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

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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In what is, according to news reports (here), the largest settlement to date in a shareholders’ derivative lawsuit in Delaware Chancery Court, four former AIG executives and former AIG managing general agent C.V. Starr today reached a $115 million settlement in the 2002 AIG derivative lawsuit.

 

The lawsuit was filed by the Teachers’ Retirement System of Louisiana in 2002 against AIG, as nominal defendant; certain former AIG directors and officers (many of whom were later dropped from the case); and Starr.

 

According to news reports (here), the plaintiff alleged that half of the $2 billion AIG paid C.V. Starr between 2000 and 2005 "represented sham commissions for work that, in some cases, was done by AIG employees." The lawsuit also questioned "why some executives were allowed to serve simultaneously as officers of C.V. Starr, a closely held insurance agency, while profiting from business between the two companies." The complaint also alleged that Starr gave the individual defendants bonuses on fees from AIG. In effect the complaint alleged that the commissions were a mechanism for the defendants to "line their pockets."

 

The case was scheduled to go to trial on September 15, 2008. The four settling individual defendants include former AIG Chairman and CEO Maurice Greenberg; former AIG CFO Howard Smith; former Vice Chairman of Investments Edward Matthews; and former director and Vice Chairman of Insurance Thomas Tizzio.

 

The vast bulk of the settlement -- $85.5 million – is to be paid by AIG’s D&O insurance carriers. A list of the carriers on AIG’s D&O program can be found here.

 

The more interesting question is where the remaining $29.5 million will come from. Some of the news reports give the impression that the individuals are funding the settlement. However, it appears that the individuals themselves are funding only a small portion of the remaining $29.5 million.

 

Greenberg’s counsel’s statements to the press (for example, here) are quite emphatic that Greenberg himself will not be contributing anything the settlement. One news report (here) does suggest that Tizzio "is expected to pay between $1 million and $5 million," Smith and Matthews "would pay very small amounts, if anything."

 

It appears that the bulk of the $29.5 million will be paid by C.V. Starr. According to Greenberg’s counsel, Starr "expects to contribute between $20 million and $30 million."

 

The details about who will be paying what seem surprisingly imprecise. In particular, the wide potential variance in Tizzio’s contributions seem odd to me, as even a wealthy individual generally would require a more precise determination of how many millions of his dollars are going to be required. Which makes me wonder whether perhaps Tizzio has an individual source of insurance that may be contributing on his behalf.

 

There are a variety of other odd features to this settlement, at least as it is described in the news reports, the most striking of which is that Tizzio apparently will be making a material settlement contribution but apparently Greenberg will not. To be sure, C.V. Starr, of which Greenberg is still Chairman and CEO, will be making a more than $20 million contribution, raising the question whether the amount of Starr’s contribution and the fact that Greenberg himself is not contributing to the settlement are linked.

 

And even with respect to C.V. Starr’s contribution, certain questions arise. For example, given the fact that some or all of the individual defendants apparently were also officers of C.V. Starr, is Starr’s D&O carrier funding some or all of Starr’s contribution to the settlement?

 

It should also be noted with respect to Starr’s payment to AIG that Starr is in fact AIG’s largest shareholder. As of July 15, 2008, Starr owned 10.5% of AIG’s outstanding shares, which represents Starr’s largest asset. Maybe that is just context, but it is an interesting context nonetheless.

 

I also have questions concerning the $85.5 million contribution from AIG’s D&O carriers. Beyond sheer curiosity about how much of AIG’s D&O insurance tower was depleted by defense expense, I also wonder whether the insurer’s settlement contribution to this derivative settlement drew upon the insurance program’s Side A coverage, which provides protection for nonindemnifiable loss. You would not expect the $85.5 million payment to AIG to be indemnifiable in the absence of insurance, so all else equal the amount would seem to represent a Side A loss. The same would also seem to be true with respect to the individuals’ own separate contribution to the settlement.

 

My question about which D&O policy coverage funded the settlement may require some context. Given the size of this derivative settlement, as well as other recent large derivative settlements (including, for example, the $50 million Hollinger derivative settlement), there seems to be a growing threat of very large derivative settlements, which is a relatively new development.

 

Many companies, particularly large financial services companies, often have D&O insurance programs built exclusively or predominantly of Side A-only protection. These kinds of programs have become increasingly common in recent years, but in general losses have really not yet caught up to this coverage to a significant degree.

 

The options backdating derivative cases presented the possibility of significant potential losses for these types of coverages, but it is my understanding that the Side A-only losses from these cases really have not yet significantly materialized. There has been speculation that the subprime litigation wave might also produce significant Side A losses, but those cases are only in their earliest stages yet, so the losses have yet to fully develop.

 

The possibility of derivative settlements of the magnitude of the recent AIG settlement may represent the most significant threat to these Side A programs and coverages, at least outside of the bankruptcy context. Which is why I am curious to know which policy coverage funded the AIG D&O insurers’ portion of the AIG settlement.

