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

The criminal trial in which Jerry Sandusky, the former defensive coordinator of Penn State’s football team, stands accused of sexually abusing at least 10 boys over a 15-year period began Tuesday, June 4, 2012, in Bellefonte, Pa. Sandusky has been charged with forty criminal counts. Sandusky has also separately named as a defendant in a civil action in which one of the alleged victims seeks damages.

Sandusky, who denies the allegations in both the criminal and civil actions, has sought coverage for the claims against him under the management liability insurance policy issued to a non-profit group, The Second Mile, of which Sandusky had been an officer. Second Mile’s insurer filed an action in the Middle District of Pennsylvania seeking a judicial declaration that it is not obligated to provide Sandusky with coverage under its policy, which incorporated both D&O and EPL coverage. The insurer contends that Sandusky was not acting in an insured capacity when he committed the alleged wrongful acts. The insurer contends that certain policy exclusions preclude coverage under the Policy for the claims against Sandusky.

The insurer moved for judgment on the pleadings in the coverage action, arguing that even if the policy were interpreted to cover the losses stemming from the allegations against Sandusky, the policy would be void as against Pennsylvania public policy. The insurer argued that it should not be required to defend or indemnify against the damages arising out of the claims.

In an opinion issued June 4, 2012, the same day that Sandusky’s criminal trial began, Middle District of Pennsylvania Chief Judge Yvette Kane held that while Pennsylvania’s public policy would not permit enforcement of the Second Mile policy to the extent that it provides for indemnification to Sandusky for civil liability for damages arising from sexual molestation, in the absence of any findings or factual record, the Court must defer the question whether any obligation the insurer owes to Sandusky to provide a legal defense to the civil claims or criminal prosecution are void as against Pennsylvania public policy. A copy of Judge Kane’s June 4 opinion can be found here.

Judge Kane began her analysis with a confirmation that Pennsylvania public policy “prohibits the reimbursement of Sandusky for any damage award that he may ultimately be found to owe arising from the allegations that he molested and sexually abused children.” What is not clear, however, and “must not be prejudged” is whether the same public policy bars coverage for The Second Mile or any other principal of that organization.

Judge Kane also found that Pennsylvania has not “squarely addressed the remaining and most pressing issue before the Court; whether in light of the strong public policy against allowing a perpetrator to insure against the consequences of his own intention wrongdoing, “the insurer’s duty to provide Sandusky a defense to the civil and criminal proceedings “is likewise unenforceable as against public policy because of the nature of the conduct alleged.” On this issue, the Court ‘writes on a blank slate.”

After reviewing relevant case law and public policy considerations, Judge Kane concluded that “without the benefit of a factual record, it is not entirely clear that Pennsylvania’s public policy would prohibit enforcement of the insurance policy to the extent that it provides Sandusky with defense costs.” Accordingly, Judge Kane concluded that she must “defer issuance of a ruling on the public policy question as it relates to [the insurer’s] obligation to provide for Sandusky’s legal costs to defend the civil action and criminal prosecution.”

Discussion

The alleged wrongful acts of which Sandusky is accused are highly repugnant. At first  I didn’t even want to write about Judge Kane’s opinion in the insurance coverage action. However as offensive and shocking as the allegations against Sandusky are, they remain at this point only that – allegations.

It is very frequently the case that individuals insured under management liability policies are accused of misconduct that is exceptional or extraordinary. But until the allegations are established, they remain only unproven charges. If mere allegations alone were sufficient to vitiate defense cost protection, the accused individuals would regularly find themselves compelled to defend themselves without the benefit of insurance to fund their defense.

At least in recent times, management liability insurance is typically  structured to provide that conduct exclusions do not apply unless the underlying allegations have been proven. It seems to me that this operation of the insurance policy should not change merely because the basis on which the insurer seeks to disclaim coverage is public policy rather than an express policy exclusion.

It comes as no surprise that Pennsylvania’s public policy would prohibit insurance for damages caused by the type of egregious and reprehensible conduct of which Sandusky is accused. However, in the absence of any factual determination or record, it would not be appropriate for the public policy principles to prohibit him from obtaining insurance protection for his defense. Insured persons accused of wrongdoing and who maintain their innocence rightfully ought to be able to look to applicable insurance coverage to provide their defense. These principles should apply regardless of how repugnant the misconduct of which the insured is accused.

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The automatic stay in bankruptcy may be lifted to permit MF Global’s D&O and E&O insurers advance the defense expenses of individual defendants in the underlying litigation arising out of the company collapse, notwithstanding the objections of the failed company’s commodities customers, according to an April 10, 2011 ruling from Southern District of New York Bankruptcy Judge Martin Glenn. The court lifted the stay without reaching the question of whether or not the policies’ proceeds are property of the debtors’ estate. A copy of the court’s April 10 decision can be found here.

As detailed here, on October 31, 2011, MF Global filed for bankruptcy after concerns about the company’s investments in European sovereign debt set in motion a chain of events that led to the company’s collapse. Following the company’s collapse, numerous directors, officers and employees have been named as defendants in action brought by securities holders, commodities customers and others alleging a host of legal violations. In response to these lawsuits, the various defendants have submitted notices of claims under MF Global’s insurance policies. Among the many lawsuits were a number of securities class action lawsuits, which have now been consolidated. Refer here regarding the securities class action litigation.

According to the Court’s April 10 opinion, during the policy period May 31, 2011 to May 30, 2012, MF Global maintained a total of $220 million of D&O insurance and $150 million of E&O insurance. The primary insurers in this insurance program had sought relief from the stay in bankruptcy to permit the insurers to pay the defense costs of the insured individuals in the various underlying matters. During an April 2, 2012 hearing on the question of whether or not the stay should be lifted, the Court was advised that lawyers have submitted claims for reimbursement or advancement of defense expenses totaling $8.3 million.

The objectors to the motion for relief from the stay included certain commodity customers of MF Global’s broker-dealer operations. The commodity customers objected to the lifting of the stay, arguing that the use of the policy proceeds to pay the individuals’ defense expenses would diminish the funds available of funds to pay claims against the debtors. The customers further argued that payment of defense costs is premature while the issue of the ownership of the policy proceeds remains unresolved.

Notwithstanding the commodity customers’ objections, the Court granted the carriers’ motions to lift the stay, finding that the carriers’ had adequately shown “cause” to lift the stay. The Court found that because there is sufficient “cause” to grant relief from the stay, it was not necessary for the Court to determine whether the policies’ proceeds are property of the estate. In concluding that the carriers’ had sufficient shown “cause to lift the stay,” among other things, the Court concluded that the individual insureds’ needs for payment of their defense costs “far outweighs the Debtors’ hypothetical or speculative need for coverage,” and that lifting the stay “would not severely prejudice the Debtors’ estates,” while the “failure to do so would significantly injure the Individual Insureds.”

The Court considered it particularly important that the primary D&O policy had a provision giving priority to payments under the insuring provisions that protects the individuals (a so-called “Priority of Payments” provision). This provision, the Court said, provide that “coverage potentially afforded to the Individual Insureds for non-indemnifiable losses must be paid prior to any payments for matters implicating coverage potentially provided to the Debtors.” The Court rejected the objectors’ contention that these provisions run afoul of the Bankruptcy Code, noting that the Debtors’ interests in the policies are limited by their terms, including the Priority of Payments Provision. The provisions “cannot be excised” because doing so would “rewrite” the policies and “expand the Debtors’ rights under them.” The Court reached similar conclusions with respect to the E&O policy as well.

