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

A June 18, 2008 opinion (here) by Judge Gerald Lynch in the coverage litigation between former Refco directors and officers and one of the company’s excess D&O insurers presents a veritable conflagration of policy application issues, including perennial questions concerning warranties, severability, and imputation, as well as a host of related issues arising from the policy procurement process itself.

 

Background: In the year preceding Refco’s ill-fated August 2005 IPO, Refco had maintained a $30 million D&O liability insurance program (the 2004-2005 program). In connection with its IPO, Refco obtained a total of $70 million of D&O insurance for the period from August 11, 2005 to August 11, 2006 (the 2005-2006 program). Both programs were arranged in multiple layers, with a primary carrier and several excess carriers.

 

In connection with placement of the 2004-2005 program, Refco completed the primary carrier’s insurance application (the “Application”). In addition, one of the excess insurers (and the ultimate litigant in the coverage dispute) required that the company submit a Warranty Letter on behalf of all insureds, affirming that no person for whom the insurance was proposed is “cognizant of any fact, circumstance, situation, act, error or omissions which … might afford grounds for any Claim.”

 

The Warranty Letter, submitted to the excess carrier on January 21, 2005, was signed by Phillip Bennett, Refco’s CEO. It later was revealed that Refco had an undisclosed $430 million receivable due from an entity Bennett controlled. The company subsequently collapsed, and Bennett, among other has pled guilty to an array of criminal offenses.  

 

At least as appears from the June 18 opinion, there were no additional applications or warranties in connection with the placement of the 2005-2006 program.

 

Following Refco’s October 2005 collapse, the company’s directors and officers were the target of extensive litigation, for which they sought defense expense coverage under the 2005-2006 program. The primary and first layer excess carriers advanced their entire limits (totaling $17.5 million) in payment of defense expense, subject to repayment of it is determined that there is no coverage under the policies.

 

The Coverage Denial:

The second level excess insurer, by letter dated March 6, 2006, denied coverage for the claims under its 2005-2006 policies. As the basis for its denial, the second level excess insurer relied on the representations in the Warranty letter and Refco’s failure to answer question 12(b) on the primary carrier’s Application (which asked whether any proposed insured was “aware of any fact, circumstance or situation” that might give rise to a claim).

 

The second level excess insurer also relied on a “Knowledge Exclusion” that was included in the insurer’s policy when issued in March 2006 (which was at or about the same time as the insurer issue its coverage denial). The Knowledge Exclusion essentially provides that the second level excess insurer is not liable for any loss (including defense expense) “in connection with any claim arising out of, based upon or attributable to any claim, fact or circumstance disclosed or required to be disclosed” in Question 12(b) of the Application.

 

The Coverage Litigation:

In May 2007, the second level excess insurer initiated an adversary proceeding in bankruptcy court seeking a judicial declaration of noncoverage under its 2005-2006 policy, largely for reasons enumerated in its March 2006 denial letter. Several of the individual Refco officers and directors filed an answer and counterclaim, among other things seeking an injunction compelling the second level insurer to advance defense fees. The bankruptcy court entered an order in October 2007 requiring the insurer to advance defense expense, which the insurer has now done, as a result of which its $10 million limit is now depleted.

 

The second level excess carrier refilled its declaratory judgment complaint in federal district court, again seeking a judicial declaration of noncoverage. The individuals refilled their counterclaims, seeking a determination of coverage. The parties filed cross motions for summary judgment, which were the subject of the June 18 opinion.

 

The June 18 Opinion

In reviewing the court’s rulings, it is important to note that the summary judgment motions were filed pre-discovery. This unusual procedural posture was a critical factor in the court’s decisions process, as the court, pursuant to established authority, was reluctant to interject merits-based rulings where further discovery might provide additional factual context.

 

The insureds argued that the Warranty Letter had been submitted in connection with the placement of the 2004-2005 program and therefore was not a part of the second level carrier’s 2005-2006 policy. The insurer for its part argued that the Warranty Letter did relate to the placement of the 2005-2006 policy and that in any event it relied on the Warranty Letter when making underwriting decisions in connection with the 2005-2006 policy. The insurer submitted an affidavit from its underwriter in support of its assertions. Judge Lynch concluded that “genuine issues of material fact abound as to whether the Warranty Letter is properly part of the 2005-2006 [policy].”

 

The insureds further argued that in any event, the applicable “severability provision” bars the insurer from imputing Bennett’s knowledge to the other insureds and therefore the Warranty Letter could not serve as a basis to deny coverage to them. The severability provision was contained in an Endorsement to the Primary Policy. The insurer argued that the severability provision restricted the imputation of knowledge exclusively to statements in the primary insurer’s Application, and therefore it had no bearing on the second level excess insurer’s ability to rely on the Warranty Letter, which was not part of the Application. Judge Lynch agreed, and he therefore denied the insureds’ summary judgment motion based on the application severability provision.

 

Judge Lynch similarly rejected the second level excess insurer’s attempt to rely on Bennett’s failure Question 12(b) on the Application. Judge Lynch found that the insurer’s issuance of its 2005-2006 policy without challenging the omission of an answer to Question 12(b) was a waiver of any objection to coverage on that basis.

 

With respect to the second level excess carrier’s attempt to rely on the so-called Knowledge Exclusion to deny coverage, the insureds argued that the insurer’s coverage binder had not listed the Knowledge Exclusion as an endorsement that was to be added to the policy, nor had the company’s broker authorized the addition of the Knowledge Exclusion. The insureds argued that the insurer had “unilaterally changed the terms of the 2005-2006 [policy] after learning of the events that would give rise to a claim.”

 

The insurer countered that the company’s broker had authorized the addition of the exclusion. The insureds contended this response “fundamentally misconstrues” the meaning of the broker’s communications. These arguments clearly reflect the detailed particulars and disputed meaning of communications between the broker and the underwriter, which Judge Lynch found suffices to raise a genuine issue of material fact precluding summary judgment on the issue.

 

The insureds further arged that the severability of exclusions language in the primary policy precluded application of the Knowledge Exclusion to them. They argued that even if Bennett’s knowledge triggered the exclusion, the excluded state of mind could not be imputed to them. Judge Lynch found that the severability of exclusions provision in the primary policy applied only to the exclusions in the primary policy, and not to the Knowledge Exclusion which was found only in the second level excess insurer’s policy.

 

Discussion:

The court’s opinion does not represent a definitive conclusion either for or against coverage under the policy. Indeed, at its most basic level, the court’s opinion merely represents a determination to allow discovery as a prelude to a later merits-based determination.

 

But the opinion raises too many questions about the potential availability to insurers of coverage defenses, and about the limitations of insureds’ policy protections, for the opinion not to raise a host of concerns. The concerns fall into two basic categories – that is, the concerns that are substantive and the concerns that are procedural.

 

The substantive concerns are numerous and relate to many of highest profile issues in the D&O insurance arena, including the use, applicability and duration of warranties and warranty letters; the extent of protection afforded to “innocent insureds” by severability provisions (including both application severability and exclusion severability); and the extent to which insureds may (or may not) be able rely on policy protections in the primary policy to preclude the assertion of policy defenses by an excess insurer.

 

The procedural concerns are perhaps equally significant for practitioners in the field. Judge Lynch’s opinion underscores the potential importance of communications between broker and underwriter and is a reminder of the opportunities for and dangers of ambiguities in communications (or, as the insureds would argue, supposed ambiguities). Perhaps these issues will get sorted out in later decisions in the case, but current state of play in the case raises troubling concerns about the pitfalls of the policy procurement process while providing little guidance (except by negative inference) about how those pitfalls might be avoided in the future.

 

There may yet be further ruling in the case that will clarify the issues. But the opinion nevertheless highlights that many of the issues the industry has been struggling with for the last decade – including in particular severability and imputation issues – remain very much alive and continue to pose significant concerns, and indeed may have edges that have not previously been addressed or even contemplated.

 

Two final observations about the case. The first is that the parties appear to have exhausted at least $27.5 million of the $70 million tower on defense expense alone, which is yet another reminder of the extraordinary expense involved in catastrophic type claims (a topic I discussed in a recent post, here).

 

The other observation is that yet again a critical D&O coverage decision has arisen in a case involving defenses raised by a follow-form excess insurer (see my prior comments on this issue here). The issues involved here underscore the myriad of difficulties that potentially can arise as losses escalate through a multilayer program. I do not mean to suggest any views one way or the other about the merits of the excess carrier’s positions in this case. Indeed, given the circumstances involved in this claim, it is unsurprising that the insurers might raise questions. Nevertheless, the specific issues in dispute suggest a level of flex in the interplay between the primary and excess layers that many policyholders would find disconcerting.

 

Special thanks to Michael Early for sending along a copy of the opinion. I hasten to add that the views and opinions expressed in this post are exclusively my own.

