, the entire claim should be excluded. The argument would be the involvement of even one insured presents too great a risk that the carrier might be dragged into corporate infighting or persona score settling.

 

There may be something to this argument; the carrier did succeed in convincing the district court that the involvement of even one insured as a plaintiff – or more specifically, the involvement here of three insured persons among the five claimants  – is sufficient to preclude coverage for the whole claim.

 

The problem with this argument – that one insured person plaintiff “taints the entire suit,” as the appellate court put it-- is that it can lead to some hard questions. As the appellate court noted, the carrier here took this “proposed rule” to “its logical limit,” arguing that it should apply and control even if there were 99 plaintiffs who were not insureds and only one insured person plaintiff. The appellate court also noted that the carrier had argued that the rule should apply even if separate complaints by an insured person plaintiff and non-insured were consolidated, even if only for pretrial proceedings. These examples from the logical limits of the insurer’s argument proved to be more than the court could accept, leading the appellate court to follow a solution based on allocation of between covered Loss and uncovered loss.

 

For carriers that nonetheless believe that Insured vs. Insured exclusion should apply even if only one of many plaintiffs is an insured person will want to consider the Seventh Circuit’s analysis of the Sphinx International opinion. The more encompassing exclusionary language at issue in that case seems likelier to preclude coverage when claimants include both insured person plaintiffs and non-insureds, particularly where the insured person plaintiff is actively involved in t he litigation.

 

For all D&O insurance practitioners the potentially different claims outcome based on the differences between the exclusionary language at issue in the Sphinx International case and the language involved here underscores the critical importance of these differences in policy wordings. In particular, those of us who are involved in representing policyholders in the insurance purchasing process will want to play close attention to the language used in the Insured vs. Insured exclusion in prospective policies, in order to determine whether it more closely resembles the language at issue in the Sphinx International case or the language involved here.

 

It is probably worth noting one particular challenge the carrier faced on appeal in the Seventh Circuit. The three judge panel that heard this case included Judge Richard Posner. Judge Posner wrote the opinion in the Level 3 case. Given that fact, it was always going to be the case that the Level 3 decision was toing to loom large here.

 

For general background regarding the Insured vs. Insured exclusion, please refer here and, here (in the bankruptcy context) and here (in failed bank litigation).

 

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One of the perennial D&O insurance coverage questions is whether or not subsequent claims are “interrelated” with a prior claim and therefore deemed first made at the time of the prior claim. This question can be particularly critical when the subsequent claims arose during a successor policy period; the answer to the “interrelatedness” question can determine whether the claims trigger one or two insurance programs.

 

In the wave of litigation that arose in connection with the subprime meltdown and the credit crisis, many of the organizations involved were hit with multiple lawsuits filed over period of time, and thus often presenting, in connection with the determination of the availability of D&O insurance coverage, the interrelatedness question.

 

A June 27, 2012 opinion in the D&O insurance coverage litigation arising out the collapse of IndyMac bank takes a close look at these issues. A copy of the opinion can be found here. In his opinion, Central District of California Judge R. Gary Klausner concluded, based on the relevant interrelatedness language, that a variety of lawsuits that first arose during the bank’s 2008-2009 policy period were deemed first made during the policy period of the bank’s prior insurance program, and by operation of two other policy provisions were excluded from coverage under the 2008-2009 program. Because of high profile of the IndyMac case and the sweeping reach of Judge Klausner’s opinion, his ruling could prove influential in the many of the other subprime and credit crisis cases presenting interrelatedness issues.

 

Background

IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).

 

As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of eleven separate lawsuits and claims pending. The first of these lawsuits was a consolidate securities class action lawsuit initiated in March 2007, which Judge Klausner refers to in his June 27 opinion as the Tripp litigation. (As noted in an accompanying post, the Tripp litigation has recently and separately settled.)

 

Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years, the first applying to the 2007-2008 period and the second applying to the 2008-2009 period. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.

 

In the insurance coverage litigation, the carriers in the 2008-2009 raised essentially three arguments: first, that the lawsuits and claims that arose during the 2008-2009 policy period were interrelated with the Tripp lawsuit, and therefore are deemed first made during the 2007-2008 policy period; that because the subsequent claims and lawsuits are interrelated with the Tripp lawsuit, which was noticed as a claim during the prior period, the subsequent claims and lawsuits are excluded from coverage under the 2008-2009 program under the applicable “prior notice” provision; and all of the subsequent claims are excluded from coverage under a specific exclusion endorsed onto the policies in the 2008-2009 program precluding coverage for claims related to the Tripp litigation. The former IndyMac officers and directors filed counterclaims contending that they were entitled to coverage under the 2008-2009 program. The various parties filed cross-motions for summary judgment.

 

The June 27 Opinion

In his June 27 opinion, Judge Klausner, applying California law, granted the insurers’ motions for summary judgment and denied the former IndyMac directors and officers cross-motions. Although his opinion is detailed, it boils down to his conclusions that each of the three sets of policy provisions at issue are unambiguous; that under each of the three sets of policy provisions, the subsequent claims are interrelated with the Tripp litigation; and by operation of the prior notice and Tripp litigation exclusions, all of the subsequent litigation is precluded from coverage under the 2008-2009 insurance program.

 

In concluding that the subsequent claims were interrelated with the Tripp litigation within meaning of the relevant language in the various policies, he noted that the policies’ definition of “interrelated wrongful act” is unambiguous and “describes a broad range of relationships between the original claim and other lawsuits that will be deemed as part of that same claim and made at the time of the first claim.”

 

The prior notice exclusion in the various policies, Judge Klausner noted, “describes a broad relationship between subsequent claims and claims that were made during prior policies such that these subsequent claims will be excluded from coverage.”

 

The Tripp litigation exclusion, Judge Klausner noted, is unambiguous and “excludes from coverage cases that have a broad range of relationships to the facts in the Tripp Litigation.”

 

Judge Klausner found that all of the subsequent claims and lawsuits “are sufficiently related to the Tripp litigation to be excluded under at least one clause of the [2008-2009] policies.”  The set of allegations that Judge Klausner found to be common among the various claims and lawsuits was the assertion that IndyMac failed to follow its underwriting standards and the resulting alleged issuance of high risk mortgages. Judge Klausner found that this commonality extended among the various suits and claims even if the specific allegations in a particular claim or suit “may fall outside the temporal scope of the Tripp litigation.”

 

Discussion

Judge Klausner’s opinion in this case is potentially significant, and not just because it means that the insurance under IndyMac’s 2008-2009 insurance program will not be available for the defense and settlement of the various subsequent claims. As I noted at the outset, many of the claims, lawsuits and disputes that have arisen in the wake of the subprime meltdown and the credit crisis present this same interrelatedness issue. Judge Klausner’s broad reading of the interrelatedness provisions, and in particular his willingness to interpret the policy provisions as not limited temporally but instead as having a broad meaning and reach, could prove influential.

 

It is important to note as an aside that Judge Klausner did not consider wording differences between the interrelatedness provisions in the “traditional” A/B/C policies and in the Side A policies in the 2008-2009 to be particularly significant (although, to be sure, he did note the differences). From an outcome determinative standpoint, the broad scope Judge Klausner gave to the interrelatedness provision could be the most significant feature. Because the interrelatedness language at issue, or substantially similar language, is found in most current D&O insurance policies, Judge Klausner’s analysis and the broad scope he gave to the policy language, could prove significant in a broad variety of other cases.

 

There is one aspect of Judge Klausner’s analysis that may limit its applicability to other disputes. That is that his ultimate conclusion that the various subsequent claims and lawsuits are precluded from coverage depended on the operation of all three of the policy provisions on which the insurers’ relied. It may be argues that it not enough for Judge Klausner to reach his conclusion that there is no coverage under the second tower that the subsequent claims were interrelated with the Tripp litigation; his conclusion that the subsequent claims were precluded from coverage also depended on the operation of the prior notice exclusion and the Tripp litigation exclusion arguably may distinguish this case from other interrelatedness disputes that may arise.

 

The practical effect of Judge Klausner’s decision is that there is insurance coverage, if at all, for the various subsequent claims under the 2007-2008 program. Although the 2007-2008 program represents a total of $80 million in insurance, the program has been eroded by over five years of attorneys’ fees in the Tripp litigation, as well as by the settlement of the Tripp litigation. The claimants in the various subsequent claims will now be in competition with each other for the remaining proceeds, while at the same time any amounts remaining will be further eroded by additional attorneys’ fees. The finite and dwindling amount of insurance and the sheer number of claims and claimants could make it challenging to resolve the claims and suits, at least to the extent insurance funds are to be involved. This observation is relevant to all claimants but it is probably worth noting that it is also applicable to the FDIC in connection with the two lawsuits the agency has filed in its role as IndyMac’s receiver against former officers of the bank.

 

A June 27, 2012 memo from the Wiley Rein law firm discussing Judge Klausner’s opinion can be found here.

 

I would like to thank the several loyal readers who sent me copies of this opinion. I appreciate everyone’s willingness to make sure that I am aware of significant developments so that I can pass them along to my readers.

 

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Along with everyone else in the professional liability insurance industry , I was fascinated by the news that my good friend David Bell, with whom I served on the Professional Liability Underwriting Society (PLUS) Board of Trustees, was leaving Bernuda and  his position at  Allied World Assurance Company Holdings, to return to Montana, where he would be taking up a position as President and Chief Operating Officer of ALPS Corporation, a Montana-based lawyers' professional liability insurance to over 12,500 attorneys nationwide.

 

I was so intrigued by the news of David’s move that I communicated with him to see if he would be willing to be interviewed for this site about the reasons for his move and about his plans and objectives going forward. I am pleased to report that David accepted, and the interview is reproduced below.

 

Until May 1^st, David was the Chief Operating Officer of Allied World Assurance Corporation, AG (NYSE: AWH) a position he held for more than four years. Prior to that David was one of the founding executives at AWAC, where he had worked since its formation in 2002 as the SVP and Global Professional Lines Manager. Prior to that David had been both an Executive Protection Manager and in External Affairs with the Chubb Corporation.

 

Over the course of his career, David has served in a number of leadership positions in the Professional Liability Society, serving as its President in 2008-09 and as a Trustee from 2004-08. David is also a cofounder – along with John McCarrick - of Grateful Nation Montana, a first-of-its-kind in the country public private partnership that provides tutoring, mentoring and a full college scholarship for every child of a Montana solider killed in action (KIA) in Iraq or Afghanistan. Montana has the highest KIA rate per capita of any state in the nation. He serves on the board of The Mansfield Center, which promotes a better understanding of Asia, and of U.S. relations with Asia. He has also presented to the Council on Foreign Relations (CFR), focusing on expropriation and kidnap/ransom in Asia and the Middle East

 

My interview with David follows. My questions appear in italics and David’s answers are indented and in plan type. I would like to thank David for his willingness to participate in this interview, for the frankness of his answers, and for his willingness to allow me to print the interview here.

 

Why did you decide to move from Bermuda to Montana?

 

I think the best way to articulate it is to say that I feel I am following my own “path”. I really do believe that there is a unique path available for each of us to choose whether or not to pursue. Call it fate, or spiritual inspiration (perhaps both), but whatever the name, it subtly illuminates each of our paths;, often running counter to the direction society says we should go. I believe that one has to listen carefully for it and be willing to look at a possible future through a lens that doesn’t necessarily correlate “success” with money or influence. My path pointed west and it was time for me to take my own leap of faith.

 

You were COO Of a $3 billion market cap publicly traded international insurance company, but you traded that in to become the President and COO of a relatively small risk retention group based in Missoula, Montana. How have your reconciled the ambition that put you into a senior role at Allied World at such a relatively young age with the decision to move to Montana in this new role?

 

It certainly was not an easy decision. Steady, increasing success can create its own inertia, and I candidly found it difficult to walk away from a successful career with a great company. That said, there is more to life. I left a wonderful career opportunity, talented colleagues and many friends to join an equally great, albeit much smaller, company. But make no mistake about it: that decision comes at a very real monetary and reputational price. But for me it’s absolutely the right decision. I’ve come back to Montana, a state I’ve loved since I first arrived here as a college freshman, and where I hope to make an impact in ways both inside and outside of our industry.

 

I am certain from the decisions I have made in my own career that there are personal reasons behind your decision to return to Montana, in the form of life lessons that have guided your decisions about your career and your family. What were the life lessons that guided your thinking and how did they affect your decision-making?

 

 A pastor at a church my wife and I attended years ago gave a great sermon about “joy”. He compared “true joy” to just being “happy,” especially in the context of how the word “happiness” is commonly defined these days. I couldn’t do his comparison justice in a few lines but I have to tell you that his sermon spoke to me in a powerful way that has stayed with me for all these years. The direct answer to your question, though, is that my life lesson is about trying to stay on my own path toward true joy and awareness; being always conscious and careful about who (or what) it is that I serve.

 

Your move is not only a big chance for you but for family as well. I know that you and your wife Brittany have two small children. What do you think the effect of this move will be on your family and why?

 

Kids are resilient and that has certainly proven to be true for my two young children in the short time since we’ve been back in Montana. Trent and Ivey instantly adapted happily to their new life here. I marvel at that gift: I grew up with a single mom and never lived in the same place for more than four years while growing up. My wife is just the opposite: Brittany is a fourth-generation Montanan who was raised on a Montana ranch her whole life, so we bring very different perspectives from our respective upbringings. In many ways, Bermuda was an easier place for me to live given my upbringing. Bermuda is a transient place by nature. During the years I lived there, people seem to be constantly moving on and off the Island. But here’s where it’s really different: when one leaves Bermuda it’s not like leaving a neighborhood you can later go back and visit, and where everything has stayed the same -- except for your departure. As I think about it, life in Bermuda is more like a point-in-time: defined by one’s friends that happen to have stopped in Bermuda on their career journey at the same time you stopped there on yours. We developed great friendships in Bermuda, and many of them will stay lifelong friends --wherever in the world we – or they -- are. I have no doubt, though, that when we next visit Bermuda, it will feel like a very different place.

 

Bermuda has changed significantly since you first arrived there in 2002. What were the biggest changes during your time there, and what changes do you see in the years ahead?