The Court further found that New York State Insurance Law Section 3420(a)(1) requires the insurers to abide by the policy provisions notwithstanding any provisions in the Bankruptcy Code. The Court also concluded that the commodity customers’ rights, if any, to the policy proceeds had not yet vested. Finally the Court concluded that the equities favored permitted the insurers to pay the defense costs, noting that while claimants can pursue their claims “without the constraints of the automatic stay,” yet they seek to enjoin the individual insureds, who are not debtors and who are not protected by the automatic stay, “from seeking coverage under valid, applicable insurance policies.”

In granting relief from the stay, the Court further imposed reporting requirements on the parties to monitor the expenditures, subject to “soft cap” of $30 million, which in turn is subject to further adjustment by agreement of the parties or further order of the Court. In a final footnote, the Court noted that the cap is intended as an aggregate limit for defense costs from the D&O and E&O policies combined. The Court observed that “as is common in such circumstances, the insurers usually agree on allocation of policy proceeds for the advancement of defense costs,” but that “nothing in this Opinion addresses the allocation issues.”

The Bankruptcy Court was of course correct in lifting the stay to permit the insurers to pay the individual insureds’ defense expenses. Failure to do so would not only have undermined the individual insureds’ ability to defend themselves in the underlying litigation, but it would have frustrated the very purpose of the insurance. Claimants often confuse the purpose of liability insurance and assume that it is there for their protection and benefit. But liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants.

To be sure, the payment of defense fees erodes the amounts available for any later settlements or judgments. That is a feature of this insurance, and is concern that affects all claims triggering this type of insurance. This concern is a particular troublesome in catastrophic claims like this one, but that has also been true in many other recent high profile claims involving failed companies, including, for example, the Lehman Brothers claims, where the stay was also lifted to permit defense expenses to be paid and where the huge defense expense rapidly depleted the available insurance and also made settlement of the underlying claims challenging.

Bloomberg's April 10, 2012 article regarding the ruling in the MF Global bankruptcy can be found here. Detailed background regarding the D&O insurance coverage issues in the Lehman Brothers’ bankruptcy, including the questions surrounding the advancement of defense expenses, can be found here.  A summary of the relevant issues affecting D&O insurance in the bankruptcy context can be found here.

'Sup Hillz?:  If you somehow managed to miss the Internet vibe about "Hillary's texts" then you need to check the April 10, 2012 Washington Post blog post here -- and also be sure to click through to the "Texts from Hillary"  site (here)  for a good laugh.

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Among the most contentious D&O claims issues are questions surrounding defense cost coverage, including in particular questions such as the allowable billable rates or the involvement of multiple firms.  In a detailed November 8, 2011 opinion, Eastern District of California Judge Lawrence O’Neill, applying California law, addressed the hornets’ nest of problems involved when these kinds of questions arise. Though the disputes involved in this case are in some ways very case-specific, the case nevertheless provides (if only by way of negative example) a good illustration of how these questions might be avoided, managed or minimized. A copy of Judge O’Neill’s opinion can be found here.

Background

Lance-Kashian & Company is the general partner of River Park Properties III (RPP III), which in turn was general partner of Park 41, a real estate partnership.  In late 2008, Lance-Kashian’s D&O policy was up for renewal. The company’s risk manager directed that RPP III’s name be removed from the policy as a named insured. The D&O insurance policy that was in force for 2009 did not include RPP III as a named insured.

In late 2009, Lance-Kashian, RPP III, and certain Lance Kashian principals were sued in a bankruptcy court adversary proceeding by the Park 41 limited partner. The company notified its D&O insurer of the claim and asked the insurer’s permission to use the Cozen O’Connor law firm as defense counsel. In late December 2009, the insurer acknowledged receipt of the claim, reserved its right to deny coverage under the policy, and consented to the Cozen O’Conner firm’s involvement in the defense, but only at specified maximum rates (partner: $350/hour; associates: $250; paralegals, $150/hour). In light of the fact that RPP III was a defendant but was not an insured under the policy, the carrier proposed to allocate the defense fees between covered and non-covered parties, allocating one-third to the covered parties and two-thirds to the non-covered RPP III. The carrier argued in support of this proposed allocation that the bulk of the claims in the underlying complaint related solely or primarily to RPP III.

The carrier’s initial letter was the first in lengthy series of communications between the carrier’s counsel and the company’s risk manager. Judge O’Neill’s opinion details these communications, largely conducted by email. The parties later disputed the extent to which the communications either expressly or by silence amounted to the company’s assent to the allocation and defense counsel arrangements that the carrier has proposed.

At least part of the email exchange confirmed the carrier’s approval in the association in the defense of the Walter Wilhelm firm at the same specified maximum rates. In a separate email, the risk manager notified the carrier of the involvement of another firm, the Allen Matkins firm, which, the risk manager advised “would probably be used as an expert witness versus defense counsel.”

The company’s risk manager later submitted to the carrier invoices from the various law firms for payment. The invoices in turn set off an exchange about the aggregate level of fees, the involvement of multiple counsel, and concerns about the role of the Allen Matkins firm.

In January 2011, the underlying adversary proceeding finally settled. In connection with the subsequent coverage litigation, the risk manager submitted a declaration stating that the total defense expenses incurred in the case were “at least $1,557,295,” of which $618,251 was paid to the Allen Matkins firm; $475,000 was paid to Cozen O’Connor; $124,777 was paid to the Walter & Wilhelm law firm; and $144,133 was paid directly to third party vendors. At that point, the carrier had paid approximately $70,000 in connection with the defense.

The carrier initiated a civil action seeking a judicial declaration that it was only obligated to pay one third of the attorneys’ fees to which it had consented (that is, the Cozen  O’Connor fees and the Walter  Wilhelm fees) and only at the specified maximum hourly rates. The company disputed that the carrier was entitled to any type of allocation of the defense expenses or that any portion of the defense fees were not covered. The company counterclaimed, asserting claims of breach of contract and of breach of the covenant of good faith and fair dealing. The company asserted several arguments in reliance on various parts of the California insurance code, which the company asserted governed in light of the carrier’s provision of the defense subject to a reservation of its rights. The parties filed cross-motions for summary judgment.

The November 8 Ruling

In his November 8 ruling, Judge O’Neill granted the carrier’s summary judgment motion “to the effect that [the carrier] reasonably set and allocated defense costs for counsel to which it had consented.” First, Judge O’Neill concluded that while the carrier had consented to the involvement in the defense of the Cozen O’Connor firm and the Walter Wilhelm firm at the specified hourly maximum rates, “the insureds point to no specific request accepted by [the carrier] for Allen Matkins’ retention.” 

