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

Carriers generally contend that  insurance does not cover amounts that represent “disgorgement” or that are “restitutionary” in nature. But what makes a particular payment a “disgorgement”?  In a December 13, 2011 opinion (here), the New York Supreme Court, Appellate Department, First Division, held that amounts Bear Stearns paid in settlement of SEC late trading and market timing  allegations represented a disgorgement that is not covered under its  insurance program.  Because the appellate court’s decision reversed the lower court ruling that the settlement payment did not constitute a disgorgement, the case provides an interesting perspective of the question of what makes a particular payment a “disgorgement” for purposes of determining insurance policy coverage.

 

Background

In 2006, the SEC notified Bear Stearns that the agency was investigating late trading and market timing activities units of Bear Stearns had undertaken for the benefit of clients of the company. The agency advised the company that it intended to seek injunctive relief and monetary sanctions of $720 million. Bear Stearns disputed the allegations, among other thing arguing that it did not share in the profits or benefit from the late trading, which generated only $16.9 million in revenue.

 

Bear Stearns ultimately made an offer of settlement and --without admitting or denying the agency “findings” – consented to the SEC’s entry of an Administrative Order, in which, among other things, Bear Stearns agree to pay a total of $215 million, of which $160 million was labeled “disgorgement” and $90 million as a penalty.

 

At the relevant time, Bear maintained a program of insurance that, according to the subsequent complaint, totaled $200 million. Bear Stearns sought to have the carriers in the program indemnify the company for the company’s settlement with the SEC. However, the carriers claimed that because the $160 million payment was labeled “disgorgement” in the Administrative Order, it did not represent a covered loss under the insurance policies.

 

In 2009, J.P. Morgan (into which Bear Stearns merged in 2008) filed an action seeking a judicial declaration that the insurers were obliged to indemnify the company for the amount of the $160 million payment in excess of the $10 million self insured retention. The company’s supplemental summons and amended complaint can be found here. The company argued that notwithstanding the Administrative Order’s reference to the amount as “disgorgement,” its payment to resolve the SEC investigation constituted compensatory damages and therefore represented a covered loss under the insurance program. In support of this contention, the company further argued that Bear Stearns’ earned only $16.9 million in revenue and virtually no profit from the late trading and market timing activities, and therefore the SEC settlement amount could not have represented a disgorgement. The carriers moved to dismiss the company’s declaratory judgment action

 

The Lower Court’s September 14, 2010 Order

In an order entered September 14, 2010, (here), New York (New York County) Supreme Court Charles E. Ramos denied the carriers’ motion to dismiss. He held that the Administrative Order’s use of the term “disgorgement” did not conclusively establish that the settlement amounts were precluded from coverage.

 

In reaching this conclusion, he noted that the Administrative Order “does not contain an explicit finding that Bear Stearns directly obtained ill-gotten gains or profited by facilitated these trading practices,” and he found that the provision of the Order alone “do not establish as a matter of law that Bear Stearns seeks coverage for losses that include the disgorgement of improperly acquired funds.” He also found that the Order does not, as would be required to preclude coverage “conclusively link the disgorgement to improperly acquired funds.”  He noted in that regard that “there are no findings that Bear Stearns directly generated profits for itself as the result” of the alleged misconduct and for him to so conclude now “would be to resolve disputed issues of material fact.”

 

Because he found that he was “unable to conclude, on the basis of the language of the Administrative Order alone that the disgorgement is specifically linked to the improperly acquired funds,” he rejected the insurers’ argument that they were entitled to dismissal.

 

The December 13 Appellate Decision

A December 13, 2011 opinion written by Justice Richard Andrias of  the N.Y. Supreme Court, Appellate Division, First Department, reversed the lower court’s holding, granted the motions to dismiss and directed the entry of judgment in favor of the insurers. Contrary to Justice Ramos, the appellate court concluded that the sequence of events and allegations “read as a whole” are:

 

not reasonably susceptible to any interpretation other than that Bear Stearns knowingly and intentionally facilitated illegal late trading for preferred customers, and that the relief provisions of the SEC Order required disgorgement of funds gained through that illegal activity.

 

The Court went on to state that “the fact that the SEC did not itemize how it reached the agreed upon disgorgement figure does not raise an issue as to whether the disgorgement payment was in fact compensatory.” 

 

The Court further noted that in generating revenue of at least $16.9 million, “Bear Stearns knowingly and affirmatively facilitated an illegal scheme which generated hundreds of millions of dollars for collaborating parties and agreed to disgorge $160,000,000 in its offer of settlement.”  

 

Discussion         

Given that the SEC Administrative Order expressly identified the $160 million portion of the settlement as a “disgorgement,” it was always going to be an uphill battle to establish that the amount was not a disgorgement. The company argued essentially that the amount was not a disgorgement because the payment did not correspond to any specific pecuniary benefit that Bear Stearns received. The company argued in paying the amount it was not so much disgorging anything so much as it was paying damages. Justice Ramos concluded that the Administrative Order was not factual conclusive and that there was enough of an issue that dismissal was not appropriate.

 

The appellate court essentially concluded that the question was not so much whether Bear Stearns was disgorging an amount corresponding to its own specific pecuniary gain, but rather whether or not it was disgorging amounts that its “illegal scheme” had “generated.”  In effect, it was enough to show that there was a benefit from the illegal conduct, whether or not person making the disgorgement directly received that benefit.

 

This case is fairly fact specific, but it still a useful and interesting decision because it reaffirms the basic principles around the insurability of disgorgements and because it illustrates the issues to be considered in determining whether or not a specific amount represents a disgorgement or not.

 

All of that said, the company may still seek to appeal this decision to the New York Court of Appeals and so there may yet be more to be heard in connection with this case.

 

Chris Dolmetch’s December 13, 2011 Bloomberg article discussing the opinion can be found here.

 

Advisen Management Liability Journal: Although I suspect that most readers of this blog have already seen it, if you have not yet had a chance, you will want to take a look at the inaugural issue of the Advisen Management Liability Journal, which can be found here. The publication is attractive and interesting and it clearly represents a welcome addition to help in the exchange of ideas in the D&O insurance industry. My congratulations to everyone at Advisen for this inaugural issue, particularly my good friend, Susanne Sclafane, the publication’s senior editor. I am sure everyone in the industry is looking forward to future editions of this publication.

 

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

 

Background

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

 

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

 

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

 

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

 

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

 

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

 

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

 

The November 8 Ruling

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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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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An inevitable part of the current wave of bank failures has been the FDIC’s filing of lawsuits against former directors and officers of the failed institutions. And though the FDIC’s initiation of this litigation has been gradual, the lawsuits have now started to accumulate in significant numbers. And just as this FDIC litigation was perhaps inevitable once the banks started to faile, so too it was also perhaps inevitable that the FDIC lawsuits would be accompanied by D&O insurance coverage litigation.

 

As discussed below, the failed bank insurance coverage lawsuits are now starting to arrive. If the initial cases are any indication, one of the main coverage battlegrounds will be the typical D&O insurance policy’s Insured vs. Insured exclusion. Specifically, the question will be whether the FDIC as receiver pursuing the failed bank’s claim against the bank’s former directors and officers is acting as an “insured” under the D&O policy so as to preclude coverage under the policy.

 

First up in this analysis is Michigan Heritage Bank of Farmington Hills, Michigan, which failed on August 29, 2009 (about which refer here). As discussed in greater detail here, on August 8, 2011, the FDIC, as the bank’s receiver, filed a lawsuits in the Eastern District of Michigan against a single former officer of the bank.

 

What followed next is that on November 1, 2011, Michigan Heritage’s D&O insurer filed an action in the Eastern District of Michigan seeking a judicial declaration that there is no coverage for the underlying lawsuit or for the bank officer’s defense expenses under the bank’s D&O policy. A copy of the insurer’s declaratory judgment complaint can be found here.

 

Among other things, the carrier seeks a judicial declaration that the policy’s Insured vs. Insured exclusion precludes coverage for the underlying lawsuit. The insurer’s argument is that as the bank’s receiver, the FDIC is asserting the bank’s own claims and is seeking to recover the bank’s losses. Therefore, the carrier contends, the FDIC’s lawsuit is a claim “by, on behalf of, or at the behest of” the bank, and as the bank and the defendant loan officer are both insureds under the policy, the policy’s Insured vs. Insured exclusion precludes coverage.

 

A very similar sequence has also followed with respect to Westernbank, of Mayaguez, Puerto Rico, which failed on April 30, 2010. As reflected here, on December 17, 2010, the FDIC, through its outside counsel, sent a letter to Westernbank’s D&O insurer asserting claims against the bank’s former directors and officers.

 

Westernbank’s directors and officers , in turn, on October 6, 2011, filed an action in local Puerto Rico court seeking judicial declaration that the FDIC’s claim is covered under the bank’s D&O policy. The complaint, which is in Spanish, can be found here. According to an October 14, 2011 press release from the direcrors and officers' counsel, the complaint seeks a judicial declaration with respect to “the controversial and critical question whether the FDIC-R can be deemed an insured under the Policy so as to excuse [the carrier] from providing coverage.”

 

Though these declaratory judgment actions have only just been filed, they are in many ways a vestige of an earlier time. As I discussed in a blog post way back in August 2008, when the current bank wave was only just starting to unfold, the question whether the Insured vs. Insured exclusion precluded coverage for claims by the FDIC as receiver against former directors and officers of failed banks was hotly contested during the S&L crisis. As I said in my earlier post, and as appears likely now, the Insured vs. Insured exclusion could be a critical part of the failed bank insurance coverage litigation during the current round of bank failures as well.  

 

During the S&L crisis, where the FDIC had its greatest success in overcoming the Insured vs. Insured exclusion was where it was able to argue successfully that the Insured vs. Insured exclusion precluded coverage only with respect to collusive lawsuits. Because it was able to show that its claims and lawsuits were fully adversarial, it was able to establish that the exclusion did not apply.

 

The FDIC was not uniformly successful in arguing that the exclusion only precluded collusive claims, and there has in fact been some intervening case law to the effect that the Insured vs. Insured exclusion applies even when the underlying claim is not collusive.

 

It will in any event be interesting to see how these coverage cases develop. The one thing that seems certain is that as the FDIC failed bank litigation continues to accumulate, so too will the related coverage litigations. Many of the related coverage suits likely will also involve these same Insured vs. Insured issues.

 

Another issue that is likely to be litigated in coverage cases arising out of FDIC failed bank litigation is the enforceabilty of the so-called Regulatory Exclusion, which when present in the D&O policy precludes coverage for claims brought by the FDIC and other regulators. Not all policies implicated in the bank failures have these exclusions, but where they are present they are likely to be relied upon by the carriers to contest coverage. It is probably worth noting that these issues were fully litigated during the S&L crisis and the courts generally found that the regulatory exclusion precluded coverge for FDIC claims. My prior blog post about the regulatory exclusion can be found here.

 

A good summary of the D&O insurance coverage issues involved in FDIC failed bank litigation can be found here.

 

Special thanks to the several loyal readers who sent me links to ths source documents referenced above.

 

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One of the highest profile D&O insurance coverage decisions last year was the district court’s October 2010 opinion  holding that Office Depot’s D&O insurance policy does not cover defense expenses the company incurred in responding to an informal SEC investigation. The company’s appeal of the district court’s decision has been closely watched. On October 13, 2011, the Eleventh Circuit issued an unpublished per curium opinion affirming the district court, concluding that Office Depot did not have coverage under the language of the policy at issue for the defense expenses incurred in connection with the informal SEC investigation. A copy of the Eleventh Circuit opinion can be found here.

 

Background

In June 2007, Office Depot was the subject of news report suggesting the company had improperly disclosed material information to securities analysts in violation of SEC Regulation FD. In a July 17, 2007 letter, the SEC advised Office Depot it was "conducting an inquiry" to determine whether the securities laws had been violated, and requested certain information from Office Depot "on a voluntary basis." Office Depot provided documents and made its employees and officers available for sworn testimony. On July 31, 2007, the SEC requested that Office Depot preserve the records of numerous employees and offices. Office Depot forwarded the letter to its insurers. Office Depot’s primary insurer accepted the letter as a "Notice of Circumstances" that may give rise to a claim.

 

In addition, in July 2007, before it received the SEC’s informal inquiry, Office Depot received an internal whistleblower letter raising concerns relating to the timing of recognition of Office Depot’s vendor rebate funds. Office Depot self-reported the whistleblower allegations to the SEC, which expanded its inquiry to include the whistleblower allegations. The company’s audit committee conducted its own investigation of the allegations, retaining lawyers, accountants and consultants for those purposes. The internal investigation resulted in Office Depot’s restatement of its 2006 financial statements.

 

In November 2007, two shareholder derivative lawsuits and two securities class action lawsuits were filed against the company. The shareholder suits alleged misrepresentations in connection with the company’s financial reporting of vendor rebates. In January 2010, the defendants’ motions to dismiss the securities class action lawsuit were granted.The plaintiffs in the derivative lawsuits voluntarily dismissed those cases.

 

In January 2008, the SEC issued a formal "order directing private investigation" and during the course of 2008 subpoened the company and at least eight current and former Office Depot officers and directors, including several who previously voluntarily testified. The notice did not name any individuals as wrongdoers. In November and December 2009, the SEC issued Wells notices to three Office Depot officers. In December 2009, the company reached an undisclosed settlement with the SEC staff.

 

Office Depot requested reimbursement from its D&O insurers of the over $23 million the company had incurred in responding to the SEC, indemnifying individuals against defense expenses, and conducting an internal investigation of the whistleblower allegations.

 

The primary carrier acknowledged its obligation to reimburse Office Depot for defense costs incurred by officers and directors after having been served with SEC subpoenas and Wells notices, and for the costs incurred in the various securities lawsuits. However, the approximately $1.1 million of acknowledged expenses did not exceed the policy’s $2.5 million retention. The primary insurer denied coverage for the other expenses, and Office Depot filed an action alleging breach of contract and seeking a judicial declaration of coverage. Office Depot’s excess D&O insurer intervened in the action.

 

The parties filed cross motions for summary judgment. As discussed here, on October 15, 2011, Southern District of Florida Judge Kenneth Marra granted the insurers’ motions for summary judgment and denied Office Depot’s motion. Office Depot filed an appeal.

 

The Eleventh Circuit’s Opinion

In an October 13, 2011 unpublished per curiam, a three judge panel of the Eleventh Circuit affirmed the district court’s decision. Office Depot had sought to have the district court’s decision overturned on four separate grounds. The Eleventh Circuit rejected each of Office Depot’s four arguments.

 

First, Office Depot had argued that the insurers’ policies did not expressly exclude coverage for costs associated with SEC investigations, and that the “carve back” language in the definition of “Securities Claim” provided coverage for the costs. The “carve back” argument refers to language in the policy definition that, on the one hand said that a “Securities Claim” is a claim “other than an administrative or regulatory proceeding against, or investigation of an Organization,” but on the other hand also provided that the term “Securities Claim” shall “include an administrative or regulatory proceeding against an Organization, but only if and only during the time such proceeding is also commenced and continuously maintained against an Insured Person.”

 

The Eleventh Circuit noted that the first of these two definitional clauses eliminates coverage for two types of potential Securities Claims – that is, claims in the form of administrative or regulatory proceedings, and claims in the form of an administrative or regulatory investigation. The Court said that “the carve-back provision restores coverage for the former under certain circumstances. But it does not restore for the latter.” Accordingly, and “because the SEC’s requests for voluntary cooperation in furtherance of its pre-suit discovery constituted an ‘investigation’ rather than an ‘administrative or regulatory proceeding,’ Office’s Depot’s expenses incurred after the receipt of the SEC’s letters are excluded from coverage.”

 

Second, Office Depot argued that the SEC’s letters were sufficient to trigger a Claim under the policy because they were sufficient to constitute notice that insured persons could have proceedings commenced against them. In rejecting this argument, the Eleventh Circuit said that the SEC’s letters “do not allege that violations have occurred or identify specific individuals that could be charged in future proceedings,” and therefore do not trigger a “Claim” under the relevant policy definition.

 

Third, Office Depot argued that the district court had erred in concluding that the policy covered only defense expenses incurred after a “Claim” had been made. In essence, the company argued that the policy has no temporal limitation precluding policy coverage for pre-Claim expenses. The Eleventh Circuit concluded that the policies’ “text unambiguously limits Defense Costs to those costs incurred after a Claim has been made.”

 

Finally, Office Depot argued that the “relation back” language in the policy’s notice of circumstances provision provides coverage for costs incurred after it provided notice to the carrier of circumstances that could give rise to a claim and before the Claim actually was made. These notice provisions specify that if the policyholder gives the insurer notice of circumstances that could give rise to a claim, and if a claim subsequently arises, then determination of the date on which the claim was first made will relate back to the date on which notice of circumstance was provided.

 

The Eleventh Circuit rejected Office Depot’s “relation back” argument, finding that the notice of circumstances provision simply “create a notification process” that allows a determination of when claim are “considered made … rather than expand[ing] coverage to the costs incurred before Claim is actually made.”

 

The Eleventh Circuit concluded that “the policy does not cover the Defense Costs associated with the SEC investigation – which did not constitute a Claim against Office Depot until events such as the issuance of subpoenas and Wells Notices occurred.”

 

Discussion

The background circumstances of this coverage dispute dramatically highlight why the questions of coverage of expenses incurred in connection with informal SEC investigations is such a fraught issue. Office Max incurred tens of millions of dollars in defense expenses before the SEC commenced its formal investigative processes. Many other companies confronted with an informal SEC investigation similarly incur substantial costs voluntarily providing information. The sheer magnitude of these expenses ensures that policyholders will continue to try to argue that their D&O insurance covers these types of expenses, even after the Eleventh Circuit’s decision in the Office Depot case.

 

Insurers confronted with these coverage demands undoubtedly will seek to rely on the Eleventh Circuit’s opinion in taking the position that their policies do not cover costs incurred in connection with informal SEC investigations. In addition to arguable limitations arising from the fact that the opinion is designated “not for publication,” the insurers will also have to deal with the fact that the opinion is in many respects simply a reflection of the specific policy language at issue in the Office Depot case. In particular, the opinion rests heavily on the distinction in the relevant policy provisions between “proceedings” and “investigations.” Other policies do not contain these same distinctions or are otherwise worded differently, in reliance upon which other policyholders may attempt to distinguish their situation from the circumstances involved in the Office Depot case.

 

But while there may be grounds on which policyholders may attempt to argue that the Office Depot opinion is not absolutely determinative of questions whether or not there might be coverage under another D&O insurance policy for costs incurred in connection with an informal SEC investigation, the opinion nevertheless provides strong support for insurers taking the position that their policies do not cover these types of expenses.

 

One aspect of the opinion on which insurers are particularly likely to rely is the Eleventh Circuit’s holding that the D&O policy at issue only provides coverage for defense expenses incurred after a claim has been made. Policyholders seeking to establish coverage for costs incurred in connection with an informal investigation often try to argue that the insurer should cover the costs because the policyholder would have incurred all of the same costs after the investigation became formal if it had not voluntarily cooperated. The policyholders’ argument is the coverage for the expenses should not depend on a mere matter of timing and the policyholders should not be penalized for cooperating with the SEC. The insurers doubtlessly will argue that in reliance on the Eleventh Circuit’s opinion that its insurance obligations do not extend to pre-claim expenses.

 

There is the potentially troublesome issue of the fact that the Eleventh Circuit’s opinion is designated “Do Not Publish.” In the current era of Internet communication, this designation seems meaningless. Indeed, the Eleventh Circuit itself posted the opinion on its website. Clearly the opinion has been published despite the designation, even if the opinion will not appear in printed case reporters at some point in the future.

 

But beyond the question of whether or not this “unpublished” opinion in fact has been published, there is the question of whether or not the “Do Not Publish” designation could otherwise preclude carriers from relying on the opinion. While there was a time when attorneys were barred from citing unpublished opinions, revised Federal Rule of Appellate Procedure 32.1(a) specifically provides that a court may not prohibit or restrict citation to unpublished opinions dated after January 1, 2007. So there does not seem to be any problems for insurers attempting to rely on the Eleventh Circuit’s opinion, notwithstanding the fact that it is designated “Not for Publication.”

 

Given that the opinion is freely available on the Court’s website and given the fact that the opinion has every bit as much precedential value as if it were not designated “Do Not Publish,” you do kind of wonder what the point is of using the designation. I worry about what it implies about what the court itself thinks about the opinion. It is almost as if the court is saying “we don’t think enough of this opinion for it to be published,” as if they really didn’t give it enough of their focus to produce a publication worthy opinion.

 

In any event, it is worth noting that since the time that Office Depot purchased the policies at issue in this coverage dispute, the insurance marketplace has evolved. Recently, some carriers have been willing to provide coverage for costs individuals incur in connection with informal SEC investigations. In addition, at least one carrier now offers a separate insurance product that provides coverage for costs that the entity itself incurs in connection with an informal SEC investigation. Although this entity protection for informal SEC investigative costs is subject to a large self-insured retention and to coinsurance, the fact remains that if such a policy had been available to Office Depot and if Office Depot had had such a policy in place, at least a significant part of Office Depot’s costs of responding to the informal SEC investigation might have been covered.

 

The Wiley Rein law firm’s October 14, 2011 summary of the Eleventh Circuit’s opinion can be found here. Special thanks to a loyal reader for providing me with a copy of the Eleventh Circuit’s opinion.

 

SEC  Issues Disclosure Guidance on Cybersecurity: Based on the number of emails I received on the topic, I suspect that by now most readers are aware that on October 13, 2011, the SEC released Cybersecurity Disclosure Guidance, a copy of which can be found here. If you have not yet read the Cybersecurity Guidance, you may want to set aside a few minutes and read the document through. It makes for some very interesting reading.

 

First, the disclosure guidance is not just directed to those companies that have experienced a cyber attack. Rather, the guidance requires reporting companies to consider “on an ongoing basis, the adequacy of their disclosure relating to cybersecurity risks and cyber incidents.” The SEC also proposes that reporting companies include a discussion of these matters in the Management Discussion & Analysis (MD&A) if known incidents or the risk of potential incidents represent a material risk, trend or uncertainty.

 

Second, readers of this blog will find it particularly interesting that among the items the SEC suggests reporting companies include in their “ongoing disclosure” is “a description of relevant insurance coverage.”

 

Third, if a reporting company or any of its subsidiaries are party to material pending legal proceeding involving a cyber incident, the registrant may need to disclose information regarding this proceeding.

 

Fourth, reporting companies are also required to disclose conclusions on the effectiveness of cybersecurity controls and procedures.

 

Although the primary objective of these disclosure guidelines is to try to ensure that investors are better informed on reporting companies’ cyber vulnerabilities, one obvious consequence is cybersecurity matters are about to become a much higher profile item for all reporting companies. In addition, the requirements about disclosures regarding the effectiveness of cybersecurity controls and procedures potentially sets the stage for shareholder claimants to later contend that the companies’ disclosures about its controls and procedures were misleading.

 

Finally, the specific reference in the SEC disclosure guidelines to cybersecurity insurance undoubtedly will lead many companies who may not have purchased this insurance in the past to consider the need for this insurance, if only to allow the company to supplement its cybersecurity disclosures to show that its precautionary measures include the purchase of insurance designed to protect the company from the harm caused by cybersecurity risks.

 

Insurance professionals whose clients include reporting companies will undoubtedly refer to this suggested disclosure item as part of the professionals’ efforts to advise their clients with respect to insurance issues.

 

What to Watch Now in the World of D&O: In the latest issue of InSIghts, I examine the current hot topics in the world of D&O. As should be clear from this post, there is a lot going on now in the world of directors’ and officers’ liability, with many additional issues on the horizon. The latest InSights issue can be found here.

 

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In a case involving multiple ghosts of long lost companies, a judge in federal court in Manhattan has held that excess D&O insurers do not have a duty to “drop down” to fill the gaps in coverage caused by the insolvency of underlying insurers. The court also held, based on the language of the excess policies at issue, that the excess insurers’ coverage obligations were not triggered merely because the insureds’ losses exceeded the amount of the underlying insurance, where the underlying insurance has not been exhausted by actual payment.

 

A copy of the Southern District of New York Judge Richard Sullivan’s September 28, 2011 opinion can be found here.

 

Background

This insurance coverage case arises out of the bankruptcy of Commodore International Limited (the manufacturer of the classic Commodore 64 personal computer, pictured above). In connection with the bankruptcy proceedings, numerous lawsuits were filed against the company’s former directors and officers. Most of these actions have been resolved, save only one proceeding remaining in the Bahamas where the claimants seek to recover $100 million. The defendants have so far incurred a total of $14 million in losses as a result of the various actions.

 

At the time of the bankruptcy, Commodore carried a total of $51 million of D&O insurance arranged in eight layers and involving six insurers. Unfortunately for the company’s former directors and officers, the first and fourth excess layers were provided by Reliance Insurance Company, and the third and sixth level excess insurance was provided by The Home Insurance Company. In 2001, Reliance went into a regulatory liquidation, and in 2003 so did The Home.

 

The primary layer of insurance was exhausted by payment of losses. However, due to Reliance’s insolvency, the individuals were unable to obtain insurance for losses that went into the next layer of insurance. The individuals then turned to the solvent upper level excess insurers, seeking to have them provide coverage for the individuals’ continuing defense fees and other losses. The solvent excess insurer that provided the second and fifth level excess insurance agreed to advance defense fees pursuant to an interim funding agreement and later filed an action (in which the other solvent excess  insurers joined) seeking a judicial declaration that there was no coverage under its excess policies as a result of the insolvent underlying insurers’ unpaid gaps. The individual directors and officers sought to establish that there was coverage under the solvent excess insurers’ policies, claiming that the excess insurers’ payment obligations had been triggered because osses exceeded the amount of the underlying insurance.

 

The policies of the solvent excess insurers all contained a similar provision essentially providing that “the Underlying Policies shall be maintained during the Policy Period ….Failure to comply with the foregoing will not invalidate this policy but the [excess insurance carrier] shall not be liable to a greater extent that if this condition had been complied with.” In addition, the excess policies all have provisions essentially providing that their policies are triggered only “in the event of exhaustion of all of the limit(s) of liability of such Underlying Insurance solely as a result of payment of losses thereunder.”

 

The September 28 Opinion

In his September 28 opinion, Judge Sullivan agreed with the excess insurers that they had no obligation to “drop down” to fill the insolvent insurers’ gaps, and he also concluded that the excess insurers’ obligations under their policies had not been triggered merely because the individuals’ losses exceeded the amount of the underlying insurance.

 

Judge Sullivan found that the laws of New York and Pennsylvania “clearly provide” that “an excess insurer is not required to fill gaps in coverage created by the insolvency of the underlying insurer.” He went on to note that

 

The Insurance Contracts themselves make no mention whatsoever of such an obligation. To the contrary, the policies expressly state that, in the event that Defendants fail to maintain underlying insurance, the insurers “shall not be liable to a greater extent than if this condition had been complied with.” This language expressly demonstrates that the coverage provided by the Excess Insurers will not be enlarged to compensate for gaps in underlying coverage.

 

In rejecting the individuals’ argument that the excess insurers’ payment obligations were triggered because the amount of the individuals’ losses exceeded the amount of underlying insurance, Judge Sullivan found that the “express language” in the excess insurers’ policies requiring exhaustion of the underlying limits by actual payment of loss in order to trigger coverage “establishes a clear condition precedent to the attachment of the Excess Policies,” and therefore it is “clear from plain language of the Excess Policies…that the excess coverage will not be triggered solely by the aggregation of Defendants’ covered losses. Rather the Excess Policies expressly state that coverage does not attach until there is payment of the underlying losses.”

 

In reaching this latter conclusoin, Judge Sullivan rejected the applicability of the 1928 Zeig v. Massachusetts Bonding & Insuance Co. casae, and similar cases. Judge Sullivan said these cases "provide not guidance because they involved circumstances where the insured had accepted partial insurance from the underlying carriers while making up the shorfall themselves. In this case and unike in Zeig, the carriers "have a clear bargained for interest in assuring that the underlying policies are exhausted by actual payment." 

 

Discussion

This case provides a sharp reminder that though insurance carriers fail infrequently, when they do it is a real mess. This reminder highlights the all-too-often overlooked importance of carrier solvency – and not just when coverage is bound but also at the time when a claim must be paid.

 

The mess created by the carriers’ insolvency, compounded by the excess carriers’ ability to avoid dropping down to fill the gap, leaves these individuals uninsured for their continuing expenses and exposures. Which in turn provides a vivid illustration of the value of a so-called Excess Side A/DIC policy, which  by its terms would drop down and provide coverage in the event of the insolvency of an underlying carrier.

 

Excess Side A/DIC policies were available at the time that Commodore procured its D&O insurance, but they were not nearly as pervasive as they are now. (The policies that were available at that time were somewhat more restrictive than those available today.) If Commodore’s insurance program had included an Excess Side A/DIC policy, the individual defendants might have been able to rely on that policy to defend themselves notwithstanding the gaps caused by the insurers’ insolvency

 

Judge Sullivan’s holding that the excess insurers’ payment obligations were not triggered even though the individuals’ losses exceed the amount of the underlying insurance is consistent with other recent decisions in which the courts have interpreted the excess insurer’s trigger language to require exhaustion of the underlying insurance by the actual payment of loss (refer for example here and here).

 

This case may also represent the first occasion on which a court applying New York law expressly declined to follow Zeig. However, the court never conclusively stated whether it was applying New York law; rather, Judge Sullivan said only that the outcome was the same whether New York or Pennsylvania law applied. He also distinguished Zeig rather than overtly declining to follow it.

 

It is worth noting that in the current D&O insurance marketplace excess insurance policies are available with trigger language that allows the amount of the underlying limits of liability to be paid either by the insurer or the insured, in order for the excess insurer’s payment obligation to be triggered. How this language would have affected the outcome of this case is not entirely clear, because it does not appear from the record whether or not the individuals have actually funded the shortfall themselves. (My impression is they did not.)

 

It is astonishing to note that ten full years after Reliance failed, problems from its failure continue to arise. It somehow seems appropriate that all of these ghosts from an earlier era have all gathered in this one locale, presided over by the specter of the late lamented Commodore 64. Clearly, the former directors and officers continue to be haunted by their former company’s remarkably unlucky choice of carriers. (This company doubled down on its bad luck, by managing to slot both of the eventually insolvent carriers in two different layers each in Commodore’s insurance program.)

 

One final note. Commodore’s primary insurance carrier has a name that would have been completely unknown to all concerned at the time Commodore procured its coverage. The primary insurer is a company now known as “Chartis” – a company that in that bygone era was known by a different name altogether.

 

Yes, there are all kinds of ghosts roaming around on the set of this production.

 

Special thanks to a loyal reader for providing me with a copy of Judge Sullivan’s opinion.

 

“As of Now, I am in Control”: There is at least one more ghost to mention here. Among Commodore’s former directors and officers was the late Alexander Haig, Jr. who among other things served as Secretary of State under Ronald Regan. Haig had a distinguished career of public service, but he will be most remembered for his unfortunate statements shortly after Reagan had been shot: “Constitutionally gentlemen, you have the president, the vice president and the secretary of state, in that order, and should the president decide he wants to transfer the helm to the vice president, he will do so. As for now, I’m in control here, in the White House, pending the return of the vice president and in close touch with him. If something came up, I would check with him, of course.”

 

Unfortunate News for Former Directors and Officers in Failed Bank Litigation: There’s some bad news for former directors and officers of failed banks defending themselves in FDIC litigation. On September 27, 2011, in the case the FDIC filed in the Central District of California against four former officers of IndyMac bank (in what was the first lawsuit the FDIC filed in the current round of bank failures, as discussed here), Judge Dale Fischer granted in part the FDIC’s motion for judgment on the pleadings as to certain of the defendants’ affirmative defenses.  A copy of Judge Fischer’s opinion can be found here.

 

Judge Fischer held that because the FDIC as receiver stands in the shoes of the failed bank, the defendants could not assert defenses based on the FDIC’s pre-receivership actions or omissions. Accordingly, she granted the FDIC’s motion for judgment on the pleadings as to the individual defendants’ defenses of unclean hands, failure to mitigate and ratification. She did deny the FDIC’s motion as to other affirmative defenses, including the business judgment rule.

 

Special thanks to a loyal reader for sending me a copy of Judge Fischer’s opinion.

 

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The options backdating scandal may now be ancient history, but questions surrounding insurance coverage for the scandal’s consequences apparently continue to live on. In a September 9, 2011 opinion applying Maryland law, Southern District of New York Judge Naomi Reice Buchwald ruled in a coverage action brought by SafeNet’s excess D&O insurer that, among many things, there is no coverage under the policy for SafeNet’s $25 million options backdating-related securities lawsuit settlement.

 

The opinion addresses a number of recurring policy issues, including questions of claim interrelatedness and relation back; imputation of fraudulent misconduct; application of the consent to settlement provision; and imputation of application misrepresentations for purposes of policy rescission.  

 

Beginning in early 2006, SafeNet experienced a series of legal problems. These problems began with the company’s February 2006 announcement that it was restating prior financial statements. On May 18, 2006, the company announced it had received a subpoena from the U.S. Attorney as well as an informal inquiry from the SEC. Shortly thereafter, the company announced that it was forming a special committee to investigate its stock option granting practice. In September 2006 the company announced that the committee concluded that certain prior stock options had been accounting for using incorrect measurement dates and as a result its financial statements for the relevant periods would have to be restated.

 

These developments led to a variety of legal proceedings, including a securities class action lawsuits (about which refer here). There was also an SEC enforcement proceeding and a criminal investigation. The SEC proceeding resulted in the entry of a permanent injunction against the company’s former CFO, Carole Argo. Argo also pled guilty to a single count of securities fraud. The consolidated  securities class action litigation was later settled for $25 million.

 

For the period March 12, 2005 to March 12, 2006, the company carried $15 million of D&O insurance, arranged with a primary $10 million layer, and a $5 million layer of insurance excess of the primary. For the period March 12, 2006 to March 12, 2007, the company also carried $15 million of D&O insurance, arranged in the same way as the prior year.

 

On February 28, 2006, the company sent its primary carrier a copy of the initial financial restatement disclosure. Both the primary carrier and the excess carrier accepted this letter as a notice of circumstances that might give rise to a claim. The company advised the carriers of the various legal matters as they later arose. The carriers took the position that all of the subsequent notices and claims related back to the initial notice of circumstances and therefore the various matters implicated only the 2005-06 policies, regardless of when the later claims may have been made.

 

Later, after Argo entered her guilty plea, the primary carrier advised the company that it was no longer entitled to coverage under its policy. The excess carrier advised the company that due to the guilty plea, “a declination of coverage is in order in certain respects” under the excess policy, and that “rescission of the policy may be appropriate.” The excess carrier asked the company to enter a tolling agreement.

 

SafeNet later settled the securities class action lawsuit and paid the settlement amount. In the later coverage action, the parties stipulated that the company did not notify the excess carrier of the settlement negotiations and did not seek the excess carrier’s consent to settlement. In the later coverage action, the company contended that it spent more than $20 million in defense costs for itself and the directors and officers, including more than $10 million in defense costs for directors and officers other than Argo.

 

The excess carrier filed an action against Safeguard, Argo and the company’s former CEO, Anthony Caputo., seeking a judicial declaration of its coverage obligations and seeking a rescission of the renewal excess insurance policy. The defendants filed a motion to dismiss arguing amount other things that the case could not proceed without the primary carrier as a party and arguing further that the case was premature because the primary policy had not been exhausted. In a December 7, 2010 order (discussed here, scroll down), Judge Buchwald denied the defendants’ motions to dismiss. The parties then filed cross-motions for summary judgment.

 

In her September 9 opinion, Judge Buchwald denied the defendants’ summary judgment motion and granted the excess carriers’ motion in part and denied the excess carrier’s motion in part. Among other things, Judge Buchwald agreed that all of the claims relate back to the 2005-06 policy and that only the 2005-06 policy was implicated; that any loss incurred by Argo was precluded from coverage by the policy’s fraudulent conduct exclusion, but that coverage for the company’s loss was not precluded by that exclusion; that because the company had failed to obtain the excess carrier’s  settlement approval, there was no coverage under the excess policy for the $25 million securities class action settlement; and that to the extent that there is coverage under the renewal excess policy, the excess carrier was entitled to rescind the policy as to Argo and the company based on Argo’s application misrepresentations.

 

In contending that they were entitled to coverage under the 2006-07 renewal excess policy, the defendants had argued that the various option backdating problems were not even discovered until the middle of 2006 and therefore could not relate  back to the February 2006 notification sent to the carriers. In rejecting these arguments, Judge Buchwald found that in the class action lawsuit, the financial irregularities disclosed in February 2006 and the stock options backdating were “part of an interrelated course of conduct.” 

 

With respect to the policy’s relation back language, Judge Buchwald said that “these provisions make clear that the relation back of a claim turns upon the nature of the allegations in a subsequent Claim, not simply on the relationship in fact between an earlier notice of circumstances and a later Claim.” Because of the interrelationship between the two types of conduct and the “broad-relation back language” in the policies, she concluded that the subsequent matters relate back to the original notification and therefore only the 2005-06 policy was implicated.

 

Although she concluded that the fraudulent conduct exclusion precluded coverage for Argo, she concluded that the exclusion did not preclude coverage for the company. Even though policy language imputed “facts” and “knowledge” possessed by Argo to the company for purposes of determining the applicability of the exclusion to the company, the exclusion still does not apply to the company unless there has been an adverse judgment against the company. There was no adverse judgment against the company, and the judgment against Argo cannot be imputed to the company. Accordingly, notwithstanding Argo’s guilty plea and the imputation to the company of the facts and knowledge possessed by her, the exclusion does not operation to preclude coverage for the company.

 

However, the fact that the exclusion did not apply to the company does not mean that the company is entitled to coverage under the policy. Judge Buchwald concluded that the company was not entitled to coverage under the policy for the $25 million settlement because it had failed to get the carrier’s prior consent to settle. She said further that the she “could not conclude that the company was excused” from complying with the consent to settlement provisions. 

 

As for the question of whether or not there was coverage under the policy for the more than $10 million the company incurred defending the directors and officers other than Argo, Judge Buchwald concluded that because there was no record evidence that the company had actually indemnified any particular director and officer and the state of the record is “undeveloped” she could not decide the question of coverage for the defense fees.

 

Finally, although she had concluded that SafeNet’s claims did not implicate the renewal excess policy, Judge Buchwald concluded that to the extent the renewal policy does apply, the excess carrier was entitled to rescission as to Argo and as to the company. She found that because Argo admitted to knowingly and with intent to defraud causing the company to file inaccurate public filing, the carrier was entitled to rescission was to her. Moreover, Argo’s knowledge was imputable to other insureds. And while the policy allows individual insureds to establish lack of actual knowledge, it does not allow the company to establish that it lacked knowledge.

 

Discussion

This case is a veritable textbook of D&O Insurance coverage issues and Judge Buchwald’s opinion contains a number of rulings that could be important in many other cases.

 

Her ruling that the subsequent legal proceedings all relate back to the date of the initial notice, and therefore that only the 2005-06 policy is triggered, is likely to be of particular interest in many of the credit crisis related cases, in connection with many of which the insurance carriers are arguing that all of the various lawsuits filed against a particular company all relate back to a single, earlier policy year. Indeed that is the position that the carriers are taking in connection the Lehman Brothers lawsuits, as discussed in a recent post. The broad reading Judge Buchwald gave to the interrelated claim and relation back language here could prove to be very helpful for the carriers in many of these cases.

 

On the other hand, Judge Buchwald’s interpretation of the fraudulent conduct exclusion, and the limitations on what she was willing to impute to the company, will likely motivate carriers to quickly review  their policy language to see whether the imputation provisions in their fraud exclusion require an adjudication of the fraudulent misconduct even when the fraud has been  imputed. I suspect it came as a surprise here that if there was an adjudication of fraud as to Argo and that fraud was imputed to the company that the company could still retain coverage under the policy if the adjudication itself was not imputed to the company or there was otherwise no adjudication of the company’s fraudulent misconduct. I suspect many carriers are going to want to hold up their fraud exclusion and compare them to the fraud exclusion applicable here to see whether their fraud exclusion might operate as the fraud exclusion did here

 

As an aside, it is probably worth noting that Judge Buchwald was satisfied that a guilty plea represented an “adjudication” sufficient to trigger the exclusion. Perhaps that is a common sense interpretation, but I can certainly imagine the argument that a guilty plea is different from an adjudication, since there was no separate determination by a finder of fact, but merely an admission. Judge Buchwald’s conclusion that the guilty plea was sufficient would seem to undercut the argument that the exclusion could have said that an admission was sufficient to trigger the exclusion, but instead it required an adjudicated determination, which is different from an admission.

 

On the other hand, with respect to the topic of imputation, in her analysis of the rescission issues, Judge Buchwald found that Argo’s knowledge was imputable to the company under the applicable policy language. Thus Argo’s knowledge of application misrepresentations was sufficient to rescind coverage not only for herself but for the company as well. What observers may find most noteworthy about this is not just the imputation to the company but the fact that the application misrepresentations to which the imputation applied were in the form of misstatements in the company’s financial filings. In other words, the very financial misrepresentations that might attract a lawsuit might also wind up removing the company’s insurance coverage – at least where as here a senior corporate official has pled guilty to knowing fraudulent misrepresentation.

 

The final determination of significance in Judge Buchwald’s opinion is her conclusion that the company’s failure to obtain prior consent to settlement precludes coverage under the policy for the settlement. While a number of court have recently reiterated the enforceability of the consent to settlement clause (refer, for example, here), what is noteworthy here is that she found that the failure to obtain consent was not waived even where the carrier has said it has grounds to deny coverage, is contemplating rescission and has asked for a tolling agreement. The company undoubtedly felt like it had been left by the carrier to do the best it could to look after its interests, yet Judge Buchwald had found that the consent requirement had not been waive.

 

Judge Buchwald’s willingness to enforce the consent requirement even in these circumstances is yet another reminder of the critical importance of communicating with the carrier even under these types of strained circumstances. One protective step the company might have been able to take to avoid triggering a consent problem would be to obtain the carrier’s agreement that it would not raise the consent issue as an additional defense to coverage beyond those the carrier had said it believed it had grounds to assert.

 

Ad Nauseum: I was flipping channels earlier this week and I stopped to watch part of a major league soccer game. The field on which the game was being played had a billboard that said “Infinitum.” I idly wondered what product or service  the billboard might be referring to, and then it hit me – the billboard is nothing less than an “ad infinitum.”

 

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I am pleased to present below a guest post by Kara Altenbaumer-Price, Esq., the Director of Complex Claims and Consulting for USI and part of its Management & Professional Services Group in Dallas. I would like to thank Kara for her willingness to publish her article on this site. I am interested in publishing guest posts from responsible commentators on topics of interest to readers of this blog. Please contact me directly if you are interested in submitting a guest post for consideration.

 

Here is Kara’s guest post:

 

 

As insureds try to navigate through the new language and products being offered by D&O carriers to address increasing costs and coverage issues associated with government investigations, insureds should consider recent remarks by the SEC’s Director of Enforcement pushing for separate counsel in SEC matters. The SEC’s initiative to encourage cooperation with the agency is likely force more corporate officials to seek separate representation, which in turn will only increase the extent of coverage sought under ever-broadening D&O insurance policies. 

 

 

In 2010, the SEC implemented a number of changes in its Enforcement Manual, a internal SEC document that guides the SEC’s enforcement staff in how—and in some cases whether—investigations proceed forward from informal inquiry to formal investigation to Wells Notice stage. Included in the 2010 revisions to the manual was a program called “Fostering Cooperation” designed to spur confessions by providing leniency—or in some cases, immunity—to individuals who provide valuable evidence to the SEC.

 

 

While voluntary cooperation with the SEC enforcement’s division has long yielded benefits for companies, individuals had not necessarily seen the same level of benefit because the SEC had never set out guidelines for granting so-called “cooperation credit” to individuals.  On the other hand, the “Fostering Cooperation” initiatives appear to also mean harsher outcomes for those who are offered a chance to cooperate but do not accept. The new enforcement policy, released in January 2010, also gives the SEC access to enforcement tools the DOJ has long used—Cooperation Agreements, Non-Prosecution Agreements, and Non-Prosecution Agreements.  Each of these gives incentives for individuals and companies to cooperate with the SEC to lessen their own punishment. 

 

 

        It is likely that more individuals will “confess” to the SEC in order to obtain the benefits of these initiatives.  The inevitable D&O insurance challenge is clear: more defense costs. Cooperation by one individual implies that other individuals will be negatively impacted by that individual’s testimony.  As more individuals cooperate and as others become the “target” of that cooperation, the need for separate counsel rises, causing a rise in defense costs.

 

 

      Although the Enforcement Manual is silent about whether the use of joint defense counsel will be considered in evaluating whether an individual has cooperated, the Manual itself acknowledges that multiple representations are common and that “representing more than one party … does not necessarily present a conflict of interest.” Yet, SEC Director of Enforcement Robert Khuzami recently warned against the common practice of defense counsel representing multiple defendants in one SEC matter. He said in a June speech, “We are taking a closer look at such multiple, seemingly adverse representations. You will likely see an increase in concerns expressed by SEC staff in those situations.”  While this common practice has always been a concern from a traditional conflicts perspective, Khuzami emphasized the cooperation initiatives only heighten the issue. As he warned in his speech, “this increases the likelihood that one counsel cannot serve the interests of multiple clients, given the real benefits that could result from cooperation, such as one client testifying against another client represented by the same counsel.” 

 

 

            There may be a number of scenarios in which multiple representations are not objectionable to the SEC or insureds, such as, in the SEC’s words, “when one lawyer or one firm represents employees who are purely witnesses with no conflicting interests or material risk or legal exposure.” However, there are many other scenarios in which defense counsel represent multiple clients whose interests may ultimately diverge. For example, Khuzami noted a scenario in which one lawyer represented both an employee and a supervisor in a failure to supervise case. 

 

 

            Indeed, not only is there the possibility that one individual may want to testify against another—or that the company may want to offer up an individual in order to gain cooperation credit for itself—there may be a conflict even between two individuals whose interests may otherwise be aligned because the cooperation incentives create a “race to the Commission.” The SEC has stated that the benefits of cooperation will be reserved for those whose assistance is timely. As Khuzami said in a speech when the initiatives were announced, “Latecomers rarely will qualify for cooperation credit, so there is every reason to step forward - before someone else does.” It is not hard to see the conflict created if a single lawyer or firm finds themselves in the position of choosing which client to help to the front of the cooperation line. This could be true even for insured executives whose culpability level may be low but who may want to avoid the dreaded career-ending director and officer bar.

 

 

            Interestingly, SEC staff have indicated that they will raise the conflict issue in scenarios in which they recognize that there are individuals who may benefit from a cooperation agreement. For example, the SEC raised just such an issue in an administrative proceeding against Morgan Keegan & Compay and Morgan Asset Management and two employees when it moved to disqualify counsel. The SEC had argued unsuccessfully that the defendants had “potential defendants involving the conflict of [each] other” but that their shared counsel prevented “any such blame-shifting.”

 

 

            The big insurance question is whether D&O carriers will agree to fund the additional counsel or whether insured companies will get caught in the middle of a push for separate counsel by the SEC (and executives) and the carriers’ push for shared counsel. In the securities context, insureds almost always choose white shoe law firms with corresponding top-of-the-market fees. Sharing defense counsel has long been a method of controlling litigation costs for both companies and carriers. Even with a push for some time by counsel for each executive potentially implicated in an investigation scenario to retain independent counsel, carriers often push back for as few counsel as possible, including offering the incentive of covering the insured entity if the entity shares counsel with individual defendants.

 

 

            In considering the likely increase in defense costs as separate representations becomes even more likely in SEC matters, insureds would be wise to consider the issue when examining the number of new D&O products on the market addressing insurance coverage for SEC investigations.  Companies may also want to consider increased limits as each separate counsel can significantly ratchet up the cost of defense, eating away at limits available for settlement of SEC matters or follow-on civil litigation.

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A recent negotiated resolution of an FDIC failed bank lawsuit suggests disputes over D&O insurance coverage may represent the real frontline in the failed bank litigation wars. The compromise was reached in the lawsuit the FDIC only recently filed in the District of Arizona involving the failed First National Bank of Nevada. As discussed below, the FDIC and the bank officer defendants have reached a settlement agreement that includes a stipulated judgment, assignment of insurance rights, release of claims against the individual defendants, and a covenant not to execute the judgment against the individual defendants.

 

First National Bank of Nevada failed on July 25, 2008 (as discussed here). First National Bank of Arizona was one of FNB Nevada’s sister banks until the two banks merged less than 30 days prior to FNB Nevada’s failure. As discussed here (scroll down), on August 23, 2011, the FDIC filed an action in the District of Arizona against Gary Dorris, who was CEO and Vice Chairman of the banks’ holding company as well as of both FNB Nevada and FNB Arizona, and Phillip Lamb, who was EVP of the banks’ holding company as well as of both FNB Nevada and FNB Arizona. The FDIC’s complaint alleged mismanagement and gross negligence at FNB Arizona that allegedly left FNB Arizona holding millions of dollars of bad loans.

 

On September 2, 2011, just days after the FDIC filed its complaint against the two individuals, the FDIC and the two defendants filed a joint motion for entry of judgment. A copy of the joint motion for entry of judgment can be found here. Though they had filed an answer denying liability, the defendants nevertheless consented to the entry of judgments “for purposes of compromising disputed claims.” Pursuant to the parties’ settlement agreement, the two individuals each consented to the entry against each of them of separate judgments in the amount of $20 million (plus post-judgment interest).

 

As part of the parties’ settlement agreement, upon the entry of the judgment the defendants will assign to the FDIC all of their rights and claims against the D&O insurer. The FDIC for its part agreed not to take any action to enforce the judgment against the individuals, except with respect to the individuals’ rights under the D&O policy. The joint motion alleged that the bank’s D&O insurer has “denied coverage, refused to defend, to advance defense costs, to indemnify, or to consider settlement of the claims brought against the defendants.”

 

Assuming for the sake of discussion that the court enters the consent judgment in the form the parties have requested, the FDIC’s obvious next move is to file a lawsuit against the bank’s D&O insurer, seeking to recover the amount of the judgments from the D&O insurer. The joint motion does identify the D&O insurer, but it does not specify the face amount of the D&O insurance policy, nor does it specify the basis on which the D&O insurer has denied coverage.

 

The fact that the consent judgment was submitted within days after the initial complaint was filed does seem to suggest that the lawsuit filing was itself part of a coordinated plan anticipating the consent judgments, as a way to shift the FDIC’s focus from the individuals themselves to the D&O insurer, the recovery of whose policy proceeds appears to have been the FDIC’s objective all along.

 

The problem with this approach is that it has not been established that the individuals in fact breached any duties or that they should be or could be held liable on the merits. Of course, the individuals would contend that when the D&O insurer failed to provide them with a defense, they were left on their own to take whatever steps they could to protect themselves from liability and to avert the accumulation of further defense expense. The FDIC, as the individuals’ successor in interest under the policy, now undoubtedly will argue that having disclaimed coverage and having declined to participate in the individuals’ defense, the carrier should not be heard to object to the basis on which the individuals compromised the lawsuit.

 

But merely because the FDIC will succeed to the individuals’ rights under the policy does not establish that there is coverage under the policy or that the D&O insurer has any liability for the amounts of the consent judgment. If it comes to that, the D&O insurer will undoubtedly attack the judgment on many bases. The D&O insurer will also likely maintain its assertion that there is no coverage under the policy for the claims against the individuals as well as for the judgment.

 

Given that this bank closed in mid-2008, which was very early in the current wave of bank failures, it is relatively unlikely that the operative policy had a regulatory exclusion (as those had only just started making their return to the D&O insurance marketplace at or about that time). The likelier possibility is that the coverage denial is based on some policy process issue, such as timely notice, claims made date, or the like.

 

As I previously noted, it could be argued that the D&O insurer, having denied coverage, should not be heard to object to the fact that the individuals have taken steps to protect themselves. However, the problem with these type of consent judgment/covenant not to execute type deals is that this approach can run the risk of slipping into a collusive arrangement, with the insured individual willingly agreeing to a settlement amount that has no relation to the his or her true liability exposure. In my prior life as an insurance company coverage attorney, I saw more than one deal that could only be described as abusive, and I have one particular deal   in mind that qualified as grotesque bad faith (it was so awful no court would touch it and it died a very ignominious death).

 

Whatever the merits or demerits of these types of deals, we undoubtedly will see many more of them before the current round of failed bank litigation finally plays itself out. FNB Nevada failed in the earliest days of this wave of failed banks, and the FDIC is just now getting around to pursuing claims and insurance coverage related to its closure. Many hundreds of banks have failed in the interim and over the coming months and years, the FDIC will be pursuing claims and insurance coverage in connection with many of those subsequent bank failures. In many of these cases, as apparently was the case here, the FDIC’s ultimate objective will be the recovery of D&O insurance proceeds.

 

As a result, there may well be many more occasions where, as here, individuals, in order to extricate from an FDIC lawsuit, similarly agree to a consent judgment and an assignment their rights to their D&O insurance policy in exchange for a covenant not to execute the judgment against them and their assets.

 

The larger message here is that as the FDIC ramps up its claims and lawsuits against the former directors and officers of failed banks, one of the consequences will be a rash of coverage lawsuits involving the failed institutions’ D&O insurance policies. All I can say is that it seems like old times to me. I expect that all across the country there are coverage attorneys getting their files from 20 years ago out of storage. 

 

As I said at the outset, D&O insurance coverage suits may represent the real frontlines of the failed bank litigation wars. (It is no coincidence that the lawsuit filed at the same time as the suit against the FNB Arizona defendants, the one filed against former directors and officers of Silverton bank, described here, apparently also is really a dispute about D&O insurance coverage; indeed in that case, the FDIC took the extraordinary step of naming the D&O insurers as defendants in the liability lawsuit.)

 

 In any event, it is clear that coverage lawsuits involving failed bank D&O policies will be one of predominant features of the D&O insurance scene for the next several years to come.

 

News coverage regarding the bank executives’ settlement with the FDIC can be found here. Special thanks to a loyal reader for sending me a copy of the parties’ joint motion for entry of judgment.

 

Court Rejects Failed Bank Directors and Officers Bid to Dismiss Claims Against Them: Meanwhile, in a case in the Northern District of Illinois involving the former directors and officers of the failed Heritage Community bank, the court has rejected the individual defendants’ motions to have the claims for negligence and breach of fiduciary duty against them dismissed, except to the extend the negligence claims are duplicative of the fiduciary duty claims.

 

As discussed here, in November 2010, the FDIC filed a lawsuit against certain former directors and officers of Heritage. The defendants moved to dismiss the FDIC’s negligence and breach of fiduciary duty allegations, arguing that the alleged misconduct that on which the negligence and breach of fiduciary duty claims are based are protected by the business judgment rule; that the FDIC had failed to sufficiently state claims for gross negligence, negligence or breach of fiduciary duty; and that the negligence and breach of fiduciary duty claims were duplicative.

 

In a September 1, 2011 order (here), Northern District of Illinois Judge Rebecca Pallmeyer denied the defendants’ motions, except that she granted the motions to the extent the negligence claims were duplicative of the fiduciary duty claims. In rejecting the defendants’ attempt to rely on the business judgment rule, she found that because these arguments represented affirmative defenses and held that the “appropriate mechanism for consideration” of the affirmative defenses is “a motion for judgment on the pleadings or for summary judgment.”

 

Judge Pallmeyer also found that the FDIC’s allegations “are sufficient to meet the liberal notice pleading requirements and to set for the duty, breach, causation and damage elements of claims for gross negligence, negligence and breach of fiduciary duty.”

 

For those involved in defending former directors and officers in FDIC litigation (and these individuals’ D&O insurers), Judge Pallmeyer’s ruling may be concerning. One of their principal defenses for individuals caught up in FDIC failed bank litigation will be that under FIRREA, they can only be held liable for gross negligence (refer here for an excellent discussion of these issues). This argument is most compelling with respect to outside directors, as  a judge in the Central District of California recently recognized in dismissing NCUA claims that had been brought against outside directors of the failed WesCorp credit union (as discussed at greater length here). Although Judge Pallmeyer did dismiss the negligence claims to the extent they were duplicative of the fiduciary duty claims, she did not reach the question whether or not under FIRREA the individuals can be held liable only for gross negligence.

 

Special thanks to a loyal reader for forwarding the Heritage bank ruling to me.

 

Annual Law Firm Survey of D&O Insurance Coverage Issues: On September 7, 2011, my good friends at the Troutman Sanders law firm issued their annual survey of coverage decisions involving D&O and professional liability insurance policies, which can be found here. The survey is very comprehensive and has the added virtue of being indexed by topic, which makes the survey a particularly useful resource for those involved with D&O insurance claims to keep at hand.

 

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A group of former executives of a Lehman Brothers subsidiary   is seeking to block the bid by senior Lehman executives to use $90 million of the remaining D&O insurance proceeds to settle the cases pending against them. As discussed here, on August 24, 2011, the senior executives filed a motion with the Lehman bankruptcy court seeking access to $90 million in insurance funds to settle the securities suits pending against them. On September 8, 2011, seven executives of Lehman’s Structured Asset Securities Corp. (Sasco) objected to the requested $90 million drawdown, arguing that it would leave the Sasco executives without sufficient insurance funds remaining to settle the claims pending against them. A copy of the Sasco executives' opposition papers can be found here.

 

The Sasco executives, like the senior Lehman executives who seek the $90 million, are defendants in a number of securities class action lawsuits involving events leading up to Lehman’s collapse. As I detailed in my prior post about the senior Lehman executives request for the $90 million in insurance proceeds, defense expenses and other costs (including an arbitration settlement) have already significantly eroded the $250 million insurance tower. The Sasco executives claim they now have an opportunity to settle the $4 billion claims pending against them for $45 million. They contend that if the senior executives draw down the $90 million they seek, there will be insufficient remaining insurance funds to settle the claims against them.

 

In their opposition papers, the Sasco executives argue that the $90 million drawdown would represent a “disproportionate and inequitable portion” of the remaining funds. They argue that “permitting one class of insureds to use such tactics to divert a disproportionate share of insurance proceeds for their benefit to the exclusion of other classes of insureds is inequitable, contrary to the purpose of the available D&O insurance and would have an adverse economic impact on the Debtors’ estate.”

 

The Sasco executives note that the fight is with respect to Lehman’s 2007-2008 tower of insurance, which originally totaled $250 million. (This tower is described in detail in an earlier post about Lehman’s D&O insurance, here.) The Sasco executives contend that their claim actually implicated the separate $250 million 2008-2009 tower,  as it was during that policy period that the claims were first made against them. However, the carriers in the 2008-2009 D&O insurance tower apparently contend that the claims against the Sasco executives relate back to claims first  made during the 2007-2008 insurance tower’s policy period, and therefore it is the 2007-2008 tower that is implicated with respect to the claims against the Sasco executives. The Sasco executives dispute this position of the insurers, but they note in the motion papers that they cannot establish their entitlement to the proceeds of the 2008-2009 tower without protracted and expensive coverage litigation.

 

It is worth noting that the senior executives request for the $90 million drawdown would not in and of itself deplete the amounts remaining in the $250 million 2007-2008 tower. As discussed in my post about the settlement, it looks as if the drawdown would leave about $50 million remaining, which would seem to be enough to fund the Sasco executives’ proposed $45 million settlement. In their motion papers, however, the Sasco executives assert that the senior Lehman executives “will quickly attempt to settle other claims asserted against them, exhausting the remaining limits under the 2007-08 D&O policy,” contending that the senior executives “seek to appropriate all of the remaining proceeds …for their own benefit, to the exclusion of the Sasco defendants.”

 

The Sasco executives argue that they have “an equal right to insurance protection” as the senior executives and that it “would be inconsistent with the purpose of D&O insurance to permit one class to monopolize the protection.” The Sasco defendants seek to have the bankruptcy court deny the senior executives’ motion for the $90 million drawdown and to enter an order adopting an “allocation scheme” that more equitably divides the remaining proceeds. They note that they are not arguing that the proposed $90 million settlement is “unreasonable,” they simply object to the fact that the senior executives’ requested drawdown would leave them using the remaining proceeds to enter a settlement of the claims against them.

 

This situation represents a classic example of the too-many-insured, too-many-claims, not-enough-insurance problem. These problems come up in all sorts of contexts, although rarely in cases as high profile as this. The most basic problem is that even with $250 million in insurance, there is not nearly enough insurance to defend and settle all of the claims involving insured persons. The question is how the insufficient insurance proceeds should be applied.

 

There are procedural mechanisms available to deal with these types of situations, such as interpleader, where the insurer(s) simply deposit the insurance with the court and the court sorts out the entitlements. The insurers themselves would have to initiate an interpleader action. The Sasco executives are hoping to enlist the bankruptcy court to perform an equivalent allocation on an equitable basis. In their motion papers, they reference an earlier bankruptcy case where the D&O insurance policy proceeds were allocated in a pro rata basis. This type of scheme might well be equitable, but the problem is that given the number of individuals involved and the seriousness of the claims against them, a per capita allocation might leave everyone with insufficient funds to settle any of the claims against them.

 

The one thing that seems likely if the Sasco executives are unable to secure for themselves a portion of the 2007-08 insurance tower to settle the claims pending against them, they will be under pressure to try to establish that they are entitled to proceeds of the 2008-09 tower. Such a bid would involve very significant questions regarding the interrelatedness of the claims made against them with the prior claims on which the carriers are relying to argue that the claim against the Sasco executives do not involve 2008-09 insurance tower, but instead relate back to the 2007-08 tower.

 

It will in any event be interesting to see how the bankruptcy court responds to these competing claims to the proceeds of the D&O insurance coverage. The situation certainly underscores the fundamental tension that arises from the fact that the D&O insurance must provide protection for a significant number of individual directors and officers, and the fact that in the event of a catastrophic claim, the various individuals can find themselves in competition for the D&O insurance policy proceeds. One way to address this problem of course is to buy more insurance. But as the Lehman example shows, there may be limits to how much can be accomplished simply by buying more insurance. If $250 million is not enough insurance, higher limits is not going to solve much for most companies.

 

This may be one of those problems that may not be susceptible to solution, but one possible approach to ameliorate this situation is through program structure. For example, if the outside directors had their own separate tower of insurance, those amounts could be applied toward defending and settling the claims against them while the proceeds of the main policy could be applied toward the settlement of the claims against the officers. Of course, even this arrangement would not have eliminated the possibility of the kinds of problems that have arisen here. It is at least one way to try to address problems due to the fact that so many individuals are entitled to and would want the benefit of the proceeds of the main D&O insurance policy’s protection.

