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

Many organizations purchase management liability insurance to provide liability and defense cost protection for their directors and officers. But the management liability insurance protects the individuals only for their actions undertaken in an “insured capacity.” The policies are not intended to not protect them for actions they undertake in a capacity other than as a director or officer of the organization. These issues proved to be determinative in the action to decide whether or not D&O insurance issued to Jerry Sandusky’s organization, The Second Mile, covered the legal fees Sandusky incurred defending criminal and civil allegations involving misconduct with children.

 

In a March 1, 2013 Memorandum Opinion, Middle District of Pennsylvania Chief Judge Yvette Kane held that because the alleged misconduct did not arise in Sandusky’s capacity as an employee or executive of The Second Mile, the organization’s management liability insurer had no obligation to provide him defense cost coverage. A copy of Judge Kane’s opinion can be found here. As I note below, I have some concerns about this ruling.

 

Background

Sandusky founded The Second Mile in 1977. From 1977 until Sandusky was criminally indicted for offenses against children. Sandusky served at times as a volunteer and at times as an executive-level employee of the organization. In November 2011, a grand jury returned a report charging Sandusky with multiple crimes involving children. Following a trial, Sandusky was convicted of a total of 45 charges involving offenses against children. Sandusky has appealed his criminal conviction. Sandusky has also been named as a defendant in a separate civil proceeding brought by one of his alleged victims.

 

Sandusky sought coverage for the attorneys’ fees incurred in both the criminal and civil matters from The Second Mile’s management liability insurer. Sandusky sought coverage under both the D&O and EPL portions of the policy. The insurer advanced Sandusky’s defense expenses subject to a reservation of its rights under the policy and initiated an action seeking a judicial declaration that it had no obligation to fund Sandusky’s defense expenses. The insurer filed a motion for judgment on the pleadings, arguing that it would be against Pennsylvania public policy to indemnify Sandusky for the child molestation charges against him. As discussed here, in a June 2012 order, Judge Kane agreed that it would be against Pennsylvania public policy for the insurer to indemnify Sandusky, she reserved the question of whether it would be against public policy for the insurer to provide Sandusky with a defense.

 

After Sandusky’s criminal conviction, the insurer moved for summary judgment, arguing that the acts alleged against Sandusky were not undertaken in an insured capacity. The policy defined the term “Insured Capacity” to mean “the position or capacity of an Insured Person that causes him to meet the definition of Insured Person.” Sandusky argued that the meaning of this provision is ambiguous and the further discovery was required to determine the extent of the coverage provided under the policy. 

 

The March 1 Opinion

In her March 1, 2013 memorandum opinion, Judge Kane granted the carrier’s motion for summary judgment. She found the policy language regarding “Insured Capacity” to be “unambiguous.” She said that in order to determine “whether the actions that form the basis of the claims against Defendant were performed in his capacity or role as an executive or employee of The Second Mile,” she must review the allegations against him. She then reviewed the various abuse allegations that had been alleged against Sandusky. Among other things, she noted that the alleged abuse was alleged to have taken place in a variety of locations, all away from The Second Mile’s facilities.

 

Based on this review, she concluded that “it is clear that Defendant Sandusky was not acting in his capacity as an employee or executive of The Second Mile in sexually abusing and molesting the victims named in the criminal and civil cases brought against him, and the Court so finds.” She added that Sandusky was not alleged to have engaged in the alleged misconduct “in furtherance of his duties for The Second Mile.” She noted that the fact that Sandusky met his victims through The Second Mile or even that he sexually abused victims “during the course of activities at” The Second Mile “does not change the fact that his sexual abuse of children was personal in nature and performed in his individual capacity.” Because Sandusky’s alleged conduct “was clearly personal in nature and not in furtherance of his duties for The Second Mile, he is owed no criminal defense under the Policy.”

 

Discussion

The nature of these allegations is so repugnant and the fact that Sandusky has been convicted criminally makes it hard to spend any time thinking about the issues here. I certainly have no interest in defending Sandusky or trying to prove that he has not been dealt with fairly here.

 

Nevertheless I do have concerns about this ruling. It is easier to see my concerns if we forget about Sandusky and imagine instead that a volunteer or employee of a nonprofit organization has been unfairly targeted by abuse allegations, perhaps as a particularly vindictive part of a smear campaign. Let us say for purposes of this hypothetical that the allegations, though false, are otherwise as heinous as those against Sandusky.

 

My concern is that under Judge Kane’s ruling, even this falsely accused individual could not look to his origination’s management liability insurer for a defense. Her ruling does not depend on Sandusky’s conviction. She expressly says that “Sandusky’s offenses against children –whether proven or alleged – were not conduct in his capacity as an employee or executive of the Second Mile.” The allegations alone are enough to determine coverage, because “sexual abuse of children” is “personal in nature” and is “performed in individual capacity.” She even said that this conclusion would apply “even if he sexually abused victims “’during the course of activities of Second Mile.’” 

 

If the mere fact that allegations of sexual abuse are personal and individual is enough to preclude coverage for Sandusky, then are mere allegations sufficient to preclude coverage even for a nonprofit official who is falsely accused as part of a smear campaign? Keep in mind, Kane is not interpreting a clause of a policy in which the insurer says “we won’t insure even allegations of sexual molestation.” She was interpreting a clause that talks about the capacity in which a person was sued and for which he or she got sued. In our smear campaign hypothetical, the only reason my hypothetical smear campaign individual was targeted was because they were an official of the nonprofit. Are we prepared to say that this falsely accused individual is under no circumstances entitled to a defense, simply because of the nature of the allegations?

 

I would be much more comfortable all the way around with this decision if it were based on the fact that Sandusky was actually convicted. Of course, given that his criminal case is still on appeal the judgment in the criminal case is not final, and so the insurer might not be able to preclude coverage on the basis of the criminal conviction for some time yet.

 

When Judge Kane says that her conclusion that Sandusky was not acting in an insured capacity applies even though he allegedly abused victims “during the course of activities of Second Mile,” that’s when I get uncomfortable with this result. It would be very easy to shrug this result off because of the terrible things for which Sandusky was convicted. But because Judge Kane’s conclusion does not depend on the conviction, this same result could apply to any nonprofit official, even one who is falsely accused and would otherwise be forced to defend him or herself against outrageous allegations without insurance and at their own expense. I am very uncomfortable with this whole subject matter, but I am also not entirely comfortable with this decision.

 

I invite readers to weigh in on this topic, particularly those who take a different point of view on this decision than I do. (I know I am setting myself up for a raft of messages about the need for separate sexual molestation coverage or the possible problems with the bodily injury exclusion in the typical D&O insurance policy, and perhaps other similar arguments as well. Please bear in mind that my concerns here are focused exclusively on Judge Kane’s reasoning in denying coverage, not on whether there may be other questions that might affect coverage or whether there are alternative insurance arrangements that might better address the sexual molestation exposure.)

 

Whistleblower Watch: In my annual year-end round up of D&O insurance and liability issues, I more or less said that I thought 2013 would be the year of the whistleblower, or at least the year in which the whistleblower bounty provisions of the Dodd Frank Act kick into high gear. Well, here we are into the third month of 2013, and there still haven’t been any more whistleblower bounty awards. So was I wrong? Maybe I was, but before you decide, you need to take a look at the list that Mary Jane Wilmoth has been compiling over at the Whistleblower Protection Blog.

 

As Wilmoth reports, the SEC posts Notices of Covered Action when a final judgment order, by itself or with prior orders and judgments in the same action, results in monetary sanctions over $1 million. Individuals who voluntarily provided the SEC original information that led to successful enforcement in the actions identified in the Notices are eligible to apply for whistleblower awards. Once the Notices are posted, individuals have 90 days to apply for an award. The blog post lists 22 actions in which Notices have been posted. The list is complete through February 8, 2013. From looking at the dates on which the Notices have been posted, the SEC is putting up Notices regularly. The pretty clear inference is that this list is going to get a lot longer very rapidly.

 

Obviously not all of the Notices will lead to whistleblower bounty awards. Indeed, many will not, as there may not be a qualifying individual. But it seems highly probable that there will be some awards, perhaps many. In other words, it still seems possible that 2013 will be the year in which whistleblower bounty provisions kick into high gear. Stay tuned.

 

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The modern public company D&O insurance policy provides coverage not only for the directors and officers of the company but also for the company itself – however, in the public company D&O insurance policy, the entity coverage applies only to securities claims, a limitation that sometimes leads to disputes whether or not a particular matter constitutes a securities claim.

 

A recent decision from the Central District of California took a look at whether the claims against a mortgage originator and securitizer involving the company’s issuance of mortgage-backed securities constituted a “Securities Claim” within the meaning of the company’s D&O insurance policy. In her February 26, 2013 order (here), Judge Josephine Tucker held that the claims were not “Securities Claims” within the meaning of the D&O policy and therefore that the insurer did not have a duty to advance defense costs.

 

Background

Until 2007, Impac Mortgage Holdings funded, sold and securitized residential mortgages. A unit of the company acquired mortgages that another company unit originated. The acquired mortgages were placed in a trust, which in turn issued certificates that were issued to an underwriter which then sold them to investors.

 

The coverage dispute relates to three separate claims that were asserted against Impac and its related entities. First, in April 2011, the Federal Home Loan Bank filed a state court complaint against Impac alleging unfair and deceptive acts as well as false and misleading statement in connection with the sale of the certificates. Second, in May 2011, Citigroup filed an action in the Central District of California against Impac, alleging violations of Sections 18 and 20 of the Securities Act of 1934, as well as negligent misrepresentation in connection with the Citigroup’ s purchase of certain other certificates. Finally, in April 2010, the Federal Reserve Bank of New York sent a letter to Impac referencing a dispute concerning priority of payments under four Impac securities offerings.

 

Impac submitted all three of these matters to its D&O insurer, seeking to have the insurer advance defense costs for all three matters and contending that all three arose out of Impac’s mortgage-backed securities business. The insurer denied coverage for all three claims and Impac filed an action against the D&O insurer, seeking a judicial declaration that the insurers ha a duty to advance defense costs. The parties cross-moved for summary judgment.

 

In pertinent part, the D&O insurance policy defined the term “Securities Claim” to mean a claim made against an insured:

 

(1) alleging a violation of any federal, state, local or foreign regulation, rule, or statute regulating securities …which is

(a) brought by any person or entity alleging, arising out of, based upon or attributable to the purchase or sale of or offer or solicitation of an offer to purchase or sell any securities of an Organization;

 

The February 26 Ruling

In her February 26, 2012 order, Judge Tucker denied Impac’s motion for summary judgment and granted the D&O insurer’s summary judgment motion.

 

The D&O insurer had argued that the phrase “securities of the Organization” in the policy’s definition of the term “Securities Claim” referred to Impac’s own securities. Impac urged that the phrase had an additional meaning extending it to the mortgage-backed securities at issue in the underlying disputes. Impac argues that the term securities “of” the company encompasses securities that were possessed, connected or associated with the company.

 

With respect to Impac’s interpretation of the definition, Judge Tucker said:

 

The fact that it would be “semantically permissible” to interpret the Policies’ language as extending coverage to securities Impac bought, sold or was involved in the creation of is not sufficient to create coverage where none would otherwise exist. Rather the court must interpret the disputed language in context, w with regard to its intended function in the policy. Here, Impac has provided no admissible evidence that such an interpretation gives effect to the mutual intention of the parties. (Citations omitted)

 

Judge Tucker went on to note that Impac’s proposed interpretation “would require the phrase ‘securities of’ to carry multiple meaning within one policy definition.” She added that in the context of the full definition and policy, “the phrase ‘securities of’ makes sense only in reference to the securities of Impac itself.” She added that by ascribing multiple meaning so the phrase, “Impac’s construction would result in the provision of vastly broader coverage when the insured happens to engage in the business of securitizing mortgages and would cause a traditional D&O Policy for those particular companies to become a defacto E&O policy, i.e., a professional liability policy for entities.”

 

Judge Tucker also concluded that coverage was precluded by the D&O policy’s Error and Omissions Exclusion, precluding coverage for the company’s “performance of (or failure to perform) any professional services.” She noted in that regard that Impac had asserted against the co-defendant in the action – that is, Impac’s E&O insurer – that the underlying claims do arise out of the provision of professional services.