 

Finally, I am curious about how likely coverage issues were dealt with in connection with this settlement. I expect that the insurers would have raised the personal profit exclusion typically found in most D&O policies as at least a potential defense to coverage. I am guessing that the existence of this issue complicated the settlement process (or at least the insurers’ contribution to the settlement). The absence of a judicial determination that the individuals had improperly profited undoubtedly ameliorated this potential impediment. The individuals' desire to avoid any determination that might preclude coverage may have helped precipitate settlement on the eve of trial.

 

As always, I am interested if any readers can shed any light on the details. I am particularly interested details involved with the individuals’ contributions; around the extent of insurance funding for C.V. Starr’s contribution; and concerning AIG’s insurers’ contributions. Anonymity will be scrupulously protected.

 

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Each fall for the last two years, I have taken a look at the current trends and hot topics in the world of D&O. There are of course certain perennial topics that are always critical, but this overview is intended  to focus on the issues the most significant current interest for D&O insurance professionals and their clients. Here is my list of the current issues to watch:

 

1. Limits Adequacy: The question of limits adequacy has long been one of the more challenging parts of the D&O acquisition process. Against a backdrop of basic affordability, the company must try to determine how much insurance is "enough"?

 

Several recent developments have surrounded these issues with even greater urgency. The most dramatic of these developments arises from the claims surrounding the collapse of auto parts supplier Collins & Aikman. The company carried $50 million D&O insurance limits, but the cumulative expense of the various civil, regulatory and criminal proceedings arising from the company’s demise have entirely exhausted the $50 million insurance program, leaving individual defendants to face ongoing criminal prosecutions and civil litigation without insurance available to fund their defense. (Refer here and here for further discussion of the Collins & Aikman case.)

 

There have been several other recent examples where astronomical defense expense has exhausted or substantially depleted entire D&O insurance programs.

 

The escalating cost of defense is only one of several factors raising limits adequacy concerns. The steady rise in average and median claims severity, as well as the growing threat of separate opt-out litigation following the settlement of class litigation (about which refer here), also underscore the growing complexity of limits adequacy issues.

 

In light of these developments, particularly the catastrophic potential for defense expense to deplete policy limits, it may be time to rethink traditional notions of limits adequacy, because past assumptions may no longer be sufficient.

 

2. Insurance Structure: For several years now, conversations in connection with the D&O insurance transaction have included the discussion of additional Side A insurance to provide additional protection for individuals’ liability and defense expense that is not indemnifiable due to insolvency or legal prohibition. In recent months, interest in Side A protection and other auxiliary D&O insurance structures has recently taken on increased urgency, as a result of two developments.

 

The first derives from the preceding topic; that is, concerns about limits adequacy inevitably lead to questions about structure, because even substantially increased limits may not be sufficient to address all concerns, given the potential for defense expense to consume available limits.

 

One way for corporate officials to ensure they are not left without insurance to protect them is through the creation of an auxiliary insurance structure dedicated solely to their protection. There are a number of different auxiliary D&O insurance products available to address these concerns. Most of these structures have been available in various forms for some time now. What has changed is the level of interest in these insurance structures.

 

A separate legal development is also driving interest in auxiliary insurance structures. In March 2008, a Delaware Chancery Court opinion in the Schoon v. Troy Corporation case held that a Delaware corporation may retroactively eliminate former directors’ advancement rights. (Refer here for my prior discussion of the case). The possibility that former directors could lose their rights to indemnification or advancement after the end of their board service may come as unwelcome news to many directors.

 

The typical D&O insurance policy provides coverage for former directors and officers. Under most circumstances, a former director from whom corporate advancement and insurance has been withheld would still be able to seek defense expense protection and indemnification under the company’s D&O insurance policy.

 

Directors who are concerned that events following their departure from the board could conspire to leave them unprotected (for example, if limits were exhausted or substantially depleted , as discussed above), yet another auxiliary insurance product is now available. A retired director insurance policy is dedicated solely to the protection of the named individual and cannot be terminated or discontinued by the action of others.

 

The point is that directors and officers rightly are more concerned about the availability of insurance protection when they need it most. As a result, interest in the wider variety of auxiliary insurance structures has increased.

 

3. Excess Insurance: For reasons that should be clear from the first point above, excess D&O insurance is an increasingly important part of the D&O claims resolution process. Perhaps because of excess D&O insurance’s increasing involvement, there have been a series of D&O insurance coverage disputes involving excess D&O insurance. These disputes have highlighted the importance of two particularly important issues concerning excess D&O insurance.

 

The first of these issues involves the excess policy’s language describing the circumstances under which the excess policy’s payment obligations are triggered. This language can become critically important if the policyholder reaches a compromise with an underlying insurer as a result of which the underlying insurer pays less than its full policy limits, leaving an insurance "gap" to be funded by the policyholder.

 

In two recent decisions, one involving Comerica (refer here) and one involving Qualcomm (refer here), courts interpreting policy language providing that the excess insurer’s obligations are triggered only if the underlying insurance is exhausted by the underlying insurer’s payment of loss held that the excess insurer’s obligations were not triggered even if the policyholder funded an insurance "gap."

 

These case developments have increased the awareness of the importance of excess insurance exhaustion language and coverage triggers. Alternatives now available in the marketplace allow payments by policyholders funding "gaps" as sufficient to trigger excess insurance payment obligations.