 

My recent post discussing whether Phillip Bennett's use of the D&O insurance proceeds was an appropriate factor in his criminal sentencing can be found here. My prior post regarding the D&O insurance implications of Bennett's cooperation with the class action plaintiffs can be found here.

 

What Awaits Those Who Spurn Berkshire: A June 25, 2008 Bloomberg article (here) reports that while recently addressing a group of Toronto business executives, Warren Buffett was asked what makes people want to sell their companies to Berkshire. Buffett reportedly said that he tells a prospective seller to think of their company as a work of art:

You can sell it to Berkshire and we’ll put it in the Metropolitan Museum; it’ll have a wing all by itself; it’ll be there forever. Or you can sell it to some porn shop operator, and he’ll take the painting and he’ll make the boobs a little bigger and he’ll stick it in the window, and some other guy will come along in a raincoat, and he’ll buy it.

And Finally: If you have not yet seen this amazing catch by the Fresno Grizzlies’ ball girl, you have to watch this video. It is truly marvelous. [UPDATE: I have to add that a reader advised me that the video may be a hoax, refer here -- alas. It is still an awsome video.]

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Last week, Towers Perrin released its report of the firm’s 2007 Survey of Directors and Officers Liability Insurance Purchasing Trends, which can be accessed here. The firm’s annual survey report is widely read throughout the D&O insurance industry, and is generally viewed as an important information resource. Every year, the survey report is full of interesting observations, and this year’s version is no exception. The report merits reading at length and in full.

 

But while the survey report is widely read, I don’t know if the survey’s limitations are always fully understood or appreciated.

 

The report itself expressly acknowledges that it is based on a “self-selecting non-probability sample” The significance of this fact is briefly explained in the final two sentences at the bottom of the report’s preface page, where the report states that:

A non-probability sample is one in which respondents choose – or are selected – to participate. Such a sample is therefore not random. Because not all potential respondents are equally likely to participate, survey biases must be considered when interpreting results.

It is this latter point – that is, that “survey biases” must be considered when interpreting the survey’s results – that is all too often overlooked when the survey’s results are cited.

 

Let me just say that in referring to “bias” here, I am not in any way criticizing the report or its authors. The word “bias” as commonly understood has a negative connotation, but in this context, the word bias simply represents a mathematical property. But while the word bias should not suggest any negative connotations here, it should also be understood that, as stated in Wikipedia (here), “a biased sample causes problems because any statistic computed from that sample has the potential to be consistently erroneous.”

 

The survey results that most clearly reflect the sample bias are in the report’s discussion of what it calls “broker rankings.” As a footnote makes clear, the table relates solely to retail brokers, and does not contain any information about wholesale brokers. But even with respect to retail brokers, the table on which the “ranking” is based shows that over 88% of the survey responses relate to just four brokerages. Nor are these four survey-dominant brokerages the nationwide industry giants – to the contrary, these four participants would more accurately be described as strong regional players with an important presence in their respective geographic regions. The three largest nationwide industry giants meanwhile are represented collectively in only about 1.2% of responses.

 

My observations here should not in any way be taken as a criticism of these four survey-predominating brokerages. I will stipulate that they are in fact strong and significant industry participants. But no informed person actually thinks they are the four largest D&O brokers in the country. They are undeniably the leading firms in getting their clients to complete the Towers Perrin survey. Again, no criticism here; I salute their enterprising spirit in achieving this result. However, no one should confuse the survey “ranking” with an actual market share ranking.

 

I emphasize this aspect of the survey report because the bias in the broker participation population has pervasive effects throughout the entire report. For example, the four survey-predominant brokerages all have portfolios that are heavily weighted toward the technology and life sciences industries. Not too surprisingly, therefore, the two industry groups most heavily represented among both public and private company survey participants are “Technology” and “Biotechnology & Pharmaceuticals.” These two industry groups together represent about half of both public and private company survey participants.

 

Obviously, this heavy concentration of survey participants in just these two industry groups does not correspond to the economy as a whole. But this industry concentration – which is a direct result of the concentration of the survey population in the portfolios of a small handful of brokerages – has very significant ramifications for the report’s other findings. The report itself expressly recognizes this in the portion where it discusses the distribution of survey respondents’ primary insurance among the various leading carriers. The report's analysis recognizes that the distribution of primary insurers is directly affected by the industry distribution, and the report examines this effect in detail.

 

But while the report examines in the impact of the survey population industry distribution on the distribution of business among primary insurers, the report does not elsewhere make this analysis. For example, the report does not similarly consider whether or not the industry concentration is relevant to the distribution of business among excess carriers, nor does it consider the possible impact of the concentration of the survey population on the other findings in the report.

 

I emphasize these points because I think they show a couple of important things. First, not only is the survey population concentrated into the portfolios of just a small handful of brokers, but this concentration has important implications for the rest of the report. It clearly affects, for example, the industry concentration of the survey population, which in turn affects the reported distribution of primary insurance among the various carriers.

 

These apparent effects raise the question whether the concentration of the survey population has similar effects on the other areas examined in the survey report. While the impact of the population concentration is most self-evident in the industry distribution, it is more difficult to tell from the report whether the other components of the report’s findings are similarly affected by the survey population’s concentration in the portfolios of just a very small handful of brokers.

 

It is a fair observation that Towers Perrin makes survey involvement available to all industry participants, not just the four survey-predominant firms. It is also a fair observation that if survey involvement were more widespread, many of the concerns noted above might be alleviated. But what has happened is that a few brokerage firms have clearly made their clients’ participation in the survey a top priority, while other brokerage firms have obviously decided to take a different approach, for reasons that one might speculate are related.

 

None of this is meant as a criticism of Towers Perrin, which should be saluted for performing the survey and distributing the survey report without charge. Moreover, Towers Perrin itself acknowledges that there may be biases arising from the survey population distribution. So I don’t mean to criticize Towers Perrin, or anyone else for that matter. Rather, my analysis here is presented as a petition to all industry participants that in using the survey data, they should explicitly recognize and acknowledge the sample bias limitations inherent in the report. In particular, no one should try to make the survey results represent anything more than they actually do, particularly with respect to the concentrations noted above.

 

The Option Backdating Case Resolution Scorecard: Over at the Securities Litigation Watch, Adam Savett has prepared an updated options backdating case resolution scorecard, which can be accessed here. Savett has a number of interesting observations about case dismissals and the speed of case resolution. The D&O Diary’s own scorecard of options backdating lawsuit dismissals, denials and settlement can be accessed here.

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In a prior post (here), I commented on former Refco CEO Phillip Bennett’s extraordinary cooperation with the Refco class action plaintiffs, following his entry of a guilty plea in the criminal case against him. As might have been anticipated, Bennett is hoping that his cooperation with the class plaintiffs, as well as the Bankruptcy Trustee, will win him leniency in his June 19, 2008 criminal sentencing. The government opposes leniency, arguing in reliance upon, among other things, Bennett’s acceptance of D&O insurance proceeds to pay his defense expenses.

 

In February 2008, Bennett entered a guilty plea, without a plea agreement, to all 20 counts against him, including conspiracy, securities fraud, filing of false statements, wire fraud, bank fraud, money laundering and lying to Refco’s auditors. He faces a statutory maximum of 315 years’ imprisonment.

 

In Bennett’s June 1, 2008 sentencing memorandum (here), which was made public on June 12, his lawyers urged the judge to impose a sentence “for a term of years well short of the remainder of Mr. Bennett’s life.” His lawyers cited, among other reasons supposedly warranting leniency, that Bennett has “offered his cooperation to both the Litigation Trustee of the Refco Estate and the Refco Civil Class Action Plaintiffs, in their efforts to return hundreds of dollars to those who lost money in the Refco bankruptcy.” His lawyers further argued that his cooperation in those cases is “an indication of the extent to which Mr. Bennett has sought to make amends for the harm he has caused, and further reason to impose a sentence well below an actual or de facto term of life in prison.”

 

In its June 6, 2008 response (here), also made public on June 12, the government urged that “given the duration and intensity of the fraud, Bennett should receive no leniency.” In urging the maximum, the government pulled out all rhetorical stops; the government argued:

Bennett’s willful frauds on Refco’s investors, purchasers, customers, counterparties, banks, the public and others resulted in countless victims being defrauded of billions of dollars, causing uncompensated losses, even after the dissolution of Refco’s assets and large legal settlements of well over $1.5 billion, and of course drove Refco into bankruptcy. The defendant’s criminal conduct, motivated by greed that drove him to lie and scheme in ways previously unimaginable, brought him wealth that has scarcely been seen before in a … fraud case, launching Bennett into the rarefied air of a billionaire. In terms of scope, length, sophistication, harm, and criminal benefit, Bennett stands on a plateau of criminality that frankly makes comparisons difficult. Accordingly, the Government respectfully submits that an appropriately stiff term of imprisonment, consistent with the sentences imposed in the similar cases discussed above, should be imposed in order to reflect the seriousness of the offense, promote respect for the law, provide just and fair punishment, and deter potential corporate criminals.