 

While she concluded that coverage was precluded under the D&O policy’s Errors and Omissions exclusion, Judge Tucker did rule in Impac’s favor ruling in a separate February 26, 2013 order (here) in Impac’s separate action against its E&O insurer. She held that that Impac’s securities transactions constituted professional services under the E&O policy. The parties had disputed whether the underlying claims, which related to Impac’s securitization of mortgages, arose out of Impac’s “performance of or failure to perform professional services for others.” The E&O policy defined Impac’s profession as “mortgage banker/mortgage broker.” Judge Tucker concluded that “the undisputed facts support the conclusion that the securitization was a central element in Impac’s mortgage banking/brokerage business.”

 

She also found that an exclusion cited by Lloyd’s was too ambiguous to warrant a denial of coverage. (The exclusion on which the E&O insurer had sought to rely excluded coverage for (1) “the depreciation (or the failure to appreciate) in value of any investment transaction” or (2) “any actual or alleged representation, advice, guarantee or warranty provided by or on behalf of an Insured with regard to the performance of any such investment.”)

 

Discussion

Like many coverage disputes, the dispute here over whether or not the claims at issue were or were not “Securities Claims” came down to an interpretation of the specific policy language at issue. But even without reference to the specific provisions in the policy, it would have represented an unexpected result for a company’s D&O insurance policy to pick up coverage for claims brought against it for its activities as a mortgage securitizer. As Judge Tucker correctly concluded, to do so would require the D&O insurance policy to provide coverage for the company’s delivery of professional services and would thereby convert the policy into an E&O insurance policy – when in fact the D&O policy carried an express exclusion of coverage for claims arising from the delivery of or the failure to deliver professional services.

 

In a Monday morning quarterbacking kind of a way, I find it irresistible to note that the extent of the policy’s coverage would have been clearer if the policy had not only generally excluded coverage for claims arising from the delivery of professional services but also expressly precluded from the definition of securities claim the company’s issuance of securities as part of its business as a mortgage securitizer.

 

While I don’t have a problem with Judge Tucker’s interpretation of the policy here, there are other gray areas that arise from time to time with respect to the extent of D&O insurance coverage for securities claims. There are claims that can arise when a company is hauled into a lawsuit alleging violations of the securities laws when the specific securities at issue may not be those of the insured company.

 

A couple of examples come to mind: say, for example, when the insured company has spun out one of its divisions as a stand alone, publicly traded entity, and the separate entities file claims not only against the new company but out of the predecessor firm as well. (For an example of this kind of claim, refer here). Another example is an aiding and abetting type lawsuit; say, for example, an insured company is alleged to have violated the securities laws by aiding another company misrepresent its financial condition (sure, private claimants can’t assert these kinds of claims under the federal securities laws, but the SEC can, and private claimants could assert their claims in reliance on state law liability theories). A D&O insurance policy limiting “Securities Claims” solely to claims relating to securities “of” the company arguably might preclude coverage for these claims. For that reason, I have preferred definitions of the term “Securities Claim” that extends coverage to any claim alleging a violation of the federal securities laws or state or local equivalents.

 

From the factual allegations in the Impac case, I can now see (from the carrier’s perspective), at least one flaw with a definition of the term “Securities Claim” that would extend coverage to any alleged violation of the securities laws. If Impac’s D&O policy had included this “any violation of the securities laws” formulation, the policy might well have picked up coverage for the claims against Impac arising from its mortgage securitization activities, which is a result I am certain that the D&O insurer did not intend here.

 

Recognition of this potential shortcoming to the “any violation of the securities laws” formulation suggests a need to devise a new formulation, one that would not hazard the kind of unintended result I noted in the preceding paragraph. My current thought is that perhaps the “any violation of the securities laws” formulation could include a provision expressly precluding coverage for the company’s issuance of securities other than its own securities.

 

This is the kind of topic that I think would benefit from a more thorough discussion. I welcome readers thoughts on this topic, under the heading – “toward a more perfect definition of the term ‘Securities Claim’.”

 

One final note for practitioners. In her analysis of the D&O policy, Judge Tucker correctly determines that traditional “duty to defend” case law and policy interpretation principles do not apply to a “duty to advance” D&O insurance policy. Those involved in litigating defense expense issues in the context of a D&O insurance policy may find her discussion of these issues useful.

 

A Stray Thought about Current Events: Pope Benedict has now moved on to his new life as Pope Emeritus. He undoubtedly hopes he can look forward to a life of quiet contemplation. Everyone here at The D&O Diary wishes him well. Whatever may lie ahead for him and for the Catholic Church, we can all be sure that Benedict will avoid the fate of one of his predecessors, Pope Formosus, who died in April 896 at the age of eighty-one after a five year papacy.

 

As described in Paul Collins’s recent book, The Birth of the West, a one-volume history of the nascent beginnings of modern Europe in the Tenth Century, following the death of Pope Formosus, his successor, Pope Stephen, convened what has become known as the “Cadaver Synod.” Ten months after Pope Formosus died, and under pressure from local magnates, Pope Stephen had his predecessor’s corpse exhumed, dressed in pontifical robes, and placed in a bishop’s chair to be tried for heresy. With troops surrounding the city, the terrified bishops called to pass judgment quickly found Formosus guilty of violating church law. All of his papal acts were declared void and his dead body, stripped of the papal robes, was reinterred as a layman in unconsecrated ground.

 

If Pope Stephen hoped this macabre ceremony would preserve peace, he was mistaken. Collins notes that “the Cadaver Synod marked the beginning of some of the worst internecine civil strife in the history of papal Rome.” All of this took place at a time when Europe was beset with recurring invasions from Vikings, Magyars and Saracens.

 

For those who are worried that the current Catholic Church faces challenges, well, things have been worse. Yet it was from this chaos that the rudiments of modern Europe slowly emerged. In any event, here’s hoping that the upcoming papal transition be smoother than some of those in the past have been.

 

Speaker’s Corner: On March 19, 2013, I will be speaking at a panel at the C5 Forum on D&O Liability Insurance in London. I will be participating on a panel entitled “The Impact of Increased Regulatory Oversight and Regulatory Investigations.” The panel will include my good friends Helga Munger of Munich Re, Cristiana Baez-Safa of XL and Ralf Rebetge of Chubb. The C5 Forum, which is excellent every year, includes a number of interesting sessions and an outstanding line up of speakers. Conference information, including registration instructions, can be found here. If you are planning on attending, I hope you will make a point of greeting me at the conference particularly if we have not previously met.

 

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In a decision that gives broad effect to a D&O insurance policy’s contractual liability exclusion, on August 17, 2012, Middle District of Pennsylvania Judge William Nealon granted the insurer’s motion for summary judgment, holding under Pennsylvania law that the insurer had no obligation to defend or indemnify the policyholder in the underlying action. A copy of Judge Nealon’s opinion can be found here.

 

Background

In 2004 and 2005, Uni-Marts sold a group of convenience stores in Pennsylvania. The buyers later contended that Uni-Marts had made misrepresentations and omissions about costs and expenses to induce prospective buyers. The buyers initiated a lawsuit in Pennsylvania state court against UniMarts (referred to as the Alliance Action). The complaint in the Alliance Action contained five causes of action against Uni-Marts: 1) fraud in the inducement; 2) negligent misrepresentation; 3) breach of the Fuel Supply Agreement;4) breach of the Purchase Agreement; and 5) breach of the Right of First Refusal Agreement. The Alliance Action ultimately settled for Uni-Marts’ agreement to pay the buyers $2 million and $25,000 in settlement administration costs, as well Uni-Marts’ agreement to certain changes in the contracts.

 

Uni-Marts sought coverage under its D&O insurance policy for its costs of defending the Alliance Action as well as for the cash amounts of the settlement. The D&O insurer denied coverage relying among other things on the policy’s contract exclusion, which provided that no coverage will be available “based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement, provided that this Exclusion … shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement.” The carrier filed an action in federal court seeking a judicial declaration that coverage was precluded. The parties filed cross-motions for summary judgment.

 

The August 17 Holding

There was no dispute that count three through five in the Alliance Action were based on Uni-Marts’ alleged liability under a written contract. The parties disputed whether or not coverage was precluded by the policy’s contractual liability exclusion for the negligent misrepresentation and fraud in the inducement counts in the Alliance Action. Uni-Marts argued that the two tort claims arise out of pre-contractual conduct and stand alone from the contract claims.

 

Judge Nealon held, “giving plain meaning to the unambiguous language of the contract exclusion,” that the fraudulent inducement and negligent misrepresentation claims “certainly are ‘based upon, arising out of, or in consequence of any actual or alleged liability’ under the contracts.” The tort claims, Judge Nealon found, “arise from the same essential facts and circumstances from those which underlie the breach of contract claims.” 

 

Of particular importance to Judge Nealon in reaching this conclusion is the fact that “the financial information relied upon by the class plaintiffs [in the Alliance Action] was incorporated into the Purchase Agreements.” Judge Nealon interpreted the plaintiffs in the underlying action as having alleged that the specific financial representations on which the plaintiffs relied as having been incorporated into the Representations, Warranties and Covenants section of the Purchase Agreement. Based on this determination, he concluded that “the fraud in the inducement and negligent misrepresentation claims are based upon, arise from, or are in consequence of Uni-Marts’ liability under the agreements.”

 

Judge Nealon also went on to make a “but for” analysis with respect to the fraudulent inducement and negligent misrepresentation claims, asking “would the store owners’ fraud in the inducement and negligent misrepresentation claims exist even in the absence of the contracts and breach thereof. The answer to that question is no. Had the class plaintiffs not entered into the contracts and had Uni-Mart no breached the contracts, there would be no independent tort claims” because “the injuries suffered by the class plaintiffs would not have occurred had there been no contracts and no breach thereof.”

 

Judge Nealon concluded by noting that requiring the insurer “to cover this loss, which its essence is derived from a business agreement gone bad, would be greatly expanding the coverage of the D&O policy beyond that which is called for by the plain language.”

 

Discussion

For many readers, this case my present something of a surprise outcome. Certainly, claims for fraudulent inducement and negligent misrepresentation arguably represent the very kinds of things for which policyholders purchase D&O insurance. However, the outcome of this case can be understood as a reflection of two factors that interacted in this situation: the exclusion’s broad preamble, and Judge Nealon’s determination that the financial misrepresentations had been incorporated into the agreement.

 

In a prior post about the contractual liability exclusion generally, I have noted how extensively a contract exclusion with the broad “based upon, arising out of” preamble can sweep. While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the broad preamble. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy. In general, courts have applied a broadly preclusive interpretation to exclusions with the broad preamble language.

 

However, not every decision has swept so broadly as to preclude coverage for the types of tort claims asserted here; in particular, Judge Nealon was forced to try to distinguish a relatively recent Western District of Pennsylvania decision in which the court, under very similar circumstances, found that misrepresentation claims were not precluded from coverage. The way that Judge Nealon distinguished the prior case and reached the conclusion that the exclusion here precluded coverage was through his determination that all of the financial misrepresentations on which the plaintiffs relied had been incorporated into the Purchase Agreement. I suspect that not every reader will be persuaded by this analytic legerdemain. But this determination is in any event a distinct characteristic of this decision that may allow it to be distinguished in any future cases involving both breach of contract and misrepresentation claims.

 

The troublesome thing about the breadth of the preclusionary effect given here to the contractual liability exclusion is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insureds could find themselves without coverge for claims of a kind that might well have assumed would be covered, but because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion are precluded from coverage.

 

The real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental to the outcome (setting aside of course the concerns about Judge Nealon’s determination that the financial representations had been incorporated into the Purchase Agreement).

 

Many carriers will insist on using the broad preamble for the contractual liability exclusion and will refuse to use the narrower “for” preamble language. However, given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose to try to apply the exclusion to preclude a wide swath of claims.

 

I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims alleging a different variety of wrongful conduct.