Second, Judge O’Neill rejected the company’s argument that the carrier was obligated to reimburse all defense fees that were “reasonably related” to the insured persons’ defense. He concluded that the question was instead governed by the policy’s allocation provision, which specified that if a claim involved both covered and uncovered matters or parties, the insureds and the carrier would “use their best efforts to agree on a fair and proper allocation between insured and uninsured Loss.” The provision does go on to add: “However, [the carrier] shall not seek to allocate with respect to Claim Expenses and shall pay one hundred percent (100%) of Claim Expenses so long as a covered matter remains within the Claim.”

Judge O’Neill found that the record showed that the carrier “committed its best efforts to reach an allocation agreement, starting with the ROR letter and continuing with [its counsel’s] dogged efforts through numerous emails.” However, he added, “the same cannot be said for the insureds,” commenting further that “the inferences from the record are that the insureds devoted substantial efforts to attempt to settle the underlying action and decided to address allocation and insurance matter later.” There is, Judge O’Neill found “no evidence that the insureds used ‘best efforts’ to agree to an allocation.”

Judge O’Neill went on to reject the company’s argument that the final sentence of the allocation provision, allowing for a 100% defense cost allocation, obligated the carrier to pay 100% of defense costs. He found that the sentence obligated the insurer to pay only 100% of the defense costs of insured persons, but that the carrier has no obligation to pay the defense costs of persons who are not insured under the policy. Since the company and RPP III mounted a joint defense, the carrier is entitled to allocate the defense fees to remove the fees incurred on behalf of insured persons. Since the company “offered nothing meaningful” to “challenge” the carrier’s proposed allocation, and since “nothing in the record reveals that [the carrier’s] one-third allocation to the insureds was unreasonable or out of line with the insured’s potential liability,” he confirmed the carrier’s one-third allocation.

Judge O’Neill then turned to an unusual feature in the policy, which provided that the carrier’s determination as to reasonableness of claims expenses “shall be conclusive on the Insured.” He rejected the company’s argument that this provision is unconscionable, noting that “there is no conscience shocking that an insurer would seek to control defense and limit them to a reasonable range,” adding that the company was sophisticated and had the assistance of a full-time risk manager and broker, who bargained for the policy on the company’s behalf. He went on to note that “the insureds fail to demonstrate that [the carrier] was precluded legally to set the rates it would pay or that [the rates] were objectively unreasonable.”

Discussion

There are a number of lessons from this dispute, which I review below. There are also a number of noteworthy holdings that are worth highlighting before moving on the moral of the story.

First, it is interesting and important that Judge O’Neill rejected the company’s efforts to try to rely on the “reasonably related” standard and instead enforced the allocation provisions in the policy. The “reasonably related” standard harkens back to an earlier time and place when D&O policies did not have express allocation provisions. Judge O’Neill’s enforcement of the provision shows that the allocation provisions themselves control – although his interpretation of the 100% Defense Cost provision is also interesting, in effect holding that the 100% allocation does not operate to require the insurer to pay the defense costs of parties who are not insured under the policy. In effect, he held that the 100% defense cost allocation applied only when there are both covered and non-covered matters, but not when there are both covered and non-covered parties. (Those involved in counseling policyholders on policy placement will want to consider this distinction in thinking about the optimal wording for these kinds of provisions.)

Second, Judge O’Neill enforced the unusual (and frankly onerous) provision giving the insurer’s determination of reasonableness presumptive weight. It may have been that he felt that a sophisticated company with competent advice had to accept the contract it had negotiated. (Again, those involved in negotiating policy placements for policyholders will want to note and watch out for this type of unusual provision.) By accepting the carrier’s presumptive right on the reasonableness issue, Judge ONeill avoided getting into the issue of whether or not the carrier’s insistence on its maximum hourly rates was reasonable. Too bad, that is an issue that in my view could use some ventilation.

Third, and perhaps most significantly in terms of the dollars involved, Judge O’Neill held that the carrier had no obligation to pay (even according to the allocation) for the defense fees and expenses to which the carrier had not consented.

This last point leads to the moral of the story – which is the importance of communication with the insurer at the beginning, during the course of, and at the end of the claim. A significant number of the problems the company faced in the coverage dispute were due to the way the company communicated with the carrier. Indeed, Judge O’Neill emphasized, and even quoted twice from, the deposition testimony of the company’s CEO that during the claim and amongst all of the other business challenges the company was facing he considered the questions the insurer was raising to be a “distraction.” 

But the first of the lessons out of this coverage dispute comes from the deliberate move the company made at its insurance renewal to remove RPP III as an insured under its policy. This decision directly led to all of the allocation issues. The move clearly was not fully thought through because as soon as the claim came in naming both the company and RPP III, the company expected RPP III’s defense expense to be paid under the policy. This sequence shows the importance of thoughtfully addressing all potential coverage issues at the time of placement. Something as basic as who should be insured under the policy should be the subject of close consideration, and should be stress tested against likely claims scenarios. It isn’t just hindsight to say that even at the time of the renewal it was apparent that if there were to be a claim involving , say, Park 41, that both RPP III and the company would be named as defendants, and that both would require a defense. The company can bemoan the outcome of Judge O’Neill’s allocation analysis, but there wouldn’t have been an allocation in the first placed if RPP III had not been removed as a named insured under the policy.

The more generally applicable lesson is the importance of communicating fully and continuously with the carrier. The company here clearly understood that the carrier’s consent to defense expenses was required, yet failed to take the steps to obtain the carrier’s consent to the involvement in the defense of the Allen Matkins firm or of the third-party vendors who provided services in connection with the defense. This oversight was not a small matter since the fees of the Allen Matkins firm and the fees of the third party vendors together amount to almost half of all of the defense expenses that the company incurred. (It is probably worth noting that the company not only failed to keep the carrier informed but  misstated the role of the Allen Matkins firm as being related to expert testimony, while disclaiming the firm’s involvement in the defense.)

The company may well have viewed the carrier’s questions and concerns as a “distraction,” but in the end the company paid a price for disregarding the carrier’s concerns. It certainly did not help the company that Judge O’Neill could find “no evidence” that the company used its best efforts to try to negotiate an allocation. By the same token, it clearly hurt the company that it did not voice its objection to the carrier’s proposed maximum rates as well as to the allocation. In the end, Judge O’Neill’s conclusions that the allocation and rates were reasonable were eased by the fact that while the claim was pending the company evinced little objection to the carrier’s positions in the regard.

Of course it is always easier to say in hindsight what a company should have done. I do not mean to find fault within anyone. But I think it is clear that the better course is to keep the carrier fully informed; to confront and address issues as they come up, not after the fact; and to work out as many issues as possible at the time, rather than later. It may not always be possible to avoid disputes, but dealing with issues as they come up may reduce the number of issues in dispute. And it will certainly help to avoid any later suggestion that “best efforts” were not used to try to work the issues out.

Finally, the best way to avoid unwelcome coverage outcomes is to make sure as many issues as possible are addressed in advance, at the time of the policy placement. As this case show, critical issues like the identity of named insured and the presence of unusual provisions (like the presumption of reasonableness for the carrier in this policy) are best addressed at the time the coverage is placed, to avoid problems later. This lesson in turn underscores the importance of the involvement in the policy placement process of knowledgeable and experience professionals who understand the kinds of issues that may be involved if claims later arise.