In this same vein, the government showed little respect for Bennett’s plea for leniency made in reliance on his cooperation with the civil claimants (or at least “some” of the civil claimants, as the government emphasizes). The government said only that while the Court is not prohibited from considering such putative cooperation, “that does not mean that the Court necessarily should give the defendant credit for such cooperation.”

 

Among other reasons why it contends Bennett should received no leniency, the government specifically argued that “rather than limit the impact of his fraud, he knowingly accepted millions of dollars from Refco’s directors and officers insurance (the premiums for which, of course, were paid with fraud proceeds) to pay his legal bills, money that Bennett knew he had no right to claim.” The government added in a footnote that Bennett was also aware that in light of the government’s asset forfeiture case “there would be no money left to repay the insurance company upon his conviction. In substance, at the same time that Bennett was supposedly accepting full responsibility for his actions, he was in fact, taking millions of dollars from insurance companies under false pretenses. Notably, Bennett has not offered to cooperate with these civil litigants.”

 

Bennett may well deserve the maximum sentence as a result of his wrongdoing. The government may persuasively argue that Bennett only belatedly acknowledged his guilt, and that his late-arriving contrition ought not to be the basis of leniency, particularly where the delay exacerbated the harm he caused. But I wonder about the government’s attempt to bootstrap this argument by citing Bennett’s use of the D&O insurance proceeds to finance his defense.  

 

Let me just say as a preliminary matter that in expressing the views below, I am expressing no opinions about the carriers’ rights or interests. I am unfamiliar with the specifics of Refco’s D&O insurance coverage and none of the opinions below should be taken as opinion about Refco’s carriers’ coverage positions in this case. The carriers certainly  have their own grievances based on these circumstances, but I am not addressing those grievances here.  My opinions here relate solely to the government’s arguments against leniency based on Bennett’s use of the D&O policy proceeds.

 

My first concern with the government’s argument is the general principle it represents. The government may be justified in arguing that Bennett knew all along that his conduct was fraudulent. But take the principle on which the government seeks to rely outside the context of this specific case. Defending against a criminal charge is extraordinarily expensive, and one of the purposes of D&O insurance is to provide for the advancement of post-indictment criminal defense expense. For many criminally accused corporate officials, particularly those whose former company is bankrupt, the D&O insurance may be their only means of defending themselves. An insured forced to rely on this last line of defense should not be have to be concerned that accepting these contractual rights will put them at hazard that it might later be used against them if they ultimately face a criminal sentencing.

 

My second concern is that the circumstances Bennett’s case presents arguably are a product of the structure of D&O policies. The policies of course preclude coverage for loss based on criminal misconduct. But at the same time, the policies provide for the advancement of post-indictment criminal defense expense, subject only to an unsecured obligation to repay in the event a coverage preclusion is triggered.

 

In the course of events, it is inevitable that some insurance proceeds will be advanced in defense of insureds whose guilt is later established. The carrier can then seek to recover the advanced expense, which the insured is obliged to repay. But as an unsecured creditor, the carrier may not be able to recoup its costs in many instances. Bennett may well have known he would never be able to repay the amounts advanced, but I suspect that most criminal defendants know that, if called upon, they too could never hope to repay the amounts advanced in their defense. If awareness of an inability to repay is bar to seeking leniency, the ability to seek leniency would be unavailable to many corporate criminal defendants.

 

Carriers could refuse to cover criminal defense expenses or require more security before advancing criminal defense expense. Of course, any carrier trying to do either of these things would sell no more policies. D&O policies are structured as they are because that is what the marketplace requires for the policies to be commercially competitive. Presumably the carriers believe they are adequately compensated for the risks inherent in the structure.

 

The government may well be justified overall in arguing that Bennett should receive the maximum sentence. But I wonder: should an insurance outcome made possible as a result of the requirements of commercial competition really serve as a factor in the length of someone’s criminal sentence?

 

I suspect that some readers may have strong views on this topic. I hope readers will be willing to publish their views using the blog’s comment feature.

 

Hat tip to the White Collar Crime Prof Blog (here) for the links to the sentencing memoranda.

 

Speakers’ Corner: On June 17, 2008, I will be in Quebec City at the spring meeting of the Casualty Actuarial Society, speaking on a panel entitled “Subprime Issues for D&O.” The conference sessions agenda can be found here. My fellow panelists include Stephanie Plancich of NERA Economic Consulting and David Bradford of Advisen.

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For many companies, one of the hardest parts of the D&O insurance transaction is determining how much insurance to buy. Against a backdrop of basic affordability, the company must consider complex issues of limits adequacy – that is, how much insurance is “enough”? These issues are even more fraught in a time of generally rising claims severity (about which, refer here).

 

As discussed below, recent developments in one current claim underscore the fact that in addition to rising settlement levels, escalating defense expense is an increasingly important part of the limits adequacy equation. In addition, these recent developments also demonstrate that many related issues should also weigh into the limits adequacy analysis, and these same issues also have important implications for the structure of the insurance program, as well.

 

University of Denver Law Professor J. Robert Brown, Jr. has a post today (here) on his indispensable blog, The Race to the Bottom, discussing developments involving Paul Barnaba, a former employee of bankrupt auto parts supplier Collins & Aikman. Barnaba is caught up in the criminal case involving David Stockman, the former head of the OMB under Ronald Reagan, who was C&A’s CEO from 2001, when Stockman’s private equity fund took control of C&A, until shortly before the company’s 2005 bankruptcy. Barnaba is described in the indictment as “employed by the purchasing department” and identified as Director of Financial Analysis and eventually Director and Vice President of Purchasing for the Plastics Division. Background regarding the criminal prosecution can be found here.

 

As Professor Brown explained in an earlier post (here), Barnaba has moved to sever his criminal case from the other criminal defendants and to set the case for an early trial date. Barnaba asserts that, due to his indictment, he faces overwhelming personal and professional difficulties. He also argues that the protracted criminal proceedings threaten him with financial ruin, and he contends further that the proceeds of the applicable D&O policy “are quickly dwindling.”

 

The government opposed Barnaba’s motion, arguing among other things that Barnaba’s concerns about the dwindling D&O insurance are “wholly speculative and unsubstantiated.”

 

In his Reply to the government’s opposition, Barnaba vigorously disagrees with the government’s attempt to belittle his concerns about the dwindling D&O policy. His Reply explains that Collins & Aikman has a $50 million insurance program arranged in four layers. This insurance “provides coverage to a wide variety of former Collins & Aikman executives and employees,” including not only the criminal defendants, but also “those who have been sued or subpoenaed in the civil SEC matter, and those who have been sued or subpoenaed in various class actions and other civil suits.”

 

Barnaba explains in his Reply that the first $15 million layer of coverage was exhausted on or about June 15, 2007, and the second $15 million layer was exhausted on or about March 31, 2008 (for defense work completed through February 2008). As Barnaba notes, “the second $15 million layer of coverage was exhausted in nine months at a rate of approximately $1.67 million per month” and he adds that the “monthly rate was higher at the end of than at the beginning of this nine-month period.”

 

In any event, for the defense work completed in March 2008 and later, only $20 million of coverage remains. Barnaba argues that “[a]ssuming a monthly burn rate of $2 million to $3 million, which is realistic and likely conservative, all policy proceeds will be exhausted sometime between mid-September 2008 and December 31, 2008. This is not speculative.”

 

It is hard not to sympathize with Barnaba’s plight, regardless of the merits of the criminal matter. He has been caught in the maelstrom. The outcome of his motion to sever and to set a trial date remains to be seen, but it is hard to imagine a court agreeing to allow a high-profile criminal case like this one to be tried piecemeal. The D&O insurance could well be gone long before the case finally goes to trial.

 

Separate and apart from the actual merits of Barnaba’s motion are the implications of his plight for the issue of D&O insurance limits adequacy.

 

The first and most basic point is the importance of defense expense in the limits adequacy analysis. The potential for defense expense to exhaust or substantially deplete the available limits is most obvious in a catastrophic claim like the one involving Collins & Aikman, but even in less catastrophic circumstances, accumulating defense expense can substantially reduce the indemnity protection available even in a large insurance program. And the insurance is supposed to able to respond adequately in all circumstances, even the unlikely event of a catastrophic claim. In considering the requirements that a catastrophic claim can present, it is important to note that the aggregate defense expense related to the Collins & Aikman claim consumed $15 million in just nine months.

 

The second point is that one of the problems in the Collins & Aikman claim is that so many different people are accessing the policy, for a wide variety of different matters. The potential for the policy limits to drain away through so many different access points is perhaps inherent in the current standard D&O policy structure, in which so many different people are included as “insured persons” and so many different kinds of matters fall within the definition of a covered “claim.”