 

SEC Awards First Whistleblower Bounty: When the whistleblower bounty provisions in the Dodd-Frank Act were enacted, there were concerns that the provisions – allowing whistleblowers an award between 10% and 30% of the money collected when information provided by the whistleblower leads to an SEC enforcement action in which more than $1 million in sanctions is ordered – would encourage a flood of reports from would be whistleblowers who hope to cash in on the potentially rich rewards.

 

However, if the SEC’s first award under this program is any indication, some whistleblowers may decide to curb their enthusiasm. As reflected in the SEC’s August 21, 2012 press release (here), the agency has now made its first whistleblower award for the relatively modest amount of $50,000. According to the press release, “the award represents 30 percent of the amount collected in an SEC enforcement action against the perpetrators of the scheme, the maximum percentage payout allowed by the whistleblower law.”

 

The press release also explains that the whistleblower’s assistance led to a court ordering more than $1 million in sanctions, of which approximately $150,000 has been collected thus far. The court is considering whether to issue a final judgment against other defendants in the matter. Any increase in the sanctions ordered and collected will increase payments to the whistleblower.

 

There undoubtedly will be other awards, some of which undoubtedly will be larger. But for the first example, this modest award itself is unlikely provide much encouragement to prospective whistleblowers.

 

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Most management liability insurance policies these days are written on a claims made basis - -that is, they cover claims that are first made during the policy period. But what determines when a claim is first made? A February 15, 2012 decision from the Western District of Texas and applying Texas law took a look at these in an insurance dispute arising under a condominium association insurance policy and concluded that under the facts presented the claim had first been made prior to the inception of the policy. The February 15 decision can be found here.

 

Background

Deer Oaks Office Park Association is an office park condo association that owns and maintains office condos in San Antonio. Deer Park was insured under a condo association insurance policy with a policy period from January 30, 2010 to January 30, 2011. The policy included a directors and officers liability insurance extension.

 

Prior to the policy’s inception, Thomas Jeneby, purchased a unit in the condo development, intended to use if for medical offices. He later alleged that he indicated his intent to install an elevator in the unit to facilitate patient access. Deer Oaks later declined to approve the elevator. Jeneby contended that Deer Oaks had made misrepresentations about his ability to install an elevator. He also had complaints about Deer Oaks’ condo maintenance.

 

Eventually, and during the policy period of the policy, Jeneby filed a lawsuit against Deer Oaks. Deer Oaks  submitted the lawsuit to its insurer. The insurer declined to provide a defense claiming that the claim had been made and that Deer Oaks had notice of the claim prior to the inception of the policy. In making this argument, Deer Oaks relied on a September 23, 2009 letter from Jeneby’s attorney to Deer Oaks, in which the attorney presented multiple complaints about Deer Park and attributing monetary losses to Deer Oaks.

 

Among other things, the letter stated that Jeneby is “adamant that he bout this building in reliance of the fact that he would be allowed to install an elevator.” The letter also complained about numerous maintenance problems. The stated that Jeneby’s disputes with Deer Oaks have been going on for two years “with expenses and loss of business continuing to increase.” Jeneby’s attorney concluded the letter by stating that “if I have not heard a response back from your client by October 2, 2009, then my client has instructed me to file suit in District Court.”

 

After the insurer declined to provide Deer Oaks with a defense against Jeneby’s lawsuit, Deer Oaks filed an action seeking a judicial declaration that the insurer was obligated to defend the claim. The parties to the insurance coverage dispute filed cross-motions for summary judgment.

 

The February 15 Ruling

In her February 15, 2012 ruling, Magistrate Judge Nancy Stein Nowak granted summary judgment in favor of the insurer and denied DeerOaks’ cross motion.

 

Deer Oaks had argued that the September 23, 2009 letter did not constitute a claim nor did it provide Deer Oaks with notice of claim. In making this argument, Deer Park relied on the fact that the policy did not define the term “Claim,” and also relied on International Insurance Company v. RSR, a 2005 decision from the Fifth Circuit, to argue that under the circumstances of this case, a “claim” means a “demand for money, property or legal remedy, and that because the letter did not explicitly demand, property or a legal remedy, it did not provide notice of Jeneby’s claims.

 

Magistrate Judge Nowak disagreed, saying that although Deer Oaks’ “use of available case law is resourceful,” its argument “fails.” She found that “the only reasonable interpretation” of the September 23, 2009 letter is that is “asserted a right to hold [Deer Oaks] liable for all of the costs Jeneby had spent and lost because of [Deer Oaks’] acts.” The letter’s “bottom line,” the Court said, was “if you do not comply with my demands, I will sue you.” The Court concluded that “under any construction, the letter constituted a claim,” and it also “constituted notice.” Because Deer Oaks “had notice before the effective date of the policy, the claim fell outside the policy and [the insurer] had no duty to defend.”

 

Discussion

To a certain extent, the value of this case may be limited by the fact that it involved a policy that did not define the term “claim.” Although there was a time many years ago when it was common for management liability policies to lack a definition of the term, in more recent years it has become very uncommon for management liability policies to be issued without a definition of the term “claim.” Indeed, the reason that many insurers incorporated the term in to their policies is that they found that without a policy definition of the term, courts were inclined to infer a very broad definition of the term.

 

As the Magistrate Judge herself noted in discussing the Firth Circuit case on which Deer Oaks sought to rely, the appellate court had sought to apply an interpretation of the term claim that was “most favorable to the insured.”  However, this dispute illustrates the fact that a broad definition of the term does not always work out in the policyholder’s favor. By applying a broad meaning to the term, the Magistrate Judge had little trouble determining that the letter sent prior to the policy’s inception was a “claim,” and therefore that the claim had first been made prior to the policy period.

 

The outcome of this case is very fact specific, turning as it does in part on the unusual absence of a definition of the term “claim” in the policy, as well as the other specific circumstances involved. There is one very peculiar aspect of the letter that does make this a troublesome case just the same. Oddly, the September 23, 2009 letter does not appear to demand anything from Deer Oaks. The letter recites Jeneby’s grievances, states that Jeneby has incurred costs, and threatens a lawsuit. But as far as I can tell, the letter does not expressly demand anything in particular from Deer Oaks.

 

The Magistrate, applying the Fifth Circuit case law, found that the term “claim” could include “the assertion of a right to hold the insured liable,” notwithstanding the absence of any explicit demand. But I wonder whether this letter would be sufficient to constitute a claim under the usual policy definition of a claim as “a demand for monetary damages or non-monetary relief.”

 

In any event, this case does illustrate the point that broad definitions and interpretations do not always work to the policyholder’s advantage, and that what the position that any particular policyholder may want to take in any specific case may well depend on the actual circumstances involved.

 

One final note. The court’s opinion, and apparently the parties’ arguments, seemed to focus on whether or not Deer Park had notice of claim. This seems odd to me. The issue from my perspective seems to me to be when the claim was first made. The question of notice seems beside the point.

 

A February 17, 2012 memorandum from the Traub Lieberman law firm discussing this ruling can be found here.

 

In Case You Missed It: If you did not see my blog post yesterday on the meaning of “relatedness” in the context of a D&O insurance policy, please refer here.

 

Yes, the Title Says it All, and, No, I Am Not Making This Up: I am quite sure that no reader of this blog would ever stoop so low as to click on a link to an article captioned “Japanese Fart Scrolls.” Certainly, no one here at The D&O Diary would stoop so low as to try to extract humor value from a web site entry entitled “Japanese Fart Scrolls.” Our motto: Dignity, always dignity.

 

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In a November 30, 2011 order (here), Central District of California Judge R. Gary Klausner has denied the motion of the FDIC as receiver of the failed IndyMac Bank to intervene in a declaratory judgment action involving IndyMac’s D&O insurance. The FDIC sought to intervene because of its interest in recovering under the policies in connection with two lawsuits it filed as IndyMac’s receiver against former IndyMac directors and officers. Judge Klausner’s denial of the FDIC’s intervention motion may be relevant in other failed bank coverage disputes where the FDIC is interested in preserving D&O insurance policy proceeds for its claims in competition with claims of claimants to the policy proceeds.

 

Background

IndyMac failed on July 11, 2008. The bank’s closure represented the second largest bank failure during the current banking crisis, behind only the massive WaMu failure. (IndyMac has assets of about $32 billion at the time of its closure).

 

As I detailed in a prior post (here), the bank’s collapse triggered a wave of litigation. The lawsuits include a securities class action lawsuit against certain former directors and officers of the bank; lawsuits brought by the FDIC and by the SEC against the bank’s former President; and a separate FDIC lawsuit against four former officers of Indy Mac’s homebuilders division. There are a total of twelve separate lawsuits pending. The underlying actions allege various improprieties, mostly centering around mortgage backed securities.

 

Prior to its collapse, IndyMac carried D&O insurance representing a total of $160 million of insurance coverage spread across two policy years. The insurance program in place for each of the two policy years consists of eight layers of insurance. Each layer has a $10 million limit of liability. The eight layers consist of a primary policy providing traditional ABC coverage, with three layers of excess insurance providing follow form ABC coverage, followed by four layers of Excess Side A insurance. The lineup of insurer involved changed slightly in second year.

 

As I also noted in a prior post (here), in early 2011, a unit of IndyMac had filed a declaratory judgment action seeking to establish coverage under the various policies in connection with claims that had been filed against the unit. In an August 2011 order, discussed in the prior blog post, Central District of California Judge R. Gary Klausner granted the defendants’ motion to dismiss the action as premature.

 

Separately, in March 2011, the four Side A carriers in the second of the two insurance towers filed their own separate declaratory judgment proceedings, against certain former IndyMac directors and officers, seeking to establish that terms in their policies preclude coverage for the various lawsuits. The directors and officers counterclaimed and also added as counter-defendants the four traditional ABC carriers in the second tower.

 

In October 2011, the FDIC, which in its capacity as IndyMac’s receiver has initiated two lawsuits against certain former IndyMac directors and officers of IndyMac, moved to intervene in the separate coverage action that the Side A carriers had initiated. The FDIC had moved to intervene on alternative grounds under the Federal Rules of Civil Procedure -- as of right; and alternatively under permissive intervention. The FDIC argued that because it is a plaintiff in the two underlying actions, it has an interest in seeing that the coverage dispute is resolved so that it can recover any eventual judgment in those actions out of the insurance proceeds.

 

The November 30 Ruling

In his November 30 opinion, Judge Klausner denied the FDIC’s motion to intervene. Judge Klausner held that the FDIC had not established its entitlement to intervene as of right because it “has not obtained a judgment against the Insured Defendants and may never do so,” and so presently it has at most “the hope of an eventual judgment.” Accordingly, he held, the FDIC has “no legally protected interest” in the coverage dispute.” He added that even if it had a legally protected interest, that interest is not related to the subject matter of the coverage lawsuit. Because the FDIC’s lawsuit against the former directors and officers and the separate insurance coverage action “involve different legal issues,” they are “not related for purposes of mandatory intervention.”

 

Judge Klausner held that FDIC’s alternative motion for permissive intervention also fails because the FDIC’s action against the former directors and officers, on the one hand, and the separate insurance coverage dispute, on the other hand,  do “not present common questions of law or fact.” He added that because the FDIC has not yet obtained a judgment against the Insured Defendants it “does not have an interest that it needs to protect” and its claims “are not yet ripe for adjudication” and therefore it does “not have standing as a permissive intervenor.”

 

Discussion

The FDIC’s interest in preserving its ability to collect the proceeds of a failed bank’s D&O insurance is not limited to this case. In connection with a host of other failed banks, the FDIC’s interest in the D&O insurance policy proceeds is in competition with the interests of a variety of other claimants, including in particular shareholders of the holding companies of the failed banks.  The various parties will be in a race to try to see who gets there first, and if they can get there before the insurance is substantially or entirely depleted by defense expenses. The FDIC’s interest in taking part in coverage litigation makes perfect sense.

 

But so too does Judge Klausner’s ruling here. It appears that until the FDIC has reduced its claims to a judgment it may have difficulty presenting its purported claims to the D&O insurance policy proceeds in a coverage action. The question of whether or not there is coverage under a D&O policy for a given claim scenario is different from the question whether or not the FDIC has any entitlement to the policy proceeds.

