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

In prior posts (here and here), I discussed two recent decisions in which courts held that D&O insurance coverage was precluded for settlements the insureds entered without first obtaining the insurers’ consent as required under the applicable policies. An August 19, 2008 Second Circuit opinion (here) addressed the related question of what happens when the insured seeks but the insurer withholds settlement consent.

Based on the somewhat strained circumstances involved, the Second Circuit affirmed a jury verdict holding two excess carriers liable under their policies to fund their portion of a settlement, even though the insured had requested settlement consent on a Sunday evening at 10:00 PM and givn the carriers only eleven hours to respond.

Background

The underlying claim arose out of the Globalstar Telecommunications securities litigation (about which refer here). After the corporate defendants sought bankruptcy protection, the case went forward solely as to Globalstar’s former CEO, Bernard Schwartz. There were various pretrial mediation and settlement conferences, but the case did not settle and proceeded to trial.

The first four layers of Globalstar’s D&O insurance program consisted of a primary $10 million layer and three successive excess layers of $5 million each. Prior to trial, the plaintiffs’ latest settlement demand was $15 million. The primary insurer’s last pretrial settlement offer was $5 million. The plaintiffs reportedly warned that once trial began, their demand would rise to $20 to $25 million.

After two weeks of trial and on the day before he was scheduled to testify, Schwartz agreed to a $20 million settlement. Schwartz’s defense counsel sought the insurers’ consent to enter into the settlement. The request for consent was sent via email on a Sunday night at 10:00 pm. According to the Second Circuit’s later opinion, Schwartz’s defense counsel "offered to discuss the reasonableness of that figure later than night or between 8:45 am and 9:00 am on Monday." Over the next few days, all four insurers refused to consent. The court entered judgment approving the settlement. Schwartz later funded the $20 million settlement with a personal check.

The Coverage Litigation 

Schwartz then sued the four insurers. Schwartz sued the primary carrier for bad faith refusal to settle and for breach of contract. Schwartz sued the three excess carriers for breach of contract. (The third layer excess carrier was involved because at the time Schwartz agreed to settle the case, defense fees had eroded the first $3 million of the primary policy, so the $20 million settlement implicated the third layer excess policy.) The second and third layer excess insurers also cross claimed against the primary insurer alleging bad faith, on the theory that as excess insurers they were equitably subrogated to Schwartz’s bad faith claims against the primary insurer.

Before the coverage lawsuit went to trial, both the primary insurer and the first level excess insurer settled with Schwartz by paying their full policy limits. The coverage trial went forward on Schwarz’s claims against the second and third level excess insurers, and on these two excess insurers’ cross claims against the primary insurer.

Following trial, the jury found in favor of Schwartz and awarded damages of $5 million against the second level excess insurer, and $4 million against the third level excess insurer (the full amount that Schwartz had sought).

On the excess insurers’ cross claims against the primary insurer, the jury awarded the second level excess insurer damages of $2 million and the third level excess insurer damages of $3 million. However, the jury also specifically found that the primary insurer had not acted in "gross disregard" of Schwartz’s rights. In a post-trial ruling, the district court dismissed the excess insurers’ cross claims, holding that New York law applied to the cross claims and that under New York law there could be no recovery for bad faith in the absence of a finding of "gross disregard."

The Second Circuit Opinion 

On appeal, the excess insurers argued "Schwartz’s failure to satisfy the condition precedent of consent to settlement absolved them of their contractual duties." The excess insurers contended that Schwartz’s settlement request "gave them mere hours (over a Sunday night and Monday morning) to decide whether to settle." The Second Circuit characterized these arguments as contending that the 11-hour period represented "the interval in which the Excess Insurers had to assess – for the first time – the risks, opportunities and settlement demands at play."