 

While this breadth of coverage is generally viewed as a positive thing from the policyholder’s perspective, it has the inherent potential (a potential that is being dramatically realized in the Collins & Aikman claim) for accelerated policy erosion and even depletion. The erosion potential inherent in the breadth of available policy coverage is a consideration that is too infrequently considered in connection with the question of limits adequacy.

 

Third, the problem Barnaba faces is not just his alone – all of the other “insured persons” are also facing imminent insurance program depletion. Once the available insurance is used up, these individuals will face continued complex litigation without further insurance available to defend or indemnify themselves. Among other things, it could prove difficult and painful for the defendants in the civil lawsuits to extricate themselves without insurance available.

 

All of that said, the solutions to these problems are not easy. With the benefit of hindsight, it is tempting to argue that the company should have carried higher limits. The fact is that many companies of Collins & Aikman’s pre-catastrophe size (the company had a market capitalization of approximately $500 million a year before it went bankrupt) choose to carry D&O limits lower than the $50 million that Collins & Aikman carried. Many companies are unwilling or unable to buy greater limits.

 

In the end the analysis comes down to the perennial question of limits adequacy – that is, how much insurance is enough?

 

In light of the escalating average claims severity, and of the numerous implications from Barnaba’s plight (including the catastrophic potential for defense expense to deplete policy limits), it may be time to rethink commonplace concepts of limits adequacy, because past notions may no longer be sufficient. Average claims severity is increasing. Defense expense does have the catastrophic potential to exhaust policy limits. In addition, new developments, such as the growing opt-out phenomenon (discussed most recently here), pose additional challenges to the traditional limits adequacy analysis.

 

Increased program limits alone, however, may not solve all of the problems. Indeed, it could be argued that even were higher limits available, they might not adequately protect Barnaba and the other Collins & Aikman defendants. Given the astonishing potential for defense expense to consume available insurance (I mean, $15 million in nine months, for crying out loud), even a substantially larger insurance program than the one Collins & Aikman maintained might prove to be insufficient.

 

Part of the solution has to be program structure. Clearly, a key reason that the Collins & Aikman program is melting away is that so many different people are accessing it. One way that well-advised corporate officials can ensure they are not left without insurance to protect them as individuals is through supplemental D&O insurance structures dedicated solely to their own protection. These supplemental structures might take any one of a number of different forms, including for example, excess Side A coverage for a specified group of individuals, or even through an individual D&O insurance policy (so-called IDL coverage). While there are a variety of ways this supplemental insurance might be structured, the crisis Barnaba faces underscores the importance of addressing these issues as part of the insurance acquisition process.

 

One final thought about Barnaba. That is, the typical insurance acquisition process conversation is usually limited to considerations involving the exposures of the most senior corporate officials. The possible exposures of “supporting cast” employees such as Barnaba are usually not a central part of the dialog. For that reason, it is relatively unlikely that the deployment of supplement insurance structures, as important as they are, would do much for someone like Barnaba.

 

In the end, someone at Barnaba’s level is, in all likelihood, going to be (as in the case of Barnaba himself) dependent on the continued availability of insurance proceeds under the traditional D&O insurance policy. This final point underscores the importance of a thorough review of all considerations involved in the issue of limits adequacy, including in particular the number of persons potentially dependent on the policy for protection. As I noted, it may be time to reconsider traditional notions of limits adequacy, in light of all of these considerations.

 

Very special thanks to Professor Brown for providing a heads up about his post.

 

Brocade Settles Options Timing-Related Securities Class Action Lawsuit: According to the company’s June 2, 2008 press release (here), Brocade Communications has reached an agreement to settle the options-backdating related securities class action lawsuit pending against the company and certain of its directors and officers, in exchange for an agreement to pay $160 million. Background regarding the litigation can be found here.

 

I have added the Brocade settlement to my table of options backdating-related settlements and dismissals, which can be accessed here.

 

A WSJ.com Law Blog post about the settlement can be found here.

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In a development that is in my experience absolutely unprecedented, Phillip Bennett, the former CEO of defunct futures trader Refco, after having pled guilty to criminal charges, is actively cooperating with the lead plaintiffs’ counsel in the civil securities lawsuit pending against the company and its former directors and officers. As discussed below, Bennett’s conduct, in addition to being highly unusual, could also raise some potentially significant insurance coverage questions.

 

A detailed description of the circumstances surrounding Bennett’s cooperation in the class action can be found in a May 28, 2008 article (here) by Bloomberg News reporter Thom Weidlich. The circumstances are also discussed in a WSJ.com Law Blog post (here).

 

Within weeks after it went public in August 2005, Refco announced that Bennett had hidden $430 million in bad debts from the company’s auditors and investors. The details of the scandal can be found here. IPO investors initiated securities class action lawsuits almost immediately. (Refer here for background regarding the class action lawsuit; a website devoted to the lawsuit can be found here.).

 

On February 15, 2008, Bennett pled guilty to bank fraud, conspiracy, money laundering and 17 other charges.

 

In connection with Bennett’s upcoming June 19, 2008 sentencing, counsel for the lead plaintiffs in the class action lawsuit – Sean Coffey of the Bernstein Litowitz firm and Stuart Grant of the Grant & Eisenhofer firm – submitted a letter to the court to provide information they hope “proves helpful as the Court considers the appropriate sentence.” A copy of their letter can be found here.

 

According to the attorneys’ letter, after Bennett pled guilty, his lawyer approached the class counsel to offer cooperation in connection with the civil case. According to their letter, “Bennett has helped to advance our understanding about matters within Refco, providing insights not readily discernable from our ongoing review of documents or cross-examination of deposition witnesses who are almost universally aligned with the defendants.” The letter goes on to report that Bennett has identified “‘red flags’ and other circumstances that would have alerted a diligent gatekeeper that things at Refco were not what they appeared to be.”

 

The letter states that Bennett’s cooperation has “materially strengthened the class claims against a number of defendants.” The defendants specifically mentioned in the letter are Thomas H. Lee, the IPO Underwriters, Grant Thorton, and Mayer Brown. The letter states that:

 

In the opinion of Lead Counsel, his assistance has substantially enhanced the ability of Lead Plaintiffs to hold those defendants more fully accountable for their role in the events resulting in the devastating losses suffered by Refco investors.

 

The Bloomberg article and the WSJ.com Law Blog post linked to above contain remarks from several commentators as to whether the letter will benefit Bennett as his sentencing.

 

There are a number of interesting things about the plaintiffs’ attorneys’ letter. Among other things, Bennett’s cooperation holds the prospect of shifting to Refco’s outside professionals some of the financial consequences for Bennett’s own criminal misconduct, based on their supposed failure to stop or catch him.

 

Another interesting thing, interesting to me at least, is the potential effect from Bennett’s behavior on the D&O insurance coverage that might otherwise be available for other former Refco directors and officers in connection with the Refco securities lawsuit. I emphasize at the outset that I have no direct knowledge of Refco’s D&O insurance program, and I am expressing no views about the availability of coverage under its D&O insurance. My comments here are strictly to note a potential coverage issue that might arise as a result of Bennett’s cooperation with the plaintiffs’ attorneys.

 

The specific insurance issue relates to the possibility that Bennett’s cooperation might trigger the so-called “Insured vs. Insured” exclusion (or IvI as it is more commonly known) that is found in most D&O insurance policies. A typical IvI exclusion provides, among other things, that the insurers is not liable for any loss in connection with a claim “which is brought by any security holder or member of an Organization, whether directly or derivatively, unless such security holder or member’s 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 Executive.”

 

Bennett’s extensive cooperation with the plaintiffs – the significance and materiality of which the plaintiffs’ lawyers expressly acknowledged – would appear at least potentially to implicate this D&O policy exclusion. Now, as a result of his criminal plea, Bennett himself would likely no longer have coverage under the policy, as would appear to be the case for other Refco officers who were criminally convicted in April of this year. But the other former Refco directors and officers, if any, who remain as defendants in the civil lawsuit and who have not pled guilty or been criminally convicted, may still hope to have remaining D&O insurance limits available to fund their defense and indemnity. (A number of the individual defendants have already entered settlements with the class, as described here.) Bennett’s cooperation with the plaintiffs could at least potentially raise coverage concerns, to the extent coverage is otherwise available to these persons.

 

In other words, Bennett’s cooperation not only represents a threat to Refco’s former outside advisors, but could also have serious adverse consequences for the company’s former directors and officers.

 

These events, as noted, are highly unusual and unlikely to recur. Nevertheless, the potential insurance issues that Bennett’s conduct could trigger are a reminder that there claims resolution is a complicated process, with a host of potentially significant consequences at every point. Although sometimes overlooked, the insurance issues can sometimes be particularly significant.

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Company managers are increasingly sophisticated about D&O liability insurance. Largely as a result of the corporate scandals from earlier in this decade, what used to be a peripheral and disfavored topic is now a top agenda item in many C-suites and boardrooms. But even as company officials have developed a deeper appreciation for the importance of D&O insurance, many misunderstandings about D&O underwriting persist. One thing that is frequently misunderstood is what D&O underwriters are looking for.