 

A September 10, 2011 Wall Street Journal article about the Sasco executives’ motion can be found here.

 

SEC Seeks to Enforce Subpoena Against Longtop Financial Auditor: The SEC is going on the warpath to try to enforce a subpoena that it served on Longtop Financial’s former auditor, Deloitte Touche Tohmatsu (DTT), which is the Shanghai-based affiliate of the global accounting firm, Deloitte Touche. As discussed here, Longtop is one of the many U.S.-listed Chinese companies to be caught up in accusations of accounting impropriety in recent months. DTT resigned as Longtop’s auditor earlier this year.

 

The allegations surrounding Longtop attracted the attention of the SEC, and at least according to news reports, the company recently received a Wells Notice from the SEC. The SEC also apparently tried to subpoena DTT in connection with its investigation of Longtop. As reported in the SEC’s Sept. 8, 2011 press release (here), DTT failed to produce the requested documents and so the on September 8 the SEC filed a motion with the United States District Court for the District of Columbia requiring DTT to comply with the subpoena. The SEC’s motion papers can be found here.

 

The SEC’s motion papers report that DTT’s U.S. counsel had sent a letter to the SEC asserting that (1) the firm could not be compelled to produce documents created prior to July 21, 2010, the effective date of the Dodd-Frank Act, and (2) that in any event producing any documents could subject the firm to sanctions for violations of Chinese secrecy laws.

 

The SEC contends that DTT’s arguments are “apparently based on a misunderstanding of the legal basis for the subpoena,” arguing further that the subpoena was not dependent on the additional powers given the SEC in the Dodd-Frank Act but rather was based on the SEC’s long standing subpoena power. The SEC argued further DTT’s “vague assertions of possible conflicts with a foreign law provide no justification” for DTT’s “continued non-compliance with the Subpoena.” The SEC argued that DTT’s “speculative” assertion that compliance would subject it to sanctions is “illusory” and furthermore a risk DTT “knowingly accepted by availing itself of the U.S. securities markets.”

 

As detailed in Nate Raymond’s September 8, 2011 Am Law Litigation Daily article about the SEC’s motion to enforce the subpoena (here), this situation represents something of a test case for the SEC, as (according to one commentator quoted in the article) “the SEC for obvious reasons wants to know if it can get to these documents in the future.” Another commentator in a September 10, 2011 Wall Street Journal article (here) said that the SEC’s move to enforce the subpoena represents a “major escalation.” The Journal article also notes that the dispute also “highlights the shortcomings of regulation in China, which is complicated by vague laws, competing regulatory agencies and a tight rein on information.”

 

Whatever the significance of the SEC’s action ultimately may prove to be, it is clear that the SEC has ramped up its activity levels in seeking to take action in connection with the U.S.-listed Chinese companies caught up in the accounting scandals. In addition to the Wells notice recently served on Longtop, the SEC also recently served a Wells notice on the Chairman of another Chinese company, Puda Coal (about which refer here).

 

The other thing about the challenges the SEC is facing in trying to enforce its subpoena is that it shows how difficult it will be for any party to pursue legal action against many of these Chinese companies. If the SEC can’t even enforce a subpoena against an audit firm that is registered with the PCAOB, it obviously is going to be a challenge for private litigants to try to pursue discovery from China-based firms and individuals. Indeed, because many claimants have recognized these limitations, they have tried to focus their actions against the outside professionals (underwriters, auditors, attorneys) that have facilitated the Chinese companies’ entries into the U.S. securities markets. But as the SEC’s struggles to enforce its subpoena show, some of these professionals may also be difficult to pursue.

 

Lawyers’ Relief Act: If you have not had a chance to read Eric Dash’s September 8, 2011 New York Times article “Feasting on Paperwork” (here), I recommend taking a few minutes now to read it. Unbeknownst to the rest of us, the Dodd-Frank Act was actually a stimulus package intended to rescue lawyers from the impact of the economic crisis on their profession. The Act is, in the words of one commentator quoted in the article, “a full employment act” for lawyers and consultants. The article goes on to note that new regulation “has long been one of Washington’s unofficial job creation tools.”

 

I don’t know whether to be appalled at the brazen profit-extracting presumption that the lawyers quoted in the article unapologetically express or to be impressed by their naked opportunism. There is little wonder, as the article states, that lawyers and consultants “are salivating at the prospect of even more business opportunities.” The firms are, as noted by one lawyer quoted in the article, “only getting started.”

 

The overwhelming impression is the main consequence of the Act is the enrichment of a small number of professionals at the expense of the entire economy. And lawyers wonder why they do not enjoy a higher regard in our society. The article reminds me of the old joke about how research scientists are now going to use lawyers rather than rats in their scientific experiments -- there aren’t enough rats; there is no danger that the scientists will become emotionally attached to the lawyers; and there are some things that rats just won’t do.

 

The Moral of the Ducks: Even when you are completely blown away by unexpected events, the thing to do is to regroup, quickly get it back together, and march on.

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Every fall since I first started writing this blog, I have assembled a list of the current hot topics in the world of directors’ and officers’ liability. This year’s list is set out below. As should be obvious, there is a lot going on right now in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. Here is what to watch now in the world of D&O:

 

1. How Massive Will the Total Cost of the Subprime and Credit Crisis Litigation Wave Turn Out to Be?: Even though the subprime and credit crisis-related litigation wave is now well into its fifth year, only a small number of the cases have settled. But in recent weeks, a number of cases have settled in quick succession, and these settlements have been very substantial.

 

The recent settlements include the largest so far in subprime and credit crisis-related cases, the $627 million Wachovia bondholders settlement, about which refer here. Other settlements include the following: Washington Mutual, $208.5 million (refer here); Wells Fargo Mortgage Backed Securities, $125 million (refer here); National City, $168 Million (refer here); Colonial Bank, $10.5 million (refer here); and Lehman Brothers executives, $90 million (refer here).

 

With these latest settlements (many of which are subject to court approval), there have now been a total of 29 settlements collectively representing a total of almost $3.4 billion, for an average settlement of $116 million (although that average is obviously skewed upward by the $627 million Wachovia bondholders settlement and the $624 million Countrywide shareholders settlement)

 

As impressive as these cumulative numbers are, there are still many more cases pending. Of course, a certain number of the pending cases will ultimately be dismissed. But many will not, and eventually those remaining cases will be settled. Although it is impossible to conjecture how large  the total tab for all these cases ultimately will be, the implication from the cases that have settled is that the total amount will be massive.

 

The possibilities here may have significant implications for D&O insurers. Of course, not all of these amounts will be covered by D&O insurance. But a significant chunk will be. Indeed, a number of the recent settlements will be funded entirely by D&O insurance, including the WaMu settlement, the Colonial Bank settlement and the Lehman Brothers settlement. Interestingly, the Lehman settlement will come close to exhausting what is left of Lehman’s $250 million insurance tower.

 

In other words, the D&O insurers have had some very big bills to pay and could have some even bigger bills to pay in the months ahead. To the extent the ultimate loss amounts are fully reserved, these funding requirements will not cause a problem. But to the extent the carriers have not adjusted their loss reserves in anticipation of these losses, the cumulative impact of the coming settlements could be disruptive.

 

2. How Extensive Will the FDIC’s Failed Bank Litigation Efforts Become?: Since January 1, 2008, 392 banks have failed, including 70 so far in 2011 (as of September 2, 2011).  Fortunately, though the closures are continuing to mount, it appears that the failures finally may be starting to wind down. Since the current wave of bank closures began, there have been concerns that, just as it did during the S&L crisis in the late 80s and early 90s, the FDIC will again aggressively pursue claims against the directors and officers of the failed banks. At least so far, the FDIC’s litigation activity has been relatively modest. However, the signs are that the FDIC has merely been gearing up, and that substantial numbers of failed bank lawsuits could be just ahead.

 

As of September 2, 2011, there have been a total of eleven FDIC lawsuits against the directors and officers of failed banks. A number of these were filed in quick succession in August, raising the possibility that the apparent backlog of FDIC lawsuit filings may finally be starting to work out. There clearly are more cases to come. The FDIC’s website states that the agency has authorized suits in connection with 30 failed institutions against 266 individuals for D&O liability with damage claims of at least $6.8 billion. The eleven cases the FDIC has filed so far involve only 77 individuals. Even just taking account of the lawsuits that have already been authorized, there are many more suits to come, and undoubtedly even more lawsuits will be authorized.

 

The latest round of failed bank litigation has been very slow to develop. But at this point it seems likely that for the next several years there is going to be a very significant amount of FDIC litigation involving the directors and officers of failed banks. Moreover, the litigation will not be limited just to cases brought by the FDIC. Many of the failed banks were publicly trade or otherwise have broad and diverse ownership, and in many instances the bank failures have been followed by shareholder litigation. These shareholder suits represent competing claims for the D&O insurance policy proceeds. The competing claimants will be vying to secure the dwindling limits, adding a layer of complexity both for the defendants and for the FDIC.

 

3. Will the Failed Bank Litigation Be Accompanied by a Wave of Coverage Litigation?: During the S&L crisis, the FDIC was involved in extensive litigation to try to establish coverage under D&O insurance policies. Many of the leading cases on the Insured vs. Insured exclusion arose out of this litigation (about which refer here), and the Regulatory Exclusion was also extensively litigated (refer here).

 

The signs are that there could be extensive coverage litigation this time around too. Indeed, when the FDIC recently filed a lawsuit against the former directors and officers of the failed Silverton Bank, it included the bank’s D&O insurers as named defendants. As discussed here, the FDIC’s claims against the D&O insurers in the lawsuit involve the insurers’ attempt to deny coverage for the claim under the Regulatory Exclusion.

 

The FDIC may not be the only litigant involved in D&O insurance coverage litigation. As multiple defendants struggle with the problems associated with too many claims and too many insured persons, the various defendants will want to sort out their entitlement to the policy proceeds. For example, as discussed here, a subsidiary of the failed IndyMac Bank, which is a defendant in a number of lawsuits arising out of the bank’s failure, recently attempt to obtain a judicial declaration of coverage in order to sort out who was entitled to what under the bank’s D&O policies. Although the subsidiary’s claims were dismissed for lack of standing, the case does show that a variety of parties may be interested in using litigation as a way to establish their rights to the proceeds of D&O insurance.

 

The coverage litigation will hardly be limited just to D&O insurance. A recent coverage action in Alabama involved the coverage disputes involving a failed bank’s bond (refer here). There are also likely to be coverage disputes involving errors and omissions insurance. And as other outside professionals, such as accountants and lawyers, get dragged into these cases, there will likely be coverage litigation involving their professional liability policies.

 

For those of us who were involved in the failed bank coverage litigation during the S&L crisis, the return of these types of coverage cases has a very familiar feeling.

 

4. Will the Dodd-Frank Whistleblower Provisions Lead to More Claims? And How Will the D&O Insurers Respond?: Among the parts of the Dodd-Frank Act that may have a significant impact on claims is the Act’s whistleblower provisions. The whistleblower provisions include the creation of a new whistleblower bounty pursuant to which individuals who bring violations of securities and commodities laws to the attention of the Securities and Exchange Commission or the Commodities Futures Trading Commission will receive between 10 percent and 30 percent of any recovery in excess of $1 million. The SEC recently promulgated rules implementing these provisions.

 

While it is too early to tell what impact the bounty provisions will ultimately have, most observers expect that the substantial incentives provided by the whistleblower provisions will lead to an increased number of whistleblower reports and that these reports will lead to investigations and enforcement actions. In some instances, the revelations in the whistleblowers’ reports will also lead to follow-on civil litigation, as aggrieved shareholders or others pursue claims for misrepresentation or mismanagement. These follow on claims represent one type of potential increase claims exposure arising from the whistleblower provisions. But the possibility of increased numbers of investigations and enforcement actions present their own sets of issues.

 

One of the perennial issues in D&O coverage litigation is the question of policy coverage for regulatory investigations. Individual directors and officers typically covered (depending on policy wording) for both informal inquiries and requests for information, and civil, criminal, administrative or regulatory investigations commenced by either the issuance of a Target Letter or Wells Notice, or after the service of a subpoena. The company itself rarely has coverage for these types of investigations, except when it was named with an individual directors and officer in a “formal” SEC investigation. There typically is no coverage for the Company for responding to informal inquiries and requests for information from the SEC.

 

Many of these issues were discussed in the Second Circuit’s July 1, 2011 opinion in the MBIA case (about which refer here), which held that, under the specific policy language at issue and under the circumstances presented, MBIA’s D&O insurance policies covered the investigative and special litigation expense the company incurred during a regulatory investigation of its accounting practices.

 

Recently, one D&O insurance carrier introduced a new insurance product intended to provide entity coverage for these costs of investigation, as discussed here.  Due to problems of cost, as well as to the high deductibles and coinsurance that the carrier is requiring, this product is still looking for widespread acceptance. But the product’s introduction shows that the D&O insurance industry is working to try to find insurance solutions to the growing need for solutions addressing the regulatory investigation risk. To the extent the new whistleblower provisions mean increased numbers of investigations, companies will be increasingly interested in finding insurance products that address these risks.

 

5. What Will be the Next “Hot” Litigation Target?: From time to time, a sector or industry will find itself as the target of plaintiff securities class action attorneys. Last summer, for a brief period, the hot sector was the for-profit education section. Since then, the hot target has been U.S.-listed Chinese companies. This year alone, there have been 32 cases filed against U.S-listed Chinese companies (through September 2, 2011).

 

This surge of litigation involving Chinese companies has arisen out of accounting scandals, many of which were first revealed by online analysts, many of whom have short positions in the companies they are attacking. The Chinese companies have attempted to deflect the assertions of accounting improprieties by charging that the online attacks were merely rumors started by those with a financial incentive to drive down the companies’ share price. Fair or not, the online reports seem to be leading directly to shareholder litigation, as in many cases the shareholder plaintiffs are simply quoting the online analysts’ reports in their complaints.

 

For now, the phenomenon shows no sign of letting up, as the lawsuits involving the U.S.-listed Chinese companies have continued to accumulate as the year’s second half has progressed. Indeed, between July 1, 2011 and September 2, 2011, there were a total of 6 of these Chinese companies sued in new securities class action lawsuits in the U.S.

 

The recent litigation outbreak involving the U.S.-listed Chinese companies is a reminder of circumstance-specific events that can drive securities class action lawsuit filings. Many things determine filing levels, many of which cannot be captured or predicted in historical filing data. As a result, it can be misleading to try to generalize from short term trends about future filing levels. Simply put, the numbers vary over time, because, for example, contagion events and industry epidemics happen.

 

6. Will M&A Litigation Continue to Surge?: One of the more interesting phenomena in the world of corporate and securities litigation has been the changing mix of litigation. As recently as just a few years ago, securities class action lawsuits represented a significant percentage of all corporate and securities lawsuits. The insurance information firm Advisen has documented that in more recent years, class action securities litigation has represented an increasingly smaller percentage of all corporate and securities lawsuits. One area that has been growing as a percentage of all corporate and securities litigation has been M&A related litigation.

 

According to Advisen, in 2010, there were 353 lawsuits challenging corporate mergers filed in state and federal courts, which represents a 58% increase over 2009. As of August 27, 2011, 352 M&A related lawsuits had already been filed, putting this year’s filings to far exceed last year’s.

 

As discussed in an August 27, 2011 Wall Street Journal article entitled “Why Merger Lawsuits Don’t Pay” (here), these lawsuits rarely produce substantial damage awards. Often, the most they succeed in accomplishing is a delay in the merger or slightly improved disclosures about the deal’s terms. The reason these lawsuits continue to be filed, and indeed continue to be filed in increasing numbers, is that these cases are good business for the plaintiffs’ firms. These firms can collect fees that range from $400,000 for typical cases to millions of dollars for bigger cases.

 

In the past, these types of cases have not represented a significant claims exposure for D&O insurers. However, now that so many more of them are being filed, and now that individual merger deals are now attracting multiple claims, these cases are becoming a much bigger problem for the D&O insurers, particularly those that are the most active as primary insurers. A basic assumption of the D&O insurance industry is that D&O claims represent a low frequency, high severity threat. But these M&A claims are exactly the opposite – they represent a high frequency, low severity exposure, for which the D&O insurers likely did not price and almost certainly cannot underwrite. And even if the typical case settles for relatively modest amounts, the claims costs including defense fees are now in the aggregate becoming an issue for the D&O insurers.

 

In the current competitive marketplace (about which see more below), the D&O insurers may not be able to do much about this problem, but this might among the first areas to which D&O insures turn if the market does start to firm. Among other things, the D&O insurers might require higher self-insured retentions for these types of claims, on the theory that they really represent a cost of doing business rather than a true third-party liability exposure.

 

7. Will the U.S. Supreme Court Continue Its Inexplicable Willingness to Take Up Securities Cases?: Years from now, when the history of the Roberts Court is finally written, perhaps the historians will be able to explain why during the second half of the first dozen years of the 21^st Century, the Court was so eager  to take up securities cases. The Supreme Court is just coming off a term in which the Court heard three different securities cases, and it has already agreed to take up one more case in the term that is about to begin.

 

The case that the Court has already agreed to hear next year is the Credit Suisse Securities case, and it involves statute of limitations issues arising in connection with Section 16(b) claims for short-swing profits. This narrow, technical issue is unlikely to have widespread significance. But what is significant is that yet again this Court has taken up a securities case. There doesn’t seem to be any particular member of the Court that is driving the Court’s interest in securities cases. But for whatever the reason, the Court’s docket increasingly includes these types of cases. Though there is only one case now on the Court’s docket in the upcoming term, the Court can always choose to hear others – which is something the Court seems inclined to do.

 

The current Court does not always rule in the favor of the defendants. For example, this last term, in the Matrixx Initiatives case (refer here), the court rejected the defense argument that plaintiffs must show “statistical significance” in order to establish materiality in a securities lawsuit. In an earlier term, in the Merck case, the court rejected the defendants’ statute of limitations arguments (refer here). But many of the Supreme Court’s recent securities law decisions  have been in the defendants’ favor, and the Court’s rulings in recent terms in such cases as Janus Capital (refer here), Morrison (refer here), and Tellabs (refer here) represent significant defense victories that have or will have a significant impact in many cases on the plaintiffs’ ability to pursue securities claims.

 

The overall cumulative impact of the Court’s interest in taking up securities cases has been favorable to companies and unfavorable to plaintiffs. There is some speculation that the increased difficulty of successfully maintaining a securities class action lawsuit through the motion to dismiss may be one reason for the shift in the mix of corporate and securities litigation away from securities class action lawsuits and toward other types of litigation (like the M&A litigation, discussed above).

 

8. Will the Implementation of the U.K Bribery Act Mean Increased Anti-Bribery Enforcement Activity?: On July 1, 2011, the U.K Bribery Act became effective, as discussed here. The Act has a broad reach, regulating prohibited conduct that takes place within the U.K. or that involves a company or person that carries on business in the U.K., regardless of where the prohibited activity takes place. The Bribery Act is broader than the U.S.’s Foreign Corrupt Practices Act, reaching a broader range of prohibited activities and providing for greater possible liabilities for those at companies involved in these activities, even if not directly involved in the prohibited conduct.

 

From the time the Act received Royal Assent, one of its features that has been the focus of particular concern has been Section 7 of the Act. Section 7 creates a new offense which can be committed by commercial organizations that fail to prevent persons associated with them from committing bribery on their behalf. Commentators have been concerned that this provision seemingly would subject any firm --even non-U.K. companies that have operations in the U.K. – to liability under the Act for violative conduct taking place any where in the world.

 

Because the Act has only just become effective, it is not yet known how aggressively it will be implemented or what its overall impact will be. At a minimum, it seems likely that the Act will lead to an increase in enforcement activity. It is also possible that as has proved to be the case with enforcement actions under the U.S. Foreign Corrupt Practices Act, follow-on civil litigation will follow in the wake of regulatory enforcement activity.

 

As companies confront these developments, among the issues that are likely to arise are questions concerning coverage for these proceedings under their D&O insurance policies, as discussed in a prior guest post on this blog.  The Act’s fines and penalties are not likely to be covered under typical policies. Whether investigative costs and defense fees will be covered will depend on a large variety of circumstances, including who is the target of the investigation. How serious these problems will turn out to be will depend a lot on the Act’s implementation, a development that will be worth watching.

 

9. What Impact Will the Changing Corporate Governance Requirements Have?: Largely due to the 2010 enactment of the Dodd-Frank Act, we have entered a watershed period of corporate governance reform. Processes now afoot have wrought a transformation in the relations between corporate boards and corporate shareholders. These changes have not only created additional burdens on affected companies but they have also resulted in some cases in a change in the corporate litigation environment as well.

 

Among the changes the Dodd-Frank Act implemented is the requirement for an advisory shareholder vote on executive compensation. As a result of Section 951 of the Dodd Frank Act and the requirements of SEC rules that went into effect January 25, 2011, all but the smallest public companies had to put their executive compensation practices to an advisory shareholder vote this past proxy season. As it turns out, about 40 companies experienced a negative shareholder vote. In some cases the negative “say on pay” vote have been followed by shareholder litigation, by activist investors seeking to reform executive compensation practices, as discussed here.

 

The requirement for a shareholder “say on pay” is only one of many current corporate governance reform under discussion. Other areas include the question of proxy access – that is, the question whether shareholders can have their board candidates listed on the annual proxy form. The D.C. Circuit recently struck down the SEC’s rules requiring proxy access, but the issue is not likely to go away.

 

As discussed at length here, other current corporate governance issues include reforms such as board declassification and majority voting. Other issues that loom ahead as other provisions of Dodd-Frank go into effect include requirements that companies disclose the ratio between total annual compensation of their CEO and the median annual compensation of their employees (rules implanting these provisions are required to be adopted before the end of 2011).

 

Another provision of the Dodd Frank Act requires to SEC to direct the national exchanges to impose new listing standards directing public companies to implement compensation clawback provisions. Under Section 954 of the Dodd Frank Act, companies making accounting restatements of prior financials must recover from any current or former officer all incentive-based compensation paid during the preceding three-year period above what would have been paid without the misstated financials. These provisions are to be implemented by this year-end.

 

These various provisions will affect different companies in different ways. But it is clear that these changes are here to stay and that as a result companies and their management are operating in a challenging environment. Companies that resist these governance developments may face heightened levels of scrutiny, both from shareholders and from the media. Moreover, as corporate governance standards change, boards will be held to standards of conduct reflecting the changed governance norms and expectations. And in an era of growing shareholder empowerment, that reality may translate into increased judicial expectation for boards to address shareholder initiatives.

 

Taken together, these changes in the corporate governance environment mean heightened scrutiny, changing shareholder expectations, and even an increased litigation risk. How extensive these changes ultimately will prove to be remains to be seen as the additional provisions of Dodd Frank are put into effect in the months ahead.

 

10. What Does All of This Mean for the D&O Insurance Marketplace?: Given all of these trends and developments, an outside observer might reasonably expect that the marketplace for D&O insurance would be becoming more restrictive. And certainly with respect to certain categories, such as U.S.-listed Chinese companies and commercial banks, the marketplace for D&O insurance is challenging. However, outside of those very particularized categories, the marketplace for D&O insurance remains generally competitive. Most financially stable companies continue to be able to obtain broad terms and conditions at relatively attractive prices.

 

There is nothing specific to suggest that the generally competitive environment is about to change, at least immediately. But there are a number of considerations that could lead to change. The first is the cumulative impact of the year’s catastrophic losses. The various natural disasters this year, from the earthquakes in New Zealand and Japan to Hurricane (and tropical storm) Irene, have had an impact on the insurance industry’s collective balance sheet. If there were to be another significant event in the four remaining months of the year, the accumulated losses could be enough to force a pricing increase or to cause carriers (or at least some of them) to pull back.

 

Given the catastrophe events that have already occurred this year, carriers are likely to be scrutinizing their books. Many of the developments discussed above will undoubtedly lead the various carriers to take a close look at their D&O portfolios. The mounting losses from the subprime meltdown and the credit crisis; the looming impact of the wave of failed banks; and the difficulties and uncertainties associated with a changing litigation and legal environment are all likely to raise concerns. These concerns inevitably lead to questions about pricing adequacy, risk selection, and scope of coverage.

 

In light of all of these considerations, it would be very rational for the D&O insurance marketplace to enter a more restrictive phase. In some sectors that may already be happening. For example, even relatively healthy commercial banks are seeing increased pricing and reduced limits. Several carriers are pulling back in that space.

 

At the same time, though, the overall marketplace remains competitive. As long as capacity remains ample and competition active, most companies outside of the most troubled sectors apparently will continue to enjoy the benefits of a competitive marketplace for D&O insurance. The question is how long these conditions will continue. Time will tell of course, but if the wind blows or the earth shakes again, among the consequences could be a harder market for insurance generally and for D&O insurance in particular.  

 

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In an opinion that provides an interesting glimpse of a complex D&O insurance program, on August 24, 2011, Central District of California Judge R. Gary Klausner granted the motions to dismiss of the insurance company defendants in an action that had been brought by a subsidiary of IndyMac bank, which was trying to establish its rights to coverage under the failed bank’s D&O insurance policies. A copy of the August 24 opinion can be found here.

 

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.  According to Judge Klausner’s August 24 opinion, there are a total of twelve separate lawsuits pending (referred to in the opinion as the “underlying actions”). Judge Klausner describes the litigation generally as alleging “various improprieties, mostly centering around mortgage backed securities.”

 

IndyMac MBS was a subsidiary of IndyMac Bank, and is now wholly owned by the IndyMac federal receivership. IndyMac MBS is a defendant in a number of the lawsuits that have been filed in the wake of the bank’s collapse. Earlier this year, IndyMac MBS filed an action seeking a judicial declaration of coverage on its behalf under the bank’s D&O insurance policies.

 

The insurance policies at issue represent a total of $160 million of insurance coverage spread across two policy years. (Judge Klausner’s opinion does not explain why two policy year’s policies are potentially implicated, rather than only one.) The coverage in the 2007-2008 policy year, providing coverage during the year from March 1, 2007 to March 1, 2008, 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 coverage for the policy year March 1, 2008 to March 1, 2009 is arranged similarly, except that the lineup of insurer involved changed slightly in the 2008-2009 program. Judge Klausner’s opinion names all of the carriers involved and their respective roles in the two programs.

 

In its declaratory judgment action, IndyMac MBS sought to have the court determine that each of the underlying actions is covered under one or the other of the two insurance coverage towers. Moreover, because the two programs are each subject to a “priority of payments” provision giving the individual defendants in the underlying actions priority to coverage under the policies, IndyMac MBS sought to have the court make a determination of coverage for the individual defendants in the underlying actions, so as to allow the court to ascertain whether IndyMac MBS  may be eligible to receive coverage under the policies. The defendant insurance companies moved to dismiss.

 

In his August 24 order, Judge Klausner granted the insurance companies’ motions to dismiss, holding that IndyMac MBS’s request for declaratory relief is “too remote to constitute a case or controversy” because any insurance coverage that may ultimately be owed “can only be determined after the underlying actions involving the Individual Defendants have been concluded.” Accordingly, IndyMac MBS “does not yet have an adequate injury that would make this case justiciable.”

 

In addition, Judge Klausner found with respect to the excess layers of insurance had not even been triggered because the underlying insurance has not yet been exhausted, and whether the excess layers “will ever be triggered in the underlying action is too speculative to give rise to a valid request for standing in the current case.” Indeed, even under the primary policy, IndyMac’s alleged injury is “too speculative” as IndyMac MBS has not yet met the $2.5 million deductible.

 

Finally, Judge Klausner separately granted the Excess Side A insurers’ motion to dismiss. Because the insurance coverage under the Excess Side A policies is only available, if at all, for the benefit of the individual defendants, IndyMac “lacks standing to request declaratory relief” because it “cannot adequately allege that it has a legal interest” in the Excess Side A policies, given that the Excess Side A policies “provide coverage only for the Individual Insured Defendants.”

 

Discussion

There is nothing surprising about the outcome of this ruling. It clearly is too early for the court or anyone else to try to sort out who is going to be entitled to what under the various policies. Nevertheless, it certainly is understandable that IndyMac MBS would want to know how much insurance it is going to have as it faces the various lawsuits in which it is involved.

 

This is a classic situation of too many claims, too many defendants and possibly not enough insurance. Even though IndyMac carried annual limits of liability of $80 million (and I note as an aside, there is nothing that says that both of the two $80 million towers of insurance will actually be available; it is entirely possible that all claims will relate back to the date of the initial filing of the first claim, in which case only a single $80 million tower would actually be available to pay the various insured persons’ losses), that may prove to be an insufficient amount to pay the defense fees and to pay settlements and judgments in order to resolve all of the various underlying actions.

 

The larger concern for IndyMac MBS is that owing to the priority of payments provision in the traditional ABC policies, and owing to the limitation of coverage in the Excess Side A policies to the individuals only, it is entirely possible that payment of the individual insureds’ defense expenses and settlement amounts will entirely exhaust all insurance. The Excess Side A insurance of course is not available at all for IndyMac MBS. IndyMac’s declaratory judgment action seems like an attempt to try to do something before all of the insurance is gone.

 

Of course, I am assuming for the sake of argument that there actually is coverage available under these policies for the benefit of the individual insured persons. Whether or to what extent there are policy terms and conditions that preclude coverage in whole or in part for the individual insureds is another question. That is of course one of the questions that IndyMac MBS wanted answered in the declaratory judgment action, because knowing the answer to the question of how much insurance is available to the individuals is a necessary predicate to knowing the answer to how much insurance might be available to IndyMac MBS.

 

The structure of IndyMac’s insurance was somewhat unusual, as it is not common for companies to carry equal amounts of traditional ABC insurance and of Excess Side A insurance, or to carry $40 million of Excess Side A, as IndyMac did here. However, from the perspective of the individuals, the unusually large amount of Excess Side A insurance that the bank carried is turning out to be a good thing from there perspective, as it is looking like they are going to need it, and it is only going to be available to them and for their benefit, without having to share with other entities.

 

Anyway, while I don’t think the outcome of this decision is particularly surprising, it is still an interesting situation. The circumstances provide insight into the ways that the various parts of a D&O insurance program operate, particularly the priority of payments provision and the Excess Side A insurance structure.

 

One final observation has to do with the fact that a lot of insureds, like IndyMac MBS, become frustrated when they are unable to find out with clarity at the outset of a claim how much insurance is going to be available. The problem is, as this case demonstrates, until the underlying litigation has played itself out, it is not possible to know how all of the various rights and interests under the policy are going to be addressed. When this type of frustration arises in the course of a claim, the insured persons often translate their frustration into anger at the carriers involved. But as this case also shows, even taking as active a step as suing the carriers to try to force a determination of coverage cannot eliminate the unavoidable constraint that requires the underlying claim to be resolved (or at least sufficiently advanced) before coverage can finally be determined.

 

I do wonder sometimes whether it is a sad commentary that I find all of this interesting.

 

Special thanks to a dedicated reader for sending me a copy of the IndyMac order.

 

Las Vegas Sands Credit Crisis-Related Securities Suit Survives Dismissal Motion: Like a lot of companies during the economic turmoil in late 2008, the Las Vegas Sands Corp. experienced serious liquidity problems that put it in breach of various covenants it has with its lenders. These disruptions affected the company’s ability to proceed with expansion plans in Las Vegas and Macao. As these events unfolded the company’s share price lost much of its value.

 

As I discussed in an earlier post, somewhat belatedly, in May 2010, a plaintiff shareholder filed a securities class action lawsuit in the District of Nevada, alleging that the company and certain of its directors and officers had made misleading statements about the company, its development plans, its liquidity and its financial condition. The defendants moved to dismiss.

 

In an August 24, 2011 order (here), District of Nevada Judge Kent Dawson denied the defendants’ motion to dismiss. He concluded that the plaintiffs “have adequately pled facts asserting that investors were misled by statements that liquidity was not an issue and that development was steadily progressing.” He also concluded that the plaintiffs have “adequately pled that Defendants knew that the statements they were making were false.”  He also found that the allegations in the complaint “show a series of public statements on material issues that were inconsistent with what was known internally.” He did conclude that certain forward-looking statements were not actionable, because they came within the safe harbor for forward looking statements.

 

I have added the Las Vegas Sands case to my running tally of credit crisis-related dismissal motion rulings, which can be accessed here.

 

Here’s A Real Shocker: Merger Objection Lawsuits Are Worthless: If the hurricane blew away your Saturday newspapers, you may not have seen the August 27, 2011 article in the Wall Street Journal entitled “Why Merger Lawsuits Don’t Pay” (here). According to the article, “legal experts” warn prospective claimants with respect to merger objection lawsuits that “the chances that you will succeed in stopping a deal or receiving a payday are minimal.”

 

The article reports data from Advisen that in 2010, there were 353 merger objection lawsuits, which represents a 58% increase from 2009. There have already been 352 merger objection lawsuits so far this year. The number of these lawsuits keeps increasing even though these suits “rarely result in a tangible award,” and the best outcomes are usually limited to “a delay in the merger or slightly improved disclosures about the deal’s terms.”

 

The answer to the question about why these cases are filed if they produce so little is that they make money for the lawyers. As the article puts it, “in many cases the biggest beneficiaries are the law firms,” which collect fees “from roughly $400,000 for typical cases to several million for bigger cases.” The article quotes a statement from Delaware Chancellor J. Travis Laster that the specific merger objection case before him was “a bunch of movement for nothing.”

 

Yes, it’s a great country, isn’t it?

 

Video Tribute: As a parting salute to Irene as she heads north and back out to sea, here's a video tribute -- The Scorpions "Rock You Like A Hurricane." (sorry about the commercial at the beginning, it is short).

 

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As numerous commentators have noted, one of the most distinctive litigation developments over the last twelve months has been the emergence of U.S. securities litigation against Chinese companies that obtained their listings on U.S. exchanges that a “reverse merger” with a publicly traded U.S. shell company.

 

Given the prominence of these issues, I am very happy to publish the following guest post from Anjali C. Das, who is a partner in the Chicago office of the Wilson Elser law firm. Many thanks to Anjali for her willingness to publish her article here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

Here is Anjali’s guest post:

 

D&O Spotlight on China: Claims Against China-Based Reverse Merger Companies: A Tempest in a Teapot of Gunpowder Green Tea?

 

 

Introduction

           

These days, nearly everything to do with China has grabbed the spotlight – not least of all the country’s extraordinary and seemingly unstoppable economic growth. Not surprisingly, many U.S. investors have been pouring millions of dollars into Chinese companies with the hopes of gaining super-sized returns. However, naysayers have long predicted a bursting of the China bubble. At least for investors in China-based issuers, perhaps that time is now. Not unlike the bursting of the internet bubble in the 1990s fueled by explosive growth and investment in “dot.com” companies, investors and regulators may now have reason to fear the rapid rise and fall of Chinese companies that have accessed U.S. capital markets through reverse mergers. While short-sellers are publicly denouncing the purported fraud at these companies (and making big bucks shorting the stock), U.S. regulators are investigating the rash of accounting scandals at these companies which have caused some auditors to abruptly resign. Meanwhile, D&O insurers have to contend with the collateral damage resulting from the multitude of claims against China-based issuers and their directors and officers. This article highlights the following topics involving Chinese reverse merger companies: 

 

 

PCAOB's Research Note on Chinese reverse mergers

SEC's investigation of China-based issuers and their auditors

NASDAQ's proposed new listing requirements for reverse merger companies

SEC's Investor Bulletin on reverse merger companies

Moody's "Red Flags" report on China-based companies

D&O insurance coverage issues for claims against China-based issuers

 

 

 

PCAOB Issues a Report on China Reverse Mergers

 

 

On March 14, 2011, the Public Company Accounting Oversight Board ("PCAOB") issued a report examining the audit implications for reverse mergers involving China-based companies. A copy of the report can be found here. As explained in the PCAOB report, a reverse merger is an acquisition of a private operating company by a public company shell company. While the public shell company is the surviving entity, the  private company's shareholders typically control the surviving company or hold publicly traded shares in the company.  A perceived benefit of a reverse merger is that it enables a company to become an SEC reporting company with registered securities without having to file a registration statement under U.S. federal securities laws.

 

 

 

The PCAOB report identified 159 companies from China that accessed the U.S. capital markets in a reverse merger transaction from 2007 through March 2010, representing 26% of all reverse mergers during the period. Reportedly, the market capitalization of these companies was $12.8 billion as compared to a $27.2 billion market cap of the 56 Chinese companies that completed initial public offerings in the U.S. during that same period. 

 

 

Reverse merger entities listed on U.S. exchanges are required to file audited financial statements with the SEC, and the auditors of the financial statements are required to be registered with the PCAOB. According to the PCAOB, U.S. firms audited 116 or 74% of the China-based reverse merger companies, while Chinese registered accounting firms audited 38 or 25 of companies. The PCAOB report raises concerns that some U.S. firms are not conducting proper audits of China-based companies, including handing off the audit work to a local Chinese accounting firm without verifying the accuracy of the results. The PCAOB has identified various "key considerations" to determine the appropriate level of oversight of firms that performs audits of foreign companies with the aid of assistants outside the firm, including:  the ability to supervise outside assistants; whether the outside assistants have appropriate language skills, and whether the auditor would have the ability to comply with the PCAOB's documentation requirements.

 

 

           

SEC Launches Investigation of China-Based Issuers and Auditors

 

 

In response to a congressional inquiry by House Representative Patrick T. McHenry, Chairman of the Committee on Oversight and Government Reform, SEC Chairman Mary L. Schapiro issued a letter on April 27, 2011 seeking to assure Congress and the public that the SEC "has moved aggressively to protect investors from the risks that may be posed by certain foreign-based companies listed on U.S. exchanges" -- particularly those companies based in China.  As SEC Chairman Schapiro noted in her letter, there has been a recent marked increase in China-based companies listed on U.S. exchanges through the process of a reverse merger.

 

           

Last summer, the SEC reportedly launched a "proactive risk-based inquiry into U.S. audit firms" which have a significant number of issuer clients based outside the U.S.  Among other things, the SEC has requested auditors to provide information concerning the firms' compliance with U.S. audit standards for foreign-based reverse merger companies based in China.  Since the SEC launched its investigation, dozens of China-based companies have disclosed auditor resignations and accounting problems.  Since February 2011, Big Four accounting firms have resigned or been dismissed from at least seven Chinese companies listed in the U.S., as reported here. These auditors have reportedly experienced difficulty obtaining independent bank confirmations of a company's bank accounts, balances, and transactions, as reported here.   In at least one case, the auditor purportedly received false information directly from the bank itself, prompting the auditor to resign. 

 

 

In an effort to protect U.S. investors, the SEC has reportedly suspended trading in several China-based reverse merger entities.  In addition, the SEC has revoked the securities registration of many other China-based reverse merger companies.  In some instances, the SEC is also pursuing these companies' auditors for improper audits.   As the SEC Chairman observed, the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank") has enhanced the SEC's ability to obtain audit documentation in connection with its investigations of issuers based in China and other countries. 

 

 

NASDAQ Proposes New Listing Requirements for Reverse Mergers

 

 

 

On June 8, 2011, the NASDAQ filed proposed rules with the SEC to adopt additional listing requirements for companies that become public through a reverse merger. Under the proposed rules, which can be found here, a company that is formed by a reverse merger shall only be eligible to submit an application for initial listing if the combined entity can satisfy the following conditions: 

 

 

traded for at least 6 months in the U.S. over-the-counter market, on another national securities exchange, or on a foreign exchange following the filing of all audited financial statements;

 

maintained a bid price of $4 or more per share for at least 30 of the most recent 60 trading days;

 

in the case of a U.S. domestic issuer, the company has timely filed its two most recent financial statements (i.e., Form 10-Q or 10-K);

 

in the case of a foreign based issuer, the company timely files comparable financial statements (i.e., Form 6-K, 20-F or 40-F) that includes an interim balance sheet and income statement presented "in English"

 

 

In support of its proposed enhanced listing requirements, the NASDAQ cited the "extraordinary level of public attention to listed companies that went public via a reverse merger," and "allegations of widespread fraudulent behavior by these companies, leading to concerns that their financial statements cannot be relied upon." The NASDAQ believes that these new listing requirements will protect investors and "discourage inappropriate behavior" by companies. 

 

 

SEC Issues an Investor Bulletin on Reverse Mergers

 

 

 

On June 9, 2011, the SEC issued a bulletin cautioning investors of the potential pitfalls of investing in reverse merger companies. The bulletin can be found here. Among other things, the SEC observed that many reverse merger companies ("RMCs") "either fail or struggle to remain viable following a reverse merger"; there have been instances of fraud and other abuses involving RMCs; and some RMCs have been using smaller U.S. auditing firms that may not have sufficient resources to conduct adequate overseas audits. The SEC bulletin also cited recent examples where it suspended trading of RMCs due to accounting irregularities and/or revoked the securities registrations of RMCs due to the companies' failure to timely file required periodic financial statements.

 

 

Moody's Issues its "Red Flags" Report on China-Based Companies

 

 

To address investors' increasing concerns with the quality of financial reporting from publicly listed Chinese companies, on July 11, 2011 Moody's credit rating agency issued a "Red Flags" report for China-based companies. The report examines 20 red flags grouped into five categories that identify possible governance or accounting risks for China-based companies, including:

 

 

            Weaknesses in corporate governance: short track record of operations and listing history,         murky shareholders' background, large and frequent related-party transactions;

 

            Riskier or more opaque business models: unusually high margins compared to peers,     concentration of customers, complicated business structures;

 

            Fast-growing-business strategies: very rapid expansion, big capital investments resulting         in large negative free cash flow and intangible assets;

 

            Poorer quality of earnings or cash flow: discrepancy between cash flows and accounting             profits, disjointed relationship between growth in assets and revenues, large swings in working capital, insufficient tax paid compared to reported profits;

 

 

            Concerns over auditors and quality of financial statements: a switch in auditing firm or    legal jurisdiction of auditor's office, delay in reporting, or adverse comments from      auditors.

 

 

Moody's applied its red flags analytical framework to 61 rated Chinese companies. According to Moody's report, due to the rapid growth of Chinese companies, nearly all Chinese high-yield issuers tripped red flags related to aggressive business and financial strategies and quality of earnings. Moody's observed that fast-growing companies put pressure on managerial and financial resources. Additionally, these companies may make large capital investments that could negatively impact cash flow for a prolonged period of time. Also, due to the prevalence of strong founding families, many Chinese companies tripped the red flag for concentration of family ownership which may reflect weaknesses in corporate governance.  Moody's also noted the so-called arms-length related-party transactions were not always transparent. Interestingly, according to Moody's report, concerns over auditors arose less frequently compared to other red flags. 

 

 

 

Shorts-Sellers Creating Havoc

 

 

 

Meanwhile, short-sellers are wreaking havoc on China-based issuers' stock and publicly accusing these companies of fraud. In several instances, detailed reports issued by short-sellers have triggered a wave of internal investigations, investigations by regulators, and shareholder litigation against companies. While some companies have gone to lengths to deny short seller's often unsubstantiated accusations, the damage is done when the investors get spooked and the company's stock price spirals downward. 

 

 

All of the negative publicity has impacted Chinese companies across the board, regardless of whether specific allegations of fraud have been asserted. Where investors were once rushing to dump huge sums of money into any business with ties to China, they are now rushing to liquidate their stock holdings at the slightest sign of any trouble. The fallout has had a devastating impact on the number of reverse merger transactions of Chinese companies. Not surprisingly, some Chinese companies have postponed plans to sell shares in the U.S., either through reverse mergers or initial public offerings ("IPOs"). As reported here, compared to 47 reverse merger transactions in the first half of 2010, there have been only 29 for the first half of 2011.  At least for now, Chinese companies are no longer the darling of Wall Street.

 

 

The Rise of Shareholder Litigation

 

 

Approximately 30 shareholder suits were filed in the first half of 2011 against China-based companies listed on U.S. exchanges and the companies' directors and officers. On the surface, many of these suits are classic securities class actions alleging securities fraud and violations of Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act") for materially false and misleading financial statements and related derivative actions.  However, suits against China-based companies may pose unique hurdles and added expense to the defense of shareholder claims in the U.S. For one thing, many or most of the individual defendants, corporate documents, and key witnesses may reside in China. Moreover, testimony and documents may need to be translated from Chinese to English. As such, defense costs can escalate rapidly. Also, given the current regulatory climate and increased suspicion of China-based issuers, the company may also be the subject of parallel proceedings or investigations by the SEC and other regulators. In some situations, the company's Board may simultaneously launch an internal investigation – particularly if the company's outside auditor abruptly resigns without issuing a clean audit opinion. That could also trigger a wave of management departures, putting added strain on the company's already stretched resources. 

 

 

D&O Insurance Coverage Issues

 

 

 

Claims against China-based issuers and their directors and officers may raise a host of coverage issues under traditional Directors and Officers (“D&O”) liability insurance policies including, but not limited to: 

 

 

Reasonable and necessary defense costs

Coverage for parallel proceedings and investigations

Rescission

Known Claim exclusion

Fraud and personal profit exclusions

Severabiity of the policy exclusions and application

 

 

 

D&O policy limits for public companies are typically eroded by defense costs. This may occur more rapidly in suits against Chinese companies in light of the complexities of transnational discovery. As such, it is in the interests of D&O insurers and insureds alike to ensure that these claims are being defended with maximum efficiency to minimize the possibility that the D&O insurance is significantly impaired or even exhausted by defense costs alone. While many large defense firms now have outposts in China, it is still imperative to gain an understanding of the anticipated division of labor between the U.S. based lead defense attorneys and their colleagues in China with respect to discovery, document collection, witness interviews, and other matters. Additionally, there should be an objective assessment to determine whether it is cheaper and more efficient to outsource certain discovery-related tasks such as collection and translation of documents.

 

 

Shareholder litigation against Chinese companies may spawn multiple parallel proceedings and investigations by the government, regulators, the Board, a Special Litigation Committee, and others. A key issue is whether such investigations constitute covered Claims or Securities Claims under the D&O policy. Historically, many D&O policies narrowly limited the availability of coverage for investigations, such as formal investigations by the Securities and Exchange Commission (“SEC”) commenced by service of a subpoena on a director or officer. However, in the past few years, some D&O policies began to offer enhanced coverage, including coverage for both formal and informal investigations by regulators. Nowadays, the definition of a Securities Claim is less standard and may contain many subtle, yet critical nuances impacting coverage. Not surprisingly, there has been a significant amount of litigation and reported decisions with respect to coverage for investigations under D&O policies. However, many of these decisions are fact-specific and driven by now obsolete D&O policy language and definitions which continue to evolve. 

 

 

Recently, on July 1, 2011, the Second Circuit Court of Appeals issued an opinion in MBIA, Inc. v. Federal Ins. Co., 2011 U.S. App. LEXIS 13402 (2d Cir.), that sets forth a comprehensive analysis of coverage for various investigations under a D&O policy. In that case, the policy definition of a covered Securities Claim included “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” First, the Second Circuit held that investigations commenced by the SEC and the New York Attorney General (“NYAG”) were covered under the policy definition of a Securities Claim. The court observed that the issuance of a subpoena by NYAG was, at a minimum, a “similar document” related to a “formal or informal investigative order”. The court also opined that requests for information by the SEC pursuant to oral requests and subpoenas were covered because they were connected to the SEC’s formal order of investigation. The court also concluded that fees incurred by an independent consultant retained by MBIA in the context of negotiating a settlement with the SEC and NYAG were also covered.

 

 

Second, the Second Circuit concluded that legal fees incurred by MBIA’s Special Litigation Committee (“SLC”) to determine whether to pursue or terminate pending shareholder derivative actions were covered and did not clearly fall within the policy’s sub-limit of liability for shareholder derivative demands. Prior to the filing of the derivative actions, a shareholder demand on MBIA’s Board had been made and ultimately rejected. After the shareholder derivative suits were filed, the SLC sought and obtained dismissal of the lawsuits. The Second Circuit determined that the legal fees incurred by the SLC arguably fell within the policy’s coverage for “costs ‘incurred in . . . investigating’ ‘Claims’ or ‘Securities Claims,’ respectively, each of which is defined to expressly include lawsuits.” The Second Circuit also determined that that the insurer had failed to carry its burden of proving that the SLC’s legal fees were not covered under the policy definition of Loss which excluded “any amount incurred by [MBIA] (including its board of directors or any committee of the board of directors) in connection with the investigation or evaluation of any Claim or potential Claim by or on behalf of [MBIA]”. 

 

 

           

To the extent claims against China-based issuers and their directors and officers allege accounting improprieties and false and misleading financial statements, D&O insurers might have a potential rescission argument if the policy was issued in reliance on these false financials. In some instances, D&O policies and/or applications contain a Known Claim Exclusion which might serve as a basis for denying coverage if an insured knew and/or failed to disclose a fact, circumstance, act, error, or omission that might give rise to a Claim under the policy. Also, standard D&O policies contain fraud and personal profit exclusions that might apply; however, these exclusions are usually restricted to a finding “in fact” or “final adjudication” that the insured committed fraud or unlawfully profited. In addition, both the application and the exclusions might be “severable,” such that the knowledge or wrongful acts of one insured cannot be automatically imputed to other insureds except in limited situations.

 

 

 

Conclusion

 

 

 

Some might conclude that the spotlight on China-based reverse merger companies is merely a tempest in a teapot, as compared to the global financial crisis precipitated by the subprime market meltdown and collapse of numerous financial institutions at home and abroad. Nonetheless, the reality is that many China-based issuers have been targeted by regulators and investors alike for purported securities and accounting fraud that could ultimately cost D&O insurers millions in losses. At least for now, this trend seems to be gaining traction. Until the pot is done brewing and the tea leaves are read, D&O insurers should tread carefully in handling claims against their China-based issuers.

 

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In its sweeping July 1, 2011 opinion in the MBIA case, the Second Circuit addressed many of the D&O insurance coverage issues that are currently the most contentious. The opinion has occasioned much discussion and commentary in the D&O insurance industry. My blog post about the case can be found here.

 

In view of the ongoing discussion about the case, I am very pleased to be able to publish here as a guest post an article analyzing and commenting on the Second Circuit’s decision written by Richard Bortnick and Micah J. M. Knapp of the Cozen O’Connor law firm. Rick is also the co-author of the Cyberinquirer blog. Many thanks to Rick and Micah for their willingness to publish their article here.  I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

 

 

Here is Rick and Micah’s guest post:

 

 

In its July 1, 2011 opinion MBIA, Inc. v. Federal Ins. Co. and ACE American Ins. Co., 10-0355-cv (2d Cir. July 1, 2011), the U.S. Court of Appeals for the Second Circuit rejected Insurers Federal Insurance Company’s (Federal) and ACE American Insurance Company’s (ACE) (collectively, the Insurers) appeals seeking to reverse a Finding of coverage for (1) expenses associated with federal and state government investigations into the insured’s accounting practices, and (2) a special litigation committee formed to investigate the shareholder derivative suits that followed the agency scrutiny. In an analysis heavily influenced by the facts, the Second Circuit swept aside the Insurers’ arguments that their D&O policies did not cover expenses associated with what they argued were informal agency inquiries and investigations only loosely associated with written agency orders and subpoenas. The court also concluded that expenses incurred by the special litigation committee formed by the insured, MBIA, Inc. (MBIA), to investigate two derivative suits were “Defense Costs” covered under the Insurers’ D&O policies. On close scrutiny, however, the impact of the decision may be limited based on the particular policy language at issue and the facts of the case.

 

 

 

The Policies

 

 

MBIA provides financial guarantee insurance for government bonds or structured finance obligations – essentially guaranteeing that bond holders would be paid with respect to MBIA’s clients’ bonds. MBIA purchased $15 million in primary D&O insurance from Federal covering the period of February 15, 2004 through August 15, 2004. ACE issued $15 million in excess coverage that followed form to the Federal policy in all respects relevant to the lawsuit (collectively, the Policies). The Policies’ entity coverage section provided: “The Company shall pay on behalf of any Organization all Securities Loss for which it becomes legally obligated to pay on account of any Securities Claim first made against it during the Policy Period ….” The Policies further covered “Defense Costs” for “Securities Claims.” “Securities Claim” was defined as “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document” that “in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or over to purchase or sell any securities issued by [MBIA].”

 

 

 

The Agency Investigations and MBIA’s Claim

 

 

In 2001, the SEC issued an Order Directing Private Investigation and initiated an investigation into potentially unlawful accounting practices in the insurance industry. The SEC targeted MBIA in November 2004 as part of that larger investigation, issuing subpoenas compelling the company to produce documents concerning transactions involving “non-traditional products” – products that could be used to “affect the timing or amount of revenue or expense recognized.” The New York attorney general (NYAG) followed suit, serving MBIA with similar subpoenas requesting similar documents in November and December 2004.

 

 

 

The federal and state investigations eventually focused on three separate MBIA transactions. In the first transaction, MBIA purchased reinsurance for its guarantee of bonds issued by a group of hospitals owned by the Allegheny Health, Education and Research Foundation (AHERF) after AHERF declared bankruptcy. The investigations sought to determine whether MBIA endeavored to disguise the impact of a $170 million loss from the transaction with AHERF.

 

 

 

In the summer of 2005, the SEC and NYAG began investigating two additional transactions. In the second such transaction, MBIA purchased an interest in Capital Asset Holdings GP, Inc. (Capital Asset), but soon found it necessary to provide additional, unanticipated funds to Capital Asset. MBIA made the payment through a subsidiary, thereby transferring the risk of the investment loss to the subsidiary and allegedly disguising a potential loss to the parent company. The third transaction involved MBIA’s guarantee of securities used to purchase airplanes for US Airways. MBIA foreclosed on the airplanes after US Airways declared bankruptcy and treated the transaction as an investment in airplanes rather than a loss. 

 

 

 

MBIA forwarded the agency subpoenas to the Insurers in May 2005, informing them that it was the target of state and federal investigations. MBIA asked for the Insurers’ consent to retain counsel. The Insurers denied that the subpoenas triggered coverage, but accepted the subpoenas as notice of a potential claim. MBIA hired counsel and responded to the agency inquiries.

 

 

 

The SEC and NYAG considered issuing additional subpoenas concerning the Capital Asset and US Airways transactions in the summer of 2005. Concerned about additional adverse publicity, MBIA requested that the agencies hold on issuing more subpoenas, and instead accept MBIA’s voluntary compliance with the agencies’ demands. The SEC and NYAG agreed and, thereafter, MBIA complied with the agencies’ informal, often oral, requests.

 

 

 

In October 2005, MBIA forwarded the agencies an over of settlement concerning the AHERF transaction investigation. That over included a payment of penalties and MBIA’s proposal to retain an independent consultant to analyze the Capital Asset and US Airways matters. MBIA notified the Insurers of the settlement discussions in September 2005 and met with Federal in October 2005. At the time, however, MBIA did not advise the Insurers of its proposal to hire an independent consultant. The SEC and NYAG finalized settlements with MBIA in January 2007 in accords substantially similar to MBIA’s October 2005 over. The independent consultant later exonerated MBIA of any wrongdoing in the Capital Asset and US Airways transactions.

 

 

 

MBIA’s shareholders followed the state and federal agency investigations with two derivative lawsuits. Upon receiving the shareholder plaintiffs’ presuit demand letters, MBIA formed a Demand Investigative Committee (DIC) – a committee of independent directors tasked with investigating the shareholders’ demand letter. The DIC retained an outside law firm, Dickstein Shapiro (Dickstein), to assist in the investigation. When the DIC failed to act on the shareholders’ derivative demand within the time allotted by Connecticut law, the shareholders filed suit. MBIA reconstituted the DIC as a Special Litigation Committee (SLC), which again employed Dickstein to aid in the investigation of the derivative suit allegations. The SLC concluded that the suits were not in the best interests of the company and, consistent with Connecticut law, moved to dismiss the complaints.

 

 

 

MBIA submitted a claim with the Insurers seeking costs associated with the agencies’ investigations of the three transactions, the cost of the independent consultant retained to investigate the Capital Asset and US Airways transactions, and expenses associated with the DIC and the SLC. Federal paid MBIA approximately $6.4 million out of its $15 million limit to cover losses from the SEC investigation of the AHERF transaction and related lawsuits. The payment included $200,000 for the DIC’s investigation of the shareholder plaintiffs’ presuit demand pursuant to the Federal policy’s derivative investigation coverage sublimit. Federal denied MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC. ACE denied that it had any obligation to pay for any of the losses based upon MBIA’s non-exhaustion of the primary policy.

 

 

 

The Motions for Summary Judgment and Appeal

 

 

MBIA filed suit against the Insurers on May 7, 2008, asserting three claims for breach of contract and seeking a declaratory judgment. MBIA and the Insurers cross-moved for summary judgment on MBIA’s claim for losses associated with the NYAG investigation of the AHERF transaction, the SEC and NYAG investigations of the Capital Asset and US Airways transactions, the independent consultant, and the SLC.

 

 

 

Judge Berman of the Southern District of New York granted in part and denied in part the parties’ cross-motions for summary judgment. On balance, however, the Southern District found in MBIA’s favor, holding that the Insurers owed coverage for the SEC and NYAG investigations of all three transactions, as well as for the expenses incurred by the SLC. The District Court determined that MBIA was not entitled to coverage for the costs associated with the independent consultant’s review of the Capital Asset and US Airways transactions because MBIA had not provided the Insurers with adequate notice of its intent to retain the consultant. The Insurers appealed and MBIA cross-appealed. 

 

 

 

The Insurers’ appeal challenged the District Court’s holdings that the Policies obligated the Insurers to cover losses associated with (1) the NYAG investigation of the AHERF transaction, (2) the SEC and NYAG investigations of the Capital Asset and US Airways transactions, and (3) the SLC. 

 

 

 

On the first issue, the Insurers argued that the NYAG subpoena was a “mere discovery device” that did not meet the Policies’ definition of “Securities Claim.” The Second Circuit disagreed, pointing out that a subpoena is the “primary investigative implement in the NYAG’s tool shed,” and that, at a minimum, it constituted a document similar to a “formal or informal investigative order,” which was within the definition of “Securities Claim.”

 

 

 

On the second issue, the Second Circuit rejected the Insurers’ argument that the SEC and NYAG investigations into the Capital Asset and US Airways transactions were not within the scope of the SEC’s formal order and the NYAG’s similar AHERF investigation. The court found that the language of the SEC order and NYAG subpoenas evidenced a “broad but definitive investigatory scope” that included all three of the questionable transactions. It further observed that the SEC and NYAG investigations of the Capital Asset and US Airways transactions were connected to the SEC’s formal order and the NYAG’s AHERF investigation, and rejected the Insurers’ argument that they were not obligated to cover MBIA’s expenses associated with its voluntary compliance with informal requests made in the course of those related investigations.

 

 

 

The Insurers’ main argument in support of its third issue on appeal was that the SLC costs were incurred solely by the SLC, and that the SLC was not an “insured person” under the Policies. The District Court found coverage for the SLC expenses primarily because the expenses at issue were owed to Dickstein, and Dickstein had entered its appearance on behalf of MBIA, a nominal defendant in the derivative suits. The District Court reasoned that because Dickstein represented MBIA in the derivative suits, Dickstein’s fees were covered “Defense Costs.” The District Court then suggested that the SLC expenses would have been covered even if the outside firm had not represented MBIA, because the SLC was not an entity independent of MBIA.

 

 

 

The Second Circuit broadened the District Court’s reasoning and concluded that the SLC expenses were covered “Defense Costs” because the SLC was part of MBIA. After a brief analysis of Connecticut law on how and through whom corporations operate, the Second Circuit proclaimed that MBIA directed or acted through the SLC when the latter moved to dismiss the derivative suits and, as a result, the SLC was an “insured person” under the Policies. Unlike the District Court, the Second Circuit did not mention, much less rely upon the fact that Dickstein represented both the SLC and MBIA in the derivative suit. The Second Circuit further rejected the Insurers’ arguments that coverage for the SLC would render superfluous the Policies’ sublimit for investigation costs, and that the SLC expenses were excluded from coverage by operation of exclusions within the Policies’ definition of “Loss.” The court found that the investigation sublimit only applied to presuit investigations, not costs related to derivative suits, and that the Insurers had failed to establish that any exclusions applied to MBIA’s claim for SLC expenses. 

 

 

 

Turning to MBIA’s cross-appeal, the court reversed the District Court’s ruling in the Insurers’ favor on the issue of coverage for costs associated with the independent consultant’s investigation of the Capital Asset and US Airways transactions. In a lengthy analysis reciting what and when MBIA reported to the Insurers, the court concluded that MBIA did not breach the Policies’ “right to associate” clause, because MBIA provided the insurers with sufficient notice of the settlement discussions with the SEC and NYAG “early enough in the process to allow the insurers to exercise their option to associate effectively.”

 

 

 

MBIA’s Affect on Future Claim Disputes

 

 

The Second Circuit’s opinion touches on two types of expenses commonly disputed in D&O claims, expenses incurred in responding to state or federal subpoenas and special litigation committee expenses associated with the investigation of allegations in derivative suits. The court accepted the policyholder’s arguments in support of coverage for both types of expenses. 

 

 

 

With respect to the first category of expenses, MBIA interprets “Securities Claims” broadly, supporting the assertion that coverage extends to expenses associated with an insured’s voluntary compliance with certain types of informal or quasi-formal agency investigations. Insureds undoubtedly will cite MBIA for the proposition that a company does not forfeit its D&O coverage when it volunteers to cooperate with investigative agency requests rather than await formal, legal proceedings and risk suffering potentially damaging publicity and harsher penalties. 

 

 

 

The court’s ruling on coverage for MBIA’s voluntary cooperation with investigators, however, cannot be universally applied without regard to the court’s view of the breadth of the investigations and the expansive language of the primary policy’s insuring agreement. Both factors may provide bases for distinguishing MBIA from other cases. In MBIA, the policy at issue broadly defined “Securities Claim” to include any “formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.” A formal order of investigation and regulatory subpoenas already had been issued by both agencies before any voluntary compliance was offered or undertaken. Given the Federal policy’s expansive definition of “Securities Claim,” the Second Circuit had little difficulty concluding that coverage existed. This should be distinguished from situations involving voluntary disclosure in the absence of formal agency process or where a policy contains more limited language. 