 

In my opinion the biggest change to Bermuda between 2002 and 2012 has created its biggest challenge going forward. In 2002 the Island began struggling to keep up with and manage the infrastructure strain created when significant amounts of capital and guest workers flooded the Island during the post-9/11 hard market. Over the next several years, Bermuda expanded its infrastructure it relied more heavily on various elements of that outside capital to fund and support that growth, and it became more dependent on the expectation of permanent outside capital. But, alas, economists tell us that capital moves where it can be deployed most efficiently (and where it feels most welcome), and other offshore jurisdictions have made a compelling case for several companies to move their base of operations away from Bermuda in recent years. I expect that trend to continue in the future. So Bermuda has some real challenges these days, some visible to the visitor and/or macro economist, but others more subtle while equally important. All of these challenges will need to be addressed in the years ahead by the Bermudian government in conjunction with the sources of outside capital. The ability to address these challenges head-on will make a tremendous difference to Bermudians and ex-pats alike -- all who call the Island home.

 

What advice would you give to others in our industry who are thinking about taking a position with an insurer, reinsurer or broker in Bermuda?

 

Bermuda can add a fantastic dimension to an insurance career. It’s one of very few places where large company professionals rotate through regularly, and where those professionals are much more accessible and visible – especially in comparison to New York or other insurance markets. I strongly believe that two of the most important ingredients for success in our industry are technical competency and relationships: these are what comprise your personal brand. Both can be achieved to greater career success over time in Bermuda. By the same token, notwithstanding its tropical appeal, Bermuda is not a place where insurance professionals can kick back and relax. It’s a small marketplace where everyone knows everyone else.   So it’s critically important to work at and maintain a strong work ethic, a reputation for integrity, and strong professional relationships if one wants to make the most of a Bermuda work experience.

 

We have all seen a lot of changes in the professional liability insurance industry over the past few years. What do you think are the most important changes in the industry since you first joined, and what do you see for the industry in the years ahead?

 

One of the most important changes I’ve seen over the years has been big companies retreating from robust entry-level training programs. Some of this training has been picked up by PLUS and other organizations, and I certainly understand that it is a challenge for companies administering in-house training to quantify with any certainty the return on the training investment. But I worry about any drop-off in technical competency among the newest generation of professional liability underwriters and brokers. That would hurt our business in almost every way possible. Our industry is becoming even more complex, and we should all be very concerned about the prospect of an underwriting environment where risks are taken that aren’t clearly understood, and where underwriting companies simply follow the decisions of other underwriters because they lack the technical skills or experience to conduct their own risk/reward analysis.   I would favor a comprehensive -back- to-basics educational and training commitment for new folks pursuing a career in professional liability. The great news is that our industry is full of experienced professionals who already have demonstrated – through PLUS and other educational outlets – their willingness to share their insights and experience with the upcoming generation of professionals.

 

What advice would you have for someone just starting out in the professional liability insurance industry?

 

I would say the following: find someone in the industry who really understands technical language and who has witnessed the carnage of loss examples. Stay close to that person and learn from their experience and history. Otherwise, history will surely repeat itself – for you.

 

I know that throughout your career, you’ve devoted considerable time and energy away from work to support organizations and causes, including your service as a trustee and officer of PLUS, your role as a founding member of the Grateful Nation Montana charity, and your participation in numerous charity efforts. What are your motivations for these activities and why are they important to you? How have you been able to reconcile all of these activities with the demands of your various jobs? How do these activities fit into your longer-term career goals?

 

I was blessed with many things growing up -- although financial security and a traditional family structure weren’t among them. So I don’t take either financial security or a traditional family home life for granted. To the contrary, I feel blessed every day to have my family around me. As a corollary to that thought, I believe that once blessed with resources – family support, monetary and otherwise, we have an obligation to extend ourselves for others who are less fortunate. I suppose the main driver for me (and for Brittany too), certainly with respect to Grateful Nation Montana, is the admiration and respect we have for both those brave men and women serving in our military, and for their families back at home who provide the primary emotional support for our warriors serving in the most dangerous places in the world.   Through our work with Grateful Nation Montana, Brittany and I have been privileged to walk a small part of a very tough journey with a parent, sibling, spouse or child of a soldier who has just been killed in action. It’s been a humbling and special gift to be invited into that circle of grief and healing. It’s a circle where outsiders are not often welcome. Brittany and I often marvel at the strength and courage of these family members, and how our experiences with them make us better people because of these interactions.

 

In many of your outside activities, you have teamed up with your alma mater, the University of Montana. What is it about the school that gives this University such a prominent role in your philanthropic and Foundation activities?

 

I have had a unique opportunity to build a strong, mutual trust relationship with UM over the past several years. I believe they know I will execute on part whenever we partner on an initiative, and that gives them confidence in me as partner. With that greater level of confidence, I notice that UM now seems to move in a more progressive, less bureaucratic, way on our joint initiatives. Together we have been able things that neither of us could have accomplished independently. My proof of concept? There is now a large, moving war memorial to Montana’s fallen soldiers in the Iraq and Afghanistan wars now situated prominently on the main campus of a public state university. I can’t imagine that happening anywhere else besides the University of Montana.

 

 Now that you are your family are off in Montana, will we ever see you again?

 

Of course!, I am hoping to make Montana and ALPS into a destination for quality professional liability insurance.

 

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In the latest of what is now a lengthening line of cases, on June 12, 2012, the New York Supreme Court, Appellate Division, First Department, applying Illinois law, ruled in a coverage case brought by JPMorgan Chase that owing to settlements by underlying carriers in a professional liability insurance program, excess insurers in the program have no payment obligation because conditions precedent to coverage under the excess carriers’ policies had not been met. As discussed below, this case presents an interesting twist on the usual set of circumstances involved in these kinds of coverage disputes. A copy of the June 12 opinion can be found here.

 

Background

Though this coverage action was initiated by JP Morgan, the insurance coverage at issue was procured by Bank One, which later merged into JP Morgan. For the policy period October 1, 2002 through October 1, 2003, Bank One had procured a total of $175 million of bankers’ professional liability insurance and securities action claim coverage. The insurance was structured in a program of eight layers, consisting of a primary layer and seven excess layers.

 

In November 2002, actions were brought against Bank One and certain of its affiliates in connection with their roles as indenture trustees of certain notes issued by various NPF entities. After it acquired Bank One, JP Morgan settled the NPF actions for a total of $718 million and sought coverage under the Bank One insurance program for a portion of the settlement amount.

 

Prior to initiating the coverage suit against the carriers in the Bank One insurance program, JP Morgan settled with the sixth level excess carrier for $17 million. The sixth level excess carrier’s policy provided excess insurance coverage of $15 million in excess of $140 million. However, the $17 million insurance settlement with this sixth level excess carrier covered both the carrier’s liability under the Bank One program and claims under a separate policy the same carrier’s affiliate company issued under a different insurance program. There was no allocation of the $17 million insurance settlement among the carrier’s various policies

 

After initiating the coverage lawsuit, JP Morgan entered a separate $17 million settlement with the third level excess carrier. This separate insurance settlement covered both the third level excess carrier’s liability under the Bank One program as well as a separate claim under a separate insurance policy the carrier had issued.

 

Following these developments, the excess carriers in the fourth, fifth, and seventh excess insurance layers moved for summary judgment in the coverage action, arguing that as a result of the settlement with the third level excess carrier (and in the case of the seventh level excess carrier, the settlement with the sixth level excess carrier), conditions precedent to coverage under their respective policies had not been fulfilled, particularly with respect to their policies’ requirement that the underlying layers should be exhausted by payment of loss.

 

In a May 31, 2011 opinion, the New York (New York County) Supreme Court granted the excess carriers’ motions for summary judgment. JP Morgan appealed.

 

The June 12 Opinion

A June 12, 2012 opinion written by Judge Leland DeGrasse for a five-judge panel off the New York Supreme Court, Appellate Division, First Department and applying Illinois law,  affirmed the lower Court’s summary judgment rulings.

 

Focusing first on the fourth level excess carrier’s position, the appellate court noted that the carrier’s excess policy provide that “liability for any Loss shall attach to [the carrier] only after the Primary and Underling Excess Insurers shall have duly admitted liability and shall have paid the full amount of their respective liability.” The court noted that the “plain language of this attachment provision” requires both the underlying insurers’ admission of liability and the payment of the full amount of their limits, as “conditions precedent” to the carrier’s liability.

 

The appellate court agreed with the fourth level excess carrier that neither of conditions precedent had been met. The first condition was not met because the third level excess carrier’s settlement agreement with JP Morgan specifically provided that the agreement “shall not constitute, or be construed as, an admission of liability.” Moreover, the court noted, there is “no way to determine that [the third level excess carrier] paid the full amount” under its excess policy in the Bank One tower, because the settlement agreement “provided for no allocation” of the $17 million insurance settlement payment between the two policies that the carrier had issued and that were part of the insurance settlement.

 

For similar reasons, the court further concluded that conditions precedent in the fifth and seventh level carriers’ policies had not been met either. Relying on the Northern District of Illinois’s 2010 opinion in the Bally Total Fitness Holding Corp. case (about which refer here) and the Fifth Circuit’s 2011 opinion in Citigroup case (about which refer here), the court concluded that the lower court had “properly granted summary judgment” because JP Morgan’s settlements with the third and sixth level excess carriers “preclude any determination” whether the settling excess insurers’ policy limits were exhausted as required by the excess policies of the carriers that had moved for summary judgment, “because there was there was no allocation of settlement between the two underlying carriers.”

 

The appellate court also rejected JP Morgan’s efforts to rely on the venerable second circuit opinion in Zeig v. Massachusetts Bonding & Ins. Co. The appellate court here said that the Second Circuit’s unwillingness in Zeig to allow the excess carrier to evade payment when an underlying carrier had settled for less than full policy limits had been dependent on a finding of an ambiguity in the excess policy at issue in that case. The appellate court found no ambiguity in the excess policies of the carriers that had moved for summary judgment here, making the present case distinguishable from Zeig. The appellate court also questioned, in reliance on the Bally Total Fitness case, whether Zeig was contrary to applicable Illinois precedent.

 

Discussion

As I noted at the outset, this decision joins a growing list of cases that have found Zeig to be inapplicable and that have required as a trigger of coverage for excess insurance coverage that the limit of liability of the underlying insurance be exhausted by payment of loss. (A full list of the growing line of cases can be found in the Discussion section of my post pertaining to the Fifth Circuit’s opinion in the Citigroup case, refer here.)

 

An interesting complication in this case was the fact that the two excess carriers that had reached settlements with JP Morgan had in each case settled the insurance dispute with JP Morgan for payment of amounts that were actually greater than the amount of their respective excess layers in the Bank One insurance program. In each of the two settlements, the involved carrier’s respective layers in the Bank One program were $15 million, and the amount of each insurance settlement was $17 million.

 

The complicating factor was that in each of these two settlements, the settlements had also involved the settlement of coverage under a second insurance policy, other than the carrier’s policy in the Bank One program. Because of the involvement of these separate policies and because of the absence of any allocation between the policies in the respective insurance settlements, there was no way (the appellate court found) to determine whether or not the insurance settlements had exhausted the applicable excess policies in the Bank One program.

 

Although it may be twenty-twenty hind sight, you can certainly see in retrospect how these insurance settlements could have been structured to avert the outcome here. Just to put this into perspective, the policy limits of the excess carriers who prevailed on summary judgment in the lower court and on appeal totaled $95 million.

 

It is probably worth adding that there is nothing that says that even if the excess carriers had not prevailed on this specific issue that there would have been coverage available under their respective excess policies. Indeed, it appears that, even though the various carriers on the third level through seventh level excess layers are now out of the case (either through settlement or through summary judgment), the carriers on the primary and first two excess layer levels all apparently remain in this case and all apparently are continuing to contest coverage.

 

While this list of case authority on the excess trigger issue is growing longer, it is important to keep in mind that the outcome of each of these cases was a direct reflection of the specific language of the excess policies at issue. These cases underscore the critical importance of the language describing the payment trigger in the excess policy. In recent years, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. This language was not generally available in 2002 when Bank One purchased the insurance that was at issue here.

 

Increasingly larger settlement amounts and increasingly higher defense expenses are increasingly driving claims losses into the excess layers, and as a result these issues pertaining to the excess policies’ coverage triggers are also increasingly important. These cases underscore the critical importance of the specific wording used in the excess policies, which in turn highlights the need to have an experienced, knowledgeable insurance professional involved in the insurance placement process.

 

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The criminal trial in which Jerry Sandusky, the former defensive coordinator of Penn State’s football team, stands accused of sexually abusing at least 10 boys over a 15-year period began Tuesday, June 4, 2012, in Bellefonte, Pa. Sandusky has been charged with forty criminal counts. Sandusky has also separately named as a defendant in a civil action in which one of the alleged victims seeks damages.

 

Sandusky, who denies the allegations in both the criminal and civil actions, has sought coverage for the claims against him under the management liability insurance policy issued to a non-profit group, The Second Mile, of which Sandusky had been an officer. Second Mile’s insurer filed an action in the Middle District of Pennsylvania seeking a judicial declaration that it is not obligated to provide Sandusky with coverage under its policy, which incorporated both D&O and EPL coverage. The insurer contends that Sandusky was not acting in an insured capacity when he committed the alleged wrongful acts. The insurer contends that certain policy exclusions preclude coverage under the Policy for the claims against Sandusky.

 

The insurer moved for judgment on the pleadings in the coverage action, arguing that even if the policy were interpreted to cover the losses stemming from the allegations against Sandusky, the policy would be void as against Pennsylvania public policy. The insurer argued that it should not be required to defend or indemnify against the damages arising out of the claims.

 

In an opinion issued June 4, 2012, the same day that Sandusky’s criminal trial began, Middle District of Pennsylvania Chief Judge Yvette Kane held that while Pennsylvania’s public policy would not permit enforcement of the Second Mile policy to the extent that it provides for indemnification to Sandusky for civil liability for damages arising from sexual molestation, in the absence of any findings or factual record, the Court must defer the question whether any obligation the insurer owes to Sandusky to provide a legal defense to the civil claims or criminal prosecution are void as against Pennsylvania public policy. A copy of Judge Kane’s June 4 opinion can be found here.