Special thanks to Michael Goodstein of the Bailey Cavalieri firm for providing me with a copy of Judge O’Neill’s opinion. The Bailey Cavalieri firm represented the carrier in this case. I hasten to add that the views expressed in the post are exclusively my own and should not be imputed to any other person, living, dead or otherwise.

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Within the space of just a few days, two federal appellate courts – the Fifth and Sixth Circuits – issued separate opinions consider D&O insurers’ obligations to advance defense expenses. The Fifth Circuit entered its March 15, 2010 decision in the high-profile Stanford Financial insurance coverage dispute. The Sixth Circuit’s March 11, 2010 opinion was entered in an insurance coverage dispute involving Abercrombie & Fitch and a rather unusual set of circumstances surrounding the company’s D&O insurance policies. The Sixth Circuit’s opinion was also accompanied by a rather spirited dissent. Both decisions are interesting and provide illuminating perspective on D&O policy interpretation.

The Fifth Circuit’s Stanford Financial Decision

The March 15 Opinion

The Fifth Circuit’s March 15, 2010 opinion (here) arises out of the expedited appeal of Stanford Financial’s D&O insurers to the January 26, 2010 opinion of Southern District of Texas Judge David Hittner entering a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford) who face SEC and criminal actions in connection with the Stanford Financial scandal. My prior discussion of Judge Hittner’s ruling can be found here. 

Stanford Financial had $100 million D&O insurance. The primary policy contained a fraud exclusion which does not apply absent a "final adjudication" that the prohibited conduct had occurred. The policy also contains a "money laundering" exclusion, which the insurers contend precludes coverage. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."

In its March 15 opinion, the Fifth Circuit considered whose determination of the facts this exclusionary provision requires. The court emphasized that the provision does not specify that the insurer was to make this determination. The court commented that "while there is nothing remarkable about an insurer reserving the right to make a unilateral coverage decision, it is equally unremarkable to require an insurer to be explicit when doing so, rather than leaving the reader to ponder the word ‘it’."

The Fifth Circuit also considered the wording contrast between the fraud exclusion, which requires a "final adjudication," and the money laundering exclusions "in fact" wording, and observed that the difference between the two exclusions’ wordings boils down to the judicial proceeding in which the determination is to be made. The "final adjudication" provision, the Fifth Circuit reasoned, requires the determination to be made in the underlying proceeding, but the money laundering exclusion’s "in fact" determination wording requires a judicial determination but allows that determination to be made in a separate proceeding such as a coverage action.

The Fifth Circuit also held, in contrast to Judge Hittner’s ruling at the district court level, that the evidence relevant to this determination is not limited to the "eight corners" of the insurance policy and the underlying complaint; rather, the policy’s terms expressly contemplate the consideration of "extrinsic evidence" in the determination of policy coverage.

The Fifth Circuit remanded the case to the district court, with the added proviso that a judge not involved in the underlying criminal proceedings should consider the insurance coverage issues. The remanded case will be the "collateral vehicle" in which coverage is to be determined.

In the interim, until the determination, the insurers are obligated to advance defense costs until the merits are resolved. To that extent, the Fifth Circuit affirmed the district court’s preliminary injunction enjoining the insurers from withholding payment of defense expenses until the judicial determination.

However, the determination cannot be "final" until the underlying proceeding is resolved, because "a determination of the facts on remand unfavorable to the executives would have to be reconsidered should the executives be cleared of all charges."

Discussion

The money laundering exclusion in the Stanford Financial D&O insurance policy is an unusual provision not found in many D&O insurance policies, and the wording arguably also reflects an unusual and awkward formulation. As the Fifth Circuit said of its own work and of the policy, its construction "is a sensible construction of an awkwardly drafted instrument."

But the Fifth Circuit’s analysis represents more than just a detailed exposition of an awkwardly worded and atypical clause. Most D&O policies have conduct exclusions requiring "determinations" as a prerequisite to the exclusions’ application to a particular set of circumstances. The Fifth Circuit’s orderly analysis of the determination processes implied by various policy formulations will undoubtedly inform future judicial consideration of the "determination" language found in the more typical D&O policy exclusions.

In particular, the Fifth Circuit’s analysis implying a requirement of a judicial determination in the first instance, and precluding unilateral insurer determinations unless expressly provided for, will illuminate coverage analysis whenever these types of conduct exclusions are at issue.

And in the underlying cases, the individual defendants will have their defense expenses advanced, for now, on an interim basis, until there is a determination in the collateral coverage case, and subject to the outcome of the underlying proceedings. Depending on how all of these circumstances unfold, the coverage dispute could go on for a considerable time. For now at least the individuals will be able to fund their defenses.

The Sixth Circuit’s Abercrombie Opinion

The March 11 Decision

In its March 11, 2010 opinion in the Abercrombie & Fitch coverage action, the Sixth Circuit affirmed the district court’s determination that Abercrombie’s D&O insurer must advance defense expense incurred in connection with the underlying claim. The Sixth Circuit’s opinion can be found here.

The coverage dispute arose out of an unusual sequence of events. Abercrombie had been insured by a $10 million D&O insurance policy that expired on September 1, 2005 (hereafter, the predecessor policy). On September 2, 2005, Abercrombie and certain of its directors and officers were sued in a securities class action lawsuit. Subsequently derivative suits were also filed and an SEC investigation ensued. On September 30, 2005, Abercrombie exercised its right under the predecessor policy to purchase one-year extended reporting period coverage.

Abercrombie also purchased a successor D&O insurance policy with a different insurer with a policy period incepting on September 1, 2005. The successor policy was amended to specify that the successor policy is expressly excess to the predecessor policy for any claims made regarding acts occurring prior to September 1, 2005. The parties to the coverage dispute agree that if the successor policy lacked this excess provision, the predecessor and successor policies would both be primary and would pay loss for the claim (including defense expense) on a pro rata basis.

The predecessor insurer contended that in this deal shifting the burden to provide primary coverage exclusively to the predecessor insurer, Abercrombie violated the policy’s cooperation clause, which specifies that "in the event of a claim," the policyholder "will do nothing that will prejudice [the insurer’s] position or its potential or actual rights of recovery."

The Sixth Circuit rejected the predecessor insurer’s argument, holding that the "purpose" of the cooperation clause, including its "no prejudice" provision, was to "enumerate the parties’ respective rights and obligations when a claim was made against an insured," but it "does not address the parties’ rights and obligations when a policy has elapsed, a claim has been made against a (formerly) insured, and the insured is deciding whether to elect – and how to structure – extended insurance coverage."

The Sixth Circuit added that "there is nothing about" the cooperation clause that "prevents Abercrombie from making fiscally driven business decisions, even if such a decision is unanticipated by an existing or past insurer." The Sixth Circuit also adopted the district court’s statement that it is an "unreasonable interpretation" of the cooperation clause "to find that it requires Abercrombie to structure its insurance needs based not on its own needs and its own best interests, but rather to minimize the insurers’ potential exposure."

Judge Kethledge’s Dissent

Circuit Judge Raymond Kethledge dissented. He emphaszied that the successor policy incepted on September 1 and as originally written was primary, and in fact, Abercrombie first reported the September 2 claim to the successor insurer. Then on September 29, Abercrombie elected discovery coverage, which Judge Kethledge noted "seemed a strange thing to do," since the $820,000 extended reporting period coverage was seemingly duplicative of the coverage in place under the successor policy.