 

Special thanks to my friends at Bates Carey Nicolaides LLP for providing me with a copy of Judge Klausner’s opinion. Bates Carey represents one of the insurers in the pending coverage action.

 

ABA Journal Top 100  Blawgs: The D&O Diary is proud to have been selected as one of ABA Journal’s Blawg 100 for 2011, the Journal‘s fifth annual list of the best blogs about lawyers and the law. This year’s Top 100 designees were selected from over 1,300 nominees. It is a particular honor to be selected along with the other five business law designees, which include some of the best blogs on the Internet: Professor Jay Brown’s Race to the Bottom Blog; Broc Romanek’s The CorporateCounsel.net blog; Professor Stephen Bainbridge’s ProfessorBainbridge.com; the Truth on the Market blog, which is maintained by a number of academics; and Francis Pileggi’s Delaware Corporate and Commercial Litigation blog .

 

Between now and December 31, 2011, you can vote for your favorite among the top six business law blogs, by clicking on the ABA Journal Blawg 100 badge in the right hand column. Everyone here at The D&O Diary would appreciate your support. Thanks to the readers who make this blog possible and worthwhile.

 

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One of the thorniest D&O insurance coverage issues is the question of the applicability of a policy exclusion when coverage preclusive conduct has been alleged – but not proven. In a November 14, 2011 opinion (here), District of Oregon Judge Ann Aiken held that the mere allegations in the underlying claim, even if otherwise sufficient to constitute precluded “bad faith” within the meaning of a policy exclusion, were insufficient to preclude coverage where the underlying claim settled and the allegations were not proven. Though the specific exclusion involved is unusual, the dispute itself raises a number of interesting issues.

 

Background

Summit Accomodators, Inc. was in the business of facilitating so-called “1031 exchanges.” The company experienced liquidity issues in late 2008 and filed for bankruptcy. In June 2009, the trustee for the Summit Accomodators Liquidation Trust filed a civil action against Umpqua Bank, alleging that the bank knowingly aided and abetted the principals of Summit in the perpetration of a multi-million dollar Ponzi scheme.

 

Among other things, the trustee’s complaint alleged that “highest level of management at Umpqua Bank … became fully aware of the Ponzi scheme and the principals’ embezzlement. …Yet [the bank officials] continued to actively encourage and materially assist the Summit principals.” The bank is alleged to have aided the scheme by providing banking services including loans and by encouraging bank customers to use Summit’s services.  Additional lawsuits later arose. The suits were later consolidated and ultimately settled.

 

At the time the claims arose, the bank was insured under a D&O liability insurance policy. The insurer funded the bank’s defense in the litigation. However, the insurer disputed that the policy provided coverage for the underlying settlement. Ultimately, the insurer contributed 41% of the settlement amount. The bank sued the insurer for breach of contract (refer here for the bank’s complaint), seeking to recover the balance of the settlement amount from the insurer. The insurer answered the complaint and also counterclaimed for return of the 41% of the settlement that it had funded, arguing that there was no coverage under the policy for the settlement (refer here for the insurer’s Answer and Counterclaim).

 

In arguing that the policy precluded coverage for the settlement, the insurer relied on Policy Section V (illegal profit/payment exclusion):

 

The Insurer shall not be liable to make any payment for Loss, other than Defense Costs, in connection with any Claim arising out of or in any way involving:

1. any Insured gaining, in fact, any profit, remuneration, or financial advantage to which the Insured was not legally entitled;

2. payment by the Company of inadequate or excessive consideration in connection with the purchase of Company securities; or

3. conflicts of interest, engaging in self-dealing, or acting in bad faith. 

 

In disputing coverage, the insurer relied principally on subsection 3 of this provision, the “bad faith” exclusion.

 

The insurer moved for judgment on the pleadings, arguing that the applicability of the bad faith exclusion could be determined “based solely on the undisputed terms of the complaints in the underlying litigation against the bank.” (The insurer’s memorandum in support of its motion for judgment on the pleadings can be found here). The bank filed a cross-motion for summary judgment.

 

The November 14 Order

In her November 14, order, Judge Aiken denied the insurer’s motion for judgment on the pleadings and granted in part the bank’s cross-motion for summary judgment. In making her ruling, Judge Aiken did not construe the phrase “acting in bad fait,” or determine whether the underlying allegations constituted “bad faith,” as she deemed it sufficient to determine whether or not the exclusion could be triggered by the mere allegations in the underlying litigation.

 

The insurer had argued that the egregious allegations of the bank’s complicity in the alleged Ponzi scheme were sufficient to trigger the exclusion. In support of its contention that allegations alone were sufficient, the insurer argued that the reference in the policy’s definition of Wrongful Act to an “actual or alleged” act, error or omission was incorporated into all of the policy exclusions, setting up an “allegations alone” trigger for all exclusions. The insurer also contrasted subpart 1 of the exclusion at issue, which expressly required an “in fact” determination that that the precluded conduct occurred, with the “bad faith” subpart, which has no such “in fact” determination requirement.

 

Judge Aiken rejected these arguments.  First, she found that, contrary to the insurer’s “surreptitious interpretation,” the exclusion “does not actually state that it is triggered by allegations of bad faith,” and that “the word ‘alleged’ is at no point used within the exclusion.” She added that “in its attempt to avoid its contractual duty to indemnify,” the insurer “erroneously substitutes the term ‘alleged act’” in its interpretation of the exclusion.

 

Judge Aiken noted further that when the insurer “intended the policy exclusions to be activated by mere allegations, it did so expressly within the actual text of the policy.” She noted in that regard that both the policy’s Pollution Exclusion and its Bodily/Personal Injury and Property Damage Exclusion both expressly reference “alleged” activity or conduct as triggering the exclusion.

 

Finally, she noted that “at the very least,” the insurer’s “imprecise drafting allows the Exclusion to have more than one reasonable interpretation,” and accordingly she was required to construe the policy in favor of coverage.

 

Discussion

A recurring problem D&O insurers face is the question of their coverage obligations in circumstances  involving alleged egregious misconduct, when the misconduct has not yet been the subject of formal proof. Two scandals currently on the front pages of the business sections illustrate this issue. The newspapers are full of stories suggesting that MF Global improperly applied customer funds. Olympus Corp. has actually admitted that it misrepresented certain transaction costs in order to mask certain investment losses.

 

The general movement in most D&O insurance policies in recent years has been toward an “after adjudication” standard for conduct exclusions, meaning that the exclusionary language does not preclude coverage unless and until there has been a judicial determination that the precluded conduct has occurred. To the extent that the conduct exclusions in the MF Global or Olympus insurance policies apply only after an “adjudication,” the exclusions in those policies would not presently operate to preclude coverage notwithstanding the allegations or admissions involving the companies. Indeed, because so few directors and officers liability cases actually go to trial, there are rarely “adjudications” and so the preclusive effect of the conduct exclusions is rarely triggered.

 

I refer to these contemporary examples to highlight the fact that, at least as most current D&O insurance policies are written, D&O insurers are often called upon to provide coverage even in the circumstances involving egregious underlying allegations. Clearly, in the Umpqua Bank case, the insurer was deeply troubled by the allegations in the underlying complaint of the bank’s complicity in the alleged Ponzi scheme. But as disturbing as the trustee’s allegations may be, the mere fact that these things were alleged does not mean that any of these things actually happened or that they happened the way the trustee alleged.

 

The exclusion at issue in the Umpqua Bank case contained no “adjudication” requirement. It did not even, as the insurer pointed out, contain an “in fact” provision requiring that the precluded conduct occurred.  The absence of these types of provisions allowed the interpretation of the exclusionary language that the carrier took in this case, and makes the carrier's position not unreasonable.

 

However, the exclusions’ lack of a specific trigger does not necessarily mean that mere allegations alone are sufficient to trigger the exclusion.Many (if not most) directors and officers liability complaints contain allegations asserting  “conflicts of interest, engaging in self-dealing, or acting in bad faith.” If those types of mere allegations alone were sufficient to preclude policy coverage, then the exclusion’s preclusive effect would reach so broadly that it would swallow up much of the intended coverage for which the policyholder purchased the policy in the first place. Certainly, it would seem that if the insurer was to narrow coverage so dramatically for mere allegations, then it ought to do so explicitly.

 

Indeed the potentially preclusive scope of this policy exclusion may explain why the exclusion is relatively unusual. Many purchasers and their advisors would find it better to avoid policies with this type of language, particularly given this insurer’s formulation of the language.

 

By the same token, the potential breadth of the exclusion’s preclusive effect is yet another reason to support Judge Aiken’s narrow interpretation. If the parties had intended mere allegations of  “conflicts of interest, engaging in self-dealing, or acting in bad faith” to preclude indemnity coverage, then the exclusion would have expressly included the word “alleged,” as was the case with the two other policy exclusions Judge Aiken referenced in her opinion. The presence of the word “alleged” in the other exclusions and its absence in the “bad faith” exclusion, at a minimum, allows, as Judge Aiken found, “more than one reasonable interpretation” of the question whether or not mere allegations are sufficient to trigger the “bad faith” exclusion.

 

Readers who are wondering why the name Umpqua Bank sounds familiar may recall that in an earlier post (here), I wrote about the derivative lawsuit that the shareholders of Umpqua’s holding company filed against company officials after t  62% of shareholders voted “no” in the advisory shareholder vote on the company’s 2010 executive compensation plan. The claims asserted in the lawsuit rely directly on the negative note.

 

FDIC Files Another Failed Bank Lawsuit: And speaking of bank litigation -- the FDIC has filed another lawsuit against the former directors and officers of a failed bank. On November 18, 2011, the FDIC filed an action in the Western District of Washington against eleven former directors and officers of Westsound Bank, which failed on May 8, 2009. A copy of the complaint can be found here.

 

In its complaint, the FDIC seeks to recover at least $15 million in principal losses the bank suffered on 28 commercial loans. The complaint alleges that the defendants failed to properly supervise the bank’s lending operations. The complaint alleges that certain loans were approved in violation of the bank’s lending policies and in disregard of regulatory warnings.

 

The complaint further alleges that 21 fraudulent loans to the Russian/Ukrainian community would not have been made if the defendants had heeded regulatory warnings and properly supervised lending operations. Finally, the complaint seeks to recover losses on preferential loans that were made to directors and director-led companies.

 

The FDIC’s complaint against the former Westsound Bank officials is the 17^th the agency has filed against former directors and officers of failed banks as part of the current wave of bank failures. Like many of the suits the FDIC previously filed, this one came well over two years after the bank’s failure. The sheer number and timing of the bank failures during the current wave (which now total over 400) and the FDIC’s deliberate litigation approach suggests that there are many other lawsuits to come in the months and years ahead.

 

The FDIC recently updated its professional liability lawsuits page on its website to reflect that the agency has approved an increased number of lawsuits. The updated page (here) shows that as of November 14, 2011, the FDIC has authorized suits in connection with 37 failed institutions against 340 individuals for D&O liability with damage claims of at least $7.6 billion. Though the FDIC has authorized lawsuits involving 37 institutions, it has filed only 17 lawsuits involving 16 institutions so far – suggesting that there are many lawsuits yet to come, just taking into account the lawsuits authorized so far.

 

With more lawsuits likely to be authorized in the future, and with banks continuing to fail (two more were closed this past Friday evening), it seem probable that the number of lawsuits involving former directors and officers of failed banks will continue to accumulate for years to come.

 

Cybersecurity Disclosure: In the quarterly Advisen webinar last week, one of the topics discussed was the SEC’s new disclosure guidelines regarding cybersecurty risks and exposures. Readers interested in learning more about the SEC’s guidelines will want to refer to the November 17, 2011 memorandum from John Nicholson of the Pillsbury law firm, entitled “Accounting for Cybersecurity: SEC Guidance in Disclosures to Investors and Regulators” (here). The memo includes a detailed discussion of the new guidelines and the challenges that companies may face in trying to comply with the guidelines.

 

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According to statistics compiled by the American Bankruptcy Institute, over 60,000 businesses filed for bankruptcy in 2009, the highest annual number of business-related bankruptcies since 1993. By way of comparison, the 2009 business bankruptcy filing levels were nearly 200% greater than in 2006. All signs are that these bankruptcy filing levels have continued unabated this year.