 

 

 

The most significant aspect of the Second Circuit’s MBIA opinion is the seemingly blanket pronouncement that special litigation committee investigative costs incurred in response to a derivative suit are covered “Defense Costs.” That holding, however, relies on two questionable propositions: (1) that the SLC was an agent of, and acted at the behest of, MBIA, and (2) that the SLC’s actions were related to the defense of MBIA or insured directors.

 

 

 

On summary judgment, the District Court strained to find coverage for SLC expenses by noting that outside counsel retained by the SLC to investigate the shareholders’ claims also represented MBIA as a nominal defendant in the derivative lawsuits. After linking the SLC’s expenses to Dickstein’s representation of MBIA in the derivative suits, the District Court decreed that the SLC costs were, in fact, “Defense Costs.” 

 

 

 

The Second Circuit abandoned the District Court’s reliance on Dickstein’s representation of both the SLC and MBIA, determining instead that the SLC was not a separate entity from MBIA and was, therefore, an “insured person” under the Policy. The court’s analysis notwithstanding, there is no support for the proposition that MBIA directed the SLC. Rather, the SLC was comprised of independent directors uninvolved in wrongdoing alleged by the shareholder plaintiffs. Indeed, under Connecticut law, the SLC was required to operate independent of MBIA and its board in the SLC’s investigation of the derivative suits. The decision to dismiss the derivative suits was the SLC’s alone. MBIA did not, and legally could not, instruct the SLC to conclude that the derivative suit was not in the company’s best interest.

 

 

 

More importantly, the SLC did not act in the defense of MBIA or the insured directors and its expenses should not have been categorized as “Defense Costs.” The Second Circuit’s opinion provides no analysis on this point, concluding simply that “the costs incurred by the SLC in terminating the derivative litigation were covered ‘Defense Costs.’” But the very purpose of special litigation committees – to investigate allegations in shareholder derivative suits and determine whether the company should prosecute those claims against the defendant directors – is a corporate governance function. The board, through the SLC, has a fiduciary duty to investigate whether wrongdoing has occurred and whether to seek relief on behalf of the corporation. Thus, the SLC’s investigative costs should be covered here only to the extent of the Federal policy’s investigations sublimit. 

 

 

 

Moreover, costs for appearing in a lawsuit are not necessarily defense expenses. The SLC, after all, was not defending itself or the corporation. It was, in this case, seeking the termination of claims against other directors on grounds that it was not in the company’s interest to pursue those claims. This is the company’s right as the true owner of the claims being prosecuted. Simply because targeted directors avoided adverse claims as a result of the SLC’s investigation does not transform the SLC into a tool to defend target directors or defeat shareholder derivative claims. Had the SLC decided to take over the prosecution of the claims, also its right, no colorable argument for coverage could have been made. The Second Circuit overlooked this crucial analytical distinction.

 

 

 

MBIA is likely to be cited by policyholders both within and outside the Second Circuit in support of arguments for broad coverage with respect to agency investigations and Special Litigation Committee costs. Insurers need to be aware of the limitations of the Second Circuit’s reasoning and the factual idiosyncrasies of the case.

 

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When an ex- Chairman, CEO and Director sues his former company, are the company’s defense expenses covered under its D&O insurance policy? According to the June 24, 2011 report and recommendation of Middle District of Tennessee Magistrate Judge John S. Bryant, applying Tennessee law, they are not. A copy of Magistrate Bryant’s report and recommendation can be found here.

 

In October 2009, David Resha, a current shareholder and former Chairman, CEO and director of American Security Bank & Trust Company, sued the company in Tennessee state court for alleged violations of law and fiduciary duty. Resha alleged that the company had violated its bylaws and asserted the right to inspect the company’s books and records. American Security is the sole named defendant in the action.

 

The company submitted the action as a claim to its D&O insurer, seeking reimbursement for its defense expenses. The carrier denied coverage for the claim and American Security filed an action against the carrier alleging breach of contract and bad faith and seeking a judicial declaration that all past and future expenses incurred in defending against Resha’s claim are covered.

 

The policy contained the standard D&O insurance agreements for nonindemnifiable loss (Side A coverage) protecting the individual directors and officers in the event indemnification is not available to them due to insolvency or legal prohibition, and for corporate reimbursement (Side B coverage), reimbursing  the company to the extent it does indemnify the individual directors and officers. At least as presented in the Magistrate Judge’s report and recommendation, the policy did not contain a separate insuring agreement providing coverage for the entity’s own losses (Side C coverage).

 

The policy defined the term “Claim” to mean a “civil proceeding commenced by the service of the complaint … instituted against an Insured Person or against the Company, coverage is granted to the Company.” 

 

Resha’s lawsuit named only American Security as defendant in the lawsuit. Due to the absence of an entity coverage insuring provision, there is no separate coverage for the company under American Security’s D&O insurance policy. The company nevertheless argued that the insurer should reimburse the company’s defense costs because the complaint asserts bad faith actions and breaches of fiduciary duty by American Security directors, and therefore “impliedly” asserts claims against the directors.

 

The Magistrate Judge rejected American Security’s arguments, holding that because Resha’s complaint did not name the directors as defendants, the action has not been “instituted against” them. He said that to find under these circumstances that Resha’s action was “instituted against” the directors, the court “would be required to find the words ‘instituted against’ to be ambiguous.” He said that ‘after considering the usual, natural, and ordinary meaning of these words, there is no ambiguity to be found and any premise to the contrary must be rejected.” He added that “to find otherwise would violate the intent of this D&O policy and effectively change it into a comprehensive corporate liability policy.”

 

The Magistrate Judge went on to hold that “to the extent that a claim has been made against the directors and officers of American Security in substance, though not in form,” the claim would be barred by the policy’s Insured vs. Insured exclusion, since Resha, as the company’s former CEO is an insured person under the policy.

 

American Security had tried to argue that because Resha was also a shareholder, his claim was in the nature of a derivative claim, and therefore his action fell within the exception to the Insured vs. Insured exclusion for derivative claims. Without deciding whether or not Resha’s action was a derivative claim, the Magistrate Judge concluded that the derivative claim exception to the Insured vs. Insured exclusion did not apply, because Resha’s action was not maintained “independently of, and totally without the participation of any Insured” as would be required in order for the derivative claim exception to the Insured vs. Insured exclusion to apply.

 

The Magistrate Judge recommended that the insurer’s motion to dismiss be granted and the complaint against it dismissed.

 

Discussion

Assuming that the description of American Security’s D&O insurance policy in Magistrate Judge Bryant’s report and recommendation is complete, its policy is somewhat unusual as most current D&O insurance policies include a so-called entity coverage insuring provision (Side C coverage) providing insurance for the entity’s own separate liability exposures. Subject to all of the typical policy’s terms and conditions, entity coverage does provide a form of corporate liability protection.

 

However, even if American Security’s D&O insurance policy had carried the typical entity coverage insuring provision, Resha’s claim would still have run afoul of the policy’s Insured vs. Insured exclusion, and indeed if anything the exclusion’s applicability would have been even more clear.

 

The inclusion of the Insured vs. Insured exclusion in the D&O insurance policy is usually explained as a way to avoid the provision of insurance coverage for “collusive” claims. But that is not the only reason the exclusion is there. It is also a means to avoid insurance for corporate “infighting” where company officials attempt to pursue their disputes and rivalries in Court. The requirement that a derivative claim must be independent and without the participation of an insured person in order for the exclusion’s coverage carve back for derivative claims to apply is just an illustration as the ways the typical exclusions seeks to avoid coverage for infighting type claims.

 

Although Magistrate Judge Bryant’s report and recommendation does not say, it seems possible that Resha’s action represents just such an example of corporate infighting. The report and recommendation does not explain why Resha no longer is Chairman, CEO and a director of the company, but his action alleging by law violations and seeking access to the company’s books and records sounds like part of an ongoing dispute after his departure from office. In any event, Resha’s claim is the kind for which most D&O insurance policy’s typically would not provide coverage.

 

For a more detailed discussion of the Insured v. Insured exclusion generally, refer here.

 

Morrison: Domestic Transaction in Other Securities?: In its June 2010 decision in the Morrison v. National Australia Bank case, the U.S. Supreme Court said that the Exchange Act applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” Among other issues with which the lower courts have struggled in the wake of Morrison has been the reach of Morrison’s second-prong; that is, what are “domestic transactions in other securities?”

 

A July 8, 2011 decision by the Eleventh Circuit may shed at least a little bit of light on this question. The case, styled as Quail Cruise Ship Management Ltd. V. Agencia de Viagens CVC Tur Limitada, which can be found here, involved the sale of M/V Pacific, a boat once featured in The Love Boat television series. The sale was effected by a transfer of shares.  The buyer alleged that it had been induced to purchase the shares through a series of misrepresentations, in violation of the U.S. securities laws.

 

The district court had concluded that it did not have jurisdiction over the dispute because the shares were not listed on a U.S. exchange (the Eleventh Circuit correctly noted that the issue was not jurisdictional at all, but was rather under Morrison a question as to whether or not the U.S. securities laws applied).

 

The Eleventh Circuit held that because the complaint alleged that "the acquisition of the Templeton stock closed in Miami, Florida, on June 10, 2008, by means of the parties submitting the stock transfer documents by express courier into this District," the Complaint at least alleged that the final act to effect the share transfer took place in the U.S. Of course, whether or not the share transfer actually took place in the United States and whether the transfer actually effected the sale of the ship are questions of fact for later determination. 

 

Accordingly, the Eleventh Circuit held that it “cannot say at this stage in the proceedings that the alleged transfer of title to the shares in the United States lies beyond § 10(b)’s territorial reach.” the Eleventh Circuit vacated the district court’s dismissal and remanded the case for further proceedings. 

 

A further discussion of this case can be found in a July 15, 2011 post on the Corporate and Financial Weekly Digest blog, here.

 

The Message is Getting Through in China, Too -- At Least to a Certain Extent: In numerous posts on this blog, most recently here, I have noted the increasingly challenging D&O insurance market for U.S.-listed Chinese companies. The word about the challenging insurance market for these firms apparently is getting heard in China, too, at least based on one recent article. On June 24, 2011, the People’s Daily Online (English edition) carried an article entitled “D&O Premiums Skyrocket After U.S. Lawsuits” (here).

 

Although it is good that this message is getting communicated in China, the article soft-pedals the problem. D&O insurance premiums for U.S.-listed Chinese companies have gone up much more than the 20% increase cited in the article – that is, if you can find coverage at all. The article does at least go on to note, with greater (but not yet complete) accuracy, that in some cases the premiums have doubled. The premium increases have in fact been even more dramatic than that.

 

“Starring Your Love Boat Crew”: Those of you interested in having a look at the M/V Pacific or who just want a short trip down memory lane will want to view this video clip of the opening credits from The Love Boat, which according to Wikipedia, aired on television from 1977 to 1986.

 

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In a sweeping July 1, 2011 opinion in MBIA’s favor, the Second Circuit held that the company’s D&O insurance policies cover the investigative and special litigation expense the company incurred during a regulatory investigation of its accounting practices. This case had been closely watched in the D&O insurance community because of widespread carrier concerns over the district court’s coverage findings. The insurers had hoped for relief on appeal. But the Second Circuit’s decision, if anything, is even more expansive in favor of coverage than was the district court.  

 

Background

For the policy period February 15, 2004 to August 15, 2005, MBIA carried $30 million of D&O insurance, arranged in a primary layer of $15 million and an additional $15 million layer of excess insurance.

 

In 2001, prior to the policy period, the SEC had issued an Order Directing Private Investigation in connection with certain of insurance industry accounting practices. In November and December 2004, the SEC issued subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2004 regarding nontraditional products. Both the SEC and the NYAG issues additional subpoenas in March 2005. In spring 2005, MBIA, because of concerns about the cumulative impact in the marketplace, asked regulators to forbear from issuing additional subpoenas and agreed to comply voluntarily with informal document requests.

 

The investigation ultimately narrowed to three MBIA transactions. The first involved MBIA’s retroactive purchase of reinsurance on it guarantee of bonds issued by an Allegheny Health hospital group (knows as “AHERF”). The regulators latter contended that MBIA’s retroactive reinsurance purchase allowed MBIA to avoid recognizing a large ($170 mm) one-time loss. In the second transaction involving General Asset Holdings GP, the allegation was that MBIA transferred its risk of an investment loss to an MBIA subsidiary, allowing the parent company to avoid reporting the loss. The third transaction involved MBIA’s guarantee of securities US Airways issued to purchase aircraft. When US Airways went bankrupt, MBIA foreclosed on the aircraft, and treated the transaction as an “investment” rather than a “loss.”

 

In October 2005, MBIA submitted an offer of settlement to SEC. In the offer of settlement, MBIA undertook to retain an independent consultant to review MBIA’s accounting for the transactions. In January 2007, the SEC entered a Cease and Desist Order and the NYAG entered an Assurance of Discontinuance, both of which documents largely incorporated the company’s prior offer of settlement. Thereafter the company hired a consultant to undertake the proposed review. The independent consultant found no wrongdoing in connection with the Capital Asset and US Airways transactions.

 

In addition to the regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits. Prior to filing the suits, the shareholder plaintiffs had sent demand letters to MBIA asking the board to file suit against the directors and officers for the alleged wrongdoing. The company organized a demand investigative committee (“DIC”) to investigate the demands, but the DIC failed to act within the statutory time limit. The shareholders then filed suit, as a result of which the company organized a Special Litigation Committee (“the SLC”). The SLC hired an outside law firm, which investigated the derivative lawsuit allegations. Following its investigation, the SLC determined that maintaining the lawsuits was not in the company’s interest and recommended that the derivative lawsuits be dismissed. The derivative suits ultimately were dismissed.

 

MBIA claimed that it has spent $29.5 million in defending or responding to the regulatory investigations and the follow-on litigation. The primary insurer had agreed it was obligated to pay the costs associated with the SEC’s AHERF investigation and also its $200,000 sublimit for the DIC investigation. The primary insurer disputed that it was obliged to reimburse other amounts incurred. Specifically the primary insurer disputed that it was obligated to reimburse the costs associated with NYAG’s AHERF subpoena; the Capital Asset and US Airways transaction investigations; the SLC expenses; and the independent consultant’s expenses. The primary carrier reimbursed MBIA $6.4 million.

 

MBIA filed an action against the two insurers alleging breach of contract and seeking a judicial declaration that the insurers were obligated to reimburse the company for legal fees and other costs associated with the regulatory investigations and the derivative actions. The parties filed cross motions for summary judgment.

 

In December 30, 2009 opinion (discussed here), District Judge Richard M. Berman held that the policies covered all of the investigative costs and the special litigation committee counsel’s expenses, but that they did not cover the independent consultant’s post-settlement investigation. The parties cross appealed.

 

The July 1 Second Circuit Opinion

In a 43-page July 1, 2011 opinion for a three-judge panel of the Second Circuit, Southern District of New York Chief Judge Loretta Preska (sitting by designation) affirmed the district court’s holdings finding coverage for the investigative expenses and for the special litigation committed expenses. However, the Second Circuit reversed the district court with respect to the independent consultant’s expenses, holding that the policies covered this category of expense as well. In short, the Second Circuit found for MBIA with respect to all items in dispute.

 

The insurers argued that NYAG’s AHERF subpoena did not represent a covered “Securities Claim” within the meaning of the primary policy. The primary policy defined a “Securities Claim,” inter alia, as “a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document.”

 

The Second Circuit agreed with the district court’s “sensible intuition that a businessperson would view a subpoena as a ‘formal or informal investigative order’ based on the common understanding of these words,” adding that in any event a “subpoena is a ‘similar document’ to those listed the definition of a ‘Securities Claim’ because it is similar to other forms of investigative demands made by the regulators.” The Court rejected the insurer’s “crabbed view” that a subpoena is a “mere discovery device” that is “not even ‘similar’ to an investigative order.”  Rather, it is the “primary investigative implement in the NYAG’s toolshed.”

 

The coverage debate with respect to the Capital Asset and US Airways transactions was whether or not the transactions fell within scope of the SEC’s formal order and the NYAG’s AHERF subpoena. The insurers had argued that descriptive limitations in the formal order’s caption put these matters outside the scope of the SEC’s order and NYAG subpoena. The Second Circuit rejected this argument holding that the order “announced a broad but definite investigative scope that includes these transactions.” It reached a similar conclusion with respect to the NYAG subpoena.

 

In addition, the Second Circuit rejected the insurers’ arguments that because the investigative documents connected with these matters were produced voluntarily by oral request rather than by subpoena or other formal process, there was no coverage in connection with the related investigation. The Second Circuit found this argument “meritless” since the investigations were connected with the formal order. The Second Circuit added that “insurers cannot require that as an investigation proceeds, a company must suffer extra public relations damage to avail itself of overage.”

 

The Second Circuit also rejected the insurers’ argument that the SLC expenses were not covered. The insurers had argued that the SLC was “independent” of MBIA and therefore was not an insured person under the policy. The Second Circuit observed that “MBIA formed the SLC to determine MBIA’s response to this litigation, and the SLC decided to terminate the litigation. The SLC entered appearances for MBIA and filed motions to dismiss on it behalf in both the state and federal cases.” Because “the dismissal of the suits was MBIA’s decision, undertaken pursuant to the powers granted to MBIA under Connecticut law,” the Second Circuit rejected the insurers’ argument that the SLC was not an “Insured Person” under the policy.

 

The Second Circuit further  rejected the insurers’ argument that because the SLC was required by law to operate “independently” of MBIA, it took on a separate identity and operated separately from MBIA. The Second Circuit characterized this as “sleight of hand,” because “independent” in this context means “independence of judgment,” a “lack of conflict of interest.” The Court noted that “independence of judgment does not generate a new source of authority to terminate derivative litigation; that authority is still exercised by the corporation, which can only act through its agents.”

 

Similarly, the Second Circuit rejected the insurers’ attempt to rely on the $200,000 sublimited coverage for investigative costs. The Court found that this sublimit related solely to pre-litigation demands. However the SLC’s activities were, consistent with Connecticut law, post-litigation, as a result of which the operative policy provisions were the general policy provisions relating to litigated matters, rather than the narrow sublimit relating to pre-litigation demands.

 

Finally, the Second Circuit rejected the insurers’ argument that against coverage for the post-settlement consultant’s investigation expenses. In a highly fact-based analysis, the Court determined that the insurers had been given adequate notice of these expenses and that MBIA’s provision of information relating to these expenses had not violated any of its notice or settlement consent obligations under the policy.

 

Discussion

The Second Circuit’s MBIA opinion is an important decision addressing many recurring D&O insurance coverage issues, Because of the Second Circuit’s reasoning and the breadth of its language, policyholders will undoubtedly seek to rely heavily on this opinion in connection with the perennial issues such as coverage for costs associated with responding to a subpoena and special litigation committee expenses.

 

The Second Circuit’s opinion largely mirrored the district court with respect to the issue of the policy’s coverage for costs associated with responding to the NYAG’s subpoena – although even there, policyholders may find the Second Circuit’s language useful.

 

But the Second Circuit’s reasoning on the question of coverage for the SLC expenses goes further than the district court did. Judge Berman had found coverage for the SLC’s outside counsel’s expenses largely because of his specific factual determination that the SLC’s counsel had appeared on behalf of MBIA to have the derivative suits dismissed. The Second Circuit’s logic was more basic, having to do with the fundamental character of the SLC and its relation to the company under Connecticut law. The Court’s rejection of the insurers’ argument that the SLC was “independent” of the company seems particularly critical.

 

Another aspect of the opinion that many policyholders may find helpful is the section where the Second Circuit found coverage for the company’s expenses incurred in voluntarily providing investigative material to the regulators. Companies are often fighting with carriers over whether there is coverage for voluntary or cooperative efforts, which are often undertaken in an effort to fend off more formal regulatory action. Insurers can expect to have quoted back to them frequently the Second Circuit’s words that “the insurers cannot require that as an investigation proceeds, a company must suffer public relations damage to avail itself of coverage a reasonable person would think was triggered by the initial investigation.”

 

From the carrier’s perspective, this is a very fact-specific opinion that in many ways is largely a reflection of the unusual circumstance that all of the investigation followed the SEC’s issuance of its very broad formal investigative order. Much of the coverage analysis, including for example the court’s discussion of coverage for the voluntarily produced information, is merely  a reflection of the fact that the disputed expenses arose  after the formal order of investigation.

 

The much more frequent dispute involves costs incurred before the issuance of a formal order of investigation, a circumstance that was not involved here.  In that respect, it is critical to note that as broad as the Second Circuit’s opinion is, the decision has nothing to say concerning the recurring question of policy coverage for expenses incurred in connection with an informal investigation.

 

In addition to being fact-specific, the Second Circuit’s analysis, particularly in connection with the SLC expenses, is very law-specific too, depending narrowly on the details of Connecticut corporate law. Carriers can be expected to argue when the laws of other jurisdictions are applicable, the Second Circuit’s determination in the MBIA case is inapplicable.

 

While there are ways that the carriers can try to narrow the application of the Second Circuit’s MBIA decision, the fact is that this decision is a strong one for policyholders. This may be one of those instances where the carriers, if they really didn’t intend to cover these things and really don’t want to cover these things, may have to go back and look at their policy language. But since the general marketplace trend recently has been toward increased investigative cost coverage, the carriers may find that they lack sufficient marketplace room to maneuver on these issues from a policy language standpoint.

 

UPDATE: Joe Monteleone has an interesting July 6, 2011 post about the SLC portion of the Second Circuit's MBIA opinion on his The D&O E&O Monitor blog, here.

 

Same Name, Different Reference: I may be the only one that cares, but there is a Camaroonian soccer player named Stephane Mbia, who plays in the French top flight soccer league, League 1, for the Olympique de Marseille club.

 

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If a verdict form contains the jury’s specific finding that the insured engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct,” you might think that would trigger the exclusion for fraudulent misconduct in the applicable D&O insurance policy. But apparently not, at least according to a May 12, 2011 Southern District of West Virginia ruling (here) in a case involving the Charleston Area Medical Center (CAMC). The case makes for some interesting reading and interesting analysis.

 

Background       

In September 2004, CAMC determined that Dr. R.E. Hamrick’s plan to self-fund his medical professional liability was inadequate and not actuarially sound. Based on this determination and the fact that Dr. Hamrick’s insurance coverage had lapsed, CMAC revoked his clinical privileges. Dr. Hamrick went to court seeking injunctive relief and three days later succeed in having his clinical privileges restored. He then pursued a damages claim against CAMC. Dr. Hamrick’s amended complaint contained a claim for defamation and a claim for invasion of privacy/false light. Dr. Hamrick also sought punitive damages.

 

In February 2008, Dr. Hamrick’s damages claim went to the jury. In Section 1 of the jury Verdict form, entitled “Liability,” the jury indicated that they found in favor of Dr. Hamrick. In Section 2 of the Verdict form, entitled “Damages,” the jury awarded Dr. Hamrick $5 million in compensatory damages. In Section 3, labeled “Punitive Damages,” the jury found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful, or reckless conduct with respect to Dr. Hamrick,” and awarded $20 million in punitive damages. In Section 4 of the form, labeled “Other,” the jury found that CAMC had acted in “bad faith, vexatiously, wantonly or for oppressive reasons with respect to Dr. Hamrick.”

 

In July 2008, the court granted CAMC’s motion for remittitur, and reduced the damages award to $2 million in compensatory and $8 million in punitive damages. The case ultimately settled for $11.5 million, representing the remittitur award of $10 million, post-judgment interest of $476,917 and attorneys’ fees of $1.023,083.

 

The Insurance Coverage Dispute

CAMC was insured, inter alia, by a  D&O insurance policy with a primary limit of liability of $10 million., including a punitive damages limit of $5 million (the punitive damages limits is part of not in addition to the primary $10 million limit.) The policy contains an exclusion stating that the insurer will “not pay Loss for Claims brought about or contributed to in fact (1) by any dishonest or fraudulent act or omission or any willful violation of any statute, rule or law by any Insured.”

 

The D&O insurer filed a coverage action seeking a judicial declaration that at least some portion of the settlement falls under the dishonest/fraudulent acts exclusion and therefore is not covered, maintaining further that the jury’s findings necessitate an allocation between covered and non-covered conduct. CAMC filed a counterclaim, and the parties filed cross motions for summary judgment.

 

The May 12 Opinion

In his May 12, 2011 opinion (here), Southern District of West Virginia Chief Judge Joseph R. Goodwin held that the insurer had not carried its burden under West Virginia law to prove the facts necessary to support an exclusion to coverage.

 

In attempting to carry its burden, the insurer had sought to rely on the jury’s determinations in Sections 3 and 4 of the verdict form. Judge Goodwin found that these portions of the verdict form “quite clearly related to damages and attorney’s fees, as the jury assessed liability only in Section 1 of the jury form,” adding that the insurer’s arguments that “the jury’s findings in Section 3 and 4 related to something other than damages and attorney’s fees is somewhat hard to fathom.”

 

Judge Goodwin noted that the standards in Sections 3 and 4 “are not elements of any of the causes of action on which the jury’s liability finding in Section 1 could have been predicated, nor are those standards relevant to compensatory damages.” As a result “the only reason for the jury to have made such findings would have been in relation to punitive damages and attorney’s fees.”

 

Judge Goodwin went on to state that the insurer

 

has lost sight of the simple fact that the claims presented to the Hamrick jury were for defamation and invasion of privacy, not fraud. Because Dr. Hamrick never pressed a cause of action that was predicated on fraudulent or dishonest conduct, the jury could not possibly have found for him on such a claim. Moreover, [the insurer] cannot identify any particular dishonest or fraudulent act or omission on the part of CAMC.

 

Instead, [the insurer’s] entire position boils down to the argument that the last two sections of the jury verdict form somehow transformed the claim into one involving dishonest or fraudulent conduct. …CAMC was alleged to have wronged Dr. Hamrick by communicating to others his lack of insurance coverage, the actuarial deficiencies of his self-insurance program, and his revoked clinical privileges. There is no fraudulent or dishonest conduct in those acts or omissions, however, and the mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.

 

Judge Goodwin further stated that “there were only two claims in this case – for defamation and invasion of privacy – and no colorable argument that the conduct giving rise to them fit within the Dishonest/Fraudulent Act Exclusion,” adding that the insurer’s “argument for denying coverage stems not from the nature of the claims or the conduct giving rise to them, but from specific findings made by the jury as part of the damages award.”

 

Judge Goodwin entered summary judgment against the insurer and in favor of CAMC.

 

Discussion

This coverage dispute is different than the usual clash over the fraudulent misconduct exclusion. Disputes about the fraudulent misconduct exclusion are usually over the fact that there are all kinds of allegations but unless there has been a finding that the precluded conduct actually occurred, then the exclusion doesn’t apply. Here the usual debate has been completely turned on its head. The assertion is that regardless of the jury’s specific finding of precluded misconduct, the exclusion doesn’t apply because the precluded misconduct was never alleged.

 

Judge Goodwin emphasizes that the specific legal theories on which Hamrick proceeded did not allege or depend upon precluded acts or omissions. Perhaps Judge Goodwin reads the phrase precluding coverage for “Loss for Claims brought about or contributed to in fact” by the excluded conduct to mean (1) that it is not sufficient if the Loss is brought about or contributed to by the precluded act or omission; (2)  the exclusion applies only if the Loss arises from Claims brought about or contributed to precluded act or omission. Because the Claims on which Hamrick relied and which he asserted did not depend on or even allege precluded conduct, then the exclusion would not apply, regardless of whether or not Loss was brought about or contributed to by precluded conduct.

 

The arguable problem with this analysis is that it  exalts mere pleading over proof – regardless of what Hamrick’s pleadings might have alleged , the fact is that the  jury specifically found that CAMC had engaged in “fraudulent, malicious, oppressive, wanton, willful or reckless conduct” with respect to Dr. Hamrick. (Moreover, Judge Goodwin doesn’t seem to have considered the jury finding’s use of the disjunctive “or” to be inconsistent with a finding of “fraudulent “conduct. He seems to accept that the jury finding represents a finding of “fraudulent” conduct.)

 

Judge Goodwin emphasizes that the jury made its fraudulent misconduct determination in the portion of the verdict form that relates to damages rather than the portion of the form relating to liability. It may well be that this distinction is as determinative as he believes it to be. But he never explains why that is so, particularly with reference to the operative policy language. In the absence of this explanation, we are left to wonder why he finds that distinction determinative of the issue.

 

All of this analysis disregards what seems to be the real problem here –there doesn’t seem to have been any fraudulent misconduct pleaded or proven.  As Judge Goodwin states, the insurer “cannot identify any particular dishonest or fraudulent omission on the part of CAMC.” In other words, Judge Goodwin seems to to be saying, the fraudulent misconduct exclusion doesn’t apply because there wasn’t any fraudulent misconduct – notwithstanding the jury’s specific finding in the jury verdict form that there was fraudulent misconduct. Judge Goodwin eludes this problem with this statement: “The mere fact that the jury made predicate findings with regard to punitive damages and attorney’s fees does not alter the nature of the conduct giving rise to the claim.” Well,  what could “predicate findings” be based upon other than conduct?

 

Judge Goodwin doesn’t say anything about it expressly , but there really does seem to be something wrong with a result in which punitive damages have been awarded based on a jury finding for which there appears to be  no basis in the record. And that’s not all. For a few days loss of clinical privileges, Hamrick was awarded millions of dollars of damages for reputational harm. Even without the punitive damages, Hamrick seem immensely better off than he would have been if his privileges had not been briefly interrupted.  

 

I will leave it to others to assess what the result in the underlying case might imply about the process involved.  But given the apparent proclivity of West Virginia juries, Dr. Hamrick’s plan to self-insure really does not look like a great idea.

 

Special thanks to a loyal reader for sending along the opinion.

 

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One of the most challenging assignments for those of us in the D&O insurance business is to try to explain to those outside the industry how D&O insurance pricing works. The explanation is difficult enough as a general matter, but it is often even more difficult to explain in connection with a specific transaction. The difficulty of the explanation is itself a reflection of a number of features of the current marketplace for D&O insurance.

 

Among the reason for the difficulty of the explanation are the expectations of many insurance buyers. Because of superabundant capacity and rampant competition, D&O insurers have managed to create an environment where many buyers simply expect a price reduction every year.

 

But for all the downward pricing pressures in a  competitive insurance environment, some insurance underwriters at least some of the time still try to segment applicants by risk and price accordingly. There are corporate attributes that even in today’s hyper competitive insurance marketplace will militate against aggressive pricing competition. These factors include, for example, financial instability, past litigation or regulatory activity, adverse business developments, management changes, and maturing debt. By the same token, relatively young companies or development stage companies will always be viewed differently than more mature companies, and companies in certain industries will always be considered more risky than other companies.

 

Looking at it objectively, it makes perfect sense that D&O underwriters might want to try to segment applicants by their relative risk exposures and price accordingly. D&O insurance remains a high severity product. Insured companies and their management are often blindsided by the bad news that leads to claims. The claims can be enormously expensive to defend and settle – in fact, they have been becoming more expensive to defend and settle for years, and at a rate much greater than the rate of general economic inflation.

 

The astonishing thing about the D&O insurance marketplace is that despite the pervasiveness and unpredictability of the risk exposure, the marketplace continues to attract new competitors. In a field where there has been abundant insurance capacity and downward pressure on prices for years, new players still continue to appear and existing players continue to try to expand their portfolios.

 

Growing capacity chasing a finite number of opportunities means that there inevitably will be further downward pressure on prices, despite an adverse claims environment. In addition to downward pricing pressure, there is also outward pressure on the expansiveness of available terms and conditions. As a result, many D&O insurance buyers continue to enjoy the ability to purchase relatively favorable insurance protection at relatively attractive prices.

 

However, even in today’s competitive marketplace, not every company will see only  reduced costs. The D&O insurance marketplace can sometimes seem completely crazy, but it is not always completely illogical. From time to time, the marketplace even manifests that most remote and elusive of all insurance industry phenomena – “underwriting discipline.”

 

The point is that even in a highly competitive insurance marketplace, some insurance buyers are going to pay more for their D&O insurance than other buyers. And even in a competitive insurance marketplace, companies whose risk profiles changed during the policy year may well find themselves paying more for their renewal policy than they did for their current policy. Companies perceived as riskier may not see their insurance cost decline, even if the companies operating history during the policy year generally has been positive.

 

The chronic lack of discipline that so often characterizes the D&O insurance marketplace makes the occasional outbreak of underwriting discipline that much harder to explain when it makes one of its sporadic appearances. For that reason, it can be critically important for companies’ insurance advisors to set expectations at the outset of the insurance placement process.

 

Insurance advisors also have a role to play in helping buyers to understand the pricing alternatives available in the marketplace, particularly if the pricing available reflects something other than a pricing decrease.

 

But the advisors’ efforts to explain marketplace pricing can be completely undercut by a couple of kinds of marketplace unpredictability. The first involves carriers whose pricing decisions are inconsistent and therefore challenging to anticipate. The second involves carriers whose different individual underwriters produce differing pricing determinations. Both of these types of inconsistencies can be difficult to explain, but the problems arising when the same carriers’ underwriters are inconsistent among themselves can be a particularly vexing.

 

No one likes surprises, and that is particularly so when it comes to big ticket expenses like D&O insurance. It is unlikely that pricing surprises can ever be completely eliminated, particularly because the surprise can be the result of expectations and assumptions that might not have been realistic to start with. The possibility for unwelcome pricing surprises be reduces by focused efforts to match expectations the marketplace realities. And finally, carriers can do their part too though the consistency with which they conduct themselves in the marketplace.

 

The Name Game: I am sure I am not alone among Americans who find place names in England particularly interesting. For example, one of the pleasures of the London underground is the memorable names of many of the stops. I am not only thinking here of the splendor of some of the more  triumphant names, like “Elephant and Castle,” “Knightsbridge,” or “Vauxhall.”  I am thinking more of the  names that have that particularly British distinctiveness, such as the termination point of the Piccadilly line service, which is announced by a business-like female voice this way:  “This is the Piccadilly line service to Cockfosters.  (Pause.)  Please mind the gap (pause) between the train (pause) and the platform.” Or on another line: “This is the District line service to Barking. (Pause.) Please mind the gap (pause) between the train (pause) and the platform.”

 

My fascination with interesting names is among the reasons why I feel compelled to follow English football. The pervasive presence of international players in the English premier league contributes a certain musicality to many of the team rosters.

 

Among the names I often wind up repeating to myself is that of the Ivorian defenseman playing for Manchester City, Yaya Touré. Another name with the same kind of pleasing musicality is that of the Cameroonian now playing for Tottenham Hotspur, Benôit Assou-Ekotto. Other names that I find oddly compelling are those of Peter Odomwinge, a Nigerian now playing for West Bromwich Albion, and José Bosingwa, the Portuguese player for Chelsea. There are also the players whose names convey a definite staccato rhythm, like the Bulgarian player for Manchester United, Dimitar Berbatov, or drumbeat finality, like the Dutch wingman for Liverpool, Dirk Kuyt (“kowt”).

 

(Just as an aside, it is worth noting that Silicon Valley venture capitalist Michael Moritz wrote an April 4, 2011 editorial in the Wall Street Journal about the immigration lessons of English Premier League football.)

 

The aural magic of so many of these names is enhanced by the way the TV announcers will track the progress of the ball during the game by simply stating the last names of the players involved. An example involving, say, an offensive set by Chelsea, might go something like this “Cech …Essien … Anelka … Kalou …Malouda …Drogba. Malouda. Drogba!!!!” (The enjoyment of this litany is significantly enhanced when accompanied by ritually appropriate quantities of beer.)

 

And then there are the players’ nicknames. For example, the back of the jersey of Manchester United forward Javier Hernández bears his nickname, “Chicharito” (“little pea”). The second best all time nickname is that of Fitz Hall, who plays for the Queens Park Rangers in the npower Championship League. His nickname is “One Size.”

 

Which brings me to the all time, indoor/outdoor world champion nickname. The nickname does not in fact have anything to do with English football, but it is simply too good to omit from this discussion. The nickname is that of my college classmate, Tom Glasscock, who was known as “STP” (for “See-Through P---s.’ )

 

Blog Update: Some readers may have seen my recent post (here) in which I raised the question of whether or not the Berkshire board could really be held liable for David Sokol's trades in Lubrizol shares. UCLA Law Professor Stepen Bainbridge has added a post to his blog (here), in which he answers my qustion. The answer according to Bainbridge is "no" for reasons he explains furhter on his site, with reference to the attempts a few years ago to hold the board of Martha Stewart's  company liable for Stewart's own insider trading.

 

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I am pleased to reproduce below a guest post from my friend Maurice Pesso, who is a parner in the White & Williams law firm, and his colleagues Sarah Katz Downey. I welcome guest contributions from responsible commentators. This article first appeared as a White & Williams law firm memo. Please note that in an earlier post (here), I summarized a speech Judge Jed Rakoff gave last summer about the Bank of America case (mentioned below). Here is the guest post:

 

 

In a March 21, 2011 opinion by U.S. District Court Judge Jed Rakoff  in Securities and Exchange Commission v. Vitesse Semiconductor Corp., et al., Case No. 10cv9239 (S.D.N.Y. March 21, 2011) (the "Opinion"), Judge Rakoff, in approving the proposed consent judgments against Vitesse and two of its officers, questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” Here are Judge Rakoff’s own words: “[h]ere an agency of the United States is saying, in effect, ‘although we claim that these defendants have done terrible things, they refuse to admit it and we do not propose to prove it, but will simply resort to gagging their right to deny it.’”

 

 

This is at least the second time that Judge Rakoff has publicly called into question the SEC’s settlement practices. In September 2009, Judge Rakoff initially refused to approve a $33 million settlement between the SEC and Bank of America relating to shareholder communications by Bank of America prior to its takeover of Merrill Lynch. Although Judge Rakoff subsequently approved the settlement on revised terms, he chastised the SEC for the initial settlement terms, stating that the settlement "does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank's alleged misconduct now pay the penalty for that misconduct."

 

 

If Judge Rakoff’s reasoning gains traction in judicial or political quarters, the SEC may be placed in a position where it must refuse to enter into settlements with defendants unless the defendants admit liability. This would create a strong disincentive for defendants, and especially individual defendants, to settle with the SEC for at least two reasons: (1) if they admit liability, they will have limited future prospects as directors or officers of any registered company; and (2) the admission of liability will significantly raise the cost of resolving any related civil litigation, such as a securities class action.

 

In the wake of the Vitesse decision, D&O underwriters should be thinking about how the inability to settle SEC enforcement proceedings will affect the costs of defense for SEC enforcement proceedings and impact defense and settlement costs for related shareholder class actions and derivative litigation. On the one hand, if defendants cannot settle with the SEC without admitting liability, there likely will be fewer settlements and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. On the otherhand, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage in its entirety based on conduct exclusions in the D&O policy.

 

SEC v. Vitesse, et al.

 

On December 10, 2010, the SEC filed an enforcement proceeding against Vitesse Semiconductor Corporation and four Vitesse officers and directors. In its complaint, the SEC generally alleged that the defendants made numerous material misrepresentations in Vitesse’s SEC filings in an effort to conceal their fraudulent revenue recognition practices and stock options backdatings. Simultaneously with the filing of the complaint, the SEC filed proposed consent judgments against Vitesse and two of its officers, apparently anticipating that the court would simply approve the settlement as negotiated.

 

The consent judgments were presented to Judge Rakoff for court approval. According to the Opinion, the consent judgments lacked information explaining why they should be approved and how they met the requisite legal standards for court approval. In response to Judge Rakoff’s request for additional information, the SEC provided a December 21, 2010 letter brief. In addition, on December 22, 2010, a hearing was held before Judge Rakoff at which time the parties provided further information.

 

In the Opinion, Judge Rakoff acknowledged that, at first glance, the terms of the proposed consent judgments appeared inadequate based on the allegations of material misconduct by the defendants. However, despite the fact that the three defendants neither admitted nor denied liability, Judge Rakoff concluded that the terms of the settlement were “fair, reasonable, adequate, and in the public interest.” In finding that the terms of the proposed settlement were adequate, Judge Rakoff considered factors outside the terms of the settlement with the SEC, such as the fact that the two officers pled guilty to parallel criminal charges and that Vitesse had little money to pay based on its current troubled financial condition.

 

Despite having approved the settlement, Judge Rakoff raised concerns with the SEC’s longstanding practice of seeking court approval for settlements in which serious allegations of fraud are asserted against the defendants without requiring the defendants to expressly admit or deny the allegations.

 

As a practical matter, the SEC’s practice of settling with defendants who neither admit nor deny liability benefits both the SEC and the defendants. By entering into the consent judgments without admitting liability, the defendants are not collaterally estopped from asserting their innocence in parallel civil actions. Because the defendants do not have to admit liability, the SEC benefits because the defendants are more likely to enter into SEC settlements at an earlier time, and without requiring the SEC to devote substantial resources to taking enforcement actions to trial.

 

According to the Opinion, the SEC’s practice of entering into settlements where the defendants neither admit nor deny liability began decades ago and has developed through the years. Prior to 1972, after a court approved a settlement, the defendant would publicly deny his or her liability in connection with the SEC’s allegations. In response, in 1972, the SEC began to require all defendants who settled with the SEC without an admission of liability to refrain from publicly proclaiming their innocence. Nevertheless, SEC defendants still found ways in which to make it known that they never admitted liability — while being careful to refrain from denying liability at the same time.

 

In the Opinion, Judge Rakoff questioned whether the SEC’s practice of allowing defendants to neither admit nor deny liability might render a proposed consent judgment “so unreasonable or contrary to the public interest as to warrant its disapproval.” According to Judge Rakoff, the public suffers from the SEC’s practice of allowing the defendants to settle serious allegations without admitting liability, leaving the public with no way of knowing whether there was any truth behind the allegations.

 

D&O Coverage Implications

SEC settlements themselves are generally uninsurable under D&O policies because they are composed of either: (1) fines/penalties; (2) disgorgement; and/or (3) equitable relief. However, the costs associated with defending against SEC enforcement proceedings are generally covered under D&O policies.

 

As discussed, if Judge Rakoff’s reasoning is followed, the SEC may find itself pressured — or obligated — to enter into settlements only with defendants who will admit liability. If defendants cannot settle with SEC without admitting liability, there will be fewer settlements, and some defendants may decide to litigate until a final judgment — all resulting in increased costs of defense. In recent years, defense costs for even a single SEC defendant have run into the millions of dollars, and sometimes even more than $10 million. Because defense fees associated with SEC enforcement proceedings are generally covered under D&O policies, D&O insurers would feel the impact of increased defense costs in SEC actions.

 

At the same time, if a defendant chooses to litigate until a final judgment and a verdict is rendered against the defendant, the D&O insurer may be able to deny coverage for the defendant based on the conduct exclusions. In addition, the D&O insurer may be able to rely on the judgment to deny coverage for one or more D&O defendants in any related civil litigations. Depending upon the policy terms at issue, the D&O insurer may also be able to seek reimbursement of all of the defense costs that it previously advanced following an adverse verdict in an SEC trial.

 

The SEC’s reaction to Judge Rakoff’s criticism remains to be seen. Although intended to be an independent regulator, the SEC can be subjected to political pressure — especially from the U.S. Congress, which sets the SEC’s annual funding budget. It will be interesting to see if there is a slowdown in SEC settlements over the next few months and if other judges refuse to “rubber stamp” SEC settlements where the defendants neither admit nor deny liability. We will follow this issue and report any findings.

 

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I am pleased to be able to print below a guest post from my friend and industry colleagueDonna Ferrara. Donna is Senior Vice President and Managing Director, Management Liability Practice Group, at Arthur J. Gallagher & Co. As Donna indicates, this guest post is the result of an email exchange between Donna and myself following one of my recent blog posts about to a recent coverage decision. Because I recognized the depth of Donna’s feelings about the need for professionalism in the insurance claims process, I invited her to submit a guest post on the topic, which she has done and which I have set out below.

 

I want to emphasize that I welcome proposed guest posts from responsible commentators throughout the industry. I also encourage readers who have reactions to Donna’s guest post to please add their thoughts using the blog’s comment function. Here is Donna’s guest post:

　

After I posted a comment on Kevin’s blog, he asked if I would write about the need for professionalism in our business. The following is my opinion and does not reflect that of my employer or colleagues. In the interest of full disclosure, I currently work for a major insurance broker. In the past, I have represented both insurers and insureds, which provides, I believe, an unusual point of view.

 

First, this is not a sniveling request for a return to the days of elaborately false good manners and courtly lawyering, if there ever were such a time.

 

Rather, this is an unscientific discussion of how civil – or Rational - behavior is good business.

 

Navigating the arcane world of D&O insurance requires a fairly high level of expertise. One would hope that this would be matched by a high level of professionalism and respect, but that is not always the case.

 

Rationally, D&O disputes should not create feelings of betrayal and personal peril. Unlike criminal or civil rights cases, the ultimate issue is money. Yet often disputes are ratcheted to an emotional level more appropriate for armed combat.

 

Recently, I looked at cases in which D&O coverage disputes had been litigated to appeals courts, an expensive and unusual event. Most litigation settles long before there is anything to appeal. At Kevin’s request, I am not including the names or identifying information of the litigants. I have no knowledge of the cases reviewed, beyond what is publically available.

 

In each case, someone was pressing an argument which was, at best, difficult. For example, in one case, a carrier asserted that even if a court ordered a litigant to pay plaintiffs’ costs, that litigant was not "legally obligated to pay" those costs. In another, the insured argued that the policy provided coverage for investigations of the corporation, although the policy limited such coverage to individuals. In a third, the parties claimed that a provision which provided only defense coverage actually provided no coverage (in the carrier’s view) or full defense and indemnity (in the insured’s view).

 

Unsurprisingly, these arguments did not succeed. After the parties had expended substantial legal fees, appeals courts found, in effect, that the policies said what they said.

 

Why did the parties fight so hard to reach what should have been an obvious conclusion?

 

The reason may be found in the pleadings and motion practice.

 

In each case, there was a substantial amount of money at stake, but probably not a "bet the company" sum for either party. Still, the dockets reveal extensive and vitriolic communications between the parties and their respective counsel. Carriers complained that their advice had been ignored. Insureds claimed deception and bad faith. Both sides bickered over discovery. Sanctions were demanded. The exhibits to the pleadings included emails and letters demonstrating that animosity had been the tone of the parties’ relationship from the beginning.

 

In short, the litigants subscribed to the Tough theory of business and litigation.

 

Probably the parties felt that the sums involved justified their mutually Tough stance. Possibly, they felt that "It was the Principle" – although, again, the issue was really only money. In any case, being Tough virtually assured that they would end up in court, yet in none of these cases did one side succeed completely.

 

Rationally, the parties might have realized that courts are poor places to make difficult arguments. Courts are not equipped to make decisions based on business considerations. With few exceptions, judges were litigators in their past lives. They come from an adversarial background and are limited to deciding specific issues. They cannot make compromises or force settlements (at least not overtly). Every issue has to be reviewed. At the end of the process, there has to be a "winner" and a "loser" on every point, even if no one actually "wins" the entire case.

 

Moreover, most judges have more cases than they can handle. Aggressive tactics slow the docket, annoying judges and magistrates. True, Tough tactics mean more money for lawyers who bill on an hourly basis. Clients, however, resent high legal fees that are not accompanied by clear success (and even those that are).

 

I suspect that, at the end of the cases reviewed, no one felt victorious or vindicated.

 

In a Rational world, the parties in this litigation would have met before a claim had even been made. The contract would have been openly discussed. There would be a Rational presumption that good coverage costs more than poor coverage, that no insurer wants to accept unlimited risk and that the insured would want the policy to respond as its words – and advertising - indicated it would.

 

It is unlikely this discussion ever took place.

 

D&O insurance is sold in a market where price is often the primary, if not the sole, consideration and that price is set by competition, not by risk.

 

Underwriters, pressured to write business, tweak their forms, but price according to what other carriers charge. Because D&O claims are historically infrequent, but relatively severe, claims handlers do not have the chance to manage and pay many claims. Insureds demand the broadest possible coverage, for the lowest cost - a Bentley for the price of a bicycle. Brokers are in the middle, often an untenable situation. They must be seen as Tough, or risk losing the business.

 

Lawyers may exacerbate the situation: Often both client and lawyer perceive attorneys as the "hired gun". As a brash young attorney once said, "If my clients wanted to make nice, they would have called a florist." D&O is especially fertile ground for disputes: policy language varies and insurance is governed by the state law. Whatever position a party takes can find support somewhere.

 

The present economic climate increases the pressure on everyone: "bad" results can have bad personal consequences. Carriers’ personnel may be fired, lawyers dismissed and brokers replaced. Rationality may be perceived as weakness or lack of commitment.

 

Rather than suggest that the other side may have merit, parties feel compelled to press every point against equally committed adversaries.

 

In my own experience, there can and should be a Rational approach to D&O issues. While difficult and even counterintuitive, it is possible for insurers and insureds to listen to each other, discuss differences and come to appropriate business decisions. Everyone should know that their position had been heard. Lawyers can recognize that their clients might benefit more from compromise than scorched earth. Although we are bound to be advocates for our clients, we can and should be counselors as well.

 

This is just good business.

 

In the cases discussed, it is easy to imagine that the relationships among the litigants were damaged irreparably. The insureds were unlikely to ever purchase insurance from the carriers again, but the brokers and lawyers may have lost their clients as well.

 

I am not so naïve as to envision a world in which carriers and their insureds are "partners", in the sense that they will both benefit from the same outcome. While I passionately serve my clients, I know that insurance is a business of trading services for money. As with any business, rational, civil behavior can be mutually beneficial.　

　

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A frequent component of derivative litigation resolution is an award to the plaintiffs of the fees and expenses the plaintiffs incurred in pursuing the suit. A contentious, recurring question is whether D&O insurance covers fee awards to derivative litigation plaintiffs. This issue received a through going over in a February 17, 2011 opinion from a five judge panel of the New York Supreme Court, Appellate Division.

 

In the opinion (here), a three-judge majority held, over the dissent of two judges, that a $8.8 million derivative plaintiffs’ fee award was covered under Loral Space & Communications D&O insurance policy, but all five judges held unanimously that the D&O policy did not cover the separate $10.7 million awarded for plaintiffs’ fees in a related action seeking damages for breach of fiduciary duty.

 

Background

The coverage suit arises out of litigation filed after Loral agreed to enter a financing transaction with MHR Fund Management. In the transaction, MHR agreed to provide Loral $300 million in exchange for convertible preferred stock Loral was to issue to MHR.

 

Two lawsuits ensure. First, a BlackRock fund filed a shareholders’ derivative action seeking to rescind the deal. Second, Highland Crusader Offshore Partners filed a damages action. Both actions alleged Loral had breached its fiduciary duty because the value to MHR of the proposed deal allegedly far exceeded $300 million.

 

The cases were consolidated. Following a trial, the Delaware Chancery Court concluded that the transaction was unfair to Loral, and reformed the deal terms so that MHR would receive nonvoting common stock rather than convertible preferred stock. The court awarded no damages and made no findings of fault.

 

Concluding that the plaintiffs’ actions had produced a substantial benefit for Loral, and applying the corporate benefit doctrine, the Court entered a fee award to BlackRock of $8.8 million and entered a fee award to Highland of $10.7 million. Loral paid these amounts and then sought coverage under its D&O insurance policy for the payments.

 

Loral’s D&O insurer denied coverage and commenced an action seeking a judicial declaration that their policy did not cover the plaintiffs’ attorneys’ fee awards. The trial court denied the insurer’s motion for summary judgment and granted summary judgment in Loral’s favor. The insurers appealed.

 

The February 18 Order

On appeal, the insurers argued that the Highland fee award was not covered because the Highland action for damages was not a "securities claim" and therefore there was no coverage under the policy for any amount related to that action. The insurers argued that the BlackRock fee award was not covered because the BlackRock litigation produced a benefit for Loral and therefore the fee award did not represent covered "Loss since it was a cost the company incurred as part of procuring the benefit.

 

The five-judge panel unanimously agreed that there was no coverage for the $10.7 million Highland fee award, because the Highland damages action was neither a derivative suit nor did it allege violation of any securities law, and therefore it did not represent a securities claim as was required to bring the claim within the Policy’s coverage.

 

The panel split badly on the question whether or not the fee award in the BlackRock derivative action was covered under the D&O policy. The three-judge majority concluded that it was. Its reasoning turned it part on the policy’s definition of "Loss," which provides that "Loss" includes "damages, judgments, settlements or other amounts (including punitive or exemplary damages where insurable by law) and Defense Expenses in excess of the Retention that the Insured is legally obligated to pay."

 

The majority rejected the insurers’ argument that because the derivative suit produced a benefit for Loral, Loral had not suffered a "Loss." The majority perceived this argument as essentially a suggestion that the fee award should be offset against the nonmonetary benefit Loral received as a result of the restructured transaction. The majority found that while Loral received a benefit in that it no longer suffered the detriment that would have followed from the transaction as originally structured "it does not follow that Loral actually made a tangible profit."

 

The attorneys’ fee award, the majority found, "constitutes damages" and representing "other amounts" that Loral has become "legally obligated to pay" and therefore comes within the Policy’s definition of "Loss." The majority also noted that the Policy expressly covers derivative lawsuits and that "to declare that Loral has no coverage for derivative plaintiffs’ attorneys’ fees would deprive Loral of the coverage for derivative lawsuits that it paid for and expected to receive."

 

The dissent objected to the majority’s conclusion about the derivative fee award. First, the dissent argued that the "legally obligated to pay" language in the definition of Loss followed and referred to "the Retention," not to "other amounts."

 

The dissent also argued that in order for the derivative fee award to be covered, it would have to represent "an actual loss, not an expense or the cost of doing business." The dissent reasoned that in this case, Loral "did not sustain a loss but rather benefitted from the judgment."

 

A fee award a derivative suit, the dissent observed, represents "the equitable entitlement of the successful derivative plaintiff to recover the expenses of his/her attorneys’ fees from all the shareholders of the corporation on whose behalf the suit was brought." The dissent observed that "if not spreading the cost of attorneys’ fees sounds in unjust enrichment, the obvious corollary is that shifting the cost to shareholders as a group cannot be characterized as a loss."

 

Discussion

The insurers in this case did not come away empty, as the appellate court unanimously agreed that because there was no coverage under the policy for the Highland damages claim, the $10.7 million Highland fee award was not covered under the Policy.

 

This holding was not preordained as at least one court has recently held that a fee award can represents damage for which there can be coverage under a D&O policy even if there is no coverage under the policy for the underlying litigation. In a February 9, 2010 ruling (here), the District of Minnesota held that a derivative lawsuit fee award represented "damages" and could be covered under a D&O insurance policy even where the underlying claim itself was not covered under the policy.

 

With respect to the question of coverage for the BlackRock derivative fee award, the insurers did manage to persuade two of three judges that because of the nature of the outcome of the underlying case and the nature of the derivative fee award, the award did not represent a loss to Loral and therefore is not covered under the policy.

 

The narrowness of split between the majority and the dissent on this issue suggests that this dispute is far from resolved. Even just in this case, there seems a substantial likelihood for further appellate proceedings in the New York Court of Appeals. And in general, given the close split, the underlying issue is likely to continue to be debated in other cases.

 

The carriers assert their position on these issues with conviction. Policyholders find the insurers’ rationale on this issue obscure and unpersuasive (those are among the milder adjectives, actually) – although obviously the insurers were able to persuade two judges of the appellate court of their position, so clearly there is something to their position on this issue.

 

The danger for all involved is that this issue will continue to come up over and over again. A colleague in the industry suggested to me in a note about the Loral case that eventually this issue may have to be addressed in the policy, along the lines of the way the industry developed a policy solution to the contentious issue that Section 11 settlements were not covered under the Policy. The way the industry addressed that issue is that it became standard to include in public company D&O policies language stating that the insurer would not take the position that a settlement of a ’33 Act case was not covered under the Policy. Perhaps, the colleague suggested, the industry will adopt a similar approach on this derivative lawsuit fee award issue.

 

I am interested in readers’ thoughts on these issues. I hope readers will add their observations to this post, using the blog’s comment feature.

 

Many thanks to the several readers who sent me a copy of the Loral decision.

 

I am Word Power: In a column in the February 28, 2011 issue of The New Yorker entitled "Who Am I" (here), Demetri Martin wrote "I am bravery. I am courage. I am valor. I am daring. I am holding a thesaurus."

 

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2010 was an eventful year in the world of D&O liability. Congress passed massive financial reform legislation, the Supreme Court issued landmark decisions in important cases and numerous claims emerged as the litigation landscape continued to evolve. With so much going on, it is a challenge to narrow the year’s events down to just the ten most significant developments.

 

With appropriate humility about the limitations of all year-end inventories, here is my list of the top ten D&O developments of 2010.

 

1. Securities Suits Pick Up in Year’s Second Half: As I detailed in my 2010 securities litigation overview (here), after a filing downturn in the year’s first half, the number of securities lawsuit filing picked up in the last six months of the year. Among other things, as the year progressed, filing activity shifted away from credit crisis-related cases and toward a broader range of other types of cases.

 

Although at least some of the litigation activity in the year’s second half was driven by limited or short term events (as was the case, for example, in the rash of cases filed against for-profit education companies and against Chinese domiciled companies), the shift away from credit crisis cases could suggest that the heightened pace of securities suit filings may continue as we head into 2010.

 

2. The Changing Mix of Corporate and Securities Lawsuits: As insurance information firm Advisen has well documented, the mix of corporate and securities lawsuits has been evolving over the past several years. The most important feature of this changing mix of cases has been the decreasing prevalence of class action securities lawsuits as a percentage of all corporate and securities cases.

 

As the percentage of class action securities lawsuits has declined, other types of lawsuits, particularly breach of fiduciary duty cases, have grown in relative frequency. Many of these breach of fiduciary duty cases are related to mergers and acquisitions activity. Indeed, as I noted in my year-end review of 2010 securities lawsuit filings, even many of the cases that are categorized as securities class action lawsuits involve merger objection cases.

 

　

It is important to keep this changing mix of cases in mind when considering the various year end reports on securities litigation activity. These reports will show that overall 2010 securities class action lawsuit filings are down compared to post-PSLRA averages. However, it would be mistake to conclude that the relatively reduced number of securities class action lawsuits means that claims activity in general is down. To the contrary, overall claims activity is actually up. The mere fact that securities class action lawsuits are down does not mean that fewer companies are being sued or that overall claims exposure has diminished, either for companies or insurers. Rather, what is happening is that the claims exposure is changing, away from securities class action lawsuits and toward other types of claims.

 

This shift away from traditional securities class action lawsuits as a percentage of all claims activity has important implications for the insurance marketplace. The shift toward higher frequency, lower severity type of claims could have a significant impact both on primary and excess carriers. Primary carriers may experience an increase in overall claims frequency, with consequences for their loss experience. Excess carriers, particularly higher excess carriers, may experience relatively fewer claims piercing their layers, possibly producing a positive impact on the excess carriers’ results.

 

　

3. Banks Fail, Lawsuits Loom: 157 banks failed during 2010, the largest annual number of bank failures since 1992. The total number of bank closures since January 1, 2008 is 322. In addition, in the FDIC’s most recent Quarterly Banking Profile (refer here), the FDIC identified 860 banks, or about one out of nine of all banks, as "problem institutions."

 

Given the magnitude of these problems in the banking industry, it is hardly surprising that litigation involving failed and troubled banks is increasingly significant. Indeed, 13 of the 177 securities class action lawsuits filed in 2010 involved failed or troubled banks. In addition, aggrieved investors in failed or troubled privately held banks also filed a variety of other lawsuits, primarily in state courts.

 

It may be anticipated that the FDIC will also actively pursue claims against failed banks’ former directors and officers. However, to date, the FDIC has instituted only two D&O claims as part of the current round of failed banks (refer here and here).

 

It appears that it will only be a matter of time before the FDIC launches further suits against former officials of failed banks. Widely circulated news reports have quoted FDIC officials as saying that the FDIC has authorized civil actions against more than 80 directors and officers of failed banks. In addition, the Wall Street Journal reported in November that the FDIC is conducting fifty criminal investigations against directors, officers and employees of failed banks.

 

While we may hope that the current round of bank failures may begin to wane as we head into 2011, it appears that the failed bank litigation may only just be getting started.

 

4. Credit Crisis Lawsuit Settlements: The Dog that Didn’t Bark This Year: The subprime and credit crisis-related litigation wave will be heading into its fifth year early in 2011. Since 2007, there have been over 230 subprime and credit crisis related securities lawsuits filed. Many of these cases continue to work their way through the system.

 

As some of these cases have survived the preliminary motions, they have moved toward settlement. There were several noteworthy credit crisis related securities class action lawsuit settlements during 2010, including Countrywide ($624 million, refer here), Schwab Yield Plus ($235 million , refer here), and New Century Financial ($124 million, refer here).

 

But while there have been a few noteworthy settlements of these cases this year, the more striking observation is how few of these cases have settled so far, particularly given how far along we are in the subprime and credit crisis litigation wave.

 

By my count, only 17 of the over 230 subprime and credit crisis-related securities class action lawsuit have settled, and only eight of these 17 settlements were announced in 2010. (My list of subprime and credit crisis-related lawsuit resolutions can be accessed here.)

 

NERA Economic Consulting stated in its year-end report on securities litigation that of the approximately 230 credit crisis securities suits, only 8% have settled, 29% have been dismissed, and 63% remain unresolved.

 

Of the 63% of unresolved cases, some of course will wind up being dismissed. But many more will settle, eventually. Given the now long duration of the credit crisis litigation wave, it can be anticipated that there may be many more settlements of these cases in 2011. The likelihood is that D&O insurers’ aggregate claims losses for these claims will mount, perhaps rapidly.

 

The question is whether the materialization of these losses will come as a surprise or has already been fully anticipated in the carriers’ prior years’ loss reserves. This answer to this question could have important implications for the D&O insurers’ 2011 calendar year results.

 

5. Megasettlements of Shareholders’ Derivative Lawsuits Surge: There was a time when the settlement of a shareholder derivative lawsuit involved the payment of little or no money, other than in connection with the payment of the plaintiffs’ attorneys’ fees. However, one of the more striking developments in recent years has been the emergence of jumbo settlements of shareholders derivative lawsuits, in which millions of dollars are paid to or on behalf of the company involved.

 

This emerging trend continued to develop in 2010, with at least two huge shareholder derivative lawsuit settlements: the $90 million AIG/Greenberg settlement (about which refer here) and the $75 million Pfizer settlement (refer here).