 

The second of the excess insurance issues involves coverage issues that so-called "follow form" excess insurers. The particularly troublesome issues arise when excess insurers raise policy defenses that the underlying insurers did not assert. Each policy of course represents a separate contract, but policyholders obviously expect each layer of a single insurance program to respond similarly to the same set of claims circumstances.

 

These issues have drawn even greater scrutiny in recent cases in which "follow form" excess insurers contend that their policy contains exclusions not found in the underlying policies, or that the excess insurer has policy application defenses different from the underlying insurers.

 

Although excess insurance frequently is described as "follow form," the increasing frequency of coverage defenses raised only by excess insurance suggest that, regardless of how the policy is characterized, the operation of excess insurance can be something substantially different than "follow form." The factors described above regarding escalating defense expense and increasing average and median claims severity ensure that these excess insurance issues are likely to be increasingly important.

 

4. Subprime Claims and The Cost of D&O Insurance: Largely as a result of the litigation activity surrounding the subprime meltdown, D&O claims activity has in recent months returned to historical levels after a period of reduced activity. Because much of the subprime litigation has been high profile, there is a frequent assumption that the cost of D&O insurance must be increasing.

 

As I noted in a recent post (here), so far, except with respect to certain marketplace segments such as the financial sector, D&O insurers generally have not restricted capacity, reduced coverage or raised prices. These buyer-friendly conditions are largely the result of the relatively positive results insurers have enjoyed in recent years. The insurance marketplace remains competitive.

 

The subprime litigation wave is continuing to spread. The risk for insurers is that in a competitive environment, pricing can fall below risk-related requirements, leading to an eventual correction. To the extent the current litigation wave produces significant insurance payouts, the current competitive conditions could change quickly, particularly if the litigation wave spreads beyond the financial sector. However, at this point, these possibilities continue to appear remote and the marketplace remains competitive.

 

Afterword: There are other developments that I think are important and worth watching, such as the growing potential for possible climate change disclosure issues (about which refer here) and the emergence of civil litigation arising from corrupt practices enforcement proceedings (about which refer here). These and other developing concerns still fall more in the category of emerging issues rather than current trends. The one thing that is clear is that the world of D&O continues to be characterized by constant change.

 

I have set out above what I consider to be the critical current issues but I am certain that others may have a different view of what the hot topics are in the current environment. I would like to encourage readers to use the comment function to add their own views about the current hot D&O insurance topics. Please note that comments can be added anonymously.

 

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Observers outside the D&O insurance industry frequently comment to me that with all the subprime-related litigation, D&O pricing must be skyrocketing. These observers are often puzzled when I respond that the D&O marketplace remains generally competitive and pricing advantageous to buyers. This same conversation recurs with sufficient frequency that if may be worth exploring in greater depth. It may also be worth considering whether or not current marketplace conditions may be vulnerable to abrupt change.

 

With respect to the litigation activity, there have indeed been a significant number of subprime and credit crisis-related lawsuits, as detailed further below.

 

 

Nevertheless, except with respect to certain marketplace segments (such as the financial services industries), D&O insurers generally have not restricted capacity, reduced coverage or raised prices. As IRMI noted in its September 2008 publication The Risk Report (here, subscription required), it may seem “counterintuitive” but “most companies, particularly those outside the financial sector, continue to enjoy ample capacity and relatively advantageous terms and conditions.”

 

 

The most important reason for the competitive marketplace conditions is that historically low securities class action activity levels prevailed during most of the period 2005 through 2007. Insurers’ D&O results for those claim reporting periods undoubtedly appear favorable. At the same time, insurers overall results during that same period were also favorable, due to low levels of catastrophe claims after the hurricane intensive period in 2004 and 2005.

 

 

Insurers’ business-writing capabilities are directly proportionate to their “policyholder surplus” (which is, in simple terms, the insurance company financial reporting equivalent to shareholders’ equity). As a result of insurers’ strong results in recent reporting years, property and casualty insurers’ industry-wide policyholder surplus is at or near record levels. The insurers’ business-writing capability is correspondingly high – and so the marketplace for most lines of insurance, including D&O, is competitive.

 

 

These are of course exactly the conditions that drive the insurance cycle, as ability to write business translates into an appetite for business, with price as the primary means of competition. Eventually, pricing falls below the risk related requirements, results deteriorate, and, when surpluses and redundancies are exhausted, the marketplace corrects.

 

 

The current heightened claim activity level is exactly the kind of circumstance that can lead to deteriorating results, particularly to the extent that there is a mismatch between pricing and the risk exposure. Indeed, IRMI noted in its recent report that if the current litigation wave “produces significant loss payouts, and spreads beyond the financial sector” the current wave could “ultimately affect the larger D&O marketplace.”

 

 

The ultimate outcome will of course only be revealed in the fullness of time. But in addition to policyholder surplus levels, there are a variety of other factors that could be mitigating the impact of the current litigation wave on the D&O insurers.

 

 

First, insurance may not even be involved in many of the highest profile subprime-related claims. Many of the largest banks, for instance, self-insure for their D&O exposure or only carry so-called Side A coverage for nonindemnifiable loss. At least for those banks that have not gone insolvent, these Side A policies are unlikely to be triggered.