 

One of the frequent accompaniments of a corporate bankruptcy filing is the initiation of litigation against the directors and officers of the failed company. This litigation often leads to complex questions of D&O insurance coverage. As discussed in the April 2010 paper from ACE Insurance entitled "Financial Crisis: Bankruptcy Implications for D&O Insurance" (here), "bankruptcy poses the greatest threat of personal financial risk and the most complicated [D&O Insurance] coverage issues."

 

Yet there may be no time when D&O insurance is more important than in bankruptcy. As Paul Ferrillo of the Weil Gotshal firm notes in his April 30, 2010 memorandum "Directors and Officers Liability Insurance in Bankruptcy Settings – What Directors and Officers Really Need to Know" (here), "when a Corporation files for bankruptcy, the D&O policy becomes one of the few protections a director or officer has against lawsuits and claims targeting his or her personal assets."

 

Because, as the ACE report notes, "bankruptcy has the potential to dramatically complicate D&O coverage issues," it is important at the time the D&O insurance is put in place that these potential issues are taken into account and that the insurance is structured to try to reduce the likelihood of these complications arising in the event of a later bankruptcy.

 

The Weil Gotshal memo outlines a number of critical steps the company can take in structuring its insurance to address these bankruptcy-related concerns, including the following.

 

First, in order to avoid the possibility that the insurance is unavailable to defend individuals in bankruptcy related claims due to a policy rescission based on application misrepresentations, the company should incorporate into its insurance program a provision that the Side A coverage (protecting individuals for nonindemnifiable claims) is not rescindable. This provision specifies that the Side A coverage cannot be rescinded and will require the D&O carrier to begin advancing defense costs immediately.

 

Second, the company’s program should incorporate a Priority of Payments provision that, as described in the Weil Gotshal memo, "created a clear path that allows for the contemporaneous payment of defense costs for directors and officers." The provision specifies that payment of individuals’ defense expense or other loss costs takes priority over those of any insured entity. As the memo notes, this provision "limits the uncertainty of whether a D&O Policy will be immediately available to fund the defense costs of directors and officers who are embroiled in litigation when a company files for bankruptcy."

 

Third, the policy exclusion precluding coverage for claims against insureds brought by other insureds (known as the "insured vs. insured exclusion) should be amended to carve back coverage to ensure that the policy exclusion is not applied to preclude coverage for claims brought by "a debtor in possession, chapter 11 trustee, creditors, bondholders, all committees and other bankruptcy constituencies."

 

The Weil Gotshal memo includes a number of other policy prescriptions which, while described within the context of bankruptcy-related concerns, actually are critically important regardless whether or not a company might eventually wind up in bankruptcy, including the following.

 

First the company should ensure that there is "full severability" in connection with the policy application, so that any insured person’s knowledge of application misrepresentations "should not affect coverage for directors and officers who were unaware" of the misrepresentations.

 

Second, with respect to the D&O policy’s conduct exclusions (excluding, for example, coverage for criminal or fraudulent misconduct) should be drafted so that they are "triggered only upon a final adjudication of the prohibited …conduct."

 

Third, it is critically important for companies to attend to questions of limits adequacy and policy structure. Complex claims, of the type that often arise in bankruptcy but that can also arise without regard to bankruptcy, have the dramatic potential to substantially erode or even exhaust available insurance. The amount and structure of insurance acquired should take this dramatic possibility into account.

 

In particular, with respect to policy structure, board members will want to determine whether the company’s insurance program includes so called Excess Side A insurance or even Excess Independent Directors Liability Insurance (IDL). As the Weil Gotshal memo notes, when D&O claims are filed, the CEOs and CFOs "generally use up most of the coverage" in the Company’s D&O insurance program, "potentially leaving the independent directors with insufficient coverage to resolve the claims against them." Even though IDL policies "are the most underutilized insurance policies," it may be in the board’s interest to purchase IDL insurance as added protection in the event of significant claims against company inside management.

 

All of these concerns underscore the importance of taking all of these issues into account at the time the insurance is put in place, which in turn highlights the importance of having a knowledgeable and skill insurance professional involved in the insurance acquisition process. As the Weil Gotshal memorandum notes, "a good insurance broker may be able to assist in finding alternative primary carriers or alternative coverage solutions that will better satisfy a Corporation’s needs."

 

The complex D&O insurance coverage issues that can arise in the event of bankruptcy related claims are a recurring concern that I have previously explored in related posts, most recently here.

 

Putting Options Backdating Into Perspective: In light of the vivid events in the global financial marketplace in the last couple of years, the options backdating scandal seems both distant and even trifling, at least relatively speaking. However, as Professor Peter Henning points out in an April 30 post on the Dealbook blog (here), the government’s record in prosecuting options backdating may provide important clues to the way the government may proceed in connection with the current financial crisis.

 

As Henning notes, the options backdating results on the criminal side "were decidedly mixed," with a few trial victories but also with "notable acquittals." In particular, Henning notes, "the cases turned out to be much more difficult to win because the conduct had neither the visceral appeal nor the impact" that prior corporate scandals had. No company’s survival was threatened and the options practices involved accounting and tax issues were murky, allowing defendants to argue successfully in some cases that they did not believe they engaged in wrongdoing.

 

Henning suggests that "the experience with options backdating prosecutions may be leading prosecutors to adopt a much more cautious approach to cases involving complex financial transactions in which the accounting rules are less than clear." He concludes that "the options backdating cases show how difficult it is to win convictions against senor executives, even when they are directly involved in the transactions," as a result of which "we will see few, if any, prosecutions from the recent financial turmoil when executives can point to the markets as the reason for any harm suffered by their companies."

 

There is Absolutely No Cause for Alarm: Tom Kirkendall on the Houston’s Clear Thinkers blog recently linked to the classic Monty Python Skit, "How to Irritate People: Airplane" which reminded me in certain air travel woes to which I have been subjected. Please remain comfortably seated while you watch this video, and be certain to reassure yourselves that no one would deliberately set out to irritate anyone like this, now would they?

 

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A liability insurance policy is not intended to provide policyholders a means to shift to the insurer their separate, voluntarily undertaken contractual obligations. Private company D&O insurance policies generally embody this principle in a separate exclusionary provision. However, the wording of the exclusionary clause can substantially affect the scope of coverage otherwise available under the policy. In particular, the expansive reading given certain exclusionary language in recent cases suggests that a more narrowly constructed exclusion would more appropriately address the concern that the provision was originally intended to address.

 

Background

Long standing case law establishes that liability insurance policies do not cover breach of contract claims, because a contractual duty is not a liability imposed by law but is rather a voluntarily undertaken obligation. By way of illustration, a debtor ought not to be able to borrow funds, neglect to repay the debt, and then shift the repayment obligation to an insurer.

 

While these case law principles are well-established, some years ago private company D&O insurers nevertheless began to insert express contract exclusions in their policies. In part the insertion of the contract exclusion was intended to address the recurring policyholder objection that the policy does not say that it will not cover contractual liability. The insurers also wanted policy language to try to address recurring problems presented by claims against insured companies that sound both in contract and in tort (e.g., a complaint that asserts both a breach of contract claim and a claim for tortious breach of contract).

 

In addressing these issues, some carriers have adopted broadly worded exclusionary language. For example, one leading carrier’s private company D&O insurance policy contract exclusion precludes coverage for claims "based upon, arising from, or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement provided that this exclusion… shall not apply to the extent that an Insured Organization would have been liable in the absence of the contract or agreement."

 

As an important aside, most public company D&O insurance policies typically have no contract exclusion, for the simple reason that the company (or "entity") coverage provided in most public company D&O insurance policies is limited exclusively to Securities Claims. Because contract claims are not within the scope of entity coverage provided in the typical public company policy, there is no need to exclude contract claims. The contract exclusion (in some form) is, however, a relatively standard part of most private company D&O insurance policies because the entity coverage afforded under the private company policy is more expansive and is not restricted merely to a single category of claims.

 

While most private company D&O insurance policies have some form of contract exclusion, not all policies have adopted the more expansive exclusionary language of the type illustrated in the example quoted above. The scope of language in the exclusion can substantially affect the extent of coverage available under the policy; in particular, courts have applied a broadly preclusive interpretation to the expansive exclusionary language of the type quoted above.

 

Recent Case Examples

Spirtas: In an April 2008 opinion (here), the Eighth Circuit affirmed an Eastern District of Missouri opinion granting summary judgment on behalf of a D&O insurer on the basis of the applicable policy’s contract exclusion.

 

The insured, Spirtas Company, had entered a contract to perform construction contract demolition work. The project manager later sued Spirtas claiming that it had not performed the demolition work properly and had failed to use funds the project manager had supplied Spirtas to pay subcontractors and suppliers. The complaint alleged breach of contract, breach of express or implied trust, conversion and unjust enrichment. Spirtas sought coverage for the claims under its D&O insurance policy.

 

The D&O insurer denied coverage in reliance on a policy exclusion that, in pertinent part, precluded coverage "based upon, arising from or in consequence of any actual or alleged liability of an Insured Organization under any written or oral contract or agreement." In the ensuing coverage litigation, the district court granted the insurer’s motion for summary judgment holding that the underlying cause of action, including the tort claims, arose from Spirtas’s obligations under the demolition contract.

 

The Eighth Circuit affirmed, holding that the contract exclusion "applies to claims sounding in tort as long as they flowed from or had their origins in the breach of contract." The Eighth Circuit made it clear that its conclusion was reinforced by the broad scope of the exclusion’s "arising from" language.

 

GE HFS: The difficulty with the breadth of scope given the "arising from" language in this context is that it potentially lacks a logical stopping point. A 2007 opinion in the GE HFS case in the District of Massachusetts illustrates the how broadly this expansive reading just might extend. (The magistrate’s report and recommendation, which was subsequently adopted by the district court, can be found here; this post refers to the magistrate’s report and recommendation.)

 

In the GE HFS case, a home health care company had a line of credit in which the company was obliged to provide the lender certain status reports, upon which the lender relied in advancing additional credit. After receiving reports and advancing funds, the lender claimed the company had overstated its assets, as a result of which it had overextended the credit. The company went bankrupt. The lender sued certain of the company’s directors and officers.

 

The lender’s complaint, by its own terms, sought damages from the individual defendants for "negligent misrepresentations…with respect to collateral available to satisfy loans." The complaint also sued certain of the individual defendants for breach of contract on a personal guaranty. (There was no contention that the claims based on the personal guarantees were covered under the policy.) According to the magistrate in the coverage action, the "crux" of the lender’s complaint is its allegation that the individual defendants in the underlying action "failed to exercise reasonable care and competence in the preparation and communication" to the lender, as a result of which the receivables collateral were overstated and the lender advanced more money than it would have if the reports had been accurate.

 

The coverage case involved one of the individual defendants, Ingoldsby, who asserted among other things that the underlying complaint did not allege that he had prepared or compiled the disputed reports, and therefore that the claim against him was in effect a claim for negligent supervision or mismanagement, rather than misrepresentation. Indeed, the magistrate assumed for purposes of its opinion that the claim against him was for "negligent supervision."

 

The D&O insurer nevertheless denied coverage for Ingoldsby’s defense expenses on the basis of the applicable policy’s contract exclusion. The exclusion precluded coverage for claims "alleging, arising out of, based upon or attributable to any actual or alleged contractual liability of the Company or any other Insured under any express contract or agreement."

 

The magistrate found that the "arising out of" language "must be read expansively," holding that because the "allegedly wrongful conduct" was "dependent upon and in furtherance of" the loan, the loan "provided more than context: the entire claim was based upon the performance under the contract." Because the "allegedly wrongful conduct was part and parcel of performance under the contract," the contract exclusion applied.

 

The court also rejected the Ingoldsby’s argument that "the exclusion is void as it excludes virtually all types of coverage." The magistrate found that "misrepresentations may occur in a business setting yet not be related to a contractual duty."

 

Discussion

The outcome in the GE HFS case may be entirely appropriate give the facts and the contractual language involved, but the practical consequences of the case should not be overlooked. The court denied coverage for an individual director and officer for a negligent supervision claim, because of the relation of the claim to the underlying contract and because of the breadth of the contract exclusion.