 

These 2010 settlements join a growing list of other jumbo derivative settlements in recent years, including the UnitedHealth Group settlement ($900 million, refer here); Oracle ($122 million, refer here); Broadcom ($118 million, refer here); and the first AIG derivative settlement (refer here).

 

The striking thing about these settlements is not only their size, but also the fact that in each case the company involved is solvent. The significance of this fact is that these settlements represent instances in which the companies’ D&O insurance potentially could have been called upon to fund an A Side loss outside of the insolvency context. These kinds of settlements provide concrete evidence of the value to policyholders of Side A insurance protection even outside of the insolvency context, and underscore the importance of added Side A protection in a well-designed D&O insurance program.

 

From the carriers’ perspective, these settlements suggest that Side A losses can mount outside of insolvency. Only the carriers themselves can answer the question whether or not they are actually pricing their Side A products for this loss exposure.

 

One final note about the Pfizer derivative lawsuit settlement concerns the unusual funding mechanism the settlement implemented. In many derivative lawsuit settlements the companies involved agree to institute corporate governance reforms. What was unusual about the Pfizer settlement is that the settlement agreement created a dedicated fund intended to finance the company’s agreed upon governance reforms. If the advance funding of corporate governance reforms were to become a standard feature of derivative lawsuit settlements, the cash cost of derivative settlements could increase substantially. This is a potential development worth watching closely.

 

6. Rare Securities Lawsuit Trials Result in Plaintiffs’ Verdicts: Very few securities class action lawsuits actually go trial. Most are settled or dismissed. But in 2010, two cases made it all the way through to jury verdicts. In January, the jurors in the Vivendi case entered a verdict on behalf of the plaintiffs against the company (about which refer here), and in November, the jurors entered a verdict for the plaintiffs in the BankAtlantic subprime-related securities suit (refer here).

 

In addition to these jury verdicts, in June 2010, the Ninth Circuit issued an opinion overturning the trial court’s post trial ruling in the Apollo Group case, a ruling that had set aside the jury’s $277.5 million jury verdict in that case. Refer here regarding the Ninth Circuit’s opinion in the Apollo Group case.

 

All three of these cases remain subject to further proceedings. The Vivendi case in particular is the subject of significant post-trial motions having to do with the composition of the plaintiffs’ class in the wake of the U.S. Supreme Court’s decision in the Morrison v. National Australia Bank case (about which refer to these prior guest blog posts, here and here. See also item 10, below).

 

The defendants in the Apollo Group case have filed a petition with the U.S. Supreme Court for a writ of certiorari (about which refer here). And the BankAtlantic case has now moved on to post-trial motions, and depending on the motions’ outcome, possible appeal.

 

But while the ultimate outcome of these cases remains to be determined, it is striking that all three of these cases not only involve rare trials, but all three resulted in jury verdicts for the plaintiffs. To be sure, there have also been recent securities lawsuit trials that have resulted in defense verdicts, as was the case for example in the JDS Uniphase trial (about which refer here).

 

According to information compiled by Adam Savett, the Director of Securities Class Actions at the Claims Compensation Bureau, there have now been ten securities class action lawsuit trial post-PSLRA and involving post-PSLRA facts. The scoreboard currently reads: Plaintiffs 6, Defendants 4. The scoreboard is of course subject to revision pending further proceedings. Nevertheless, the juries themselves seem to have been favoring the plaintiffs, a phenomenon that may make plaintiffs’ threats to push a case to trial represent a particularly threatening tactic.

 

7. Assessing Coverage for "Bump Up" Claims: As noted above, a significant and growing number of corporate and securities lawsuits arise out of merger and acquisition activity. Often, the goal of this litigation is to try to increase the transaction consideration. One recurring question is the availability of D&O insurance coverage for amounts paid in settlement of so-called "bump up" claims.

 

In October 2010, the First Circuit entered an opinion in coverage litigation involving Genzyme Corporation, discussing the question of the preclusive effect of a D&O policy’s "bump up" exclusion. The First Circuit overturned the lower court’s decision that had held that the company’s D&O insurance policy did not provide coverage for additional amounts paid to claimants who asserted they did not received adequate consideration in a share exchange.

 

Though the First Circuit reversed the lower court’s holding of noncoverage, the First Circuit did not invalidate the bump up exclusion and agreed that the exclusion precluded entity coverage for bump up amounts.

 

The First Circuit remanded the case to the lower court for further allocation proceedings (that is, because the First Circuit held that the bump up exclusion precluded coverage only under the policy’s entity coverage provision, further proceedings are required to determine whet portion if any of the underlying settlement is allocable to settlement of liabilities of persons insured under other insuring provisions of the policy).

 

Of critical importance is that the First Circuit found that exclusion is enforceable and is effective to preclude coverage according to its terms. The holding clearly will be relevant to questions of coverage in future cases involving settlements of "bump up" claims, at least where the implicated D&O insurance policies include bump up exclusions.

 

8. D&O Insurance Coverage for Informal SEC and Internal Investigations: Among the perennial D&O insurance issues are the questions of coverage for informal SEC investigations and for internal investigations. In either case, the question is whether or not there is a "claim" as required to trigger coverage under the policy.

 

In one of the year’s most noteworthy D&O insurance coverage decisions, Southern District of Florida Judge Kenneth Marra, applying Florida law in a summary judgment ruling in coverage litigation involving Office Depot, held there is no coverage under the company’s D&O insurance policies for either of these categories of expenses.

 

Though the holding in the Office Depot case is direct reflection both of the specific policy language involved and the facts presented, the decision nevertheless could be influential in future claims involving questions of coverage for informal SEC investigations and internal investigations. The Office Depot decision suggests that policy definitions of the terms "Securities Claim" and "Claim" are critical, particularly with respect to the definitional references to "investigations" and "proceedings." Refer here for a more detailed discussion of the case and the decision.

 

The Office Depot ruling is hardly the final word on these issues, but it clearly will loom large in future consideration of questions of coverage for these kinds of expenses. Insurers undoubtedly will seek to rely on the decision to try to preclude coverage for costs incurred in connection with informal SEC investigations and internal investigations.

 

On a related note, a separate court held in the MBIA coverage case that there is coverage under the D&O insurance policy at issue for special litigation committee expenses, as discussed here.　

 

9. Is a Whistle the Sound of the Future?: The massive Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 enacted in July will affect virtually every aspect of our financial system, in ways that may only become clear over time. But among the Act’s innovations that seem likeliest to have a significant litigation impact are the Act’s new whistleblower provisions.

 

The whistleblower provisions include the creation of a new whistleblower bounty pursuant to which persons who first bring securities law violations to the attention of the SEC will receive between 10 percent and 20 percent of any recovery in excess of $1 million.

 

Give the magnitude of the fines paid in many recent SEC enforcement actions, particularly those involving Foreign Corrupt Practices Act violations (about which refer here), the prospective size of potential bounties is enormous. These bounty provisions seem likely to encourage a flood of whistleblower reports to the SEC. This could create an administrative nightmare for the SEC, and the agency is already struggling with funding limitations that may constrain its ability to implement the whistleblower requirements. On the other hand, the SEC, under pressure to rehabilitate its regulatory credentials after its failure to detect the Madoff scheme, will face significant pressure to pursue whistleblower claims.

 

Another 2010 development that seems likely to encourage an entirely different sort of whistleblower activity is the series of WikiLeaks disclosures. The extensive media attention give to the disclosures, as well as the suggestions of WikiLeaks founder Julian Assange that future disclosures will expose corporate misconduct, raise the possibility of that other self-appointed corporate scourges will launch similar guerilla campaigns involving the disclosure of internal corporate communications.

 

These two types of prospective whistleblower risks arguably represent an entirely new level of corporate exposure that could leave companies and their senior officials susceptible to claims of wrongdoing based on public or regulatory disclosures by persons inside the company with access to sensitive information. Indeed, companies and their senior officials could even be susceptible to claims for the alleged failure to implement and maintain sufficient controls to prevent embarrassing or harmful disclosures. Regardless, companies could face the prospect of significant risks involving person inside (or with access to) their own operations.

 

10. Foreign Companies, U.S. Courts: In June 2010, the U.S. Supreme Court issued its long-awaited decision in the Morrison v. National Australia Bank case, holding that Section 10(b) of the Securities Exchange Act of 1934 applies only to transactions taking place on the U.S. securities exchanges, or domestic transactions in other securities.

 

Among other things, the Morrison decision seems to represent the end of so-called "f-cubed" claims, involving foreign claimants who bought their shares in foreign companies on foreign exchanges.

 

Lower courts are now wrestling with Morrison’s implications, including, for example, the question of whether or not Morrison precludes claims under the U.S. securities laws against companies whose American Depositary Receipts trade on U.S. exchanges. (Surprisingly, at least one court has held that case has that effect, as discussed here.) Other courts have struggled to determine what falls within Morrison’s second prong relating to "domestic transactions in other securities." Clearly, there will be much further lower court activity as these kinds of issues are sorted out.

 

In the meantime, one consequence that seemed likely in the wake of Morrison is that there might be fewer (or at least only narrower) cases filed in U.S. courts involving non-U.S. companies. Contrary to expectations, however, there were quite a number of securities cases filed in U.S. courts involving foreign-domiciled companies in 2010, including many filed after the Supreme Court issued its Morrison opinion.

 

As reflected in my recent year-end analysis of 2010 securities lawsuit filings, there were 19 new securities class action lawsuits filed in 2010 involving foreign domiciled companies, representing 10.7% of all 2010 securities lawsuit filings. Of these 19 cases, 12 were filed after the Supreme Court issued its opinion in Morrison.

 

One possibly temporary factor driving many of these filings is the rash of new cases filed against Chinese- domiciled companies. There were ten new lawsuits against Chinese companies in 2010, eight of which were filed post-Morrison. It should be noted that the shares of many of these Chinese companies trade on U.S. exchanges and in fact many of the cases directly relate to the companies’ securities offerings in the U.S., facts which made these companies susceptible to securities lawsuits in this country even under Morrison.

 

The lower courts will continue to interpret and apply Morrison in the months ahead. In the meantime, it seems that lawsuits involving non-U.S. companies will continue to arise, at least where the companies’ shares trade on U.S. exchanges.

 

A Final Note: Readers of this blog post may also be interested in my September 2010 post entitled "What to Watch Now in the World of D&O," which can be found here.

　

Ten Top Ten Lists: Top ten surveys proliferated at year end, and so it seems like a list of ten top ten lists would be the appropriate accompaniment to The D&O Diary’s own top ten list:

The Year’s Top Ten Insurance Coverage Decisions

Top Ten YouTube Videos of 2010

Top Ten Annoying Things British Men Do While Abroad

Top Ten New Species (International Institute for Species Exploration)

Top Ten Goals from the 2010 World Cup

Top Ten TV Commercials of 2010

Top Ten Encyclopedia Britannica Queries 2010

Top Ten Must-Reads in the Law, 2010

Princeton Review Top College Ranking 2010-2011

Time Magazine’s Top Ten of Everything List

　

　

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As reflected in detail below, noted D&O maven Dan Bailey of the Bailey & Cavalieri law firm has submitted the following guest blog post in response to an earlier guest post on this site. I would like to thank Dan for his willingness to have his comments published here. Dan’s guest blog post is as follows:

　

Kevin,I am responding to thearticle in your November 15, 2010 blog by John Iole at Jones Day regarding the "no broader than underlying" provision in virtually all excess D&O policy forms. I normally do not comment on articles which I think are misguided since conducting a public debate often elevates the visibility of the article and usually accomplishes little. However, in this instance it appears that John’s article has resulted in a number of brokers requesting the deletion of the "no broader than underlying" provision from excess D&O policies without fully appreciating the issues involved and the importance of that provision.

 

As summarized below, I think John’s article overstates the alleged concerns with such a provision and ignores the purpose and value of such a provision. Here is a brief summary of many of my concerns about the article.

 

 

1. Purpose of Provision

   The primary purpose of this provision in excess policies is to avoid an excess insurer covering loss which is not covered under an underlying policy and thus to avoid the risk the excess policy would drop down in that situation. Excess policies typically state that liability attaches to the excess policy only if and when the underlying insurers and/or the Insureds pay loss which is covered under the underlying policies in an amount equal to the Underlying Limit.

    

   If the excess policy covers a loss not covered by the underlying policies, the Underlying Limit presumably would never be depleted by such loss since such loss is not covered by the underlying policies. In that event, a literal reading of the excess policy’s attachment provision would result in liability never attaching to the excess policy for such loss even though such loss is otherwise covered under the excess policy.

    

   That nonsensical result could cause a Court to conclude the excess insurer must pay the loss notwithstanding the fact that the Underlying Limit has not be exhausted as required by the attachment provision in the excess policy. In other words, there would be a risk that the excess policy would be forced to drop down and pay that loss at a much lower level within the insurance program than the excess insurer intended. Such a result would violate the intent of the parties and force the excess insurer to incur far greater loss exposure than was reflected by the excess insurer’s pricing and underwriting analysis.

   　

   Other purposes of this provision include (i) allowing the excess insurer (which is receiving substantially less premium that the underlying insurers) to rely on the underwriting analysis of underlying insurers (i.e. if an underlying insurer identifies and excludes an unacceptable risk, the excess insurer gets the benefit of that analysis), and (ii) providing assurance to the excess insurer 　that all of the underlying insurers will be actively involved in monitoring and adjusting any claim covered under the excess policy. Those purposes would obviously be lost if the provision is deleted from the excess policy.

    

   Therefore, this provision is important in order to preserve the integrity of the excess program structure and in order to avoid an excess insurer paying more losses than the excess insurer intended or contractually agreed to pay.

    

    

2. Concerns with Provision

John’s article identifies several purported problems or concerns with this very standard provision, each of which are addressed below. It is important to note, though, that the article fails to even identify – much less address - the very important purposes and value of the provision from the excess insurers’ perspective. Plus, one should note that although this provision has been in virtually all excess D&O policy forms for decades, virtually no caselaw exists with respect to the meaning and applicability of this provision, thus indicating that in practice the provision does not create the controversies touted in the article.

 

 

1. The article states that the provision allows the excess insurer to "pick and choose"　 among various underlying policy terms in defining the coverage afforded by the excess policy. That is simply incorrect. The provision is clear and absolute – if a loss is not covered under an underlying policy, that loss is not covered under the excess policy. There is no discretion involved, and the excess insurer cannot and need not "pick and choose" which provisions in the underlying policies the excess insurer does or does not want to adopt. The article cites to several examples of situations where this discretion could purportedly exist. However, those examples (e.g. different arbitration provisions in different underlying policies) are not valid examples since they deal with different procedural provisions in the underlying policies. The "no broader" provision only applies to the scope of coverage (i.e. is a loss covered or not) and does not apply to other procedural provisions, such as the notice, claims participation, cooperation, ADR, etc. provisions.

    

2. The article states that this provision creates a "bewildering patchwork of coverage arguments". That is simply incorrect. Actually, the provision creates greater consistency within an insurance program by better aligning the scope of coverage among different policies within the program. By including this provision in all the excess policies, all of the excess polices will provide more consistent coverage throughout the program. It is only if the provision is deleted will the "bewildering patchwork of coverage arguments" be increased since there would be a higher likelihood that each policy within the program will have a different scope of coverage.

    

3. The article states that the provision can create the risk that different insurers could apply inconsistent interpretations to the same term in an underlying policy. But that risk exists with or without this "no broader" provision. Even if the provision is deleted, the excess policies follow the terms of the Primary Policy and thus there is a risk the primary insurer may interpret a term of the Primary Policy differently than an excess insurer may interpret that provision.

    

4. The article questions what does "broader coverage" mean for purposes of this provision. That is answered simply: is loss otherwise covered under the excess policy but not covered under the underlying policy?

    

5. The article states that one cannot determine if coverage is broader until the loss is incurred. That is correct in many instances, but that dynamic is not due to the "no broader" provision. Under any policy, coverage typically cannot be determined until the loss is incurred, and deleting the "no broader" provision will not change that result.

　

In summary, the stated concerns regarding this provision are either not valid or not material, particularly when compared with the compelling purpose and value of this provision.The provision has survived the test of time over several decades without creating undue problems for Insureds while accomplishing some important benefits to excess insurers. Therefore, on balance I think the provision should be retained in excess policies.

 

*******

Once Again, I would like to thank Dan for his willingness to have his comments published here. The D&O Diary welcomes guest blog post submissions from responsible commentators. Please contact me if you think you might be interested in submitting a guest blog post.

 

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An insurance broker’s settlement of claims for disgorgement of undisclosed contingent commissions does not represent covered loss under a combined lines professional liability insurance policy, according to a December 3, 2010 decision of the Illinois (Cook County) Circuit Court. A copy of the December 3 opinion can be found here.

 

Background

Aon Corporation was first sued in 1999 in a class action lawsuit brought on behalf of its customers who alleged the firm had acted improperly with respect to its receipt of certain contingent commissions from insurance carriers. This class action lawsuit came to be known as the Daniel action. Aon was also the subject of certain regulatory investigations from several states’ Attorneys General based on the same allegations.

 

As originally pled, the Daniel action sought damages as well as other relief. However, the Daniels action was amended multiple times. As ultimately pled, the Daniel action sought only a disgorgement into a constructive trust of the amounts allegedly improperly received.

 

On March 4, 2005, AON entered into a settlement with the Attorneys’ General in which it agreed to deposit $190 million into a fund to be paid to former clients of the firm. The agreement specified that the firm would not seek indemnification from its insurers for the funds paid in the settlement.

 

On March 9, 2005, AON entered a separate settlement in the Daniel action, in which the firm agreed to pay an additional $38 million. The Danies action was approved by the Court.

 

Aon sought indemnification from its insurers for the amounts paid in settlement of the Daniels case as well as defense expenses incurred in the Daniel case and the Attorneys General action.

 

Aon’s insurance program included a Combined Lines Policy which combined certain lines of professional liability insurance, including directors and officers liability insurance, errors and omissions insurance and other lines as well. The Combined Lines Policy insurance program consisted of a layer of primary insurance and multiple layers of excess insurance.

 

In August 2006, AON initiated an action in Illinois (Cook County) Circuit Court seeking a judicial declaration of coverage under the Combined Lines Policy for loss incurred in connection with the Daniels action and related matters. The parties filed cross motions seeking to establish whether or not the Danies settlement and the defense costs incurred in the Daniel and the Attorneys General actions represented covered loss under the Combined Lines Policy.

 

The December 3 Order

In arguing that there was no coverage under the Combined Lines Policy for the settlement and defense expenses, the carriers argued that "Loss" covered under the Policy does not include "disgorgement of an ‘ill-gotten’ gain, that is, money of property an insured allegedly had no right to receive in the first place." The insurers argued that the Daniel plaintiffs sought only a constructive trust, not individualized damages, making it clear "that they were seeking disgorgement as their only remedy." The carriers also argued that it would be against Illinois public policy to allow the firm to pay restitution or fund a constructive trust with insurance proceeds.

 

AON in turn argued that there were genuine issues of material fact whether or not the remedies the Daniel plaintiffs sought were restricted solely to restitution. AON argued further that even if the pleadings as amended sought only restitutionary relief, the original pleadings had sought damages, and therefore the firm was entitled to its costs of defending the original pleadings. AON also argued that there was a genuine issue of fact whether the Attorneys General actions sought only restitutionary relief.

 

In her December 3 opinion, Judge Kirie Kinnaird rejected AON’s arguments and held that the relief sought in the Daniel action was "restitutionary and not an insurable loss." Judge Kinnaird rejected the firm’s contention that it was entitled to the defense expenses incurred before the pleadings were amended to remove the damages allegations, since the ultimately operative complaint, and the one to which AON filed its motion to dismiss, sought only restitutionary relief.

 

Judge Kinnaird also rejected AON’s argument that because there had been no determination in the Daniel action that the contingent commissions were "ill-gotten," the commissions represented amounts the firm was entitled to receive, and therefore the Daniels settlement represented covered "Loss." Judge Kinnaird said:

 

Insurability does not depend on whether a claim has merit, but rather what the settled claim sought….This Court will not make a finding or determination of whether AON’s alleged actions in the Daniel litigation were "ill-gotten gains" or unlawful. The lawfulness of collecting contingent commissions was not at issue in the Daniel litigation and is not relevant here. It was the Daniel plaintiffs’ allegation that AON failed to disclose its eligibility to receive the contingent commissions and the retention thereof that gave rise to AON’s potential liability.

 

Finally, Judge Kinnaird held that the firm was not entitled to recover its expenses incurred in defending the Attorneys General actions because the matters were in the nature of disgorgement and restitution. Judge Kinnaird rejected AON’s argument that the way that the claims were characterized in the settlement documents altered this conclusion. Because the underlying claims were not covered, the expenses incurred in the defending the matters likewise were not covered.

 

Discussion

There is an extensive body of case law holding that D&O insurance does not cover disgorgement or amounts incurred that are restitutionary in nature. What makes this holding interesting is Judge Kinnaird’s express observation that the question of coverage for the amounts AON sought does not depend on whether or not the amounts themselves were "ill-gotten."

 

Rather, the Judge held, the question of coverage for the amounts sought depending solely on the fundamental nature of the relief sought. Because the relief sought in both the Daniel action and the Attorneys General action was fundamentally restitutionary in nature, there was no coverage under the policy at issue.

 

The part of Judge Kinnaird’s holding worth thinking about is the ruling with respect to defense expenses. I think most would accept that liability insurance can’t be used as a way for insured’s to finance their repayment of amounts that were not the insured’s in the first place. However, the determination of noncoverage for the amounts incurred in defending against wrongful acts may or may not be as obviously reasonable to many observers.

 

I would be interested in knowing readers’ thoughts on the defense expense question. I think there may be some difficult issues there to consider, especially with respect to individual defendants (particularly in the bankruptcy context).

 

Special thanks to a loyal reader for providing me with a copy of the AON decision.

　

SafeNet’s Excess Carrier’s Rescission Action to Go Forward: On December 7, 2010, Southern District of New York Judge Naomi Buchwald denied the motion to dismiss an action to determine whether or not there is coverage under SafeNet’s excess D&O insurance policy for the settlement of the company’s options backdating related securities class action lawsuit. A copy of the opinion can be found here.

 

The excess carrier’s action seeks to rescission. In her December 7 opinion, Judge Buchwald held that neither the underlying carrier nor individual directors and officers who had not been named as defendants in the rescission action were indispensible parties to the rescission action.

 

Judge Buchwald also rejected the argument that the rescission action was not yet ripe, because the primary policy had not yet been exhausted by payment. She held that the rescission action represented a ripe controversy notwithstanding the fact that the underlying limit had not been exhausted because the securities class action lawsuit settlement presented the "practical likelihood" that the excess limits would be called upon.

 

Semtech Options Backdating Securities Class Action Lawsuit Settles: On December 8, 2010, Semtech announced that it had settled what is one of the last remaining options backdating-related securities class action lawsuits. As reflected in Semtech’s December 8 press release, which can be found here, the case has settled for $20 million.

 

I have added the Semtech settlement to my running tally of options backdating related class action lawsuits, which can be accessed here.

 

According to data compiled by Adam Savett of the Claims Compensation Bureau, of the 39 options backdating related securities class action lawsuits, seven (or 18% were dismissed) and 31 have been settled or partially settled. The total value of all options backdating related securities class action lawsuit is $2.38 billion. The average settlement is $68.7 million, and the median settlement is $14 million. Savett’s data also reflects average and median insurer settlement contributions.

　

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Settlement is the critical goal in every claim that cannot be resolved otherwise. It terminates the open dispute, it provides the parties with finality, and, perhaps, most importantly, it provides the parties with repose. After a settlement is final, everyone is free to get on with their lives.

 

Notwithstanding these fundamental settlement values, are there times when a D&O insurer may nevertheless seek to recoup from its own insured the amount the insurer previously paid in settlement of a third-party claim? A November 22, 2010 Eastern District of Virginia decision, applying Kansas law, in a case involving Sprint Nextel Corporation, addressed this issue. The court held that an excess D&O insurer could not, two years after a settlement was final and based upon post-settlement case law developments, recoup from its insured the amount the insurer paid toward settlement.

 

Background

In February 2004, Sprint Nextel’s board voted to recombine the company’s two separate tracking stocks, leaving a single surviving equity interest. The holders of shares to be retired received, in exchange for their shares, additionally issued shares of the surviving share class.

 

In March 2004, investors who had held shares of the retired class of stock filed class action lawsuits alleging that the company’s board breached its fiduciary duty by implementing a conversion ratio that undervalued the retired shares.

 

Sprint Nextel provided notice of claim to its D&O insurers. At the time of the shareholder claims, Sprint Nextel carried a total of $100 million in D&O insurance, which was written over a $25 million self-insured retention. The first three layers of the D&O insurance program consisted of three layers of $15 million each, arranged between a primary layer of $15 million, and two excess layers of $15 million.

 

In 2007, as a result of mediation, the parties to the shareholder litigation agreed to a $57.5 million settlement. The settlement was to be funded by Sprint Nextel’s payment of the $10 million remaining under the deductible, as well as full $15 million contributions from the primary, first excess and second excess carriers. The fourth level excess carrier contributed the remaining balance.

 

The second level excess carrier agreed to pay its limit but sought in its letter of consent to "reserve its rights to deny coverage and seek repayment."

 

The carriers ultimately funded their respective contributions toward the settlement. On December 12, 2007, the court entered final judgment in the shareholder litigation. The second level excess carrier closed its claim file.

　

However, in December 2009, after the District of Massachusetts issued its opinion, in the Genzyme case, the second level excess carrier filed a complaint against Sprint Nextel in the Eastern District of Virginia against its insured, seeking to recover the $15 million it had paid in the 2007 settlement.

 

As I discussed in a prior post, here, the district court held in the Genzyme case that under Massachusetts law Genzyme’s D&O insurance did not cover amounts Genzyme paid to settle the claims of individuals who asserted they had received inadequate consideration in an exchange for their tracking shares of an internal Genzyme division.

 

The second level excess carrier and Sprint Nextel filed cross-motions for summary judgment.

 

The November 22, 2010 Decision

In seeking to recover its settlement payment, the second level excess carrier argued that the settlement did not represent covered loss under the policy because it represented a delayed payment of a preexisting obligation (in that the company had preserved the Board’s right to decide to recombine the two separate classes of tracking stock into a single class). The second level excess carrier also argued that the settlement represented a mere redistribution of assets among different classes of Sprint shareholders.

 

In making these arguments, the second level excess carrier relied on the Massachusetts District Court’s September 28, 2009 opinion in the Genzyme case. As I as discussed at length here, the district court’s opinion in Genzyme was overturned by the First Circuit on October 13, 2010.

 

In rejecting the second level excess carrier’s argument that the settlement merely represented a preexisting obligation, Judge Claude Hilton wrote that "it is no understatement to say that one of the principal reasons for D&O insurance is to cover D&Os when they are alleged to have breached such preexisting obligations. The mere existence of generalized obligations to follow the law and honor one’s fiduciary duty does not render uninsurable a lawsuit alleging that corporate directors failed to do so."

 

Judge Hilton also rejected the second level excess carrier’s further argument that there is a general public policy against insuring this type of settlement. Judge Hilton also noted that the second level excess carrier only decided to file its recoupment action after the Massachusetts District Court entered its opinion in Genzyme, which the second level excess insurer characterized as "a case of first impression" – which contention, even if true, is inconsistent with the notion that there is a clear and pervasive public policy against payment of these types of settlements.

 

To the contrary, Judge Hilton found, Kansas public policy "favors enforcement of D&O insurance policies" and the second level excess carrier had not identified any grounds that would justify restitution or recoupment of the settlement payment.

 

Judge Hilton specifically noted that though the D&O policy allows the reinsurer to seek repayment of defense costs if the costs were not covered, "there is no basis under the policies for an insurer to make a settlement advance and later to seek its return."

 

Judge Hilton said that he would not allow the second level excess carrier "to retroactively amend its policy by trying to infer a recoupment right or attempt to circumvent the policy’s terms by invoking restitution." Although the carrier may have made its payment "grudgingly," there "can be no question that the payment was made voluntarily." Judge Hilton also found there was no excuse for the second level excess carrier’s delay in brining its action.

 

Discussion

I can certainly see the argument that amount paid in the underlying settlement represents nothing more that a payment by or on behalf of the company to make up for the inadequate consideration the company allegedly paid to the holders of the retired shares in the share recombination.

 

But in the end, I don’t think that Judge Hilton’s grant of summary judgment in favor of Sprint Nextel necessarily depended on the merits of the second level excess carrier’s arguments about the nature of the settlement amount or even on the fortuity that the Genzyme decision was reversed after the second level excess carrier filed this action.

 

I think the summary judgment ruling is best understood as a reflection of the second level excess carrier’s timing. It might have been one thing if the second level excess carrier had asserted its position and resisted its settlement obligation while the underlying claim was still pending. The simple fact is that the second level excess carrier did not bring its recoupment action until two years after the settlement of the underlying claim was final.

 

Moreover, as Judge Hilton noted, the grounds on which the second level excess carrier sought to recover the amounts it had paid in settlement was not "fraud, duress or mistake of fact," which might justify setting a prior settlement aside and requiring a restoration of funds. Rather, the second level excess carrier’s bid to recoup funds was based solely on a district court opinion entered two years after the underlying claim was finally settled.

 

If carriers were able to seek the return of settlement payments years after the fact based on nothing more than post-settlement case decisions, the case resolution process could be seriously compromised. Settlements could become nothing more than a contingent arrangement, a state of affairs which frankly is in no one’s interest.

 

Whatever else might be said about second level excess carrier’s decision to pursue this belated action, one can only hope that the outcome of this case and the impression it makes might deter other carriers from seeking to recoup settlement payments long after the fact, at least in the absence of fraud or other similar factor.

 

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I am pleased to reproduce below the latest guest post submission. This post has been submitted by John Iole, a partner in the Pittsburgh office of the Jones Day law firm. In submitted this post, John emphasized that "comments expressed are those of the author and do not necessarily represent the views of Jones Day or its clients." In addition, John has expressly retained the copyright to the content. John previous guest post submission to this blog can be found here.

 

I would like to thank John for his willingness to post his submission on this site. The D&O Diary welcomes guest submissions from responsible persons on differnent points of view. Readers who may be interested in submitting a guest post should please feel free to contact me. John's guest post follows below:

 

 

            Large insureds often purchase substantial D&O coverage limits in layers that comprise a tower, with each D&O insurer occupying one or more layers and attachment points.[1] The excess policies commonly contain provisions that dictate how the overall program will respond to claims that implicate multiple layers. Ideally, the policy responses will be harmonious, because all participants are interested in efficiency of administration as well as a satisfactory level of coverage predictability. This guest post addresses the “narrowing clause” found in many such excess D&O policies, and how this feature can raise extremely difficult issues of policy interpretation and coverage that are not always obvious -- or even knowable -- at the time of policy placement.

 

 

            Assume that each excess policy in a layered program contains a “follow form” endorsement providing that the excess policy will follow the terms, conditions and exclusions of a designated underlying policy. A standard explanation of a follow form policy is that it provides coverage that is neither more broad nor more narrow than the followed policy.[2]

 

 

            If all of the policies in a tower are written on a “pure” follow form basis, then it is likely (but not inevitable) that coverage issues will be determined in essentially the same way at each layer of coverage. However, many D&O excess policies are not pure follow form, but instead contain terms and conditions specific to particular insurers. This is where the “no broader than underlying” provision (called a “narrowing clause” for the purposes of this post) comes in.

 

 

            A sample narrowing clause from an “Underlying Insurance” section in a Bermuda D&O excess form provides:

 

 

In no event shall this policy grant broader coverage than would be provided by any of the Underlying Policies.[3]

 

This provision clarifies that the excess policy does not to provide coverage if the underlying policies do not provide coverage.[4]  The excess policy might impose additional restrictions on coverage, but it is a one-way ratchet. Coverage can only get more narrow as a claim rides up the coverage tower.[5]  The following sections discuss the potential coverage impact presented by narrowing clauses.

 

 

 

            What Are The Mechanics Of Applying A Narrowing Clause?

 

 

            In the most basic situation, a narrowing clause can be interpreted to allow an excess insurer to incorporate a selected, “more narrow” provision from an underlying policy. In many cases, the effect of incorporation will be to erase a contrary term that otherwise would be applicable through the followed policy, or to erase such a term in the (incorporating) excess policy itself. As a consequence, the upper-level policy might, in operation, provide drastically different coverage than is implied by the direct terms of the upper-level policy (but for the narrowing clause).

 

 

            Narrowing clauses do not actually provide that they permit “incorporation” of provisions in underlying policies, nor do they provide any guidance on how incorporation is to be achieved. Nevertheless, it is likely that courts will permit incorporation as the method for executing such a clause. A good example of this in the D&O context is Fed. Ins. Co. v. Raytheon Co., 426 F.3d 491 (1st Cir. 2005). In Raytheon, the court held that a prior and pending litigation exclusion in the primary policy negated coverage under the excess policy, even though the excess policy had its own, differently-worded PPL exclusion that might not have excluded the claim.[6] The narrowing clause therefore deleted the excess policy’s stated PPL provision.

 

 

            Assuming that the narrowing clause permits incorporation by reference, a more difficult question is how much leeway it gives the excess insurer to pick and choose amongst underlying provisions. For example, assume that two excess policies each have an arbitration clause. Further assume that each clause has two provisions, one that deals with selection of arbitrators, and another that deals with the conduct of the arbitration itself. Further assume that the lower-layer policy is more limited in respect of arbitrator selection, and the upper-layer policy is more limited in respect of the arbitration proceedings. Can the upper-layer excess insurer invoke the narrowing clause to incorporate the selection provision from the lower-layer policy, but retain the proceedings provision from the upper-layer policy, thereby stitching together the most narrow, combined arbitration clause applicable to the upper-layer policy? If this is possible in practice, then a high-level excess insurer would be able to pick and choose from amongst numerous underlying provisions. One can easily envision a situation in which this exercise could lead to a bewildering patchwork of coverage arguments in a multi-issue case.[7]

 

 

            One can say with almost certain confidence that an “unlimited incorporation” approach, resulting in a hodgepodge policy, is likely to be rejected as unfair. Accordingly, it is likely that an insurer will have to incorporate underlying provisions in full (“jot for jot”), or not at all. Even this rule of thumb could be difficult to apply in practice. If the upper- and lower-layer policies are structured in ways that do not allow provisions to be easily matched up (or are endorsed so as to make a match-up confusing), then an incorporation exercise can lead to difficult questions about the scope of coverage.

 

 

            Can A Narrowing Clause Be Applied To All Underlying Provisions?

 

 

            Again assuming that a narrowing clause permits incorporation of underlying policy provisions, one must ask whether all underlying provisions are candidates for incorporation.  A policyholder would contend that the excess policy is not restricted in all instances to what is provided by the underlying insurance. A trivial example is the limit of liability provision of the excess policy, which is unaffected by “narrower” underlying provisions.

 

 

            Another seemingly obvious example is the notice provision. That is, if an underlying policy requires notice “immediately” and the excess policy requires notice “as soon as practicable”, it would seem to be absurd to import the more rigid standard into the excess policy, even if doing so would potentially affect the timeliness of a claim under the excess policy. Nevertheless, it is perhaps not completely free from doubt as to whether incorporation in this setting would be refused by a court.

 

 

            There are additional provisions that, one could argue, are not candidates for incorporation because they do not directly pertain to coverage, such as forum selection, choice of law, and claims participation clauses. However, these provisions can have an important impact on the effective coverage available, and therefore an insurer might well contend that they are subject to incorporation as “more narrow” provisions. An insurer would likely contend that the purpose of the narrowing clause is to limit the net effective coverage under the excess policy to what is available from the underlying coverage. Therefore, it would contend, any term in the underlying coverage that has the practical effect of limiting coverage also should apply to the excess policy. These arguments are left to the courts or other tribunals to determine without guidance from the narrowing clause itself.[8]

 

 

            If Incorporated, Should Policy Provisions Be Interpreted Uniformly?

 

 

            Once the incorporation of underlying text is settled, there is another problem awaiting the parties – interpretation of the text. Is the text to be incorporated “bag and baggage”, such that a 2nd-layer excess insurer is bound by a reading of the text that satisfies the 1st-layer excess insurer? The answer to this is perhaps “No”, at least in those jurisdictions that follow reasoning similar to the Supreme Judicial Court of Massachusetts in the Allmerica case.[9] If the policyholder and the 1st-layer excess insurer obtain a court or arbitral declaration on the meaning of the text, does this bind the 2nd-layer excess insurer in its own use of the text? The answer here is “Yes, perhaps,” but I am not aware of any authority for this outcome.[10]

 

 

            A related question can arise in the case of policy mistakes. It is not unknown for a mistake to be made in an insurance policy, perhaps through misunderstanding or inattention on the part of the underwriter, broker or policyholder. Assume that an underlying policy is reformed on the basis of mistake, where does that leave the excess policy? An excess insurer can probably make a strong case for leaving the underlying policy intact (as to the excess insurer) insofar as the unreformed policy provides narrower coverage than the as-reformed policy. The excess insurer probably would contend that its excess policy was placed in actual or presumed reliance on the terms of underlying coverage, and therefore no change via reformation is effective as to the excess policy.[11] Moreover, if reformation of the underlying policy has the opposite effect – i.e., reformation results in a narrowing of coverage, that change might well trickle up to the excess policies, narrowing them as well. These dynamics greatly magnify the potential consequences of any mistake that occurs at the time of placement.

 

 

            What Does it Mean to be “Broader Than” Underlying Coverage?

 

 

            The previous three issues are somewhat mechanical. A more fundamental question provoked by narrowing clauses is what it means to be “broader than” the underlying coverage. In some respects, such a characterization is not far different from asking whether one restaurant is “better than” another – the distinction works perfectly well for extreme (or at least reasonably clear) examples, but breaks down when a more precise differentiation is required.

 

 

            An example helps to illustrate the problem. Let’s assume that a 1st-layer excess policy in a coverage tower selects New York substantive law for all matters of policy interpretation, including insurability of punitive damages, and that such damages are uninsurable as a matter of New York law. Then assume that the 2nd-layer excess policy specifically selects Wisconsin law, under which punitive damages are insurable. Is coverage afforded by the 1st-layer policy “less broad” than that afforded by the 2nd-layer policy? If the answer to that question is “Yes”, is the New York choice of law swept into the 2nd-layer excess policy so as to supplant Wisconsin law? The 2^nd-layer (and above) excess insurers might well contend that this is what should happen.

 

 

            Well, if the 2nd-layer excess insurer is correct (New York law supplants Wisconsin for purposes of punitive damages), then what happens if the dispute involves multiple issues? Let’s assume in our same example that the parties also dispute how a prior and pending litigation exclusion in the excess policy should be interpreted. In our hypothetical, let’s say that Wisconsin has a much more expansive (favoring insurers) application of PPL exclusions, which has the ultimate affect of narrowing coverage. Does Wisconsin law retain its place in the dispute for this purpose, via some type of party-dictated depecage (New York law applies so as to preclude coverage for punitive damages and Wisconsin law applies so as to favor application of the PPL exclusion)?[12] The excess insurer(s) might again say that this is an available outcome.

 

 

            When Is The True Scope Of Excess Coverage “Knowable”?

 

 

            There is a major consequence of the “no broader than underlying” exercise that should be apparent from the foregoing discussion. If one stops to think about it, the implications of a narrowing clause are potentially ominous. The content, meaning and coverage of the excess policies – as determined only after the incorporated provisions have been selected – cannot be known until the point of a claim, or even a good bit thereafter. It is impossible to say, on an a priori or categorical basis, whether a lower-level policy is more or less broad than an upper-level policy. First, one needs to know: (a) exactly the claim for which coverage is being requested and, potentially, (b) how the claim has been resolved in each of the underlying layers. Although a party and its counsel can hypothesize examples and anticipate how the coverage would respond, it is not possible to know exactly what issues the next claim will bring.  This raises the prospect of inefficient and contentious claims resolution.

 

 

            One might counter that all insurance policies are somewhat indeterminate until a claim has crystallized to the point at which coverage can be analyzed, rendering trivial this observation. In a standard insurance situation, however, the wording is static, and all that is left to do is apply the policy wording to the claim as presented. The major difference with “no broader than underlying” provisions is that the actual wording of the policy is not fixed until a claim is asserted. The excess policy is “inchoate” until the point of a claim and the wording floats and metamorphoses until determinations are made under each of the underlying layers. The text of the excess policy cannot truly be determined until each of the underlying policies has responded.

 

 

            Potential Solutions to Ponder

 

 

            Perhaps the most simple and comprehensive solution to the “problem” of narrowing clauses is to negotiate “pure” follow-form coverage if possible. This solves the problem through identity of wording and avoids the prospect of vertical discontinuity. Obviously, this alternative will not always be available. Another potential solution is to implement quota-share insurance.[13] In that event, the problem of layered coverage is eliminated through a change in program structure. Again, however, knowledgeable observers have identified problems with this approach, including the difficulty in arranging for claims control, and the potential for losing horizontal continuity on a long-standing program. Notwithstanding these potential solutions, it appears likely that layered, non-uniform programs are going to continue into the foreseeable future. Therefore, a solution that directly meets the terms of narrowing clauses could be useful.

 

 

            When seeking to determine the field over which a narrowing clause operates, and the clause states that the excess policy provides coverage no broader than underlying, it is reasonable to interpret the provision as applying to the coverage grant, and terms that specifically pertain to the scope of coverage. Under this interpretation, the narrowing clause would not incorporate “non-coverage” elements of the underlying policies, perhaps those dealing with notice, choice of law, forum selection or cooperation and settlement.[14]  In the context of reservation of rights letters, and for the purpose of crafting rules dealing with waiver of defenses and avoiding “coverage by estoppel”, some courts already distinguish between “coverage defenses” and “policy defenses” available under the policies at issue.

 

 

            Under these cases, a “coverage defense” is one asserting that a claim simply does not fall within the scope of insurance for which a premium was charged. For example, a claim seeking coverage under a D&O policy when no “wrongful act” has been alleged, or seeking Side-C coverage for something other than a securities claim, would be deemed to fall outside the scope of coverage, and therefore would be subject to a coverage defense.

 

 

            A “policy defense” is one in which the insurer acknowledges that the claim comes within the scope of coverage, but contests the claim based on the policyholder’s failure to comply with some other provision in the policy, such as a requirement of cooperation. See, e.g., Ideal Mut. Ins. Co. v. Myers, 789 F.2d 1196 (5^th Cir. 1986) (Texas law); Continental Ins. Co. v. Bayless & Roberts, 608 P.2d 281 (Alaska 1980).

 

 

            This distinction obviously cannot be applied woodenly, and it is beyond the scope of this post to engage in a full-blown discussion of the merits, deficiencies and complexities it poses in a particular situation. Nevertheless, there is no simple way to craft a rule that can be applied in all instances, and this approach can form a basis for striking a fair balance between the interests of insurers and policyholders.

 

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All too often, the securities class action litigation process seems like a complicated and costly mechanism for transferring large amounts of money to the lawyers involved but only small amounts to the aggrieved investors, all at the expense of the D&O insurers. It is hard not to wonder sometimes what the whole process accomplishes, other than making D&O insurance indispensible and expensive.

 

Even worse, the deterrent effect that securities litigation is supposed to have is undermined because the presence of insurance insulates companies and their managers from any consequences for their alleged misconduct, at least according to a new book by Penn law professor Tom Baker (pictured, left) and Fordham law professor Sean Griffith (pictured, right).

 

The irony is that D&O insurers are in a position from which, at least in theory, they could positively influence corporate conduct and advance the regulatory goals of the securities laws. In their book, "Ensuring Corporate Misconduct: How Liability Insurance Undermines Shareholder Litigation," Baker and Griffith explore the ways D&O insurers might provide a "constraining influence" on their policyholders. The authors conclude that as a result of actual practices and processes insurers do not in fact perform that role.

 

Rather, the authors conclude, D&O insurance "significantly erodes the deterrent effect of shareholder litigation, thereby undermining its effectiveness as a form of regulation." In order to try to "rehabilitate the deterrent effect of shareholder litigation, notwithstanding the presence of liability insurance," the authors propose three regulatory reforms, as discussed in detail below.

 

To understand how D&O insurance works and how it affect securities litigation, the authors interviewed over 100 professionals from across the D&O insurance industry, as well securities litigators from both the plaintiffs and defense side. (Full disclosure: I was one of the people interviewed.) The authors previously published interim assessments of their research in three separate law review articles, about which I previously commented here, here and here. This new book pulls their prior publications together in a single volume comprehensively presenting their research and the bases for their reform proposals.

 

D&O Insurers’ Three Opportunities to Advance Securities Litigation Deterrence Goals

The authors postulate that there are three ways D&O insurers might, in theory, preserve the deterrence function of shareholder litigation.

 

First, insurers might use insurance pricing as a way to motivate corporate behavior, by forcing companies engaging in riskier behavior to pay more for insurance.

 

Second, the insurers might monitor their policyholders and force them to avoid risky conduct or adopt governance reforms.

 

Third, the insurers could control claim defense and settlement to insure that settlements reflect the merits of the claim and force defendants to pay more toward the defense and settlement when there is evidence of actual wrongdoing.

 

 

The D&O Insurers Failure to Pursue Opportunities to Advance the Deterrence Goals

The authors found from the interviews, however, that D&O insurers do not take advantage of these opportunities, despite the seeming financial incentives to do so.

 

What they found is that the pricing mechanism does not affect policyholder conduct, in part because the insurance cost is a very small part of most companies’ overall cost structure, and in part because the difference between the premiums riskier companies pay and the premiums less risky companies pay is relatively slight.

 

The authors also found that D&O insurers do almost nothing to monitor their policyholders or to try to influence their conduct. The authors puzzled over this issue at length, because insurers not only have an incentive to try to improve conduct but also because insurers effectively and positively influence their policyholders’ behavior with respect to other hazards and other lines of insurance.

 

Ultimately the authors concluded that monitoring and loss prevention services related to D&O insurance are not valued by corporate managers, and that in a competitive insurance environment it is hard to charge a price that supports the costs associated with delivering these services. (When the authors previously published their research pertaining to this particular topic, I wrote a lengthy blog post, here, discussing my views on why D&O insurers do not offer monitoring and loss prevention services.)

 

Finally, the authors found that, as a result of the way that D&O policies are structured, D&O insurers have little control over defense costs, and that insurers’ authority over settlements is constrained by the dynamics of the claims process – in particular, by the fact that the plaintiffs’ theoretical damages usually so far exceed the policy limits. The authors also found that insurers have some ability to use coverage defenses to insist on greater contributions to defense and settlements from defendants when there is greater evidence of actual wrongdoing, but that insurers' ability to deploy these influences is limited.

 

The Authors’ Three Proposed Reforms

The authors concluded that each of these problems "increases the likelihood that insurance substantially mutes the deterrence effect of shareholder litigation." But rather than jumping to the extreme position of suggesting the abolition of D&O insurance, the authors suggest three reforms they contend would reinvigorate the deterrence function.

 

First, the authors suggest that the SEC require reporting companies to disclose their D&O insurance information (premium, limits, retentions, and the identity and attachment point of various insurers). The authors contend that these details "will convey an important signal concerning the quality of the firm’s governance," and that changes in premiums will alert investors to changes in the risk. The limit selected, the authors contend, would signal the managers’ belief about their companies’ relative risk of serious securities litigation, and the identity of carriers (and in particular whether the carrier is "a market leader" or a "cut-rate insurer") could "signal governance quality."

 

Second, in order to ensure that corporate defendants have "skin in the game" and therefore become more deeply invested in avoiding litigation and more deeply involved in managing defense costs and settlement amounts, the authors propose the mandatory requirement of coinsurance. By ensuring that the settlement of a securities lawsuit would produce a loss for the company, coinsurance would reduce the "moral hazard" of D&O insurance.

 

Third, in order to "provide capital market participants a window onto the merits of claims," the authors propose that the SEC require the disclosure of information about settlements, including the extent to which insurance funded the settlement and defense costs.

 

Discussion

Baker and Griffith have written a readable, interesting and important book. Their discussion of the actual role of D&O insurance in the securities litigation process is enhanced by their research methodology. All too often, theoreticians postulating about D&O insurance lack any understanding of the way things actually work. Because the authors took the time to interview the marketplace participants, their analysis is grounded in the practical realities of the real world.

 

As a result, the authors bring an informed outsider perspective to their discussion of the D&O insurance industry. The authors are painfully successful in highlighting the peculiar pathologies of the D&O insurance industry and the ways that D&O insurers and other marketplace participants systematically undermine both the insurers’ financial interests and the regulatory goals of the securities litigation system.

 

I am grateful to the authors for not just coming right out and advocating the abolition of D&O insurance – the career change I would face would be rather unwelcome at this point in my work life.

 

The authors do propose some regulatory alternatives. Some of the authors’ proposed reforms have substantial merit. In particular, I agree with the authors’ suggestion that the entire process would be improved if corporate defendants were required to have "skin in the game" in some form. The threat that companies would have to contribute to defense and settlement would encourage companies to try to avoid risky behavior. It would also provide a healthy influence both on the defense and settlement of securities lawsuits.

 

I know that many companies and their advocates will object to the idea of requiring  companies to participate financially in the lawsuit. Companies clearly would prefer to avoid that cost. But the benefits that would follow from greater company participation will ultimately inure to the benefit of everyone, and ultimately lead to a more disciplined, more rational and less costly system.

 

There might be ways other than coinsurance to bring about this reform. One possibility has already been implemented in Germany, where D&O insurance is now required to include a self-insured retention for individual liability. This is a more extreme version of the solution Baker and Griffith have proposed, but it undeniably has the potential to motivate corporate officials to avoid misconduct and risky behavior. My lengthy discussion of the new German requirement can be found here. (I am not advocating the German alternative, merely pointing out there there are alternatives to coinsurance.)

 

The authors’ proposal to require the disclosure of settlement and defense cost information also has some merit. At a minimum, investors are entitled to know the actual financial impact the litigation has had on the company. Investors would be astonished to learn how much these cases cost to defend, and the extent of insurance contribution to the defense and settlement is also highly relevant in order to understand the financial impact of the litigation on the company.

 

The availability of defense cost and settlement information would also be enormously helpful to companies themselves when deciding how much insurance to buy. As it stands, the settlement information that companies rely on to decide how much insurance to buy lacks any connection to insurance contribution toward settlements, and also lacks the vital detail regarding the costs of defending these cases. This kind of information would be valuable for everyone.

 

I am less persuaded by the authors’ proposal that reporting companies should have to disclose their D&O insurance information. I do not believe the publication of insurance information would provide the marketplace "signal" the authors think it would. I also think that requiring this disclosure could also could distort corporate behavior in ways that would be harmful to shareholders.

 

The analytic flaw with the authors’ proposal is that it treats D&O insurance as if it were a fungible commodity, like wheat. The fact is that these days, every single public company D&O policy is heavily negotiated. In the process of negotiation, it frequently happens that buyers will have to make a choice of whether or not to incur the cost required in order to obtain a particular term -- say, for example, adding increased limits with or without full past acts coverage. The insurance the company winds up with is the product of a host of these kinds of decisions.

 

As a result, every policy is different and those differences have important pricing implications. If you were to go down your street and find out how much each one of your neighbors paid for their car, you still wouldn’t know everything you need to know. I drive a small compact, my neighbor across the street has a squadron of kids and so he drives a Yukon. If you didn’t know about the differences between the vehicles, and also the reason for these differences, you wouldn’t understand the meaning of the differences in what we paid for our vehicles. The same goes for D&O insurance.

 

The authors give a nod to the notion that D&O policies are not standardized by suggesting that public companies should be required to publish their policies on their website. (As a person who makes his living off of policy wording expertise, I find this suggestion absolutely loathsome.) But even this extreme step would not supply the necessary information to explain the tradeoffs and choices the company went through in order to make its insurance purchase. The bare policy alone would not, for example, reveal what selections the company did not make or how those choices affected the final policy and the policy’s ultimate price.

　

The bottom line is that companies that make prudent, conservative choices sometimes pay more for D&O insurance that provides better protection. Moreover, there are other important considerations that would distort the author’s postulated signal. For example, many buyers attach value to stability in their insurance relationship. These buyers bypass opportunities to reduce their insurance costs in exchange for stability and continuity. Other buyers who have had positive claims experiences feel loyalty to their carrier (yes, that really does happen) and even recognize the carrier’s need to try to recoup claims costs in higher premiums.

 

In other words, premium levels reflect a host of considerations that have nothing to do with the governance signaling assumptions underlying the authors’ proposal. But on the other hand, if companies nevertheless had to confront the possibility that investors and analysts might downgrade them because of the amount they pay for D&O insurance, the companies inevitably would cut corners to bring costs down, for example by buying less or narrower coverage. This could leave both executives and the company’s balance sheet exposed to losses that could financially harm the company and thereby harm investors’ interests.

　

In the end, whatever else might be said, Baker and Griffith have certainly raised a host of issues meriting further discussion. Indeed, Professor Baker will be participating in a panel to discuss the impact of D&O insurance on securities litigation this upcoming Thursday, November 11, 2010, at the PLUS International Conference in San Antonio. I suspect this will be the first of many industry discussions about the authors’ book.

 

Professor Griffith’s prior guest post on this blog in which he defended the authors’ suggestion of requiring companies to disclose their insurance information can be found here. My apologies to Professor Griffith for my not being able to figure out how to make his picture the same width as that of Professor Baker.

 

 

See You in San Antonio: I will also be in San Antonio for the PLUS Conference, and I look forward to seeing and greeting readers of The D&O Diary while I am there. I hope readers who see me will say hello, particularly if we have never met before.

 

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the seventh in the series, I examine the perennial questions of limits selection and program structure – that is, how much insurance is enough, and how should the insurance be structured? As explained below, these two questions are inextricably linked

 

Limits Selection

One of the most challenging questions for anyone that advises D&O insurance buyers is the question of what is the right amount of insurance The question inevitably involves a mixture of art and science, particularly because the analysis is affected by basic considerations of cost and risk tolerance. While there are certain objective benchmarks that can help to inform the process, the benchmarks must be considered in conjunction with relevant considerations that should also influence the analysis.

 

The question of D&O insurance limits selection is, of course, different depending on whether the buyer is a publicly traded company or is privately held. The difference in analysis between the two is not just in the total quantity of insurance purchased but also in how the limits selection question is analyzed. I discuss the question of limits selection for public and privately held companies separately below.

 

For publicly traded companies, there are some basic benchmark reference points and some additional considerations that every insurance buyer should asses.

 

Publicly traded companies will first want to approach questions surrounding limits selection from the perspective of basic limits adequacy, taking into account the company’s likely securities class action litigation settlement exposure. The securities suit settlement exposure is the appropriate starting place because for most companies in most circumstances, a securities suit represents the company’s largest management liability exposure. The company should be provided with information sufficient to allow it to assess the range and distribution of settlements for companies of its size and other characteristics.

 

A second benchmark publicly traded companies may want to consider are peer purchasing patterns – that is, how much D&O insurance do other companies like ours buy? Some buyers find this information reassuring, although care should always be taken to make sure that peculiar purchasing patterns, which sometimes can be industry-wide, do not inappropriately drive an important decision like limits adequacy.

 

In addition to these basic, relatively objective guidelines like settlement trends and peer purchasing patterns, there are additional considerations that should also be taken into account.

　

The first is that information about securities class action settlements, discussed above, does not take into account defense expense. Defense costs must be considered, because under most D&O insurance policies, defense costs erode the limits of liability. Every dollar of defense cost means one less dollar available for settlements or judgments. For a company to be sure that it has adequate limits of liability both to defend and to settle serious claims, appropriate consideration must be given to likely defense expenses as well as to settlement amounts. Along those lines, it is critical to note that both settlements and defense expenses have been escalating in recent years, much faster than the rate of economic inflation.

 

The other consideration that should be taken into account is that the most important value of D&O insurance is the protection it affords individual insureds in the event of a catastrophic claim. When things go seriously wrong, the D&O insurance may be the individuals’ last line of defense.

 

When these catastrophic type events occur, the company and the individual directors and officers may find themselves battling multiple legal proceedings simultaneously. In addition, the interests of the various defendants in the various proceedings may conflict dramatically, particularly when ousted former management is faulted for the company’s woes. Often when this occurs, each defendant will retain separate counsel. Under these circumstances, defense expenses can mount astonishingly quickly, causing the rapid depletion or even the complete exhaustion of the available insurance (for more about which, refer here).

 

The possibility of a catastrophic claim that could consume available limits underscores the importance of careful consideration of limits selection issues. Simply put, what other cases might have settled for in the past or how much insurance other companies buy may provide little guidance for the question of how much insurance a particular company might need in the future, particularly since the settlement and purchasing pattern data tend to be backward looking and incorporate historical patterns that may not be relevant to future requirements.

 

On the other hand, the difficulty of using a catastrophic claim scenario is that it may quickly lead to the rather unhelpful conclusion that no amount of insurance is enough to address the top end exposures. At some point, the analysis must shift from the quantity of insurance to the structure of the insurance, a question I address further below.

 

With respect to private companies, the issues are different, primarily because privately held companies do not typically face class action securities litigation risks. However, merely because private companies have no class action securities litigation exposure does not mean that private companies and their directors and officers do not face serious liability risks. I have in fact seen numerous private company D&O claims that have settled for millions of dollars. For that reason, an appropriate awareness of the possibilities should also inform private company D&O limits selection issues.

 

For private companies, the objective reference standards are peer purchasing patterns by company asset size. These peer data have the same benefits and limitations as they do for public companies, but many buyers find this data useful and reassuring in the insurance acquisition process.

 

The limits of liability for private company D&O insurance is, like public company D&O insurance, in most instances subject to erosion by defense expenses. so many of the same considerations concerning defense expenses should also be taken into account for questions of private company D&O limits selection.

 

One added consideration particular to private company D&O insurance is that the entity coverage available under a private company policy is quite a bit broader in the private company policy than is the entity coverage in a public company policy. (The public company policy is limited to securities claims; the private company policy is not so limited.)

 

The broader entity coverage available in the private company policy creates the possibility that the limits of liability could be eroded by the defense expenses and settlements of the entity, potentially leaving the individuals with less (or no) insurance remaining to defend themselves or settle claims. The broader entity coverage in the entity policy could influence some buyers to increase the D&O insurance limits of liability, as one way to protect against erosion or exhaustion of the limits by entity claims.

 

Program Structure

In light of the escalating average claims severity and of the catastrophic potential for defense expense to deplete policy limits, it may be necessary to reconsider commonplace concepts of limits adequacy. Increased limits alone, however, may not solve all of the problems.

 

Part of the solution has to be program structure. Clearly, one of the factors that can contribute to limits depletion or exhaustion is that so many different people are accessing the insurance, particularly when there are multiple simultaneous claims. 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 possibility of catastrophic claims underscores the importance of addressing these issues as part of the insurance acquisition process.

 

The point of these supplemental insurance structures is to ensure that no matter what happens, the individuals (or some subset of them, for example, the non-officer directors) will have a pot of money with their name on it, as reassurance that the individuals will not be left with unresolved claims but no insurance remaining with which to defend themselves. For more about structuring D&O insurance to protect non-officer directors, refer here.

 

Moreover these alternative structures often have broader coverage than the "traditional" D&O insurance; for example, they often contain fewer exclusions. They also provide so-called "drop down" protection when they provide first dollar coverage, in the event, for example, that the underlying traditional D&O insurers have become insolvent or seek to rescind coverage. In addition, because these alternative insurance structures protect only specified individuals, the insurance cannot be siphoned off for the payment of entity claims or the claims of other individuals who are not insured under the structure.

 

The complexity of these limits selection and program structure issues underscore how indispensible it is that insurance buyers enlist knowledgeable and experienced advisors in their D&O insurance acquisition process. In particular, it is important that buyers ensure not only that their advisors have access to the data described above that is relevant to the limits selection process but also have the ability to explain the limitations of the data as we well as the additional considerations that should be taken into account. In addition the insurance advisor should be able to guide the company through the process of selecting the right insurance structure to ensure that the company and its directors and officers are adequately protected even in the event of a catastrophic claim.

 

Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:　

Executive Protection: Indemnification and D&O Insurance – The Basics　　

Executive Protection: D&O Insurance – The Insuring Agreement

Executive Protection: D&O Insurance—The Policyholder’s Obligations

D&O Insurance: Executive Protection – The Policy Application

Executive Protection: Private Company D&O Insurance 

Executive Protection: D&O Insurance Policy Exclusions

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The astonishing pace of legislative and judicial changes - just over the last few months alone - underscores how rapidly the liability exposures in the directors and officers arena can be transformed. In the latest issue of InSights (here), I take a look at the current hot topics in the world of directors’ and officers’ liability. There is much to discuss in the world of D&O, with further changes just over the horizon. The year ahead could be very interesting and eventful. The latest InSights article reviews what to watch now in the world of D&O.

 

The Latest Bulletin From Our San Francisco Bureau:  Our SF correspondent filed this report before last night's game (names removed to protect privacy, swear words modified to conform with the family-oriented approach of this blog):

 

So living with a wacko Giants fan is actually really fun right now. Yesterday {name removed} and her mom and godmother went kayaking outside the stadium and it sounds like SO MUCH FUN. I have added it to my to-do list of things while I live in the Bay.

 

Anyway, aside from kayaking (and drinking, and eating, and singing while kayaking) Giants fans wear these ugly fake beards to mimic the "rally beards" that the pitchers have (well, all the pitchers except Lincecum). And they have t-shirts that say "Fear the Beard." I have seem some television footage of very small children and very blonde women in beards. Very strange.

 

Also, just to prove that Tim Lincecum really could never play on any team except the Giants or the A's, everyone knows he smokes pot like it's his job, and the fans wear shirts that say "Let Timmy Smoke." I very much doubt that would be the public reaction ANNNYwhere else. Also he doesn't cover his mouth when he swears, so "F*ck Yeah" t-shirts are also very popular.

 

Unfortunately, I'm still not overly interested in the BASEBALL...just the funny things that San Franciscans do while they WATCH baseball.

 

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Among the most frequently recurring and arguably most vexatious D&O insurance coverage issues are the questions of the carrier’s obligation under the policy for defense expenses incurred either in connection with an informal SEC investigation or an internal investigation.

 

In an October 15, 2010 summary judgment ruling in insurance coverage litigation involving Office Depot, Southern District of Florida Judge Kenneth Marra, applying Florida law, denied coverage for both of these categories of defense expense. Though the decision is a direct reflection of the specific facts involved and the particular policy language at issue, the ruling provides an interesting insight into these recurring issues.