 

Judge Kane began her analysis with a confirmation that Pennsylvania public policy “prohibits the reimbursement of Sandusky for any damage award that he may ultimately be found to owe arising from the allegations that he molested and sexually abused children.” What is not clear, however, and “must not be prejudged” is whether the same public policy bars coverage for The Second Mile or any other principal of that organization.

 

Judge Kane also found that Pennsylvania has not “squarely addressed the remaining and most pressing issue before the Court; whether in light of the strong public policy against allowing a perpetrator to insure against the consequences of his own intention wrongdoing, “the insurer’s duty to provide Sandusky a defense to the civil and criminal proceedings “is likewise unenforceable as against public policy because of the nature of the conduct alleged.” On this issue, the Court ‘writes on a blank slate.”

 

After reviewing relevant case law and public policy considerations, Judge Kane concluded that “without the benefit of a factual record, it is not entirely clear that Pennsylvania’s public policy would prohibit enforcement of the insurance policy to the extent that it provides Sandusky with defense costs.” Accordingly, Judge Kane concluded that she must “defer issuance of a ruling on the public policy question as it relates to [the insurer’s] obligation to provide for Sandusky’s legal costs to defend the civil action and criminal prosecution.”

 

Discussion

The alleged wrongful acts of which Sandusky is accused are highly repugnant. At first  I didn’t even want to write about Judge Kane’s opinion in the insurance coverage action. However as offensive and shocking as the allegations against Sandusky are, they remain at this point only that – allegations.

 

It is very frequently the case that individuals insured under management liability policies are accused of misconduct that is exceptional or extraordinary. But until the allegations are established, they remain only unproven charges. If mere allegations alone were sufficient to vitiate defense cost protection, the accused individuals would regularly find themselves compelled to defend themselves without the benefit of insurance to fund their defense.

 

At least in recent times, management liability insurance is typically  structured to provide that conduct exclusions do not apply unless the underlying allegations have been proven. It seems to me that this operation of the insurance policy should not change merely because the basis on which the insurer seeks to disclaim coverage is public policy rather than an express policy exclusion.

 

It comes as no surprise that Pennsylvania’s public policy would prohibit insurance for damages caused by the type of egregious and reprehensible conduct of which Sandusky is accused. However, in the absence of any factual determination or record, it would not be appropriate for the public policy principles to prohibit him from obtaining insurance protection for his defense. Insured persons accused of wrongdoing and who maintain their innocence rightfully ought to be able to look to applicable insurance coverage to provide their defense. These principles should apply regardless of how repugnant the misconduct of which the insured is accused.

 

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On May 30, 2012, Representative Barney Frank introduced a bill entitled the “Executive Compensation Clawback Full Enforcement Act” (here) that by its own terms is designed to “prohibit individuals from insurance against possible losses from having to repay illegally-received compensation or from having to repay civil penalties.” The proposed Act’s appears primarily addressed to the compensation clawback sections in the FDIC’s “orderly liquidation authority” in the Dodd-Frank Act. However, the proposed Act’s separate prohibition of insurance for “civil money penalties” appears to address the long-standing question of insurance for civil money penalties imposed on bank officials by the FDIC.

 

Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act provides for “orderly liquidation authority” for the FDIC to act as a receiver of failed “systemically important” financial institutions. Section 210(s) of the Act permits the FDIC to recover compensation from any senior executive or officer deemed to be “substantially responsible” for the failure of the financial institution. The FDIC may clawback all compensation the executive or director received during the tw0-year period preceding the FDIC’s appointment as receiver.

 

In response to these provisions, at least one industry participant introduced a new insurance product designed to provide protection against these new compensation clawback measures. The new insurance product was not only intended to provide protection for the costs of defending against a clawback action, but also “indemnification for damages sought by the FDIC “for “ earned salaries, wages, commissions, benefits, or other compensation obligations repudiated and recouped by the FDIC.

 

In public statements about this new product, a spokesman for the company that introduced it conceded that product could “possibly” provide indemnification for these clawbacks “if they're insurable under the law," adding that "the basic premise, of course, (is that) you're not going to be able to insure something that the law says is not insurable,"

 

As least as interpreted in news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to this compensation clawback insurance product. Frank himself is quoted as saying “"the creation of insurance policies to insulate financial executives from claw-backs is one more effort by some in the industry to perpetuate a lack of accountability.”

 

However, the proposed Act’s provisions reach more broadly than just the Dodd-Frank orderly liquidation authority clawback provisions. The proposed Act’s provisions also seem expressly designed to address the question of insurance for the FDIC’s imposition of “civil money penalties” against senior officials at depositary institutions.

 

The proposed Act provides in Section 2 that an officer, director, employee or “institution-affiliated party” of “a depository institution, depository holding company or nonbank financial company” who is required by law “to repay previously earned compensation or pay a civil money penalty” shall be “personally liable for the amounts so owed” and “may not , directly or indirectly insure or hedge against, or otherwise transfer the risks associated with, personal liability for the amounts so owed.”

 

The proposed Act provide further that the Section 2 is not intended to preclude a person from “being provided funds necessary to defend against a previously earned compensation recovery,” either from the company itself or “under an insurance policy.” The proposed Act also specifies that the Act is not intended to preclude a person from obtaining insurance against being held personally liable for “penalties, judgments or other amounts assessed against a depositary institution, depositary institution holding company, or nonbank financial company.” The Act is also not intended to prohibit insurance for personal liability against “unintentional outcomes associated with the ordinary exercise of trade or business judgment”

 

The question of insurability of civil money penalties is a long-standing one. As discussed in a prior guest post on this site, the FDIC has taken the position on an individual institution level basis that insurance protecting individual bank directors and officer from civil money penalties was prohibited. But while there was some discussion of and concern about these issues, the question of insurability of civil money penalties remained an uncertain issue (at least for the banks themselves, if not for the FDIC). However, if Rep. Frank’s bill becomes law, or at least of its provisions prohibiting insurance of civil money penalties becomes law, the question would obviously be resolved.

 

With respect to the Act’s provisions relating to compensation clawbacks, it is worth noting that the provisions prohibit insurance only with respect to the returned compensation. The proposed Act expressly allows insurance for defense costs. The insurance industry’s working presumptions about the FDIC’s clawback authority generally has been that the company’s traditional D&O insurance would, all else equal, provide defense cost protection, but that the traditional policy would not cover the returned compensation amounts. In other words, Rep. Frank’s proposed bill would not appear to change the insurance coverage arrangements that would likely apply in most situations. The bill seems only to change things with respect to the recently introduced new insurance products that promised provide insurance protection for the returned compensation.

 

Finally, it is probably worth noting that the proposed Act by its own terms applies only to corporate officials as depositary institutions, depositary institution holding companies and nonbank financial companies. Accordingly, the proposed bill would not seem to have any impact on the vast run of companies, one way or the other.

 

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A company’s D&O insurance policy provides liability protection for the company’s individual directors and officers, but only for their actions undertaken in their capacities as directors and officers. It does not protect them when they are acting in a personal capacity. So, when a company’s CEO signs a loan guaranty for the company, is he acting in an official or personal capacity, and will the D&O insurance policy provide protection for liability under the guaranty? Those were the questions addressed in a May 14, 2012 decision of a three-judge panel of the Court of Appeals of the State of Washington. A copy of the opinion can be found here.

 

Background

In March 2008, S-J Management LLC (SJM) obtained a $3.5 million line of credit from Commerce Bank. Michael Sauter, SJM’s CEO and manager, signed the loan agreement and promissory note in his official capacity on behalf of SJM. In addition Sauter provided Commerce Bank a guaranty, which he signed as “Michael J. Sauter” and which was secured by seven deeds of trust on real property owned by Sauter and his wife.

 

In May 2009, SJM’s line of credit matured and SJM failed to pay its indebtedness. Commerce Bank demanded that Sauter pay in full under his “personal guaranty of indebtedness” SJM’s $2.8 million obligation. Sauter in turn demanded that SJM indemnify him for the amount he was obligated to pay, to which SJM’s members (of which Sauter was one) agreed. However, SJM was financially unable to indemnify Sauter. After Commerce Bank threatened that Sauter’s failure to cure the default could result in the sale of the six real properties securing the guaranty, SJM’s counsel tendered the bank’s demand to SJM’s D&O insurer.

 

SJM’s insurer denied coverage with respect to Sauter’s obligation, and Sauter filed an action against the insurer seeking damages and a judicial declaration of coverage. The parties filed cross motions for summary judgment. The trial court denied Sauter’s motion but granted the insurer’s motion, holding that there was no coverage because no act by Sauter constituted a “Wrongful Act” under the policy and Sauter suffered no “Loss” as defined by the Policy. Sauter appealed.

 

The Appellate Court’s May 14, 2012 Opinion

In an opinion written for the three-judge panel by Judge Stephen J.  Dwyer and applying Washington law, the intermediate appellate court affirmed the trial court’s ruling. The court noted that the policy provides that an act by an “Insured Person” constitutes a “Wrongful Act” only when that person commits the act “while acting in [his or her] capacity as…such on behalf of the Insured Organization.” An “Insured Person” acts “in his capacity as ...such on behalf of the Insured Organization” when that person commits the act in his or her official capacity as a “director, officer, general partner, manager or equivalent executive” of the insured company.

 

In recognition of this language, the court said that because the policy “explicitly provides coverage for the personal liability of the corporate officer incurred for acts performed in his or her capacity as such,” the policy “does not insure against losses incurred where the officer acts in his or her personal capacity.”

 

The court said that “the fact that Sauter is an officer of SJM is not dispositive of the question presented,” which is -- in what capacity did Sauter sign the guaranty, his capacity as an officer or his personal capacity? The Court noted that “a guaranty executed by a corporate officer that secures the indebtedness of the corporation is not executed in the officers’ official capacity.” Indeed, the execution of the guaranty in an official capacity “would result in the corporation itself guaranteeing its own indebtedness, thus negating the very purpose of the guaranty.”

 

Because Sauter was acting in his personal capacity when he signed the guaranty, Sauter committed no “Wrongful Act” as defined in SJM’s D&O insurance policy, and thus the court concluded that the policy does not provide coverage for Sauter’s financial obligation to Commerce Bank.

 

The Court went on to note in addition that any purported “Loss” suffered by Sauter did not result from a “Claim” made against Sauter for a “Wrongful Act.” Rather, the court noted, “Sauter incurred the obligation to pay SJM’s indebtedness by executing the guaranty – not by failing to satisfy his obligation pursuant thereto.” In other words, the court said, “his obligation to Commerce Bank was not the result of Commerce Bank’s demand on the guaranty; instead his obligation was the result of the guaranty itself.” Accordingly, because his obligation to pay was the result of his voluntary undertaking, “it is not a ‘Loss resulting from any Claim … for a Wrongful Act.”

 

Discussion

D&O insurance policies protect individual directors and officers. But that protection does not extend to everything those individuals might do. Rather, the protection only extends to their actions undertaken in their capacities as directors and officers, not to actions undertaking in the personal capacities.

 

There principles are easy to state, but the lines of demarcation between actions undertaken in an official capacity and actions undertaken in a personal capacity may not always be clear. This case illustrates how the lines can sometimes be difficult to discern. Here, it was SJM that wanted to borrow the money, and Sauter was clearly motivated by a desire to facilitate SJM’s borrowing. What matters though is not his motivations but his actions. When he signed the loan agreement and the promissory note, he was clearly acting in his official capacity. But he separately signed a guaranty. Sauter’s guaranty was designed to obligate Sauter not the corporation, and his undertaking was clearly a separate, personal undertaken, as evidence by the fact that the guaranty was secured by deeds of trust on property owned by Sauter and his wife.

 

There is a further reason why Sauter’s guaranty should not be the responsibility of the insurance company. One cannot undertake an obligation to pay, default on that obligation, and send the bill to the insurance company. For that reason, many courts have held that as a matter of public policy repayment of a contractual obligation does not represent a Loss under a D&O insurance policy. As discussed here, many D&O policies incorporate express contractual liability exclusions.

 

Coverage disputes arising from the questions of whether or not an individual was or was not actin g in an insured capacity are occur frequently, particularly in connection with smaller or closely held corporations, when an individual’s roles may overlap or run together. It may sometimes be very difficult, for instance, in the context of a closely held company to distinguish when an individual is acting as an investor or shareholder and when the individual is acting as a director or officer.

 

Indeed, in many instances, individuals may have been acting in dual capacities or multiple capacities, which can make questions concerning coverage for related claims particularly challenging. One critical coverage issue that is sometimes overlooked in the dual capacity context is that to trigger coverage under most policies, an individual need only have been acting in an insured capacity – most policies do not require that the individual have been acting “solely” in an insured capacity. The problem then of course, if the individual is insured only to the extent he or she was acting in an insured capacity, is figuring out the extent of coverage. The fact that these kinds of disputes tend to be very fact-specific does not make them any easier to resolve.

 

Similar questions can also arise when a director or officer is also acting a director or officer of more than one entity or organization -- for example, where an individual is serving at the request of a private equity or venture capital firm on the board of a portfolio company. These concerns are among the many issues that may arise as a result of the interplay between the investment firm’s insurance and the portfolio company’s insurance, as discussed here.  

 

Many thanks to Aidan McCormick of DLA Piper for sending me a copy of the decision. DLA Piper represented the D&O insurer in this case.

 

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One of the critical issues in putting together a D&O insurance program is the question of how to structure the insurance. Among the more complex issues is how to divide the program between “traditional” D&O insurance coverage and Excess Side A DIC insurance (which in effect provides catastrophic protection for individual directors and officers in certain defined circumstances). A more basic issue is the question of how to “layer” the program between primary and excess insurers, and how large each of these layers should be in the overall program.

 

The question of how to layer a D&O insurance program is certainly not new, but it remains a vital question and even a source of continuing scrutiny and debate. The latest example of how topical these issues are appeared in a May 8, 2012 post in Alison Frankel’s On the Case blog (here). Within  the context of a post in which Frankel discusses the overall importance of D&O insurance in securities suit settlements, Frankel quotes Steve Toll of the Cohen, Milstein, Sellers & Toll law firm. Toll has some harsh words to say for the way in which companies structure their D&O insurance.