 

The troublesome thing about the breadth of the preclusionary effect applied in these cases is that some type of transaction is at the heart of many claims under a private company D&O insurance policy. The danger is that insured individuals could find themselves facing claims of a kind that might well have assumed would be covered (say, for example, a negligent supervision claim), because of the involvement in the claim of an underlying transaction and because of the expansiveness of the D&O insurance policy’s contract exclusion.

 

Which brings me to the ultimate point– that is, the real problem here may be the expansiveness of the preamble to the exclusion. Clearly, the use of the broad "based upon" and "arising out of" language was instrumental in the two cases discussed above.

 

The court in the GE HFS case more or less recognized this when it acknowledged that "the coverage provided by the policy at issue… may be more limited than other available D&O policies." The inverse of this statement is, of course, that coverage provided by other policies is less limited. While that does not necessarily mean that a differently worded policy would have covered the claims at issue in the GE HFS case, the differently worded policy would not be as "limited."

 

My own observation is that carriers whose policies have the broad preamble language in the contract exclusion of the type discussed above perceive that coverage under their policies is indeed limited, demonstrating that as a practical matter there may be no logical stopping point in interpreting the coverage restrictions created by an expansive exclusionary provision.

 

By significant contrast, certain carriers’ private company D&O insurance policies have contract exclusions that do not use the broad omnibus "based upon" or "arising out of" preamble language. Rather, these carriers’ policies use the more restricted "for" wording.

 

Given the extent of the preclusive effect that courts have found in interpreting policies with the broad omnibus wording, policy forms using the narrower "for" wording are, in this respect at least, clearly superior from the policyholder’s perspective, particularly if carriers whose policies have the broader wording choose (as some are now doing) to try to apply the exclusion to preclude a wide swath of otherwise covered claims, including not just contract claims against entities but tort claims against individuals.

 

Indeed, I would argue that the "for" wording is much closer to the original purposes for the inclusion of the contract exclusion in private company D&O insurance policies – that is, an exclusion with the "for" wording makes it clear that insurers do not intend to pick up the insured company’s contractual liability, without extending the potential preclusive effect, for example, to tort claims against individuals.

 

Many prospective insurance buyers would be surprised indeed to learn that their prospective insurer intended to take the position that their policy would not cover even defense expense for, say, a negligent supervision claim if the claim also involves an underlying business transaction. Indeed, I suspect that many D&O underwriters would be surprised to learn that the claims handling counterparts would take such a position.

 

The use of the "for" wording in the contract exclusion provides at least some assurance that these reasonable expectations will not later be defeated by a reading of the contract exclusion that is so broad that is arguable defeats coverage for claims that might reasonably be presumed to be covered.

 

One final note. I want to acknowledge that my thoughts on this topic were triggered by the excellent November 2008 PLUS Journal article by Joseph A. Bailey III of the Drinker Biddle law firm entitled "Trio of Recent Cases Affirms Broad Scope of Contract Exclusion" (here). I hasten to add that the views expressed in this post are exclusively my own.

 

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Investors whose fortunes were tied to Bernard Madoff and his firm have already been counting (and mourning) their losses. But for the insurers that provided coverage for financial firms targeted in the Madoff-related litigation, the losses have only just begun to accumulate.

 

How high the insurance losses ultimately may run remains to be seen, but early estimates suggest that that the insurance losses, even just for defense expenses, could be significant.

 

A January 9, 2008 Bloomberg article (here) reports that Madoff-related claims "may cost insurers who cover financial institutions more than $1 billion as they pay legal costs for investment managers who gave client money to Madoff." Indeed one respected industry participant is quoted as saying that a total of $1 billion "feels a little low to me."
 

 

The losses could well affect not only D&O insurers, but also insurers offering"error and omissions" E&O insurance. For many of the kinds of investment firms involved in these cases so far, the type of insurance protection they would most likely purchase provides both coverages within a single package.

 

The article correctly points out that how large the insurance losses ultimately turn out to be depends on how many of the Madoff "feeder funds" and other litigation targets actually have purchased these kinds of insurance. As one observer quoted in the article notes, hedge funds and other investment vehicles "often don’t buy coverage."

 

There are a variety of other factors that also could affect the total cost to insurers of the Madoff-related claims. The first is the question of who is insured under the policies. In many of these Madoff-related lawsuits (a complete list of which can be accessed here), the plaintiffs have named a laundry list of related defendants, often including not only investment managers and advisors, but also investment funds, offshore entities, and a squadron of associated individuals.

 

These claims are going to stress-test the insurance policies involved. The policyholders will find out how well put together the policies were, in light of the entities’ related structures and operations. There may well be instances where the entire family of advisors, managers and funds were not fully yoked together under the coverage umbrella.

 

But an even more important set of issues that potentially could affect the scope of insurance losses are the potential coverage defenses the carriers may seek to assert. In particular, insurers will be looking closely to see whether the allegations raised in these lawsuits trigger one of more of the standard conduct exclusions, particularly the personal profit and the fraud exclusions.

 

The conduct exclusions typically are written on an after adjudication basis, meaning that the only apply to preclude coverage only after an adjudicated determination that the prohibited conduct actually took place (as I recently noted in my discussion of the potential coverage insurance issues arising in connection with the Satyam scandal, here).

 

Moreover, at this point the fraud involved appears to involve misconduct of Madoff himself, rather than the feeder funds, although obviously investigators are probing the potential complicity of a wide variety and number of persons associated with Madoff.

 

The personal profit exclusion may prove to be the more relevant. A typical exclusion precludes coverage for loss "based upon, arising from, or in consequence of … an Insured having gained any profit, remuneration or advantage to which such Insured as not legally entitled, if a judgment or final adjudication in any proceeding establishes the gaining of such remuneration or advantage."

 

Investors have already claimed that the feeder funds inappropriately exacted management fees or other compensation without conducting appropriate due diligence or otherwise earning their fees. However, an adjudicated determination of these allegations would be required for the profit exclusion to preclude coverage.

 

Although there is currently no reported reason to suggest that the "feeder funds" were aware of Madoff’s scheme, insurers will also be looking closely at who know what and when, looking for possible bases to rescind coverage based on alleged misrepresentations in the policy application.

 

Yet another factor that could restrict the total insurance losses is the limitation on the amount of insurance potentially involved. In my experience, many investment advisory firms and hedge funds buy relatively lower limits of insurance coverage. Thus, in many cases, the available insurance involved could be relatively slight and could quickly be exhausted by defense costs alone. As a result, a portion of the potential defense expense and the amount of some settlements could wind up being uninsured.

 

I suspect that as a result of the Madoff-related events, many investment advisory firms, hedge funds and other financial firms will now need far less persuading of the value of this type of insurance or that more than just minimal limits could well be advised. Unfortunately, for the firms acquiring this insight for the first time now, this type of coverage could well become much more expensive even if otherwise available.

 

As noted in a December 31, 2008 publication of the Lloyd’s insurance market entitled "Madoff Scandal Poses Challenges for Directors" (here), the "sheer scale of the fallout from Madoff could seriously affect the financial insurance market’s dynamics, affecting the availability and cost of both professional indemnity and directors and officers coverage." The article quotes one source as stating with respect to this type of coverage that "prices are going to increase and cover will be restricted."

 

More Madoff Lawsuits: Meanwhile, the Madoff-related lawsuits continue to flood in. For example, on January 8, 2009, Pacific West Health Medical Center, Inc. Employees Retirement Trust sued Fairfield Greenwich Group and related entities and individuals in the Southern District of New York on behalf of all persons who purchased shares of the Fairfield Sentry funds, alleging that the defendants breached their fiduciary duties. The defendants are also accused of negligence, unjust enrichment and breach of contract.

 

A copy of the Pacific West complaint can be found here. A copy of a January 9, 2009 Bloomberg article describing the complaint can be found here.

 

It also looks as if overseas investors are about to get involved in Madoff litigation, which may be unsurprising give that, as the Financial Times reports (here), as much as half of the Madoff losses have been borne by non-U.S. investors.

 

According to a January 8, 2009 Reuters story (here), investment activist group Deminor is readying to sue UBS, HSBC, Hyposwiss and others in courts in Luxembourg and Ireland in connection with the Madoff scandal. The charge is that the defendant banks acts as depositories for sponsored funds that invested clients’ money in Madoff-related vehicles. The allegation is that the depository banks were responsible for the sponsored funds and negligently failed to check what was inside the clients’ portfolios.

 

According to an earlier Financial Times article (here), UBS at least sought to exculpate itself from any responsibility for clients’ assets through the subscription documents it used.

 

In any event, I have updated my running tally of the Madoff-related litigation, which can be accessed here.

 

Special thanks to David Demurjian for the link to the Bloomberg article, and to a loyal reader who prefers anonymity for the Reuters and Financial Times articles.

 

Can Madoff Losses Be Recovered?: In addition to all of the factors noted above that could diminish the aggregate Madoff-related insurance losses, there is also the question whether the investors’ claims are meritorious. That is, do the claimants actually have a legitimate basis upon which to try to recover their losses from the Madoff "feeder funds" and others?

 

These questions will be addressed in a webinar entitled "Madoff Litigation: Can the Lost Billions Be Recovered?" to be hosted by Securities Docket on January 14, 2009 at 2:00 P.M. The speakers include Gerald Silk of the Bernstein Litowitz firm, Brad Friedman of Milberg LLP, and Fred Dunbar of NERA Economic Consulting. Further background regarding the webinar can be found here. Registration for the webinar can be accessed here.

 

A replay of a prior Securities Docket webinar entitled "2008: A Year in Review" can be accessed here. (I was one of the speakers at this prior session.)

 

"Hitler Previews the Cubs’ Winter Meeting": This video is in questionable taste, contains foul language, and is very very funny, at least for those having some acquaintance with the Chicago Cubs. (The humor is more accessible if, for example, you know who Kerry Wood is.) Special thanks to a loyal reader for sending along a link to this video.

 

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

 

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

 

Background

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

 

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

 

 

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

 

 

The Coverage Litigation 

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

 

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

 

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

 

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

 

The Second Circuit Opinion 

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

 

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

 

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

 

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

 

Discussion 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In an unpublished August 18, 2008 per curiam opinion (here), the United States Court of Appeals for the Eleventh Circuit has affirmed the district court’s summary judgment ruling in the CNL Resorts case that a Section 11 settlement is not covered "loss" under a D&O insurance policy. The appeals court reversed and remanded the case on other grounds, as discussed below.

 

This coverage action arose out of an underlying securities class action (about which refer here), in which the plaintiffs alleged violations of Section 11 of the Securities Act of 1933. The plaintiffs alleged that they had purchased their CNL shares at an inflated price of $20/share. The plaintiffs sought to recover the $8/share difference between what they had paid and the $12/share valuation that was later placed on the company. CNL settled this shareholder action for $35 million. Details regarding the settlement can be found here.

 

CNL had a $30 million D&O insurance program, arranged in three layers of $10 million each. CNL initiated a declaratory judgment action against the three insurers, seeking a determination of coverage for the settlement as well as related litigation costs and expenses and other amounts. CNL reached a settlement with the primary insurer, but the action proceeded as to CNL’s two excess insurers.

 

As I discussed in a prior post (here), on March 17, 2007, the district court granted partial summary judgment on behalf of the two excess insurers. The district court held that the $35 million settlement represented a disgorgement of CNL’s "ill-gotten gain," which did not constitute a "loss" under the relevant policy language and therefore is not insurable under applicable law.

 

In its August 18 opinion, the Eleventh Circuit affirmed this portion of the district court’s rulings. The Eleventh Circuit said that "because we conclude that the payment to the Purchaser Class was restitutionary in nature, the payment was not covered loss" and the excess carriers are "not liable for payment."

 

CNL had argued on appeal that the $35 million settlement did not represent the return of ill-gotten gains, contending that "without a finding of fraud, it is impossible to conclude that the money was wrongly acquired." The Eleventh Circuit said that "the return of money received through a violation of law, even if the actions of the recipient were innocent, constitutes a restitutionary payment, not a ‘loss’." The Eleventh Circuit also affirmatively held that Section 11 damages are restitutionary in nature.