The Second Circuit, in an opinion by Chief Judge Dennis Jacobs, said that "the insurers’ opportunity to consider settlement extended over a prolonged course of consultation, monitoring and negotiation, so that the settlement was in the nature of anticlimax rather than surprise." The Second Circuit found the jury appropriately considered this evidence and concluded that the excess insurers "had an adequate opportunity to consider and evaluate the settlement opportunities; that $20 million was a reasonable sum; and that [the excess insurers] unreasonably withheld consent." The Second Circuit held that there was sufficient evidence to support the jury’s verdict in Schwartz’s favor.

The Second Circuit also rejected the excess insurers’ argument that the trial court inappropriately applied New York law to the excess insurers’ equitably subrogated bad faith claims against the primary insurer.(Under New York law, but not under California law, a finding of "gross disregard" is required to support the imposition of bad faith liability.) Among other things, the excess insurers argued that it was not appropriate to apply California law to Schwartz’s breach of contract claims but New York law to their equitably subrogated bad faith claims.

The Second Circuit found that applicable choice of law principles allowed different jurisdictions’ laws to apply to different aspects of the same dispute. The Second Circuit also rejected the excess insurers’ argument that application of different law to their cross-claims inappropriately deprived them of the same right of recovery as the person to whom they were equitably subrogated.

Discussion 

The most critical fact in these strained circumstances may be that in the absence of the insurers’ consent Schwartz accepted personal liability for the settlement and funded it out of his own assets. That step substantially undercut the insurers’ ability to argue that the settlement amount was unreasonable, and by extension that their withholding of consent was reasonable.

These circumstances nevertheless present some very troublesome aspects. One particularly questionable part is the settlement consent request that was presented in an email at 10 pm on a Sunday evening with an 11-hour response time. However one might characterize this communication, it was hardly calculated to provide the insurers with what most people would consider a reasonable opportunity to consider the request and respond.

In seemingly overlooking the unorthodox nature of these communications, the Second Circuit placed great weight on the excess insurers’ prior attendance at mediation and settlement conferences, and at trial. During these proceedings there were opportunities to settle the case for $15 million. To be sure, the plaintiffs had indicated that the settlement demand would rise once trial started. The second and third level excess insurers had demanded that the primary and first level excess insurers settle the case for the $15 million amount. Had the case settled for that amount, the second level insurer would only have paid a portion of its limits and the third level excess insurer’s limit would not have been implicated at all.

Under these circumstances it seems that what this case really was about was the question of who ought bear the costs of the $20 million settlement. In that regard, it is significant to note that the jury specifically awarded substantial damages in favor of the second and third level excess insurers against the primary insurer, notwithstanding the jury’s finding that the primary insurer had not acted in "gross disregard" of Schwartz’s interests.

The amount of the cross claim awards seems to be explained by the fact that at the time of the settlment, the first $3 milion of the primary policy had been eroded by defense expense. The sum of the $7 million remaining on the primary policy, the $5 million under the first level excess policy, and the first $3 million of the second level excess policy collectively represented the $15 million amount at which the case could have been settled before trial. The jury shifted to the primary insurer responsibiltiy for the incremental $5 million difference between the $15 million for which the case could have been settled before trial and the $20 million for which it actually settled, by awarding damages of $2 million to the second level excess insurer and $3 million to the third level excess insurer.

However, the trial court negated these cross claim damage award in its post-trial choice of law decision, which the Second Circuit affirmed. I am insufficiently steeped in "decapage" and other rarified choice of law principles to have any informed opinion about the merits of the Second Circuit’s analysis of the law to be applied to excess insurers’ cross claims. The excess insurers undoubtedly are frustrated that they were found liable to Schwarz (to whom they were equitably subrogated) under California law, but that the primary insurer was not liable to them (despite the jury verdict in their favor on the cross claims) because New York law rather than California law applied to their cross claims.

The net effect is that the excess insurers are left holding the responsibility for amounts that the jury assigned to the primary carrier. The primary insurer of course would that in the absence of a finding of "gross disregard" it would be inappropriate for it to have to bear liability for these amounts.