Abercrombie was, Judge Kethledge wrote, "behind the scenes" negotiating with the successor insurer, for the successor insurance to be excess to the predecessor insurer’s coverage. It was not until November 22, 2005 that the successor policy was endorsed to make the successor policy expressly excess.

The effect of these changes, Judge Kethledge noted, was "retroactively to foist" on the predecessor insurer "the entire burden of coverage for the claim up to the $10 million policy limit." The reason Abercrombie did that, and was willing to pay the $820,000 premium for the extended reporting period coverage, was that in exchange the successor insurer waived its $2 million retention for the securities claims and promised not to increase Abercrombie’s premium for the following renewal.

Judge Kethledge viewed these events as having "prejudiced" the predecessor insurer in violation of the "no prejudice" provision in the cooperation clause, because it extinguished the predecessor insurer’s right to collect half of the claims costs from the successor insurer. Judge Rutledge noted that the "very purpose" of Abercrombie’s post claim action was to "increase [the predecessor’s] liability by $5 million and to extinguish its contribution claim for that amount." Judge Rutledge found the no prejudice clause’s requirement that the policyholder "do nothing" to prejudice that predecessor to be unambiguous and to clearly govern these circumstances.

Discussion

What makes this situation so awkward is that Abercrombie’s negotiations with the successor insurer took place after the claim arrived. The opinion is not sufficiently clear on this point, but it seems as if at the time of the September 1, 2005 renewal the successor insurer competed to move onto the account and then got smacked by a claim airmailed in the second day it was on the policy.

It isn’t clear who initiated the negotiations, but the successor insurer was bargaining to reduce its exposure to the walk in claim. Reading between the lines, the predecessor insurer’s gripe is not with Abercrombie but with the successor insurer, for (as Judge Kethledge put it) "foisting" the claim on the predecessor insurer.

The deal Abercrombie and the successor insurer struck clearly benefited both of them – the successor insurer reduced its claim expense (for a claim that was clearly made during its policy period), and Abercrombie was able to obtain valuable concessions.

I can certainly see why the predecessor insurer objected under these circumstances. The question is whether as a matter of contractual rights and duties (as opposed to more basic notions of fair play) the detrimental impact of the successor insurer’s deal with Abercrombie represents the kind of "prejudice" that violates the provisions of the cooperation clause.

On the one hand, as a result of the deal, the predecessor insurer was obligated to do nothing more than it was otherwise obligated to do under the extended reporting period coverage, which all agree that Abercrombie was entitled to purchase, even if it did so after the claim came in.

On the other hand, the predecessor insurer’s rights and obligations under its policy also include the right to proceed against alternative sources of recovery. Abercrombie’s entry into the deal with the successor insurer compromised the predecessor insurer’s rights and it did so after the claim had come in. You can certainly see the predecessor insurer’s argument that this violated the requirement that the policy "do nothing" after a claim to prejudice the predecessor insurer’s right of recovery.

The majority found that there is nothing in the policy to prevent Abercrombie from structuring its insurance according to its own interests. There is certainly nothing here to suggest that Abercrombie did anything to prejudice the underlying claim. Moreover, there is nothing about the "no prejudice" provision that requires a policyholder to subordinate its interests to those of the insurer, and that consideration seems particularly relevant after a policy’s expiration.

In the end we may all nod sympathetically in response to the plight of the predecessor insurer here. Our sympathetic nods, however, reflect the sentiment expressed in the words of Judge Keithridge’s dissent: "What is legal is sometimes different than what is right."

And Finally: "Cigarettes are very like weasels – perfectly harmless unless you put one in your mouth and try to set fire to it." Boothby Graffoe.

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The individual defendants in the various Stanford Financial-related SEC enforcement and criminal proceedings have been engaged in a long-running and procedurally complicated battle over whether the firm’s D&O insurers must advance the individuals defense expenses. In a sweeping January 26, 2010 opinion (here), Southern District of Texas Judge David Hittner rejected the grounds on which the insurers sought to avoid coverage and ruled that the insurers must advance the individuals’ defense costs.

Background and the January 26 Opinion

The defense fee dispute has a complex procedural history but for purposes of the January 26 opinion the critical fact is that on November 16, 2009, the insurers sent the individuals letters "retroactively declining to extend coverage for costs." The insurers contended that coverage was precluded by the Policy’s "money laundering" exclusion. The exclusion precludes coverage for loss "arising directly or indirectly as a result of or in connection with any act or acts (or alleged act or acts) of Money Laundering," as that term is defined in the policy.

In his opinion, Judge Hittner noted that the carrier’s were not seeking to avoid coverage based on the exclusion precluding coverage for fraud or criminal misconduct, because that exclusion has a requirement of an "adjudication" that the precluded conduct had occurred. The money laundering exclusion has no "adjudication" requirement, leaving, the insurers’ argued, the determination that money laundering has in fact occurred, to the insurers.

Judge Hittner also noted parenthetically that the insurers urged this position even though only one of the twenty-one counts in the criminal action alleges money laundering or conspiracy to commit money laundering. (The insurers argued that the policy’s definition of money laundering was broad enough to encompass all of the allegations.)

The plaintiffs first opposed the insurers’ position based on the "eight corners" rule, arguing under Texas law that in determining an insurer’s defense obligations, a court may not consider anything beyond the four corners of the policy and the four corners of the complaint. Judge Hittner found that despite the insurers’ arguments to the contrary, the Supreme Court of Texas "never has recognized an exception to the eight corners rule."

Judge Hittner was in any event strongly against a broader view of what a court properly might consider in determining the insurers’ obligations.

If a contemporaneous duty to advance or reimburse defense costs were judge on an "actual facts" basis, an insurer’s contractual obligation to pay defense costs could change on a daily basis as additional "facts" are developed. Essentially, coverage that directors and officers relied upon and expected when the Policies were purchased on their behalf could be withdrawn at the insurer’s whim. If, as Underwriters suggest, the Policies afford Underwriters absolute discretion to withhold payments whenever charges of intentional dishonesty are leveled against directors and officers, then insurers will be able to withhold payment in virtually every case at their discretion. That would leave directors and officers in an extremely vulnerable postion , as any allegation of dishonesty, not matter how groundless, could bring financial ruin on a director or officer. Essentially an insurer could act as judge and jury and convict its own insureds, thus avoiding any further financial responsibility for the insureds’ defense. This simply cannot be the case. (Citations omitted.)

The court found in applying the eight corners rule that the allegations were insufficient to establish that the precluded conduct had occurred. The insurers nevertheless sought to argue that the individuals refusal to testify in support of the application for a preliminary injunction is proof enough that the allegations against the individuals are true. The insurers sought to argue that the refusal to testify supported an inference that money laundering did in fact occur.

Judge Hittner held that the "given the magnitude, complexity and nature of the charges," he declined to draw the inference, and that in any event, because of the eight corners rule, the insurers’ reliance on the supposed inference from the individuals refusal to testify is "misplaced."