 

Among other things, Toll objects to the fact that over the last decade insurers have splintered their D&O insurance into multiple layers, which in the event of a claim means that plaintiffs ‘ lawyers are often negotiating multiple insurance company representatives. In Toll’s eyes, the problem with this arrangement is that “at every step, every carrier puts up a roadblock,” which he says “dramatically affects the resolution of these cases. In almost every one, it’s the same fight.”

 

Toll is one of the country’s leading plaintiff’s securities attorneys. I understand that his comments are based on extensive experience and that his frustration about the settlements is real. However, with all due respect for Toll, I think it is fair to note that it is hardly a concern to the parties to the insurance contract(s) that the plaintiffs or the plaintiff’s attorneys don’t like the way the insurance is structured. D&O insurance is not there to make claimants or their attorneys happy nor is it intended to be a reserve pool on which claimants or their attorneys’ get to draw; it is there to protect the company’s directors and officers.

 

It could be argued that it is to the long term benefit of both companies and their insurers that there is a certain amount of friction for plaintiffs and their attorneys to be able to get at the insurance. It ensures that loss costs are contained, which in turn should help to keep insurance costs down.

 

Indeed, at least one leading defense attorney has recommended that D&O insurance should be arranged in tiers, for that very reason. In his venerable article entitled “The Veil of Tiers: Shareholder Lawsuits and Strategic Insurance Layers” (here), first published way back in 1997, Boris Feldman of the Wilson Sonsini law firm argued that “the ‘strategic tiering’ of directors’ and officers’ (D&O) insurance is a useful consideration in designing an effective risk management program.” Feldman argued in favor of arranging D&O insurance program in multiple layers, asserting that “Each separate layer of insurance constitutes a firebreak. It is extremely difficult, in ordinary cases, for plaintiffs to jump from layer to layer in funding a settlement – especially early in the litigation.” That is, what the plaintiffs’ lawyer is complaining about is the very thing that the defense attorney is recommending.

 

Alas, there is a lot more to the question of how to structure D&O insurance that just splitting the program up in to a bunch of layers to the everlasting frustration of plaintiffs’ lawyers. Even Feldman acknowledges in his article that “there is no magic formula as to the right amount or structure of a D&O portfolio.” He also says that if there are too many layers “you may expend substantial energy trying to keep your insurance house in order during a lawsuit” and “should you find yourself in a situation where you really need all of that insurance to settle a troublesome claim, it will be harder to get carriers to participate as you go higher up the chain.” In other words, the issue of too many insurers and too many insurers’ representatives in the settlement room can be a problem for policyholders and for defense counsel as well as for plaintiffs’ lawyers.

 

More recently, an entirely different perspective on the layering of D&O insurance has emerged. In his April 2012 paper “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (which can be found here, and which I previously reviewed here – and the author’s comments on my review can be found here), Fordham Law School Professor Richard Squire raises an entirely different set of objections to the layering of D&O Insurance.

 

Professor Squire contends that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” The compulsion results in a “cramdown” effect, where the upper layer excess insurers and the policyholder pressure the primary insurer and lower level excess insurers to settle.  These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

 

That is, Squire contends that as a result of the pressures that the insurance layering brings about, plaintiffs (and, presumably their lawyers) are “overcompensated.” I suspect that somehow Steve Toll might dissent from this perspective, or from any contention that his clients or he are overcompensated. Toll’s comments certainly don’t evince any awareness of a cramdown effect.

 

In my view, there is no single perspective that explains the way that the layering of D&O insurance will affect the settlement dynamic in every case. In cases involving particularly egregious facts, the layering is going to be irrelevant. (For example, the entire Lehman Brothers D&O insurance tower was always going to be toast, regardless of how it was layered). And in weaker cases, layering could have the firewall effect that Feldman described in his article, which given the weakness of the case involved is a good thing. In most other cases, the impact will be complicated and will vary according to the circumstances, including in particular how quickly defense expenses are accumulating and how likely it is that future defense expenses will burn through several of the lower layers.

 

What is important to understand is why D&O insurance is layered in the first place. The reason that D&O insurance programs are layered is that no D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. As a result, the insurance needs of most buyers of D&O insurance (particularly among public companies) exceed the insuring capacity of any one carrier – and usually, the insurance capacity of several carriers is required in order to put together a program large enough to meet the insurance needs of most buyers.

 

In general, most buyers would probably prefer fewer, larger layers in the program. However, it is not always feasible to obtain larger layers, and as a result in most cases the participation of multiple carriers will be required in order to complete most buyers programs.

 

There might be ways to avoid the layered insurance structure. One possibility would be to arrange the D&O insurance in a quota share program. In a quota share program, the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate many of the conflicts the various commentators have noted.

 

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. The other thing about quota share D&O insurance is that people have been talking about it for years, yet it has never gone anywhere. As a practical matter, at least as things currently stand, quota share insurance is not an available alternative to the current customary layering of D&O insurance.

 

If D&O insurance layering is an inevitable aspect of most D&O Insurance programs, at least as things currently stand, the question then is how can the problems the various commentators have identified be reduced? I have no comprehensive solutions, but I do have a few suggestions of ways some of the problems might be reduced:

 

1. Keep the Excess Carriers in the Loop: Problems often arise when the excess carriers are advised only at the eleventh hour that there is a settlement demand that pierces their layer or that the defense expenses are about to exhaust the underlying layers. If the excess carriers are provided complete information as the claims develop, they are less likely to resist requests for quick action based on lack of information.

 

2. Keep Track of Difficult Players: I have long felt that as an industry we don’t do nearly enough to hold carriers accountable over time for recalcitrant behavior. I think that over the long haul, everyone would benefit if there were more of a league table of claims responsiveness. If carriers knew that their claims reputations truly depended on their responsiveness, there would be greater disincentives against foot-dragging and other undesirable behavior.

 

3. Horses for Courses: This point is really a corollary of the prior point. That is, when the D&O insurance program is being structured at the outset, a great deal of care should be taken to give precedence to the carriers that have consistently demonstrated themselves to be responsive players.

 

4. The Broker Has a Role to Play: One way to try to keep the claims process on track and settlement efforts moving forward is to enlist the assistance of the broker that place the coverage, at least to the extent that the broker has claims resources sufficiently knowledgeable and experienced to be able to participate meaningfully in the claims process and to be able to act as a claims advocate for the policyholder. The broker can also serve as a reminder to the various carriers involved of points 2 and 3 above.

 

There are probably a lot more points that might be made here, and I strongly urge readers who have thoughts along those lines to weigh in here by adding their thoughts using the comment feature on this blog.

 

The final point I want to make is that all of this underscores the fact that the process of putting together an appropriate D&O insurance program is an art not a science, and it requires not only a great deal of technical knowledge, but it also requires a broad perspective on the claims process and on the various carriers’ track records in that process. All of which is another way of saying that perhaps the most important step in putting together an appropriate D&O insurance program is making sure that a knowledgeable and experienced broker has been enlisted to guide the process. 

 

This Could Get Interesting: Readers of this blog are well aware of the rash of securities litigation involving U.S.-listed Chinese companies that arose in the last couple of years. Securities regulators have also gotten interested in some of the revelations involving Chinese companies. A significant challenge that faces both private litigants and the U.S. regulators is the difficulty of investigating and conducting discovery involving companies that have their principal places of operation in China.

 

Along those lines, the SEC has now taken an aggressive move in its efforts to try to investigate alleged accounting issues involving Longtop Financial. The SEC had attempted to subpoena Longtop’s auditor, Shanghai-based Deloitte Touche Tomahtsu, in an attempt to obtain the audit firm’ audit work papers in connection with the firm’s audit of Longtop. The audit firm has resisted producing the work papers, asserting that production of the work papers would violate Chinese law.

 

On May 9, 2012, the SEC instituted an administrative proceeding against the audit firm. A copy of the SEC’s order instituting the administrative proceedings can be found here. The SEC’s May 9, 2012 press release about the action can be found here. The firm is charged with violating the Sarbanes-Oxley Act, which requires foreign public accounting firms to provide audit work papers concerning U.S. issuers to the SEC upon request. This is the first time the SEC has brought an enforcement action against a foreign audit firm for failing to comply with a request. The administrative proceeding will be assigned to an Administrative Law Judge at the agency. The judge would determine the appropriate remedial sanctions if the judge finds in favor of the SEC staff.

 

As reflected in Ross Todd’s May 9, 2012 Am Law Litigation Daily article about the SEC’s action (here), the SEC's latest action follows extensive procedural efforts by the agency to try to obtain the work papers. Todd also reports that efforts between regulators in the U.S. and China may have resulted in the development of some type of compromise that may break the impasse.

 

Whether or not these issues can be worked out remains to be seen. But in the meantime, the SEC’s so far unproductive efforts serves to underscore the difficulties involved with trying to pursue actions involving companies with their principal places of business in China.

 

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On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (commonly referred to as the JOBS Act). This legislation, which enjoyed strong bipartisan support in Congress, is intended to ease the IPO process for emerging growth companies and to facilitate capital-raising by reducing regulatory burdens and disclosure obligations. Among other things, the Act also introduces changes that could impact the potential liability exposures of directors and officers of both public and private companies. These changes could have important D&O insurance implications.

 

In the latest issue of InSights, I take a detailed look at the provisions of the JOBS Act and consider the Act’s possible impact on D&O liability and insurance. The InSights article can be found here.

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In a prior post,  I discussed Fordham Law Professor Richard Squire's April 2012 article entitled “How Collective Settlements Camouflage the Costs of Shareholder Litigation” (here). After my post appeared, Professor Squire communicated to me his concerns about my comments regarding his paper. Because his comments and concerns about my post were quite substantial, it seemed that the best approach would be simply for Professor Squire to publish his response in full in a separate blog post. I have set out Professor Squire’s response below. I am very grateful to Professor Squire for taking the time to present his views in full here. I encourage readers to review Professor Squire’s paper as well. As Professor Squire indicates at the conclusion of his guest post, he and I will be participating in a session at Fordham Law School on May 8, 2012 to discuss his paper. Information about the session can be found here . Here is Professor Squire’s response:

 

 

I am most grateful to Kevin both for devoting a full blog entry to pay my current article on D&O insurance, titled “How Collective Settlements Camouflage the Costs of Shareholder Litigation,” and for giving me here the chance as a guest blogger to respond to his comments. This has been a valuable opportunity for me to learn more about the D&O field from Kevin, a recognized expert whose knowledge of the market for D&O insurance greatly exceeds my own. 

 

 

In his generously extensive comments about my article, Kevin identifies several places in which he thinks I describe the dynamics of D&O insurance settlements accurately. At the same time, however, he expresses numerous concerns with my proposed method for reforming such settlements. In this blog entry, I wish to focus on his concerns, and in particular to say why I think several of them are not warranted or are addressed by other aspects of my article that Kevin’s comments do not mention. 

 

 

To provide context, it will be useful to begin with a summary of my article, which has five interrelated points as follows:

 

 

1.      In a shareholder lawsuit against a defendant with one or more D&O insurance policies, the current practice is to require any settlement of the suit to be a single, collective resolution that binds all defense-side parties, meaning the defendant and each of its insurers.

 

 

2.      The current system of collectivized settlements encourages strategic liability-shifting among defense-side parties. This strategic behavior imposes a variety of costs on shareholders, only some of which have been previously recognized by judges and academic commentators.

 

 

3.      The collective action problem we see in shareholder lawsuit settlements is not inevitable.  Rather, it is “contrived” in the sense that it is a byproduct of how D&O insurance contracts are written and enforced.

 

 

4.      At least in theory, settlements could be de-collectivized in a manner that greatly reduced or eliminated the costs to shareholders from strategic liability-shifting. My article describes such an approach, which I calls “segmented” settlements.

 

 

5.      Even if de-collectivizing the settlement process would benefit shareholders, corporate managers would oppose it because the change would reduce the managers’ ability to use D&O insurance to shift settlement liability to insurers and thus to insulate corporate earnings reports from the impact of the managers’ conduct that gives rise to shareholder litigation.

 

 

Kevin’s comments suggest that he agrees with me on points 1, 2 and 5. Most of his criticisms of my paper are aimed at points 3 and 4—my arguments that settlements could in theory be de-collectivized and that such a change would benefit shareholders.  His comments also stress how “policyholders” would resist my proposal, though in so doing he does not acknowledge the degree to which he and I are in agreement on this point as long as by “policyholders” we mean the corporate managers who actually make the decisions to buy D&O insurance on behalf of themselves and their corporations.

 

 

Since most of Kevin’s concerns are focused on the desirability of my alternative system of segmented settlements, I will illustrate my proposal here with a very simple example. Imagine a corporate manager who is covered by a single D&O policy with a limit of $1 million. This means that if the manager is sued in a shareholder lawsuit, the insurer is responsible for the first $1 million in liability, and the manager is responsible for the excess, if any. Under the current system of collective settlements, the insurer could not settle with the plaintiff unless the plaintiff also agreed to waive his rights to collect from the manager, including his right to collect damages in excess of the $1 million policy limit. Conversely, the manager and plaintiff could enter into a settlement for, say, $1.2 million, and then use the “duty to contribute” (a duty not previously identified in the academic literature, but whose existence and importance Kevin confirms) to force the insurer to “tender” (pay) its $1 million policy amount in support of the settlement. In this way, any settlement must be “collective”—i..e, jointly binding on both the insured (the manager) and the insurer. 

 

 

One of the main problems with this system of collective settlements is that it can lead to plaintiff overcompensation. Since the manager and plaintiff can enter into a settlement whose costs are borne mostly by a third party—i.e., the insurer—they can jointly gain at the insurer’s expense by entering into a settlement that exceeds the expected damages at trial. In my article I call this the “cramdown” dynamic.  The manager’s incentive to engage in this settlement is that it avoids the risk of a trial at which the total damages in case of a verdict for the plaintiff may exceed the $1M policy limit by a large amount, leaving the manager with greater personal liability than she incurs by settling. 