This post is intended to provide an overview of the key components of public company D&O underwriting. Of course, the underwriting concerns for different specific companies could vary substantially. In addition, there are many D&O insurers, and underwriting practices vary significantly between (and, regrettably, even within) insurers. That said, there are certain common elements that will likely be part of the D&O underwriting for any company. These elements are listed below. A great deal more might be said about each of these items, but in the interest of brevity, I have provided a summary description only.

1. The Company’s Basic Characteristics: First and foremost, the underwriter must understand the company’s basic profile. Specifically, the underwriter will want to know the company’s size (by market capitalization) and industry. These factors may seem basic and obvious, but they will nonetheless have a significant impact on an underwriter’s willingness to accept a risk, as well as on the price, terms and conditions likely to be offered.

2. The Company’s Financial Picture: A basic component of D&O underwriting is developing an understanding of the company’s financial circumstances, particularly its key income statement components (revenue, expenses and expense ratios, etc.) and balance sheet items (especially cash and other liquid assets, debt, and reserves/accruals). Although there are many important financial issues, the key question is whether or not the company has sufficient cash or available credit to fund its operations and service its debt during the proposed policy period.

3. The Company’s Accounting Practices: A very specific component for underwriters in developing an understanding of the company’s financial picture is developing an understanding of the company’s accounting policies and practices. The most important issue here is usually revenue recognition, but depending on the kind of company at issue, other critical issues may be the company’s practices regarding reserves and accruals, and these days, asset valuation.

4. The Company’s Corporate History and Structure (Including M&A): Because share offerings, financing activities and M&A activity are the kinds of events that often generate claims, the underwriter will want a complete understanding of the company’s involvement in all of these kinds of activities.

5. Continuity Risk (Things That Have Already Happened): An underwriter will want to establish whether the company has already experienced events or circumstances that could lead to subsequent claims. The list of potential problems could be infinite, but the kinds of things that will particularly attract the underwriter’s concern are things like significant stock price drops, earnings disappointments, regulatory setbacks, product recalls, adverse litigation developments, officer resignations, and so on.

6. Going Forward Risk/Vulnerabilities: A key risk attribute for any company is whether or not the company is susceptible to a single event or change that could substantially alter the company’s fortunes. These kinds of vulnerabilities include such things as: dependence on a single customer, contract, product or supplier; a looming regulatory milestone for a company with a single product in development; or a company-dependent debt obligation with a single-trigger acceleration clause or covenant.

7. Stock Price Volatility: A company that has a share price that dramatically registers even small events is capable of producing large shareholder-style damages. For that reason, companies with volatile stock prices represent a disfavored risk class for many underwriters. 

Some underwriters go so far at to make stock price volatility the most important component in their risk selection and stock price algorithms. I have always felt this analysis represents both an oversimplification and a confusion of correlation and causation. Simply put, while many companies involved in securities class action lawsuits have volatile stock prices, not all companies with volatile stock prices are involved in securities lawsuits. In my view it is the presence or absence of the above identified factors are more indicative of risk than volatility alone.  

8. Company Management and Executive Compensation: The background and experience of the company’s senior management and board members is important information. Underwriters will be particularly interested in any changes in the lineup, and in particular will want to understand the reasons for any changes.

A significant issue related is executive compensation. Some industry observers go so far as to assert that outsized executive compensation is the single most reliable risk marker, as it usually invites a host of dangerous (and sometimes destructive) behaviors. Certainly, many of the most egregious corporate scandals in the last several years have involved excessive executive compensation. Accordingly, underwriters will consider executive compensation information as an important component of the risk analysis.

9. Insider Trading: The most dangerous component of a serious securities class action lawsuit is the presence of significant insider trading at suspicious time and in suspicious amounts. A skilled underwriter will plot the timing of insider trades on the company’s stock graphs to understand who is trading and when. The corollary of this point is that the underwriter will also be interested in the company’s insider trading policy, and in particular will look to see that the company has well-established trading windows and rational trading blackouts, as well as an effective compliance officer.

10. Disclosure practices: The nature, content and tone of the company’s public disclosures are important risk indicators. Underwriters are concerned about companies that devote a lot of energy to generating hype. They are also focused on companies that are very publicly setting and straining to meet very specific short-term earnings estimates. Again, the corollary is that companies with conservative disclosure practices, particularly those that avoid specific, short-term earnings guidance, are viewed more favorably.

11. Corporate Governance: A detailed review of a company’s corporate governance practices is an important part of public company underwriting. However, most underwriters understand that standard corporate governance practices alone are no guarantors that a company will not be involved in a claim. But by the same token, underwriters understand that companies that are actively implementing best practices are the kinds of companies that are interested in trying to play by the rules and perhaps less likely to have problems elsewhere – and better able to defend themselves if a claim does arise.

There is obviously a lot more that might be said about each of these items. In addition, there are a host of other factors that could be relevant to any specific company or to companies in certain industries.

A common misconception is that the D&O underwriting process is like picking a stock. (Frustratingly, some underwriters labor under the misimpression, too.) Many company officials think that their role in the underwriting process is to tout the company and its prospects, as if they were on a road show speaking to prospective investors and analysts. Because most underwriters are by nature suspicious of hype, an underwriting meeting characterized by a high level of salesmanship can be counterproductive.

Underwriters generally do not care whether or not a company’s stock is a good investment, as such. Companies that are mediocre investments are often (although not always) attractive D&O risks, and companies that are Wall Street darlings are sometimes rotten D&O risks. Underwriters are trying to figure out if a company is susceptible to a claim during the policy period, which is often a very different question than whether or not the company’s stock is doing or will do well.

Another common misunderstanding is the expectation that if the company does or does not do certain things, the company ought to get a discount of a certain type or amount. In the soft insurance market that has persisted in recent years, risk specific discounts are hard to isolate, since many companies are enjoying favorable pricing. But more to the point, because underwriting is an uncertain science, the most important factors in determining the price, terms and conditions to be offered are the company’s outward characteristics, which are categorical attributes.

Which is not to say that better managed companies will realize no benefit. But rather than a discount, the benefit is often in the form in the absence of a debit. Or, to put it another way, companies presenting certain specific negative risk factors will be debited, even in the current underwriting environment.

All of that said, there unquestionably are things companies can do to advance their interests during the underwriting process. Working with a skilled insurance professional, a company can identify and address likely underwriting concerns, in an effort to inoculate the company against adverse underwriting perceptions. Moreover, it will be useful for every company to adopt a systematic, timely and business-like approach to the underwriting process, as these practices will expedite the process, remove potential impediments, and encourage efficiencies that benefit all process participants.

The foregoing is merely a summary; there is a great deal more that could be said about all of the above. There are good resources available to supplement the above. One very good resource is the curriculum materials created by the Professional Liability Underwriting Society (PLUS) entitled “Public/Financial D&O Insurance” and available on the PLUS website (here).

Because this is one of those topics on which a great deal more might be said, I would like to encourage readers and observers to post their comments to this blog. I always welcome audience participation but I am particularly interested in readers' comments on this topic.

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It is generally understood that under Delaware law, directors enjoy broad rights of indemnification and advancement. The Delaware statutory regime does allow corporations a great deal of flexibility in how they adapt these provisions to their own circumstances. But while these principles are generally understood, it may nevertheless come as a surprise to many that a corporation’s flexibility to adjust the provisions includes the ability to eliminate former directors' advancement  rights, at least according to a recent Delaware Chancery Court opinion.

A March 28, 2008 opinion in Schoon v. Troy Corporation (here) by Vice Chancellor Stephen P. Lamb held that as a result of a board approved by-law amendment eliminating advancement rights for former directors, a former company director did not have the right to advancement of attorneys’ fees.

The company’s by-law had originally provided that “the Corporation shall pay the expenses incurred by any present or former director.” After one of the company’s directors left the board but before the director became involved in litigation relating to his prior board service, the company’s board deleted the by-law’s reference to former directors.

The former director argued to the court that his right to advancement had vested when he commenced his board service. The former director also sought to rely on a prior Delaware court decision which had held that a board cannot terminate a former director’s advancement rights while litigation is pending. Vice Chancellor Lamb rejected the former director’s arguments, holding that the director’s advancement rights do not become “vested” until litigation is actually commenced.

As Steven M. Haas of the Hunton & Williams law firm noted on the Harvard Law School Corporate Governance Blog (here), “[t]his holding may surprise some practitioners, given that the purpose of indemnification and advancement is to encourage board service and assure directors that their expenses relating to their official actions will be repaid – even if litigation arises after they resign from the board.”