Judge Hittner, applying the standard required for a preliminary injunction motions ruled that though the money laundering exclusion does not require a judicial determination to apply, the exclusion’s requirements "also may mean much more than an insurer’s own determination." He said that he need not decide what level of factual determination must be made, and instead ruled only that plaintiffs have a substantial likelihood of succeeding on the merits at trial, satisfying the standard for awarding preliminary injunctive relief.

The court, in further consideration of the preliminary injunction standard, noted that the plaintiffs would suffer "irreparable harm" if the relief they sought was withheld. He noted that it is "unmistakable and cannot be seriously disputed" that the harm the individuals will suffer is "real, immediate and irreparable." He rejected the insurers contrary position that, he said, would "essentially require [the individuals] to prove their innocence." Judge Hittner commented that
 

Underwriters’ position is absurd because these circumstances are precisely why corporations procure D&O insurance on behalf of their directors and officers. Indeed, it would contravene the very purpose of the Policies – as well as the policy language itself – to require Plaintiffs to prove their innocence before being entitled to funds for their defense.

Judge Hittner found the harm to the insurers from granting the preliminary injunction was relatively slight and that public interest also weighed in favor of granting the preliminary injunction. He finally held that the individuals did not have to post a bond.

Discussion

Given the nature of the allegations against the individuals and the notoriety of the circumstances, as well as the number of people who lost money as a result of the collapse of Stanford Financial, the tone and temperature of Judge Hittner’s words are a little surprising. If nothing else is clear, Judge Hittner was certain that individuals needed to be able to defend themselves, and the insurers were obliged to provide the defense. The depth of Judge Hittner’s discussion of these defense cost issues are such that his words may prove useful for other individuals who are seeking to have their defense expenses paid under their policies.

You do get the sense that Judge Hittner ducked the hard issue – that is, if the money laundering exclusion, unlike the fraud exclusion, doesn’t have an "adjudication" requirement, then an adjudication can’t be required, so what is sufficient? Given Judge Hittner’s certainty that the eight corner rule is absolute under Texas law, there might be no way to meet the requirement. It does make you wonder whether it matters from a practical perspective whether or not there is an "adjudication" requirement.

Even though the usefulness of Judge Hittner’s determinations for others seeking insurance coverage arguably might be limited to those jurisdictions that also absolutely enforce the eight corners rule, the breadth of his pronouncements about the limitations on insurers’ ability to make preclusive coverage determinations virtually guarantees that his phrases will appear in the legal briefs of other individuals who are seeking defense cost coverage. His unwillingness to allow the individuals’ refusal to testify on their own behalf in the preliminary injunction proceeding may also prove helpful to other policyholders.

Because of the tone of Judge Hittner’s rhetoric and the high profile nature of the case, I suspect there may be some strong views about this decision. I invite readers who have thoughts about this decision to add their views to this post using the blog’s comments feature.

A January 26, 2010 Bloomberg article about Judge Hittner’s ruling can be found here.

Special thanks to Bill Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of the decision.

Vivendi Watch: The Vivendi securities class action case went to the jury on January 11, 2010, but still no verdict. The parties are anxiously awaiting the verdict and in the meantime debating what the length of the jury deliberations may mean, according to a January 26, 2010 article by Andrew Longstreth on AmLaw Litigation Daily (here). The article also reports that almost regardless of the verdict, there will likely be an appeal, if for no reason that because of the potential jurisdictional implications of the National Australia Bank case now pending before the Supreme Court. Stay tuned (to the second power, apparently).

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Seventh Circuit Weighs In on State Court ’33 Act Jurisdiction and Removal: A January 5, 2009 Seventh Circuit decision in the Katz v. Gerardi case (here) may make it more difficult for plaintiffs to pursue ’33 Act litigation in state court, at least in the Seventh Circuit -- and possibly elsewhere, too.

As I detailed in a recent post (here), plaintiffs’ lawyers have proven keenly interested in pursing subprime and credit crisis-related litigation in state court, apparently for forum shopping type reasons. Defendants generally have sought to remove these cases to federal court, relying, among other things on the Class Action Fairness Act of 2005 (CAFA) and the Securities Litigation Uniform Standards Act of 1998 (SLUSA).

However, this past summer, the Ninth Circuit held in the Luther v. Countrywide case that the nonremoval provision in Section 22 of the ’33 Act (which provides concurrent state and federal court jurisdiction for ’33 Act cases) effectively trumps the more recently enacted SLUSA and CAFA because it more specifically relates to securities lawsuits. My discussion of the Luther v. Countrywide case can be found here.

An October decision in the Second Circuit in the New Jersey Carpenters’ Fund v. Harborview Mortgage case had refused to remand to state court a ’33 Act case, as is more fully discussed on the 10b-5 Daily blog (here). The Harborview decision was primarily based on the fact that the underlying securities lawsuit did not involve "covered securities" for which SLUSA created an explicit removal exception; because the exception did not apply, the case could appropriately be removed to federal court notwithstanding the nonremoval provision in Section 22.

In the recent Seventh Circuit opinion, Judge Frank Easterbrook wrote that the provisions of the more recently enacted statutes, particularly CAFA, trump Section 22. Judge Easterbrook expressly rejected Luther v. Countrywide’s conclusion that the more specific securities statute prevailed. However, Judge Easterbrook’s opinion, like the Second Circuit opinion in Harborview, also depended in part on the fact that the investment instruments involved are not "covered securities" (i.e., do not trade on a national exchange), and therefore did not come within one of CAFA’s removal exceptions.

In addition, Judge Easterbrook’s opinion does seem to have been influenced significantly by the fact that the plaintiff in the case was really a seller of the investments involved, rather than a buyer, and therefore lacked a legal basis to assert a ’33 Act claim. Although the opinion nevertheless examined the removal/jurisdictional issues as if the plaintiff had a legal right to assert the claim, the opinion’s starting point arguably influenced the outcome of its analysis.

In any event, the Seventh Circuit’s recent opinion, together with the Second Circuit’s Harborview opinion, clearly could create substantial jurisdictional hurdles (at least outside the Ninth Circuit) for the numerous plaintiffs now seeking to pursue ’33 Act claims in state court. Many (if not all) of the various subprime and credit crisis-related cases filed in state court related to investment instruments that are not traded on national exchanges and therefore are not "covered securities." Accordingly, contrary to the title of one of my prior posts, Section 11 cases may not be "coming soon to a state court near you" after all.

A January 12, 2009 Law.com article discussing the Seventh Circuit opinion can be found here.

Collins & Aikman Defendants Criminal Charges Dropped: On January 9, 2009, prosecutors dropped securities fraud and other criminal charges against former Collins & Aikman CEO David Stockman and three others. As reported in the January 10, 2009 Wall Street Journal (here), the U.S. Attorney’s office said further prosecution "wouldn’t be in the ‘interests of justice’ following a renewed assessment of the case."

While the individuals involved undoubtedly are relieved to have the prosecutorial threat removed, the government’s action comes only after the now-defunct company’s directors and officers insurance was entirely exhausted by defense fees, as I discussed at length in a prior post (here). Unfortunately for these individuals, they continue to face SEC enforcement proceedings as well as civil litigation (about which refer here), now without any further insurance available to fund their defense in these proceedings, not to mention any settlements or judgments that may follow.