 

The Eleventh Circuit also rejected CNL’s argument based on the statement in the settlement agreement that the $35 million was not "restitution or disgorgement." The Eleventh Circuit said that the settlement agreement "is not binding on any third party or this Court. The policy, not the settlement agreement, governs our resolution of this appeal."

 

The Eleventh Circuit did reverse a separate summary judgment ruling of the district court. The separate ruling related to the question of coverage for the settlement of the claims of a separate plaintiff class, the so-called Proxy Class, which had alleged misrepresentations in proxy materials. CNL had settled with this separate class in an agreement that, among other things, had resulted in its payment of the Proxy Class counsel’s fees of $5.5 million.

 

The primary insurer, in its separate settlement with CNL, had agreed to reimburse CNL for this $5.5 million settlement. The excess insurers argued, based on language in the primary policy, that the $5.5 million settlement did not represent covered "loss," and therefore the primary policy had not been depleted by payment of covered loss and the excess carriers’ payment obligation had not been triggered. The district court granted summary judgment on this issue for the excess insurers.

 

The Eleventh Circuit reversed this portion of the district court’s ruling. The Eleventh Circuit remanded the case to the district court for further factual proceedings on the question whether the language on which the excess carriers sought to rely properly is a part of the primary policy. The question to be determined is whether or not the relevant policy endorsement form had been filed with the Florida Office of Insurance Regulation, as the form would be void if not so filed.

 

At one level, the Eleventh Circuit’s affirmance of the district court’s ruling on the question of coverage for Section 11 settlements represents a significant development. A federal appellate court’s adoption of the position that a company’s Section 11 settlement is not covered loss under a D&O policy certainly reinforces the developing case authority on this point. The possibility that another court might reach a different conclusion seems increasingly remote.

 

At the same time, there are limitations on the significant of the Eleventh Circuit opinion. The first is that the opinion itself carries the designation "Do Not Publish." This is less of a restriction in the Eleventh Circuit than it might be in other courts; some courts actually prohibit the citation of unpublished opinions. The Eleventh Circuit’s Rule 36-3 (refer here) specifies that "unpublished opinions are not binding precedent, but they may be cited as persuasive authority." Thus, the Eleventh Circuit’s opinion may at least be cited, but it still does not represent binding authority.

 

There is a practical development that also diminishes the significance of the Eleventh Circuit’s opinion. That is, since the time of the district court’s summary judgment ruling on the question of coverage for Section 11 settlements, most D&O carriers have introduced policy endorsements specifying that they will not take the position that there is no coverage under their policies for settlements under Sections 11 and 12 of the ’33 Act. Not all of these endorsements were created equal, and they are all as yet untested in court, but at a minimum they ought to restrain most carriers whose policies have this endorsement from taking the position that a Section 11 or Section 12 settlement does not represent a covered loss under the policy.

 

Of course, not all policies have yet been adapted to this new approach, and there are still many claims pending in which the relevant policy does not have this new language. In connection with these existing policies and claims, it is important to note a couple of things.

 

First of all, even if a company’s Section 11 settlement is not covered under a D&O policy, the company’s expense incurred in defending against the Section 11 claim still ought to be covered.

 

Second, because the settlement of Section 11 claims against individual defendants (as opposed to the company itself) typically would not represent the return of ill-gotten gains, (since typically they would not have received any of the offering proceeds), a D&O policy ought to provide coverage for the settlement of a Section 11 claims against them, as well as their costs of defense, all other things being equal.

 

Very special thanks to a loyal reader for providing me with a copy of the Eleventh Circuit opinion.

 

Auction Rate Settlements: Plaintiffs’ Bar Bummer?: As I noted in a recent post (here), one of the as yet unanswered questions surrounding the high-profile auction rate securities buybacks is what impact these settlements will have on the numerous auction rate securities class action lawsuits (about which generally, refer here).

 

In an August 18, 2008 Legal Week article entitled "Billions Not for the Plaintiffs Bar" (here), Michael Rivera and Erik Frias of the Fried, Frank, Harris, Shriver & Jacobson law firm suggest that these settlements could have a "debilitating impact on the numerous class actions and other private lawsuits filed since the market seized up." The basis on which the authors reach this conclusion is that as a result of the buybacks and other settlement elements, "the losses of individual investors who might be plaintiffs will now be fully compensated, leaving little to no damages to pursue in court."

 

The authors suggest that as a result of the buybacks and other reimbursements incorporated into the settlements, the "bottom line" is that the claimants "will be made whole without assistance from the courts." As they put it, "government and industry have worked cooperatively to craft a solution to the auction-rate securities problem in such a way that private litigation will be largely unnecessary and unavailable." As a result, the authors suggest, there may now be "little opportunity for the plaintiffs bar to profit."

 

The authors may have a point, but I haven’t yet seen the voluntary dismissal of any of the pending auction rate securities lawsuits. The plaintiffs’ lawyers may not go quietly, and one angle I can imagine them trying to work relates to institutional investors, benefits under the various settlements are less defined and less comprehensive.

 

In any event, there are still a host of auction rate securities lawsuits that have been filed against banks and other institutions that have not yet reached a regulatory settlement. To be sure, it may only be a matter of time before the regulators set their sights on these others. In the interim, the existence of the shareholder lawsuits may represent one additional factor pressuring them to reach a regulatory settlement.

 

Finally, as I recently noted (here and here), though the settlements have started to mount, auction rate securities lawsuits continue to accumulate. There apparently are some members of the plaintiffs bar who continue to perceive an opportunity to profit from the auction rate debacle. It will certainly be some time before it is all sorted out.

 

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In a June 25, 2008 decision (here), the Delaware Superior Court (New Castle County) refused to apply a D&O policy adjudicated fraud exclusion to preclude coverage for the settlement, defense fees and costs incurred in connection with an underlying securities lawsuit.

 

The coverage action arose out of the AT&T Corporation Securities Litigation, the background regarding which can be found here. The case ultimately settled for $100 million. Prior to the settlement, the trial court granted the defendants’ motion for partial summary judgment, narrowing the case. The case went to trial on the remaining issues, but the parties reached a settlement before the jury reached a verdict. The court in the subsequent coverage litigation specifically noted that “there is no dispute that no court has held, and no jury has every found, that AT&T or any of the defendants in the Common Stock Litigation engaged in any deliberate, dishonest, fraudulent, or criminal act or omission.”

 

The primary policy in the applicable D&O insurance program provided in its base form that the insurer “shall not be liable to make any payment in connection with any Claim: brought about or contributed to in fact by any dishonest, fraudulent or criminal act or omission.” However, by Endorsement, this exclusion was deleted and replaced by language providing that he insurer is not obligated to pay any claim:

brought about or contributed to in fact by any deliberate dishonest, fraudulent or criminal act or omission, or any personal profit or advantage gained by any of the Directors and Officers to which they were not legally entitled and providing any such finding is material to the cause of action so adjudicated.

The primary carrier’s $20 million limit had been exhausted through payment of defense fees and costs. The first level excess carrier provided $25 million in “follow form” excess coverage. The excess carrier refused to pay either defense fees or contribute toward the settlement, claiming that the fraud exclusion bars coverage.

 

The Delaware court first turned to the question of what law to apply. The court ultimately determined that New York law governed. Interestingly, the basis of the court’s decision was language in the fourth level excess carrier’s policy. Because the court assumed that the parties’ intended that only one jurisdiction’s law would govern the entire program, the court found that the fourth level excess carrier’s language controlled even though the fourth level excess policy sits above the first level excess carrier’s policy.

 

The court then turned to the merits of the insurance coverage issue. The court paraphrased the exclusion as precluding coverage “for deliberate, dishonest, fraudulent, or criminal acts or omissions upon ‘such finding is material to the cause of action so adjudicated.’”

 

The court said that “no fact finder considered all the evidence and rendered a ‘finding” or verdict.” The court also observed that neither the summary judgment ruling nor the settlement adjudicated anything.

 

The court also specifically ruled that “the ‘adjudication’ contemplated in the policy does not, as [the excess insurer] asserts, mean an adjudication within the coverage dispute. It means an adjudication in the underlying action.” The court specifically noted that the excess insurer “cannot argue its way around” the change that the Endorsement introduced in the dishonesty exclusion wording. The court said the position argued by the excess carrier is “belied by the plain language of the policy.” The court added that “it is not a close question.” The court also observed that “to hold the fraud exclusion applicable” to a securities claim in the absence of an adjudication “would effectively eviscerate the purpose of the policy.”

 

The precise wording at issue in the AT&T coverage case is not typically used today. But the court’s analysis is nevertheless important as it pertains to the adjudication requirements for the typical adjudicated fraud exclusion that is found in many policies today. The court’s refusal to read into the clause a right by the insurer to adjudicate the issue of fraud in a separate coverage case amounts to a ruling that an adjudication fraud exclusion does not permit the fraud issue to be separately litigated, at least absent language to the contrary.

 

This is an important holding because while most contemporary D&O policies have an “adjudicated” fraud exclusion, there are also still some other policies that allow the insurer to litigate the fraud exclusion in a separate proceeding. The court’s holding in the AT&T case underscores the point that, without the separate proceeding language, the “”adjudication” referenced in the fraud exclusion pertains to the underlying proceeding, and the fraud exclusion therefore is inapplicable if there has been no fraud determination in the underlying proceeding.

 

The excess carrier’s inability to further litigate the fraud issue in the ATT&T coverage case also demonstrates the value to the policyholder of fraud exclusion language that does not permit separate adjudication. The presence of separate adjudication language potentially could have permitted the AT&T coverage litigation to go forward and potentially could have led to a finding that could have barred coverage. For that reason, a fraud exclusion that permits separate adjudication is undesirable from the policyholder’s standpoint. In the current insurance environment, most policyholders should be able to obtain adjudicated fraud exclusion language without any provision allowing separate adjudication.

 

A couple of final points about the decision. The first is that yet again a coverage dispute has arisen in which the excess carrier contested coverage after the primary carrier’s limits were exhausted. As I have frequently noted (most recently here), the D&O insurance industry continues to be challenged with issues arising as losses escalate through the insurance tower. The problem of excess insurer coverage disputes is an increasingly important issue that the industry must address.

 

Second, the court’s resolution of the question of the law to be applied to the first level excess carrier’s policy based on language in the fourth level excess carrier’s policy is interesting but at the same time potentially troublesome. The court’s reasoning seems practical and informed by a desire to reach a common sense solution; it is logical that only one jurisdiction’s law   should apply to the entire tower.

The troublesome part is the court’s reference to upper layer policy provisions to resolve lower layer issues. The lower layer insurers often are unaware of provisions in the upper layer policies, and problems could emerge if the view were to develop that the meaning of lower layer policies can be discerned from language in upper layer policies. Maybe this concern reads too much into the court’s opinion, but the mere suggestion is troubling.

 

Very special thanks to Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog (here) for alerting me to the AT&T coverage decision and providing me a copy.

 

Nearer to the Heart’s Desire: A July 12, 2008 Cleveland Plain Dealer article (here) reports that 34 Ohio charitable organizations will share a $14 million pool of uncollected money from a class action lawsuit. The settlement arose out of a class action lawsuit based on an auto insurer’s alleged overcharges for uninsured motorist coverage. The case settled for $51 million, but when some of the funds went unclaimed, the plaintiff class’s attorney succeeded in having the doctrine of “cy pres” applied to the unclaimed funds so that, rather than going back to the defendant insurer, the funds would go the charitable organization.

 

The term "cy pres" is law French, derived from the phrase  cy pres comme possible  -- meaning as near as possible or as close as possible to the original intent. The phrase is sometimes relevant in the trust and estates context when the trustor’s or the testator’s original intentions can no longer be fulfilled due to changed circumstances.

 

The concept of a cy pres settlement is actually not new, although it apparently has gained popularity recently among certain plaintiffs’ attorneys. Ted Frank wrote an interesting article earlier this year entitled “Cy Pres Settlements” (here) in which he discusses other recent cy pres settlements and some of the problems they present.