 

 

Under a system of “segmented” settlements, by contrast, the manager and insurer could settle separately out of the case, and by so doing could neither shift liability onto the other nor bind the other in a settlement without the other’s consent. So, for example, the insurer could settle separately with the plaintiff, in which case the insurer would pay the plaintiff a settlement amount and the plaintiff in exchange would waive his right to collect the first $1 million in damages awarded at trial (if any). If the manager did not also settle, then a trial would occur, but only damages awarded in excess of $1 million would be collectible. Conversely, the manager could settle separately from the insurer, whereby the plaintiff would waive his right to collect any damages awarded that exceed $1 million. Under this system, “cramdown” settlements could not occur, and collective-action costs would be reduced for the reason that defense-side parties would no be able to shift liability onto each other.

 

 

Many corporate defendants have not just one D&O policy, but rather a primary policy plus one or more excess policies, forming an insurance “tower.” Adding these additional insurance layers increases the opportunity for strategic conduct but does not otherwise alter the basic conflict of interests created by a collectivized settlement approach nor the benefits of the alternative approach I describe.

 

 

With that overview for context, I’ll now turn to Kevin’s specific concerns and criticisms.

 

 

Holdouts:  Kevin argues that strategic holding out by insurers would still occur under if settlements were de-collectivized. To illustrate, he gives an example of a case in which all defense-side parties have settled except for one mid-level insurer.  I actually anticipate something close to this hypothetical on pages 29 and 30 of my article.  Contrary to Kevin’s argument, under the system I describe a mid-level insurer in that position would not have an incentive to hold out, as by doing so the insurer could not externalize liability onto the policyholder or other insurers.

 

 

To make the example concrete, let's assume a policyholder with a tower of five D&O policies worth $1M each.  We’ll assume further that all defense-side parties, including the policyholder, have settled with the plaintiff except for the excess insurer occupying the $2M to $3M slice of the tower. This means that if a trial occurs, the plaintiff could collect only those awarded damages (if any) that fall between $2M and $3M, and these would be collectible solely from the holdout insurer.  Thus, regardless of whether the holdout insurer ultimately settles or goes to trial, no damages liability can be shifted to the policyholder.  

Kevin expresses in connection with this example a concern that defense costs (i.e., attorneys’ fees and similar expenses) might reduce this "sole remaining layer" of coverage, leaving the policyholder exposed (though, to be sure, only to defense costs plus damages in the $2M to $3M range—i.e., the unsettled remaining slice).  I anticipate this concern on pages 29-30, but I offer a simple solution:  "We can predict that [if settlements were de-collectivized] liability policies would be written so that the non-settling insurers in such cases [in which the policyholder had separately settled] bore the defense-side trial expenses without regard to policy limits, as otherwise those insurers could externalize onto other defense-side parties some of the costs of their refusal to settle."   

 

 

Kevin earlier in his post had expressed “trepidation” about the “world of academic analysis,” which seems to him “unbound by constraints that operate in the world to which I am accustomed.” But there is nothing otherworldly about my simple solution to the holdout problem with respect to defense costs. Under most other types of liability insurance (such as auto and homeowners insurance), defense costs do not count toward the policy limit.  It is D&O insurance that is unusual in its use of "burning candle" policies. Thus, by suggesting that defense costs would no longer count toward policy limits in situations in which the policyholder has settled out of the case, I am incorporating a solution to the cost-shifting hazard that will already be familiar to people with real-world knowledge of liability insurance.  

 

 

After presenting his holdout hypothetical, Kevin goes on to write that my proposal would "substitute a different cramdown dynamic for the existing one" and would "put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their insured."  It seems to me that his concerns here stem from this same misunderstanding about how holdouts would be handled under my proposal.  For this reason, I don't think these concerns are warranted.  Under my proposed system, defense-side parties would have significantly less ability to engage in strategic cost-shifting than they do now.

 

 

Distributional Impact:  Kevin observes that the distributional impact of separate settlements would be to reduce liability for primary insurers and increase it for excess insurers.  This observation is accurate, as my article acknowledges at several points. But it is not grounds for concern, as the excess insurers would adjust by charging higher premiums ex ante, and so they would not on net be worse off.  However, because the current system’s cramdown dynamic would be eliminated, overall settlements would be lower, as there would be a reduction in plaintiff overcompensation (a phenomenon which Kevin acknowledges occurs under the current system).  So overall insurance costs will be lower, a benefit to policyholders.

 

 

Expected Trial Liability:  Kevin devotes several paragraphs to criticizing my reliance on the concept of "expected trial liability" (meaning expected damages if the case goes to trial).  In particular, he criticizes my article for arguing that this figure is "objective" rather than "subjective" and can be reduced to a "single knowable measure."  Here I think Kevin is attacking a straw man.  Nowhere does my article claim that expected trial damages are knowable with certainty ex ante or that parties will form identical estimates of them.  To the contrary, I acknowledge that estimates will differ, and on pages 35 and 36 I model what settlement negotiations look like when they do.

 

 

Similarly, Kevin criticizes me for not taking into account "myriad factors" that affect negotiations, including "whether some insurers believe they have unique coverage defenses."  But on pages 37-40 I do model the impact of coverage exclusions on settlement negotiations.  

 

 

To be sure, I don't model the impact of another factor Kevin identities—namely, the pendency of related lawsuits.  But the fact that a model does not include every conceivably relevant factor does not mean that we can derive no insight from its results.  Indeed, the article’s models are what revealed to me how the cramdown effect under the current system can lead to plaintiff overcompensation, a result whose accuracy Kevin confirms.  More generally, while Kevin calls into question the usefulness of abstract models in the study of complex insurance negotiations, he does not identify any specific results produced by the article’s models that he thinks are inaccurate or unrealistic.

 

 

Delay:  Kevin worries that separate settlements would introduce delay.  But delay results from holdout problems, and de-collectivizing the settlement process would greatly reduce the advantages to holding out.  Indeed, under my system, as each defense-side party settles out of the case, the incentive both for the plaintiff and for the remaining defense-side parties to settles increases.  This is because each settlement reduces the plaintiff's potential recovery at trial but not the trial expenses that both sides would have to incur if trial occurred.  Returning to the example above involving the mid-level insurer holdout, that insurer's incentives to settle are maximized when it is the only defense-side party left in the case, since at that point it will bear all of the defense-side trial costs.   And the plaintiff's incentive to settle is maximized as well since the damages recoverable at trial have been pared down to a thin slice, but winning that slice would still require the plaintiff to incur the full costs of putting on his case.  Since there is no advantage to anyone under my proposed system of delaying resolution of a lawsuit, we can expect less rather than more delay than we see now.

 

 

Achievability:  Kevin criticizes me for writing that "segmented settlements could easily be achieved contractually," a statement he says "lacks a connection to the insurance marketplace" because insurance buyers would resist such a change.  But all I meant was that nothing prevents segmented settlements as a matter of contract law.  I acknowledge full well that D&O insurance buyers—i.e., corporate managers—benefit from the current system of collectivized settlements. See, for example, my abstract:  "Yet corporate managers probably prefer the status quo."  That's why on pages 42 and 43 I argue that, if reform were to occur, it probably would have to be initiated by courts. 

 

 

Reinsurance:  In my article I make the uncontroversial observation that excess insurance and reinsurance are substitutes:  both help insurers diversify their risk exposure. A simple example will illustrate.  Imagine that Company A buys a $10 million primary policy and a $10M excess policy.  Meanwhile, Company B buys a $20M liability policy, and its insurer then purchases coverage for the top half of this policy from a reinsurer.  In both cases we have a division of risk between two insurers.

 

 

I think it interesting that in the D&O market we see Company As rather than Company Bs—that is, we see towers rather than reinsurance. I raised the question in my article whether this might reflect a preference among insurance buyers for a system that encourages covered settlements through the cramdown dynamic. Kevin criticizes me on this point, arguing that there are "a finite number of reinsurers and they require a spread of risk every bit as much as the insurers do."  But the fact that currently there is a relatively small number of reinsurers is not a criticism of my hypothesis; rather, it is a restatement of the question my hypothesis seeks to answer—i.e., the question why this particular insurance market has developed to rely on towers rather than reinsurance. And his claim that reinsurers also "require a risk spread" is misleading since reinsurance is, by definition, risk-spreading, as my example of Companies A and B illustrate.

 

 

Finally, Kevin claims that the presence of towers is explained solely by the preferences of insurers, but this claim is in tension with his earlier claim that D&O insurance is a buyers' market, and it fails to explain why the carriers should prefer the tower model over the reinsurance model.

 

 

***

 

As I said at the beginning of my comments, I am most grateful to Kevin for not only highlighting my article on his blog but also giving me the chance to respond as a guest as I’ve done here. As Kevin mentioned, he and I will be co-panelists at a conference at Fordham Law School (where I’m privileged to teach) next month, where I’ll have the opportunity to be able to discuss these matters with him further. I hope Kevin’s readers have found my exchange with him interesting. If any reader has any comments or questions on the subject matter discussed here, I’d welcome hearing from you at rsquire@law.fordham.edu.  

 

 

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The negotiated resolution of securities class action lawsuits – and absent dismissal, there is rarely any other types of securities suit resolution – is always complicated and occasionally messy, and often involves inefficiencies and sometimes produces distortions and even excesses. Anyone who has ever been through a securities suit settlement negotiation likely will have had the thought that there has to be a better way for resolving the cases.

 

In an April 12, 2012 paper entitled “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (here), Fordham Law School Professor Richard Squire catalogues the many shortcomings in the current securities class action settlement process and sets out his proposal to improve the process and to eliminate process inefficiencies and excesses. UPDATE: Please note that Professor Squire also completed a separate response to this blog post in a seprate guest post of his own. His guest post can be found here.

 

According to Squire, securities class action settlements suffer from a “collective action problem,” owing to the fact that current practices and law require a single case resolution that collectively binds the defendant and all of its D&O insurers – even though the D&O insurance itself is “segmented” in a tower of insurance with the insurers in the different layers having different settlement positions and differing perspectives and interests regarding the settlement.

 

Among other things, Squire notes that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

 

Identifying the requirement for collective settlements as the source of the problem, Squire proposes allowing “segmented settlements” – that is, allowing each defense-side party (and in particular each of the carriers in the D&O insurance tower) to “settle with the plaintiffs separately for its respective slice of the damages ranges.” Under this approach, trial would occur unless all slices settled and the plaintiff would collect at trial only those awarded damages (if any) that fell within the unsettled slice.

 

Squire postulates that this approach would eliminate the conflict of interest between the defense-side parties, “removing the cramdown dynamic that can lead to plaintiff overcompensation.” The elimination of this dynamic will, Squire contends, ultimately lead to more shareholder lawsuit settlements being paid by corporations rather than by insurers, an outcome Squire that further contends would “benefit shareholders, as it would improve the accuracy of a firm’s reported earnings as a measure of the contribution of that firm’s managers to overall shareholder wealth.”

 

I have set out below my thoughts about Squire’s proposal. I note at the outset that I approach commenting on academic papers with trepidation. Even though D&O insurance and D&O claims resolution are areas to which I have devoted my entire professional life, the world of academic analysis, even with respect to a topic within my area of expertise, seems unbound by constraints that operate in the world to which I am accustomed. My usual trepidation is even greater where, as here, I am already committed to commenting in person on the academic analysis in a public forum. Specifically, on May 8, 2012, I will be attending a conference at Fordham Law School at which I will be participating in panel in with my friends Tom Baker of U.Penn. Law School and Sean Fitzpatrick of Endurance Risk Solutions. The purpose of the panel is to discuss Professor Squire’s paper.

 

As a threshold matter, I will say that an important aspect of Squire’s analysis for which I give him high marks is his understanding of the central importance of D&O insurance in the securities class action settlement process. All too often, commentators under-appreciate the significance of the role that D&O insurance plays in the process. A particularly important insight Squire has with respect to the role of D&O insurance is that the different D&O insurers’ interests and positions in the settlement process differ based on where they are in the insurance tower.

 

Squire’s understanding of the role of D&O insurance is particularly accurate when he describes the “cramdown” effect – that is, the pressure that the insured company and the upper level excess carriers can bring to bear on the primary and lower level excess insurers to force the lower level insurers to throw in their limits. Squire perceptively describes what is too often unconsidered, which is the presumed “duty to contribute” that compels lower level insurers to tender their limits where there is pressure to settle a case at a number beyond their limit of liability.

 

Squire is also on target with his identification of the undesirable consequences this dynamic can produce. It can, as he notes, produce plaintiff overcompensation (which he also correctly notes, inures disproportionately to the benefit of the plaintiffs’ lawyers) and it can result in higher priced liability insurance. And the opportunity for further occasions of overcompensation undoubtedly attracts additional lawsuits.

 

Having identified these problems with the current system, the question is whether Squire’s proposed solution would in fact solve the problems in an appropriate and acceptable way, a question to which I turn below. However, having noted above the respects in which I agree with Squire’s understanding of the process and the dynamic, I must also as a preliminary matter identify the respects in which my understanding differs from Squire’s. These considerations may or may not alter the ultimate merits or demerits of Squire’s proposed solution to securities suit settlement; but to the extent these considerations might (and they well might, given that much of Squire’s analysis depends on these understandings and assumptions), it is worth my setting out here my differing understandings.

 

First and foremost, D&O insurance provides a contractual way for companies to manage their indemnification obligations, and to ensure that these indemnification obligations can be honored even if the company itself is unable to do so when the need arises. Because D&O insurance derives from the indemnification obligation, and because the company’s indemnification obligation includes both the obligation to provide for defense expense and for indemnity amounts, the D&O insurance policy has always provided coverage for both defense expense and for settlements and judgments.

 

Second, companies buy D&O insurance in a marketplace that has been “soft” for almost all of the last 25 years. During that time, dozens of new insurers have entered the marketplace, while at the same time there are many fewer public companies than there were even a short time ago. With an abundance of insurance capacity chasing a dwindling number of insurance buyers, the marketplace is heavily tilted in the favor of the buyers. Buyers expect and get very broad coverage for prices that remain advantageous for the buyer. Owing to the constraints of competition, insurers have a limited ability to impose defensive measures or to constrain coverage. The insurers’ options are two-fold: either to play ball or to sit out the game. Most decide to continue to play.

