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

In what the plaintiffs’ lawyers claim to be the largest derivative lawsuit settlement ever, the parties to the News Corp. shareholder derivative litigation have agreed to settle the consolidated cases for $139 million. The company also agreed to tighten oversight of the company’s operations and to establish a whistleblower hotline, as well as other corporate therapeutics. The cash portion of the settlement is to be funded entirely by D&O insurance. The settlement is subject to court approval.

 

The parties’ April 17, 2013 memorandum of understanding regarding the settlement can be found here. The plaintiffs’ lawyers’ April 22, 2013 press release in which, among other things, the plaintiffs’ lawyers state that the settlement is “the largest cash derivative settlement on record” can be found here. The lead plaintiffs’ press release can be found here. As reflected in the press releases as well as is stated in the many media reports about the settlement (refer for example, here), the entire cash portion of the $139 million settlement is to be funded by D&O insurance.

 

The first of the lawsuits against the News Corp. board was filed in Delaware Chancery Court in March 2011, asserting claims in connection with the company’s $675 million acquisition of Shine Group, Ltd., a U.K.-based television production company owned by Elizabeth Murdoch, daughter of News Corp. Chairman Rupert Murdoch. Elizabeth Murdoch allegedly made $250 million in the acquisition.. Later complaints expanded on claims relating to the Shine Group acquisition and  added extensive additional claims seeking to hold the company’s directors accountable for the scandal surrounding the company’s use and attempted cover-up of illegal reporting tactics of some News Corp. journalists in the U.K. The various cases were later consolidated in the Delaware Chancery Court.

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In their Third Amended Consolidated Complaint (here), the plaintiffs alleged that the company’s board’s oversight of the company’s affairs represented a “textbook example of failed corporate governance and domination by a controlling shareholder.” The complaint alleges that for years “the Board has condoned Murdoch’s habitual use of News Corp. to pursue his quest for power, control and political gain and to enrich himself and his family members, at the Company’s and its public shareholders’ expense.” The complaint alleges that the ongoing scandals have not only harmed the company’s reputation and cost it millions of defense costs and other expenses, but also that the company’s share price is artificially depressed because of the negative association of the company with Murdoch.

 

The defendants filed a motion to dismiss the consolidated amended complaint. The parties argued the motion to dismiss on September 19, 2012 (refer here). While the dismissal motion was pending, the parties engaged in mediation that ultimately resulted in settlement.

 

The plaintiffs’ lawyers claim that this is the largest cash shareholders’ derivative settlement ever, and I am certainly in no position to dispute that. I have been tracking derivative suit settlements for years. There have been several shareholder derivative suit settlements that were nearly as large as the News Corp. settlement but as far as I can tell none that were quite as big:

 

• The El Paso/Kinder Morgan merger-related derivative suit settled in September 2012 for $110 million (refer here)

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• In 2005, the Oracle derivative suit settled based on the payment by Oracle CEO Larry Ellison of a total of $122 million (refer here and here).

 

• In September 2009, the parties to the Broadcom Corp. options backdating-related shareholders’ derivative suit agreed to settle the case, as to most but not all of the defendants, for the D&O insurers’ agreement to pay $118 million (as discussed here).

 

• In September 2008, the parties to the 2002 AIG shareholders’ derivative lawsuit agreed to settle the case for a payment of $115 million (of which $85.5 million was to paid by D&O insurance) in what was touted at the time as the largest Delaware Chancery Court derivative lawsuit settlement (about which refer here).

 

These settlements are all dwarfed by the  $2.876 billion judgment entered in June 2009 against Richard Scrushy in the HealthSouth shareholders' derivative lawsuit in Jefferson County (Alabama) Circuit Court, but that astronomical judgment represents its own peculiar point of reference, like some odd parallel universe. It also was of course a judgment following trial rather than a settlement.

 

Another peculiar point of reference is the $1.262 billion judgment that Chancellor Leo Strine entered in October 2011 the Southern Peru Copper Corporation Shareholder Derivative Litigation (about which refer here). That case also represents its own form of litigation reality, and it too represents a derivative suit judgment following trial, rather than a settlement.

 

Another derivative lawsuit resolution that is worth considering in the context of the “largest ever” question is the December 2007 settlement of the UnitedHealth Group options backdating-related derivative lawsuit. As discussed here, the lawsuit settled for a total nominal value of approximately $900 million. However, while the press reports at the time described the settlement as the largest derivative settlement ever, the value contributed to the settlement consisted of the surrender by the individual defendants of certain rights, interests and stock option awards, not cash value in that amount.

 

Aside from the question of the News Corp. derivative suit settlement’s sheer size, there is also the fact that the settlement was funded entirely by D&O insurance. Given the amount of the settlement, the settlement costs undoubtedly were distributed across the several carriers that participated in News Corp.’s D&O insurance program. This large settlement not only represents a serious and unwelcome development for the specific carriers involved but it also represents a potentially unwelcome event for the D&O insurance industry in general, for what it might represent as far as the severity potential of shareholders’ derivative litigation.

 

In the past, going back ten years or so, shareholders’ derivative suits typically did not present the possibility of significant cash payouts for D&O insurers, at least in terms of settlements or judgments. The cases did present the possibility of significant defense expense and also of the possibility of having to pay the plaintiffs’ attorneys’ fees, but by and large there was usually not a cash settlement component. As the significant examples above show, that has clearly changed in more recent years.