In the end, the outcome of this case may be best understood as the result of the strained circumstances. It should probably be emphasized that demanding insurer consent on a Sunday evening with an 11-hour deadline does not, shall we say, represent an advisable approach. Of course there may be sufficiently pressing circumstances (including, it should be noted, during the constraints of trial) where rushed communications may be unavoidable. But in general, complete, timely and business-like communications are to be preferred, and are likelier to avoid disputes with the carrier.

Special thanks to a loyal reader for providing a link to the Second Circuit opinion.

When Introducing Her, McCain Did Say Something Like "And Now For Something Completely Different": Prior to this past Friday, the only person I had every heard of with the last name of "Palin" was Michael Palin, of Monty Python fame.

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In an April 9, 2008 opinion (here) written by Chief Judge Frank Easterbrook, the Seventh Circuit held that there was no coverage under Arthur Anderson’s fiduciary liability policy for the firm’s settlement of a retiree pension benefits dispute.

The dispute arose after the firm’s Enron-related difficulties undercut the firm’s ability to honor retirees’ demands for lump-sum payment of retirement benefits. Litigation ensued. The retirees claimed, among other things, that the firm had breached its duties under ERISA. The firm retained defense counsel and also (through its broker) provided notice of claim to its fiduciary liability insurer. The plaintiffs then voluntarily dismissed the lawsuits and initiated arbitration proceedings instead. (The full details of the underlying retiree dispute and of the communications between the firm’s representatives and the insurer are set out at length in the district court’s summary judgment opinion, here.)

In November 2002, Arthur Anderson “proposed a compromise to all retirees and wrote to its insurers that it needed at least $75 million from them to fund a settlement.” The firm asked its primary fiduciary liability insurer to tender its full $25 million policy limit. The insurer responded that the arbitration claim did not allege negligence or breach of any fiduciary duty, but rather that it was a “pure contract action” for benefits due, for payment of which coverage is precluded under the terms of its policy. (The relevant policy provisions are set out in the district court opinion linked above.)

In January 2003, the firm settled with most of the retirees for $168 million, and it ultimately settled with the rest of the retirees in 2006 for a further $63 million. In February 2003, the fiduciary liability insurer initiated an action for a judicial declaration that it was not required to defend or indemnify Arthur Anderson.

The district court held (here) that the policy does not require the insurer to fund the settlement but that (as later summarized by the Seventh Circuit), the insurer’s “failure to provide a defense coupled with its delay in filing the declaratory judgment action might require it to pay anyway.” Following a jury trial, the district court entered judgment in the insurer’s favor except to hold that the insurer was liability for $5 million toward the arbitration settlement. Both sides appealed.

The Seventh Circuit affirmed the district court except to reverse as to the $5 million payment required toward the settlement. The Seventh Circuit found first that there was no coverage under the fiduciary liability policy for the retirees’ arbitration claim, because it did not allege negligence or breach of a fiduciary duty, but rather was limited exclusively to an alleged breach of contract. The Seventh Circuit also held that the policy’s “benefits due” exclusion also precluded coverage. Judge Easterbrook commented that “the settlement reflects the present value of the pension promise…rather than damages for anyone’s misconduct,” and he noted further that:

No insurer agrees to cover pension benefits; moral hazard would wipe out the market. As soon as it had purchased a policy, the employer would simply abandon its pension plan and shift the burden to the insurer. Knowing of this incentive, the insurer would set as a premium the policy’s highest indemnity, and no “insurance” would remain. Illinois would not read a policy in a way that made it impossible for people to buy the insurance product they want (here, coverage of negligence and disloyalty by pension fiduciaries).

The Seventh Circuit also found that the firm’s failure to obtain the insurer’s prior consent to the settlement provided another preclusion to coverage. Judge Easterbrook noted that “Arthur Anderson didn’t ask for the consent or even the comments of its insurer; it presented the deal to them as a fait accompli. By cutting [the insurer] out of the process, Arthur Anderson gave up any claim of indemnity.”