 

Background

In June 2007, Office Depot was the subject of news report suggesting the company had improperly disclosed material information to securities analysts in violation of Sec. Regulation FD. In a July 17, 2007 letter, the SEC advised Office Depot it was "conducting an inquiry" to determine whether the securities laws had been violated, and requested certain information from Office Depot "on a voluntary basis." Office Depot opted to voluntarily cooperate by providing documents and making its employees and officers available for sworn testimony. On July 31, 2007, the SEC requested that Office Depot preserve the records of numerous employees and offices, which it identified by job title.

 

Office Depot forwarded the letter to its insurers. Office Depot’s primary insurer accepted the letter as a "Notice of Circumstances" that may give rise to a claim.

 

In addition, in July 2007, before it received the SEC’s informal inquiry, Office Depot received an internal whistleblower letter raising concerns relating to the timing of recognition of Office Depot’s vendor rebate funds. Office Depot self-reported the whistleblower allegations to the SEC, which expanded its inquiry to include the whistleblower allegations. The company’s audit committee conducted its own investigation of the allegations, retaining lawyers, accountants and consultants for those purposes. The internal investigation resulted in Office Depot’s restatement of its 2006 financial statements.

 

In November 2007, two shareholder derivative lawsuits and two securities class action lawsuits were filed against the company. The shareholder suits alleged misrepresentations in connection with the company’s financial reporting of vendor rebates. In January 2010, the defendants’ motions to dismiss the securities class action lawsuit were granted. The dismissal is now on appeal. The plaintiffs in the derivative lawsuits voluntarily dismissed those cases.

 

In January 2008, the SEC issued a formal "order directing private investigation" and during the course of 2008 subpoened the company and at least eight current and former Office Depot officers and directors, including several who previously voluntarily testified. The notice did not name any individuals as wrongdoers. In November and December 2009, the SEC issued Wells notices to three Office Depot officers. In December 2009, the company reached an undisclosed settlement with the SEC staff.

 

Office Depot requested reimbursement from its D&O insurers of the over $23 million the company had incurred in responding to the SEC, indemnifying individuals against defense expenses, and conducting an internal investigation of the whistleblower allegations.

 

The primary carrier acknowledged its obligation to reimburse Office Depot for defense costs incurred by officers and directors after having been served with SEC subpoenas and Wells notices, and for the costs incurred in the four securities lawsuits. However, the approximately $1.1 million of acknowledged expenses did not exceed the policy’s $2.5 million retention. The primary insurer denied coverage for the other expenses, and Office Depot filed an action alleging breach of contract and seeking a judicial declaration of coverage. Office Depot’s excess D&O insurer intervened the action.

 

The parties filed cross motions for summary judgment.

 

The October 15 Ruling

The insurers argued that there is no coverage for Office Depot’s costs incurred in voluntarily responding to the SEC’s investigation and for the costs of Office Depot’s internal investigation of the whistleblower allegations because the costs did not arise either because of a "Securities Claim" against Office Depot or a "Claim" against an insured director or officer. All policy references below refer to the language of the primary policy.

 

The policy’s definition of Securities Claim contains threshold language that excludes from the term "an administrative or regulatory proceeding against, or investigation of, an Organization." However, the definition contains a "carve back" which specifies that the term Securities Claim "shall include an administrative or regulatory proceeding against an Organization, but only if and only during the time that such proceeding is also commenced and continuously maintained against an Insured Person."

 

Judge Marra found it significant that the threshold language excluded coverage for "an administrative or regulatory proceeding against, or investigation of" an Organization, but the carve back preserving coverage refers only to "an administrative or regulatory proceeding" – and thus the carve back does not refer to "an investigation" as does the threshold language. Judge Marra concluded that "the carve-back clause does not restore coverage for ‘an investigation of’ the Organization"

 

Judge Marra also found the policy’s definition of "Claim" distinguishes between "a proceeding for relief" and an "investigation of an insured person," specifying that an investigation constitutes a "Claim" only once the insured person has been notified in writing that he or she may be a target or after service of a subpoena.

 

In addition, Judge Marra rejected Office Depot’s argument that the term "proceeding" was broad enough to encompass the SEC’s informal and formal investigation of Office Depot. In reaching this conclusion, Judge Marra referenced the policy’s distinction between "proceedings against" and "investigations of" insured persons and organizations. Judge Marra said this distinction can only be given "any meaning" by giving the term "proceeding" its "plan meaning," which he defined as "a formal legal action or hearing conducted in a court of law or some official tribunal."

 

Judge Marra concluded therefore that the company’s costs of voluntarily responding to the SEC do not represent "loss of the Organization arising from a Securities Claim."

 

Judge Marra also concluded that the voluntary, pre-subpoena costs incurred on behalf of the individual directors and officers were not incurred in connection with a "Claim." In reaching this conclusion he specifically referenced the trigger required to bring an "investigation" within the definition of "Claim."

 

Office Depot had argued further that the policy’s "relation back" language brought all of the pre-claim costs within coverage when the claims finally did emerge. Office Depot made this argument in reference to the language in the policy’s notice provisions which provide that when a policyholder provides a notice of circumstances that could give rise to a claim, and a claim subsequently arises, the claim relates back to the time of the original notice.

 

Judge Marra ruled that the "relation back" language pertained solely to the question of when a "Claim" is first made for purposes of determining the appropriate claims made policy period. The relation back language, Judge Marra said, "simply serves to identify the policy period in which the ‘subsequent Claim’ was made; it does not operate to expand the Policy definition of ‘Claim’ to absorb any allegations of wrongdoing which happen to be related or similar to the wrongdoing described in the insured’s original Notice of Circumstances."

 

Judge Marra also rejected Office Depot’s related argument that the November 2007 securities lawsuit "relate back" to provide coverage for the company’s internal investigation. The company had argued that because the subsequent lawsuits were "subsequent claim," the Policy’s "relation back" language brought under the Policy’s coverage all defenses expenses incurred from the date of the Notice of Circumstances.

 

Judge Marra said that even if the securities suits were "subsequent claims" that relate back for notice purposes to the date of the original notice of circumstances, "it does not follow that any pre-suit investigation costs which may have related to and benefitted the defense of those suits…are transformed into a covered ‘loss’ which ‘arises from’ that securities litigation."

 

Finally, Judge Marra held that the Policy’s definition of covered Loss does not include the costs of investigating potential or anticipated claims, rejecting Office Depot’s argument that those costs are "arising from" the defense of a claim. He found that the "arising from" phrase "connotes a sequential relationship" between the Claim and the Loss that "arises from it" – that is, Loss that "follow sequentially in time." He said that covered loss "does not include related pre-suit or pre-claim investigation costs, regardless of how ‘related’ or ‘beneficial’ those costs may have ultimately proved to be in defending against the claim which ultimately materialized." He added that "while these costs may well have reasonably been incurred in contemplation of anticipated or potential litigation, that is not enough to meet the Policy’s requirement that the ‘resulted solely from’ the investigation or defense of a Claim."

 

UPDATE: In a subsequent October 27, 2010 order (here), Judge Marra rejected Office Depot's further assertion, based on the prior order, that the company was entitled to insurnace payment for all costs the company incurred in responding to the SEC after November 5, 2007, the date on which the first of the shareholder lawsuits was filed.

In his October 27 order, Judge Marra said that volunarary SEC response costs the company incrred after the shareholder suit was filed "may have followed the securities lawsuit sequentially in time, they did not 'grow out of' or 'flow from' the subject lawsuits, and therefore did not 'arise from'" those suits. Judge Marra added that even though the comany incurred SEC response costs after the shareholder suit was filed, that "does not transform the post-suit SEC response costs into covered 'Loss" ... even though some of those response costs may have been related to or had utility in Office Depot's defense of the securities lawsuit."

 

Discussion

Judge Marra’s analysis and conclusions are a direct reflection of the specific language at issue in the Office Depot case, and his analysis might or might not produce the same or similar outcome under different policy language. He seemed particularly persuaded that Office Depot’s primary D&O policy draws a clear distinction in how the policy responds to "investigations" on the one hand and "proceedings" in the other.

 

That said, Judge Marra’s analysis is quite detailed and represents a very thorough examination of what policyholders are entitled to under the policy before an investigation ripens into a formal administrative or regulatory proceeding. The opinion also represents a detailed examination of what insurers are responsible for before a claim has been made under the Policy.

 

Insurers will undoubtedly welcome this decision and will attempt to rely on it in other cases. As a district court opinion, the decision has limited precedential value, but the insurers will seek to rely on the decision for its persuasive value. The extent to which other courts will follow Judge Marra necessarily will depend on the policy language at issue in the other cases. Indeed, Judge Marra himself rejected Office Depot’s attempt to rely on prior decisions in which courts had held that an "investigation" is a "proceeding," stating that the policies involved in those other cases involve different language.

 

Notwithstanding Judge Marra’s decision, policyholders will continue seek coverage for defense costs incurred in informal investigations and for internal investigation, particularly where distinctions in policy language would seem to justify a different outcome. The sheer dollar costs involved alone (see, e.g., Office Depot’s $23 million in expenditures) ensure that policyholders will continue to agitate on these issues.

 

Given the perennial nature of these issues, the question arises of what are the practical lessons of Judge Marra’s opinion. The most important lesson seems to be that the policy’s wordings of "Securities Claim" and "Claim" are very important and the specific wording used with relation both to "investigations" and "proceedings" can be critically important. A particularly important issue for insurance buyers and their advisors to keep in mind is that a court may differentiate "regulatory and administrative proceedings" on the one hand and "investigations" on the other hand, and it is critically important to analyze coverage with respect to these two sets of considerations separately.

 

One final note relates to Judge Marra’s analysis of whether pre-claim defense expenses may be said to be "arising from" a subsequent claim. Judge Marra reduced this analysis to a question of temporal relation, in effect concluding that any particular item of defense expense can only "arise from" a claim if it comes later in time. I am not sure this analysis takes into account all of the possibilities, In particular, there are occasions when defense expenses are incurred earlier that would inevitably have been incurred later, the argument being the expenses "would have been incurred in any event" and the fact that they were incurred prior is an accident of timing. Arguably, Judge Marra’s analysis is not (or perhaps fairly ought not to be) preclusive of this argument. (Please refer to the Update above for further on this point).

 

It is probably worth noting that there have been recent innovations introduced into the D&O insurance marketplace designed to try to provide coverage for certain preclaim expenses incurred by or on behalf of individual directors and officers. The most recent formulations would not address the pre-claim expenses or internal investigative expenses of the insured entity itself, but it would at least provide direct or reimbursement coverage for costs incurred by or on behalf of individuals before a "Claim" has emerged.

 

　

These issues surrounding informal inquiries and internal investigations raise many points of contention, and policyholders and their insurers will continue to struggle with these issues. It seems probable that insurers facing these disputes will attempt to rely on Judge Marra’s opinion.

 

Special thanks to Steve Brodie of the Carlton Fields law firm for providing me with a copy of Judge Marr’s opinion. The Carlton Fields firm represented the primary insurer in the coverage litigation.

 

For discussion of a recent decision in which a court held that there was coverage under a D&O insurance policy for investigative expenses of a special litigation committee, refer here.

 

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the sixth in the series, I examine the range of D&O insurance policy exclusions. Though some exclusions are found in most D&O insurance policies, others appear only occasionally , while yet other particular exclusions may only appear in specific policies or specific kinds of policies. For purposes of analysis, I have tried to group the various kinds of exclusions in separate categories below.

　

As a preliminary matter, it is important to note that while generalizations are possible about the kinds of exclusions that may appear in "most" or "many" policies, there are always exceptions. For example, one type of D&O policy, the so-called Excess Side A/DIC policy, often has fewer exclusions than the traditional D&O policies. In addition, more recently introduced D&O insurance policies may have different or narrower exclusions that are found in the typical policy. D&O insurance policies for financial institutions often have exclusions relating specifically to the type of financial activity in which the institution is engaged.

 

Any attempt to try to identify all of these exclusions and exceptions would be far beyond the scope of this post. For purposes of this introductory overview, I have limited my observations to what generally is the case, and in most cases, my observations relate to traditional D&O insurance policies.

　

Exclusions to Define the Policy’s Relation to Other Policies: In order to avoid overlapping policies or duplicate coverages, most D&O policies contain exclusions providing that coverage is precluded for matters that have been reported or the subject of notice under other policies. Consistent with the claims made nature of D&O policies, many policies also include exclusions precluding coverage for litigation that was pending prior to the policies inception.

　

Exclusions to Fit the Policy with Coverage Afforded by Other Types of Insurance: D&O insurance policies are built with the presumption that it is just a part of the policyholder’s overall program of insurance. With that in mind, most D&O policies contain exclusions to preclude coverage for claims that are typically covered by other types of insurance. Thus, most policies contain exclusions for loss arising from claims arising from bodily injury or property damage, as those hazards are typically insured under Commercial General Liability Insurance (CGL) policies. Similarly, most D&O policies exclude coverage for claims under ERISA and similar laws, as those claims typically would be covered under Fiduciary Liability Insurance policies.

　

Catastrophic Hazards: Many policies include separate exclusions for loss arising from catastrophic hazards, such as nuclear events, environmental damage and war. Some of these exclusions, particularly the environmental damage exclusion, will often have coverage coverage carve backs for shareholder claims or for loss for which the company is unable to indemnify individual directors and officers. In addition, in the wake of the events of September 11, 2001, and in compliance with the Terrorism Risk Insurance Act (TRIA), many policies will also contain specific provisions relating to acts of terrorism.

 

Refer here for an example of a coverage dispute arising in connection with the question whether or not a D&O policy’s pollution exclusion precluded coverage for a shareholder claim alleging pollution related misrepresentations and omissions.

　

Conduct Exclusions: Most D&O policies contain one or more exclusions precluding coverage for certain types of conduct. The conduct exclusions typically preclude coverage for two categories of conduct: first, for loss relating to fraudulent or criminal misconduct; and second, for loss relating to illegal profits or remuneration to which the insured was not legally entitled.

　

These exclusions can often have subtle wording differences that can significantly affect the availability of coverage. The most important wording variant is with respect what is required in order for the exclusion to be triggered. In recent times, these provisions usually require a prior "adjudication" that the precluded conduct has actually occurred in order for the exclusion to be triggered. Different variations of the adjudication requirement may require the adjudication to take place in the underlying claim, while other exclusions may allow the determination to be made in a separate proceeding (such as a declaratory judgment proceeding).

 

Another important aspect of these exclusions are the accompanying provisions defining when one insured person’s conduct may be attributed to another person or to the insured entity. In more recent times, many policies restrict the imputation of conduct among insurerds – policies with these provisions are said to have "full severability of conduct."

 

An example of a recent case illustrating the importance of the precise wording of the adjudication trigger in the fraud exclusion can be found here.

 

Insured vs. Insured Exclusion: Most D&O policies have exclusions precluding claims brought by one insured against another insured, in order to preclude coverage for collusive claims and for infighting among senior corporate officials. The Insured vs. Insured exclusion typically includes numerous exceptions (or "carve backs" as they are usually called). The exceptions preserve coverage for derivative claims, cross claims, certain employment practices claims, and claims brought by bankruptcy trustees.

　

The Insured vs. Insured exclusion (often referred to as the I v. I exclusion) has evolved over time, and so there are many variants both to the exclusion and to the carve backs. As others have noted (refer here), the Insured vs. Insured exclusion continues to be heavily litigated and is often at the heart of many coverage disputes. Insured vs. Insured disputes can often arise in the context of corporate bankruptcy, as noted here. More recently, whistleblower provisions in the Sarbanes Oxley Act and the Dodd-Frank Act have also potentially raise Insured vs. Insured concerns, if the whistleblower is also an insured person. Many insurers will agree to Insured vs. Insured exclusion carve backs designed to preserve coverage for whistleblower claims.

　

Particular Circumstances: In the course of insurance acquisition process, it sometimes happens that the insurance underwriter will identify a specific circumstance or event that represents a risk the underwriter is unwilling to accept. In that event, the underwriter will sometimes insist on an exclusion precluding coverage for the event or circumstance. While these kinds of specific event (or "laser" exclusions as they are sometimes called) are not uncommon, the typical insurance buyer that has an alternative will try to acquire a policy without the event exclusion.

　

Private Company D&O Insurance Policy Exclusions: As discussed in the preceding post in this series, the entity coverage available in a private company D&O insurance policy is quite a bit broader than the entity coverage in a public company D&O policy. In a public company policy, the entity coverage extends only to securities claims. The entity coverage available under a private company policy is not so restrictive, and in fact is quite comprehensive.

 

In order to protect themselves from the breadth of claims that otherwise might come within the entity coverage, many private company D&O insurers will include a number of exclusions applicable solely to the entity coverage. Some examples of entity coverage exclusions of this type include the contract exclusion (about which refer here), an exclusion precluding coverage for intellectual property claims, and an exclusion for antitrust and other competition related claims.

 

The antitrust or competition exclusion is not found in all private company D&O policies, and many insurers will remove or at least modify the exclusion upon request. There are a very limited number of insurers who insist on retaining this exclusion or at most allowing only defense cost coverage. In the current competitive insurance environment there are usually private company D&O insurance alternatives available that do not include the antitrust exclusion.

 

Since private company D&O insurers do not want to include the risks associated with public securities trading, most private company policies contain exclusions relating to public securities offerings and trading. It is important for these exclusions to be worded appropriately so that they do not preclude coverage for activities that might take place in advance of a planned public offering. If the planned offering does not go forward, the private company policy will have to respond to any claims, so it is important that the wording of the exclusion contemplates that possibility.

 

Miscellaneous and Anachronistic Exclusions: As the exclusion involved in the Stanford Financial coverage dispute demonstrates, there a many other kinds of exclusions out there in the insurance marketplace, some of them quite unusual. Among other exclusions that sometimes appears is the so-called "bump up" exclusion, precluding coverage for additional amounts paid to investors claiming inadequate consideration in a corporate buy out situation (about which refer here).

 

There are a host of other exclusions that have been around for a long time but that you just don’t see that much any more. An example of this kind of exclusion is the "failure to maintain insurance" exclusion (or FTMI exclusion, as it sometimes is called), precluding coverage for claims against corporate officials based on their negligent failure to obtain or maintain insurance.

 

Another example of this type of exclusion is the old "Commissions" exclusion The commissions exclusion, as typically worded, precludes coverage for loss incurred in connection with any claim "alleging, arising out of, based upon or attributable to payments, commissions, gratuities, benefits or any other factors to or for the benefit of" an agent or employee of any foreign government.

 

This exclusion was instituted after the Foreign Corrupt Practices Act was enacted in the late 70s. The exclusoin has largely fallen into disuse since that time, although you still see it on some policies from time to time. As discussed at greater length here, in an era of heighted FCPA enforcement activity, the Commissions exclusion is highly undesirable from the policyholder’s perspective.

 

As I noted at the outset, D&O insurance policies for companies in the financial sector sometimes contain exclusions particularly relevant to claims and exposures associated with the companies’ specific activities. An example of this kind of exclusion is the so-called regulatory exclusion sometimes found on policies issued to commercial banks. This exclusion became relative rare in the mid-90s and until recently, but as the number of failed banks began to rise a couple of years ago, the exclusion began to reappear in at least some commercial banks’ D&O insurance policies. Refer here for a brief overview of the regulatory exclusion.

　

A Final Note about Policy Wording: One final note is that language accompanying the exclusions can often be critically important. As discussed here, some exclusions are preceded by all-encompassing omnibus language, precluding all loss "based upon, arising out of, or any way relating to" the excluded conduct or matter. In other instances, the exclusion is preceded only by the more limited "for" preamble. The broader preamble can substantially expand an exclusion’s preclusive effect, and accordingly it is critically important to consider not only what exclusions a policy contains, but also how the exclusions are worded and what terms and conditions accompany the exclusions.

 

Towers Watson Survey 2010: The 2010 version of the Towers Watson survey is underway, but the window is closing soon. This survey, which so many of us in the industry depend upon, queries companies about liabitliy issues and D&O insurance questions. Because we all depend on the survey results, and because the more survey responses the more complete the survey results will be, we all have an interest in as many respondents as possible completing the survey.

 

The survey, the questionnaire which can be accessed here, will close Friday October 22, 2010, so please have your clients and companies complete the survey form.

　

Prior Installments in the D&O Nuts and Bolts Series: Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:　

　

 

 

 

Executive Protection: Indemnification and D&O Insurance – The Basics　　

 

 

 

　

 

 

 

Executive Protection: D&O Insurance – The Insuring Agreement

　

Executive Protection: D&O Insurance—The Policyholder’s Obligations

　

D&O Insurance: Executive Protection – The Policy Application

　

Executive Protection: Private Company D&O Insurance

 

 

 

 

 

 

　

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fifth in the series, I examine D&O insurance issues of particular concern to private companies. Both the potential liability exposures and the available insurance solutions for private companies and their directors and officers are quite a bit different than for public companies.

 

Why Should Private Companies Buy D&O Insurance?

Most public companies don’t need to be persuaded that their company needs D&O insurance. Public company executives generally understand that D&O insurance is an indispensible prerequisite for a company whose securities are publicly traded.

 

However, the view among at least some private company managers is different. These officials, particularly those at very closely held companies, feel they are unlikely to need the insurance because, they believe, they are unlikely to ever have a D&O lawsuit. In my experience, just about every company that has ever had a claim was quite sure, before the claim arrived, that they would never have a claim. Executives who have survived a claim know better; too many company officials find out the hard way that when they recognize they need the insurance after all, it is too late. The fact is, the right time to buy the insurance is when you think you don’t need it.

 

Many of those who resist the need for D&O insurance are affiliated with companies that have only a very small number of shareholders. These company executives look at the ownership structure and conclude their company could never have a D&O claim. This perspective overlooks the fact that the plaintiffs in D&O claim include a much broader array of claimants than just shareholders. D&O claims plaintiffs also include customers, vendors, competitors, suppliers, regulators, creditors and a host of others. In our litigious age, just about anybody is a prospective claimant.

 

And when a company has claim, expenses mount quickly. Even frivolous suits can be expensive to defend and resolve. At the same time, the cost of insurance to protect private companies against D&O claims is relatively low. Indeed, the incremental costs of private company D&O insurance, on top of the company’s employment practices liability insurance (and no entity should do business in this country without EPL insurance) is relatively slight.

 

For the relatively low cost, private company D&O insurance buyers obtain coverage that is quite broad. Private company D&O insurance policies are materially broader than D&O insurance for public companies. In particular, the entity coverage under a private company D&O policy is significantly broader than the entity coverage under public company D&O insurance policies. The entity coverage in public company D&O insurance policies is generally limited just to securities claims. However, private company D&O policies contain no such limitation, so the private company D&O insurance policy provides significant balance sheet protection for the insured entities.

 

Because the private company D&O insurance policies provide broad coverage at relatively low cost it should be a part of every private company’s risk management portfolio – not just private companies with a broad ownership base.

 

Combined or Separate Limits?

A recent D&O insurance innovation is the development of modular management liability policies. These permit various management liability coverages to be combined in a single policy. The typical modular policy consists of a declarations page (identifying the limits of liability and the policy period, and so on), a general terms and conditions section applicable to all of the separate coverage parts, and then separate coverage parts for each of the various management liability coverages (such as D&O, EPL, Fiduciary, Crime, etc).

 

These modular policies have become quite popular. They do have certain advantages. The first is that the policies simplify the management liability insurance acquisition process by reducing what would otherwise be a series of discrete transactions into a single insurance transaction. The modular structure also ensures that the various coverages are coordinated, which could be important in the event of a claim the straddles several coverages.

 

The modular structure does present questions with respect to the limits of liability. Many buyers, attracted by the convenience of multiple coverages combined in a single policy are also attracted by the possibility of combining the limits of liability for the various coverages into a single, combines aggregate limit, under which a claim payment under any of the various coverages would reduce the amount of insurance remaining for a separate claim under any of the coverages.

 

There is no doubt that combining the limits of liability into a single aggregate limit affords costs savings for the buyer. For some insurance buyers, particularly very small enterprises, the cost saving consideration justifies the decision to structure the insurance into a single aggregate limit.

 

For most other enterprises, however, the combination of all of the coverages into a single limit may be a poor choice. A combined limit presents the possibility that a prior claim might reduce the amount of insurance available for a later, more serious claim. The fact is that when things go wrong, multiple problems can arise at once.

 

My greatest concern is that a prior unrelated claim against the company might leave company executives with insufficient remaining insurance to protect them if a separate claim later arises against them as individuals. This concern is particularly applicable in the bankruptcy context, in which company indemnification is unavailable. The executives could be left without insurance or with insufficient insurance at the time when they need it most.

 

I am Old School on this issue. I have a bias in favor of separate limits for the separate coverages, because I believe that there should be a fund of insurance available to protect the individual executives, without a concern that entity claims might drain the insurance away. Of course, as noted above, cost considerations may nevertheless dictate that some small enterprises will purchase combined limits. But most insurance buyers should not allow relatively small premium differences to drive important insurance decisions, potentially leaving the company with insurance that might not afford sufficient protection with the hour of need arises.

 

Duty to Defend or Duty to Indemnify?

Public company D&O insurance is written on reimbursement basis, based on the insurer’s duty to indemnify the insured company for its defense expenses and claim resolution costs. Under this duty to indemnify type of coverage, the insureds select their defense counsel, subject to the insurer’s consent, and the insureds control the claim. The insurer reimburses the insureds for these costs.

 

Private Company D&O insurance is also often written on a duty to indemnify basis. In addition, however, private company D&O insurance is also sometimes written on a duty to defend basis, under which the insurer selects the defense counsel and controls the defense. Many private company D&O insurance carriers offer their prospective insureds the choice of whether or not the coverage will be written on a duty to indemnify or a duty to defend basis.

 

There are certain advantages to the duty to defend structure. The first is ease of administration. Under the duty to defend coverage, the carrier appoints defense counsel and takes care of managing the claim. The policyholder doesn’t have to deal with legal bills and so on. This can be particularly helpful for smaller and more routine claims. In addition, the counsel the carrier selects often are experienced with these kinds of claims, which can also contribute to smoother claims resolution.

 

Another advantage of duty to defend coverage is that, in general, if any part of the claim is covered, the insurer must defend the entire claim, even those parts of the claim that are not covered. This unified defense avoids what can be a recurring problem under a duty to indemnify policy when a claim encompasses both covered and uncovered matters; in that circumstance under a duty to indemnify policy, the defense costs must be allocated between the covered and uncovered matters and the insurer reimburses only the defense expenses associated with the covered matters (often only a percentage of total defense expenses). The process of determining the allocation can be contentious and disruptive at a time when the insured and the insurer ought to be trying to work together to resolve the claim.

　

But despite these advantages of the duty to defend coverage, there may be times when duty to defend coverage is not the best choice. In particular, many policyholders are not comfortable having the insurer’s counsel defending a claim. This may be particularly true with more serious and more sophisticated litigation, which some insureds feel are outside the capabilities of some insurer-selected defense counsel. Also, although the topic involves issues far beyond the scope of this blog post, a host of issues arise when the insurer is defending a claim subject to a reservation of rights to deny coverage for any settlements or judgments.

 

There are no absolute answers to the question whether the D&O coverage should be written on a duty to defend or a duty to indemnify basis. It is a question each insurance buyer must decide in consultation with their insurance adviser.

 

One innovation the D&O insurance industry has introduced in recent years is an optional duty to defend policy, which gives the policyholder the option of tendering the claim defense to the carrier at the outset of the claim. The advantage of this arrangement is that it allows the policyholder to let the carrier handle the smaller or more routine matters, while allowing the company to select its own counsel and manage its defense on more significant matters or matters of greater concern to the company.

 

Public Offering Exclusion

The critical distinction between private and public companies is that public companies have publicly traded securities and private companies do not. Private company D&O insurers do not intend to cover exposures arising from the issuance or subsequent trading of publicly traded securities, and so private company policies typically have a public offering exclusion.

 

One particular concern with this exclusion is that it should not be written so broadly that it would preclude coverage for claims arising from pre-IPO activities. If a company is preparing to go public, the company and its senior executives undertake a variety of activities that may create potential liability exposures. If the company ultimately goes public, the public company D&O insurance policy, put in place on the offering date, should pick up coverage for all claims arising from the offering related activities. However, if the company does not complete the offering and claims result, or if offering activity claims arise prior to the offering date, then private company policy is the one that will respond to the claims.

 

Because of the heightened claims exposure associated with pre-offering activities, it is critically important that the public offering exclusion is worded in a way to afford coverage for these kinds of claims. Unfortunately, this is an area where there is a significant and serious lack of uniformity in available wordings, and many of the wordings available are not well-designed to provide the full extent of coverage needed. For example, many carriers, in an attempt to address this concern, will include a so-called "roadshow carve back" from the securities offering exclusion. These wordings, while helpful, are not sufficient to address all of the potential pre-IPO exposures, because pre-offering problems might arise that have nothing to do with the roadshow.

 

The concerns arising in connection with coverage for pre-IPO activities is a good illustration of the unavoidable fact that even with respect just to private company D&O, it is critically important for insurance buyers to associate knowledgeable and experienced insurance advisors in the insurance acquisition process. Otherwise the insured could wind up with D&O insurance coverage that is not well suited to the company’s needs and exposures, and that does not reflect the best coverage available in the marketplace.

　

Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:　

　

 

Executive Protection: Indemnification and D&O Insurance – The Basics　

 

　

 

Executive Protection: D&O Insurance – The Insuring Agreement

　

Executive Protection: D&O Insurance—The Policyholder’s Obligations

　

D&O Insurance: Executive Protection – The Policy Application

　

 

 

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In a series of posts, I have been exploring the "nuts and bolts" of D&O insurance. In this post, the fourth in the series, I examine issues surrounding the application for D&O insurance and the surrounding application process. Although this might seem like a pretty straightforward topic, there are actually quite a few issues involving the D&O insurance application.

　

The Policy Definition of "Application"

As with most insurance, D&O insurers usually require insurance applicants to complete an insurance application as part of the insurance acquisition process. The D&O insurance application is of course a physical document – but it is not just a physical document. The term "application" is usually defined to comprise several categories of materials beyond just the physical document.

　

The term "application" is often defined broadly to include all prior applications the applicant previously submitted; all materials submitted with the application; and, in the case of public companies, all documents filed with the SEC or equivalent regulatory bodies. These policy definitions of the term "application" are sometimes unnecessarily overbroad and need to be narrowed to avoid sweeping in an entire universe of information that has no reasonable relationship to the actual application process. For example, many carriers will agree to revise the category of publicly filed documents to be included within the "application" to be narrowed to documents filed within the preceding twelve months.

 

The Application Form Itself

With respect to the physical application document itself, there is a further question of which application form an insured appropriately may be asked to complete and submit. Specifically, there is an important difference between the questions that appropriately may be asked when new coverage is being placed (or increased limits are being procured), compared to what appropriately may be asked when existing coverage is being renewed.

 

When new coverage or increased limits are being put in place, the insurer appropriately can ask the so-called "warranty question" – that is, whether the applicant is aware of any fact, situation or circumstances that might reasonably be expected to give rise to a claim. (The actual wording of the representation required varies among insurers and applications.) Any matters disclosed pursuant to the warranty statement will be excluded from coverage.

 

Because the policyholder is entitled to expect complete continuity of coverage in successive policy years, the warranty question emphatically is not appropriate in connection with the renewal of existing coverage.

 

Unfortunately, process participants sometimes use applications including the warranty question even in connection with renewals of existing coverage. The problem with providing an answer to the warranty question on renewal is that it potentially can provide the carrier with a basis on which to try to disclaim coverage, when the question should not even have been asked or answered in the first place. (In a previous post, here, I discussed a case in which a carrier successfully relied on this defense to disclaim coverage, in a situation where it fairly may be asked whether the policyholder should have answered the warranty question in the first place.)

 

Application Misrepresentations and the Consequences

This whole question of the carrier seeking to rely on application responses to disclaim coverage leads to the larger question of policy rescission – that is, the question of when the carrier may, on the basis of alleged material misrepresentations in the policy application, seek to have the policy declared void ab initio – that is, as if it had never been put in place. There are several components of this question, each one raising important considerations in connection with the wording of key policy terms and conditions.

 

The first issue of course is what the application consists of, as noted above. The second question is whose alleged misrepresentations may be relied on by the carrier and against whom may they be used.

 

The Representations Clause

Many policies will specify in a representations clause whose knowledge of the mispreresented facts will result in a vitiation of coverage. For example, the policy might specify that if certain top company executives are aware that application statements were untrue, then coverage will not apply to those executives or to the company. Because the operation of the representaitons clause could void coverage for the company, it is critical that the group of persons who knowledge will void coverage for the company be restricted and as narrow as possible, preferably just the CEO, CFO and General Counsel.

 

Nonimputation and Severability

Two related issues pertain to questions of imputation and severability. The question is basically whether one individual’s knowledge will be imputed to the company or to other individuals. As noted in the preceding paragraph, certain officials’ knowledge will be imputed to the company. But ideally, the policy terms will be structured so that no individual’s knowledge is imputed to another individual – or to put it another way, that each individual’s knowledge is severable from that of other individuals. (Please see the note below discussing the difference between this type of severability – that is, application severability – from a different type of severability that may arise under the D&O policy—that is, exclusion severability).

 

The inclusion within the policy of a provision of so-called "full severability" (that is, the specification that no individual’s knowledge will be imputed to another individual for purposes of determining the effect of an application misrepresentation) is critical in order to ensure that coverage for innocent insureds remains unimpaired.

 

Policy Rescission and Claim Exclusions

The final question that should be asked about policy provisions pertaining to application misrepresentations is the issue of what the consequences of an application misrepresentation will be. As noted above, absent policy provisions providing otherwise, the carrier may seek to rely on application misrepresentations as a basis on which to rescind the policy. From the policyholder’s perspective, policy rescission is highly undesirable on many levels, not least of which is that the voiding of the policy means not only that coverage will be unavailable for the specific matter at hand, but also for any and all future matters that might arise.

 

In light of this latter consideration, many carriers will agree to amend their policies so that in the event of an alleged application misrepresentation, policy coverage is unavailable only for persons aware of the misrepresentation and only with respect to claims pertaining to the allegedly misrepresented matter. This formulation allows for the possibility that coverage might be available for future matters that might arise, even if it is not available for certain persons in connection with the immediate matter at hand.

 

Non-rescindable Policies

In addition, in many instances, carriers are willing to incorporate provisions specifying that the policy is nonrescindable. In some cases, the policy may provide that it is nonrescindable only as to Side A coverage (that is, the coverage protecting the individuals in the event that corporate indemnification is unavailable due to insolvency or legal prohibition). In other cases, the policy may be fully nonrescindable.

 

Completing the Application and Polling the Board

As noted above, there are times when it is undeniably appropriate for the carrier to ask the warranty question. The issue for the applicant company is how to answer the question in a way that will need lead to problems down the road. The applicant obviously wants to make sure that all known circumstances are disclosed, so that coverage is not later impaired if it later turns out that there were known circumstances that were not disclosed.

 

In order to address this issue, the applicant company should poll its senior executives and board members, in a process that communicates the importance of the inquiry. The polling process and responses to the survey should also later serve to substantiate the fact that the applicant company took reasonable steps to determine whether or not any person was aware of any fact, circumstance or situation.

 

Two Different Kinds of Severability

As noted above, in an appropriately structured policy, no person’s knowledge will be imputed to any other person for purposes of determining the scope and effect of any alleged misrepresentations. This non-imputation is sometimes referred to as "full severability." This type of application severability is separate and distinct from another type of severability that operates in many D&O policies.

 

That is, many D&O policies contain provision, typically at the end of the exclusions section, in which it is provided that for purposes of determining the operation of the policy exclusions, no individual’s conduct will be imputed to any other individual. This "exclusion severability" is analytically separate and distinct from "application severability" but the similarity of the names can sometimes be confusing. Both types of severability are critically important but they are dealt with in separate parts of the policy and they must be addressed separately.

　

Readers who would like to read the prior posts in this series about the nuts and bolts of D&O insurance should refer here:

　

　

 

 

 

Executive Protection: Indemnification and D&O Insurance – The Basics

 

 

 

　

 

 

 

Executive Protection: D&O Insurance – The Insuring Agreement

　

Executive Protection: D&O Insurance—The Policyholder’s Obligations

 

 

 

　

　

　

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If the number of out of office messages sent back when I sent out new blog post email notifications during August are any indication, many readers have been away for some or all of the past few weeks. I hope you saved the little paper umbrella from the fruity drink that you and your spouse shared on the terrace of the outdoor café and that you are still finding sand in your tennis shoes.

 

Sadly, the summer eventually ends and everyone eventually has to go back to school.

 

 

Now that you are back at your desk, you will want to get caught up, especially because while you were away, the blogosphere continued to gyrate, and The D&O Diary continued to publish new posts. Here’s just some of what you missed:

 

 

The Nuts and Bolts of D&O: I have now published three installments in my ongoing series about the nuts and bolts of D&O insurance, the latest of which relates to the policyholder’s obligations under the D&O policy. The prior posts in the series related to the relationship of indemnification and insurance, and to the insuring agreement in the Policy. Additional installments will be forthcoming in the weeks ahead.

 

 

Guest Posts: I have been delighted to be able to publish a number of interesting guest posts over the past several weeks.

 

 

First, I published, in the form of two separate posts (here and here), an interesting exchange between Milberg partner Michael Spencer and Minnesota Law Professor Richard Painter, on the question of the impact of the Morrison v. National Australia Bank case.

 

 

Second, I published a post from Jones Day partner John Iole on the topic of conflicts in the insurance transaction.

 

 

And finally, I published a post (here) written by former plaintiffs’ securities attorney Bill Lerach, who had some spirited comments about my prior post discussing an article by three academics about whether corporate defendants that settle securities suits suffering continuing financial detriments. I published the academics’ response to Mr. Lerach over this past weekend.

 

 

Failed Banks: The number of banks that have been closed as a result of the current failed bank wave continues to grow.  Indeed, according to the FDIC’s most recently quarterly report, one out of ten banks in the U.S. is a “problem institution.” The FDIC has filed its first lawsuit, as part of the current failed bank wave, against former directors and officers of a failed bank. Meanwhile, investor litigation involving failed banks continues to move forward. For example, in the PFF Bancorp and Banco Popular cases the dismissal motions were denied, although in the Raymond James loan loss reserve case the dismissal motion was granted. In the meantime, at least one investor lawsuit involving a troubled bank appears headed to trial. NERA has published a comprehensive report on failed bank litigation.

 

 

Subprime Cases: There have been a number of significant dismissal motion rulings in subprime-related securities cases, including the partial dismissal in the BofA/Merrill merger case and the dismissal in the SunTrust case. In addition, the New Century Financial case settled for about $125 million. My updated list of subprime and credit crisis-related lawsuit dismissal motion ruling can be found here.

 

 

Coming Attractions: Now that everyone is caught up, tomorrow morning I will be publishing my annual survey of the D&O marketplace, “What to Watch Now in the World of D&O.” Watch this site.

 

 

Speakers’ Corner: On September 29, 2010, I will be speaking at C5’s 5^th European Forum on D&O Liability Insurance in Cologne, Germany. I will be participating on a panel with Maurice Pesso of the White & Williams law firm on the topic “Why European Directors of U.S. Companies Should Worry About Their Exposure to U.S. Class Action Claims” – a topic that has changed pretty dramatically in the last few months. Information about the conference can be found here. I will look forward to seeing and greeting my European readers at this upcoming conference.

 

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The question of insurance coverage for the attorneys’ fees of Allen Stanford and his co-defendants is at issue in a three-day bench trial before Southern District of Texas Judge Nancy Atlas that began on Tuesday, August 23, 2010 in Houston.

 

Stanford and several other individuals have been criminally charged with financial fraud in connection with the collapse of the Stanford Financial Group. The criminal trial is set to commence in January 2011. Stanford and several of the other individuals are also defendants in an SEC enforcement action as well as numerous other civil proceedings.

 

Stanford Financial had $100 million in D&O insurance. The primary policy contains a money laundering exclusion that the insurers contend precludes coverage under the policies. The money laundering exclusion specifies that it does not apply "until such time as it is determined that the alleged act or acts did in fact occur."

 

In a January 26, 2010 opinion, Southern District of Texas Judge David Hittner entered a preliminary injunction prohibiting the insurers from "withholding payment" of defense expenses from four individuals (including Allan Stanford), as discussed here.　

 

In a March 15, 2010 opinion (about which refer here), the Fifth Circuit reversed and remanded the case to the district court, concluding that the money laundering exclusion’s "in fact" wording required a judicial determination to establish whether or not the exclusion had been triggered, but also concluding that this determination can be made in a separate proceeding such as a coverage action.

 

Based upon the trial that began on Tuesday in Houston, the court will determine whether or not the money laundering exclusion has been triggered, and therefore whether the insurers have any obligations to pay the defendants’ attorneys fees or other amounts on the defendants’ behalf under the policies.

 

According to news reports, there were a number of interesting developments in the first day of trial.

 

First, the lawyer for Laura Pendergest-Holt, Stanford Financial’s former Chief Investment Officer, told the court that Pendergest-Holt had entered a settlement with the insurers. The details of the settlement were not disclosured.

 

Second, in response to a question from Judge Atlas as to where the policy’s unusual definition of "money laundering" had originated, the lawyer for the insurers told the court that the language had been in prior policies through several renewals, but the language originally "been brought to the contract negotiation …by Stanford’s insurance broker." The insurers’ lawyer said that the insurer did not plan to offer a witness on the origins of the language.

 

Judge Atlas commented: "All I can say, it’s turning out not to be such a bargain."

 

Third, the witnesses are unlikely to testify during the coverage trial, given the risks that would entail for the criminal case. Judge Atlas said she will not determine yet whether she will draw an adverse inference about the individuals’ guilt from the individuals’ decision not to testify during the coverage case.

 

Finally, the insurers revealed that to date the insurers had advanced over $15 million dollars to pay for attorneys’ fees on behalf of the individuals and other insured persons under the policy.

 

Think Your Commute is Bad?: According to an August 24, 2010 Wall Street Journal article, a 60-mile traffic jam near Beijing "could last until mid-September." Traffic has been backing up since earlier this month due to construction on the Beijing-Tibet highway. Traffic is now backed up "almost all the way to Inner Mongolia."

　

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I am pleased to present below an article submitted by John Iole, a partner in the Insurance Recovery Practice of the Jones Day law firm. John notes with respect to his guest post that “the views expressed in this post are those of the author and not necessarily those of the firm or any of its clients.”

 

I welcome proposed guest post submissions from responsible persons on topics relevant to this blog or its readership. Please contact me if you think you might be interested in submitting a guest post.

 

 

I note that John’s post addresses conflicts of interest that may arise in connection with the D&O insurance policy. In addition to the conflicts John discusses in his post, an additional conflict that can arise under the D&O policy is a conflict between the interests of the non-officer directors and other persons insured under the policy. I discussed these conflicts involving non-officer directors in a prior post, here.

 

 

Here is John’s post.

 

 

D&O insurance rightfully attracts the scrutiny of highly-placed personnel at purchasing companies. Likewise, the placing brokers are specialists with broad and deep experience in this line of cover. Nevertheless, a recurring issue that is infrequently addressed is the balance of interests that must be struck each year at the time of D&O renewal. This issue can arise again at the point of a claim.[1]

 

 

            Several characteristics combine to create divergent interests among the parties involved in D&O coverage. First, standard D&O insurance is sold on an aggregate limits basis, meaning that the program limits in any given policy period are available for any and all claims made against the policy. With exceptions that are essentially immaterial, any claim made against a D&O policy will, to the extent it is paid, result in an erosion of the limits available to pay all other claims that are made during (or allocated to) that same policy period. This means that a claim that is paid today necessarily reduces the insurance limits available to pay another claim tomorrow.[2]

 

 

            The second -- and for present purposes the most significant -- characteristic of D&O insurance is the fact that there are multiple insured persons who stand to receive the benefit of the insurance limits available. Each insured person has a separate interest in maximizing the limits available to pay a claim that might be asserted against that individual (or entity). Because insurance is protection purchased today against the financial consequences of events that might take place tomorrow, each insured person has an interest in guarding against erosion of limits – this holds true even when no claim has been asserted or is expected. Of course, if claims are known to be likely (known risks, not known losses, which would be excluded), then each insured person has an even greater interest in making sure that expenditures are kept to a minimum in order to protect the availability of funds. In addition, some individuals might have a particularly acute sensitivity to the potential for claims. For example, a member of the audit or compensation committee might expect a higher incidence of claims than non-member insureds. Although many insurance contexts represent the situation in which payment of claims results in a consumption of limits, the multiple insured persons that exist in the D&O context creates a potential for conflict.

 

 

            A third complicating consideration is the interest of the entity in the case of a company that has cover under Side-B (reimbursement of the entity for claims paid on behalf of directors and officers) or Side-C (which provides coverage to the entity itself, generally for securities claims). Take the case of a claim asserted against a director or officer that falls within the Side-B cover, and the entity not only is permitted to indemnify the individual, but also is required as a matter of corporate by-laws and/or indemnification agreement to do so. In such a case, the entity will pay the individual’s legal expenses as they become due, and these can be significant. In addition, the entity will stand ready to pay any judgment (or settlement) that results on the merits of the claim. In turn, the entity can expect to be reimbursed by the D&O insurance proceeds for the amount outlaid on behalf of the individual.[3] The individual’s interests are protected by the entity’s funds, and the individual has no direct concern as to whether the entity is reimbursed. Thus, a Side-B claim presents a conflict situation that is similar to the straightforward competition for limits (or preservation of limits) that exists between any two directors or officers. In a Side-B context, however, the competition is between the individuals (as a whole) and the entity.

 

 

            The conflict is essentially the same when a Side-C claim is asserted, in that the entity’s consumption of limits in the defense or resolution of a covered claim likewise reduces the limits available for other purposes (such as payment of Side-A claims). One significant difference in Side-C claims is that, unlike Side-B claims, a Side-C claim does not present any retirement of individual liability, but only pays for the elimination of corporate liability. In the case of a Side-B claim, the entity is reimbursed only after the individual claims already have been paid, whereas Side C claims potentially put the entity at the front of the claims line.

 

 

            Additional conflicts arise when a D&O program is laden with coverage “enhancements” that branch out from the core purpose of D&O cover. These enhancements sometimes are offered as a way to add value to an expensive line of insurance. In this respect, it can be an alluring prospect to equip the D&O program with optional coverages with the idea that the entity is saving premium dollars that otherwise would be spent on separate policies. For example, some D&O programs include special coverages (or combined limits) for employment-related claims or fiduciary claims. This type of cover might take the place of separate Employment Practices Liability or Fiduciary coverage.[4] Similarly, some D&O programs provide Employed Lawyers coverage for in-house counsel when acting as a lawyer (as opposed to coverage for counsel acting as an officer of the company).[5] As with securities claims against Side-C cover, these coverage grants can result in claims that compete for limits with “standard” D&O claims. Moreover, these coverages can extend the scope of insured persons to a broad swath of employees.

 

 

            These conflicts are not necessarily insurmountable problems, but should be adequately recognized and harmonized within the overall D&O program. There are many ways to deal with these issues, both at the point of policy placement, and also at the point of a claim. For example, a potential solution to invoke at the time of placement is to purchase substantial limits so that the risk of complete exhaustion is minimized, but of course this will bring extra cost. Another time-of-placement solution is to purchase Side-A only coverage (either excess, or excess difference in conditions) that sits above the Side A/B/C cover and comes into play if the A/B/C cover is exhausted (but of course this does not eliminate the potential for conflicts among insured persons). Another option is to purchase stand-alone individual Side-A-only cover for particular directors and officers.

 

 

            So long as the policy language provides sufficient flexibility, different solutions can be used at the point of a claim in order to reduce competition for limits. If it appears that the program limits could be compromised by pending and expected claims, the potentially competing demands can be harmonized by an automatic or discretionary deferral of payments to the entity through an order of payments clause.[6] A problem with an automatic order of payments clause (e.g., a clause stating that side A claims shall be paid before side-B or side-C claims), however, is that it can only operate with respect to known and ripe claims.  If the policy also combines a discretionary feature that allows the designated person to direct when and how payments will be made, then a deferral can be invoked to preserve limits for pending claims that are not yet ripe for payment, or for potential unasserted claims.[7] Because of the delicate interests that must be balanced in such a situation, the designated decision-maker will play a critical role.

 

 

            Given the inherent conflicts facing the directors and officers (both inter se and as between the entity), an additional consideration confronts each lawyer or other professional involved in policy placement and negotiation -- namely, the interests that he or she is protecting, and the extent to which he or she is charged with representing conflicting interests. It is basic black-letter legal ethics law that a lawyer representing a corporation represents “the organization acting through its duly authorized constituents.”[8]

 

 

            In the context of D&O insurance, however, the representation analysis is complicated by the fact that the entity is providing coverage for the benefit of the individuals, and potentially also for its own benefit. In that setting, there are multiple potential clients – or at least acutely interested parties – who do not share identical interests. Furthermore, because the actual or potential conflicts of interest might not be fully appreciated by each of the affected persons, and the role of counsel might not be clearly understood, some statement of role clarification ordinarily will be prudent.[9] Nevertheless, a potential adversity of interests does not necessarily require separate legal representation. In the case of divergent interests among clients, the basic ethics rules still permit a multiple representation, so long as the lawyer reasonably believes that each client can be competently represented and each provides informed consent.[10] Although conflicts of interest at the time of placement have not generated reported disputes or case decisions, similar conflicts that arise at the point of a claim can produce major difficulties if the rules are not carefully observed.[11] 

 

 

            Therefore, when embarking on a representation involving D&O insurance that might affect multiple constituencies, the most prudent course to follow is to clearly define and limit (if necessary) the scope of the representation, and to obtain informed consent of each affected client if representation of more than one party is undertaken.[12] Another option is to make clear that some constituencies are being represented as clients and others are not being represented. In cases of particular risks or sensitivities, there is always the option to retain separate counsel to represent one or more constituents who are adverse to the others. Depending on the interests and jurisdiction involved, this potentially could be accomplished through separate lawyers from the same organization, or might require separate outside counsel.[13] In the end, there is no certain decision that is foolproof, but a consideration of these items, along with thoughtful guidance when appropriate, hopefully will yield the most prudent decisions that properly accommodate the different interests involved.

 

 

 

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My primary objective on this blog is to address important developments in with world of directors’ and officers’ liability as they occur. From time to time, however, readers contact me with more fundamental questions about executive liability and protection, particularly regarding the basics of indemnification and D&O insurance. In response to these recurring questions, I intend to prepare a series of posts, to be published intermittently in the weeks ahead, discussing these more basic issues.

 

This post is the first of the series and will address the basics about indemnification and insurance and how they interact.

 

Introduction

It is a basic fact of life in this day and age that individuals serving as corporate directors and officers face a significant litigation exposure. Claims are regularly brought against corporate officials on a wide variety of legal theories, including, for example, allegations of breach of fiduciary duty or of securities law violations. These lawsuits are expensive to defend and they also potentially expose the individual to significant personal liability.

 

Companies typically protect their executives from these legal expenses and liability exposures are through indemnification and insurance.

 

Indemnification

Corporate officials’ front line of liability protection is indemnification. This statutorily authorized protection is usually embodied in corporate documents such as articles of incorporation or by-laws, and generally encompasses the rights to both advancement of defense expenses and indemnification.

 

Corporate indemnification represents important protection for company officials, even for those at companies that purchase and maintain significant levels of D&O insurance. D&O insurance is subject limits of liability, whereas indemnification is theoretically unlimited (although, of course, practically limited by the indemnifying company’s financial resources). Indemnification is often very broad, often extending "to the maximum extent permitted by law", whereas D&O insurance polices contain numerous exclusions and conditions. In addition, D&O insurance must be renewed each year, with possible changes in terms and conditions. Indemnification rights are much less likely to be changed, particularly for corporate officials who negotiate their own indemnification contracts.

 

The company’s indemnification provisions specify the procedures individuals must follow in order to obtain indemnification. It is worth considering that indemnification questions often arise when at a time of corporate turbulence, which may complicate an individual’s efforts to obtain indemnification or advancement. A separate written indemnification provision can not only provide much greater procedural specificity but it can also provide certain protections against wrongful withholding of indemnification, by providing presumptions in favor of indemnification and providing for "fees on fees" (that is, fees incurred in order to enforce rights to advancement or indemnification).

 

Although corporate indemnification is broad, it is not unlimited. There are times when a corporation may not indemnify an individual – for example, there generally are limitations on a corporation’s ability to indemnify individuals found liable in shareholders’ derivative suits. In addition, insolvency may prevent a company from honoring its indemnification obligations.

 

D&O Insurance　

D&O insurance provides protection for company officials when corporate indemnification is not available, whether due to insolvency or legal prohibition. D&O insurance also provides a mechanism for corporations to be reimbursed when they do indemnify their executives.

 

The coverage provision in which the D&O policy provides individuals with insurance protection when indemnification is not available is commonly referred to as Side A coverage. The D&O insurance policy’s provision for reimbursement of a company’s indemnification obligations is referred to as Side B coverage.

 

In more recent years, many D&O insurance policies have also incorporated a Side C coverage as well, which provides insurance protection for the corporate entity’s own liability exposures. In D&O insurance policies for public companies, this Side C protection is usually limited just to the company’s liabilities under the securities laws.

 

Coverage B and C essentially operate as balance sheet protection for the company. Coverage B also provides a way for companies to contractually transfer their indemnification obligations to the insurer (subject of course to all of the policy’s terms and conditions).

 

Coverage A is essentially catastrophe protection for the individual executives. It provides a way to ensure that litigation protection is still available to them even if the company is financially unable to indemnify them or legally prohibited from doing so.

 

D&O insurance policies are generally built to complement other types of insurance that most companies carry. For example, D&O policies will typically exclude coverage for loss arising from bodily injury or property damage, because those exposures are addressed in the company’s general liability and property insurance policies. The D&O policy, by contrast to these other types of coverage, protects the insured persons from economic loss arising from claims made against the insured persons for wrongful acts in their insured capacities.

 

Many companies find that the amount of insurance available in a single policy of D&O insurance insufficient to provide adequate protection and so they purchase additional limits of liability through excess D&O insurance policies as part of a tower of insurance arranged in various layers.

 

One of the most important functions of D&O insurance is to protect the individuals when the company has become insolvent and unable to honor its indemnification obligations. This protection is afforded under Side A, as discussed above. Because of the critical importance of this insurance protection, some companies choose to buy additional amounts of insurance providing additional limits of liability just for this Side A coverage, in the form of Excess Side A insurance.

 

In the current marketplace, this Excess Side A insurance often provides certain additional insurance protection in the form of coverages whereby the Excess Side A insurance will "drop down" and provide first dollar protections. These additional coverages are in the form of "Difference in Condition" (or "DIC") protection, and would apply, for example, in the event an underlying D&O insurance carrier is insolvent or if the underlying policy is rescinded.

 

Many D&O insurance buyers are very sensitive about the cost of the insurance -- and appropriately, as D&O insurance is often perceived as expensive (although currently relatively less expensive than it has been at times in the past). However, the scope of insurance protection afforded is much more important than the cost. Small incremental cost savings sometimes available pale by comparison to the potential financial significance of the scope of coverage afforded.

 

There is no standard D&O insurance policy. Each D&O insurance carrier has forms that differ from their competitors’ and most policies are generally the subject of extensive negotiations. In order for D&O insurance buyers to be assured that they have the broadest available terms and conditions and the appropriate insurance structure put in place, it is critically important that they associate a knowledgeable and experience broker in their acquisition of the insurance. The best brokers also have skilled and experience claims advocates available to protect their clients’ interests in the event of a claim.

　

　

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In a June 30, 2010 opinion (here), a three-judge panel of the Second Circuit reversed the lower court’s ruling that coverage under a directors and officers liability insurance policy for an underlying claim was precluded by the policy’s "insured vs. insured" exclusion, holding that the D&O policy at issue was "ambiguous" under Virginia law.

 

Background

Prior to May 2004, Community Research Associates, an Illinois corporation, was controlled by three shareholders, referred to in the coverage action as the Legacy Shareholders. In May 2004, CRA was reorganized as a Delaware corporation as part of a stock purchase agreement by which Sterling Investment Partners became the majority shareholder, and the Legacy Shareholders became minority shareholders. The pre-transaction entity was referred to in the coverage litigation as CRA-Illinois and post-transaction entity was referred to as CRA-Delaware.

 

The May 2004 transaction contemplated several events occurring simultaneously at the time of the transaction closing. Among other things, the Legacy Shareholders were to assume positions as officers or directors of CRA-Delaware in order to sign the paperwork to complete the reorganization plan. In addition, as a condition of closing, the Legacy Shareholders were required to resign their positions as directors of CRA-Delaware in order to close the merger.

 

In October 2004, CRA-Delaware purchased D&O Insurance policy. In its application for insurance, CRA-Delaware stated, among other things:

 

On May 3, 2004, the company had a merger with an investment entity. A new Chairman and Chief Executive Officer was installed. The prior ownership remained in a minority capacity but were no longer participants on the Board or officers of the corporation. On August 2, 2004 a new Chief Financial Officer was hired.

　

In August 2005, CRA-Delaware approved a merger whereby all of CRA-Delaware’s stock was sold to a third-party, CRA Acquisitions Corp. The Legacy Shareholders filed a lawsuit against certain directors and officers of CRA-Delaware, alleging a breach of fiduciary duty in connection with the August 2005 merger. The breach of fiduciary duty action ultimately settled for $3 million.

 

The CRA-Delaware directors who were sued in the breach of fiduciary duty action filed a claim under the company’s D&O insurance policy for the losses incurred in connection with the claim. The D&O insurer denied coverage for the claim in reliance on the policy’s "insured vs. insured" exclusion, and coverage litigation ensued.

 

The district court in the coverage action granted the carrier’s motion for summary judgment, holding that the "insured vs. insured" exclusion was unambiguous and that because the Legacy Shareholders were all former directors and officers of CRA-Delaware, having assumed those roles briefly in order to effectuate the merger, the losses from their claim fell within the Policy’s exclusion.

 

The Second Circuit’s Opinion

The Second Circuit first found that when the district court had concluded that the Legacy Shareholders "briefly assumed" the role of directors of CRA-Delaware in order to effectuate the merger, the district court "assumed[ed] the answer without addressing the parties’ argument."

 

The coverage claimants argued that CRA-Delaware "did not exist as an entity until after the closing of the merger." The Second Circuit said that "at the very least, the question should have gone to a jury to determine whether CRA-Delaware existed prior to the merger or, if it did, whether it was the same entity that existed after the merger for purposes of policy coverage."

 

In reaching this conclusion the Second Circuit, referenced CRA-Delaware’s policy application, which was attached to and, by the Policy’s terms, incorporated into the policy. The Second Circuit found that the application, which the Court emphasized was part of the policy, described the May 2004 transaction in a way that raised these questions about when CRA-Delaware came into existence, and in particular about whether the Legacy Shareholders were ever officers or directors of CRA-Delaware as such.

 

Citing Virginia law, the Second Circuit held that "the Policy, when read in its entirety, can reasonably be ‘understood in more than one way’ and is thus ambiguous." Both of the parties’ interpretations of when CRA-Delaware came into existence "rely only on language of the Policy and are reasonable in light of the various provisions of the Policy."

 

Accordingly, the Second Circuit remanded the case to the district court "to undertake any additional fact finding to interpret the Policy provisions in light of the facts to be found."

 

Discussion

At first impression, this case is a bit of head-scratcher, since the record does seem to suggest that the Legacy Shareholders were briefly directors of CRA-Delaware in order to effectuate the merger, which is exactly what the district court found.

 

On further reflection, however, the question may not be quite as straightforward as the first impression might suggest. There is a question about exactly when CRA-Delaware first came into existence, and whether the Legacy Shareholders were ever directors of CRA-Delaware when it came into existence. The application itself, which was incorporated in to the policy, seemingly suggests that the Legacy Shareholders were not officers or directors of CRA-Delaware as such.

 

Significantly, the Second Circuit did not affirmatively say that there was coverage here under the D&O policy, only that further findings of fact were required before it could be determined whether or not the insured vs. insured exclusion applied.

 

At some level, this coverage dispute may simply be a reflection of a very specific and arguably unique set of facts. However, the parties’ dispute is a reminder of the complexities that can sometimes arise in connection with the application of the "insured vs. insured" exclusion, which is frequently the source of contentious coverage issues.

 

That said, I don’t think the Second Circuit was saying the insured vs. insured clause in and of itself was ambiguous. Rather, the finding of ambiguity turned on the fact that the policy application was incorporated into the Policy – that is, by the Policy’s terms, the application was a part of the policy. The finding of ambiguity related to the interaction between the application as part of the policy and the insured vs. insured exclusion. In essence, the Second Circuit said that because of the ambiguous relation between these two parts of the policy, further fact finding is required.

 

My prior posts on the Insured vs. Insured exclusion can be found here and here.

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One of the recurring D&O insurance coverage issues is the question of excess D&O insurers’ obligations when the underlying insurers have paid less than their full policy limits as a result of a compromise between the underlying insurers and the policyholder.

 

In the latest of a growing line of recent cases examining these issues, Judge Wayne Anderson of the Northern District of Illinois, in a June 22, 2010 opinion applying Illinois law, held that the "plain language" of the excess D&O insurance policies at issue required the actual payments of full policy limits in covered claims before the insureds could access the excess insurance.

 

Background

During the relevant period, Bally Total Fitness Holding Corporation carried a total of $50 million in D&O insurance arranged in five layers of $10 million each, between a primary insurer and four excess insurers. Bally and certain of its directors and officers were named as defendants in a securities class action lawsuit (about which refer here) in connection with which Bally incurred $33 million in defense expenses, for which Bally sought coverage under from its D&O insurers.

 

The primary insurer initiated an action in the Northern District of Illinois seeking a judicial declaration of noncoverage. Bally joined the excess insurers to the action as third-party defendants. Ultimately the primary insurer and the first and second level excess insurers reached a compromise by which they agreed to contribute a total of $19.5 million toward Bally’s defense expenses. The first level excess insurer settled for $8 million, $2 million less than its full policy limit. The second level excess insurer settled for $1.5 million.