 

 

Second, much of the current claims activity may not involve losses to which D&O insurance even applies. For example, the buybacks at the center of the recent high-profile auction rate securities settlements (about which refer here) may not involve insurable losses. To the extent that there are damages paid (for example, if the losses must pay investors’ consequential damages), the losses are likely to be more in the nature of investment bank errors and omissions losses than D&O losses.

 

 

Third, although the subprime and credit crisis-related litigation wave has spread, the vast majority of the lawsuits have been concentrated in the financial services sector. There are certain D&O carriers that are more exposed to this space than others, but many other carriers have long shunned this space. As a result many carriers may not be experiencing the current heightened claims activity levels, and the ones bearing the brunt of the activity arguably are larger and more diversified.

 

 

Fourth, a certain amount of the litigation wave involves companies domiciled (and, most likely, insured) overseas – for example, UBS, Swiss Re, RBS, RBC, Fimalac, Societe Generale, and so on. Losses related to these claims, which represent a significant portion of the subprime related litigation, may not impact the domestic D&O insurance market.

 

 

Fifth, although I have on this blog, and even in this post, referred to the current litigation as a “wave,” one could argue that although the current activity exceeds the claim level of the preceding three years, the current level is not far above historical claims activity levels. I suspect there are senior insurance executives whose D&O unit managers are telling them that current claims activity levels are within expected ranges. (Some of these managers may have different employers three to five years from now.)

 

 

Sixth, but perhaps most importantly, most of these claims are only in their earliest stages. Carriers’ case reserves may not yet be fully developed. There is also the danger that aggregate loss reserve picks are skewed by several years of better than average results. Carriers may feel confident they have a handle on this situation and fully understand their ultimate exposure, and their confidence may be warranted. It will of course be years before they know for sure.

 

 

Earlier on as the subprime litigation wave was just gaining steam, there were a number of dramatic pronouncements (refer, for example, here) about how large the large the potential loss for the insurance industry from the subprime meltdown could be. It has been awhile since anyone has ventured any similar pronouncements, probably because the sky has not yet fallen. But while prognosticators may have become more circumspect, there remains an abiding danger in the current circumstances.

 

 

Despite -- or maybe because of -- all of the foregoing, the subprime and credit-crisis litigation wave remains highly dangerous for the D&O insurance industry. Among other things, there is the possibility that the most significant danger could be underestimation of its long-run significance.

 

 

Thanks to the several readers with whom I have spoken and corresponded on these topics in recent days. And very special thanks to Bob Bregman at IRMI for permission to quote The Risk Report.

 

 

Another State Court Subprime Class Action Lawsuit: In an earlier post (here), I noted that as part of the current subprime and credit crisis-related litigation wave, plaintiffs’ lawyers have seemed increasingly interested in filing actions under Section 11 of the Securities Act of 1933 in state court. In the latest example of this phenomenon, on August 26, 2008, a plaintiff filed a purported Section 11 class action lawsuit against National City Corporation and several of its directors and officers in Florida (Palm Beach County) Circuit Court. A copy of the complaint can be found here.

 

 

The complaint is brought on behalf of the former shareholders of Fidelity Bankshares who acquired National City stock in connection with National City’s acquisition of Fidelity, which was completed in January 2007. The complaint alleges that the offering documents “concealed billions of dollars of risky construction loans” that National City made to finance residential real estate construction, in Florida and elsewhere.

 

 

Among other things, the complaint alleges that the construction loans were plagued by “bad product design” and were susceptible to “the high likelihood of default and extreme loan loss severity.” Many of the loans “featured the worst qualities of subprime” though National City supposedly represented its loans as “prime” and “conforming.” The complaint also alleges that the offering documents misrepresented other aspects of National City’s financial condition, including its “nonperforming assets” and its loan loss reserves.

 

 

This new lawsuit is merely the latest lawsuit filed against National City regarding subprime-related issues (refer here and here). In any event, I have added this latest lawsuit to my running tally of subprime and credit crisis-related securities lawsuits, which can be accessed here. With the addition of this latest complaint, the current tally of subprime and credit crisis-related securities lawsuits now stands at 109, of which 69 have been filed in 2008.

 

 

Special thanks to Adam Savett of the Securities Litigation Watch for providing a copy of the National City/Fidelity Bankshares complaint.

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It remains to be seen whether the current economic turmoil will result in significant additional bank failures. But if history is any guide, to the extent that there are further bank failures, there likely will also be follow-on lawsuits in which the regulators pursue claims against the failed institutions’ former directors and officers. As these claims emerge, there may also be disputed issues regarding the applicability of the failed institutions’ D&O insurance policies.

 

As I noted in a recent post (here), among the issues that may arise is the applicability of the regulatory exclusion. In addition, another issue that may arise relates to the potential applicability of the so-called “insured v. insured” exclusion found in most D&O insurance policies.

 

The “insured v. insured” exclusion typically precludes coverage for claims by or on behalf of the insured corporation, its affiliates or directors and officers against other insured persons. Over the years, the standard exclusion has been modified to provide coverage carve-backs for certain types of claims for which coverage would otherwise be precluded, such as derivative claims and employment practices claims.