 

The phrase has a certain poetic quality, and not merely because of its gallic residue. The very concept is almost literary, as it requires an exercise of the imagination to implement. I have always felt this attribute of the doctrine is nicely summarized in the lines from The Rubaiyat of Omar Khayyam: “Ah Love! could you and I conspire/To grasp this sorry scheme of things entire/Would not we shatter it to bits—and then/Remold it nearer to the heart’s desire!”

 

And Finally: In a recent post (here), I discussed an academic paper in which three Stanford professors analyzed four corporate governance companies’ governance ratings. In the post, I expressly invited the governance rating companies, if they so desired, to provide a response to my discussion of the academic paper.

 

In reply to my invitation, Ric Marshall, the Chief Analyst of The Corporate Library, and Kimberly Gladman, the Director of Research and Ratings at The Corporate Library, sent me a response, which I have added to the end of my original post.

 

Because Ric and Kimberly make a number of interesting points, I urge all readers to refer back to the now updated post (here) to see their comments.

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

 

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

 

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

 

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

 

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

 

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

 

The Coverage Denial:

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

 

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

 

The Coverage Litigation:

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

 

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

 

The June 18 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion:

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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."

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With the year-end fast approaching, it is time to take a look back and review the top D & O stories of 2007. It was an eventful year, with some important developments that will have implications for the year ahead, and perhaps for years to come. Here are the top stories, with the year's most important story leading the way.

1. Subprime Meltdown Launches Litigation Wave: When I first started tracking subprime-related litigation in April (here), I already knew that the subprime meltdown was going to be an important story. By July (here), I knew that the subprime story was "this year's model"--that is, the hot litigation trend being driven by the business scandal most prominent at the time. By August, I wrote (here) that the developing story had become "All Subprime, All the Time." But even at that point, I don't think I really appreciated what the subprime story would become. I certainly didn't envision that it would lead to a surge of lawsuits against some of the giants of the financial services world, such as Merrill Lynch (refer here), Citigroup (refer here), Washington Mutual (refer here), and UBS (refer here).

As of year end, my current tally (refer here) of subprime-related lawsuits stands 34; the recently released NERA year-end securities litigation survey (here) put the number at 38. The litigation includes lawsuits against accountants (here), real estate brokers (here), and many others. The securities lawsuits have come not just against the lenders and the investment banks, but home builders, bond insurers, credit rating agencies, mutual funds, and a host of others. Even more ominously, there is an unmistakable sense of foreboding that the worst may lie ahead (refer here). But whatever may actually lie ahead, there is no doubt that the litigation resulting from the subprime meltdown is the 2007 D & O story of the year.

2. Two-Year Lull in Securities Filings Comes to an End: In mid-year 2007 studies, NERA (here) and Cornerstone (here) both observed that securities filings had been well below historical averages since mid-2005. Stanford Law Professor Joseph Grundfest questioned (here) whether or not there might have been a "permanent shift" to a lower level of securities lawsuit filings.

But as I detailed more thoroughly here, and as further documented in NERA's recent 2007 year end survey (here), the two-year lull came to an end in the second half of 2007. Indeed, the 81 securities lawsuits filed during the period between August 1, 2007 and November 30, 2007 represents the highest level of lawsuit filings in a four-month period since June-October 2004, and the 25 new securities lawsuits filed in November 2005 represents the highest monthly total since January 2005.

Perhaps even more noteworthy is the fact that the new lawsuit activity is not being driven exclusively by the subprime litigation wave; while the subprime lawsuits collectively represent one important factor, the lawsuits are actually hitting a wide variety of companies for a wide variety of reasons, many having nothing to do with the subprime meltdown. The likelihood of continued financial marketplace volatility suggest that litigation levels may remain elevated for some time to come.

3. Supreme Court Issues Tellabs Decision: The Supreme Court does not take many securities cases; for that reason, and because the Tellabs case had the potential to significantly affect the threshold resolution of many securities cases, the Supreme Court's opinion in the Tellabs case was much anticipated. When the Tellabs opinion finally came out in June 2007, it was a victory for defendants, although perhaps not as extensive a defense victory as it could have been, as detailed further here and here.

The Tellabs opinion reversed the Seventh Circuit's ruling and held, interpreting the securities lawsuit pleading standards described in the Private Securities Litigation Reform Act, that for an inference that a defendant acted with scienter to be "strong," the inference "must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." The majority opinion expressly rejected the position urged by concurring Justices Scalia and Alito that "the test should be whether the inference of scienter (if any) is more plausible than the inference of innocence."

While the Tellabs court's more balanced approach seemed less likely to have a dramatic impact on dismissal motions as would the position urged by the concurring justices, the early returns suggest that the Tellabs case has made it more difficult for securities cases to survive a motion to dismiss (as discussed on this post on the 10b5-Daily blog, here). The Tellabs case has, in fact, proven to be an important factor in many of the motions to dismiss in the options backdating cases (about which refer here). The Tellabs decision and the Supreme Court's 2005 opinion in the Dura Pharmaceuticals case are now important tools for defendants to try to use at the motion to dismiss stage in securities class action litigation.

4. Top Plaintiffs' Lawyers Face Criminal Woes: Even a short time ago, who would have thought that the two leading securities plaintiffs' attorneys would face criminal prosecution? Yet on October 29, 2007, Bill Lerach entered a guilty plea (refer here), and on September 20, 2007, Mel Weiss was indicted on criminal charges (here). (For more about Lerach's criminal charges, refer here; for Weiss's, refer here).

The impact of the criminal issues involving the two leading securities plaintiffs' lawyers is perhaps incalculable, but it does not seem a mere coincidence that shortly after Lerach left his former law firm (now reconstituted as Coughlin, Stoia,Geller, Rudman & Robbins) the firm seemingly went into high gear, filing numerous new securities class action lawsuits. The Milberg Weiss firm, meanwhile, which also faces its own criminal charges, has essentially filed no new lawsuits since 2005.

While there are many opportunistic lawyers hoping to capitalize on the changes at the leading plaintiffs' firms, it remains to be seen whether any of these firms can duplicate the role that the erstwhile leading firms have played in the past.

5. Largest Derivative Settlement Ever in UnitedHealth Option Backdating Case: The 2006 D & O story of the year undoubtedly was the options backdating scandal. The story has faded from the headlines in 2007 as the subprime scandal has emerged, but the numerous backdating lawsuits (refer here for a complete tally) are now working their way through the system. Although many of the options backdating lawsuits have been dismissed or have settled for relatively nominal amounts (refer here for a complete list of options backdating case dispositions), there have been some exceptions. The most exceptional outcome is the record settlement in the UnitedHealth Group options backdating derivative lawsuit, which apparently represents the largest derivative settlement ever.

As detailed here, in the settlement, former UnitedHealth CEO William McGuire and several other former UnitedHealth directors and officers agreed to a combination of surrender or relinquishment of stock others and other interests; repayment of certain compensation; and the repricing of other stock option awards, all of which collectively represents a value to the company in excess of $900 million. The value of McGuire's contribution alone reportedly was valued at more that $600 million.

The sheer magnitude of these values makes this settlement noteworthy. The more interesting question is the extent to which this settlement will affect the resolution of the options backdating cases that remain pending, as well as future shareholders' derivative lawsuit resolutions.

6. Stoneridge Case Argued: The Tellabs decision was not the only important D & O story out of the Supreme Court this year. On October 9, 2007, the Supreme Court head argument in the Stoneridge v. Scientific Atlanta case. At the time, the case was described as the "business case of the year." How important it will ultimately be remains to be seen, but it could have a very significant impact, as detailed at greater length here.

The case will determine the extent to which a third-party that did not actually make a misrepresentation or misleading statement can be held liable under for securities fraud under Section 10 of the '34 Act and Rule 10b-5 thereunder. The seemingly likeliest outcome is a narrow holding that does not expand the scope of Section 10(b) liability. The Court's opinion will be released some time before the end of the current Supreme Court term in June 2008. Until the outcome is known, the possibility (however remote) that the Court might overturn the Eighth Circuit and find an expansive basis for "scheme liability" makes this an important case to watch.

7. Global Warming Disclosure Issues Heat Up: Because global warming is one of the predominant social, political and economic issues of our age, it is almost inevitable that it would be come an important D & O issue as well. As I discuss at length here, the Supreme Court's April 2007 decision in the Massachusetts v. EPA case provided a new context within which global warming has emerged as a concern for corporate officials. Existing disclosure requirements and activists' proxy ballot initiatives ensure that this issue will remain as a significant corporate challenge.

Several developments that emerged as the year progressed underscore that global climate change is likely to remain a hot button issue for the foreseeable future, as detailed further here. The first occurred on September 14, 2007, when the New York Attorney General subpoened (refer here) five energy companies demanding that they disclose the financial risks of their greenhouse gas emissions to shareholders. The second is the petition submitted to the SEC by 22 different groups seeking to have the SEC require companies to assess and fully disclose their financial risks from greenhouse gas emissions and global climate change.

The activists' focus on disclosure issues has serious implications because issues surrounding are at the heart of most D & O claims. Because this issue is likely to grow in importance in coming years, companies may face even greater disclosure pressures and a corresponding increase in liability exposures.

8. Busted Buyouts Beget Litigation: The bursting of the private equity buyout bubble has not only left a raft of busted buyouts in its wake, but has also led to a host of new securities lawsuits. Disappointed target companies that have not become the target of securities class action lawsuits included Radian (about which refer here), Harman Industries (refer here), United Rentals (refer here), and Genesco (refer here). Disappointed target companies that have also lawsuits against their erstwhile acquirers include United Rental's unsuccessful lawsuits against Cerberus Management Company (refer here) and Genesco's lawsuit against Finish Line (refer here).

There are a host of other deals that are dead or on life support, as detailed on the M & A Law Prof blog (here). There may be one or more of the companies on this list that may yet find themselves with a securities lawsuit to complement their woes. In any event, the busted deal securities lawsuits collectively represent just one more factor driving the increase in securities lawsuits in 2007.

9. Qwest Opt-Out Settlements Exceed Amount of Class Action Settlement: There have always been opt-outs from securities class action settlements, but during 2007, a number of separate and very substantial opt-out settlements raised potentially important implications for future class action settlements, as well as for D & O insurers' severity assumptions and policyholders' views of limits adequacy.

The case with the highest dollar value of publicly reported opt-out settlements is the AOL Time Warner securities litigation, where the nine publicly disclosed opt-out settlements total $795 million, as detailed here. But perhaps even more significant is the Qwest securities litigation, where the $411 million aggregate value of the collective opt-out settlements exceeded the $400 million class action settlements, as further detailed here. When the value of the opt outs settlements tops the value of the class settlement, you know you've got a problem.

The emergence of the opt-out settlements presents a host of potentially complicating problems for current and future securities class action litigants, particularly if significant opt-out settlements become a regular part of securities litigation. These developments could increase litigation expense and aggregate settlement expense in civil securities litigation, and even further complicate efforts to resolve class action lawsuits.

10. Section 11 Settlement Held Not Covered "Loss": Although there had been a prior case holding that a Section 11 settlement is not a covered "loss" under a D & O policy, the prior decision was an intermediate state appellate court decision from Indiana, and was viewed as an anomaly in some quarters. So there was quite a reaction when, on March 14, 2007, Judge Gregory Presnell of the United Stated District Court for the Central District of Florida held (refer here) that the $35 million settlement to which CNL Hotels & Resorts agreed to resolve Section 11 claims does not constitute covered "loss" under a D & O policy and was not insurable as a matter of law.

While at one level, Judge Presnell's decision was merely an extension of existing case law, it did pose a challenge for the D & O insurance industry to address Section 11 settlement issues in the policy itself. Judge Presnell did specifically note that Section 11 settlements are not "per se" uninsurable. Since the CNL Hotels & Resorts opinion came down, the industry has been scrambling to come up with a policy-based solution, to address policyholder expectations of coverage for Section 11 settlements. The industry is still struggling toward equilibrium on this issue, which remains potentially very important for insured companies and their directors and officers.

Top Top Ten Lists: What could top a top ten list but a list of top top ten lists-- Time Magazine has compled fifty top ten lists for 2007 here.

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