A criminal prosecution has such an enormous potential to cause harm. On the one hand, it is commendable that the government was willing to reassess the case and to drop it before any further harm was done. On the other hand, even though the prosecution is over, it has done material damage to the individuals who were unfortunate to be subject to a prosecution that lacked an adequate basis. It is extremely regrettable when the government uses its enormous power when it is unwarranted. In this instance the government can drop the case and walk away without so much as an apology, but the unfortunate consequences of an unjustified prosecution continue for the individuals involved.

University of Denver law professor Jay Brown has extensively covered the Collins & Aikman criminal prosecution on the Race to the Bottom blog (here), including in particular his discussion (here) of how the criminal prosecution exhausted the company’s D&O insurance. The SEC Actions blog has a good summary description (here) of the criminal case and raises the question whether the SEC will proceed with the civil enforcement proceeding in light of the discontinuance of the criminal case. All of the key pleadings in the criminal case can be found on the University of Denver Law School’s corporate governance website, here.

2008 Delaware Case Law in Review: Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog has released the2008 installment of his annual review of key Delaware opinions. Pileggi’s report, which is must reading for anyone who wants an overview of important legal developments in Delaware’s court’s during 2008, is entitled "Selected Key Corporate and Commercial Delaware Decisions in 2008" and can be accessed here.

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For many companies, one of the most challenging parts of the Directors and Officers (D&O) insurance procurement process is determining how much insurance to purchase. Against a backdrop of basic affordability, the company must consider complex issues such as limits adequacy – that is, how much insurance is enough?

Determining limits adequacy is even more challenging in light of today’s escalating claims severity. Recent developments underscore the fact that in addition to rising settlement levels, growing defense expense is an increasingly important part of the limits adequacy analysis.

In the September 2008 issue of InSights (here), I review recent D&O claims defense expense developments and consider their ramifications for purposes of both limits selection and insurance program structure. The article concludes with a brief review of claims management implications arising from these defense expense issues.

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The 2007 settlement of an Ontario securities class action may suggest the eventual direction of many of the lawsuits in the current subprime and credit crisis-related litigation wave. Even though the lawsuit was filed in a Canadian court and involved a company (FMF Capital Group Ltd.) whose shares traded only on a Canadian exchange, the lawsuit did arise from the early stages of the subprime mortgage meltdown in the U.S. And although the lawsuit preceded the current litigation wave, many of the allegations raised in the lawsuit have also arisen in the more recent U.S. subprime lawsuits.

Through an affiliate, FMF offered residential mortgages to subprime borrowers. According to the company (here), FMF originated mortgage loans throughout in 39 of the 50 United States and the District of Columbia. FMF resold packages of these mortgages to institutional buyers.

As summarized in a recent memorandum (here) written by NERA Economic Consulting, which served as the Ontario court’s damages expert and settlement consultant, in March 2005, FMF conducted a $197.5 million IPO. Following the offering, the securities issued in the IPO traded on the Toronto Stock Exchange. According to later news reports (here and here), the company apparently sought the Canadian listing as a way to obtain favorable treatment as a Canadian income trust.

In November 2005, just eight months after its IPO, FMF announced that it was suspending the monthly distributions due to investors in connection with its publicly traded securities. Within two trading days of the announcement, the company’s securities had declined 76.8% from their preannouncement price.

In January 2006, plaintiffs initiated a securities class action in the Ontario Superior Court of Justice against FMF and certain of its directors and officers, the offering underwriters, and FMF’s auditors. Background regarding the lawsuit can be found here.

As described in NERA’s memorandum, the plaintiffs alleged that the company "dismantled" its underwriting standards in order to maintain growth in its loan originations, and that the defendants concealed the company’s degraded underwriting standards and poor loan quality. FMF contended that its woes were due to industry-wide factors including interest rates and increased defaults, which undermined its ability to conduct securitizations and finance distributions.

According to co-counsel for the class (here), the class action ultimately was settled for over CAN$28 million. US$21 million of the settlement was funded by FMF’s insurers and by FMF’s privately-held affiliate. The remaining CAN$4.55 million of the settlement was to be paid by the IPO offering underwriters and FMF’s auditors.

According to NERA, the settlement, which the Court approved on April 11, 2007, is "the largest settlement in a class action securities case in Canadian history."

In addition to its status as the largest Canadian securities settlement ever, the settlement may be significant in a number of other respects as well, due to the circumstances surrounding the lawsuit.

That is, even though the lawsuit was filed in a Canadian court and involved a Canadian listed company, the lawsuit arose out of the meltdown in the U.S. subprime mortgage market. The claimants’ allegations about the lender’s deteriorating loan underwriting standards and poor loan quality, and the alleged failure to disclose these factors, are substantially similar to the allegations raised in class actions now pending in U.S courts against numerous other mortgage lenders. The company’s attempt to blame macroeconomic factors for its demise also mirrors the response of many defendants in the U.S subprime lawsuits.

Indeed, given these similarities, NERA described the FMF case as "the proverbial ‘canary in the coal mine’ for the current credit crisis." The similarities between the FMF case and many of the cases in the current subprime litigation wave suggest that the outcome of the FMF case could be a harbinger of things to come in the current subprime cases.

None of the securities lawsuits that have been filed in the current litigation wave have yet been settled, which makes the FMF lawsuit and its settlement at least potentially significant, for what it might indicate about the outcomes of the lawsuits in the current wave.

By my analysis at least, the FMF litigation settled for a fairly significant percentage of the company’s market capitalization loss. The company’s IPO raised $197.5 million at $10/share. The company’s share price declined by $5.21/share in the two days following the company’s announcement that it was terminating the income distributions. There undoubtedly are a number of ways the investors’ losses might be quantified, but by any measure, the eventual settlement of more than CAN$28 million appears to represent a significant percentage of alleged investor loss.

Because of the FMF lawsuit’s Canadian connection, litigants in the current U.S.-based subprime related litigation wave may or may not consider the case a relevant reference point. But to the extent it is relevant, the magnitude of the settlement as an apparent percentage of investor loss may point toward some very large settlements in the current U.S. subprime lawsuits, where the dollars involved are in many instances significantly greater than in the FMF case. Whether or not the FMF case does have significance for the eventual outcome of the current U.S cases, it is nonetheless interesting because the case has settled and been concluded while most of the recent U.S. cases are only in their earliest stages.

A prior post in which I discussed subprime related securities litigation in Canada, including a brief mention of the FMF lawsuit, can be found here.

More About Defense Expense and Limits Adequacy: In a prior post (here), I discussed the limits adequacy and program structure implications arising from the threatened depletion -- solely as a result of accumulating defense expense -- of the Collins & Aikman D&O Insurance program. As noted on the Race to the Bottom blog (here), counsel for one of the individual defendants has now advised the court that the remaining limits in the company’s $50 million D&O insurance program have been completely exhausted.

In his blog post, Professor Jay Brown of the University of Denver Law School, spells out what the depletion of the policy’s limits means for one of the minor defendants. The individual, Paul Barnaba, has now petitioned the court for the appointment of a legal aid attorney. Fortunately for Barnaba, it appears that his own counsel, whose fees previously had been paid by the now depleted insurance, is willing to accept the derisory legal aid fee rate. The other defendants may not be so fortunate.