 

During the S&L crisis in the late 80s and early 90s, the federal banking regulators actively pursued claims against the failed institutions’ former officials. As described in a July 29, 2008 memorandum from the Latham & Watkins law firm entitled “The ‘Insured v. Insured’ Exclusion in D&O Policies” (here), many of these regulator claims implicated the insured v. insured exclusion.

 

As the law firm’s memorandum explains, in many instances the regulators were able to argue successfully that the exclusion should not apply to preclude coverage for their claims, because the lawsuits were not the “collusive” type disputes for which the exclusion historically was meant to preclude coverage. However, as the memorandum also notes, there were cases in which the exclusion was held to bar coverage for the regulators’ claims, on the grounds that the regulator was in effect “standing in the shoes” of the failed institution.

 

The memorandum correctly points out that the “insured v. insured” exclusion is “heavily litigated” and “continues to be at the heart of many coverage disputes.” There are a number of reasons why coverage disputes involving the exclusion are so frequent.

 

First, over the years, the scope of persons insured under the typical D&O policy has expanded – for example, to include “employees” within the definition of insured persons for purposes of securities claims. In addition, many companies for their own reasons have sought to schedule additional named insureds to the policy by endorsement. While these policy extensions may be desirable from the policyholder’s perspective, problems can arise later if the extensions are not also coordinated with the language and operation of the “insured v. insured” exclusion.

 

Second, companies may take on forms or structures that raise fundamental questions about who is an insured under the policy. For example, insolvent companies may continue in business as a debtor-in-possession or may have its activities taken over by a receiver. These and other situations have raised and continue to raise a myriad of contentious questions about the scope and applicability of the insured v. insured exclusion.

 

Third, in many lawsuits, the plaintiffs’ claims may be based on information or assistance provided by former company officials. The former officials’ involvement may run afoul of the wording in the typical insured v. insured exclusion, which specifies that for claims to be covered they must be “instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of” any insured person.

 

The question whether a former official’s litigation involvement falls within one of these precluded categories is a frequent source of contentious coverage disputes. (Refer here for discussion of a recent case involving these issues.) In order to try to reduce the opportunities for these types of disputes, many carriers will now agree upon request to add wording providing that the exclusion will not apply in the event of the involvement of former officials whose departure was more than a specified amount of time before (typically, four years).

 

As the Latham & Watkins memorandum discusses, one of the issues frequently disputed in these cases is whether the underlying claim must be “collusive” in order for the exclusion to be triggered. As the Latham & Watkins memo explains, the exclusion’s original intent was to bar coverage for collusive claims. However, not all courts have required collusion for the exclusion to be applied (refer, for example, here), although there are many jurisdictions in which collusion has been held to be required.

 

The importance of the “insured v. insured” exclusion and the opportunities to revise the standard wording to reduce the exclusion’s preclusive effect highlights the importance of addressing these basic wording issues at the time the policy is purchased. As the Latham & Watkins memorandum notes, each company “should seek the assistance of an insurance broker to attempt to limit the exclusion’s breadth.” The potential significance of these issues underscores the need for companies to enlist the assistance of an experienced and knowledgeable broker in their acquisition of D&O insurance.

 

Duties of Outside Directors Under Delaware Law: As noted by the ever-vigilant Francis Pileggi on his Delaware and Commercial Litigation Blog (here), on July 29, 2008, the Delaware Chancery Court issued an opinion in the Ryan v Lyondell Chemical Company case (opinion here) that has important implications for the duties and potential liabilities of outside directors in the merger and acquisition context.

 

The court held that the outside directors were not entitled to summary judgments and would have to stand trial for their role in the sale of the company, as Pileggi notes, “despite selling the company to the only known buyer for a substantial premium.”

 

As explained in the opinion, when the Lyondell board received the offer, it delegated much of the negotiations to the company’s Chairman and CEO; never conducted a “market check to determine whether a better price could be obtained; agreed to a deal that included protective rights, including a “no-shop provision.” Moreover, “the whole deal was considered, negotiated, and approved by the Board in less than seven days.”

 

The Chancery Court held that the Board could not invoke the exculpatory provisions under the company’s charter and the Delaware Code because “the Board’s apparent failure to make any effort to comply with the teachings of Revlon and its progeny implicates the directors’ good faith and, thus, their duty of loyalty, thereby, at least for the moment, depriving them of the benefit of the exculpatory charter provision.”

 

Pileggi’s post does an admirable job explaining the implications of the decision. Further valuable analysis of the decision can be found on the Legal Profession Blog (here).

 

Monster Settlement, Dude: As reflected in its July 31, 2008 press release (here), Monster Worldwide has reached a settlement in the options backdating related securities action lawsuit pending against the company and certain of its directors and officers. As reflected in the press release, the settlement consists of “a payment to the class by the defendants of $47.5 million in full settlement of the claims asserted in the securities class action. The Company's cost is anticipated to be approximately $25 million (net of insurance and contribution from another defendant).”

 

The Monster settlement is only the latest of the options backdating related securities class action settlements. A full list of settlements and case dispositions in the options backdating related litigation can be accessed here.

 

A WSJ.com Law Blog post describing the Monster settlement (and containing a nice link to The D&O Diary) can be found here.