 

Third, as a result of the number of persons insured under D&O policies and the number of insurers that are involved in the typical D&O insurance tower, there are in connection with any securities class action settlement many participants, each with their own counsel. Often there are other parties (auditors, underwriters) who are named as defendants but who are strangers to the D&O policy. Not only are the insurers’ interests not aligned but often the insured persons’ interests are not aligned, and the insured persons’ interests often differ from the other named defendants. The carriers’ interests differ not only according to their attachment point in the insurance tower, but also based on situation specific factors such as how much defense expense has been expended and what the anticipated defense expense burn rate will be. The various carriers’ approach to settlement may also depend upon whether they believe they may have coverage defenses that potentially affect their payment obligations.

 

Not only are there a host of negotiating parties, there often are a host of proceedings involved, other than just the securities class action lawsuit. If a securities suit is serious enough to implicate the excess insurance, there will almost always be multiple other actions ongoing at the same time – usually a parallel derivative suit, often a pending SEC investigation or enforcement action, sometimes even a DoJ investigation or prosecution. The existence of these other proceedings can complicate the settlement dynamic in myriad ways. Serious securities class action settlement negotiations usually do not take place in a vacuum.

 

A final point about securities suits that should be emphasized is that securities class action lawsuits go to trial so rarely that the possibility of trial can safely be disregarded for most practical purposes. Everyone involved in the case knows it will never go to trial. There are very good reasons that these cases very rarely go to trial. The most important is that the theoretical damages almost always exceed the available insurance and in many cases outstrip the defendant company’s financial resources as well. A less dramatic constraint is that trials are costly, burdensome, and unpredictable and would constitute a huge distraction on senior company management. By the same token, the company could ill-afford a judicial determination that conduct that would preclude coverage has taken place. The plaintiffs have their own concerns; the expense of a complex jury trial could be enormous yet at the same time involves the risk of a defense verdict.

 

Together with these preliminary observations about D&O insurance and about the settlement process, I should also add the following observations on Professor Squire’s understandings and assumptions about D&O insurance.

 

First, Professor Squire assumes that corporate buyers consciously and deliberately structure their D&O insurance in multi-layered tiers because that creates “conflicts of interest among insurers that serve the interests of corporate managers,” as, he postulates, the conflicts “actually make insurance-covered settlements more likely.” There may be some buyers out there who are so canny that they manage their insurance buying decisions with these calculations in mind.

 

My own experience is that most insurance buyers would prefer to buy fewer, larger layers of insurance, because that would afford claims administrative simplicity, eliminate the headaches that always arise in the claims context when the insured company has to fight its way through multiple layers, and would simplify the insurance acquisition process.

 

The reason that D&O insurance programs are layered is because of the carriers’ preferences, not the buyers’ preferences. No D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. Professor Squire assumes away this concern by saying that insurers could issue a single policy and simply “protect themselves from this risk through reinsurance.” However, there are a finite number reinsurers and they require a spread of risk every bit as much as the insurers do. The layering of D&O insurance is an inevitable by-product of an insurance marketplace where any given company’s insurance needs exceed the ability of any one insurer (or even one insurer and its reinsurers) to absorb all of the concentrated exposure associated with one risk.

 

Professor Squire also sees something amiss with the fact that D&O insurance policies cover both defense expenses and indemnity amounts. From my perspective, this arrangement is a natural reflection of the outgrowth of D&O insurance as a way for companies to contractually manage their indemnification obligations. In any event, the typical insurance buyer would consider it a strange notion indeed that their D&O liability insurance would not provide defense expense protection or at least that they would have to buy a defense cost policy separate from their liability policy.

 

With respect to Professor Squire’s analyses of the settlement dynamic, I note that in all of Professor Squires hypothetical settlement examples (and all of his examples are in fact hypothetical), he refers to the “expected trial liability” or “the actuarially fair settlement amount.” These are abstractions. There is no such thing in the securities context as “expected trial liability,” simply because there is effectively no data to describe such a thing. (For the same reason, talk of a party’s “bias to toward trial” or “aversion to trial” is equally inapposite.) By the same token, the idea that there is an objectively knowable amount equivalent to an “actuarially fair settlement amount’ is equally unwarranted.

 

What we actually have is a much rougher, much more approximate concept that usually is described as “what cases like this settle for.” Basically every single person in the settlement room will have their own version of this number, as well as their own concept of what features of the case make the comparables relevant. These points of reference are subjective, not objective; rarely the subject of agreement between the parties, at least at the outset; dependent on a host of assumptions; and allow for a range of possible outcomes that might constitute reasonable case resolutions depending on the myriad of factors.

 

In addition, the procedural posture of the case matters; the existence of related pending actions matter; the level of defense expenditure and the anticipated defense expense burn rate matters; the extent to which the defendants’ interests are aligned matters; whether some insurers believe they have unique coverage defenses matters; these and many other features matter and will influence the settlement dynamic and possibly affect the outcome of negotiations.

 

My point is that the settlement dynamic is complex and multifaceted. The very idea that settlement negotiations can be reduced to a mathematical formula with a few variables that explain outcomes in all cases – or even one case – is an interesting theory, as is the idea that settlement outcomes might be measured against a single, knowable measure that represents the “fair” outcome.  The idea that settlement of the class action could be taken in isolation from the myriad other factors – for example, the existence of other related pending proceedings – is an interesting hypothesis.

 

Turning to the specifics of Professor Squire’s proposal that settlements should be segmented rather than collective, I have the following observations. It is possible that the alternative settlement arrangement Professor Squire has proposed could work to produce settlements that are fairer to all participants and that could eliminate the many ills that Professor Squire has identified. I suspect his proposal would be particularly attractive to the carriers that are most routinely in the primary and first level excess layers. It would less attractive to the insurers that are most often in the upper excess layers. And it would be extremely unattractive to policyholders.

 

First, with respect to the upper level excess participants, if all defense side participants have to negotiate their own settlements, there could be an unfortunate dynamic that forces the excess to the settlement table and forces them to pony up money that they otherwise shouldn’t have to pay and wouldn’t pay now. This effect, the direct result of reducing the protection to the excess carrier from the underlying layers, would increase the loss costs of the excess insurers. This would likely make excess insurance more expensive and partially or entirely offset any savings that might be available if primary and lower level excess carrier loss costs were reduced. In other words, to eliminate the cramdown effect, the segmented settlement process would substitute a “cram-around” effect, or maybe a “cram-up” effect.

 

Second, the possibility of a settlement holdout will not be eliminated. But the process when there is a holdout will change. Let’s consider the possibilities. Assume that all of the other participants have settled except one middle layer insurer. Sure, there would be a lot of pressure on the holdout. But there would be enormous pressure on the policyholder, too. Every additional dollar of defense expense incurred will reduce the sole remaining layer, forcing the policyholder toward a possible trial with ever-dwindling amounts of defense costs protection and little or no insurance remaining for any judgments that might result. For all the reasons outlined above, the policyholder could never run this trial risk, and so could be forced to contribute to settlement to avoid the range of unpalatable outcomes. Indeed, crafty insurance players aware of this possible dynamic might become strategic obstructionists, in order to compel the policyholder to absorb settlement costs and possibly allow the obstructing insurer to negotiate a discount settlement deal.

 

My concern is that one almost inevitable outcome of the segmented settlement process that Professor Squire has proposed is that policyholders would be compelled to contribute more frequently and in much greater quantities toward settlement. To the extent I read Professor Squire’s proposal correctly, he fully anticipates this process effect. For example, he says “If the settlements were segmented, more of them would be paid for by corporations rather than by their insurers.” Indeed, as I understand his analysis, he reckons this as one of the positive factors supporting his proposal, because it would force more companies to recognize in their securities litigation loss costs in their financial statements.

 

However, if I am right about the way that this settlement dynamic would work out, the introduction of a segmented settlement process would simply substitute a different cramdown dynamic for the existing one. The new dynamic would be particularly pernicious as it would threaten to put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their own insured. I am at a loss to see how this could ever be viewed as an appropriate or desirable arrangement of affairs between an insurer and a policyholder. No insurer interested in maintaining its reputation as a good corporate citizen would ever propose such a thing. No well-informed policyholder would ever propose such a thing, either.

 

Another practical concern is that requiring segmented settlements would prolong cases. Process participants jockeying for position would have every incentive to try to game the system, hoping that the eroding limits and the ongoing litigation burden will compel other participants, particularly the policyholder, to pony up to get rid of the case. Company management would be burdened and distracted by a complex multistage process that never seems to end and distracts them from the things they need to do to make their businesses successful. Litigation is bad enough as it is, but one settlement deal ends it. If multiple deals were required, it could go on and on and on… And all of these problems would be magnified enormously if there are other related procedural matters pending. 

 

My most important objection to Professor Squire’s proposal is that it is commercially impractical. He simply asserts that “segmented settlements could easily be achieved contractually.” This statement lacks a connection to the insurance marketplace. The theoretical possibility that in the long run segmented settlements might lower insurance costs or reduce the number of lawsuits will have no meaning to an insurance buyer, when compared to the very real possibility that the segmented settlement arrangement would cause the buyer to have to absorb loss costs that would otherwise be covered. No company would ever agree to do it -- nor should any company ever agree to it.

 

All of that said, there unquestionably are serious ills with the current securities suit settlement process, many of which ills Professor Squire identifies in his paper. I am not sure I know how to remedy these ills. One possibility that Professor Squire considers and rejects is the possibility of a quota share arrangement, where the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate the conflict of interest problems Professor Squire identifies.

 

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. But on the plus side, there are multiple places in the insurance world now where quota share arrangements already are in place and functioning successfully. There is a lot to be said for an insurance arrangement that already actually exists as a possible solution for an insurance-related problem.

 

I would like to thank Professor Squire for allowing me the opportunity to read his interesting and thought-provoking paper and for allowing me to comment about his paper here. I enjoyed reading his paper and writing this comment – it kept from going crazy on a very long plane flight. I hope that readers of this blog will review the Professor’s paper on their own and will post their thoughts and comments about his paper here using this site’s comment feature.

 

And in Other News: With a long plane flight on Saturday, I not only had the leisure to type out this long blog post, but I also had the opportunity to read the Financial Times weekend edition at length and in full. With a more thorough reading than I am usually able to enjoy, I gleaned a couple of very interesting observations from articles in the paper.

 

First, in a April 14, 2012 article entitled “Unorthodox Behavior Rattles Russian Church” (here), the article’s author notes the following about Kirill I, the patriarch of the Russian Orthodox Church: “Last week bloggers discovered that a photograph of the patriarch on the Church’s website had been altered to remove a $30,000 Bruguet watch from the churchman’s wrist. While someone had used Photoshop to erase the offending object, they had forgotten to erase the watch’s reflection on a nearby mahogany table.”

 

And in an April 14, 2012 article entitled “Who Needs the Shard When You Have Shakespeare?” (here), commenting on the latest addition to the London Skyline (now under construction), the article’s author notes that

 

The skylines of European cities have traditionally told us something about what they believe in, and they still do. Until Harold Macmillan eased restrictions on buildings exceeding the height of St. Paul’s, London’s skyline consisted of two 100m-high buildings: St. Paul’s and the Big Ben clock tower. It was easy to see what London stood for: the Church and parliamentary sovereignty and not necessarily in that order. The skyline of modern London, with its dozen or so buildings more than 100m-tall, also sends a message. It is best summed up by the London Eye, which proclaims the city less a workplace than a tourist attraction. The rest of the buildings are about money.

 

On the Road Again: This upcoming week I will be a panelist at a session in Beijing co-sponsored by the American Bar Association Torts and Insurance Practice Section and by the China Council for the Promotion of International Trade. Information about the conference, which is entitled “Doing Business in the United States: What you Need to Know about Investing, Product Liability and Dispute Resolution,” can be found here. I will be on a panel entitled “Directors and Officers Liability, Securities Issues and Class Action Exposure” with my good friend Perry Granof, as well as Patrick Zeng of Zurich China, whom I am looking forward to meeting for the first time on this trip.

 

From Beijing, I will be going on to Professional Liability Underwriting Society (PLUS) Chapter events in Hong Kong and Singapore. Perry Granof will also be joining me educational sessions at these PLUS Chapter Events, as will my old friend Joe Monteleone. To those readers who may be attending the PLUS Chapter events, I am looking forward to seeing you. If we have not met before, I hope you will please take the opportunity to introduce yourself.

 

With the distances, time differences and commitments involved, I am not sure what sort of publication schedule will be possible over the next few days. The D&O Diary’s normal publication schedule should resume the week of April 30, 2012. 

 

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The process of restructuring financially distressed companies is complicated and fraught with challenges. Among the many potentially complicating challenges that can arise is the possibility of claims against the company’s management. Because of the risks involved with these kinds of claims, it is critically important that steps are taken to insure that directors and officers are protected appropriately throughout and after the reorganization process.

 

The “best practices” for ensuring that directors and officers are protected before, during and after a reorganization are reviewed in an interesting March 14, 2012 memorandum from Shaunna Jones and Jeffrey Clancy of the Willkie Farr law firm entitled “Reorganization and D&O: Not Always Business as Usual” (here).

 

The memo contains key observations and practical advice regarding D&O insurance for companies involved in a financial reorganization. I review the memo’s key points below. However, it is important to note at the outset that the specific requirements of any particular company will be a reflection of the company’s financial circumstances; the specific reorganization process in which the company engages and how that process unfolds; and the particulars of the D&O insurance program that the company has in place at the time of its reorganization.

 

Because of these variables, there is no one single set of insurance-related steps that will apply to every financial reorganization. In order to determine the appropriate D&O insurance-related steps that any particular financially distressed company should take, the company should consult closely with its financial, legal and insurance advisors. That said, however, there are certain considerations that should be taken into account when these circumstances arise.

 

First, a company should determine whether the reorganization process has triggered the “change in control” provisions of the company’s existing D&O insurance program, and if the process has or will trigger those provisions, when the chance in control took place or will take place. This question is relevant, because the existing D&O insurance program will not provide coverage for any acts, errors or omissions that occur after the change in control.

 

The typical D&O insurance policy will provide that a change in control occurs when another person or entity acquires 50 percent or more of the voting control or power to select a majority of the board of directors of the insured company. Many policies also provide that that a change in control is triggered upon the appointment of a receiver, liquidator or trustee (although other policies do not have these trustee provisions, or the provisions are deleted by endorsement).