The complete exhaustion of $50 million of D&O insurance solely through the accumulation of defense expense is a nightmare scenario for any director or officer. The individual defendants in the Collins & Aikman case, or at least those that are not independently wealthy, must now face serious criminal charges in a complex financial with only legal aid counsel to protect them. In addition, they continue to face significant civil litigation as well, again without any insurance remaining to fund a settlement.

As I noted in my prior post about the Collins & Aikman case, these developments may have important implications for traditional notions of limits adequacy. In addition, it is also clear that in order to make sure that individuals are not left to face serious litigation or even criminal charges without insurance, the consideration of alternative insurance structures should be an important part of every D&O insurance transaction.

They Stab it With Their Steely Knives, But They Just Can’t Kill the Beast:  The D.C. Circuit  rejected an attack on the constitutionality of SOX (here). OK, now everybody get back to work.

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On June 26, 2008, Judge Gerard Lynch of the Southern District of New York issued another opinion (here) in the D&O insurance coverage litigation arising out of the Refco debacle (My recent post discussing Judge Lynch’s prior opinion in the case discussing insurance application issues can be found here.)

In yet another judicial decision that resonates with significance for excess D&O insurance issues, Judge Lynch, hearing an appeal from a bankruptcy court ruling, addressed the question whether an excess insurer may withhold advancement of defense costs based on its determination that an exclusion in its policy precluded coverage. Judge Lynch held that even if the excess policy has the distinct exclusions, the policy's terms do not  affect the operation of the applicable defense cost advancement provisions, and the advancement provisions should be enforced according to their terms.

The background of the case can be found in my prior post. Of significance here, the primary insurer’s $10 million limit and the first level excess insurer’s $7.5 million were exhausted in payment of defense expense. As also discussed in the prior post, the second level excess insurer disputes coverage on a number of grounds. The second level excess insurer also disputes that it has any obligation to advance defense costs pending a determination of coverage.

The parties agree that the advancement provisions in the primary policy control the advancement issue; they dispute how the provisions apply in the context of the second level excess carrier’s policy.

The primary policy specifies that:

The Insurer will pay covered Defense Costs on an as-incurred basis. If it is finally determined that any Defense Costs paid by the Insurer are not covered under this Policy, the Insureds agree to repay such non-covered Defense Costs to the Insurer.

The second level excess insurer [hereafter in this post, simply “the insurer”] contended that notwithstanding this language, it has no obligation to advance defense costs. In making this argument, the insurer relied on the word “covered” in the first sentence of the advancement provision, qualifying the type of defense costs that the provision requires to be paid on an as-incurred basis.

The insurer’s argument is based on its contention that its policy’s conduct exclusions, unlike the primary and first level excess policies’ exclusions, do not have an adjudication requirement. The insurer argued, according to the court, that because the conduct exclusions in its policy have no adjudication requirement, “prior to a court determination, [the insurer] has the unilateral right to determine whether defense costs are ‘covered,’” and that it has made a “good faith determination” that the insureds’ claims are precluded under its policy.

As the court paraphrased the insurer’s position, the insurer contended that the terms of its contract “authorize it to apply its exclusions to deny coverage unilaterally – and thus to refuse to advance defense costs – unless and until a court determines that the costs are ‘covered’” under its policy.

The insureds contend in their counterclaim in the coverage litigation that the exclusions on which the insurer relies to deny coverage “are not, in fact, part of the policy.” With respect to the advancement issue, the insureds argued that the advancement provisions require the insurer to advance defense expense, contending that as long as the claim “falls within the policy’s insuring agreement, it is covered unless and until there is a final determination that an exclusion applies.”

The insureds also argued that nowhere in the insurer’s policy does it state that the insurer can unilaterally withhold defense expense absent a court determination, and nothing in the insurer’s policy states that its exclusions are not subject to the “final determination” language in the second sentence of the advancement provisions.

In his June 26 opinion, Judge Lynch observed that “in essence, the central dispute among the parties centers on who bears the burden regarding whether defense costs are ultimately covered.” Judge Lynch, while noting that the insurer’s position regarding advancement “is not unreasonable on its face,” also noted that the insurer’s interpretation “places enormous emphasis on the word ‘covered.’” Judge Lynch said that the word’s inclusion in the advancement provisions “can hardly be said to make an unambiguous change in the provision’s literal meaning,” and “seems, at best, an unusual way to effectuate a fundamental change in the parties’ expectations.”

Because the court found the wordings to be ambiguous, it interpreted the provision in favor of the insureds – a result that the court noted “makes eminent sense, as adopting [the insurer’s] interpretation … would effectively render the advancement obligation worthless.” Judge Lynch concluded by saying that if the insurer “wants the unilateral right to refuse a payment called for in the policy, the policy should clearly state that right.” (citations omitted)

Whatever else might be said about the court’s opinion, it is certainly a sharp reminder of the importance of inclusion of adjudication requirements in the D&O policy’s conduct exclusions. If, in the absence of an adjudication requirement, the insurer may contend (as did the insurer in the Refco coverage litigation) that it has the unilateral right to determine coverage and withhold policy benefits, then the omission of adjudication requirements is perilous indeed for insureds.

But the crux of the dispute is whether the second level excess insurer’s policy contains exclusions not found in the primary or first level excess policies. The insureds apparently dispute that the exclusions are part of the second level excess policy (although the precise nature of that dispute is not clear from the face of the opinion). Assuming that the distinct exclusions are in fact part of the second level excess insurer’s policy, it does suggest that the insurance program is something less than pure “follow form” insurance. Indeed, many insurance programs that are characterized as “follow form” in fact have characteristics that may make them something less than follow form, a consideration that may sometimes be overlooked in the insurance transaction process.

It is of course true that each policy in a tower of insurance represents a separate contract. Excess insurers have every right to insist on terms differing from the underlying layers. The Refco coverage dispute highlights the pitfalls that can arise when (or perhaps if) an excess policy has terms that differ from the underlying policies. Indeed, the arguments raised by the second level excess insurer in the Refco coverage litigation show that differences in wording between the layers potentially can cause the different layers to operate quite differently, potentially in ways that may not necessarily be apparent or anticipated.

One final note has to do with the parties’ apparent dispute whether the exclusions are in fact part of the second level excess policy. It is hard to tell from the face of the opinion, but this dispute may be due to the process issues discussed briefly in my prior post. At least until the merits are sorted out, it may be premature to try to draw any conclusions. But as I noted in my prior post, and to the extent the dispute is due to process issues, this case may be a reminder of the opportunities for and the dangers of ambiguities in insurance placement process communications. From the perspective of every process participant, after a serious claim has arisen is a very difficult time to have to try to sort out, for example, whether or not exclusions are part of a policy.

Special thanks to Kelly Reyher for providing me with a copy of Judge Lynch's June 26 opinion.

And Finally: For those of us laboring in the salt mines of the blogosphere, it is always exciting when a fellow blogger steps out in some dramatic way. And so I was delighted to see in the July 16, 2008 Wall Street Journal that Mark Herrmann of the Drug and Device Law Blog published a book review critically analyzing the recent book "Side Effects" by Alison Bass. Kudos to Mark for his excellent and well written review.

May all new media practitioners continue to prosper and succeed. Gradus ad Parnassus.

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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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