The possibility that directors could lose their rights to indemnification or advancement after they leave the board may not only “surprise some practitioners,” but it would shock many directors, whom I believe rightly would be appalled to learn that they could be stripped of these rights after they leave the board. At a minimum, this holding strongly reinforces the need for each director to have their own separate indemnification agreement with the company, to reduce the possibility for a later board to eliminate these rights after the director has left board service. Without a separate contractual undertaking, directors may have no assurance that after they leave the board their rights to advancement and indemnification will be preserved.

At the same time, however, it should be emphasized that most directors and officers liability insurance policies include former directors within their definition of insured persons, and that under most circumstances a former director for whom corporate advancement and indemnification has been withheld would still have right to seek defense expense protection and indemnification under the company’s D&O liability policy. There might be some question about which retention would apply under the policy, but that issue aside, the insurance coverage should be available to protect the former director (subject to all of its terms and conditions).

Accordingly, In most circumstances, the company’s D&O insurance program should provide adequate protection even for former directors – assuming that the company has procured and continued to maintain insurance protection, and assuming further that the limits available under the insurance program are not otherwise consumed by other insured persons’ defense expense and indemnity requirements.

For directors who have left board service and who are concerned that events could conspire (whether through by-law revision, or as a result of discontinuance or exhaustion of the D&O insurance) to leave them unprotected, there is another insurance solution available. That is, a director concerned about these circumstances may want to consider a so-called former director and officer liability insurance policy. This kind of coverage, which was described at greater length in a recent CFO.com article (here) is buyer-specific; that is, it belong exclusively to the individual director or officer, and would not be subject to termination or discontinuance by the action or inaction of others. It is also noncancelable, nonrescindable, and provides coverage for up to 6 years after the director resigns, retires or is fired.

The point that should not be lost here is that the director in the case cited above lost his anticipated rights after he left the board. Directors concerned about their rights following board service will want to fully consider the available insurance alternatives.

The Ropes & Gray law firm has a May 5, 2008 memorandum (here) discussing the ways in which by-laws and indemnification agreements might be modified to protect against retroactive elimination of directors' rights.

The Delaware Corporate and Commercial Litigation Blog has a post (here) discussing other aspects of the Schoon v. Troy decision.

Speakers’ Corner: On May 6, 2008, I will be in Montreal, Quebec, participating in a panel sponsored by the Canadian Chapter of the Professional Liability Underwriting Society (PLUS). The panel (more information about which can be found here) is entitled “The Subprime Meltdown and its Impact on the Canadian Insurance Landscape” and includes a number of distinguished speakers, included Dr. Faten Sabry of NERA Economic Consulting, David Williams of Chubb, and Denis Durand of Jarislowsky Fraser Limited.

In addition, on May 8, 2008, I will be moderating a panel at a American Bar Association Tort Trial and Insurance Practice Section conference in New York. The title of the conference is "Beyond Legal: A Business Approach to Corporate Governance" and the panel is entitled "Identifying, Predicting and Minimizing Securities Litigation Risk." Joining me on the panel will be Nell Minow of the Corporate Library, Professor Eric Talley of the Boalt Hall School of Law at UC Berkeley, and Patrick McGurn of RiskMetrics. A copy of the conference brochure can be found here.

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As I have noted in prior posts (most recently here), due to increasing average claims severity and escalating defense expense, excess D & O insurance is an increasingly important factor in the resolution of claims involving directors and officers of public companies. The greater involvement of excess D & O insurance has also meant an increasing number of claims disputes involving excess D & O insurers.

A recurring issue has been the question of the excess carrier’s obligations when the primary carrier has paid less than its full policy limits as a result of a compromise with the primary carrier. A March 25, 2008 opinion (here) by California’s intermediate appellate court held, that given the policy language involved, an excess D & O insurance policy was not triggered where the underlying insurer neither paid nor was obligated to pay its full policy limit of liability.

For the policy period March 15, 1999 through March 15, 2000, Qualcomm had $40 million of D & O insurance, structured with a primary layer of $20 million and an excess “follow form” layer of $20 million above the primary $20 million. During the policy period, Qualcomm employees and former employees brought lawsuits asserting rights to unvested company stock options. Qualcomm later settled these lawsuits and sought reimbursement from its D & O insurers for its defense expense and the settlement amounts.

Qualcomm ultimately reached a compromise with its primary D & O insurer, whereby Qualcomm gave the primary insurer a full policy release in exchange for the primary carrier’s payment of $16 million. Even with this $16 million payment, however, Qualcomm still had unreimbursed defense expense of $3.6 million and also had an additional unreimbursed $9 million in settlement expense.

In October 2006, Qualcomm sued its excess D & O insurer for breach of contract and declaratory relief, seeking compensatory damages as well as a judicial declaration that the excess carrier was obligated to indemnify Qualcomm for more than $9 million in unreimbursed expenses. The excess carrier contended, among other things, that the underlying policy had not been “exhausted” as required by the excess policy. The excess policy’s exhaustion clause provided that the excess carrier “shall be liable only after the insurers under each of the Underlying policies have paid or have been held liable to pay the full amount of the Underlying Limit of Liability.”

The trial court sustained the excess carrier’s demurrer (in effect, granted the carrier’s motion to dimiss) without leave to amend on the grounds that the excess policy had not been triggered, and Qualcomm appealed.

On appeal, Qualcomm argued that an excess carrier was liable for losses exceeding the actual limits of underlying primary insurance, even where the primary carrier settled for less than the actual policy limit. Qualcomm also argued that denying excess coverage in the circumstances presented would be contrary to public policy because such a denial would work a forfeiture, provide a windfall to the excess carrier, and encourage litigation by discouraging settlement.

The court of appeals declined “to reach a broad holding on public policy considerations” and instead concluded that “the literal policy language in this case governs.” The court said that the excess policy was not triggered because Qualcomm’s pleadings “establish that the primary insurer neither paid the ‘full amount’ of the liability limit nor had it become legally obligated to pay the full amount of the primary limit.” The court said that

the exhaustion clause here compels us to conclude that the parties expressly agreed that [the primary carrier] was required to pay (or be legally obligated to pay) no less than $20 million as a condition of [the excess carrier’s] liability. Because [the primary carrier] did not so pay, [the excess carrier’s obligations] did not arise.

The Qualcomm decision is consistent with the 2007 decision in the Comerica case, about which I wrote here, and which the Qualcomm court said presented “factual circumstances almost identical to those present in this case." This developing line of case authority has important implications both for the claims resolution and for the insurance acquisition processes.

Let me say at the outset that I am not attempting to criticize the position taken by the excess carrier in the Qualcomm case. Given the court’s ruling, it would be difficult to suggest that the carrier’s legal position was not well founded, and I do not propose to do so here.

In general, however, a claims outcome where a policyholder is stuck with millions of dollars of unexpectedly uninsured claims, after having funded a coverage gap as a result of a compromise with the primary insurer, and after having paid substantial insurance premiums, is highly undesirable from the policyholder’s perspective. Indeed, everyone involved in the D & O insurance industry, including ultimately even excess D & O insurers, has an interest in avoiding claims outcomes where policyholders gets “stuck,” as the value component of the insurance equation—the very thing that insurers’ sell – depends on the policyholders’ not getting “stuck.”

By the same token, the industry could be doing its customers and itself a service by keeping track of claims activity that produces adverse policyholder outcomes, whether it is a primary carrier that is hotboxing the policyholder into making a compromise or an excess carrier that is refusing to play along. Our industry could be improved were it to keep track of the carriers whose claims decisions result in policyholders getting “stuck” – by keeping track the industry might ensure that claims decisions involve not only detached legal analysis but also due consideration of the concrete business assumptions on which our industry ultimately depends.

At a minimum, it is increasingly clear that policyholders should consider only global compromises, involving all insurers, as any other arrangement could leave the policyholder exposed.

The Qualcomm decision has lessons for the policy acquisition process as well. The outcome in the Qualcomm case was a direct reflection of the excess policy’s exhaustion trigger language. While alternative language was not generally available at the time Qualcomm placed the D & O program involved in that case, many excess D & O carriers now offer exhaustion trigger language that reduces the restrictions on the kinds of payments that could trigger the excess carrier’s payment obligation. Indeed, many policies recognize payment by the policyholder as satisfying the underlying limit. The need for these issues to be address in the insurance placement process underscores the need to have skilled insurance professionals involved in the D & O insurance acquisition process.

Special thanks to John McCarrick of the Edward Angell Palmer & Dodge law firm for providing me with a copy of the Qualcomm decision. I should add that the views expressed in this post are solely my own.

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One of the standard provisions of the typical D & O insurance policy is a clause requiring the insurer’s prior consent to settlement. This clause can be the source of tension between carriers and policyholders, and policyholders and their counsel sometimes view the clause as little more than an impediment. However, a March 13, 2008 opinion (here), the New York Court of Appeals makes it clear that policyholders who disregard the settlement consent requirements do so at peril to coverage under the D & O policy.