 

The Securities Litigation Watch blog as updated its detailed analysis of the options backdating securities class action lawsuits, which can be found here.

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The recent news (here) that federal regulators had seized IndyMac Bank in one of the largest bank failures in history brought back memories from the late 80’s and early 90’s, when numerous financial institutions around the country met a similar fate. The litigation surrounding the financial institutions’ collapse kept legions of lawyers profitably employed for years, including your humble correspondent.

 

Among the many types of cases litigated in that era were D&O insurance coverage disputes, and in particular, disputes involving the applicability of the so-called “regulatory exclusion.” The regulatory exclusion typically precludes coverage for claims brought by any governmental, quasi-governmental, or self-regulatory agency.

 

In the competitive underwriting environment that has prevailed in recent years, the regulatory exclusions has become an infrequent part of financial institutions’ D&O insurance policies, a development that has seemed unremarkable as the prior failed bank era has receded into the past. However, with the dramatic news of IndyMac’s regulatory seizure, and the consequent concern that further financial institutions failures may lie ahead (refer here), the issues surrounding the regulatory exclusion could once again become relevant.

 

Undoubtedly in response to these very issues, on July 21, 2008, the Latham & Watkins law firm issues a memorandum entitled “D&O Policies – Regulatory Exclusions” (here). The memorandum briefly reviews the issues that were debated concerning the regulatory exclusion in the last era of failed banks.

 

Among other things, the memorandum correctly recollects that it was not just the insured persons who disputed the regulatory exclusion’s applicability, but it was the governmental agencies as well. The agencies “fought regulatory exclusions clauses using mainly public policy arguments” because the exclusions “impair the ability of the government to seek redress in the situation of a failed bank.”

 

The memorandum notes that the courts found that the “freedom to contract overrode the government agency’s right” to bring claims against individuals. The courts also found that it would not have been against public policy for banks to purchase no D&O insurance at all, so therefore “excluding optional coverage in certain situations would clearly not fall against public policy.”

 

The government also tried to argue that the exclusions were ambiguous. But the courts read the exclusions broadly and in the context of the policy as a whole, and on the basis did not find them to be ambiguous. The courts found that the exclusions applied whether the government was pursuing claims as a regulator or as a liquidator, and regardless whether then government actually brought or was merely maintaining the claims.

 

It remains to be seen whether or not there will in fact be further financial institution failures, and if there are, whether the regulators will pursue claims against the failed institutions’ former management. Even if the government does pursue these kinds of claims, it is relatively unlikely that many of the institutions current policies contain a regulatory exclusion that would preclude coverage for these claims.

 

But the spate of bad news that banks have reported in recent days is a vivid reminder of the challenging circumstances that banks face. D&O underwriters are monitoring these developments with mounting anxiety. As conditions continue to deteriorate, and in particular if there are any further significant financial institution failures, D&O insurers relatively benign approach to the regulatory exclusion could change. The regulatory exclusion could once again become a more common part of D&O coverage for some financial institutions.

 

Of course, all of these things will be revealed in the fullness of time. But the IndyMac bank failure sure does have a familiar ring to it. As Mark Twain famously said, “History doesn’t repeat itself, but it does rhyme.” Along those lines, the current circumstances could start to sound more and more like the prior era of failed banks, and it could involve many of same endings.

 

Oy, Canada: The subprime litigation wave has been sweeping the U.S. for now well over a year. But now the wave finally seems to have spread to our neighbors to the north.

 

On July 23, 2008, a Canadian law firm announced (here) that it had launched a securities class action lawsuit in the Ontario Court of Justice against the Canadian Imperial Bank of Commerce and certain of its directors and officers.

 

According to the press release, the Complaint alleges that:

CIBC misrepresented the magnitude and level of risk associated with its U.S. subprime residential mortgage investments. In particular, CIBC represented during the class period that its total exposure in USSRMM investments, including both hedged and unhedged investments, was "not a major issue" when, in fact, the bank had exposure to billions of dollars of losses, as was only subsequently disclosed.

Further, CIBC failed to disclose that one of its principal hedge counterparties, ACA Financial, was woefully undercapitalized with an asset to guarantee ratio of "1-180" and was far from able to provide any meaningful hedge protection to the bank's USSRMM investments

CIBC had previously been named as a defendant in a U.S. securities class action lawsuit (as detailed here), but that prior lawsuit involved investments and disclosures by CIBC’s MFS family of mutual funds, and did not relate to CIBC’s own disclosures or activities.

 

In addition to CIBC, another Canadian company, the Royal Bank of Canada (RBC), was also previously named as a defendant in a U.S.-based securities class action lawsuit (refer here), but that lawsuit relates to the sales of auction rate securities by RBC’s affiliate, RBC Dain Rauscher, and does not relate to RBS’s own disclosures or activities.

 

So far as I am aware, the recent lawsuit filed against CIBC in the Ontario Court of Justice represents the first subprime-related securities class action lawsuit to be filed against a Canadian company for the company’s own disclosures or activities.

 

A July 23, 2008 Bloomberg article describing the CIBC lawsuit can be found here.