 

The third and fourth level excess insurers refused to settle or otherwise contribute toward Bally’s defense expense. These two excess insures argued that the conditions precedent to coverage in their excess insurance policies had not been triggered. In making this argument, the third level excess insurer relied on its policy’s language that its payment obligations are triggered "only after the insurers of the Underlying Policies shall have paid, in the applicable legal currency, the full amount of the Underlying Limit." The fourth level excess insurer relied on language in its policy specifying that its payment obligations apply "only after all Underlying Insurance has been exhausted by payment of the total underlying limit of insurance."

 

The Court’s June 22 Opinion

In his June 22 opinion, Judge Anderson granted the third and fourth level excess insurers’ motions for summary judgment, finding that the plain language of their policies requires that the underlying insurers each "make actual payments of $10 million each in covered claims before Insureds can access coverage provided by the Third and Fourth Layer Excess Policies."

 

The insureds had argued that the third and fourth level excess policies were "ambiguous" as to whether the underlying policies had to make actual payment of a full $10 million each to trigger the top level excess carriers’ coverage. The insureds argued that the third and fourth level excess carriers had contracted to pay claims in excess of specified levels "regardless of who makes payment for covered claims" below those levels.

 

Judge Anderson considered the case law on which the insureds relied, particularly the 1928 Second Circuit decision in Zeig v. Massachusetts Bonding & Ins. Co.. In examining this line of cases, Judge Anderson concluded that "if an excess insurance policy ambiguously defines exhaustion, as in Zeig, courts generally find that settlement with an underlying insurer exhausts the underlying policies." However, Judge Anderson went on, "in cases where the policy language clearly defines exhaustion, the courts tend to enforce the policy as written."

 

Judge Anderson went on to find that the third and fourth level excess policies clearly defined how the underlying insurance must be exhausted prior to the insureds accessing coverage. Accordingly, and because the underlying insurance had not been exhausted by the underlying insurers’ payment of covered loss, Judge Anderson granted summary judgment in the third and fourth excess insurers’ favor.

 

Discussion

As a result of rising settlement levels and escalating defense costs, excess D&O insurance has become increasingly important in D&O claims resolutions. As more and more claims get pushed into the excess layers, more and more questions are arising, including this recurring question of whether the excess carriers’ payment obligations are triggered when the policyholder has compromised with the underlying carriers.

 

Judge Anderson’s holding in the Bally Total Fitness case joins a line of several recent cases in which courts have similarly held that, given the excess policy language at issue, the excess carriers’ payment obligation were not triggered when the underlying carriers paid less than their full policy limits as a result of a compromise with the policyholder. These recent cases include the July 2007 Eastern District of Michigan decision in the Comerica case (about which refer here) and the March 2008 California intermediate appellate court decision in the Qualcomm case (about which refer here).

 

The outcome of these various coverage disputes is a direct reflection of the excess policy language involved, and in particular the language specifying what is required in order for excess insurers’ payment obligations to be triggered. These cases underscore the critical importance of the language describing the payment trigger in the excess policy.

 

In recent months, and in large part as a reaction to these cases, excess carriers increasingly have been willing to provide language that allows the excess carriers’ payment obligations to be triggered regardless whether the underlying amounts were paid by the underlying insurer or by the insured. (I note as an aside that this language was not generally available at the time that Bally Total Fitness purchased the D&O insurance at issue in this case.)

 

The potential importance of the excess insurance payment trigger language, and the availability of language alternatives in the current insurance marketplace, in turn underscores the importance for policyholders of involving a knowledgeable and experienced D&O insurance broker in their acquisition of D&O insurance. The presence of the most favorable excess trigger language, among many other critically important policy language issues, could make a significant difference in the availability of coverage in the event of a claim.

 

Speedy Justice: According to Judge Wayne Anderson’s official biography (here), the Judge is the co-holder of the record for the 100-yard dash at Harvard University, from which he graduated in 1967.

　

　

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The SEC has made it clear that it intends to use Section 304 of the Sarbanes-Oxley Act to "clawback" compensation from CEOs and CFOs of companies that restate their financial statements, even if the individuals are not alleged to have engaged in any wrongdoing. A recent district court opinion confirms that the statute gives the SEC the authority to proceed on that basis. These actions raise complex D&O insurance coverage concerns that arguably suggest certain necessary policy adjustments.

 

Section 304 provides that if a company restates its financials, the company’s CEO and CFO, who certified the financial statements under Sox Section 302, "shall reimburse" the company for any bonus compensation received during the 12 months following the restated period, as well as any stock sale profits earned during those twelve months.

 

There is no requirement in Section 304 that the CEO or CFO from whom reimbursement is sought have any involvement in the events that necessitated the restatement; indeed, the statute doesn’t require any showing of wrongdoing or fault.

 

The SEC’s first use of this statutory provision to clawback compensation from a corporate official against whom no wrongdoing is alleged was the enforcement action filed in July 2009 against Maynard Jenkins, the former CEO of CSK Auto. I first wrote about this enforcement action in a prior post, here.

 

CSK Auto had restated its financial statements for the fiscal years 2002 to 2004. The SEC filed separate enforcement actions against the company and four company officials for securities law violations in connection with the restatements. However, Jenkins is not among the company officials alleged to have violated the securities laws.

 

The SEC’s action, filed in reliance on Section 304, seeks to compel Jenkins to reimburse CSK Auto for more than $4 million he received in bonuses and stock sale profits "while CSK was committing accounting fraud." Jackson not only is not alleged to have had any role in or awareness of the alleged scheme, but the SEC has actually alleged in its separate enforcement action against the other CSK officials that the others concealed their scheme from Jenkins.

 

Jenkins moved to dismiss the SEC’s clawback action on numerous grounds, arguing that he cannot properly be forced to disgorge compensation in the absence of any personal wrongdoing.

 

In a June 9, 2009 order (here), District of Arizona Judge G. Murray Snow held that the SEC’s complaint against Jenkins alleges facts sufficient to state a claim under Section 304, stating further that "the text and structure of Section 304 require only the misconduct of the issuer, but do not necessarily require the specific misconduct of the issuer’s CEO or CFO."

 

Judge Snow elaborated by saying that "the misconduct of the issuer is the misconduct that triggers the reimbursement obligation of the CEO and the CFO." Before reimbursement can be required "the issuer’s misconduct must be sufficiently serious to result on material noncompliance with a financial reporting requirement."

 

The SEC has already made it clear that it intends to use Section 304 to try to clawback compensation from other CEOs and CFOs who are not alleged to have done anything wrong. For example, just a few days ago, the SEC settled a Section 304 filed against Walden O’Dell, the former CEO of Diebold, even though, as noted in the SEC’s June 2, 2010 litigation release, the SEC’s complaint does not allege that O’Dell engaged in the alleged fraud at Diebold.

 

Judge Snow’s opinion in the Jenkins case confirms that the SEC may properly pursue Section 304 clawbacks even against corporate officials who are not alleged to have engaged in personal wrongdoing (although he did leave open the question whether the statute could be used in ways that would be unconstitutionally punitive).

 

Though statutorily authorized, the statute’s use to effect a forfeiture without culpability or fault raises troubling questions, including even basic questions of fairness. On the other hand, it might also fairly be asked whether the CEO or CFO ought to be able to retain benefits accumulated at a time when the investing public was being misled, by financial statements that the CEO and CFO certified, about the company’s financial condition.

 

Beyond these issues, these kinds of actions may also raise complex D&O insurance coverage questions.

 

A Section 304 claim potentially would raise at least two possible coverage concerns – first, whether the claim involves an allegation of a "wrongful act" as required to trigger coverage; and second, whether coverage for the claim is precluded by the "profit or advantage" exclusion.

 

D&O insurance typically is only triggered by a claim made against an insured person for an actual or alleged wrongful act. Under a Section 304 claim in which no personal wrongdoing is alleged, the question would arise whether a wrongful act has been sufficiently alleged to trigger coverage under the policy.

 

I think it could fairly be argues that a Section 304 claim does involve a wrongful act even if no personal wrongdoing is alleged against the individual defendant. As Judge Snow’s opinion in the Jackson case emphasized, a prerequisite to a Section 304 claim is misconduct by the issuer (which is an "insured" under the typical public company D&O insurance policy’s "entity coverage" provision).

 

Given the statutory prerequisite of issuer wrongdoing, a Section 304 claim necessarily involves a claim for a wrongful act, even if the wrongful act alleged is not that of the targeted individual. The typical D&O policy emphatically does not say that the claim must be made against an insured person for that insured person’s own wrongful act – to the contrary, the typical policy requires only that the claim be made for "an actual or alleged wrongful act," without specifying whose act it must be.

 

Nevertheless, I can still imagine a carrier bent upon denying coverage urging that this policy provision requires a wrongful act by the insured person against whom the claim has been made, which may indicate the need for certain policy revisions, as detailed below.

 

Even if the wrongful act concern can be overcome, there is still the policy exclusion to be dealt with. The typical D&O policy excludes coverage for any loss based on a claim for any "profit or advantage" to which the insured is not legally entitled. A carrier might attempt to rely on this provision not only to deny coverage for the amount of any reimbursed compensation, but also to try to deny coverage for the costs of defending the claim.

 

One way to try to circumvent this concern about Section 304 defense costs is to amend the exclusionary provision to required a judicial determination in the underlying claim that the insured was not legally entitled to the "profit or advantage," which would at least allow defense costs to be advanced up until there has been such a judicial determination. The limitation of this approach is that once there has been a judicial determination, the carrier might seek to be reimbursed for the advanced defense costs.

 

The point here is that the question of D&O insurance coverage for the costs of defending a Section 304 clawback claim could be problematic. One approach to try to address these concerns would be to amend the policy to provide that the "profit or advantage" exclusion will not be applied to the costs of defending a Section 304 act, and to further amend the policy to provide that the carrier will not take the position that a Section 304 action does not allege a wrongful act.

 

At least one insurer has taken an alternative approach to address the Section 304 defense cost issue in its revised policy form. Under this approach, the costs of defending a Section 304 claim are expressly included in the policy’s definition of Loss.

 

It is not my intention here to debate the merits of these alternative approaches (which indeed may not be mutually exclusive) or of any other alternative approaches that might exist. My purpose here is simply to point out that this issue has reached the point where the question of Section 304 defense expenses ought to be addressed in the D&O policy form.

 

Just as a few years ago, the D&O insurance industry quickly adapted express policy language designed to address concerns arising from SOX whistleblower claims, it may now be time for the industry to adapt express policy provisions addressing Section 304 defense costs. Policyholders should not have to wait until the claim has been filed to find out what the carrier’s position will be on Section 304 defense expenses.

　　

2010 World Cup: Some Early Notes:

1. Vuvuzela: Did the site selection committee know about those damned vuvuzela horns when they chose South Africa as the 2010 World Cup venue? What an awful, idiotic noise. (There are reports that the event organizing committee is considering a ban.)

 

2. Remember, The Beautiful Game is Fast, Too: England was up on the U.S. by a goal before I even had a chance to turn the T.V. on.

 

3. U.S. Goal Inspires Headline Writers Everywhere: Here’s my entry – "English Green’s Gift Gaffe Gives Yanks a Goal."

 

4. Most Underappreciated: Tim Howard ought to be one of the most celebrated athletes in the U.S. He certainly is one of the most talented.

 

5. Go Figure: The official nickname of the Australian team is the "Socceroos." Discuss.

 

6. Self-Destruction (and Team Takeout, Too): Substitute Algerian striker Abdelkader Ghezzal entered his team's game against Slovenia in the 58th minute (which was a scoreless tie at the time). Approximately five seconds later he was given a yellow card for an aggressive tackle. Then in 74th minute, he earned his second yellow (and an automatic red card, requiring his ejection from the game) for a flagrant hand ball . Within minutes, his shorthanded team conceded Slovenia's winning goal.

 

7. Divided By a Common Language: The "pitch" is the playing field. A "side" is a team. A "strike" is a shot. To "win a cap" is to be selected to play for your country’s team. "Nil" means zero. "Draw" means tie. And "nil-nil draw" (usually preceded by the word "dreaded") means a scoreless tie. The phrase "argy bargy" is not susceptible to translation. 

　

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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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In a March 23, 2010 Summary Order (here), the Second Circuit affirmed the March 2, 2009 ruling of Southern District of New York Judge Gerald Lynch, in which he held that the excess insurers’ prior knowledge exclusion precluded coverage under their policies for claims brought against former Refco directors and officers.

 

Background

As detailed in a prior post about Judge Lynch’s district court order (here), at the time that the Refco scandal emerged, Refco had $70 million of D&O insurance arranged in multiple layers. The primary and first level excess insurers advanced their entire combined $17.5 million limits of liability in payment of defense expenses. In a separate ruling not involved in this appeal, Judge Lynch ruled that the second level excess insurer also must advance its defense expense.

 

In his March 2, 2009 ruling (here), Judge Lynch granted summary judgment for the third and fourth level excess insurers, based on exclusions in those policies (not found in the underlying policies) precluding coverage for claims arising from any facts or circumstances of which "any insured" had knowledge at policy inception and that might reasonably be expected to give rise to the claim. (In a portion of his opinion not relevant to this appeal, Judge Lynch denied summary judgment as to the fifth level excess insurer.)

 

The critical question before Judge Lynch was whether the knowledge of the fraudulent scheme of Refco’s CEO Phillip Bennett could be imputed to the other directors and officers. These individual had sought to rely on so-called severability provisions in the primary policy, to which the excess policies were "follow form," and from which they sought to argue that the prior knowledge exclusion was not applicable to them. Their argument was that Bennett’s knowledge could not be imputed to them due to the non-imputation language in the primary policy’s severability provision.

 

Judge Lynch rejected their argument that the severability provision in the primary policy precluded the operation of the prior knowledge exclusion in the excess policy.

 

The Second Circuit’s March 23 Summary Order

In its March 23 Summary Order, the Second Circuit expressly adopted Judge Lynch’s "comprehensive and well-reasoned analysis." The Court quoted Judge Lynch’s language that "in the context of the [prior knowledge exclusion] the words ‘any insured’ unambiguously precludes coverage for innocent coinsureds."

 

The Second Circuit also expressly affirmed that because the exclusionary language in the excess policy "cannot be reconciled with the severability language provision of the underlying policy, the language in the excess policy controls." The Second Circuit also affirmed that the claims against the individuals come within the "arising out of" preamble of the exclusion.

 

Discussion

As I detailed in my prior discussion of Judge Lynch’s opinion, this case illustrates the complicated ways that the various components of a single D&O insurance program can operate in unanticipated ways to produce unexpected results. The case also demonstrates the extent to which supposed "follow form" excess coverage is not always truly "follow form."

 

The outcome also underscores the importance of application and exclusion severability issues not just at the primary levels but all the way up the insurance tower.

 

My other ruminations about this outcome are set forth at length in my prior post about Judge Lynch’s opinion.

 

The Second Circuit’s Summary Order states on its face that it has no precedential effect. However, the practical effect of the Summary Order is the validation of Judge Lynch’s analysis, to which future litigants undoubtedly will refer.

 

It is probably worth noting that while Judge Lynch was a district court judge in March 2009 when he wrote his coverage opinion in the Refco case, by the time the Second Circuit got around to reviewing the case, Judge Lynch had become a member of the Second Circuit bench, where his new Circuit Court colleagues found his prior work as a district court judge to be "comprehensive and well reasoned." Perhaps the preservation of domestic tranquility around the courthouse water-cooler requires no less.

 

Special thanks to Neil McCarthy of Lawyer Links for providing me with a copy of the Second Circuit’s Summary Order.

　

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

The Fifth Circuit’s Stanford Financial Decision

The March 15 Opinion

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

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

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

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

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

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

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

　

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

Discussion

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

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

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

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

The Sixth Circuit’s Abercrombie Opinion

The March 11 Decision

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

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

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

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

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

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

Judge Kethledge’s Dissent

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

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

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

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

Discussion

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

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

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

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

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

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

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

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

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

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In recent posts (here and here), I have discussed the issues surrounding coverage under D&O insurance policies for investigative costs and special litigation committee expenses. In response to these posts, readers Jeff Kiburtz and Cindy Forman of the Santa Monica law firm of Shapiro Rodarte & Forman have submitted the following guest blog post. This guest post of course reflects the views of the post’s authors, and not necessarily those of the author of The D&O Diary. Cindy and Jeff's guest post is as follows:  

 

Having recently ended an unusual week straight of rain in normally sunny Los Angeles, the saying "when it rains it pours" comes to mind. This phrase aptly describes the situation in which many companies find themselves when revelations of accounting irregularities or other alleged misconduct surface – first there is a story in the press, then a letter indicating the SEC opened an informal investigation, next a DOJ subpoena, and, sometime during this period, the company’s stock drops and a shareholder makes a demand for an investigation or forgoes the demand and files a derivative suit.

 

The response to this downpour is immediate and expensive. Typically, at least three sets of law firms are retained – one to handle the government investigations and private litigation, a second to conduct an internal investigation and report to a special committee established by the company, and a third, which usually consists of several different firms, to defend the implicated directors and officers.

 

Recognizing the potential to spend large amounts of money very quickly, in-house counsel and the company’s outside lawyers move to create a division of labor between the various firms to coordinate the overall effort. Central projects such as the review, coding and scanning for privilege of all of the documents potentially relevant to the underlying issue are assigned to a specific firm, frequently the internal investigation counsel. Work specific or unique to the various groups is, however, done by the respective group’s own counsel.

 

Although each firm represents the unique interests of their clients, and potential or actual conflicts are therefore implicit, in many circumstances the various interests are largely aligned and the attorneys can and do work together for the mutual benefit of all. If, for example, the company needs to respond to a DOJ document subpoena, there is no reason their theoretically diverging interests should prevent the company’s defense counsel from tapping into the document review work done by the internal investigation counsel to locate responsive documents.

 

The single greatest beneficiary of this collaboration is the company, which in many circumstances is required to pay the bill for all of the various lawyers. We would think that, by extension, the company’s D&O insurers would also see and appreciate the extent to which collaboration between the various groups reduces the overall legal spend. It seems, however, that many D&O insurers are quite restrained in their enthusiasm, often declining coverage for various categories of fees incurred by the company under numerous theories. One fee category that is almost uniformly declined is fees incurred by internal investigation counsel, which, perhaps coincidentally, also happens to be the largest single line-item in many situations.

 

When declining coverage for internal investigation fees, insurers often argue that because the definition of "Claim" does not specifically reference internal investigations, fees incurred by internal investigation counsel were not incurred "in connection with a Claim." Insurers also argue that the internal investigation counsel represents only the special committee, which typically is not one of the enumerated categories of "Insureds" under most D&O policies. A related argument is that internal investigation counsel is supposed to be neutral and objective, such that their work cannot be described as defensive in nature and, therefore, cannot be considered "defense costs."

 

Most policyholders regard these arguments as formalistic and compartmentalized, divorced from the business realities of these "when it rains it pours" situations. For one, the carriers do not give adequate consideration to the fact that much of the internal investigation work (e.g., construction of an electronic document database and obtaining witness statements) is relevant and necessary to defending any securities claim or government investigation, and would need to be performed even in the absence of any internal investigation. In this sense, the insurer’s objection is one of form not substance, as the nature of the substantive work is less relevant to the insurer than the designation of the firm who handled that work (e.g., document review conducted by defense counsel is admittedly covered, but that same work is allegedly not covered merely because it was performed by internal investigation counsel).

 

Further, the insurers’ arguments tend to disregard the direct and obvious connection between the allegations of and investigation into potential wrongdoing and the coordinated effort taken and paid for by the company to investigate and respond in an appropriate manner. When the allegations surface, all of the attorneys involved, whether they represent the company, the special committee or the individual insureds. need to review documents and interview witnesses to determine the relevant underlying facts that impact their respective clients’ interests. It often is not until much later, if at all, that facts surface which demonstrate that the various parties’ interests are in fact adverse. That the information gained during the earlier investigation phases might be used by the special committee in a manner inconsistent with coverage (e.g., advising the board to pursue litigation against directors and officers) does not justify a wholesale declination of all fees incurred by the special committee.

 

A few of these issues came up in the recent MBIA v. Federal Ins. Co. coverage action Kevin has addressed (here and here), where the court seemed not to have been overly warm to the legal principles underlying the insurer’s arguments.

 

 

Federal argued that the firm which handled the internal investigation, Dickstein Shapiro, represented only the special committee, not the company or any of the other insureds. Although the court dismissed this argument on a factual basis (finding that Dickstein made an appearance on behalf of the company in the securities litigation), it also noted that, independent of this fact, the special committee was comprised of members of the board of directors who were expressly charged with acting in the best interest of the company and who "could readily reach independent decisions without being independent of [the company]." While this portion of the opinion could have been more clear, the court’s decision cuts against both the notion that special committees are necessarily separate "entities" from the company and that their required independence precludes characterizing as "defense costs" the work done on their behalf.

 

Another aspect of the court’s decision in MBIA is also worth noting. Insurers frequently argue that internal investigation counsel’s work was not performed "in connection with a Claim," but rather was performed "in connection with" something other than a "Claim," e.g., an internal investigation. This argument makes relevant the causal nexus implied by the "in connection with" language. Policyholders often argue that the implied nexus in this non-exclusionary term is very broad, something akin to an incidental or minimal causal connection; for example, the fees are covered if they bear some reasonable relationship to a covered claim. In our experience, insurers appear reluctant to characterize the allegedly required nexus, but by implication seem to suggest something like predominant causation; for example, the fees are covered only if the predominant reason for doing the work was to defend against the covered claim. While it does not appear that the parties in the MBIA case briefed this issue, by finding coverage for the internal investigation fees related to the derivative suits the court arguably recognized that "in connection with" implies only a minimal causal connection in this context.

 

The insurance bar is likely concerned by the MBIA decision, as it could have widespread implications. It will be interesting to see whether Federal seeks appellate review or whether insurers in the future will simply seek to downplay the significance of a district court decision and attempt to confine it to the facts before the court. 

 

The D&O Diary would like to thank Cindy and Jeff again for their submission of this guest post. The D&O Diary accepts appropriate guest posts from responsible commentators on topics relevant to this blog. My goal in hosting guest posts is to encourage discussion of important topics and to facilitate the exchange of contrasting points of view. Readers who are interested in submitting guest posts should feel free to let me know using the "Contact" function on this blog. 

 

 

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The problems facing many banks in the current economic environment are well-documented. For troubled banks’ directors and officers, the banks’ D&O insurance may represent a last line of protection. But what if the insurers could just cancel the policies? Surprisingly, many bank D&O insurers have that right under their policies, and while cancellation is rare, it is not unprecedented, and some insurers are now invoking that right to shed the risks associated with failing or problem institutions.

 

As reflected in a January 24, 2010 FinCri Advisor article entitled "Your D&O Insurer Might Be Scouring Your Call Report Looking to Cancel Coverage" (here), the policy forms of many bank D&O insurers have cancellation clauses that permit the insurer to cancel the policies mid-term, either because there is a "material change in the risk" or for any reason at all.

 

Many of these clauses are found only in policies that were issued on a multiyear basis, but even some single-year bank D&O insurance policies contain cancellation clauses. While many policies also specify that the insurer must give the policyholder 60 days (or more) notice so that the policyholder can try to replace coverage, the fact is that if something serious enough to cause the insurer to cancel coverage has occurred, it likely will be a very difficult time for the policyholder to try to find replacement coverage.

 

For D&O insurance practitioners who don’t venture into the Financial Institutions arena (or FI as it is known), the very existence of these clauses in bank D&O policies may come as a surprise, since these clauses do not appear in most mainstream commercial D&O insurance policies.

 

The obvious question is how did a cancellation clause get into bank D&O policies when it is rarely if ever seen in other kinds of D&O insurance policies? Part of the answer is that, particularly with respect to community banks, the D&O insurance marketplace has over the years become both very specialized and intensely competitive.

 

Before the current troubled bank era began, D&O insurance for community banks became increasingly less expensive. But as buyers became increasingly (or even exclusively) focused on price, some carriers looked for ways to trim coverage. And so a term such as the cancellation clause that isn’t seen in other D&O insurance policies found its way into the basic forms of several community bank D&O insurance carriers.

 

A neutral observer might question the value of a contract that one party can simply cancel unilaterally. The promise to provide insurance seems tenuous indeed if the insurer can walk away because problems have emerged – which is of course the very circumstance for which buyers purchase insurance in the first place.

 

All of this does raise the question of why any buyer would agree in the first place to accept a policy that has a cancellation clause. The answer is either that the buyer is unaware the clause is there or the buyer has no other choice.

 

Given the number of bank D&O insurers that have cancellation clauses in the policy forms, there undoubtedly are many banks whose policies have these clauses. I am guessing only a very small number of these banks (many of whom may have purchased their insurance on a direct basis) have any idea the clauses are there.

 

The problem is that the market for D&O insurance for banking institutions is in turmoil now due to the number of failed and troubled banks. For banks that are struggling, it may be challenging in the current environment to obtain a policy without a cancellation clause. Or, if they can a policy without a cancellation clause, the coverage afforded may otherwise be restricted (as for example, by the inclusion of a regulatory exclusion or the absence of past acts coverage).

 

Healthy financial institutions in many instances can still get coverage on a relatively attractive basis. Healthier banks should not have to accept a policy with a cancellation clause. However, even the healthy banks can only avoid the cancellation clause and other undesirable policy features if their advisor is well-informed and knows what to look and ask for.

 

One added note is that even some bank D&O policies that do not have cancellation clauses have other undesirable features that are almost as bad. For example, the policy form of at least one D&O insurer that is active with community banks does not allow the policyholder the option of purchasing extended reporting period coverage, even in the event of nonrenewal, which could have a similarly negative impact on a bank whose D&O insurance is not renewed. Again the presence or absence of an extended reporting period option is a term that the bank’s D&O insurance advisor will, if well-informed and knowledgeable, be looking for.

 

For the banks whose D&O insurers hit them with a notice of cancellation, the only recourse may be for the banks to provide their insurers with a "laundry list" notice of circumstances that may give rise to a claim – always a challenging proposition because of the uncertainty of knowing what claims may arise later. But the laundry list may be the only chance the bank has to lock in coverage before it is unilaterally taken away.

 

All of this underscores the critical importance for banks and for all insurance buyers of involving a knowledgeable and experience advisor in the acquisition of D&O insurance. Without informed advice, policyholders can be left with inadequate insurance protection when problems arise.

 

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

 

Background and the January 26 Opinion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In an earlier post (here), I wrote about a December 30, 2009 ruling in the MBIA coverage litigation that special litigation committee investigation expenses were covered under a D&O liability insurance policy. As I anticipated, the decision has proven to be controversial.

 

Two law firms that traditionally act as coverage counsel for D&O carriers recently released memoranda discussing the opinion. The Wiley Rein issued a brief memo (here) discussing the case and its holding. The Edwards Angell Palmer & Dodge law firm released a longer memorandum (here) also discussing the opinion.

 

The Edwards Angell memo, written by my friend John McCarrick and his colleagues, Maurice Pesso and Peter de Boisblanc, is particularly interesting because opens by reviewing the justification for the insurers’ standard position that special litigation committee expenses are not covered under the typical D&O insurance policy.

 

The Edwards Angell memo also includes a review of implications of and the likely consequences that flow from the decision. Among other things, the memo stresses that the decision did not hold that special litigation committee expenses will always be covered, but only under the facts presented. The memo also recites the difficulties and logical problems involved with characterizing the special litigation committee expenses as "defense costs" (including the likelihood that plaintiffs might use the characterization as a way of challenging the independence of the special litigation committee.).

 

The Edwards Angell memo concludes with this observation:

　

Unless and until the D&O insurers in MBIA press a successful appeal of this ruling to the Second Circuit Court of Appeals, D&O insurers should brace themselves for the likelihood that the MBIA ruling will be cited by policyholder counsel and brokers in an effort to significantly expand the scope of coverage for these kinds of legal expenses and costs, as well as to cover other fees and expenses that an insured can argue were incurred "in connection with" a covered D&O claim.

 

The memo provides an interesting presentation of the carrier perspective on the decision. Reading the memo, I wondered whether any policyholder-side coverage attorneys had written their own analyses of the decision from the perspective of insured companies. I hope that any readers aware of these alternative perspectives will please send them along to me. I will update this post with any additional materials that are sent to me about the case.

 

One final note on a related subject -- the Wilmer Hale law firm has an interesting memo about recent developments in shareholder derivative litigation (here), which, among other things, discusses court's' increased scrutiny of special litigation committees, particularly with respect to the  question whether or not the committees are in fact independent.

　

NAB Update: The closely watched National Bank of Australia case pending before the U.S. Supreme Court on a writ of certiorari from the Second Circuit has now been scheduled for oral argument. According to a post on The 10b5-Daily (here), oral argument in the case, which will address the question of the extraterritorial jurisdiction of U.S. courts over foreign domiciled companies under the U.S. securities laws, is now set for March 29, 2010.

　

The 10b-5 Daily post also has a link to the Petitioners’ Brief., which argues that under the federal securities laws there are no extraterritorial limitations on the U.S. courts’ jurisdiction. Finally, the blog post also links to a National Law Journal article (here) written by Columbia Law School Professor John Coffee suggesting that, in light of various pending legislative proposals, Congress and the Supreme Court are on a "collision course" on the question of extraterritorial jurisdiction of the U.S. securities laws. Coffee concludes by suggesting that "a legal train wreck might result from opposing approaches to global class actions."

　

Detailed background regarding the NAB case can be found here.

　

Another Belated Securities Lawsuit Filing: In prior posts (for example, here), I have noted the phenomenon that developed in the second-half of 2009 where plaintiffs’ lawyers were filing securities class action lawsuit complaints well after the proposed class period cutoff date. In a more recent post (here), I noted that at least one lawsuit first filed in January suggested that this trend has continued in the New Year.

 

Yet another case filed this week suggests that this trend is continuing. In a January 21, 2010 press release (here), plaintiffs’ lawyers announced that they had filed a securities class action lawsuit in the Northern District of Illinois against Motorola and certain of its directors and officers. The lawsuit relates to alleged misrepresentations about the company’s sales of its RAZR2 telephone handset. The complaint in the case can be found here.

 

Though the complaint was only just filed, the proposed class period cutoff date is January 22, 2008, a full one year and 364 days prior to the filing date, and just before the expiration of the two-year statute of limitations applicable to ’34 Act claims.

 

In his comments in connection with the recent release of Cornerstone’s year-end analysis of the securities class action lawsuits, Stanford Law School Professor Joseph Grundfest had a number of choice comments about these belated securities class action lawsuit filings, essentially suggesting that the plaintiffs are scraping the bottom of the barrel (my words, not his) to file these belated lawsuits because they had run out of more meritorious cases to file. Public statements by leading plaintiffs’ attorneys (refer, for example, here) suggest more neutrally that they are just getting around to filing cases that were "backburnered" while the lawyers were concentrating on getting the subprime and credit crisis cases on file.

 

But whatever the explanation may be for the belated case filings, it is a very distinct phenomenon that has appears to be continuing as move well into 2010.

　

New SEC Climate Change Disclosure Guidance Ahead?: In prior posts (here), I discussed the possibility that the SEC could issue guidelines for public companies’ disclosures about climate change related issues and exposures. As discussed on the FEI Financial Reporting Blog (here), the SEC has announced (here) that in a meeting on January 27, 2010, it will be considering "a recommendation to publish an interpretive release to provide guidance to public companies regarding the Commission's current disclosure requirements concerning matters relating to climate change."

　

As the FEI Financial Reporting Blog explains, an interpretive release of this type is designed to provide final guidance on existing disclosure requirements. The blog post speculates that the guidance could be effective immediately upon release.

 

Cheers: I have joined the Facebook group "A Glass of Wine Solves Everything." (here). In vino veritas, dude. I recently have developed an affinity for two very different kinds of red, Oregon Pinot Noir and Argentine Malbec -- in part because one of the problems I have to solve is that I can't afford the Burgundys, Bordeauxs and Super Tuscans I would prefer. In my next life, my blog will be about wine.

 

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Among perennial D&O insurance issues are questions whether policy coverage is available for defense expenses incurred in connection with investigative costs, subpoenas and the costs associated with special litigation committees. A December 30, 2009 decision in the coverage lawsuit brought by MBIA against its D&O insurers considered all of these recurring issues, and reached some interesting decisions.

 

Background

For the policy period February 15, 2004 to August 15, 2005, MBIA carried $30 million of D&O insurance, arranged in a primary layer of $15 million and an additional $15 million layer of excess insurance.

 

In 2001, prior to the policy period, the SEC had issued an Order Directing Private Investigation in connection with certain of MBIA’s loss mitigation insurance products. In November and December 2004, the SEC issues subpoenas to MBIA concerning "nontraditional products." The New York Attorney General also issued subpoenas in November and December 2003 regarding nontraditional products. Both the SEC and the NYAG issues additional subpoenas in March 2005. In spring 2005, MBIA, because of concerns about the cumulative impact in the marketplace, asked regulators to forbear from issuing additional subpoenas and agreed to comply voluntarily with informal document requests.

 

In October 2005, MBIA submitted an offer of settlement to the SEC in connection with certain specific transactions. In the offer of settlement, MBIA undertook to retain an independent consultant to review MBIA’s accounting for the transactions. In January 2007, the SEC entered a Cease and Desist Order and the NYAG entered an Assurance of Discontinuance, both of which documents largely incorporated the company’s prior offer of settlement. Thereafter the company hired a consultant to undertake the proposed review.

 

In additional to these regulatory investigations, the company, as nominal defendant, was also sued in two derivative lawsuits, as a result of which the company organized a Special Litigation Committee. An outside law firm "represented the SLC," and according to MBIA, also "represented MBIA through its representation of the SLC." The derivative lawsuits were later dismissed.

 

MBIA claimed that it has spent $29.5 million in defending or responding to the regulatory investigations and the follow-on litigation. The primary insurer had reimbursed $6.4 million but disputed that it was obliged to reimburse other amount incurred. MBIA filed an action against the two insurers alleging breach of contract and seeking a judicial declaration that the insurers were obligated to reimburse the company for legal fees and other costs associated with the regulatory investigations and the derivative actions. The parties filed cross motions for summary judgment.

 

The December 30 Ruling

The defendant insurance companies had disputed coverage for the investigative items, in part of the grounds that the matters in connection with which the defense costs were incurred were not "securities claims" within the meaning of the primary policy.

 

The primary policy defined a "securities claim as "a formal or informal administrative or regulatory proceeding or inquiry commenced by the filing of a notice of charges, formal or informal investigative order or similar document" that "in whole or in part, is based upon, arises from or is in consequence of the purchase or sale of, or offer to purchase or sell, any securities issued by" the company.

 

In his December 30 Order, Southern District of New York Judge Richard M. Berman reviewed each category of defense expense separately.

 

Judge Berman first considered the defendants’ arguments that there was no coverage for fees incurred in responding to the NYAG’s subpoenas because the subpoenas were not a proceeding commenced by the filing of an "order or similar document." Judge Berman first found that the subpoena, which literally "commanded" compliance, was an "order" within the "common understanding" of "an ordinary businessman." He found further than even if it were not an "order" it was "sufficiently a ‘similar document’ that triggers coverage under the policy."

 

Judge Berman then considered the certain aspects of the SEC’s investigation, which the defendant insurers contended pertained to "traditional reinsurance" rather loss mitigation products. The defendants argued that the SEC’s 2001 Order Directing Private Investigation pertained only to the investigation of loss mitigation products, and so the SEC’s investigation of traditional reinsurance transactions was not pursuant to an "order."

 

Judge Berman rejected this argument among other reasons on the grounds that "Defendants have offered no persuasive evidence to support their argument that the SEC ran a series of concurrent investigations."

 

The defendant insurers also argued that the NYAG’s oral requests for documents pertaining to traditional reinsurance transactions were not pursuant to an "order." Judge Berman found that "defendants point to no persuasive evidence to suggest that the NYAG’s request for documents" relating to the reinsurance transactions "were part of separate investigations."

 

MBIA had also sought reimbursement for its costs incurred in connection with the independent consultant. Judge Berman found that there was no coverage under the policy for the costs associated with the independent consultant because MBIA "did not permit Defendants to effectively associate with it" because it did not inform the insurers about the independent consultant (and arguably did not get the insurers consent to agree to the independent consultant) "until at least ten months after it had committed to retaining" the independent consultant.

 

Finally, Judge Berman found that there was coverage under the policy for the fees incurred by counsel for the special litigation committee. MBIA had argued that the law firm had represented MBIA through its representation of the SLC. The carriers argued that the SLC was, by definition, independent, and therefore its counsel could not have represented the company.

 

In rejecting the insurers’ arguments, Judge Berman found that the SLC’s counsel had appeared as counsel for MBIA in the derivative actions and had filed pleading in the actions on behalf of MBIA. But even assuming that the law firm represented only the SLC, Judge Berman found there would still be coverage, because the SLC was composed of individual members of MBIA’s board who were acting pursuant to delegated authority from the board. Judge Berman noted that "the SLC could readily reach independent decisions without being independent of [MBIA]."

 

Discussion

The questions whether the kinds of defense fees in dispute in this case will be covered is often going to be a factor both of the policy language at issue and the specific facts involved. To a certain extent, Judge Berman’s decision may simply be a reflection with a very distinctive set of facts. In particular, it is a rather unusual feature of this set of circumstances that all of the disputed legal fees were incurred after the SEC had entered a formal order of investigation. Given that, it seems as if the only remaining dispute was whether or not the other investigative actions of the regulators were or were not related to the Order.

 

Judge Berman’s finding of coverage for the SLC legal counsel’s expense may also be a reflection of the fact that the law firm also entered an appearance on the company’s behalf in the derivative suit. These circumstances are not always present in connection with disputes over SLC’s counsel’s fees (although that fact certainly does not answer the question of the SLC’s counsel’s fees incurred prior to making an appearance in the derivative suit.)

 

But even though the decision may be a reflection of the particular facts involved, Judge Berman’s ruling nevertheless is significant as an example where a court found coverage for fees incurred with regulatory subpoenas, oral document requests, and special litigation counsel fees.

 

In particular, Judge Berman’s finding that, at least under these circumstances, the policy covered oral document requests and that the policy would have covered the SLC counsel’s defense even if it had not been counsel of record for the company in the derivative suit are particularly noteworthy.

 

Judge Berman’s finding the policy covered the SLC counsel’s expense because the SLC, though independent, was a committee of the Board operating pursuant to the Board’s delegated authority, is particularly noteworthy, and may represent a basis on which other insureds may seek to argue for coverage for SLC counsel fees.

 

This interesting case combines a number of frequently disputed issues. I expect that many readers may have reactions to this ruling and I would be very interested in hearing readers’ thoughts.

 

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2009 was an eventful year, with significant developments across a wide variety of economic, financial, judicial and legislative fronts. With the arrival of the New Year, it seems appropriate to take a look back at the past year’s most significant D&O developments.

 

So, in the finest tradition of year-end punditry, here is The D&O Diary’s list of The Top Ten D&O Stories of 2009.

 

1. Credit Crisis Litigation Wave Wanes: The subprime and credit crisis-related litigation wave that began in February 2007 continued to surge as 2009 began, but as the year progressed, the long-running wave finally seemed to lose momentum. During the wave’s nearly three-year duration, there were by my count 205 subprime and credit crisis-related securities class action lawsuits filed, 62 of which were filed in 2009, primarily during the first half of the year.

 

NERA’s annual securities litigation survey noted that during 2008, over 40% of all filings had involved credit crisis cases, but that this proportion decreased to "around 30%" in 2009, and "by the second half of the year, credit crisis filings began to slow down." Nevertheless, the NERA report also noted that "total levels of filings have remained relatively high," as "standard cases appear to have made up much of the decrease in filings related to a slowdown in credit crisis litigation" during the second half of 2009.

 

2. Plaintiffs’ Lawyers Turn to "Backburnered" Cases: One of the main drivers in the return to the filing of "standard cases" in the second half of 2009 was belated filing of cases to which the plaintiffs’ lawyers returned after the credit crisis cases died down. Many of the cases during the second half of 2009 were filed long after the purported class period cut off date, a phenomenon I noted most recently here. According to public statements of one leading plaintiffs’ attorney, the plaintiffs’ lawyers are going back to cases that they have "backburnered for two years."

 

By my count, 22 of the 94 securities class action lawsuits in the second half of the year were filed more than a year after the proposed class period cut-off date. Indeed, NERA noted with respect to the cases that were filed in the second half of 2009 that the average time to filing from the end of the class period to the filing date had grown to 279 days, compared to historical averages of 161 days, and only 69% of the cases in the second half of the year were filed within one year of the end of the class period, compared to historical averages of 84%.

 

The plaintiffs’ lawyers efforts to work off the backlog that developed while they were concentrating on the credit crisis cases poses a challenge for D&O underwriters, because it means that companies with long distant stock price drops could still find themselves getting dragged into securities litigation long after the event. As a result, it is hard for underwriters to be sure when a company is "out of the woods."

 

Moreover, the arrival of the belated filings still seems to be going strong, as a number of the new securities suits filed in December 2009 presenting these same backlog characteristics. It seems probable that this trend will continue, at least for the short run, as we head into 2010.

 

3. The Stockpile of Subprime and Credit Crisis Cases Slowly Makes Its Way through the System: The number of subprime and credit crisis-related filings may finally have slowed, but due to this nearly three-year onslaught of new cases, there is a stockpile of accumulated lawsuits that still are just beginning to be resolved.

 

As NERA noted in its annual securities litigation survey, over 80% of the subprime and credit crisis cases remain pending. About 15% of the cases have been dismissed, and only about 4% have been settled. This proportion of settlements to dismissals is consistent with historical experience, in which cases are more likely to be dismissed than to settle in the first few years after filing.

 

As reflected in my own running tally of subprime and credit crisis-related lawsuit dismissal motion rulings (here), there have been 28 dismissal motion rulings granted (eleven with prejudice) -- although in three cases in which dismissal motions were initially granted, the subsequently filed amended complaint survived renewed dismissal motions. The three cases in which the renewed motions were denied include the Washington Mutual and PMI Group cases (about which refer here and here). One dismissal (in the NovaStar Financial case) has already withstood appeal.

 

On the other hand, dismissal motions have been denied in whole or in part in 14 subprime and credit crisis-related cases, including several high profile cases, such as the cases involving New Century (here), Countrywide (here) and Accredited Home Lenders (here).

 

Though only a small number of subprime and credit crisis cases have settled, the settlements to date are impressive. The settlements include not only the outsized Merrill Lynch settlements (about which refer here), but also include significant settlements in other cases as well, including the Beazer Homes and Accredited Home Lenders cases.

 

With only a small percentage of these cases yet resolved, it is clear that the resolution of the subprime and credit-crisis related cases will remain an important part of the litigation landscape for years to come.

 

4. Bank Failures Mount: In a troublesome development with many worrisome implications, 140 lending institutions failed in 2009, by far the largest number of annual bank closures since the end of the S&L crisis. (By way of comparison, in 2008, there were 25 bank closures.) The number of bank failures increased as the year progressed, as 95 of the 140 bank failures (or roughly 68%) took place in the second half of 2009.

 

Though the bank closures were spread across 32 states, more than half of 2009 failed banks were concentrated in just four states: Georgia (25), Illinois (21), California (17) and Florida (14).

 

Despite the mounting numbers of bank failures, there has not yet been significant amounts of D&O litigation involving former directors and officers of the failed institutions. The are significant signs, however, that significant amounts of failed bank litigation ahead. Not only have investors and even employees of some failed banks filed lawsuits (about which refer here), but the FDIC has also shown a commitment to preserving its prerogative to assert claims against the directors and officers of failed banks. The FDIC has also begun to file notices of claims, in an attempt to preserve insurance against which to recover for claims against the directors and officers.

 

The FDIC’s latest quarterly banking report shows that it reckons there were 552 "problem" institutions as of September 30, 2009, up from just 416 at the end of 2Q09. With the numbers of both failed and troubled banks growing, and with the signs already pointing toward increased litigation involving these institutions, it seems likely that failed bank litigation will be a significant part of D&O litigation activity in 2010.

 

5. Business Bankruptcies Swell: According to the latest quarterly report of the Administrative Office of the U.S. Courts (about which refer here), business bankruptcy filings were up 52 percent in the 12 months ended September 30, 2009. The number of business-related bankruptcy filings has increased in the 12-month period preceding the quarter end of each quarter since the end of the third quarter 2006. The highest monthly total was in April 2009, when there were 5,621 business-related bankruptcies, compared to 4,853 in September 2009.

 

The possibility of a bankruptcy filing remains a significant threat for financially troubled businesses. As a general rule, D&O claims follow the filing of a bankruptcy petition.

 

Bankruptcy-related claims present a host of complications, not least of which is the intricate way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought be a company as debtor in possession against former directors and officers of the company, as a result of the policies insured vs. insured exclusion.

 

The likelihood of further business bankruptcies, with the prospect of related D&O claims, suggests that these kinds of coverage complications will appear frequently during 2010.

　

6. Rising Derivative Lawsuit Settlements: Threaten Increased Excess Side A Losses: The $118 million settlement in August 2009 of the Broadcom options backdating-related derivative lawsuit is the latest in a series of massive derivative lawsuit settlements. But perhaps even more significantly from the D&O insurance industry’s perspective, the Broadcom settlement appears to be the first instance where Excess Side A insurers were called upon outside of the insolvency context to contribute significantly toward settlement.

 

As detailed in greater length here, Broadcom’s Excess Side A insurers contributed $40 million toward the $118 million settlement. If nothing else, the settlement certainly underscores the value to companies (and their directors and officers) of the Excess Side A product, even outside the insolvency context.

 

The Broadcom settlement also represents a significant development for D&O insurers, who up until now have enjoyed the opportunity to offer Excess Side A insurance in a relatively low cost environment, particularly outside of the insolvency context. The Broadcom settlement highlights the potential for Excess Side A insurers to sustain significant losses on this product. The increasing incidence mega settlements, along with the growing numbers of business insolvencies, underscore the growing possibility for these kinds of losses.

　

7. Ponzi Schemes Emerge, Lawsuits Follow: The dramatic December 2008 revelation of Bernard Madoff’s massive Ponzi scheme proved to be only the first in a series of Ponzi scheme disclosures. According to a December 29, 2009 AP story (here), more than 150 Ponzi schemes collapsed in 2009, compared to "only" 40 in 2008. Among others, the schemes revealed in 2009 included the alleged Stanford Financial Group fraud and the alleged fraud of disbarred Florida attorney Scott Rothstein.

 

The one inevitable product of these disclosures has been the subsequent emergence of related litigation. The Madoff scandal along is its own litigation phenomenon. Indeed, the list of just the Madoff-related lawsuits – most of which were filed during 2009 – runs to over 25 pages. The Stanford Financial scandal also generated its own mass of litigation, beginning shortly after the fraud was revealed in February 2009. Many of the other Ponzi schemes have also generated their own burst of related litigation activity.

 

All of this litigation has produced a flood of claims activity for insurers. To be sure, many of these claims are more likely to trigger losses under E&O or even Fiduciary liability policies, rather than D&O policies. However, D&O insurance is implicated in a number of these suits, and the sheer claims volume as well as the accumulating costs of defense undoubtedly will adversely affect the results of D&O (and E&O) insurers for some time to come.

 

8. Supreme Court Grants Cert in Two Securities Cases: There was a time not too long ago when the U.S. Supreme Court only rarely took up securities lawsuit appeals. But in recent years, securities cases have become increasingly common on the Supreme Court’s docket. Just within the last couple of terms, the Court has handed down the Tellabs and Stoneridge cases (about which refer here and here).

 

Even with these recent developments, it remains noteworthy when the Supreme Court agrees to hear securities related cases, and for that reason it is significant that during 2009 the Supreme Court agreed to hear the appeals of two different securities suits. These two cases potentially could have a material impact on securities litigation procedure and jurisdiction.

 

First, in May 2009, the Supreme Court granted Merck’s petition for a writ of certiorari in the securities class action relating to the company’s disclosures about Vioxx. The Supreme Court will in this case address the question of what is required to establish "inquiry notice" sufficient to trigger the running of the two-year statute of limitations for private securities suits under the ’34 Act. Background on the Merck case can be found here.

 

Second, in November 2009, the Supreme Court granted cert in the National Australia Bank case. As a result of taking the case, the Supreme Court is likely to confront generally the question of extraterritorial application of the U.S. securities laws and will address specifically the question of when U.S. court properly can exercise jurisdiction over the claims of so-called "f-cubed" claimants (that is, foreign investors who bought their shares in foreign-domiciled companies on foreign exchanges). Background on the NAB case can be found here.

 

Both of these cases are likely to be decided during 2010. The Supreme Court heard argument in the Merck case in late November and it will likely hear argument in the NAB case during 2010. These cases potentially could have a significant impact on many securities lawsuits. The Merck case could affect frequently recurring statute of limitations issues and the NAB case could affect jurisdictional issues, and perhaps other concerns, in cases involving foreign companies (though pending Congressional initiatives could wind up superseding the Court on the jurisdiction question, about which see below).

 

While the outcome of these cases remains to be seen, the very fact of the Supreme Court’s involvement makes these cases significant. The anticipated rulings likely will represent among the more significant developments in 2010.

 

9. Congress Tackles Financial Reform: As a result of the political and financial events of the past two years, Congress is now poised to address a host of issues affecting both the financial markets and the securities laws, and some of the Congressional initiatives commenced in 2009 likely will have a significant impact on securities litigation.

 

The House of Representatives has already approved "The Wall Street Reform and Consumer Protection Act of 2009" H.R. 4173 (here), a sprawling 1279-page Bill that would institute a number of reforms that could have dramatic impact on the financial services industry.

 

As I detailed in a prior post (here), the Act also incorporates a number of provisions that could significantly affect securities litigation. Among other things, the Act provides a statutory standard for extraterritorial jurisdiction of the securities laws in certain circumstances. The Act also clarifies the pleading standard applicable to private securities lawsuits against the credit rating agencies. The Act would also significantly increase the SEC’s funding.

 

The House Bill must now be reconciled with several financial reform proposals pending in the Senate. Among other competing Senate initiatives are two bills introduced by Senator Arlen Specter.

 

The first of these, "The Liability for Aiding and Abetting Securities Violations Act of 2009," S. 1551 (here), would legislatively overturn Stoneridge and allow private securities suits for aiding and abetting claims. (Refer here for a discussion of this Bill.)

 

The second of the bills, "The Notice Pleading Restoration Act of 2009," S. 1504 (here, would legislatively overturn the Iqbal case and set aside the "facial plausibility" pleading requirement. (Refer here for a discussion of this Bill.)
 

 

While the legislative proposals are likely to go through many changes before financial reform legislation finally is enacted, these initiatives suggest that whatever finally becomes law will likely include provisions that could significantly impact securities litigation in the years ahead. It seems probably that Congress will enact financial reform legislation in some form during 2010, and so these Congressional initiatives could prove to be among next year’s top stories as well.

 

10. Significant D&O Exposures Emerge Outside the United States: For many years, the increasing threat of significant D&O exposures outside the United States has been a recurring theme amongst D&O insurance professionals. But in 2009, there were several significant developments demonstrating that D&O exposures outside the U.S. are no longer merely theoretical possibilities.

 

Perhaps the most significant developments in that regard are the two December 2009 rulings by Ontario Superior Court Justice Katherine van Rensberg allowing the securities lawsuit pending against IMAX and certain of its directors and officers to go forward, and certifying a global class of investors on whose behalf the case will now proceed. Legislation permitting this type of lawsuit in Ontario had been enacted several years before, but the IMAX case represented the first instance in which a lawsuit filed under the relatively new statutory provisions was allowed to proceed, as discussed at greater length here.

 

Though the IMAX case is still only in its earliest stages, a separate development in the liability case filed in Germany against certain directors and officers of Siemens underscores the fact that lawsuits outside the U.S. are potentially capable of producing massive D&O insurance losses.

 

As discussed at greater length here, in December 2009, Siemens reached a 100 million euro settlement with its D&O insurers in connection with claims arising from the company’s bribery scandal.

 

These developments are interesting and significant in and of themselves. But they are perhaps even more significant to the extent they underscore the fact that D&O exposures outside the U.S. are both growing and substantial. Clearly, the U.S. no longer has serious liability exposures for directors and officers.

 

Conclusion

One of the most noteworthy aspects of the 2009’s top D&O stories is that extent to which many of them indicate the trends we can expect to emerge or to continue in the year ahead. Certainly, the number of banks that failed during 2009 suggests the probability during 2010 of extensive litigation against the directors and officers of failed banks. The anticipated decisions of the Supreme Court and the probable Congressional action on financial reform legislation are also likely to be among the significant developments in 2010.

 

For that matter, the continued resolution of credit crisis-related litigation and the Ponzi scheme lawsuits are also likely to be a significant part of the litigation activity in 2010 (and for years to come).

 

What lies ahead in the coming year remains to be seen. But based solely on the events during the year we just concluded, 2010 promises to be both interesting and action packed. All I can say is that it is a great time to be a blogger.

 

More Year End Lists: As we head into 2010, a number of my fellow bloggers have also produced retrospective posts about the year we just concluded.

 

Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog has published a list of the "Top 5 Corporate and Commercial Cases from Delaware for 2009" (here).

 

In an interesting complement to Pileggi’s post, University of Denver Law Professor Jay Brown has begun a series on his Race to the Bottom blog of "Delaware’s Top Five Worst Shareholder Decisions for 2009" (here). This list apparently will be published in a series of posts, the first of which may be found here, and the rest to be published in the days ahead.

 

The FCPA Blog has published its annual "FCPA Enforcement Index" (here), which among other things, tallies up the SEC and DOJ enforcement actions under the FCPA, as well as FCPA-related civil litigation.

 

The Drug and Device Law Blog has a list of the "Top Ten Prescription Medicine/Medical Device Decisions of 2009" (here).

 

Legally related but more on the entertainment end of the continuum, Above the Law published its list of its "Top Ten Most Popular Stories of 2009" here.

 

Randy Maniloff and Sarah Damiani’s "Ninth Annual Review of the Year’s Ten Most Significant Insurance Coverage Decisions" (including the "Second Annual Insurance Coverage for Dummies) can be found here.

 

And finally, with a look ahead, my friend Evan Rosenberg of Chubb has written "A D&O Liability Wish List for 2010" which appeared in the January 2010 issue of Directors & Boards magazine, here.

 

Early January Observation: It is a truth universally acknowledged that early January is a rotten time to use a health club. I have belonged to many different clubs in many different cities, and the invariable pattern regardless of the facility or the location is that after New Year’s the clubs fill up with earnest, first-time users. This year has proven no exception.

 

Usually, by the 15^th of the month or so, all of the hubbub dies down and the only ones in the club are the regulars. My advice to anyone who has made a New Year’s resolution this year to start going to the gym is – don’t get discouraged, working out will be much more enjoyable after the middle of the month or so. Hang in there.

　

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In many prior posts (refer here), I have suggested that FCPA-related losses could represent a growing D&O exposure. In a recent demonstration of just how significant these kinds of exposures can be, Siemens disclosed  earlier this week that it has reached a 100 million euro settlement with its D&O insurers in connection with the claims arising from the company’s bribery scandal. The filing, which incorporates the insurance settlement documentation, raises a number of interesting issues.

 

In its December 8, 2009 filing of Form 6-K (here), Siemens reports that on December 2, 2009, the company reached a settlement agreement with its D&O liability insurers, while simultaneously announcing that it had also reached settlements with a number of its former directors and officers against whom it has asserted damages claims arising out of the bribery scandal. The settlements include the agreement of the company's former CEO Heinrich von Pierer to pay 5 million euros, and of his successor, Klaus Kleinfeld, to pay 2 million euros. Other former board members agreed to pay amounts ranging from 1 million euros to 3 million euros.

 

The filing explains that Siemens had a total of 250 million euros of D&O insurance coverage, arranged in five layers of 50 million euros each. Each layer had a lead insurer as well as participating coinsurers. The settlement agreement, which can be found in Annex 10 to the filing, identifies the lead insurers and the participating coinsurers for each layer.

 

The insurance settlement requires a payment to Siemens of up to 100 million euros, consisting of two parts: a payment of 90 million euros (against which prior defense payments of 5.5 million euros are to be credited) and as well as the payment of an additional fund of 10 million euros. The 10 million euro fund is to be maintained for the defense of future claims as well as for the satisfaction of "justified claims." that are asserted against former Board Members based on the bribery allegations or that have no connection with bribery allegation but for which coverage would have otherwise have been available under the D&O insurance program.

 

All of the layers in the Siemens D&O insurance program participated in the settlement, with each successive layer contributing a proportionately smaller percentage of the layer's 50 million euro limit.. (The percentage participations applicable to each layer are specified in the settlement agreement.) The 10 million euro fund is to be managed by the lead insurer on the primary layer on behalf of all the insurers.

 

The settlement agreement recites that the insurance settlement was the result of "intensive discussion" and that the Insurers had previously indicated that coverage might be denied on the grounds of, among other things, "pre-contractual knowledge and/or fraudulent/intentional violations of duties, and/or certain rights by unilateral declaration [that] can be exercised, which would lead to retroactive rescission of the D&O insurance." The parties reached the settlement in order to avoid the need to litigate these issues as well as to avoid the need for Siemens to pursue an action against … former Board Members who settled with Siemens in order to establish their liability as a precondition for the obligation to provide coverage."

 

Siemens’ SEC filing also reflects the settlement agreements reached separately with various former company officials. The filing recites that in connection with the individual settlements the individuals have agreed "not to draw on the D&O insurance coverage" in connection with their agreed payments to the company.

 

The agreement is subject to shareholder approval, which will be determined at the company’s January 26, 2010 shareholder meeting. (The shareholders will also vote on the individual settlements as well). The agreement clarifies that upon the effectiveness of the settlement, the insurance policies will be "retroactively terminated."

 

If it is "determined by a non-appealable court decision that individual Former Board Members intentionally or knowingly … violated their duties," then the Insurers shall be entitled to ask for reimbursement of defense costs paid to the respective former Board Member. The lead primary insurer is designated to administer this portion of the agreement.

 

There are a host of interesting things about this settlement.

 

The first is the marginal note accompanying the settlement stating that Michael Diekmann, a member of Siemens’ Supervisory Board, is the chairman of the Management Board of the parent holding company of the lead insurer on Siemens’ primary D&O insurance policy. The filing states that "Mr. Diekmann did not participate in the consultations and decisions pertaining to the Coverage Settlement." Call me cynical, but even if he didn’t participate in the consultations, this connection didn’t exactly impede the settlement either, if you take my meaning. To me this fact seems like it might help explain how there was any settlement at all, rather than the mother of all European D&O coverage lawsuits.

 

The second interesting thing is the way the D&O insurance policies are responding. The insurers are making a claims payment directly to the company, for claims that have been asserted by the company against its former officers. Unless the company’s European-issued insurance policies lack the kind of Insured vs. Insured exclusion that is standard in D&O policies issued in the U.S., there is something very peculiar about this payment. Even if the company itself is not an insured under the policy, it would seem like there would be an exclusion to protect against the possibility of collusive claims. Of course, there might have been such as exclusion in Siemens program and it was simply compromised as part of the settlement. (Readers who can help rationalize this apparent Insured vs. Insured problem are cordially invited to clarify, using this blog’s comment function.)

 

UPDATE: A knowledgeable European reader who prefers anonymity sent me a note with the following observation:"Regarding the payment towards the company we usually don´t carry IvI-exclusions over here in Germany. Most of the claims are made by the companies against individual directors and officers, word is that it´s around 80% or more of the times. We are basically still in the fledging stages of D&O litigation over here, D&O coverage was allowed in 1986, distribution really didn´t took off until the end of the 90s. The mentality over here regarding the pursue of claims against your directors and officers is totally different than in the US. Until the middle of the 90s, courts hadn´t even ruled on supervisory boards being forced to pursue claims against directors and officers."

 

The other thing about the insurers’ 90 million euro payment (less defense expenses previously paid) is the question of what exactly it represents. Simultaneously with the insurance settlement, Siemens settled its claims against most of the former company officials. So those claims have been resolved by individual payments for which the individuals are prohibited from seeking insurance. There are remaining claims against other individuals, but that is what the 10 million euro fund is for. So what exactly is the 90 million euro (less prior defense expense) payment for? Of course, the company has incurred literally billions of costs, expenses, fines and penalties in connection with the bribery scandal, but I don’t think the insurers are paying for the company's own scandal related expenses. 

 

The settlement agreement recites that, among other things, the insurance settlement relieved the company of the need to file and pursue actual lawsuits against former board members. I guess the internal logic of the settlement agreement is that the company could have pursued the lawsuits, and if they did, each would have to be litigated and separately settled, and the insurer would have to pay (assuming the claims were covered). The insurance settlement in effect says that we are just going to cut out all the intervening steps and compromise everything for a single payment.

 

The third feature is the way the settlement incorporates a settlement fund for future losses. It is on the one hand an escrow fund, but on the other hand it is more like insurance, or perhaps the residue of insurance with certain insurance-like attributes (e.g., it only applies to "justified" claims) The insurers are in effect providing a limited amount of insurance, but in a bargained down amount, with many fewer conditions.

 

Fourth, to the extent the insurance policies provided any type of insurance coverage for securities claims, the compromise and termination apparently precludes the availability of insurance in connection with the securities class action lawsuit filed in the Eastern District of New York last week, in which the plaintiffs alleged violations of U.S. securities laws solely against Siemens. (The $10 million fund would not be available in connection with this claim, because the claim was filed solely against the company, but the fund was set up only for claims asserted against former board members.)

 

Finally, I wonder what this settlement and the company’s settlements with the individual former company officials do to the derivative lawsuit that was filed in New York earlier in connection with the bribery scandal (refer here, see page 18). It is entirely possible that that case fell by the wayside earlier on, or that it was preempted by the claims the company itself asserted against the individuals. But it is an interesting question what impact these developments would have on the New York derivative lawsuit if it were still an active case. (Readers who may have any insight into the status of the derivative lawsuit are encouraged to provide updated information via the comment feature of this blog.)

 

Whatever else may be said about the settlement, it clearly represents a massive hit to the European D&O insurers. Hits on this scale may have become almost commonplace in the U.S., but this type of loss is still represents an extraordinary D&O insurance development in Europe. I wonder if this settlement is a game changer for the European D&O insurance community. UPDATE: Readers have advised me that massive D&O settlements on this scale are unfortunately becoming all too common in Europe as well; one example cited is the recent 57.5 million euro settlment involving EM.TV.