 

Whether and when the provisions are triggered will depend on the specific reorganization process in which the company has engaged. A Section 11 bankruptcy filing may not trigger a change in control, particularly where (as is often the case) no trustee has been appointed. The change in control in a Chapter 11 bankruptcy may not take place until the reorganization plan is implemented, on the plan’s “effective date.” The routine appointment of a trustee in a Chapter 7 bankruptcy, by contrast, potentially could trigger the change in control, depending on the applicable policy wording.

 

Regardless of the form of the reorganization and the timing of the change in control, if there is to be a “going forward” business following the reorganization, steps must be taken to protect the officers and directors of the new entity, and to ensure that the “going forward” protection dovetails with the insurance protection that is in place for the directors and officers of the former entity or operation. To make sure that all of these things are in place when and as they should be, without gaps in coverage, several steps should be taken at the before and during the reorganization process.

 

 The two critical insurance-related structures that need to be addressed are the implementation of an appropriate “run-off” for the directors and officers of the former entity and that “going forward” coverage is available for the directors and officers of the new entity (if there is to be one following the reorganization). The run-off coverage extends the period within which claims arising in connection with pre-reorganization conduct may be noticed. The “going forward” coverage is necessary to address claims involving post-reorganization conduct.

 

One question that often arises is why directors and offices need run-off coverage if the plan of reorganization involves a release of claims that could be asserted by creditors. The fact is that post-organization claims can and often do arise and they can be costly to defend, even if the directors and officers have a defense based on the release. There is also always the risk that the particular claim that arises may not be precluded by the release.

 

A practical complication that often arises is that the financial distress and/or the commencement of the restructuring process “may complicate a company’s ability to expend funds on D&O insurance.” Also, a potentially complicating factor that often arises is that the existing program may expire before the date of the change in control, which could require the company to go through a renewal transaction before the run off coverage is put in place.

 

Many companies facing a renewal date during the reorganization process will extend their existing program rather than acquiring a renewal program. This approach may be less time-consuming and may actually be more attractive to the insurer(s), who may not want to expose “fresh limits” to a financially distressed company. There may be drawbacks to an extension, particularly if the current program’s limits are “impaired” by an existing claim. The key is to ensure that the insurance protection remains in place throughout the reorganization process.

 

It may be that the payment of the premiums for the extension or renewal will require bankruptcy court approval. In some situations, it may be possible to include within a restructuring support agreement or plan support agreement a provision allowing for both the purchase of both necessary extensions or renewals of the D&O insurance and for the purchase of run-off coverage. Similarly, if the company is purchasing debtor-in-possession financing, the company should take steps to ensure that the costs associated with extensions and run-off purchases are including within the financing.

 

Provisions may be made for the post-reorganization entity to indemnify the directors and officers of the former entity. This indemnification may be structured in a variety of ways. The authors suggest that the “best practice” is to confirm the indemnity arrangements with the insurers, including adding the new entity as an insured under the run-off policy to ensure coverage for the new entity’s indemnification. The authors suggest that it should be confirmed that notwithstanding the indemnification that no retention would apply under the run-off policy and that the insured vs. insured endorsement should be modified to insure coverage for claims by the new entity against the directors and officers of the former entity. The authors acknowledge that while all of these options may be available, they should be considered and pursued.

 

Discussion

The authors’ memo is interesting and contains much sound advice. Notwithstanding the authors’ practical approach, the memo does underscore how complicated the insurance issues can be for companies going through financial reorganizations. The complications underscore how important it is for companies planning a financial reorganization to coordinate with the insurance advisors – as well as how important it is to have knowledgeable, experienced financial advice before and during a financial reorganization.

 

One particular issue the authors do not address is the way in which the “run-off” and “going forward” programs should be organized in order to allow for the possibility of a claim that “straddles” the past-acts/future acts dates of the two programs. It is important in protecting against this possibility that the “other insurance” provisions of the policies are coordinated.

 

Although the memo contains many useful observations, perhaps the most important is the authors’ emphasis on the need for these issues to be monitored and addressed before, during and after the reorganization process. Advance planning can reduce the likelihood that problems will arise, for example, in connection with payment for extensions and run-off purchases. Reassessment may be required throughout the reorganization process, particularly if the process unfolds differently than was expected at the outset (if for example, the plan changes from a reorganization to a liquidation).

 

I know that there is a lot more than can be said on these topics and that there are additional issues involved beyond those discussed above. I encourage readers to add their thoughts and comments on this topic, using this blog’s comment feature.

 

The Latest FDIC Failed Bank Lawsuit: On March 16, 2012, the FDIC filed its latest failed bank lawsuit. In its complaint (here), filed in the Northern District of Georgia in its capacity as receiver of the failed Omni Bank of Atlanta, the agency has sued ten of the bank’s former officers, seeking to recover over $24.5 million the bank allegedly sustained on over two hundred loans on loans involving low income residential properties and $12.6 million in wasteful expenditures on low income other real estate owned properties. The complaint, which can be found here, asserts claims against the defendants for negligence and for gross negligence.

 

As Scott Trubey reported in his March 16, 2012 Atlanta Journal Constitution article about the suit (here), since its failure, the bank has been the center of several criminal investigations involving both banker and borrower misconduct. Jeffrey Levine, a former bank executive vice president who was also named as a defendant in the FDIC’s lawsuit, is among those who have been hit with criminal charges.

 

The FDIC’s latest lawsuit is the seventh that the agency has filed so far involving a failed Georgia bank, the most of any state. (Georgia has also had more bank failures than any other state). The latest suit is the 27^th that the agency has filed as part of the current wave of bank failures and the ninth so far in 2012. It is interesting to note that the agency filed this suit just short of the third anniversary of the bank’s March 27, 2009 closure. As the current year progresses, the agency will be facing similar anniversaries of bank closures, which coincides with the FDIC’s three year statute of limitations for bringing suit. Since the bank closure rate hit its high water mark in 2009, we are likely to see increasing numbers of suits this year. It already seems that the pace of lawsuit filing has picked up, as I noted in a recent post. 

 

Counsel Selected for Second Circuit Appeal of Issues Surrounding the Settlement of the SEC’s Enforcement Action Against Citigroup: As I noted in a recent post, the Second Circuit has stayed the SEC’s enforcement action against Citigroup, so that the appellate court can consider whether or not Southern District of New York Judge Jed Rakoff erred in rejecting the parties settlement of the case. One of the anomalous features of the case is that in connection with the motions to stay and for interlocutory appeal, since both the SEC and Citigroup had moved for the stay and for the appeal, the adversarial position had not been represented. In its ruling staying the case and granted the motion for appeal, the Second Circuit directed the Clerk of the district court to appoint counsel so that the adverse position (that is, that Judge Rakoff had not erred in rejecting the settlement) would be represented before the merits panel.

 

The counsel to represent the adverse position has now been selected – it will be John “Rusty” Wing, of the Lankler, Siffert and Wohl law firm. As Susan Beck notes in her March 16, 2012 Am Law Litigation Daily article about the appointment (here), there are a variety of unusual aspects of this appointment. The first is that it has been well over a decade since Wing argued before the Second Circuit. The second is that Wing apparently was selected by Rakoff himsef, almost as if Wing were to be representing  Rakoff in person, rather than merely arguing in support of his ruling rejecting the settlement. Wing is in fact a former colleague of Rakoff’s when the two served in the U.S. Attorney’s office together. The selection of Wing, and more particularly the process by which he was selected, raise a number of interesting questions about who he is representing and what his role will be. For example, should Wing be consulting with Rakoff in preparing his appellate brief?

 

The selection of Wing represents just one more unexpected and unusual twist in a case that has already had more than its fair share of unexpected twists and turns. In any event, Wing will face an uphill battle given the finding of the three-judge Second Circuit that granted the stay that the SEC and Citigroup have demonstrated a “substantial likelihood” of success on the merits.

 

Alison Frankel has an interesting March 16, 2012 post about Wing’s selection on Thomson Reuters News & Insight (here).

 

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On March 7, 2012, Towers Watson released the report of its 2011 Directors and Officers Liability Survey. This report, which summarizes the results of the firm’s annual survey, reflects the survey respondents’ D&O insurance arrangements and purchasing patterns. The annual Towers Watson report is much-anticipated for its insights into the practices of corporate insurance buyers, and this year’s report does not disappoint. The 2011 report can be found here.

 

The Survey Pool

As with the results of any survey, it is very important in connection with this survey report to understand the characteristics of the survey participants. In particular, it is very important to understand that the pool of respondents to the 2011 survey is heavily weighted toward very large companies. Excluding nonprofits and charities, the average annual revenues of the survey participants was $4.254 billion. The average asset size (excluding nonprofits and charities) was over $5 billion. The average market capitalization of the public company participants was $5.3 billion. Only 19 of the public company participants had market caps under $1 billion. Even the private company respondents were very large; about half of the private company respondents had assets over $1 billion.

 

The respondents were also concentrated in certain industries. Over half of the respondents were concentrated in just four industries: financial service/insurance; manufacturing; energy and utilities; and financial services excluding insurance. The pool of respondents including only small percentages of respondents from other industries, including communications; natural resources; transportation; and healthcare/pharmaceuticals.

 

The Survey Results

Over half of the survey respondents reported that the premium charged for their primary D&O insurance policy had declined at the last renewal. However, this result diverged between the public company and private company respondents. Among public companies, 62% reported a decline in the premium for their primary D&O insurance policy, but only 35% of private company respondents reported a decline. In addition, a slightly higher percentage of private company respondents saw a premium increase (18%) compared to public companies (14%). The report states that these data can be interpreted to suggest “a potential hardening in the private/nonprofit segment with insurers looking to drive rates.”

 

The survey’s information regarding limits purchasing patterns is very highly reflective of the respondent pool’s composition of very large companies. Thus, excluding charities and nonprofits, the average total limits purchased among all survey respondents is $98 million. Even among private company respondents, the average total limits purchased was $36.3 million. The average total limit for public company respondents was $126.8 million. However, among public companies with market caps under $250 million, the average total limits purchased was $25.7 million and the median was $15 million. Among private companies with assets under $250 million, the average limits purchased was $8.3 million and the median was $5.5 million. A quarter of public companies reported that they had increased their limits at the most recent renewal, compared to 14% of private and nonprofit organizations.  

 

Over three quarters (77%) of respondents reported that, in addition to primary D&O insurance, they purchased excess insurance from at least one additional insurer. 57% of all respondents purchased excess Side A or Side/DIC insurance. However, 78% of public company respondents reported that they purchased Side A or Side A/DIC insurance. Consistent with the heavy representation in the respondent pool of very large companies, the average Side A and Side A/DIC limits purchased among public company respondents was $54.6 million, and the median was $30 million. These average and median figures were much lower for smaller public companies; for example, for public companies with market caps under $250 million, the average was $13 million and the median was $10 million.

 

Though the majority of respondents said that the most important consideration in purchasing D&O insurance was the scope of coverage for the directors, only a very small percentage of respondents reported that the purchased independent director liability insurance. For example, only 7% of public company respondents reported that they purchased IDL insurance.

 

Excluding charities and nonprofits, 56% of respondents, and 68% of public company respondents, reported that they have international operations. Of the public companies with international operations, 39% reported that they purchased local D&O insurance policies in foreign jurisdictions, while 17% of private companies reported that they have international units that purchase local policies. These figures undoubtedly reflect the predominance in the respondent pool of larger organizations, as the survey itself showed that the larger the company, the more likely it was to purchase local policies. The report itself notes with respect to the local policy purchasing patterns that the “results continue to demonstrate the strides organizations have made in understanding the complexities and exposures when conduction business outside the United States.”

 

66% of the survey respondents reported having had a D&O claim in the past then years. The larger companies were more susceptible to claim activity, with the largest companies reporting the highest levels of claim activity. About two-thirds of respondents who had claims reported that they were satisfied with their insurers’ handling of the claim, but nearly 20% of the respondents reported that they were dissatisfied with how the insurers handled the claims. (This 20% figure is consistent with same level of dissatisfaction reported in the 2010 survey.)

 

Discussion

The Towers Watson survey report is a very valuable resource for the D&O insurance industry and for D&O insurance buyers. The survey report provides valuable insight into limits purchasing patterns, program structure and program design. All of us in the industry should be grateful that Towers Watson has undertaken the survey and made its report publicly available.

 

Anyone using or relying on the survey data, however, should take into account the fact that the pool of survey respondents was weighted toward very large companies, even among the private company respondents. Because a number of the survey results directly reflect that presence of a significant number of larger companies among the respondents, some results may be less relevant for smaller companies. In addition, as noted above, the survey pool was heavily weighted towards companies in certain industries. This should be taken into account in connection with companies from industries that were not as well represented in the respondent pool.

 

The survey’s results with respect to Side A purchasing patterns and with respect to the inclusion of local policies among companies with international operations are interesting. These results show the extent to which these program structures are becoming pervasive, at least among larger public companies. 

 

The survey’s results regarding the survey respondents’ claim experience represents something of a mixed review for the industry. On the one hand, about two thirds of respondents were generally satisfied with the way their insurers handled their claims. On the other hand, fully one out of five of respondents was dissatisfied, and this level of reported dissatisfaction was consistent in both the 2010 and the 2011 survey reports. This level of reported dissatisfaction suggests that there may be significant opportunities for the D&O insurance industry to deliver claims services in more customer focused way.

 

One final note about the survey. Everyone in the industry benefits from this survey and the survey report is a resource that is available to everyone. I hope that the industry will keep this in mind in future years and in particular make sure that the survey itself is distributed as broadly as possible so that the survey results are as fully representative as possible. Everyone can do their part to make the survey results even more meaningful in the future.

 

Very special thank to the survey report’s principal author, Larry Racioppo of Towers Watson, for providing me with a copy of the report.

 

The Latest FDIC Failed Bank Lawsuit: On March 2, 2012, the FDIC filed its latest failed bank lawsuit, against certain former directors and officers of the failed Freedom Bank of Georgia, of Commerce Georgia. The FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. In its lawsuit, the FDIC seeks to recover over $11 million dollars it alleges was caused by the twelve individual defendants’ negligence and gross negligence.