 

UPDATE: In response to my comment above about Canadian subprime litigation, Ari Karoly of NERA Economic Consulting sent along the following observation: "I wanted to point out that the FMF capital class action which settled last year (refer here) was a class action brought against a US company in Canadian courts with respect to alleged misrepresentations made by FMF regarding subprime exposure and risks. You were technically correct because FMF was a US company which traded on the Toronto Stock Exchange, but I still wanted to bring that case to your attention."

Now We Know Where the Airline Industry Found Its Service Model:  According to a complaint filed on July 18, 2008 in the Hamilton County (Tenn.) Circuit Court (here), when a resident of the Shallowford Trace luxury apartment homes complained of being unable to find a parking place, an employee of the apartment company put a gun between the resident’s eyes and stated “You f***ing b**ch, I’ll blow your f***ing brains all over this concrete” and also “Please give me a reason. I’ve got a permit. I’ll blow your brains out.”

The permit makes everything nice and legal. You wouldn't want someone without a permit putting a gun between your eyes.

Hat tip to Courthouse News (here) for the Shallowford complaint.

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The specific insurance issue relates to the possibility that Bennett’s cooperation might trigger the so-called “Insured vs. Insured” exclusion (or IvI as it is more commonly known) that is found in most D&O insurance policies. A typical IvI exclusion provides, among other things, that the insurers is not liable for any loss in connection with a claim “which is brought by any security holder or member of an Organization, whether directly or derivatively, unless such security holder or member’s claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of, any Executive.”

 

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Over the past several weeks, several industry observers and analysts have tried to put a number on the insurance industry's aggregate subprime-related loss exposure. At one end, Bear Stearns on January 24, 2008 estimated the industry's exposure at $8-9 billion (refer here). By contrast, on February 8, 2008, Lehman Brothers estimated (here) that the insurance industry's losses might range up to $3 billion, and on February 6, 2008, Advisen announced (here) that it will be releasing a report estimating that the industry's ultimate losses at $3.6 billion.

I don't envy these experts whose job it is to try to quantify something as big, amorphous and evolving as the subprime-related litigation wave. Nor do I profess to have any particular insight into whose estimate is more accurate or what the ultimate number will be. I do have some observations about some considerations that are or should be being taken into account in making these kinds of estimates, in light of the circumstances surrounding the evolving subprime meltdown. (I should add that in making these observations, I have not had the benefit of reading the entire Advisen report, which as of this writing is not yet available; I have only had an opportunity to review the press release summary.)

In general, I think the various estimates have correctly noted that a potentially large portion of the amounts to be paid in settlements or judgments in the subprime litigation may not represent insured loss. In particular, the observers have correctly noted that many of the largest commercial and investment banks that are involved in the subprime-related litigation carry very large self-insured retentions and also often carry only Side A insurance programs (covering only nonindemnifiable loss, unlikely to occur here for these entities) or in some cases no insurance at all for certain exposures. These various observers have made a number of other valid observations concerning other factors that could restrict the impact of subprime losses for D & O insurers.

But at the same time, it seems to me that there are a number of other considerations that these observers have undervalued or even overlooked in assessing the possible impact of the subprime meltdown on insurers.

First and foremost, I think it is important to stress that we are only at the very earliest stages of the emergence of the subprime-related litigation. To be sure, there are (as documented here) already 43 subprime-related class action lawsuits, as well as nine subprime-related ERISA lawsuits, but before all is said and done, there are going to be many, many more of these and other kinds of lawsuits. We have not even completed the first round of subprime loss truth-telling (refer here), and it is probable that there will be even further deterioration in the mortgages underlying the subprime-backed assets as homeowners find it easier to walk away that to continue to pay down debt on a house that is declining in value (about which refer here).

As Couglin Stoia attorney Sam Rudman observed at last week's PLUS D & O Symposium, there are likely to be more securities class action lawsuits in 2008 than any year since the passage of the PSLRA (Rudman is himself already involved as plaintiffs' counsel on many of the subprime-related lawsuits).The subprime-related litigation wave is likely to continue to emerge well into 2009 and possibly beyond (just as the options backdating litigation wave continues to emerge). The possible extent of this future litigation threat may be discerned from the recent litigation commenced against the Cadawalader firm (about which refer here), in which the allegations relate to commercial mortgage securitization documents the firm prepared in 1997. In other words, any dollar estimate of the possible subprime-related insurance losses should be accompanied by a healthy appreciation of how little of the ultimate amount of subprime-related litigation we can currently even see. Since we still don't know how big of an event this ultimately will be, and because it is likely to be years before we have clear idea, any attempt at quantification should carry some very substantial caveats.

Second, many of these estimates seem to presume that the insurance industry's subprime-related losses will be limited to the financial institutions sector. I do not think this is a conservative assumption. To the contrary, I think it should be assumed that the subprime-related litigation wave will both spread beyond subprime and beyond the financial sector (as I discuss at greater length here). The recent securities class action lawsuits against student loan company SLM Corporation (about which refer here) and Levitt Homes (about which refer here) underscore that the claims have already spread. Bristol Myers Squibb's recent $275 million write-down for subprime-related investment losses (refer here) further highlights that the credit crisis is no longer just about the financial sector. The possibility of further credit-related losses in many sectors outside the financial sector, and for ensuing claims, at this point seems likely -- or at least that would appear to be the conservative assumption.

