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

The current global financial crisis may result in "unprecedented levels of litigation" that "will either serve to identify ‘weak links’ in the chain of participants who originate, appraise, and service collateral and underwrite, manage, insure, rate and sell securities," or it will serve to "highlight where the market may have underappreciated certain risks or failed to appreciate certain circumstances," according to a paper featured in a March 17, 2009 post (here) on the Harvard Law School blog.

The paper, entitled "Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis," was written by Babson College Professor Jennifer Bethel, Harvard Law Professor Allen Ferrell, and Babson Professor Gang Hu, can be found here.

The paper explores the "economic and legal causes and consequences of the 2007-2008 credit crisis." In particular, the paper examines "the risks that can arise from financial and technology innovations and losses that are uniquely related to correlated events in the setting of loan markets." The paper sets for a detailed and interesting overview of the economic and financial causes that contributed to the current credit crisis.

The paper also notes that "the credit crisis is not solely an economic phenomenon, but a legal one as well." The paper discusses a number of different types of lawsuits that have arisen, but focuses in particular on securities class action lawsuits against public companies, which the paper describes as "by far the most important litigation likely to arise out of the credit crisis."

The paper asserts that "plaintiffs that bring Rule 10b-5 class action lawsuits will face substantial challenges," and notes in particular that the securities plaintiffs will have to navigate around three basic legal principles: "(i) there can be no ‘fraud by hindsight’; (ii) there can be no actionable disclosure deficiency with respect to information the market already knew (the ‘truth on the market’ defense); and (iii) plaintiffs must establish loss causation for their claims."

First with respect to the "fraud by hindsight" concern, the paper notes that it will not be enough for plaintiffs to show that there have been economic losses; they will also have to show that the adverse developments were reasonably foreseeable at the time the supposedly disclosures were made. The authors note that

Whether a failure of certain market participants to provide detailed disclosures regarding the implications of an event – the first full national fall in housing prices since World War II in conjunction with a dramatic and increasingly global crisis – from which the actors themselves suffered huge losses is actionable will likely prove an important stumbling block, in our judgment, for a number of actions being brought.

The authors add that "the presence of disclosure failures and materiality thereof must be assessed in light of what was known at the time of the disclosures without the benefit of 20/20 hindsight, even if losses occur."

Second, with respect to the "truth on the market" defense, the authors question whether the target companies in fact had "special knowledge that was not known by the market at large." The authors suggest that this may have been a situation where the market was at least as informed, or at least no less informed, than the defendants on relevant issues.

Third, the authors suggest that "loss causation is likely to be a challenging litigation issue for plaintiffs, because market prices, especially of financial-sector securities, declined overall."

The few dismissal rulings that have accumulated so far provide at least some support for the authors’ theories. In at least two cases where dismissal motions have been granted with prejudice – the NovaStar Financial case (about which refer here) and the Impac Mortgage case (refer here) – the courts seemed particularly concerned that the defendant companies had been caught in an industry-wide or even economy-wide downturn. Even if the courts did not use the price phrase "fraud by hindsight," the concept was seemingly implied in the rulings.

At the same time, however, there have also been significant cases where courts have had no difficulty denying dismissal motions – for example, New Century Financial (refer here) and Countrywide (here) – in which the courts have expressed open outrage regarding the alleged misrepresentations and omissions. The authors’ analysis seems deficient to me to the extent it fails to recognize the possibility that at least some courts’ judgments potentially may be affected by this sense of outrage, particularly over the extent of damage done, to investors and to the economy. (A list of all of the subprime dismissals and dismissal motion denials can be accessed here.)

In addition, given the authors overall hypothesis that plaintiffs will face substantial hurdles in pursuing these cases, it seems a noteworthy and even odd omission that the authors detailed and exhaustive paper neglects to even mention the possibility that the U.S. Supreme Court’s decision in the Tellabs case could also represent a significant hurdle for the plaintiffs. In that regard, the Tellabs decision has generally proven instrumental in those cases where dismissal motions have been granted thus far.

Finally, with respect to the authors’ suggestion that loss causation issues may prove critical, I note that in a prior post (here) I discussed the challenge that plaintiffs may face where they have sued for supposed economic losses on securities that continue to provide scheduled interest payments on time and in full. These arguments may be particularly relevant in claims brought by mortgage-backed securities investors who have sued the securities issuers and the securities offering underwriters.

Defenseless: Laura Pendergast-Holt, the erstwhile Chief Investment Officer of Stanford Financial Group, has a few legal problems to sort out. First, she is a defendant in an SEC enforcement proceeding involving the Stanford Group. Second, she was arrested on February 26, 2009 and charged with obstructing a proceeding before an agency of the United States. Third, she has been named as one of the defendants in numerous civil lawsuits brought by irate Stanford group investors. (A complete list of Stanford-related litigation can be accessed here.)

Ms. Pendergast-Holt clearly needs the services of an attorney. Unfortunately, she is also party to one more lawsuit, one in which she is the plaintiff, and which suggests the challenges she may have in providing for her legal representation in the above matters.

On March 17, 2009, she filed a lawsuit in Texas (Dallas County) District Court against Stanford Group’s directors and officers’ liability insurer, alleging that the insurer has "failed and refused to provide a defense so that she can defend herself in the SEC action, the civil class action, and in the criminal matter." A copy of her Original Petition can be found here.

Ms .Pendergast-Holt seeks a judicial declaration of coverage. Arguing that she has no way of satisfying any self-insured retention, she also seeks a "declaration that any self-insured retention or deductible be waived, held inapplicable or enjoined." She also alleges breach of contract and bad faith. She seeks damages estimated to exceed $5 million, as well as punitive damages estimated to exceed $40 million.

The bases on which the insurer has declined coverage for Ms. Pendergast-Holt’s defense are not specified in her Original Petition. While the scandal surrounding Stanford Group is notorious, as yet there have been no verdicts and no guilty pleas, nor to my knowledge have there even been any admissions. Whatever the facts ultimately prove to be, nothing has as yet been determined. These considerations may prove relevant to the coverage dispute, for example, with respect to the potential applicability of policy exclusions. On the other hand, representations made in connection with Stanford’s policy application (particularly with respect to Stanford’s finances) may also figure into the insurer’s coverage position.

A March 18, 2009 AmLaw Daily post regarding the coverage lawsuit can be found here. Hat tip to the Courthouse News Service (here) for a copy of the Original Petition.

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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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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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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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