The insurance coverage dispute in the case arose out of the securities analyst/conflict of interest investigation that unfolded earlier in this decade. Among the investment banks targeted in investigation was Bear Stearns. On December 20, 2002, Bear Stearns entered a settlement in principle with the regulators in which it agreed to pay a total of $80 million, with $25 million allocated as a penalty, $25 million in disgorgements, $25 million for independent research, and $5 million for investor education.

On April 21, 2003, Bear Stearns executed a consent agreement in which it acceded to the entry of final judgment in the SEC’s pending enforcement proceeding. Bear Stearns also agreed to payment of the $80 million and explicitly agreed not to seek insurance coverage for the $25 million penalty.

Three days after executing the settlement agreement, Bear Stearns sent letters to its D & O carriers requesting the carriers’ consent to the settlement. Bear Stearns sought coverage for $45 million of the settlement (which represented the settlement amount, excluding the penalty, in excess of the policy’s $10 million self-insured retention). The insurers disclaimed coverage and initiated a declaratory judgment action.

In October 2003, the federal court presiding over the regulatory enforcement action entered judgment on the terms to which Bearn Stearns previously had agreed.

The insurers disputed coverage on a number of grounds, but because the Court of Appeals opinion addresses only the consent to settlement issue, that is the sole issue I discuss in this post.

Bear Stearns’ primary D & O insurance policy had a provision specifying that:

The Insured agrees not to settle any Claim, incur any Defense Costs or otherwise assume any contractual obligation or admit any liability with respect to any Claim in excessof a settlement authority threshold of $5,000,000 without the Insurer's consent, which shall not be unreasonably withheld . . . The insurer shall not be liable for any settlement, Defense Costs, assumed obligation or admission to which it has not consented.

The New York Supreme Court (trial court) found that triable issues of fact existed whether Bear Stearns breached the consent to settlement clause. The Appellate Division modified the lower court’s opinion in certain other respects, but affirmed the Supreme Court on the consent to settlement issue. The Appellate Division then certified the case to the New York Court of Appeals.

The Court of Appeals, in an opinion written by Justice Victoria A. Graffeo, held that “Bear Stearns breached [the consent] provision when it executed the April 2003 consent agreement before notifying the insurers or obtaining their approval.” The Court of Appeals said that it was “unpersuaded by the contention that a triable issue of fact exists because the federal court did not approve the settlement until it entered a final judgment in October 2003.”

Judge Graffeo specifically noted that

As a sophisticated business entity, Bear Stearns expressly agreed that the insurers would "not be liable" for any settlement in excess of $5 million entered into without their consent. Aware of this contingency in the policies, Bear Stearns nevertheless elected to finalize all outstanding settlement issues and executed a consent agreement before informing its carriers of the terms of the settlement. Bear Stearns therefore may not recover the settlement proceeds from the insurers.

The Court of Appeals reversed the Appellate Court and granted the carrier’s motion for summary judgment. Because of its ruling on the consent provision, the Court of Appeals did not reach the other issues on which the carriers disclaimed coverage.

There may well have been additional grounds that could also have precluded coverage here, but it is still an arresting development – and a cautionary tale – that the Court of Appeals precluded coverage altogether based solely on the failure to obtain advance consent to settlement. Significantly, the Court of Appeals enforced the consent provision without superimposing any requirement for the insurer to show that it was prejudiced in any way by the failure to obtain consent. The Court of Appeals focused strictly on the policy’s language.

Companies and their counsel sometimes regard the consent settlement requirement as if the language were merely precatory, or perhaps even as optional if they believe settlement circumstances suggest the need to press ahead without bringing the carrier into the loop. It is not an unprecedented development for a carrier to learn of a settlement only after the fact. But the Bear Stearns opinion provides unambiguous notice to companies and counsel that they disregard the policy’s advance consent requirement at peril of precluding coverage.

The larger lesson here is that the carrier should be kept in the loop. Indeed, the better practice, the one likeliest to produce the best claim outcomes, is for companies and their counsel to treat the carrier as a collaborative partner in the claims process. While there are unfortunate situations where the carrier does not respond appropriately, even in those situations the policyholder will be better off (for example, before a court if coverage litigation ensures) if the policyholder has consistently maintained professional and timely communications with the carrier.

And whatever else may be said, it is clear, at least in New York, that the D & O policy provision requiring the carrier’s advance consent to settlement means what it says, and policyholders should take care to comply with its requirements.

Special thanks to a loyal reader for providing a copy of the New York Court of Appeals opinion.

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Last week, I added a post (here) discussing the March 2, 2008 paper entitled “How the Merits Matter: D&O Insurance and Securities Settlements” (here) by Connecticut Law Professor Tom Baker and Fordham Law Professor Sean Griffith. In response to my invitation, Professor Griffith prepared a reply to my comments, which is as follows:

Before beginning, I’d like to thank Kevin for his careful and thoughtful reading of our paper and for his many kind words and comments. Kevin’s comments have improved all of our papers in this area, and they will surely improve this one. I do, however, have a few remarks to make in response to three comments Kevin made towards the end of his write-up. I’ll address: (1) the impact of disclosure on insurance, (2) the possibility that additional disclosure will increase the incidence of lawsuits against corporate insureds, and (3) the ways in which additional disclosure will make the world a better place.

1.         In his review of our paper, Kevin writes that Baker and I “do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry.” Not so. We have indeed run the idea of additional disclosure by folks in the insurance industry. In fact, I well remember one of the first conversations I had on this subject. I was working on an earlier paper (here) that proposed mandatory disclosure of D&O insurance details when I received a voicemail message from one of the broker’s I’d been talking to. He excoriated me on the message, offering a stream of expletives that would have made George Carlin blush. He’d read my draft (or, at least the title) and, I gathered, was rather displeased at the prospect of public disclosure of D&O insurance information. This, I believe, is the general reaction, of folks in the insurance industry to the proposal, although their reactions are typically more calmly expressed.

I am neither surprised nor particularly bothered by this reaction. First, it is hardly surprising that more transparency within a market would make an intermediary’s life more difficult. Intermediaries will worry that their profit margins will be eroded away if their customers can see the price paid by comparable companies. Buyers will insist that brokers get them an equally good deal as a competitor or justify why they can’t. But why is that a bad thing? What’s bad for the broker looks good for the consumer. Moreover, brokers often say that they do more than just price a coverage package. If that’s really true, then there will be a place in the market for them post-disclosure. They’ll still be providing a service that’s not available elsewhere. But if it’s not true, then the broker’s role starts to look like waste, and why wouldn’t we then want to disintermediate the market and, perhaps, let risk managers build their own coverage towers?

Second, moving to the insurer’s perspective, I’m not sure that disclosure would be bad. It might be a problem if the insurer is offering discounts for some clients but not others on the basis of factors that are not risk-related, perhaps because a buyer’s price on their D&O program is tied to the fact that they’re buying a (more expensive) general liability policy from the same insurer. (Some suggested to us that tying arrangements of this sort occur in the D&O market.) If we had a disclosure rule, we can expect buyers to demand the same D&O premiums as all similarly situated companies, which would make it harder to engage in tying arrangements. The only valid basis for an insurer to offer different prices would be differences in risk. Underwriters would be in the position of having to articulate why Company A is a better risk than Company B. This would obviously be good for the buyer, but I suspect in the long term it would be good for the seller too. It would focus underwriters on what matters—risk-assessment—and inhibit their ability to make sales that discriminate on some other basis (like tying). From the insurer’s perspective, that’s probably a good thing because insurance that is sold with better risk assessment up front is less likely to lead to losses down the road than insurance that is sold on some other basis.

Now, I don’t know how any of that would ultimately play out. I’m just skeptical of the gloom-and-doom-for-the-industry story. I suspect that those within the industry who are doing what the industry is supposed to do—assessing risk and tailoring coverage—will survive. Also, to be honest, my concern is not so much with the insurance industry as it is with the corporations buying the insurance. And, frankly, when anyone other than the consumer complains about market reform, that’s usually a sign that market reform is a good idea. Producers and (especially) intermediaries have shown themselves across industries and throughout history to be opposed to reforms that enhance competition. I suspect that this market reform would benefit the consumer in a variety of ways, not just in the bottom line price paid by insureds, but more about that in my response to #3, below.

2.         Second point. Disclosure would be bad for corporate insureds, Kevin suggests, because the additional disclosure will make them “lawsuit targets.” In other words, the incidence of lawsuits will go up if plaintiffs lawyers know more about corporate insureds’ coverage packages.