Third, much of the analysis of the insurance industry's exposure has been concentrated largely (although, it must be recognized, not exclusively) on potential losses for D & O insurers. To be sure, the growing number of subprime-related securities class action lawsuits represents a very substantial threat to the D & O insurance industry. But the potential for insured losses in coverage lines outside of D & O could also be very substantial. By way of illustration, State Street's recent $618 million charge for anticipated subprime-related litigation expenses was in connection with lawsuits that do not (as discussed in my recent post, here) appear to implicate D & O coverage, but that could present significant fiduciary liability or even investment management E & O losses.

By the same token, the recently revised complaint in the subprime-related securities litigation involving Countrywide (about which refer here) added accountant liability claims, as well as claims against Countrywide's offering underwriters. Other professionals undoubtedly will find themselves caught up in subprime related litigation, including, for example, lawyers; hedge fund and pension fund managers; mortgage brokers; appraisers and surveyors; real estate brokers; and insurance agents, among many others. The cumulative losses from claims against other professionals could be very substantial, and at this early stage particularly difficult to prognosticate.

Even with respect to the analysts' breakdown of the likely D & O losses, the breadth of the current and likely future claims may or may not be being fully taken into account. That is, while it is true that some of the lawsuits against the largest financial institutions may not, because of the way that these entities structure their insurance, involve the prospect for insured losses, most of the current and likely future subprime litigation defendants do not have these types of insurance arrangements. As the claims spread to secondary players and targets in the hinterlands (about which refer here), the claims are hitting defendants that have more traditional insurance structures. Those (far more numerous) claims may involved a greater percentage of insured losses than (the relatively few claims, as a percentage matter) against the largest banks and financial institutions.

Fourth, I am well aware that one of the issues with which these analysts have had to grapple is the need to try and put the subprime meltdown into context. The challenge is not just to say how it compares, for example, to the S & L crisis or the bursting of the dotcom bubble, but also to come up with a figure for those prior events in order to compare the current subprime crisis. I don't have data for those prior events, but I do know that the still unfolding options backdating scandal may present a useful comparison. As I have detailed in another post today, the options backdating losses, on the few cases that have been resolved so far, already represent in aggregate some very impressive numbers. There are many more options backdating cases yet to be resolved. The total options backdating related losses are likely to by very substantial. Given that just about everyone assumes that the subprime related crisis represents an even greater threat to insurers than the options backdating scandal, the implication is that the subprime related losses could be very significant indeed.

Fifth, whatever else might be said, nothing meaningful about the extent of the subprime threat can be derived from the D & O insurers' current marketplace behavior. My comment here relates specifically to the comment in the Lehman Brothers report linked above that "if insurers were concerned about suffering multi-billion dollar subprime D & O losses that could spread outside financial institutions sector, the market would tighten significantly." If the D & O industry had a long track record of skillfully adjusting its prices to changing exposures, this remark might have greater validity. Unfortunately, the industry's consistent history suggests that the industry is only capable of disciplining itself when losses become so painful that it is forced to change its ways. The current D & O pricing environment is a reflection only of the amount of available capacity, not of any calibration to emerging exposures. The marketplace will remain competitive until cumulating losses force the changes of necessity, and then any changes would be abrupt and disruptive -- as they have always been in the past.

Sixth, as most of the analysts have noted, the defense expense associated with the subprime cases in and of itself could be staggering. As an example of how expensive these cases can be, Apollo Group recently reported (here) that it had spent $25 million dollars taking the securities lawsuit pending against the company through trial. Because of the legal and factual complexity surrounding the subprime cases, they could be extremely costly to defend. Much of the associated defense expense, other than for the large investment bank defendants, is likely to be covered loss. For each of the securities cases, the defense expenses are likely to be many millions of dollars, and, for the cases in the aggregate (including those already filed and those yet to be filed), to be many hundreds (and possibly thousands) of millions of dollars. To these costs must be added the costs of defending the claims raised against other professionals.

Finally, it would be unfortunate if the subprime hype were to obscure the fact that the subprime-related litigation is only one of several very important current developments affecting D & O insurers' exposure. As I have noted elsewhere (refer here) securities litigation levels would be elevated compared to the prior two years' activity levels even without the subprime-related litigation. The Securities Litigation Watch blog recently noted (here) that January 2008 securities activity remained at elevated levels, only in part because of the subprime related litigation. None of this could be discerned from D & O insurers' current conduct. It has been ever thus.

Blog Warning: This week I hope to be making some long needed adjustments to The D & O Diary. While these changes are taking place, I will not be adding any new blog posts (although the current posts will remain available). These adjustments should result in several improvments to The D & O Diary. I will report further on the adjustments once they have been completed.

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In an earlier post (here), I discussed the March 14 , 2007 ruling (here) in the CNL Resorts case, in which the federal district court held that an issuing company's settlement of a claim under Section 11 of the Securities Act of 1933 did not constitute covered "loss" under the company's D & O liability insurance policy. In that prior case, the court did say that Section 11 settlements are not per se uninsurable, and noted that "in a Section 11 case, if an entity makes a payment that constitutes something other than disgorgement of its ill-gotten gains, it has suffered a loss."