 

Finally, it is worth noting that the massive amount of the insurance settlement underscores the extent of the exposure that bribery-related claims represent. Though the Siemens case is extraordinary on many levels, the kind of insurance losses on claims related to bribery-related allegations are becoming increasingly common. As the Siemens insurance settlement demonstrates, the exposures are clearly not limited just to the United States.

 

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In a series of recent rulings in coverage litigation arising out of the 2007 collapse of Brookstreet Securities Corporation, a California-based securities broker-dealer, Central District of California Judge Cormac Carney addressed the claims of several claimants to the proceeds of a professional liability insurance policy that had insured the defunct company. Though the rulings are narrow and tied to the specific facts presented, the issues in dispute are likely to recur in claims arising from the subprime meltdown and accordingly the rulings may be of more general interest on that basis.

 

Background

Brookstreet provided broker dealer services nationwide until mid-2008 when the company experienced a financial collapse. The company ceased operations in June 2007 and is now insolvent.

 

Brookstreet was insured under a Securities Broker Dealer Professional Liability Insurance Policy for the period November 8, 2006 to November 8, 2007. The policy provides coverage for claims made against Insured Persons for actual or alleged Wrongful Acts in the rendering of "Professional Services." The policy had limits of $3 million.

 

The policy is an express "claims made and reported" policy, requiring in order for coverage to apply both that the claim be made within the policy period and that notice of claim be given within thirty days and during the policy period.

 

The insurer brought an action for interpleader and posted a $3 million bond. The insurer then filed three separate motions for summary judgment as to certain separate groups of interpleader defendants, all of whom are in turn claimants against Brookstreet or certain of its former directors, officers or employees.

 

Judge Carney’s Rulings

In a three separate rulings, Judge Carney addressed each of the insurer’s summary judgment motions.

 

Claims Made/Late Notice Issues: First, in a November 20, 2009 opinion (here), Judge Carney addressed the insurer’s motion for summary judgment as to the defendant claimants who had not made their claim against Brookstreet prior to the policy’s expiration or with respect to whose claims Brookstreet had not provided notice of claim to the insurer prior to the policy’s expiration.

 

Judge Carney quickly granted the insurer’s motion as to the claimants whose claims were made after the policy’s expiration, or with respect to whose claims Brookstreet had not provided notice of claim to the insurer during the policy period.

 

The more interesting questions about notice sufficiency arose with respect to the claimants who had made their claims during the policy period and with respect to whose claims Brookstreet had provded notice of claim during the policy period, but with respect to whose claims Brookstreet had not provided notice within the 30-day period required under the policy.

 

Judge Carney, enforcing the policy’s notice requirements strictly, found that the insurer was entitled to summary judgment even as to this latter group of claimants. Judge Carney found that the 30-day notice requirement was a "condition precedent" to coverage and that "to force" the insurer to have to demonstrate prejudice in order for the notice provision to be enforced "would be to rewrite the insurance contract, and the Court is unwilling to take this step."

 

Derivative Claim Exclusion: The insurer had also moved for summary judgment as to those claimants whose claims arose out of or were based on transactions involving Collateralized Mortgage Obligations (CMO). The insurer relied upon a policy exclusion precluding coverage for claims "based upon, arising out of or attributable to the sale, attempted sale, or servicing of … any type of …derivative." Relying on this exclusion, the insurer argued that the CMOs are derivatives, and therefore the policy precluded coverage for claims relating to the CMOs.

 

In a November 20, 2009 ruling (here), Judge Carney concluded, based on extensive material provided by the insurer, that CMOs are "derivatives" within the meaning of the policy. Accordingly, he granted summary judgment as to those claimants whose claims were based on CMOs.

 

Interrelated Acts: The insurer had also moved for summary judgment as to a claimant who asserted that a Brookstreet employee had mismanaged her investments, through a pattern of "churning, making unauthorized trades, buying and selling high risk stocks, and failed to advise [her] of investment losses" during the period 1996 though June 2006.

 

The insurer argued that her claim arose out of an Interrelated Wrongful Act that first occurred prior to the policy’s September 10, 2002 retroactive date. The insurer further argued that the pre- and post-September 10, 2002 conduct constituted a single, non-covered Interrelated Wrongful Act. The claimant asserted that each of the improper acts was a separate Wrongful Act, and that each time Brookstreet failed to supervise its employee, it also committed a new and discrete Wrongful Act.

 

In a November 18, 2009 ruling (here), Judge Carney held that while he "does not discount the possibility that [the employee’s] actions may have constituted an Interrelated Wrongful Act …there are genuine issues of material fact as to whether the acts after September 10, 2002 were interrelated with those occurring before that date." Because a "reasonable jury could conclude" that each time the employee "made an unauthorized trade, churned [the claimant’s account] or bought and sold high risk stocks" each was a separate Wrongful Act.

 

Discussion

Judge Carney’s rulings are interesting in and of themselves, but they are also interesting for what they suggest more generally.

 

First, his holding that the claims based on CMOs were precluded from coverage under the Brookstreet policy’s exclusion for derivatives claims is a reminder that the way insurance policies respond to many of the current claims based on complex financial instruments could involve a host of complicated insurance issues.

 

Although the exclusion that the CMO claims triggered in the Brookstreet case is peculiar to the specific type of insurance policy involved in that case, similar questions could arise under other policies in connection with other claims relating to complex investment securities and other financial instruments.

 

Many of the types of recurring claims asserted in the current litigation wave (e.g., the auction rate securities suits and the Madoff feeder fund lawsuits) present allegations of the type for which professional liability policies like that involved in the Brookstreet case were designed to respond. However, as the Brookstreet case shows, there potentially could be a host of complex coverage issues associated with many of these claims, depending on the facts alleged and the specific policy language involved.

 

Second, Judge Carey’s ruling on the interrelatedness issue is a reminder of how difficult interrelatedness questions can be. The term "interrelated" is neither defined in the typical policy nor is it self-defining. At a certain level of generalization, everything in the universe is interrelated, and at the same time, at another level, nothing is interrelated. What makes something interrelated for insurance coverage purposes can become quite situational and subjective, which leads many judges, like Judge Carney here, to want to leave interrelatedness questions to the jury.

 

Many of the cases in the subprime and credit crisis litigation wave present interrelatedness questions. Different complaints against the same or similar defendants in different policy periods raise the question whether one or several policies have been triggered. Judge Carney’s ruling in this case shows how difficult it may be for carriers seeking to rely on interrelatedness arguments. My own experience, consistent with Judge Carney’s ruling, is that courts tend to resolve interrelatedness questions in a way that maximizes the amount of insurance available.

 

Finally, Judge Carney’s rulings on the claims made and late notice issues are largely unremarkable, except as pertains to the question of the timeliness of notice for notices provided within the policy period but beyond the 30-day notice period. Judge Carney strictly enforced the policy’s 30-day notice requirement, and declined to even consider arguments based on the absence of prejudice.

 

Judge Carney’s literal enforcement of the notice requirement is is particularly noteworthy in that his ruling operated to preclude coverage for the claims of claimants where were in no way themselves involved with or responsible for the late provision of notice. ‘

 

In any event, Judge Carney’s rulings present an interesting case study. Special thanks to a loyal reader for providing me with copies of Judge Carney’s rulings.

 

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Pop quiz: the law of which jurisdiction should govern a coverage dispute arising under D&O insurance policies issued by U.S-domiciled insurers to an NYSE company incorporated in Delaware with its headquarters in Oregon? If you find the answer "British Columbia" as surprising as I do, read on. The court decision discussed below could have important implications for the typical U.S. D&O policy, with its extension of "worldwide coverage," particularly as both commerce and litigation become increasingly global.

 

Background

Now-bankrupt forest products company Pope and Talbot, Inc. was incorporated in Delaware and had its corporate headquarters in Portland, Oregon. Until its bankruptcy, its shares traded on the NYSE. Pope and Talbot conducted business through several operating subsidiaries, the largest of which was P&T Ltd., a Canadian federally chartered company with its principal operations in British Columbia. The bulk of Pope and Talbot’s operations ran through P&T Ltd. and the bulk of Pope and Talbot’s employees were employed by P&T Ltd.

 

P&T Ltd. is now in receivership. PricewaterhouseCoopers is the receiver for P&T Ltd. PWC, in its role as receiver, has instituted an action in British Columbia seeking a judicial declaration of coverage under the parent company’s D&O insurance policies for claims against P&T Ltd.’s directors and officers brought by former P&T Ltd employees under the Canadian Business Corporations Act for unpaid wages.

 

Pope and Talbot’s D&O insurance program was structured in several layers, involving three U.S. domiciled insurers. The negotiation and placement of the policies took place in the United States.

 

In a prior ruling, British Columbia Supreme Court Justice Paul Walker determined that the British Columbia court had jurisdiction over PWC’s declaratory judgment action. The insurers then sought a declaration that Oregon law would govern the dispute.

 

The November 12 Opinion

In his November 12, 2009 decision (here), Justice Walker determined that British Columbia law is the proper law to be applied to the interpretation of the policy.

 

He began with the determination that the parties intended different laws to apply to different parts of the policy (a choice of law principle known as dépeçage). In reaching this conclusion, Justice Walker referenced several different parts of the policies at issue, including in particular the primary policy’s definition of "Loss," which contained a provision specifying that the policy’s coverage for punitive and exemplary damages would be determined under the law most favorable to the insured. Justice Walker also referenced the policy’s Oregon state amendatory endorsements, which specified that Oregon law would govern any disputes regarding alleged misrepresentations in the insurance application.

 

Justice Walker determined that given these clause-specific choice of law provisions, and given the absence from the policies of any general choice of law provisions, the "proper law" governing the disputes arising under other policy provisions "is left to be determined by the court hearing the dispute to find based on the application of its own laws, taking into account the directing language in the policies."

 

Reviewing these circumstances in this light, and discounting the policies’ various connection to jurisdictions in the United States, and applying British Columbia choice of law principles, Justice Walker concluded that "the policies have the closest and most substantial connection with BC," and therefore BC law governs the coverage dispute presented by the receiver.

 

In substantiating this decision, Justice Walker stated that given the importance of the Canadian subsidiary, "most of the claims could be expected to arise from Canadian operations," and he stressed that the P&T Ltd. employees’ wage claims are "unique to Canadian operations" and have "no equivalent in Oregon," as a result of which Justice Walker concluded that "the proper law of the policies to determine the carriers’ coverage obligations for these claims is BC law."

 

He added that the parties "would reasonably have expected BC law to apply to determine the insurers’ coverage obligations."

 

Discussion

Suffice it to say that I have concerns with Judge Walker’s analysis. He managed to blow right past the fact that all of the acts involved with the formation of the insurance contracts took place in the U.S. and that insurance contracts were formed between a U.S.-domiciled company and U.S.-domiciled insurers, and that the key risks insured against and for which the policy was purchased were U.S.-based.

 

Justice Walker simply jumps to the conclusion that given the size of the P&T Ltd’s operations, the insurance contracts were primarily designed to protect against Canadian exposures. However, the company that purchased the policy was the parent company, a U.S.-domiciled company whose shares traded on a U.S. securities exchange. Is there any possible doubt that the most important reason the company bought the policy – and the reason the policies cost so much in U.S. currency – is because the company and its directors and officers wanted protection against corporate litigation in U.S. courts under U.S. law?

 

Of course the policies do provide "worldwide coverage" and, yes, of course substantive local law governs the local claims wherever the claims might arise. But Justice Walker seems to have telescoped the primacy of local law regarding the underlying dispute into a determination that local law should govern questions of policy interpretation, which analytically are two completely different issues.

 

All of that said, there are a couple of points in Justice Walker’s analysis that do give me pause. In particular, the considerations on which he relied in concluding that principles of dépeçage control the choice of law issue are by no means far-fetched. His consideration of the "law of the most favorable venue" wording in the provisions relating to coverage for punitive and exemplary damages is interesting and raises issues I had not previously considered. He may have a point that this language could be interpreted to suggest that the parties intended the laws of different jurisdictions to apply to different parts of the policy.

 

Where his analysis goes off track, in my view, is having found that different jurisdictions’ laws may apply to different policy provisions, he concluded both that BC choice of law principles should determine which law should apply, and he applied these BC choice of law principles in a blunderbuss way to conclude that BC law governed interpretation of the policy (see, e.g., his assertion that the likeliest claims to arise under the policies were Canadian claims.)

 

But the most significant aspect of Justice Walker’s decision is the unmistakable message that if a policy provides "worldwide coverage," the policy not only applies to claims wherever they may arise, but courts in those far flung jurisdictions may push ahead and apply their own local laws to questions of coverage relating to the local claim.

 

In the increasingly global economy, many businesses have significant operating subsidiaries in many countries. And as the rest of the world become increasingly litigious, too, the possibility of claims arising in these multifarious jurisdictions is increasingly likely. But while the U.S. D&O insurance industry has long noted the increasing possibility of claims arising outside of the U.S., I suspect it may come as a big surprise to many U.S. D&O insurers that local will law will not only govern the local claim itself, but the local court could also determine that local law governs questions of policy coverage for the local claim.

 

I have no idea what the insurance coverage laws are in vast smorgasbord of countries outside the U.S. Who knows what a court in, say, Vietnam or Slovakia or Gabon might conclude about a U.S-issued D&O insurance policy’s coverage for a local claim? I doubt that many domestic U.S. D&O insurers do either, and I suspect they have little interest in finding out.

 

On that score, it should be noted that Justice Walker repeatedly recognized the right of the parties to choose the law that would govern the interpretation of the policies, and it was only the absence of any such a provision that allowed him to conclude that BC law should govern.

 

All of which suggests to me that we may have reached the point where, at least from the carriers’ perspective, it may be time to for U.S.-based D&O insurers to consider the inclusion of a general choice of law clause in their policy. The inclusion of a choice of law clause would have the advantage of predictability and certainty, and it would spare the parties from a post-claim surprise discovery that, for example, the parties reasonably expected that BC law would govern the interpretation of these policies. (I am sure it was news to these carriers to learn that they had "expected" the interpretation of these polices to be governed by the law of British Columbia.)

 

Given the increasingly global nature both of commerce and of litigation, the inclusion of a choice of law clause arguably could be the reasonable next step in the evolution of the U.S. D&O insurance policy. Many international contracts in many contexts (including the insurance and reinsurance context) as a matter of course specify which jurisdiction’s law should govern the interpretation of the contract. Indeed, the typical D&O policy, with its "worldwide coverage" provision, really is itself an international contract, and to that extent it may be anomalous that U.S. D&O policies often do not have choice of law provisions.

 

Of course, were general choice of law clauses to be included in D&O insurance policies, the clauses would have to be carefully coordinated with other policy provisions, including in particular the most favorable venue wording relating to coverage for punitive and exemplary damages.

 

I recognize that both my analysis of Justice Walker’s opinion and my suggestions about the inclusion of choice of law language in U.S. D&O insurance policies could be controversial. I can well imagine D&O professionals who advocate for policyholders arguing that the local law ought to govern policy coverage issues. I can also imagine some insurance professionals objecting that whatever benefit a choice of law clause might produce in the international context, it might produce some unexpected and even unwanted results in the domestic context.

 

I am very interested in readers’ views, particularly those who may have a perspective different than mine regarding Justice Walker’s opinion and also with respect to my suggestions about choice of law provisions.

 

Very special thanks to loyal D&O Diary reader Raymond Sieh, whom I just met for the first time at last week’s PLUS International Conference, for providing me with a copy of the opinion.

 

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Beginning with the corporate scandals earlier in this decade and continuing with the more recent financial meltdown and Ponzi scheme revelations, these has been a widespread push toward corporate governance reform. In some European countries, these developments have been accompanied by the implementation of mechanisms to provide some form of relief to the victims of corporate misconduct.

 

These legal trends have in turn had a significant impact on the European D&O insurance marketplace, as discussed at length in the November 2009 Advisen report entitled "European D&O Insurance Market to Benefit from Governance and Legal Reforms" (here, $ required).

 

As discussed in the report, Europe has had its own share of accounting scandals, as a result of which "governments across Europe have passed laws requiring new disclosures, enhanced shareholder protections, and greater transparency." There have also been actual or proposed changes to litigation procedures, many of which represent moves toward the development of various forms of collective action. Though the progression of these changes varies by country, the "clear trend" is toward a "more collective-friendly civil legal system"

 

As a result of these developments (both the scandals and the legal reform), "the number of shareholder suits filed in European courts is substantially up."

 

In discussing this European litigation, the report uses its own terminology, and in particular, the report (apparently – the report does not expressly define the term as used in connection with the European litigation) uses the expression "securities suits" to describe both actions initiated by private litigants as well as regulatory enforcement actions.

 

With this specific use of the phrase "securities suits," the report states that since 2005, "32 large securities suits were filed in European courts against European companies." (The report does not specify what is meant by "large.") Of these 32 "large securities suits," 18 were filed in the first half of 2009 alone. In addition, of the 32, 29 were collective action suits. For cases settled since 2005, the average settlement per case was a "staggering" 117 euros ($155 million).

 

In addition, European companies have become increasingly susceptible to "securities suits," as the report uses that term, in U.S. courts as well. Claims against European companies doing business in the U.S., particularly those whose shares trade on U.S. securities exchanges, have "mushroomed" in recent years. The number of "securities suits" against European companies increased from 10 in 2005 to 37 in 2008, and to 23 in the first half of 2009.

 

Many of these "securities suits" against European companies in U.S. courts hare securities class action lawsuits – of the 113 "securities suits" filed against European companies in U.S. courts since 2005 (through mid-2009), 54 are securities class action lawsuits. The remainder of "securities suits" apparently includes enforcement actions, individual lawsuits and derivative actions.

 

The average settlement of "securities suits" against European companies in U.S. courts during the period 2005 through mid-2009 is 55 million euros ($78 million).

 

These litigation developments have amplified the risks to corporate directors and officers, and according to the report have affected the perceived need for D&O insurance as well. Most large European companies carry some amount of D&O insurance, although the "perceived level of D&O insurance coverage need varies among countries." Many small to mid-sized European public companies do not purchase D&O insurance at all. This relatively low penetration, together with the changing legal environment that could encourage more companies to purchase D&O insurance, represents a "once-in-a-lifetime growth potential" for D&O insurers.

 

The report estimates that the European D&O insurance market represents 2008 written premium of 1.37 euros ($2.0 billion), up from about 1.01 billion euros ($1.25 billion) in 2004. By contrast, the Advisen report estimates, the 2008 U.S. D&O insurance marketplace was worth about $6.8 billion.

 

The European market has grown in recent years at a compound between 2004 and 2008 of about 7.9 percent, but due to improved product take-up rather than to rate increases. The report projects that the European D&O insurance market is likely to continue to grow, though the growth is likely to vary from country to country, commensurate with the countries’ changing levels of legal reform.

 

The report contains a detailed overview of the specific legal developments in the U.K., German, Netherlands, Italy and France, and also includes summaries of legal developments in Austria, Denmark, Finland, Norway, Spain, Sweden and Switzerland.

 

The report is interesting and timely, and provides a thorough overview of European legal developments and the way they will impact the European D&O insurance marketplace.

 

My prior post on the development of collective action procedures in Europe and the contrast of these procedures with the U.S. class action system can be found here. My previous discussion of current D&O insurance issues in Germany can be found here. The state of securities litigation exposures for directors and officers of Japanese and Canadian companies, respectively, can be found here and here.

 

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There are certain constant issues in the D&O insurance marketplace, but at the same there is always a steady stream of critical issues that emerge and dominate the dialog. In the latest issue of InSights (here) entitled "What to Watch Now in the World of D&O," I take a closer look at the current hot topics affecting the marketplace for D&O insurance.

 

Bribery Probes and D&O Insurance: Regular readers know that I have written frequently on this blog (most recently here) about the increasing concerns about  the rising number of Foreign Corrupt Practices Act enforcement actions, including possible threats arising from follow on civil actions. The problems that issues may present for D&O insurers is discussed further in an article by Zack Phillips in the November 9, 2009 issue of Business Insurance entitled " Rise in Bribery Probes May Hit D&O Insurers" (here). Special thanks to a loyal readers for sending along a link to this article.

 

On a related note, Frederick Bourke, Jr., the individual mentioned in the Business Insurance article as having been convicted on criminal FCPA charges, was sentenced yesterday to one year in prison. Refer here for Andrew Longstreth's November 10, 2009 AmLaw Litigation Daily article.

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D&O insurance policyholders typically do not have to provide "fresh warranties" when they renew their policy of the kind they provided when they originally purchased the coverage – that is, they do not have to represent to the insurer that at the time of the renewal they are not aware of any facts or circumstances that could give rise to a claim. However, when policyholders increase their limits of liability at the time of renewal, they often are required to provide "fresh warranties" as to the increased limits, whether in the form of an increased limits application or in a separate warranty letter.

 

An October 26, 2009 Tenth Circuit opinion (here) illustrates the potential pitfalls for policyholders required to provide fresh warranties for increased limits. In its recent opinion, the Tenth Circuit held that an increased limits warranty exclusion precluded coverage for the defense fees of insured persons that fell within the amount of the increased limits. The Tenth Circuit held that the allegations in a later SEC complaint showed that at the time the policyholders’ representatives signed the letter, individual insured persons had knowledge of accounting improprieties that might (and subsequently did) give rise to claims.

 

Background

Fisher Imaging carried $5 million of primary D&O insurance, as well as an excess D&O policy providing an additional $2.5 million of insurance. At the time of the company’s April 2002 D&O insurance renewal, the company sought to increase the excess policy’s limits of liability from $2.5 million to $5 million.

 

In order to obtain this additional $2.5 million of excess coverage, Fisher supplied the excess insurer with a warranty letter signed by the then-CFO and the CEO representing that "no person or entity for whom this insurance is intended has any knowledge of information of any act, error, omission, fact or circumstance which may give rise to a claim which may fall within the scope of the insurance." The warranty letter stated further that it was an "express warranty for all insureds." (This last sentence is capitalized in the original.)

 

In April 2003, Fisher was sued by its shareholders in two securities class action lawsuits, both of which were later dismissed. In addition, in June 2005, the SEC filed a civil enforcement action against five officers and directors of Fischer. The SEC amended its complaint in May 2008. The amended complaint alleges that from January 2000 through September 2002, the officials had engaged in a scheme to fraudulently inflate the company’s share price by improperly recognizing revenue, misstating financial reports and misleading the company’s outside auditors.

 

Defense expenses incurred in connection with these actions exhausted the primary $5 million as well as the first $2.5 million of the excess layer. (The primary insurer and the excess insurer advanced these amounts subject to a reservation of rights to challenge these payouts later) However, the excess insurer took the position that the allegations in the SEC’s complaint triggered the exclusionary language in the warranty letter and therefore that it had no obligation to advance defense fees that fell within the "top" $2.5 million layer.

 

The individual directors and officers who are defendants in the SEC enforcement action filed a separate action against the excess insurer seeking a judicial declaration of coverage for their fees within the top $2.5 million, or in the alternative for a declaration that the excess insurer had a duty to advance defense fees within the layer.

 

The parties cross moved for summary judgment. The district court held that the allegations in the SEC’s amended complaint triggered the warranty letter exclusion, because "when read together," the SEC complaint and the exclusion show that certain of the individual SEC enforcement action defendants "knew of the wrongful activities at Fischer that could give rise to a claim."

 

The court granted summary judgment in favor of the insurer and the plaintiffs appealed.

 

The Tenth Circuit’s Opinion

On appeal, the plaintiffs argued that in reaching its conclusion that the warranty letter exclusion had been triggered, the district court improperly considered matters developed in discovery in the underlying SEC action, and that therefore represented matter "extrinsic" to the question whether the SEC’s amended complaint triggered the exclusion. The Tenth Circuit rejected this argument, stating that "we … confident that the court confined its legal analysis to the allegations in the SEC’s amended complaint."

 

The plaintiffs next argued that the district court had improperly used an "objective" standard in determining that the exclusion had been triggered – that is, the plaintiffs argued, the district court based its decision on what the plaintiffs (or some of them) must have known, rather than what they subjectively knew. The Tenth Circuit found that the district court properly used the required subjective standard, rather than an improper objective standard. The Tenth Circuit noted:

 

While the district court did not use the term "subjective knowledge" when it recounted the allegations, its reliance on those allegations about each director’s or officer’s knowledge about and participation in Fischer’s irregular accounting practices establishes that the court properly applied a subjective knowledge standard.

 

The plaintiffs raised several additional arguments, each of which the Tenth Circuit rejected with a variation on its conclusion that "the district court correctly concluded that the SEC’s claims, when read together, compelled the conclusion that the SEC’s allegations were within the exclusion in the Warranty Letter."

 

Discussion

Upon initial review, I found a number of things about the Tenth Circuit’s opinion puzzling. The first is that the opinion refers throughout to a warranty "exclusion" – yet there is nothing in the warranty letter language quoted in the Tenth Circuit opinion that would or even could affirmatively precludes coverage. Without any expressly exclusionary language, the excess carrier would lack any contractual basis to disclaim coverage within the top $2.5 million layer, even if there were warranty letter misrepresentation.

 

In order to try to answer to this puzzle, I tracked down the parties’ appellate briefs on PACER. Upon review of the briefs, it turns out that there was additional, critically important language in the warranty letter that the Tenth Circuit opinion neglects to even quote (a rather astonishing oversight, given that but for this exclusionary language in the warranty letter, there would have and could have been no coverage dispute).

 

That is, as described in the excess insurers’ appellate brief (here, see page 5), the warranty letter contains additional language, following the warranty statement in which the applicants disclaim the existence of knowledge of any facts or circumstances that may give rise to a claim, providing that "it is agreed that if such knowledge or information exists, any claim arising therefrom…is excluded from the proposed coverage." (The original is in all capital letters.)

 

So, you wouldn’t know it from the text of the Tenth Circuit’s opinion, but there was critically important exclusionary language in the warranty letter, and that language was in fact the language that the Tenth Circuit was deciding whether or not to apply.

 

The other thing that puzzled me about the Tenth Circuit’s opinion (and for that matter, the district court’s opinion) is that it seems to make an awful lot out of what are unproven allegations. Merely because the SEC has alleged some things doesn’t mean they are true. Yet the Tenth Circuit repeatedly says the district court properly relied on what the courts themselves both acknowledge were just pleading allegations. Both courts concluded that the mere allegations were enough for the excess insurer to withhold payment of defense fees that fell within the top $2.5 million.

 

A review of the plaintiffs’ appellate brief (here) did little to help clarify this puzzle. The plaintiffs never quite seem to get around to arguing that just because the SEC has thrown up a bunch of allegations that doesn’t mean that any of individual actually had knowledge of the facts or circumstances that might give rise to a claim at the time the warranty letter was signed.

 

Indeed, in its brief the excess insurer notes how far away from this argument the plaintiffs stayed, observing that the plaintiffs "understandably have nothing to say about the detailed litany of wrongdoing alleged in the SEC’s Amended Complaint" adding later that the plaintiff "never address this litany of facts." Instead, the plaintiffs seem (to me at least) to get hung up on arcane arguments about whether the objective or subjective standard should apply. It seems to me that only facts are sufficient to satisfy either an objective or a subjective standard, but that mere unproven allegations cannot suffice to satisfy either standard, regardless of which one applies.

 

This puzzling aspect of the opinion is all the more bewildering (to me at least) given the Tenth Circuit’s conclusion that the "subjective" test is the proper standard to apply. That is, the exclusion could be triggered only if the insured persons had subjective knowledge of the triggering facts. How can a test of subjective knowledge be satisfied by mere allegations rather than upon the proof of actual knowledge? Particularly if, as the Tenth Circuit further held, extrinsic matter is irrelevant -- nothing outside the complaint can be relied upon to show that the allegations are true.

 

Claimants assert all sorts of bizarre things, but mere allegations alone should not be enough to trigger policy exclusions, particularly an exclusion that is triggered only by what insured persons subjectively knew. Readers who may be able to explain to why I should not be troubled by this aspect of the Tenth Circuit’s decision are strongly encouraged to clarify this for me and other readers using this blog’s comment function. I am particularly interested to know how mere allegations could possibly provide a sufficient basis to trigger an exclusion requiring subjective knowledge of the triggering facts.

 

One possible explanation does occur to me. It may well be that the plaintiffs did not make the argument that the SEC amended complaint represents mere allegations because they felt they simply couldn’t make an argument premised on the suggestion that they did not have knowledge of some or all of the facts described in the complaint.

 

Indeed, it probably should be noted in that regard that the company itself had in 2004 voluntarily entered a cease and desist order with the SEC (refer here).Among other things, the agreed order recited that the company, "acting through certain of its officers and personnel," had improperly recognized revenue, overstated inventory, improperly classified expenses, among other things. The plaintiffs may felt under these circumstances that there were limitations on how much they could argue that the SEC’s complaint against them represented "mere allegations."

 

However, the existence of the cease and desist order might (or then again, might not) explain why the plaintiffs’ may not have raised the argument that the SEC complaint represents mere alletgations; they don’t really explain why the Tenth Circuit concluded that mere pleading allegations were sufficient to trigger the exclusion.

 

It is worth noting that the circumstances involved in this coverage dispute may be a vestige of the time period in which these events took place. The excess insurer’s warranty letter used provisions that would be unlikely to be used today. Specifically, the excess insurer’s warranty letter was set up so that if any one insured had knowledge of the preclusive facts or circumstances, the top $2.5 million would be unavailable to any insured person, even those without knowledge.

 

A well-crafted increased limits application or increased limits warranty letter today would likely provide (or the policy to which it referred would provide) that no knowledge of any person would be imputed to any other person. This nonimputation language would operate to preserve coverage for those without knowledge of the preclusive facts, which is clearly a preferable arrangement from the standpoint of insured persons.

 

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Because private equity firms often place representatives on the boards of their portfolio companies, questions can sometimes arise about the interplay between the private equity firms’ and the portfolio companies’ D&O insurance when claims are asserted against portfolio companies’ boards. All too often, these questions are considered only after claims have emerged. However, the better approach is for these issues to be considered at the outset, when the coverages are first put in place.

 

An October 19, 2009 article entitled "Getting Your Portfolio D&O Insurance Right (The First Time Around)" (here) by Paul Ferrillo of the Weil Gotschal law firm takes a look at the factors to be considered in connection with structuring both the portfolio companies’ and the private equity firm’s insurance in order to ensure that the policies are appropriately coordinated.

 

The first question the memo addresses is the issue of how much insurance the portfolio company should carry to ensure that the insurance is sufficient "to insulate the sponsor’s own D&O coverage and more importantly the fund from liability." There are, the memo notes, a host of factors to be considered, including how large the portfolio company is and whether or not the portfolio company under consideration is private or public, but the memo correctly points out that the most important consideration is that the portfolio company’s insurance "should be adequate to insure the portfolio company and its directors and officers against risks related to that company."

 

As the memo notes, the question of the sufficiency of the portfolio company’s policy limits "is not an area to get caught short" because otherwise the private equity firm’s insurance might be looked to in order to "make up the difference."

 

The memo notes that in addition to the adequacy of the portfolio company’s limits of liability, the adequacy of the terms and conditions in the portfolio company’s policy must also be considered, since neither all D&O policies nor all D&O carriers "are created equal."

 

The memo lists a number of particularly important policy features to consider, including: making sure the policy is non-cancelable and that the Side A coverage is non-rescindable; confirming that the Insured vs. Insured exclusion has a broad coverage carve back for claims brought by the bankruptcy trustee, receivers or other bankruptcy constituencies; that the policy has a priority of payments clause; and ensuring that the conduct exclusions are fully severable so that no one’s conduct is imputed to another insured person for purposes of precluding coverage. (I have more to say below about the memo’s comments concerning the conduct exclusions.)

 

The memo also discusses indemnification issues that can arise when private equity firm’s representatives sit on portfolio companies boards. In a prior post (here), I discussed the potentially conflicting indemnification issues that can arise when private equity firm representatives serve on portfolio company boards, and I reviewed recommendations on how these conflicts may be addressed. The law firm memo also notes that the potentially conflicting indemnification obligations could lead to confusion over the applicability of the private equity firm’s and the portfolio company’s insurance. In particular, the memo raises the concern that if these indemnification issues are not addressed in advance, the portfolio company’s carrier might try to claim that the private equity firm’s insurance should "share" in settlement and litigation expense incurred in connection with a claim against the portfolio company’s board.

 

In order to prevent an outcome that is not a "result that anyone intended," the memo suggests that the private equity firm’s D&O insurance policy should incorporate wording in its "other insurance clause" stating that with respect to a portfolio company claim against a private equity firm representative on the portfolio company’s board, the portfolio company’s D&O policy is primary and the portfolio company’s policy is excess. The portfolio company’s policy should contain "similar clarifying language."

 

The memo also suggests that the private equity firm and the portfolio company should enter "separate letter agreements" confirming that the portfolio company is the primary indemnitor for advancement, indemnification and D&O insurance purposes.

 

Overall, the memo provides a good overview of the issues and raises some important considerations. However, I respectfully disagree with the memo on two points.

 

The first has to do with what the memo describes as important with respect to the conduct exclusions in the portfolio company’s policy. The memo states that the "fraud and personal profit exclusions should contain ‘in fact’ and/or ‘final adjudication" language.

 

I disagree with the memo’s suggestion that "in fact" and "final adjudication" wordings may be viewed as somehow equally acceptable, as they most definitely are not.

 

The "after adjudication" wording requires a judicial determination that the precluded conduct has occurred. The superiority of an adjudication requirement is in fact well-established (see for example my discussion here), as an "in fact" wording potentially could permit a carrier to try to deny coverage even though there has been no determination that the precluded conduct actually took place. Contrary to the suggestion in the memo, the "in fact" wording should be avoided. Indeed, in the current competitive insurance marketplace, there will rarely be a circumstance where any insured should have to accept "in fact" wording in the conduct exclusions.

 

The second point with which I respectfully disagree is the memo’s repeated suggestion that insurance brokers cannot be relied upon to guide firms with respect to the issues raised in the memo. I agree with the memo’s statement that the task of coordinating private equity firm’s insurance with that of their portfolio companies "is not a task for many ‘generalist’ brokers." However, I disagree with the memo’s later suggestions that brokers may not be a reliable source on the issue of carrier’s claims reputations, or that getting the portfolio company’s insurance right is "not a job to leave" to the insurance broker.

 

Generalist brokers may not be adequately equipped to address these issues, but there are specialized brokers who have the requisite experience and expertise to deal with these concerns. Of course many companies will also find it reassuring to have their outside counsel involved in the insurance transaction, but experienced insurance professionals with the requisite specialized expertise are eminently qualified to put together insurance programs that coordinate appropriately between private equity firms and their portfolio companies.

 

UPDATE: After this post's publication, I spoke with Paul Ferrillo, the author of the law firm memo referenced above. To be clear, Paul's comments on insurance brokers were only directed to the "generalist" broker without specific cross-training in Private Equity/Portfolio company D&O issues. Paul notes that he has a great many friends on the brokerage side who add tremendous value to complex D&O insurance transactions involving Private Equity firms and their portfolio companies. His practice pointer here was only that this area is a complex one involving both insurance and legal questions, which all must be melded into a wholistic solution for the client.

 

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One of the questions insurance professionals have been asking with interest and anxiety since the financial crisis began is whether the economic recession will lead to a "hard market" for insurance (characterized by rising prices and tightening terms and conditions).

 

Earlier this year, Advisen, the insurance information firm, created a stir by predicting that a hard market for insurance would "begin to set in" as early as mid-2009, and in any event no later than 2010. The earlier Advisen report did, however, note that the current recession could reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition. My post about the prior Advisen report can be found here.

 

In an updated October20, 2009 study entitled "Planning for 2010: The Recession Will Keep Insurance Premiums Under Pressure" (here), Advisen now reports that "while rates are firming in a few isolated segments of the market," overall, due to falling demand resulting from the recession, insurance buyers "will continue to enjoy favorable pricing in 2010," and "materially higher rate levels most likely will have to wait until 2011."

 

The insurance cycle is basically a result of the shifting relationship between the demand for and supply of insurance. Prices fall when supply increases faster than demand. In order to track these shifting relationships, the Advisen report uses Gross Domestic Product (GDP) "as a proxy for demand," on the assumption that demand for insurance moves in relation to overall economic activity.

　

The study notes that historically, when the ratio of the supply of insurance (the insurers’ policyholder surplus) to GDP crosses the 3.2 percent mark, either up or down, "the market changes directions within the next 12 months or so." Part of the reason Advisen had earlier this year made its prediction of an approaching hard market is that the ratio fell to about 3.2 percent at the end of 2008 and continued to fall in the first quarter of 2009. However, the ratio crept back up to 3.27 percent at the end of the first half of 2009. Now, "the market remains unsettled with conflicting forces pushing and pulling on both sides of the tipping point."

 

The reason for this uneasy equipoise is that the recession is affecting both the supply and the demand sides of the equation. On the supply side, declining investment portfolio values has significantly reduced the insurers’ policyholder surplus. On the other hand, reduced economic activity has resulted in lower demand due to reduced numbers of "exposure units" (such as payroll levels, sales, vehicle units, etc.)

 

Other factors that have complicated the insurance cycle transition are: lower levels of catastrophe losses during 2009 compared to prior years; heightened competition from wounded market participants; the entry of new insurance capacity; and the insurers’ release of redundant loss reserves from prior years. Some of these factors could disappear (for example, catastrophe claims could emerge with little advance warning), or are less likely to be a factor going forward – in particular, loss reserve redundancies "now have been almost fully harvested," which eliminates insurers’ "cushion against adverse developments" and "could contribute to upward pressure on rates in 2010 and beyond."

 

Even if the recession may have ended as a matter of technical economic analysis, its effects are still being widely felt and the impacts from recovery "will be uneven, leading to further complexity and uncertainty" with respect to capacity and pricing. While these factors will continue to complicate the insurance cycle transition and "delayed the hard market," the shifting elements of the supply and demand equation "favor a modest increase in insurance demand by the end of 2010" – though "materially higher rate levels most likely will have to wait until 2011."

 

In the meantime, other than in certain areas, commercial insurance rates "on average continue to drift downward, though at a much reduced rate compared to a year ago." With respect to D&O insurance, financial sector premiums have "increased sharply" and financially stressed or highly leveraged companies "are likely to see higher premiums and some may have trouble finding adequate coverage." However other companies can expect to see premiums continue to fall into 2010, though "at a much slower pace."

 

Even at the time of Advisen’s earlier report, I had commented that "if there is going to be a hard market, its arrival could be more delayed than the report suggests." The more recent report seems consistent with my prior view that a hard insurance market could prove to be a long time coming. At this point, I don’t think I have any better sense of when it might arrive. I do agree that the uneven and gradual nature of the economic recovery could further delay the cycle transition. Unanticipated events (such as significant natural catastrophes) could intervene to accelerate the change, but absent those kinds of developments, the prospects for a market change anytime soon seem remote.

 

In any event, at 11 am EDT on October 22, 2009, Advisen will be hosting a free one-hour webinar on the State of the Insurance Market and the 2010. Registration for the webinar can be found here.

 

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Stanford Financial Group’s D&O insurer may advance the individual directors’ and officers’ defense expenses without violating the court’s receivership order, according to an October 9, 2009 ruling by Northern District of Texas Judge David Godbey. A copy of Judge Godbey’s ruling can be found here.

 

As detailed in a prior post (here), the insurer had been prepared to begin advancing defense expenses of Stanford Group’s former CFO, Laura Pendergest-Holt, subject to a reservation of its rights to later deny coverage under the policy if circumstances should warrant. However, before the insurer began advancing these amounts, the Stanford group receiver had notified the receiver that if the insurer advanced Pendergest-Holt’s defense expenses, the receiver would seek to have the insurer held in contempt of court for violating the court’s receivership and asset freeze orders.

 

The receiver asserted that the proceeds of the D&O insurance policies are "receivership assets" within the meaning of Judge Godbey’s prior receivership and asset freeze orders. The receiver also argued that his right to the proceeds "supersedes" the rights of insureds under the policy.

 

Pendergest-Holt filed a motion in the SEC enforcement proceeding (here) seeking a judicial clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeking authorization for the disbursement of the proceeds for payment of her defense expense.

 

The insurer itself had also inquired of the court whether it could advance the defense expenses without "running afoul" of the receivership order. However, the insurer, which has separately filed an action seeking a judicial declaration that the Stanford receivership is not entitled to payment of claims as a result of the operation of policy exclusions, did not request the court in the SEC enforcement proceeding to decide whether or to what extent any insured is entitled to coverage—it sought only to determine whether the receivership order barred it from advancing the individuals’ defense fees.

 

In his October 9 ruling, Judge Godbey concluded that he did not need to determine whether or not the proceeds were receivership assets, because he concluded that he would exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate."

 

In deciding to exercise his discretion to allow the proceeds to be advanced for defense expenses, he noted that "there is no argument that the insurance proceeds are potentially tainted by fraud" and therefore "the Court has not duty to preserve them as such." As for the possibility that the insurance premiums might have been paid with "stolen money," he noted that while this might be "unjust and regrettable," that fact "would not entitle victims to proceeds of policies intended to pay defense costs."

 

With respect to the receiver’s argument that allowing policy proceeds to fund the individuals’ defense expense would "decrease the coverage dollars eventually available for distribution," Judge Godbey found that "the possibility that the D&O proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims." The judge noted that the receiver "has not yet tendered any claims against the Stanford entities to [the insurer] for a defense," noting further that even if it had, "it is not at all clear" that the insurer would ever pay a claim into the receivership, owing to the insurer’s policy defenses.

 

Finally, Judge Godbey found that the "interests of fairness" justify allowing the individuals to access the insurance proceeds. The receivership’s potential claims are "speculative" while the individuals "expected that D&O proceeds would afford a defense" and the "potential harm to them if denied is not speculative but real and immediate: they might be unable to defense themselves."

 

Judge Godbey emphasized that in his ruling that his prior orders the insurer from disbursing policy proceeds to fund the individuals’ defense, he was not holding that any defendant "is entitled to have its defense costs paid by D&O proceeds." Moreover, Judge Godbey emphasized that his October 9 ruling does not authorize the insurer "to pay any claims other than defense costs."

 

Though Judge Godbey ruled only on Pendergest-Holt’s motion, his ruling expressly "extends to any covered officer or director whose claim is approved" by the insurer. Judge Godbey’s ruling seemingly applies to R. Allen Stanford himself, at least to the extent that the ruling represents a determination that the court’s prior receivership orders are no bar to the insurer advancing defense costs.

 

Whether the insurer will in fact advance Allen Stanford’s defense expenses may be yet to be determined, notwithstanding the October 9 ruling that the receivership order is no bar. An October 9, 2009 Bloomberg article (here) presumes that as a result of Judge Godbey’s ruling, Stanford is now entitled to have his attorneys’ fees advanced. Indeed, absent a judicial "determination" that Stanford in fact engaged in excluded misconduct, the basis on which the insurer might withhold advancement of Stanford’s defense expenses is not immediately apparent, notwithstanding the seriousness of the allegations against him.

 

The problem for everyone involved is the sheer number of persons who will seek to have their defense fees paid by the insurance and the extent of the collective defense expense. According to the Bloomberg article, as many as 60 Stanford officials are seeking to use the D&O insurance proceeds to pay their legal bills. Moreover, many of these individuals are involved in numerous civil and criminal proceedings.

 

The total amount of D&O insurance available is not entirely clear from the published reports. The Bloomberg article variously reports that the total insurance limits are "as much as $50 million" and "as much as $90 million" – kind of a big swing on a rather important detail. But the potential for defense expenses in catastrophic claims to substantial erode or even exhaust insurance programs of a similar magnitude has already been demonstrated in other claims (refer for example here).

 

Given the seriousness of the allegations and the multiplicity of proceeding involved, the various individuals’ collective defense expenses could quickly erode the available limits, particularly if, as seems possible, Stanford himself accesses the policy proceeds for his defense expenses.

 

It is worth noting that Judge Godbey exercised his discretion to allow the proceeds to be advanced toward the defense expenses, notwithstanding the Stanford entities’ potential claims, even though this policy reportedly lacked a "priority of payments" provision, which would have given the individual defendants priority to the policy proceeds over the entity, as a matter of policy language. As discussed in an October 4, 2009 Business Insurance article (here), this type of provision is now standard in most D&O insurance policies, and might have helped sort out this dispute, although in the end the outcome apparently would have been no different.

 

Special thanks to William Schreiner of the Zuckerman Spaeder law firm for providing me with a copy of Judge Godbey’s October 9 ruling.

 

No D&O Policy Coverage Where Claim Made Only Against the Company: In an October 8, 2009 opinion (here), the First Circuit held that a D&O insurance policy does not cover the settlement of a disability discrimination claim that did not name any individual directors and officers as defendants.

 

The Medical Mutual Insurance Company of Maine had been sued in an administrative proceeding by a former company executive who claimed that the company had discriminated against him due to his stroke-related disability. The administrative proceeding resulted in a "right to sue" letter, pursuant to which the former executive initiated a federal court discrimination lawsuit. Both the administrative complaint and the federal complaint named only the company itself as a defendant.

 

The company settled the lawsuit and sought coverage under the D&O insurance policy for $325,000 of the settlement amount. The D&O insurer denied coverage under its policy, arguing that because there had been no claim made against an individual director or officer, there was no coverage for the settlement under the policy’s "corporate reimbursement" coverage. (The opinion explains in footnote 3 that while the policy also separately provided "entity coverage" for "securities claims," the discrimination complaint was not a securities claim and accordingly the policy’s separate entity coverage provisions were not implicated.)

 

In an October 8 opinion written by Judge Bruce Selya, the First Circuit held that the company’s argument that the policy’s coverage extended to claims in which directors and officers were not named as defendants "would if accepted transmogrify D&O policies into comprehensive corporate liability policies," and that "such a transmogrification is contrary to both the letter and the spirit of the D&O policy at issue."

 

The company had argued that the Policy’s claims made requirement had been satisfied because the underlying discrimination complaint consisted "largely of allegations of misconduct on the part of the directors and officers." The First Circuit held that "no matter what conduct the complaint describes, it is not a claim ‘made against’ any of the directors and officers."

 

The court went on to note that the policy’s separate requirements of both allegations of wrongful acts and for claims against insured persons "are complementary requirements and allegations of wrongful acts, without more, do not satisfy both."

 

The First Circuit’s opinion is arguably unremarkable, as D&O policies clearly and separately require both allegations of wrongful acts and claims to be made against insured persons.

 

The only puzzling thing to me about this case is why there was a D&O insurance dispute at all. The more natural place for the company to have looked for coverage for a claim like this is an Employment Practices Liability (EPL) insurance policy. EPL policies are designed to provide coverage for employment-related discrimination claims and generally provide coverage for claims against the insured organization.

 

Because I was curious, I ran down the parties’ appellate briefs on PACER. As it turns out, and as might have been predicted, the insured company did indeed also submit this claim to its EPL insurer.

 

As reflected in the D&O insurer’s appellate brief (here, at pages 4-6), not only did the EPL insurer provide the company with a defense for the underlying claim but it also paid $225,000 toward a total settlement amount of $500,000. The remaining $325,000 portion of the settlement amount for which the company sought coverage under the D&O policy represented the amount the company paid in resolution of the former executive’s unpaid contractual severance and benefits, for which the EPL carrier denied coverage under its policy.

 

So – that explains why this company was trying to stick what is rather obviously an EPL claim into the D&O policy, because there was a portion of the underlying EPL claim settlement for which the EPL policy did not provide coverage.

 

In any event, congratulations to my friend and former colleague Leslie Ahari, who represented the insurer in this action.

 

An October 12, 2009 Law.com article discussing the opinion can be found here. Special thanks to alert reader Marty Fox for providing me with a link to the Law.com article.

 

The Transmogrifier: For reasons unrelated to the merits or even the issues involved, the First Circuit’s opinion is one of my new favorites -- it is the first judicial opinion of which I am aware using the words "transmogrify" and "transmogrification." (Judge Selya, the opinion’s author, has a well-established reputation for using flamboyant and occasionally obscure language in his opinions.)

 

The word "transmogrify" in its various formulations was forever immortalized in the Calvin and Hobbes comic strip, in which Calvin turned an empty cardboard box into a "transmogrifier," capable of changing a person into "whatever you’d like to be."

 

There is a truly wonderful website here dedicated exclusively to the Calvin and Hobbes transmogrifier comic strips. And the excuse to be able to link here to the Transmogrifier site is more than enough justification for discussing the First Circuit opinion above.

 

Please click through to the site and enjoy the comic strips. They will make you smile. You too could consider turning yourself into a "500-story gastropod, a slug the size of the Chrysler Building." However, do keep in mind, as Calvin reminded Hobbes, that "transmogrification is a new technology."

 

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One of the recurring D&O insurance issues is the question of policy coverage for additional acquisition consideration paid to an acquired companies’ shareholders – so-called "bump up" claims. In an interesting and colorfully written September 28, 2009 opinion (here) that insurers undoubtedly will cite profusely in future disputes of this kind, District of Massachusetts Judge Nancy Gertner held that Genzyme Corporation’s D&O insurance policy did not cover amounts Genzyme paid to settle the claims of individuals who asserted they had received inadequate consideration in an exchange for their tracking shares of an internal Genzyme division.

 

Background

From 1993 to 2003, Genzyme’s capital structure included "tracking stock" to track the performance of separate business units within the company. In May 2003, Genzyme’s board decided to eliminate the tracking stocks, and the company announced that it would exchange the business units’ tracking stock for a certain number of the company’s General Division’s shares.

 

The ensuing exchange "proved to be unpopular among many Biosurgery Division shareholders," who subsequently initiated a securities class action lawsuit against Genzyme and certain of its directors and officers. The Biosurgery Division shareholders alleged that the defendants had schemed to depress the Division’s tracking stock so that Genzyme could fold the Biosurgery Division into the General Division at an exchange rate favorable to General Division shareholders. In August 2007, Genzyme agreed to settle the Biosurgery Division shareholders’ claim for $64 million. More detailed background regarding the lawsuit can be found here.

 

Genzyme sought to recover part of this settlement amount from its D&O insurer. The insurer denied coverage on two grounds: (1) that the settlement did not represent insurable "loss" under the policy; and (2) that coverage was precluded by the policy’s "bump up" exclusion. Genzyme initiated coverage litigation. The D&O insurer moved to dismiss.

 

The September 28, 2009 Opinion

Judge Gertner opened her opinion with an assessment of the "plethora of cases" on which the D&O insurer sought to rely to argue that "an insured does not incur insurable loss when she is merely forced to disgorge money or other property to which she is not entitled." Judge Gertner noted that "this legal principle is undeniably correct and would almost certainly be adapted by a Massachusetts court."

 

Judge Gertner then made the first of the several vivid commentaries that characterize her opinion, when she noted that

 

A thief should not be able to claim the return of stolen property as an insurable loss. Similarly, an individual who breaches her contract and then is forced to pay damages should not be able to seek indemnification under an insurance policy. If I pay only $100for an item for which I promised to pay $200, and I am later ordered by a court to pay the additional $100, I should not be able to claim the additional $100 as an insurable loss. Had I paid the full $200 due up front, then clearly no part of the $200 would constitute loss covered by insurance. The dilatory nature of my obligatory payment should not transform it into an insurable event.

 

Genzyme sought to distinguish the referenced case law by arguing that it had received no benefit to which it was not entitled or that could be disgorged. Judge Gertner agreed, noting that the company had merely reorganized its capital and issued additional shares. But while Genzyme itself did not benefit, its shareholders "surely did" benefit from the reduced exchange ratio, and the class action was "meant to redress the imbalance."

 

As a result of these circumstances, Judge Gertner found, this case "does not fit comfortably within the existing case law holding that the mere return of an ill-gotten gain was uninsurable." She expressly rejected the insurer’s "attempt to force this case into the existing case law."

 

Having determined that the existing case law was inapposite, she proceeded to address defendants’ motion based her own analysis of the question presented, which she stated to be as follow: "When a corporate pays a settlement to resolve a claim that it benefitted one group of shareholders at the expense of another group of shareholders, is this settlement payment an insurable loss?" The answer to this question, she found, "must undoubtedly be ‘no.’"

 

To explain this conclusion, Judge Gertner resorted to a "somewhat strained – but one hopes enlightening – hypothetical." In her hypothetical, a father and his two sons, Daniel and Eli, are in a restaurant and have ordered a singled milkshake divided into two cups. The father redistributes the milkshake between the cups in a way that leaves Daniel with two-thirds of the milkshake and Eli with one third. The father, she noted, would be expected equalize the distribution, not "to turn to the restaurant owner and demand that he provide more milkshake to make up the difference."

 

Drawing upon this hypothetical, she found that the lawsuit settlement had merely "recalibrated the division" in the share exchange by giving the Biosurgery Division shareholders additional cash in place of the additional shares to which they claimed they were entitled. Genzyme should not, she said, be able to demand indemnification from the insurer for what is in effect a share redistribution.

 

If Genzyme’s interpretation of the policy were correct, she found, "a corporation merely need issue several classes of shares, cancel one class in an arguably unfair way, and then demand that the insurer pick up the tab." She rejected this possibility noting that the policy "should not be read in a way that produces absurd results."

 

Judge Gertner then turned to the insurer’s alternative argument that there was no coverage under the policy for the settlement because of the policy’s "inadequate consideration" or "bump up" exclusion, which provides that the carrier is not liable for "the actual or proposed payment by any Insured Organization of allegedly inadequate consideration in connection with its purchase of securities issued by any Insured Organization." Genzyme argued that the exclusion did not apply because the share exchange did not involve a "purchase" of securities, but rather the mere exchange of one class of securities for another.

 

After reviewing dictionary definitions, Judge Gertner concluded that the share exchange was "unambiguously a ‘purchase’ within the natural and ordinary meaning of the word." She also found that Genzyme sought coverage under a policy provision applicable only to a "securities claim," defined inter alia as the "purchase or sale of securities." Genzyme, she noted, was contending that the share exchange was a "purchase" for purposes of relying upon the policy’s definition of securities claim, yet did not explain why the same word should have a different meaning in a different policy provision.

 

Judge Gertner rejected Genzyme’s further argument that even if Genzyme itself no claim in its own right under the policy, there would still be coverage for the settlement under the policy’s separate insuring clause providing reimbursement for Genzyme’s indemnification of its directors and officers.

 

Judge Gertner found that "it makes little sense to allow a corporation to sidestep coverage limitations in its insurance policy through the simple expedient of claiming that a settlement payment was made to indemnify its directors and officers." She noted that a contrary holding could "encourage fraud" and "chicanery," as otherwise a corporation could use calculated indemnification resolutions to try to create coverage for otherwise noncovered claims.

 

Discussion

Judge Gertner’s opinion is not only highly readable and even entertaining, it is also potentially significant, for a number of reasons.

 

First, Judge Gertner made it clear that she was not relying on prior case law in reaching her decision. As a result, her opinion potentially represents a new line of analysis in connection with the perennial questions about coverage under the D&O policy for "additional consideration" claims. In particular, her analysis does not depend on whether or not the payment for which coverage was sought was "restitutionary." Rather her analysis turned on whether the insurer could fairly be asked to pay for what was effectively a redistribution or "recalibration."

 

At a minimum, this line of analysis could give insurers disputing coverage for "bump up" settlements an additional ground on which to base their position, arguably without even having to get into the question whether the payment in dispute was "restitutionary." Insurers instead (or perhaps alternatively) will strain to rely on Judge Gertner’s milkshake hypothetical.

 

Second, and perhaps more significantly, Judge Gertner did not base her decision on the bump up exclusion alone, although she did grant the motion in the alternative based on the exclusion. The significance of the fact that she separately and independently granted the motion to dismiss on the ground that the settlement is not an insurable "loss" is that even today many policies do not contain a bump up exclusion. Indeed, over the years, many of the "additional consideration" coverage disputes that have arisen have involved policies lacking such exclusions. Judge Gertner’s reasoning could be particularly influential in future "additional consideration" disputes involving policies without bump up exclusions.

 

Third, even though her opinion did not rely on the prior case law holding that restitutionary payments are uninsurable, her detailed elaboration of the intellectual basis for the principles behind the case law will undoubtedly add weight (and color) to legal arguments relying on these cases.

 

Fourth, the decision is also significant for its interpretation and application of the bump up exclusion. As I noted in a prior post (here), these exclusions are still relatively new, vary widely, and generally have not been subject to extensive judicial scrutiny. There is still relatively little case law interpreting bump up exclusions. Judge Gertner’s enforcement of the exclusion here, particularly her conclusion that the share exchange was a "purchase" within the exclusion’s meaning, helps illuminate how these exclusions operate and how they will apply.

 

Finally, Judge Gertner’s opinion may be particularly noteworthy because of her willingness to dispense with prior case law formulas and to base her decision instead on a careful consideration of the underlying transaction and facts. However, I expect that not everyone is going to be equally impressed with her milkshake hypothetical. Even those inclined to cheer Judge Gertner’s opinion here should reflect on the possibility that other judges, perhaps lacking Judge Gertner’s intellectual rigor, might unburden themselves of their own hypotheticals that may or may not have anything to do with the parties’ reasonable expectations of how the policy should operate.

 

In any event, insurers undoubtedly will find much to like in Judge Gertner’s opinion, which is not only highly literate but highly quotable. Her colorful phrases will undoubtedly be featured heavily in insurers’ future legal briefs both on bump up claims and with respect to questions regarding restitutionary payments. The only things that may undercut insurers’ attempts to rely on the Genzyme decision are the somewhat unusual facts involved in the case. Those seeking coverage will certainly try to argue that Judge Gertner’s "redistribution" or "recalibration" analysis is restricted to the specific and unusal circumstances of the Genzyme case.

 

A September 29, 2009 memo by the Wiley Rein law firm summarizing the opinion can be found here. Wiley Rein represented the D&O insurer in the Genzyme coverage dispute.

 

Special thanks to the several loyal readers who sent me copies of the Genzyme opinion.

 

All That, and She’s A Fellow Blogger, Too: Readers curious about Judge Gertner’s willingness to express herself so freely in a judicial opinion may be interested to know that in addition to being a federal judge, she is also a blogger. According to a Boston Globe profile (here), she began blogging because she determined with respect to blogs (correctly in my view), that "if this is where people are getting information, this is where to be." She also noted, in an observation to which every blogger and would-be blogger will relate, that the hardest part about blogging may be finding time to blog.

 

She apparently has had found little blogging time lately, because there have been relatively few recent entries by any of the contributing authors on the site for which she has been blogging, the Convictions blog on the Slate website (here). (Believe me, Judge Gernter, I know all about the way a pesky day job can interfere with important blogging activities.)

 

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On September 9, 2009, Towers Perrin released its report of the firm’s 2008 Survey of Directors and Officers Liability Insurance Purchasing Trends, which can be accessed here. Towers Perrin’s anticipated annual report again this year will undoubtedly be widely read throughout the D&O insurance industry. The report is a good resource and it is full of useful and interesting information.

 

Because the Report is so widely read, I think it is very important to highlight some specific issues about  the report. As I noted in connection with the 2007 report (here), the survey report is subject to some very important limitations that may not always be fully appreciated or understood.

 

In my view, the most significant limitation is one that is duly noted in the final two sentences of the Report section headed "Statistical Terms Used in This Report." As the Report states, the Report is the product of a survey, which means that the data in the Report are drawn from a "non-probability sample." That is, participants "choose – or are selected" to participate, and therefore the sample "is not random." Most importantly, because "not all potential respondents are likely to participate, survey biases must be considered when interpreting results."

 

It is the danger that this last point – the possibility that the reported results reflect "survey biases" – that most concerns me. In particular, the reference to the possibility that the survey respondents were "selected" is particularly relevant.

 

Specifically, the broker rankings section of the Report reveals that fully 95.2% of all survey responses came from the clients of just four brokerage firms. The same four firms also dominated the 2007 survey results, but the 2008 results reflect an even greater concentration, as the four firm’s clients represented "only " 88% of the survey respondents in the 2007 survey. In the 2008 survey, only 4.8% of all respondents are clients of firms other than the four brokerages. Indeed, clients of the three global insurance carriers represented just 1.8% of the respondents.

 

These observations should not 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, nor could anyone fairly attempt to use the survey results to try to create that impression.

 

I emphasize this aspect of the Report because the survey bias in the broker participation population has pervasive effects throughout the entire report. Indeed, given that the pool of actual survey respondents for all practical purposes represents the clientele of those four brokerage firms, the Report fairly might be characterized as a description of the purchasing patterns of the clients of those four firms, rather than of the marketplace as a whole.

 

However, the Report itself does not address whether or not this rather categorical "skew" in the survey response population affects the other reported results, although it pretty obviously could significantly affect many of the other observations in the report. For example, the Report’s attempt to rank carriers by policy count and premium could simply be a reflection of the predilections of the four firms. The same is true with respect to such issues as respondents’ decision whether to purchase Side A insurance or IDL insurance.

 

There are other limitations arising from the characteristics of the respondents. Many of the respondents are very small.—nearly 40% reported assets under $6 million. Nearly 70% of the respondents had under 100 employees.

 

Another perhaps more significant concern with the 2008 Report is that the survey participants completed the survey during the third quarter of 2008. Not only does that mean the data are a year old, but also the survey results may fail to reflect the enormous changes in both the global economy and in the insurance marketplace during the last twelve months. Thus, there is some risk that the survey results, to whatever extent they fully and accurately reflect marketplace conditions of a year ago, may not reflect current conditions, given the enormous changes since the survey was conducted.

 

In addition, the Report also makes numerous year over year comparisons, noting changes between the results of the 2007 survey and the results of the 2008 survey. The difficulty with these comparisons is that there is no way of knowing whether or not the differences in the survey results are simply the result of a different mix in survey respondents, rather than a change in the underlying circumstances. To be sure, the Report does several times work hard to provide comparisons showing the results reported by repeat survey respondents. But there are numerous comparisons throughout the Report that are not so limited.

 

With respect to the concern noted above about the concentration of survey respondents in the portfolios of just four brokerage firms, it is a fair observation that the survey is open to all. If survey participation were more widespread, many of the concerns noted above might be alleviated. However, the opposite appears be happening, as participation by other brokerage firms is clearly declining, for reasons that might well be surmised.

 

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.

 

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Each fall for the last three years I have taken a look at the current trends and hot topics in the world of D&O. There are of course the perennial topics that always remain important. However, this overview is intended to address the most significant concerns of current interest for D&O insurance professionals and their clients. My list of the current issues to watch is set out below.

 

Will Rising Corporate Bankruptcies Produce Increased D&O Claims?