We here this objection fairly often, but I think it’s easily disproven. Here’s how: First, everybody knows that virtually every public company in the US carries D&O insurance. Second, everybody knows that average settlements are much less than average coverage limits (in spite of the rare high profile above-limits settlement, just look at Tillinghast, Cornerstone, or NERA—average limits far exceed average settlements). Those two things being true, plaintiffs’ lawyers needn’t fret about insurance when they file claims. They can reasonably assume that coverage will be there. Moreover, insurance coverage is one of the first disclosures that the parties must make once they’re in litigation. If, in the rather unlikely event that a corporate defendant is not well covered, the plaintiffs’ lawyer can drop the claim before their sunk costs have gotten too large. Bottom line: currently, plaintiffs’ law firms reasonably assume that most corporate defendants will have sufficient D&O coverage to fund claims, and they file any time they can put together the basic elements of liability. If Tom and I got the disclosure rule we want, true, plaintiffs law firms would know the coverage profile of the corporate defendant, and they’d file any time they could put together the basic elements of liability. In other words, the additional disclosure would not be a boon to the plaintiffs’ bar, and the incidence of suit would be about the same.

3.         Kevin also remarks that although we, as academic researchers, would benefit from additional disclosure (true!), we haven’t really specified how additional disclosure would deter securities violations. 

            First, regarding Tom’s and my self-interest. Yes, if we got the disclosure rule we want, we’d crunch the data in more papers. But, let’s face it, we’re not going to get famous doing this. And Tom and I both have tenure, so we don’t really have career incentives that distort our devotion, putting it somewhat grandly, to truth and justice. We want the additional disclosure because we think it would be good for the world and we write the papers because we think the world ought to know what’s good for it.

            Okay, so why would additional disclosure be good for the world? Or, more concretely, how would it deter securities law violations? 

As we said in the papers about underwriting, disclosure of D&O pricing, limits, and coverage structure would enable financial analysts to use this information as a proxy for downside risk and, on the basis of that proxy, to change their valuation of corporate insureds. With enough people in the market using this information (which one might assume on the basis of the efficient capital markets hypothesis), insurers’ collective assessment of a prospective insured’s risk should have a direct impact on the prospective insured’s share price. And, last step, because managers care about share price, anything that has an effect on it (e.g., wobbly corporate governance structures) is something they’re likely to address. So disclosure of D&O pricing, limits, and coverage structure would improve corporate governance. 

What’s different in this paper is that we think the required disclosures should be broadened. Not only should corporations be made to disclose their limits, pricing, and coverage structure on a regular basis (with each renewal), but also any time a corporation settles a securities claim, they should be required to disclose how the settlement is funded. E.g., What amount comes from insurers? What amount comes from the company? Putting this information together with information about the corporate insured’s coverage package, financial analysts and capital market participants ought to be able, as we say in the paper, to assess “which corporations are likely to have engaged in bad acts and which have not.” In other words, which corporations got stuck settling a nuisance claim and which allowed some form of fraud to occur.

How would analysts be able to draw this conclusion? Consider a settlement well within total limits to which a corporate insured nevertheless contributes a substantial amount. The insured’s contribution in this case might indicate that the insurers were able to cash in their coverage defense for savings off of their full exposure. Granted it might indicate other things as well, but if I were a financial analyst, I’d want to know why did the company pay when it had more limits available. And if the insurers had a strong coverage defense, doesn’t that suggest that there was some merit to the plaintiffs’ claim (i.e., that it was not just a nuisance suit)? And if there was some merit to the plaintiff’s underlying claim, have the problems that led to the claim been fixed or management just back to business as usual, denying all the while that the plaintiffs’ claim had any basis at all. Either way, this information would make me reconsider my valuation of the insured corporation’s shares. Again, with enough people in the market acting on this information, the corporation’s share price ought to be effected. And, because managers care about share price, this creates an incentive for managers to actually avoid the kind of things that lead to fraud claims. In other words, disclosure, in the context of both underwriting and claims, gives the market what it needs to provide deterrence. If the information disclosed is useful to capital market participants (we obviously believe that it would be), they will use it in ways that create natural incentives for managers to mend their ways. In my view, that’s the big payoff of all of our research in this area.

Thanks again to Kevin for his comments and for the lively debate as this project has evolved.

I would like to thank Professor Griffith for taking the time to write a detailed response to my prior post. I hope other readers will post their thoughts, comments and reactions to Professor Griffith’s observations by using the “Comment” feature in this blog’s right-hand column. I look forward to hearing readers’ reactions to Professor Griffith’s observations.

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Although there have been some significant exceptions in recent years, it is still generally the case that securities class action settlements are largely funded by D & O insurance. Yet the impact of D & O insurance on the process and ultimate value of securities lawsuit settlements is little understood outside the small world of practitioners in this area. In an excellent March 2, 2008 paper entitled “How the Merits Matter: D & O Insurance and Securities Settlements” (here), Connecticut Law School Professor Tom Baker and Fordham Law Professor Sean Griffith take a closer look at the role of D & O insurance on securities lawsuit settlements.

In this paper, the authors use a technique they have employed in their prior studies of D & O insurance (about which I previously commented here) – that is, in order to understand that actual workings of the D & O insurance industry, they have interviewed a wide variety of involved participants. In this case, they interviewed over fifty persons, including plaintiffs’ attorneys, defense counsel, insurance claims professionals, insurer’s monitoring counsel, and others. As a result of this practical approach, the authors have developed a realistic understanding of the actual settlement dynamics, and what emerges is a perceptive overview of the actual settlement process.

They describe a dynamic where the plaintiffs’ lawyers’ principle objective is to survive the motions to dismiss, and having passed that barrier, to maneuver the case to settlement. The question that often arises is whether the merits of the case matter to the ultimate amount of settlement. However, the absence of any significant trial-based data means there are no “experienced-based” ways to measure the plaintiffs’ likelihood of success on the merits.

The authors found that in the absence of trial-based data, the case settlements are influenced by a number of factors, including, for example, the presence or absence of “sex appeal” or the magnitude of potential damages involved. Case characteristics that might provide “sex appeal” include “SEC investigations, criminal charges, suspicious stock purchases program… and a variety of other case specific facts that cast the defendants’ motives or honesty in a bad light.” On this basis, a number of the individuals the authors interviewed expressed the view that the merits do sometimes matter.

But in addition, there are other “non-merits” factors that may affect the settlement, and “the most significant non-merits factor in the securities class action context is the ability to pay,” and the “willingness to pay that matters is, more often than not, that of the D & O insurer.”

The most significant value of the authors’ research and analysis is their detailed explanation of the role of D & O insurance in the securities lawsuit settlement process. The authors do a commendable job explaining the factors that limit the insurer’s ability to influence the process; the dynamics that drive plaintiffs’ and defendants’ counsel to align against the insurer; the effect that D & O limits and program structure have on the process; and how the other participants’ motivations interact with those of the D & O insurer.

Among the authors' more provocative conclusions is their suggestion that "plaintiffs and defendants collude to pressure the D & O insurer to settle on terms that may nore reflect the ultimate merits of the claim."

The authors note  that “settlements are largely funded, often entirely, by D & O insurance,” as a result of which “insurance companies are the real parties in interest.” The consequence of this is that “the outcomes of securities class action lawsuits … are driven not by the opinion of a judge or the decision of a jury, but by the consent of the insurers.”

With this dynamic, and in the absence of trial-based data, the sole settlement reference points are prior settlements. Because of this, the authors note, “insurers are bargaining not in the shadow of the law, but in the shadow of prior bargains, at a further remove from decisions by judges or juries on the merits.”

In the end, the authors say that they “cannot draw a strong conclusion about whether the merits do or do not matter.”

They do conclude on the basis of their research that “non-merit factors contribute significantly” and accordingly they explore a couple of alternatives for making the merits matter more: first, they suggest, but sensibly quickly reject, the idea of requiring a specified number or percentage of securities cases to go to trial; and second, they advocate “mandatory disclosure of (1) the amount and structure of a corporation’s insurance coverage, and (2) information on how settlement and defense costs are funded.”

The authors’ advocacy of the compelled disclosure of D & O insurance information is clearly borne of their own frustration at the lack of access, as research academics, to this kind of information. It may be unfair to point out that few others are demanding disclosure of this kind of information. But it does seem fair to point out that even though the authors’ study of settlements was based on interviews with industry practitioners, they do not seem to have reviewed the idea of compelled disclosure with anyone in the insurance industry. If they had, I doubt they would find anyone who would support the idea.

In particular, insurance professionals would like have two areas of concern regarding the compelled disclosure of this information: (1) the impact of the disclosed information on an already complex commercial insurance environment; and (2) the possible impact of the disclosure of insurance information on which companies become lawsuit targets. The authors neither consider nor discuss these practical concerns.

I also wonder about the authors’ suggestion that compelling this information would do anything to make the merits matter more or to deter securities law violations. The authors’ own research shows that a multitude of factors can sometimes affect settlement amounts, including, for example,  the presence or absence of coverage issues or the existence of business considerations that compel a company to throw money at a case to make it go away, even without significant insurer contribution. The disclosure of the kind of information the authors advocate would of course provide research academics with extensive additional information to contemplate, but the possibility that this kind of disclosure would significantly affect the settlement dynamic, much less deter securities law violations, seems remote.  

In any event, the