 

With this lawsuit, the FDIC has now filed 24 lawsuits in connection with the current wave of bank failures, including six so far in 2012. Of the 24 lawsuits overall, six have involved failed Georgia banks. Like many of these cases, this latest suit was filed just short of the expiration of the three-year statute of limitations. (The March 2 filing date came shorty before the third anniversary of the bank’s March 6, 2009 closure.) Because so many banks failed during 2009, it may be expected as the current year progresses we will be seeing an increasing number of lawsuits involving the class of 2009.

 

Scott Trubey’s March 6, 2012 Atlanta Journal Constitution article about the Freedom Bank case can be found here.

 

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One of the perennial D&O insurance issues is the question of coverage for investigative costs. Several recent cases have taken a close look at these recurring issues.  In the following guest post, my good friend Kara Altenbaumer-Price (pictured) examines recent developments in this area and the important factors that can affect the analysis. Kara is the Director of Complex Claims & Consulting for insurance broker USI.  

 

Many thanks to Kara for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

The potentially high cost of internal investigations has increased demand for insurance coverage. This article explores how investigation costs may, at least in part, not be covered by traditional directors and officers (D&O) policies, and options that may provide greater protection.

 

 

Traditional D&O insurance policies afford some level of investigations coverage.  As with any insurance arrangement, however, the parties must carefully assess whether the risk being covered is the same risk that they seek to have covered.  Thus, while companies may believe they have purchased so-called “investigations coverage,” these policies are often seriously lacking in comparison to the number, size, complexity, and cost of modern investigations.  These limitations can be so consequential that the insured’s expectations for the policy will not be substantially met.  This article addresses a number of the gaps between common expectations and commonly available policies and suggests how companies and individuals can more accurately locate the extent of coverage that they desire.

 

 

Before discussing some of the pertinent aspects of investigation insurance products, we turn to a   2010 U.S. federal court ruling that illustrates some of the issues and potentially costly gaps in investigations coverage that can arise for any company, public or private. The case addressed a not atypical sequence of investigation-related events that gave rise to significant costs for a public company. Office Depot found itself the subject of an inquiry by the U.S. Securities and Exchange Commission (SEC) related to potential violations of Regulation FD (Fair Disclosure). This regulation requires that public companies release the same information — at the same time — to the public as they do to investors and securities professionals. Office Depot chose to cooperate with the SEC by voluntarily providing requested documents and making its officers and employees available for sworn testimony without the issuance of subpoenas. About the same time, an internal whistleblower raised issues related to Office Depot’s accounting. The Company self-reported the allegations to the SEC, which expanded its investigation. Office Depot’s audit committee also began an internal investigation, which led to a financial restatement

 

 

The SEC later issued a Formal Order of Investigation against the Company, which included “allegations of wrongful conduct generally attributable to [Office Depot’s] officers and directors” but did not identify any individuals by name. The Formal Order led to subpoenas issued to the Company and a group of its current and former officers and directors, some of whom had previously voluntarily testified in the informal investigation. Two years later, the SEC reached a settlement with the Company and issued Wells Notices informing several Company officers of charges the SEC planned to bring against them.

 

 

Over the course of the SEC and internal investigations, Office Depot incurred costs of over U.S. $20 million and turned to its D&O carriers for reimbursement. The primary carrier acknowledged coverage for approximately U.S. $1 million in costs incurred by officers and directors in responding to SEC subpoenas and Wells notices and costs incurred in several related shareholder securities lawsuits, but denied coverage for the Company’s voluntary response to the SEC or the internal investigation. The company then sued its primary insurance carrier; the excess carrier intervened into the suit. The issue in the litigation was whether the costs of voluntarily responding to the SEC and conducting an internal investigation related to the same issues were covered by the policy. The court held that “the disputed investigatory costs do not fall within the … policy’s definition of loss ‘arising from’ a covered ‘Securities Claim’ made against [Office Depot], or a covered ‘Claim’ made against one of its officers, directors or employees.

 

 

First, the court held that the informal SEC investigation and the company’s internal investigation did not meet the policy’s definition of “securities claim.” Specifically, the policy language exempted an “administrative or regulatory proceeding against or investigation of” the Company unless “such proceeding is also commenced and continuously maintained against an Insured Person.” The court determined that the use of the term “proceeding” and the absence of the term “investigation” in the carve-back language for proceedings involving both the Company and insured individuals meant that coverage did not include investigations, whether formal or informal. Second, the court held that while the policy did provide coverage for investigations of insured individuals, it did not provide such coverage unless the individuals were “‘identified in writing’ by the investigating authority as a person against whom a civil, criminal, administrative or regulatory proceeding ‘may be commenced’ or in case of an investigation by the SEC … after service of a subpoena upon such Insured Person.” The court agreed with the carriers’ assertion that “[b]ecause the SEC informal and formal investigations began well before either one of these discrete signal points, …the investigations do not fall within the Policy’s definition of a ‘Claim.’” It did not matter that three individuals ultimately received Wells Notices. Third, the Company had argued that “relation back” language in the policy served to pull pre-claim costs into coverage. The language at issue was a common provision in the policy providing that when an insured notifies the carrier of facts that could later give rise to a claim and a claim does indeed later arise, the claim relates back to time of the original “notice of circumstances.” The court held that the relation back language in the notice of circumstances portion of the policy related only to determining when the claim was made for determining the applicable policy period for a “claims made” policy. Office Depot had a substantial retention — or deductible — on its primary D&O policy, effectively resulting in no loss transfer in this case.

 

 

The implications for D&O insurance coverage related to investigations are significant. In order to ensure the maximum coverage possible for costs associated with investigations, several portions of a policy must be addressed. In considering these changes, it is also important to remember that D&O insurance policies are not off-the-shelf products. Instead, they differ widely from carrier to carrier and insured to insured and can — and should — be tailored to meet a given company’s needs.

 

 

Definition of claim

 

Generally, a D&O policy does not provide coverage until a “Claim” has been made against a company. More importantly, costs incurred before a formal “Claim” has occurred under the policy do not apply toward a company’s self-insured retention, nor do they get retroactively picked up later by the policy. What constitutes a claim is a defined term under each D&O policy and almost universally includes lawsuits, written demands for monetary relief, and administrative proceedings in court or before an administrative body. Policies differ widely, however, in how they cover — or not — government investigations. Many provide coverage upon the receipt of a subpoena, a Wells Notice, or a target letter. As was discussed above, however, these triggers imply a formal investigation and can occur very far into an investigation.

 

 

Indeed, significant legal costs can be spent in trying to prevent an informal investigation from becoming formal, and policy language varies widely in how it covers — or doesn’t cover — these costs. This can be avoided by ensuring that the definition of “Claim” in your policy incorporates government investigations and, if possible, informal investigations. In 2010, at least one major insurance company released a new D&O policy form that provided for coverage of informal investigations of insured individuals by updating its public company D&O form to include coverage for certain “preclaim” inquiries. The policy defines “pre-claim inquiry” as a “verifiable request for an Insured Person … to appear at a meeting or interview or produce documents that, in either case, concerns the business of that Organization or that Insured Person’s insured capacities.” The request must come from a government enforcement body, or the entity or its board must request that individual to appear in relation to an inquiry into or investigation of the entity by an enforcement body. Interestingly, the policy goes on to define “pre-claim inquiry costs” independently of “defense costs” so as to exclude the costs of responding to document requests if the documents are in the control of the company, meaning that coverage for document production is only provided if those documents are in the control of an individual insured, which very few documents will be. By specifically including coverage for the costs associated with attending a request for an interview by an enforcement body, the policy seems to be focused only on the costs of lawyers’ preparation time. The policy, in its unendorsed form, excludes coverage for all   investigations — formal or informal — of the company unless those investigations are also maintained against insured persons.

 

 

A number of other carriers responded to this insurer’s new policy. For example, one released an endorsement that provides coverage for individuals incurred in responding to “a request by an Enforcement Unit for an Insured Person to appear for an interview or meeting with respect to the Insured Capacity of such Insured Person or an Organization’s business activities.” Like the policy discussed earlier, this insurer’s endorsement also includes scenarios in which the company requests that an insured individual appear for an interview or meeting in relation to a government inquiry. The endorsement specifically excludes coverage for costs associated with a “document production demand or discovery request.” This exclusion is notable since the cost of producing potentially millions of pages of documents in a large investigation can be substantial.

 

 

Co-defendant language

 

A number of D&O policies that provide investigations coverage either restrict coverage to insured individuals or require individuals to be co-defendants before a company’s costs in defending itself could be covered. The trigger in these policies is usually when an insured individual is named in a Wells Notice or target letter or, in some cases, when an insured individual receives a subpoena. In addition to the late coverage trigger discussed above, this language presents an additional problem in that it does not match up with the reality of how investigations are pursued. It is rare for a government investigation to name an individual up front. Instead, if anyone is named in the early stages, it is the entity itself. Even when it is clear to the entity’s lawyers and forensic accountants that one or more individuals are the targets of an investigation, the D&O policy is not triggered unless the individuals are named.

 

 

Because individuals do not have the same incentive to cooperate that entities do, individuals are often named only as an investigation is nearing its end. As a result, if such language is included, as is demonstrated by the Office Depot case above, little to no coverage may be afforded even if “investigations coverage” was purchased.

 

 

Definition of loss

 

Presuming that a policy does provide investigations coverage, a policy will still only cover those costs that are defined as “loss” under the policy. Loss will almost universally be defined to include costs associated with defending any Claim under the policy. While “defense costs” is often undefined, some policies do explicitly define it. In order to ensure broad investigations coverage, it is important to consider all the costs of defending an investigation, not just legal fees. Significant fees can be spent on forensic accountants, document production vendors, and other specialists in responding to the often very in-depth investigations of a government regulator. It is important to consider all of these costs when defining “loss” and “defense costs” under a D&O policy and, where possible, explicitly define the costs to include non-lawyer defense costs.

 

 

Conduct exclusions and adjudication language

 

D&O policies typically contain certain conduct exclusions that prohibit coverage in cases of certain intentional conduct, such as fraud, criminal conduct, or intentional violations of the law. Mere allegations of such conduct, however, do not prevent coverage. Instead, each policy should contain language that defines when these conduct exclusions are triggered. For example, policies may state that a guilty plea triggers the conduct exclusion, while others may state that a determination by a court that the conduct occurred triggers the exclusion.

 

 

In the context of investigations coverage, the broadest trigger is “final adjudication in the underlying action,” meaning that the conduct exclusion will not be triggered until a court

involved in the enforcement action at issue makes a final adjudication of wrongdoing. This prevents a carrier from bringing a declaratory coverage action in another court in order to cut off defense costs. Also, because the vast majority of government investigations are settled without court involvement or are filed in a court simultaneously with an agreed settlement, in many cases the conduct exclusions will never be triggered. Two changes in SEC enforcement methods may have particular impact on these conduct exclusions.

 

 

First, the SEC is considering releasing more detailed findings of its investigations. Currently, when an investigation is settled, often only a brief release is issued stating the statutory violations and a bare bones recitation of the factual allegations. Releasing more detailed factual findings could lead to coverage issues as additional facts are laid out that could implicate conduct exclusions. Second, changes made in 2010 to the SEC’s Enforcement Manual designed to spur cooperation provide leniency — or in some cases, immunity — to individuals who provide valuable evidence to the SEC. It is likely that more individuals will “confess” to the SEC in order to obtain these benefits. This could create coverage issues in policies containing certain conduct exclusions. Additionally, cooperation by one individual implies that other individuals will be negatively impacted by that individual’s testimony. As more individuals cooperate and as others become the “target” of that cooperation, the need for separate legal representation rises, also causing an increase in defense costs.

 

 

Civil fines and penalties coverage

 

Historically, the insurance market has considered civil fines and penalties to be uninsurable for public policy reasons. Recently, however, the demand for investigations coverage and increased competition among D&O carriers has led some carriers to offer civil fines and penalties coverage. While it is still unclear when and how much these policies will pay out in the event of claims, it is important to understand that such coverage is now available.

 

 

When evaluating such coverage, however, companies should read the policy terms very closely to understand exactly what is being offered for the price. Endorsements may appear to be broad, but may be limited by the statutes under which coverage is provided. For example, a number of carriers are now offering coverage for a certain amount of civil fines and penalties assessed under the U.S. Foreign Corrupt Practices Act (FCPA).

 

 

However, the language of a given endorsement, when read closely, may reveal that it provides coverage only to insured individuals and only for civil penalties assessed by the U.S. Department of Justice (DOJ). Another important consideration in fines and penalties  coverage is the actual language of the FCPA and similar statutes, as well as the reality of settlements and whether such insurance could be tapped at all under the terms of a government settlement. The statute states that whenever a civil fine or penalty “is imposed … upon any officer, director, employee, agent, or stockholder of an issuer, such fine may not be paid, directly or indirectly, by such issuer.” Also, it is now standard language in SEC settlement documents that individuals stipulate that their companies will not pay their fines, including any payments from insurance proceeds. Arguably, this issue may be solved by assigning a portion of the D&O premium to the fines and penalties coverage and requiring that premium amount to be paid by individual officers and directors.

 

 

Separate investigations policies

 

In addition to updating its public company D&O form, a major insurer has also released a new stand-alone policy designed to cover investigation costs. The policy addresses one of the primary issues present in expanding investigations coverage — the eroding of insurance limits for use by officers and directors when the company’s investigations costs are transferred to insurance. The policy provides up to $25 million in coverage for investigations by the SEC, DOJ, and similar authorities into violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 or any of the acts’ associated rules and regulations. It covers both formal and informal government investigations and can be endorsed to provide up to $5 million coverage for investigations related to violations of the FCPA. In addition to investigation costs, the policy also covers insurable settlements other than disgorgement, fines, penalties, or remediation costs. A separate policy gives companies the option to look only to an investigations policy for coverage and choose not to seek coverage under their D&O policies, even if some coverage is provided.

 

 

A major insurance broker also announced the creation of a policy that covers legal, accounting, auditing and consulting costs associated with FCPA investigations. Although the insurance carrier underwriting the FCPA Corporate Response form was not publicly named, the form is designed to cover both FCPA and UK Bribery Act investigation costs incurred by both insured individuals and the company. Although it is not clear from the literature released on the policy, it appears to cover informal investigation costs, at least to some degree. Similar policy releases from other insurance carriers are likely as corporate demand increases.

 

 

When considering the options for transferring a portion of the risk associated w