According to the Administrative Office of the U. S. Courts (refer here), the number of business-related bankruptcies increased 63% (to 55,021 from 33,822) during the year ended June 30, 2009. Although there are some encouraging signs that the overall economy may be beginning to recover, significant numbers of individual companies could continue to face the risk of bankruptcy for some time to come.

 

Among other problems associated with bankruptcy filings is the risk of increased claims against officials at the bankrupt firms. For example, in its 2008 year end report on securities litigation activity, Advisen noted that since 1995, roughly 35 percent of the large public companies (defined as having assets of over $250 million in 2008 dollars) that filed for bankruptcy also sustained securities class action lawsuits against their directors and officers. During 2007 and 2008, the percentage increased to 77 percent. The directors and officers of private companies also face a heightened claims exposure when their companies file for bankruptcy.

 

Bankruptcy associated-claims present a host of complications, not least of which is the intricate (and sometimes problematic) way that D&O insurance policies respond in the bankruptcy context. One recent development illustrating the difficulties that can arise in the bankruptcy context was the July 2009 decision in the Visitalk case (about which refer here), in which the Ninth Circuit upheld the carriers’ denial of coverage for a lawsuit brought by a company as debtor in possession against former directors and officers of the company, as a result of the policies’ insured vs. insured exclusion.

 

These kinds of complications underscore the need for D&O insurance policies to be closely scrutinized for their ability both to withstand and to respond to claims arising in the context of bankruptcy.

 

One final concern is that the rising tide of corporate bankruptcies could trigger increased losses under Excess Side A insurance that many companies now carry. This possibility is one of several factors, many of which that are discussed below, that could represent a changing environment for carriers offering Excess Side A insurance. The increased number of bankruptcies in any event further reinforces the proposition that Excess Side A insurance is an indispensible part of a complete D&O insurance program for any corporate insured, whether public or private.

 

Will the Growing Number of Bank Failures Produce a Wave of Failed Bank Litigation?

The number of 2009 year to date failed banks is now up to 89 (as of September 4, 2009, about which refer here), and the total number of bank failures since January 1, 2008, is up to 114. Alarmist commentators have made predictions that as many as 1,000 banks could fail by the end of 2010, as discussed here. Whether or not the number of bank closures will come anywhere near that level, it is clear that we are in the midst of the most significant wave of bank failures since the S&L crisis.

 

The question remains whether this time around we will see the same level of litigation activity as we saw during the last failed bank wave. Somewhat surprisingly, so far the FDIC has initiated relatively little litigation to try to recoup its losses from the directors and officers of the failed financial institutions. However, for now the FDIC is preoccupied dealing with further bank closures. And even during the S&L crisis, the FDIC and the other regulatory agencies usually did not act until statutes of limitations were just about to expire. There could yet be another round of failed bank litigation, in a 21^st Century edition.

 

Private litigants might also be expected to get in the act -- for example, investors who lost their entire investment when a bank closes might well be expected to pursue claims. There has been a certain amount of that (refer here). There has also been some securities class action litigation activity involving failed banks whose shares were publicly traded. Of the 25 banks that failed in 2008, six of them are involved in securities class action litigation, even though only 11 of them were publicly traded.

 

However, the securities class action litigation involving the failed banks has not fared particularly well so far. For example, in the Downey Financial securities class action lawsuit (about which refer here), the district court recently granted the renewed motion to dismiss following the plaintiffs’ attempt to amend their complaint to try to remedy the pleading defects noted in the initial dismissal without prejudice. In addition, in the Fremont General securities lawsuit (refer here), the court also granted the defendants’ motion to dismiss, albeit with leave to amend.

 

These early returns potentially could be discouraging some potential litigants. Nevertheless, if for no other reason than the fact that there was so much failed bank litigation last time around, it seems likely that when all is said and done, the growing number of bank failures will at some point lead to an extended round of failed bank litigation.

 

Whether or the failed bank litigation ultimately emerges, the D&O insurers have responded defensively to the wave of bank failures. Many financial institutions, including even smaller community banks, are facing significantly more challenging circumstances when trying to renew their D&O insurance. Many banks find that they can obtain coverage, if at all, at significantly greater cost for significantly restricted terms and conditions, and in many instances with significant new limitations such as reduced limits of liability or the addition of additional exclusions, such as a regulatory exclusion. The wave of failed banks has already had a significant impact in the D&O insurance marketplace.

 

Will the Rising Number of Derivative Lawsuit Mega Settlements Mean Significant Excess Side A Losses?

Within the last several years, there have been a rising number of unprecedented mega settlements in shareholders’ derivative lawsuits, particularly during the last 12 to 24 months. These massive derivative lawsuit settlements include the $900 million UnitedHealth Group options backdating settlement (refer here); the $118 Broadcom options backdating settlement (refer here); and the $115 AIG settlement (refer here).

 

One consequence of this outbreak of massive derivative lawsuit settlements is that now for the first time Excess Side A carriers are being called upon to contribute significantly toward settlement outside of the insolvency context. The recent Broadcom settlement, in which the Excess Side A insurers collectively contributed $40 million to settlement, appears to represent a milestone development in that regard. While there may well have been prior occasions on which Excess Side A insurance contributed toward settlement outside of insolvency, the Broadcom settlement is by far the most public example. Based on the reactions I have heard, the Broadcom settlement has been a wake up call of sorts for many players throughout the D&O industry.

 

Among other things, the Broadcom settlement underscores the value for companies and their directors and officers of the Excess Side A product, which, along with the insolvency related considerations noted above, should further encourage policyholder take up of this product. As also noted above, Excess Side A protection increasingly will become a standard part of any well designed D&O insurance program.

 

The Broadcom settlement also represents a significant development for D&O insurers as well, who until now have enjoyed the opportunity to offer Excess Side A insurance in a relatively low loss cost environment, particularly outside the insolvency context. The Broadcom settlement highlights the potential for Excess Side A insurers to sustain significant claims losses on this product, even outside of the insolvency context. The increasing incidence of mega derivative lawsuit settlements underscores the growing possibility of these kinds of losses.

 

Another significant side effect of the Broadcom settlement is that the plaintiffs’ lawyers clearly will now have developed an appreciation of the value of presenting claims that trigger the Excess Side A coverage. The question arises whether they might now attempt to craft claims for the express purposes of accessing the Excess Side A limits. The attempt to pursue this strategy would face considerable challenges – derivative lawsuits, for example, are subject to formidable defenses, including the demand requirement and the business judgment rule defense. Nevertheless, the possibility of claims targeted expressly at the Excess Side A limits is a consideration that should not simply be disregarded.

 

Will Securities Lawsuit Filings Return to Historical Levels?

As discussed in a prior post (here), securities class action lawsuit filings dropped during the second quarter of 2009. This decline was largely due to the low filing activity during May (when there were only 11 new securities class action lawsuits) and during June (when there were only six new securities lawsuits), compared to historical monthly filing levels in the range of 15 to 20 new lawsuits a month.

 

At least to this point in the third quarter, it seems as if the second quarter filing decline was just a temporary dip that has already ended. There were at least 20 new securities class action lawsuits in July, and at least 17 in August, both of which monthly filing levels are well within historical norms.

 

Another interesting attribute of the most recent lawsuit filings is that so far the third quarter filings are not nearly as concentrated in the financial sector. During the first half of the year, about two-thirds of the securities class action lawsuit filings involved financial companies. However, of the 37 securities lawsuits filed in July and August, only about 13 (or roughly a third) involved financial institutions. In other words the proportion of lawsuits filed against financial companies to lawsuits filed against nonfinancial companies seems to be completely reversed from the first half of the year.

 

The other interesting thing about the third quarter filings is the extent to which the cases involve proposed class period cutoff dates that are well in the past, sometimes by as much as a year or more prior to the actual filing date. As I have previously noted on this blog (most recently here), these belated filings suggest that while the plaintiffs lawyers were scrambling to file subprime and credit crisis-related lawsuit against financial companies in the first part of the year, they were also developing a backlog of other cases that they are now working off.

 

All signs indicate that by the end of this year, securities class action filing levels will likely have returned to historical levels after the brief and apparently temporary decline in the second quarter. The concentration of filings in the financial sector also seems to be abating, with distribution of filings by industry starting to look more like historical norms.

 

How are Plaintiffs Faring in the Subprime and Credit Crisis-Related Securities Lawsuit?

We are now more than two and a half years into the subprime and credit crisis-related litigation wave, yet in many respects the cases are still only in their earliest stages. But there have been a number of recent significant developments suggesting that the evolving subprime litigation wave recently may have passed a significant milestone, and that it could be an appropriate time to take a closer look at the status of the subprime and credit crisis cases. For that reason, I will be publishing a post within the next few days providing a detailed status report on the litigation wave. I will update this post with a link when the status report is available. UPDATE: My September 8, 2009 status report on the subprime and credit crisis related litgation can be found here.

 

In the meantime, though the wave is still in its early stages, it is possible to make a number of generalizations. First, it seems like the defendants again have the upper hand at the motion to dismiss stage. Among other things, the Eighth Circuit’s recent decision affirming the district court’s dismissal in the NovaStar Financial case (about which refer here) represents a significant victory for defendants. The Downey Financial dismissal, discussed above in connection with the failed banks is another example. The recent dismissals in the Citigroup subprime-related derivative lawsuit (refer here) and Citigroup ERISA lawsuit (refer here, scroll down) also suggest that plaintiffs may be faring poorly in those cases as well.

 

On the other hand, there have also been some significant recent settlements suggesting that if the plaintiffs can survive motions to dismiss in these cases, the cost of settlement can be significant. Along those lines, the recent $32 million settlement in the RAIT Financial case (refer here) and the $22 million settlement in the Accredited Home Builders case (refer here) illustrate how costly it can be to try to settle cases that survive motions to dismiss.

 

Two equally significant settlements in cases in which the dismissal motions had not yet even been heard – the $37.25 million settlement in the American Home case (refer here) and the $30.5 million settlement in the Beazer Homes case (refer here) – suggests that in cases that are sufficiently serious the plaintiffs may be able to avoid the initial pleading hurdle altogether.

 

The American Home settlement may be particularly noteworthy because in that case both the offering underwriter defendants and the company’s auditor contributed substantially toward the cost of settlement. That, together with the Judge Scheindler’s September 2, 20009 partial denial of the motion to dismiss the claims against the rating agencies in the Cheyne Finance lawsuit (about which refer here), could suggest that in at least some of these cases the possibility of gatekeeper liability could be an important part of the overall claims resolution.

 

The final point is that these cases are proving to be extremely costly to litigate. The most dramatic illustration of this point is State Street’s August 10, 2009 announcement (here) that the approximately $625 million subprime-related litigation expense reserve the company had established in January 2008 was as of June 30, 2009 already down to $193 million, and further that there could be no assurances that the remaining amount would be adequate for the company’s continuing litigation.

 

So while the defendants may have won some important victories in the courtroom, the overall costs of defending and settling these cases taken in the aggregate nevertheless continues to look as if it will be enormous. By any measure, the subprime and credit crisis-related litigation wave continues to represent a tremendous loss exposure for D&O insurers.

 

Will the SEC’s Renewed Aggressiveness Expand Individual Liability Exposures for Corporate Officials?

The SEC is under considerable pressure to reestablish its regulatory credentials and to try to restore its tarnished reputation. As a result, the SEC recently has shown a renewed aggressiveness and even an apparent willingness to try to expand the weapons in its arsenal, in ways that may pose increased threats to corporate officials.

 

Two recent enforcement actions underscore this pronounced new aggressiveness. First, in July 2009, the SEC launched an enforcement action against the CEO of CSK Auto. As discussed here, the SEC is seeking to clawback the compensation the CEO earned during the period for which the company later restated its financial statements. Significantly, the SEC is pursuing this claim even though the CEO is not alleged to have engaged in any wrongful misconduct or even to have had any role in or knowledge of the issues that triggered the company’s restatement.

 

The second example of the SEC’s recent aggressiveness is the July 2009 enforcement action filed against two corporate officials at Nature’s Sunshine Products. As discussed here, the SEC sought to impose control person liability on the two officials for the company’s activities that violated the Foreign Corrupt Practices Act, even though the two individuals were not themselves alleged to have been involved in or even aware of the corrupt activities.

 

Though the SEC’s apparently needs no further encouragement to pursue liability claims against individuals, the agency nevertheless is facing significant additional pressure to target individuals as part of its enforcement activities. Indeed, among other reasons that Judge Jed Rakoff has questioned the proposed settlement of the enforcement action involving the Merrill Lynch bonuses is that the settlement does not involve any specific allegations against or claims against the individuals who caused the alleged wrongdoing to take place. (Refer here for additional details regarding Judge Rakoff’s objections). Regardless of the outcome of the Merrill Lynch settlement, going forward the SEC likely will have to anticipate this objection and incorporate targeted allegations against individuals in an effort to forestall further objections of this kind.

 

The bottom line is that as a result of these developments, corporate officials could find themselves increasingly on the firing line. Of particular concern is that the CSK Auto and Nature’s Sunshine Products enforcement actions evidence an arguably disturbing willingness on the SEC’s part to try to impose liability on corporate officials even in the absence of culpable involvement in or even awareness of the alleged wrongdoing.

 

Will Claimants Increasingly Target Outside Directors?

The $61.55 million settlement earlier this year of the claims against the outside director defendants in the Peregrine Systems securities lawsuit is merely the latest example where outside directors have found themselves required to contribute toward a separate settlement of significant liability claims against them. As discussed at greater length here, at least some of the outside director defendants appear to have been required to contribute toward the Peregrine Systems settlement out of their own assets.

 

As was also shown in the now infamous Just for Feet settlement (about which refer here), the threat that outside directors will be targeted and could be called upon to contribute toward settlement out of their own assets is a growing concern, and one that is significantly increased in the bankruptcy context. Given the growing number of corporate bankruptcies, outside directors could find increasingly find themselves on the front lines of D&O claims.

 

These developments underscore yet again the need for alternative insurance structures such as Excess Side A insurance to be included as an important part of the corporate D&O insurance program. Indeed, among the defendants whose potential liabilities were settled by the Excess Side A insurers’ contribution in the Broadcom options backdating derivative lawsuit settlement were several of that company’s outside directors.

 

These cases also highlight the extent to which the outside directors’ liability exposures and interests should be separately considered as part of the construction of a company’s D&O insurance program. Simply put, the outside directors’ interests and the interests of the company’s officers may or may not be completely aligned. These developments and considerations suggest that the non-officer directors could be well advised to have their insurance interests independently reviewed, in order to ensure that their interests are appropriately addressed in the way the company’s insurance program is constructed, as I discuss at greater length here.

 

What Will be the Next Industry Event for the D&O Insurance Industry?

It is commonly understood that the D&O insurance industry’s historical experience is characterized by a sequence of industry events – for example, we went from the bursting of the Internet bubble to the era of corporate scandals, and we went from options backdating to the subprime litigation wave.

 

So what will be the next industry event? It might be one or more of the issues discussed above, like the failed bank litigation wave, or the rising number of derivative lawsuits. Or it could be a further extension of existing trends, like the rising numbers of FCPA follow-on civil lawsuits. Or it could be something entirely new, like lawsuits arising from climate change related disclosures.

 

Only time will tell for sure what the next industry event will be. The one thing that is for certain is that there will another event that will emerge and define the industry’s experience in the months and years that follow.

 

Is the D&O Insurance Marketplace Headed for a "Hard Market"?

Earlier this year, Advisen took the bold and provocative step of predicting that the D&O insurance marketplace is headed toward a "hard market" as early as late 2009 or early 2010, as discussed at greater length here. Whether or not we are actually headed to an overall harder insurance market remains to be seen, though as 2009 progresses, the possibility to that we will see a hard market earlier rather than later seems less and less likely.

 

To be sure, the D&O insurance marketplace for companies in the financial sector is definitely harder than for the rest of the marketplace, and some financial institutions are now "hard to place." The speed with which the D&O marketplace for community banks firmed up shows how quickly conditions can change.

 

Nevertheless, for most companies, particularly those that are financially stable, the D&O marketplace remains competitive, with ample capacity and coverage available on favorable terms and conditions. The pricing declines that have characterized the marketplace over the last several years have largely ended, but outside the financial sector significant pricing increases (at least for financial stable companies) remain the exception.

 

That is not to say that the possibility of a generalized harder market is completely out of the question. The losses and defense expense associated with the subprime and credit crisis related litigation wave, in combination with several years’ of pricing declines and coverage expansions, could start to affect carriers’ overall results and trigger pricing increases and marketplace restrictions. Whether and when these circumstances might arise remains to be seen.

 

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In prior posts (refer here), I have observed that the D&O insurer’s consent to settlement really is required. An August 10, 2009 decision by the Delaware Supreme Court (here) confirms that not only is the insurer’s consent required, but the D&O insurer may under certain circumstances reasonably withhold its consent to settlement. The Court, applying Missouri law and observing that the excess carrier in the case had been "cut out" of the settlement process, affirmed the jury’s verdict that the excess carrier had not unreasonably withheld its consent.

 

Special thanks to Francis Pileggi of the Delaware Corporate and Commercial Litigation Blog (here) for providing me with a link to the opinion. Pileggi's blog post on the opinion can be found here.

 

Background

Payless Cashways was insured under three different layers of insurance from three different carriers, a primary carrier and two excess carriers. The first level excess insurer is referred to in this post as the excess insurer.

 

In 2003, Hilco Capital and another entity sued Payless’s directors and officers alleging that in connection with certain loans Hilco made to Payless the defendants had misrepresented the value of Payless’s inventory.

 

Prior to trial, the parties scheduled a mediation session. The primary carrier’s representative attended the mediation, but because the defense counsel (Shay) and the primary carrier valued the case within the primary insurer’s $10 million limit, and because Shay told the excess carrier’s representative that he would rather try the case than settle for more than the the primary limit, all parties agreed that the excess carrier’s representative should not attend the mediation, but rather  be available by telephone.

 

After the mediation’s first day, the mediator proposed mediation of a single issue – whether the defendants were aware that a Payless employee had falsified the company’s inventory numbers. He further proposed a "high-low" outcome, whereby the primary insurer would pay Hilco $5 million immediately, and then if Hilco lost the single issue mediation, it would keep the $5 million, but if it won the mediation, it was also get the remaining limits of the primary policy (about $3.7 million) -- and in addition approximately $7 million under the excess insurer’s policy.

 

Unfortunately, it was 10:00 P.M. by the time the mediation parties agreed to this proposal, and they couldn’t get the excess insurer’s representative on the phone. As the Delaware Supreme Court later put it, "rather than wait until the next morning," the parties finished the deal that night by agreeing that the individual defendants would not be liable for the settlement and would assign their rights under the excess policy to Hilco.

 

Upon reviewing the memorandum of understanding (MOU), the excess insurer’s representative rejected the proposed settlement, among other grounds on that a "straight" settlement would be lower than the high-end number in the high-low settlement.

 

The excess carrier asked the mediation parties to withhold finalizing the MOU until after a January 5, 2005 settlement conference, but they did not. The mediation parties later mediated the single issue, and Hilco prevailed. The primary insurer paid its remaining limit. The excess insurer denied coverage for the settlement, asserting a breach of the policy’s consent to settlement requirement.

 

Coverage litigation ensued. The trial court granted summary judgment for the excess insurer on certain legal issues, and the coverage action then went to trial. The jury found for the excess insurer on three issues: that the individual insureds had breached the policy before the excess insurer withheld consent; that the excess insurer did not unreasonably withhold its consent; and that the excess insurer was not permitted to reasonably associate in the negotiation. Hilco appealed.

 

The Delware Supreme Court’s Opinion

One of the issues on which the trial court had granted summary judgment was whether or not the excess insurer had breached the covenant of good faith and fair dealing under Missouri law. The Court affirmed the trial court’s ruling but on alternative grounds, holding that even viewing the record in the light most favorable to Hilco, the excess insurer was entitled to judgment as a matter of law.

 

In reaching this conclusion, the Court noted that "all agreed" that the excess carrier’s representative should not attend the mediation because it would "send the wrong message," so, the Court concluded, there was no breach in the excess carriers’ failure to attend the mediation. And, the Court noted, it was the mediation participants "who refused to wait until the next day to discuss the proposal" but instead "effectively cut [the excess carrier] out of the process by agreeing that the Insureds would assign their rights to Hilco."

 

Hilco argued that while the MOU was being negotiated, the excess insurer "was willing to negotiate" but that the "straight settlement" it sought required the primary insurer to tender its limits. The Supreme Court noted that the primary insurer refused to tender its limits "because the MOU gave it a better deal," under which, at worst it would pay its limits, but "at best "it would save approximately $3.5 million.

 

The excess insurer’s "only recourse" under the circumstances was to object to the settlement at the January 5 settlement hearing, but the "mediation participants mooted that effort by executing a definitive settlement agreement the day before the conference." Thus, the Court said based on these circumstances, "in sum, there is no record of a breach of good faith claim against [the excess insurer]."

 

The Court also ruled in the excess carrier’s favor on other legal grounds and held as well that even if the trial court erred in excluding certain evidence at trial, it "did not deny Hilco a fair trial."

 

Among Hilco’s evidentiary objections was that the trial court had allowed Shay to testify that the excess carrier "had a reasonable basis to withhold settlement." The Court noted that Shay testified that "he believed it was more likely than not that the Insured would win if the case went to trial and that Hilco had grossly overstated its damages." Shay also testified that he "believed a ‘straight’ settlement could have been negotiated for less than the ‘high’ end …of the high-low agreement."

 

The Court found that given his testimony "it was obvious" that Shay thought the excess insurer "had a reasonable basis to withhold its consent," so his testimony on that question "did not deny Hilco a fair trial."

 

The Court reached similar conclusions regarding Hilco’s other evidentiary objections and concluded that because the jury found the excess carrier had "a reasonable basis to withhold its consent," it did not need to reach the jury’s other rulings, and affirmed the jury’s verdict.

 

Discussion

There are two sides to every story, and there may well be a side to this story that does not appear from the face of the Court’s opinion. Perhaps the information in the excluded evidence paints a different picture.

 

All of that said, though, the only surprising thing to me about this case is that it went all the way to the Delaware Supreme Court. Pretty clearly, the settlement looked like a set up deal to the jury, and that seems to be the way the Supreme Court saw it too.

 

Whatever else might be said in defense of the settlement process, it is undeniable that the mediation participants’ actions managed to eliminate any possibility that the process would later appear to have been fair to the excess insurer. Their repeated actions to, as the Supreme Court put it, to "cut out" the excess insurer, make it appear as if their goal was to keep the excess insurer from upsetting a settlement that they clearly found advantageous for themselves, even if objectionable – for obvious reasons – to the excess insurer.

 

The details of the settlement that the Supreme Court chose to emphasize in its opinion are telling. The Supreme Court twice noted that at the mediation (a mediation "all agreed" the excess carrier’s representative should not attend to avoid "sending the wrong message"), the mediation participants decided not to wait until the following morning to discuss the proposed settlement. Instead, the Court observed, they cut the excess insurer out of the deal, with the assignment of rights and the agreement that the inidividuals would not be liable.

 

The Court also noted that the mediation participants, having refused even to wait until the next morning to discuss the deal with the excess insurer,  refused to forebear from finalizing the settlement until after the January 5 hearing, depriving the excess insurer of its only means of objecting to the settlement.

 

In addition to the obvious question of fairness of a process that appears to have been calculated to cut out the excess insurer but that nonetheless exposed its interests, there are the further questions of the fairness of the amount of the settlement and the burden it imposed on the excess insurer, given Shay’s trial testimony about the trial prospects of the underlying case and the appropriate settlement valuations at the high end.

 

The interesting thing about the outcome of this case is its suggestion that absent a reasonable opportunity to consider a settlement, a D&O insurer may reasonably withhold its settlement consent. The further implication is that a set up deal that deprives a D&O insurer of a reasonable opportunity to consider a proposed settlement may represent a sufficient basis for the insurer to withhold its consent. Perhaps with an awareness of this possibility, other settlement participants might think twice about taking steps that later could be portrayed as cutting an insurer out of the process.

 

About Those Late Night Settlement Demands: 10 P.M. seems to be a popular time to send D&O insurers unexpected settlement demands. As I noted in a prior post (here), former Globalstar CEO Bernard Schwarz sought his company’s D&O carriers’ consent to a $20 million at 10 P.M. on a Sunday night before his Monday morning trial testimony.

 

In that case, by contrast to the one discussed above, the Second Circuit held that the insurers’ did not reasonably withhold consent to Schwarz’s settlement. However, the critical difference between that case and the case discussed above is that in connection with his settlement, Schwarz accepted personal liability and in fact funded the settlement out of his own assets while seeking coverage from the carriers. This willingness to assume responsibility for the settlement deprived the carriers of the ability to argue that the amount of the settlement was unreasonable and by extension that their action in withholding consent reasonable.

 

In other words, the difference between the two cases is that in the case discussed above the deal looked like a set up. That seems to be how the jury saw it and how the Delaware Supreme Court saw it. That is why I say I am surprised the case went all the way to the Supreme Court. It is hard to argue that someone else wasn’t reasonable when your own conduct can be portrayed as unreasonable.

 

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In a move that recapitulates a classic dispute that has been brewing in bankruptcy court for years, the Stanford Financial Group receiver has asserted that the proceeds of Stanford’s D&O insurance policies are "receivership assets" and that his right to the proceeds "supersedes" the rights of insureds under the policy. Moreover, he has specifically threatened the insurer with "contempt" if it were to advance the individual insureds’ defense expenses. This sequence raises some fundamental issues about the D&O insurance structure and coverage and could highlight the importance of certain policy provisions that have recently become prevalent. It also raises some questions about some coverage structures.

 

Let me just say at the outset that I am not involved in this case and I do not intend in this post to express my opinions on the merits of the parties’ respective positions. Rather, the purpose of this post is simply to note the parties’ dispute and to make some observations.

 

According to a June 30, 2009 motion filed in the Stanford Financial SEC proceeding pending by former Stanford CEO Laura Pendergest-Holt (here), Stanford’s D&O insurance carrier had advised her that it would begin advancing her defense expense, subject to a reservation of its rights to deny coverage under the policy, on July 1, 2009. However, on June 25, 2009, the receiver sent the carrier a letter claiming that the D&O policy proceeds are "Receivership Assets" and that the receiver’s right to the proceeds "supersedes" the right of the other insureds under the policy. The carrier has withheld payment.

 

Pendergest-Holt’s motion seeks clarification that the receivership order does not apply to the D&O policy proceeds, and alternatively seeks authorization for disbursement of the D&O policy proceeds for payment of her defense expense. A host of other individuals claiming also to be insureds under Stanford’s D&O policy have sought to join in Pendergest-Holt’s motion, as reflected, for example, in the August 6, 2009 motion (here) filed by two former Stanford brokers. UPDATE: The receiver's response to Pendergest-Holt's motion can be found here. Special thanks to a loyal reader for providing a copy of the response.

 

The question of ownership and entitlement to D&O policy insurance proceeds is a long-standing question in the bankruptcy context. This recurring question became even more troublesome after so-called "entity coverage" was added to most D&O policies in the mid-90s. This coverage extension provides liability protection for the company itself. In public company policy’s, the coverage is limited just to securities claims. However, for private companies, like Stanford, the entity coverage is usually more extensive.

 

As reflected in a memo (here) by my friend Kim Melvin of the Wiley Rein firm, courts have continued to struggle with these issues in bankruptcy, with some courts finding that the policy proceeds are not a part of the bankruptcy estate and therefore not subject to the stay in bankruptcy, and others reaching a contrary conclusion.

 

But these questions may take on a different light in the context of the question of the advancement of defense expenses subject to a carrier’s reservation of rights. In these circumstances, policy funds are advanced without a final determination of coverage (one that might, in fact, never come, if the claims are compromised). When it comes to the entitlement to advancement of defense expense, it could be argued that, all else equal, the various insureds’ rights -- including the bankrupt company’s rights – under the policy could be regarded equivalent.

 

These issues could be even further complicated where, as here, the bankrupt company faces a likelihood of its own third-party liability claims, in which the company will likely incur its own defense expense.

 

One critical element of this dispute may be the question whether Stanford’s policy has a priority of payments provision, which predetermines the order of payment under the policy. This type of provision has become fairly standard in recent years. These provisions generally specify that payment of loss will first be made under the policy’s A Side coverage (which provides individual protection in the event the corporate entity is unable to indemnify them due to insolvency or legal prohibition). These provisions confirm the parties’ intent that the D&O policy serves primarily to protect the individual directors and officers.

 

Whether Stanford’s policy has this type of provision, and if so how the court will interpret and apply it here remains to be seen. The court’s interpretation of this provision (assuming it is in the policy) could be determinative of the parties’ dispute.

 

While the outcome of this dispute remains to be seen, the receiver’s position caused me to reflect on an auxiliary D&O insurance policy that many insureds have acquired in recent years, the so-called Excess Side A/DIC policy. The "difference in condition" coverage extension under this type of policy provides that the policy will "drop down" and provide first dollar coverage under certain circumstances.

 

Although these policies vary significantly, one of the relatively standard features of the DIC coverage is a provision specifying that the policy will "drop down" and provide first dollar coverage if the insured company is in bankruptcy and the proceeds of any traditional underlying insurance cannot be paid because the proceeds are subject to the automatic stay.

 

The circumstances of the dispute involving the Stanford D&O insurance policy present a situation where the individual insureds might well find themselves unable to access the protection of a traditional D&O insurance policy, at least if the receiver’s current efforts are successful. However, even if Stanford Financial D&O insurance program included a Side A/DIC policy, the typical Side A/DIC policy would not appear to provide drop down protection to the individual insureds in this circumstance, because their inability to access the policy proceeds is not as the result of the initiation of an action under the U.S Bankruptcy Code and not as a result of the automatic stay in bankruptcy.

 

The apparent nonapplicability of the drop down coverage to these circumstances under the typical Excess Side A/DIC policy made me reflect that there could be a need for an extension of the DIC coverage’s drop down protection to circumstances like this one where the proceeds of the traditional D&O insurance policy may be unavailable for the individual insureds’ protection for reasons other than the operation of the U.S. Bankruptcy Code. There may well be some DIC policies out there that might respond in this situation, but the typical Excess Side A/DIC policy likely would not.

 

The Stanford Financial insurance dispute will be interesting to watch, although it is an extremely unwelcome situation from the perspective of the individuals involved. In any event, the specifics of the situation suggest a possible (and arguably necessary) extension of the DIC coverage in the typical Excess Side A/DIC policy.

 

I know that many readers may have much more experience with the coverage issues involved in the receiver’s actions in the Stanford Financial case, and many readers may also have views about the extent and limitations of the typical Excess Side A/DIC policy. I encourage readers to share their views with others using the blog’s "Comment" feature.

 

Quelle Surprise: The Lawyers Want to Be Sure They Will Be Paid: Among other things, the receiver’s asset freeze together with the dispute of over the D&O policy proceeds may have left the various individuals’ lawyers wondering when and how they will be paid. R. Allen Stanford’s new criminal defense lawyers want assurance they will be paid before they will take any actions.

 

As reflected in an August 10, 2009 Texas Lawyer article entitled "Stanford’s Lawyers Want Assurance on Pay" (here), Stanford’s erstwhile new legal defense team has entered an appearance in the criminal proceeding against Stanford – solely for the limited purpose of determining "whether Mr. Stanford will be granted access to monies to pay for his legal fees and expenses."

 

"Private Companies Need D&O Insurance, Too": The Stanford Group case may represent an extreme example, but it does illustrate that private companies can become involved in serious claims for which D&O insurance is required. But many private company officials remain unconvinced of the need for D&O insurance, particularly when it comes to closely held companies.

 

A recent memo by Shannon Graving and Thomas H. Bentz, Jr. of the Holland & Knight law firm entitled "Private Companies Need D&O Insurance, Too" (here) takes a look at this recurring question about private companies and D&O insurance. As the article shows, private companies and their directors and officers may be susceptible to a wide variety of claims, as a result of which, the companies – even family owned businesses – would be well advised to secure D&O insurance protection.

 

More Madoff-Related Coverage Litigation: As I noted in a prior post (here), Madoff-related coverage litigation has started to arrive, and there undoubtedly will be more to come. Along those lines, Bloomberg reported today (here) that Madoff feeder fund Tremont Group Holdings and its related organizations have filed an action in Delaware Chancery Court against its insurers for denying coverage for Madoff-related claims.

 

According to the article, Tremont is owned by OppenheimerFunds, a unit of Mass Mutual Financial Group. The article reports that the complaint alleges that Mass Mutual’s D&O insurers and its bond insurers "have ignored repeated requests to pay defense costs." The complaint apparently contends that MassMutual’s D&O insurer has taken the position that the company’s bond insurer should pay a portion of the defense expense, but that "the primary bond underwriters have refused to pay any portion of the joint defense expense." The complaint seeks a judicial declaration of coverage under the applicable policies.

 

I don’t yet have a copy of this complaint, but I will post a link as soon as I get a copy. I would be grateful if any reader that has a copy of the complaint would forward a copy to me (anonymously, of course, if necessary), so that I can post the link. UPDATE: A copy of the complaint can be found here. Special thanks to a loyal reader for providing a copy of this complaint.

 

Special thanks to a loyal reader for sending me a copy of the Bloomberg article.

 

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Claims arising out of corporate bankruptcy represent a significant stress test for directors’ and officers’ liability insurance coverage. Among other frequently recurring issues are questions whether post-bankruptcy claims against the bankrupt company’s directors and officers run afoul of the Insured vs. Insured (I v. I) exclusion found in most D&O insurance policies.

 

In a July 10, 2009 opinion (here) that highlights many of these perennial bankruptcy-related D&O insurance coverage issues, the Ninth Circuit held that a D&O policy’s Insured vs. Insured exclusion bars coverage for claims that were brought against former directors and officers of a bankrupt company by the post-bankruptcy debtor in possession and later assigned to a creditors’ trust. The decision may have important implications for the prospective wording of coverage “carve backs” from the  I v. I exclusion.

 

  

Background

 

Visitalk, which had filed a Chapter 11 bankruptcy petition, and while acting as “debtor and debtor in possession,” sued four of its recently discharged directors and officers for breaches of their fiduciary duties. Visitalk’s D&O insurers refused coverage for the claim, in reliance on the I v. I exclusion.

 

 

Visitalk’s primary D&O insurance policy’s I v. I exclusion provided as follows:

 

 

V. EXCLUSIONS

 

The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against the Directors and Officers . . .:

 

(D) brought or maintained by or on behalf of an Insured in any capacity or by any

security holder of the company except:

 

(1) a Claim, including, but not limited to, a security holder class or derivative action that is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of an Insured;

 

(2) an Employment Practice Claim3 by a former Director or a present or former Officer;

 

(3) a claim for contribution or indemnity if the Claim directly results from another Claim that is otherwise covered under this Policy; or

 

(4) a claim by any employee(s) of the Company described in IV.(D)(2) of the Policy.

 

 

Visitalk filed a Chapter 11 reorganization plan that assigned its claims against the directors and officers to a trust created by the creditors. The trustee for the creditors trust (Biltmore) and the four director and officer defendants agreed to settle Visitalk’s claims for about $175 million. The four directors and officers assigned to the creditors’ trust their rights against the D&O insurers. (The record does not disclose whether or not the settlement with Biltmore also included a provision typical of these kinds of arrangements, which is a covenant by the settling claimant not to execute any judgment entered pursuant to the settlement on the assets of the settling defendants.)

 

 

Biltmore, as trustee for the creditors’ trust, then sued the D&O insurers in reliance on the individuals’ assignment to Biltmore of their rights under the D&O policies. The District Court dismissed Biltmore’s complaint on narrow grounds relating to the relation between Visitalk’s primary D&O insurer and the primary insurer’s successor in interest. The Ninth Circuit did not reach the successor in interest issue but nevertheless affirmed the District Court’s dismissal of the case on the grounds that the I v. I exclusion applies.

 

 

The Ninth Circuit’s Opinion

 

The Ninth Circuit’s July 10, 2009 opinion (here) written by Judge Andrew J. Kleinfeld opens with a review of the reasons for the inclusion of an insured vs. insured exclusion in D&O insurance policies, noting that “because risks such as collusion and moral hazard are much greater for claims by one insured against another insured … than for claims by strangers, liability policies typically exclude them from coverage.”

 

 

The Court then noted that because none of the exceptions to the policy’s I v. I exclusion apply, the only question was whether the underlying suit was “brought or maintained on behalf of an Insured in any capacity.”

 

 

The Court found that the underlying claim had been “instigated and continued” by Visitalk as Chapter 11 “debtor and debtor in possession.” Though coverage was now being sought by the trustee of the creditor’s trust, it was doing so merely as an assignee. The court noted that “an assignee of a claim against an insurance company can have no stronger claim than the assignor who assigned the claim.”

 

 

The question then is whether Visitalk’s status as debtor in possession at the time it initiated the claim triggered the I v I exclusion.

 

 

Biltmore argued that Visitalk, the chapter 11 debtor in possession that brought the underlying suit, is not the same entity as Visitalk, the insured corporation. However, the Ninth Circuit concluded after a review of authorities that “for purposes of the insured versus insured exclusion, the prefiling company and the company as debtor in possession in chapter 11 are the same entity.”

 

 

The Ninth Circuit acknowledged that “it is certainly true that interests differ once a debtor goes into bankruptcy.” Among other things, due to the bankruptcy “ownership of the cause of action fell into the bankruptcy estate” and Visitalk as debtor in possession of the bankrupt estate was “empowered to act as fiduciary for its creditors and shareholders.”

 

 

Biltmore argued that because Visitalk as debtor in possession was acting as representative for the estate’s creditors in bringing the suit, the I v. I exclusion does not apply. The Ninth Circuit reasoned that while suit might be brought for the benefit of creditors, it was not brought “on behalf of” the creditors. The Ninth Circuit said that the suit is “for the benefit of the creditors, but on behalf of the pre-bankruptcy corporation.”

 

 

The Court said that the question was not whether the creditors might benefit from any recovery. The court said that the insurance “cannot be turned into an available pot for the corporation’s creditors by enforcing the insurance obligations while disregarding the parties’ agreement to limit those obligations to exclude insured versus insured claims.”

 

 

The Ninth Circuit concluded its analysis of the I v. I exclusion issues by noting that a contrary holding would

 

 

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

 

 

Discussion

 

As I have previously noted (here), the insured vs. insured exclusion is heavily litigated and continues to be at the heart of many D&O coverage disputes, particularly in the bankruptcy context, as this case demonstrates. In response to these many continuing disputes, the exclusion itself has continued to evolve, and the I v. I exclusion in the typical D&O policy in today’s marketplace is quite a bit different than the exclusion at issue in the Visitalk case.

 

 

Among other things, the I v. I exclusion in most D&O policies today contain additional exceptions to the exclusion, or coverage “carve banks” as they are usually called. Among other provisions now more or less standard is a carve back to the I v. I exclusion specifically relating to the bankruptcy context. A typical carve back of this type would specify that the I v. I exclusion would not apply “in any bankruptcy proceeding by or against an Organization” to “any claim brought by an examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Organization.”

 

 

It would have been interesting to see how the Ninth Circuit would have addressed the issues in the Visitalk case if the policy as issue had contained these now fairly standard provisions. However, even if Visitalk’s policy had contained a carve back of this kind, it likely would not have altered the outcome, because the underlying action in the Visitalk claim had not been brought by any of the creditors’ representatives referenced in the carve back, but rather had been brought by Visitalk as debtor in possession.

 

 

The solution to this coverage problem would seem to be simply to include the debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion. Indeed, parts of the Ninth Circuit’s opinion in the Visitalk case suggest that this would be appropriate, particularly the Court’s comments about how a debtor’s status changes upon becoming a debtor in possession, and how an action by a debtor in possession as representative of the estate is for the benefit of creditors.

 

 

However, throughout the Ninth Circuit’s opinion is a pervasive concern with the possibility of collusive litigation. The Court clearly was concerned that if there were coverage, a debtor in possession action might represent a collusive attempt by a debtor company to use the cover of a bankruptcy filing and the ruse of a supposed claim as a way to access insurance proceeds to pay off the company’s debts.

 

 

Without minimizing the collusive possibilities to which the Ninth Circuit refers, I believe there is also a legitimate concern that without policy recognition in some way for debtor in possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.A debtor in possession claim is not inevitably collusive, and in that regard I note that the individuals named as defendants in the underlying suit in the Visitalk claim were former directors and officers, targeted post-bankruptcy on behalf of the bankrupt estate.

 

 

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor in possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

 

 

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

 

 

To be sure, the individual defendants in the Visitalk claim were not left to defend themselves without coverage; they entered into the settlement and assignment of rights with the trustee to the creditors’ trust. The parties’ entry into this settlement arrangement clearly troubled the Ninth Circuit, and the Court’s concerns about these kinds of settlement and assignment of rights deals clearly affected the court’s analysis. However, it should be noted that there is nothing about the debtor in possession claim context that uniquely encourages this kind of settlement, and litigants in many other contexts enter similar arrangements. Indeed, if the individuals were clearly covered and thus able to defend themselves, they would have far less incentive to enter these kinds of arrangements.

 

 

While I don’t mean to trivialize concerns about the possibility of collusive claims, for me the most important message from the Ninth Circuit’s decision in the Visitalk case is not necessarily the threat of collusive claims but rather then need to address in the policy the possibility of debtor in possession claims against individual directors and officers. The clear implication seems to be that the now fairly typical bankruptcy-related coverage carve back to the I v I exclusion should be modified to preserve coverage for debtor in possession claims.

 

 

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

 

 

Because of the issues raised in the Ninth Circuit’s opinion, particularly the court’s concerns about the possibility of collusive claims, I would like to hear readers’ views about these issues, and I encourage everyone to post their thoughts for others using this blog’s “Comment” feature.

 

 

Very special thanks to Mike Early of the Chicago Underwriting Group for providing me with a copy of the Visitalk opinion. I hasten to add that the views expressed in the blog post are exclusively my own.

 

 

2009 Failed Banks – The Slideshow: This past Friday night, the Bank of Wyoming of Thermopolis, Wyoming, became the fifty-third bank to fail this year (refer here for more details). Regular readers know that the FDIC maintains a detailed list of failed banks (here). But who needs a list when you can see a slideshow, including pictures of all of the banks that failed this year? Check out Clusterstock’s failed bank slideshow, which is complete prior to the closure of the Bank of Wyoming, and can be accessed here.

 

 

Mid-Year Review: Securities Litigation and Enforcement: On July 9, 2009, I participated in a Securities Docket webinar entitled “Mid-Year Review: Securities Litigation and Enforcement” that included as panelists Lyle Roberts of the 10b5-Daily blog, Francine McKenna of the Re: The Auditors blog, Tom Gorman of the SEC Actions blog, as well as Bruce Carton of Securities Docket. Carton has posted a brief summary of the topics discussed in the webinar in a July 10, 2009 Compliance Week column entitled “Bloggers Offer 2009 Mid-Year Review” (here).

 

 

The webinar itself is available to be viewed online and can be accessed below:

 

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Most reasonably sophisticated consumers understand that the cheapest running shoes may be no bargain, that the least expensive cellular plan may have big gaps, and that selecting legal counsel based on which attorney charges the least is fraught with peril. Yet when it comes to D&O insurance, these same buyers are often only concerned with which is the lowest cost alternative, without complete consideration whether the cheapest coverage fully addresses their insurance needs.

 

The assumption behind many insurance purchasing decisions is that the various alternatives are basically equivalent, and the only relevant variable is price. Whether or not this assumption would be valid for personal insurance like home or auto, for which the insurance is generally issued on standard forms, it definitely is not true with respect to D&O insurance.

 

 

There is no standard D&O insurance policy form; to the contrary, the various carriers’ base forms vary significantly, and many of the key terms are negotiable, particularly with respect to public company D&O insurance.

 

 

So the assessment of D&O insurance alternatives often involves – or rather should involve – careful comparison between a host of relative advantages and disadvantages, among which price is one of many important factors to be considered.

 

 

Despite the many subtle but nonetheless critically important differences between D&O insurance alternatives, many insurance buyers, even those who otherwise qualify as very sophisticated, ultimately make their selection based solely upon price, even though they would never depend solely on price alone when selecting, say, a pair of running shoes, a cellular plan, or an attorney to represent them.

 

 

When it comes to running shoes, cellular plans or attorneys, consumers both understand what these goods and services are for and they also fully expect to use these goods and services. When it comes to D&O insurance, however, the same buyers are unconsciously assuming that they will never actually need to use the product, and that the insurance acquisition is nothing more than a box-checking exercise. D&O insurance? Yep, got that.

 

 

The one subset of insurance buyers who do not need to be reminded when selecting among D&O insurance alternatives of how important it is to consider all issues, and not just price, are company officials who have previously been involved in a D&O claim. These individuals fully understand what D& O insurance is for, and they often have a deep appreciation of the way that seemingly small difference in policy language can have a significant impact on the extent of coverage in the event of a claim.

 

 

After over a quarter of a century of involvement with directors’ and officers’ liability issues, I have seen hundreds of claims involving thousands of individual director and officer defendants. I have seen highly regarded individuals, who have amassed a lifetime’s worth of wealth and prestige, have everything they worked for their entire careers come crashing down around them. I have seen formerly powerful executives taken away in handcuffs. I have seen grown men cry. None of these individuals ever thought they would ever find themselves in these circumstances – but they did. I guarantee you that not one of them, finding themselves caught up in these circumstances, thought to themselves “Boy, I sure am glad we got the cheapest D&O insurance we could find.” .

 

 

The D&O insurance acquisition process cannot be built on the assumption that those things might happen, but not to my company and certainly not to me.  The entire acquisition process has to be built on the assumption that these things will happen to this company.

 

 

Of course, not all D&O claims are catastrophic, but the one thing I know for sure about D&O claims is that, whether or not they are catastrophic, the quality of the D&O insurance available at the time of the claim is critically important. The time to analyze whether or not the D&O insurance program is built to respond to the range of possible claims circumstances is not when the claim comes in, but when the insurance is purchased.

 

 

Cost is of course an indispensible consideration and price considerations should always be taken into account. In fact, I have many times recommended to clients that they select an alternative that is the lowest cost option. But when I make that recommendation, price alone is neither the sole nor the most important criterion.

 

 

D&O insurance buyers whose advisors recommend the lowest priced alternative need to consider whether (a) the advisor is recommending the lowest priced alternative because it really is the best option for the company based on full consideration of all relevant factors; (b) the advisor is recommending the lowest price alternative because he or she thinks that is what the buyer wants to hear and that’s what it will take for the advisor to get or keep the business, and he or she doesn’t have the guts to provide an independent and fully considered recommendation; or (c) the advisor doesn’t have a clue what the important differences are between the available alternatives and the only distinction the advisor can explain is the cost difference.

 

 

I am often asked to review public companies’ D&O insurance programs. In many cases, the companies have insurance programs that are more or less matched to their requirements and circumstances. But in a surprising number of cases, the programs I review lack critically important features that could dramatically affect the availability of coverage in various claims circumstances. Sometimes these underserved policyholders are also over-paying for their insurance, which has its own set of implications. But more often, the company itself has selected into an inadequate insurance program because they chose their insurance based solely on price.

 

 

Price considerations alone are not enough to allow a buyer to select the best running shoes, cellular plan or legal counsel. Price considerations are important of course, because no one should overpay for something. Often the way to make the optimal purchase is to get assistance from someone who knows more about the products and services.

 

 

Insurance buyers may never have to use their D&O insurance, but policyholders don’t want to find out when a claim arises that the cheap insurance they bought was no bargain. That is why it is indispensible to have a skilled and experienced insurance advisor involved in the D&O insurance transaction, one that understands and can explain the differences between the insurance alternatives and that can recommend the alterative that will best meets the company’s needs and finances.

 

 

Where are You Going, Al? Can’t You Read?: Any alpaca having the temerity to disregard this sign will find itself in very serious trouble.

 

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In what has become a weekly ritual as 2009 has progressed, each Friday evening after the close of business, the Federal Deposit Insurance Corporation (FDIC) announces the names of the banks it has taken over that week. The current number of year-to-date bank closures stands at 37, which already represents the highest annual total since 1993, the end of the last era of failed banks. All signs are that the number of bank failures will continue to grow in the months ahead, a prospect that is affecting the D&O insurance marketplace, even for smaller community banks.

 

In the latest issue of InSights (here), I take a look at the background regarding the current wave of bank closures and examine the D&O insurance marketplace’s reaction to these developments.

 

 

One of the issues discussed in the article is the surprising number of failed banks in Georgia. The June 10, 2009 Wall Street Journal has an article entitled "Failed Banks's Dot Georgia's Vista" (here) discussing the reasons for the high number of bank failures in that state.

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One byproducts of the turmoil that has swept over insurance giant AIG has been a cascade of litigation. But even before the company’s latest woes, it was locked in a series of hotly contested legal battles with its former Chairman and CEO, Maurice Greenberg. The latest front in this ongoing war apparently is a fight over the proceeds of the company’s primary D&O insurance policy, as a result of which the D&O insurer has now initiated an interpleader action to sort out whose claims to the policy proceeds should prevail.

 

As reflected in the complaint (here) that the insurer filed on May 8, 2009 in the Southern District of New York, the insurer issued a $15 million primary D&O insurance policy over a $10 million self-insured retention for the policy period May 24, 2004 through May 25, 2005. As the D&O insurer’s complaint notes, "AIG is at the center of a firestorm," as a result of which the company and its present and former directors and officers are the targets of numerous lawsuits. (The lawsuits themselves are not specified in the D&O insurer’s complaint.)

 

But as the insurer’s complaint observes, "even before the current issues at AIG became front page news, a very public split" occurred between AIG and Greenberg, as a result of which the company and Greenberg have "taken strongly adversarial positions" in the various lawsuits that have accumulated against AIG. Both AIG and Greenberg and his related entities have expended significant sums in their defense of the underlying litigation, and both AIG, on the one hand, and Greenberg and his related entities, on the other hand, have demanded that the D&O insurer advance to them the proceeds of the D&O policy, presenting the insurer with "competing adverse demands to the proceeds of the Policy."

 

According to the complaint, AIG was advancing Greenberg’s defense expenses until mid-2007, after which Greenberg’s defense expenses were advance by his various related entities. The D&O insurer’s complaint alleges that the defense expenses that AIG has incurred on Greenberg’s behalf and on behalf of other individual defendants in the underlying litigation exceed both the D&O policy’s $10 million self-insured retention and its $15 million limit of liability.

 

The D&O insurer’s complaint is filed in the form of an interpleader action under Rule 22 of the Federal Rules of Civil Procedure. Using this procedure, the insurer is basically disclaiming any right or interest in the policy proceeds, and tendering them to the court, for the court to sort out the competing interests to the policy proceeds.

 

The precipitating event that triggered the initiation of the interpleader action was the attempt by Greenberg to pursue arbitration, in reliance on the arbitration clause in the D&O insurance policy. While the policy does provide for arbitration, Greenberg did not join AIG as a party to the arbitration, while at the same time purporting on his own to select an arbitrator. The D&O insurer is concerned both that AIG must be a party to the arbitration, and that the Policy reserves to AIG rather than to individual insureds the right to select the arbitrator.

 

In light of this separate arbitration proceeding, the D&O insurer’s recently filed complaint seeks, in addition to interpleader, a judicial declaration whether or not Greenberg is entitled to use the arbitration procedure under the policy, and if so whether AIG is a necessary party to the arbitration, as well as whether or not AIG has the right under the policy to select the arbitrator. The D&O insurer also seeks a judicial declaration of the appropriate disposition of the policy proceeds pending the outcome of the arbitration.

 

Obviously one of the things that makes this new action interesting is the high profile of the litigants involved. But the case is also interesting as an illustration of the kinds of problems that can arise between current and former directors and officers – clearly, the disputes can even include vehement disagreement over the proper allocation and distribution of D&O insurance proceeds.

 

The arbitration dispute also demonstrates some the shortcomings that can arise in the application of arbitration provisions in a D&O insurance policy. The sequence of events here not only raises questions about who can initiate arbitration, but also who has what rights in the event of an arbitration. Individual insureds might well be concerned to learn that their company could reserve the exclusive right to select arbitrators in any dispute in which the individuals might become involved with the D&O insurer. (These issues illustrate one reason why I have always thought that the preferred approach to alternative dispute resolution clauses in an insurance policy is for the specified procedures to be at the option of the aggrieved insured, rather than mandatory.)

 

Another interesting note in this dispute is that it relates to a D&O insurance policy that incepted in 2004. Obviously, the hottest parts of the "firestorm" in which AIG is now engulfed arose well after the policy period for the policy that is in dispute in this case, raising the question of how many (if any) other policy years’ of coverage have been triggered by the various lawsuits in which AIG is involved. How many of the various lawsuits "relate back" to this policy year, and how many triggered policies that were in force in subsequent policy periods? The total amount of insurance potentially in play depends on the outcome of this question.

 

It is also worth noting that the interpleader complaint described above involves only the primary policy in AIG’s D&O insurance program for the policy period 2004-05. AIG undoubtedly carried significant additional amounts of insurance (i.e., excess insurance) during that same policy period. While the excess insurers in the program may be indifferent whether the primary policy is exhausted in payment of AIG’s or Greenberg’s defense expenses, once the primary policy is exhausted, the dispute between AIG and Greenberg will just move up to the first level excess carrier, and so on up the ladder.

 

So it is obviously important to the excess insurers to know how the present dispute is resolved, because the outcome potentially could dictate the excess carriers’ rights, obligations and interests.

 

One final point that the many claimants in the various lawsuits pending against AIG and its present and former directors and officers may well want to note is that the deluge of litigation in which AIG is involved is rapidly depleting whatever amounts of insurance may remain. At some point, the insurance could well be exhausted even just by defense expense alone, leaving only the assets of the now nationalized entity as the primary source of funds out of which to try to extract a settlement or judgment – putting the claimants’ interests in direct conflict with those of U.S. taxpayers.

 

The theoretical possibility that these claimants might be able to recover from the individual defendants out of the individuals’ own assets must be tempered by the awareness that these individuals, although once wealthy, had most of their net worth tied up in AIG stock. My point here is that well-advised claimants might want to focus on trying to figure out how to maneuver cases toward settlement as soon as possible with the least possible additional defense expense. Not that I have a dog in this particular fight, I’m just saying …

 

Bloomberg reporter Thom Weidlich has a May 11, 2009 article about the interpleader action, here.

 

Mayday, Mayday!: Readers may be interested to know that Hank Greenberg just celebrated his 85th birthday on May 4. Everyone here at The D&O Diary wishes Hank a belated Happy Birthday.

 

And speaking of May anniversaries, with a May 24 inception and expiration date for the insurance policy at issue in this dispute, is it possible that the AIG D&O insurance program is up for renewal once again in just a few days?

 

Pertinent to the possibility of an impending AIG D&O insurance renewal during the month of May, I note that, according to Wikipedia (here), the universal distress signal "mayday" is a derivation of the French expression "m’aider," short for "venez m’aider," meaning "(you) come help me."

 

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Deteriorating economic conditions threaten a massive wave of corporate defaults.  Corporate borrowers’ inability to fulfill debt obligations could not only prompt a bankruptcy filing surge, but could also result in a flood of lawsuits and claims as creditors and shareholders seek to recoup their losses.  These claims could present a host of challenging D&O coverage issues. 

 

In the latest issue of InSights (here), I take a look at the conditions that could contribute to an increase in corporate bankruptcies, the likelihood that more bankruptcies could translate to increased litigation, and the D&O insurance issues that bankruptcy litigation could present.

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The global financial crisis has produced challenges across the entire economy, but the financial sector, where all the problems arguably began, has been particularly hard hit. While the most investment firms and other banking institutions may have experienced the most dramatic consequences, insurance companies have also been swept up in the whirlwind.

 

The extent of the recession’s impact on insurance companies and the resulting consequences for the insurance marketplace are the subjects of an April 2009 paper from insurance industry data firm Advisen entitled "The Impact of the Economic Crisis on the P&C Insurance Industry" (here, $ required). Advisen’s April 2, 2009 press release describing the report can be found here.

 

According to the paper, the various economic forces at play will likely shrink insurers’ policyholder surplus, thus diminishing the supply of insurance. These circumstances ordinarily would produce a so-called "hard" market, characterized by rising prices for insurance. However, the reduction in economic activity as a result of the current recession could also reduce the demand for insurance, which in turn could complicate the insurance cycle’s transition and "make for a very turbulent 2009" for the insurance industry.

 

The major cause for the reduction in the demand for insurance, which according to the paper could delay the transition to a hard market, is "shrinking exposure units." An exposure unit is the basis for calculating premium – for example, the size of an employer’s workforce will determine the employer’s workers comp and EPL insurance premiums.

 

Many of the exposure units that are critical for determining pricing for a variety of insurance lines – such as sales, real estate square footage, number and mileage of vehicles, payroll, and property values – are all likely to shrink in the months ahead, as a result of the recession. The shrinking exposure base will produce a fall-off in insurers’ top-line revenue.

 

In addition, insurance demand will also likely be further eroded as businesses close or fail. Even companies that survive may seek to increase self-insured retentions or limits, as a way to cut costs.

 

The reduction in demand will also likely be accompanied by a reduction in supply, in the form of policyholder surplus, both as a result of increased claims losses and as a result of diminished investment income and investment losses.

 

The likely increased claims losses could arise from a variety of sources. The paper states that job losses frequently are accompanies by an increase in the frequency and severity of workers’ comp claims. Reductions in force also could trigger EPL claims. And as has been well documented on this blog (refer here), the current economic crisis has also produced a wave of shareholder claims. As the Advisen report notes, these claims are particularly complex which will make them costly to defend and could also make them costly to resolve. D&O claims arising from bankruptcies and E&O claims arising from the various Ponzi scheme scandals could exacerbate the claims losses that insurers experience.

 

On the investment side, insurers’ investment results have taken a massive hit. Many insurers have had to take huge write-downs, both in their fixed income assets and with respect to more exotic investments. A few insurers have been particularly hard hit with valuation issues concerning "toxic" assets.

 

In more typical cycle transitions, insurance pricing swings result from changes on the supply side (i.e., policyholder surplus). But the depth of the current economic crisis could also uncharacteristically affect the demand for insurance. One proxy for insurance demand is GDP. When policyholder surplus declines relative to GDP, a hard market usually follows. In the current circumstances, GDP is under pressure, but the decline in policyholder surplus is relatively greater.

 

These circumstances, together with the likely difficulty insurers will face trying to raise fresh capital, suggest that the insurance marketplace will eventually harden, and higher premiums eventually will result. The Advisen paper projects that the hard market could "begin to set in" as early as mid-2009, and in any event no later than 2010.

 

However, the hard market will "likely take off slowly" due to lack of consumer and business confidence. When it comes, though, the hard market "could extend longer than previous hard markets owing to the lack of new capital entering the market."

 

The Advisen report is accompanied by extensive supporting data and analysis, and I think the author makes an excellent point about the pressure that the recession will put on the demand side of the insurance equation

 

As for the report’s predictions of the arrival and timing of a forthcoming hard market, I guess time will tell. In my view, a hard market is characterized by more than just rising prices; among other things, it also means a shortage of capacity as well as a constriction of terms and conditions. If there really were going to be a hard market as early as mid-2009 (which at this point is only a couple of months away), you would expect some sign of these things in the marketplace, but so far there is very little evidence of any of these things. Which at a minimum suggests to me that if there is going to be a hard market, its arrival could be more delayed than the report suggests.

 

That said, the report does make a compelling case for the likelihood that there actually will be a hard market this time. It may not be a question of whether, but only of when. Overall, the report is interesting and provides useful analysis of the current insurance marketplace and its likely future direction. The report is well worth reading at length and in full and I commend it to everyone.

 

Rescission Denied: Policy rescission is a controversial topic. But because the debate often involves high profile cases where the insurer has successfully rescinded a policy, it is sometimes overlooked how difficult it is for insurers to rescind coverage. A recent decision illustrates the difficulties carriers face when they seek to rescind a policy.

 

In a March 25, 2009 opinion (here), New York (New York Country) Supreme Court Justice Charles Ramos granted summary judgment for JP Morgan Chase in an insurance dispute involving several high profile claims. An excess insurer in J.P. Morgan’s bankers professional liability insurance program had sought to rescind its policy based on alleged misrepresentations in the company’s 2001-02 insurance renewal.

 

The excess insurer claimed that the company had made misrepresentations about its exposure to Enron, both in a Notice of Potential Claim submitted under the prior insurance program and in a Press Release.

 

As reflected in the April 2009 memo from the Proskauer Rose law firm entitled "Court Grants Summary Judgment Dismissing Insurer’s Rescission Claim" (here), Judge Ramos found that the Notice and the Press Release were not part of the renewal materials, and the insurer had not asked the company to warrant either document in connection with the renewal.

 

Judge Ramos also found that there was no issue of triable fact either that the insurer’s underwriters relied on the documents or that the company officials who prepared the documents were aware of any misrepresentations in the documents.

 

Judge Ramos also found that the insurer had waived rescission because it did not raise the defense until 2006, several years later, and had retained the premium.

 

While much more might be said about this decision, if nothing else, Judge Ramos’s opinion demonstrates the many hurdles carriers face in attempting to rescind a policy. Any carrier considering policy rescission might well want to review the opinion.

 

A prior post in which I discuss the difficulties carriers face in attempting to rescind coverage can be found here. Among other things, I note that "policy rescission wreaks havoc on all concerned."

 

Special thanks to John Gross and Michelle Migdon of the Proskauer Rose firm for providing a copy of the opinion.

 

More About the Bailout: Much has been written and said about the gargantuan federal bailout. A March 19, 2009 Rolling Stone article entitled "The Big Takeover" (here) presents a particularly irreverent and occasionally profane perspective on the subject.

 

Although the overall tone of the article borders on feverish, and the article definitely tends toward the conspiracy view of the world, it also contains some funny lines as well as some interesting observations. I particularly liked the author’s take on AIG: "AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror."

 

The article’s overall take on the bailout is summarized in this paragraph:

 

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world's most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations.

The report concludes with the observation about the bailout that "it’s AIG’s rip-roaringly shitty business model writ almost inconceivably massive." (I should probably emphasize that the view in the article quoted above are those of the article’s author, and do not necessarily represent the view or sentiments of this blog’s author.)

 

Special thanks to a loyal reader for providing a copy of the Rolling Stone article.

 

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