Having decided that there was no coverage under the policy, the Seventh Circuit then went on to consider whether Illinois principles of “equitable estoppel” nonetheless barred the insurer from asserting its defenses to coverage, as a result of the insurer’s delay in providing a defense and bringing its declaratory judgment action.

The Seventh Circuit first considered the question of what constitutes “delay,” noting that “treating eight months,” the period of the insurer’s putative delay, “as excessive is questionable.” Judge Easterbrook also noted that had the firm complied with the policy’s advance consent to settlement requirement, the insurer could have filed its declaratory judgment before the settlement.

In the end, the Seventh Circuit concluded that the question whether eight months constitutes delay is irrelevant, since at no point did the firm ever ask the insurer “to send a team of lawyers to represent it”; rather, the firm “made it clear that it would control both the defense and the law firm conducting the defense.” By “not tendering its defense," the firm “gave up and basis for demanding immediate action by the insurer.” Judge Easterbrook noted that:

An insured’s need to have legal assistance for its defense from the outset of a suit is the main justification for the rule that Illinois has adopted. When the insured does not want the insurer to supply a defense (lest the insurer also control the defense), it has no complaint if the insurer takes a while to contemplate the question of indemnity. The urgent need is for a defense to the pending suit; liability for indemnity (the coverage question) can safely be decided later.

Finally, Judge Easterbrook concluded that the insurer did not in the end have a duty to defend as the arbitration complaint was “based on contract and nothing but.”

There are several noteworthy things about Judge Easterbrook’s opinion. The first pertains to his commentary that adverse consequences might follow if the insurer were compelled to fund the settlement. It is the very rare court that is willing to consider not only that in some circumstances compelling the insurer to pay might not only undermine the existence of the market for that type of insurance, but could even constitute a “moral hazard.” Judge Easterbrook’s analysis evinces an unusually developed understanding of the insurance mechanism’s fundamental components.

The court’s analysis of the consent to settlement requirement is also noteworthy; indeed, the Seventh Circuit’s discussion of this issue in many ways mirrors the analysis of the recent New York Court of Appeals opinion (discussed here) in which the New York court also enforced the consent to settlement opinion strictly according to its terms. These two holdings underscore not only that the provision means what it says but also that it will be enforced according to its terms. These rulings unmistakably highlight that policyholders who fail to follow the policy’s requirement for advance consent to settlement do so at peril to their insurance coverage.

There is a further important lesson from this case, one that is similar to the lesson of the prior New York case, and that is that nothing good comes from a policyholder’s failure to keep the insurer in the loop. Indeed, if there is one common element in almost every litigated coverage dispute, it is that at some point preceding the litigation, there was some breakdown in communications between the policyholder and the insurer.

There are no guarantees that carriers will respond appropriately even when they are provided with full information. But the single most important way for policyholders to reduce the possibility of a litigated dispute with their insurer is to maintain full and professional communications with their insurer. Indeed, point number on in my list of “Seven Ways Counsel Can Help Clients with D&O Claims” (here) is to “Keep the Carrier Informed.”

Finally, I note that the Seventh Circuit’s discussion of the “benefits due” exclusion is an important accompaniment to my analysis (here) of the insurance implications of the U.S. Supreme Court’s opinion in the LaRue case. As Judge Easterbrook’s opinion makes clear, these policies are not intended to provide a substitute funding mechanism for companies’ benefit obligations to their employees. However, the policies are intended to provide companies with indemnity protection when an insured’s alleged or actual negligence or breach of a fiduciary duty harms a plan participant’s interests. For that reason, it is analytically consistent for insurers to offer, as some now do, an endorsement to their policies to carve out from the benefits due exclusion an agreement to cover a plan participant’s claim of harm to their individual plan investment interests, of the kind recognized in the LaRue decision.

Special thanks to a loyal reader for providing me with a copy of the Seventh Circuit’s opinion.

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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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