 

This trend gained particular momentum with the options backdating scandal. Many of the options backdating cases were filed as derivative suits rather than as securities class action lawsuits (largely because the options backdating disclosures did not always result in the kinds of significant share price declines required to support a securities class action lawsuit). Many of the options backdating cases settlements included a cash component, and as illustrated by the Broadcom case mentioned above, some of the options backdating derivative suit settlements included very substantial cash components

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The inclusion of a significant cash component has also been a feature of the settlements of some of the merger objection suits that have been filed as part of the current upsurge in M&A-related lawsuit that have been filed in recent years, as illustrated by the El Paso settlement mentioned above.

 

This upsurge in the number of derivative suit settlements that include a significant cash component can only be viewed with alarm by the D&O insurance industry. For many years, D&O insurers have considered that their significant severity exposure consisted of securities class action lawsuits. The undeniable reality is that in at least some circumstances, derivative suits increasingly represent a severity risk as well. And the settlement amounts themselves represent only part of the D&O insurers’ loss costs. The D&O insurers also incur millions and possibly tens of million of defense cost expense in these derivative suits. I can only imagine that in the News Corp. derivative suit, for example, that the cumulative defense expense was in the millions of dollars.

 

An even more concerning aspect of the rise of significant cash settlements in derivative cases for D&O insurers is that these settlement amounts represent so-called “A Side” losses. That is, the losses are paid out under the portion or the D&O insurance policy that provide insurance for nonindemnifiable loss. A derivative suit settlement obviously is not indemnifiable, because if it were to be indemnified, the company’s would make the indemnity payment to itself. For the “traditional” D&O insurance carriers, there is perhaps no particular pain associated with the fact that the loss is paid under the “Side A” portion of the policy, as opposed the other policy coverage (that is, the “Side B” or “Side C” coverage that are more typically called into play). But these days many companies carry --in addition to their traditional D&O insurance that includes all three coverages (that is, they include Sides A, B and C coverage) -- additional layers of excess Side A insurance.

 

This excess Side A insurance would not be available to provide funding for, say, a securities class action lawsuit, at least if the corporate defendant were solvent, because the settlement of a securities class action lawsuit is an indemnifiable loss to which coverages B and C might apply but to which coverage A does not apply. However, the Side A coverage does apply to a shareholders’ derivative lawsuit settlement because the settlement amount represents a nonindemnifiable loss. So while a jumbo securities class action settlement typically would not trigger coverage under an Excess Side A policy, a jumbo derivative settlement would trigger the Excess Side A policies.

 

The question for the carriers providing this type of excess Side A insurance is whether or not the premiums they are getting are adequate to compensate them for the risks of the kinds of losses associated with large cash shareholders derivative settlements. By and large, the carriers providing this insurance consider that their most significant exposure is related to claims in the insolvency context. But as this settlement and the Broadcom settlement mentioned above demonstrate, it is also possible that the Side A insurance can be implicated in a jumbo derivative settlement as well as in a settlement in the insolvency context.

 

The increasing risk of this type of settlement represents a significant challenge for all D&O insurers, but particularly for those D&O insurers concentrating on providing Excess Side A insurance. Those insurers will have to ask how they are to underwrite the risks associated with these kinds of exposures, and how they are to make certain that their premiums adequately compensate them for the risk.

 

Dan Fisher has an interesting April 22, 2012 article in Forbes (here) discussing the questions associated with the funding of this type of settlement exclusively through D&O insurance.

 

Finally, as Alison Frankel points out in an April 22, 2013 post on her On the Case blog (here), the News Corp. settlement includes what she describes as an “historic concession”: in the settlement, News Corp. agreed “to disclose its campaign and political action committee contributions to shareholders and its lobbying and Super PAC spending to the board.” Frankel quotes sources to the effect that the News Corp. case represents the first time that a derivative lawsuit has been used as a vehicle to obtain enhanced disclosure of corporate political spending.

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Lee Farkas, the criminally convicted former Chairman and majority shareholder of  the defunct Taylor Bean and Whitaker Mortgage Corporation, must repay the nearly $1 million in defense fees the company’s D&O insurer had advanced on his behalf, according to an April 11, 2013 Fourth Circuit opinion. The terse three-page appellate opinion adopts the ruling of the lower court, holding that Farkas’s criminal conviction triggered the D&O insurance policy’s “in fact” conduct exclusions which in turn triggered the insurer’s right to recoup the defense fees it had previously paid. The Fourth Circuit’s opinion can be found here, and the March 21, 2012 district court opinion, which the appellate court affirmed, can be found here.

 

Background

In June 2010, Farkas was indicted on multiple counts of committing and conspiring to commit bank, wire and securities fraud. On April 19, 2011, a jury found Farkas guilty of all 16 counts of fraud and conspiracy to commit fraud. As detailed here, Farkas was, among other things, alleged to have conspired with employees of the failed Colonial Bank to sell the bank approximately $400 million of mortgage assets that had no value. Taylor Bean was also alleged to have engaged in numerous other transactions with the bank that had no value. The bank’s collapse followed after the fraudulent scheme unraveled.

 

After he was indicted, Farkas sought to have his criminal defense fees paid by the company’s D&O insurer. With bankruptcy court approval, the D&O insurer advanced $928,977 toward Farkas’s defense. Farkas incurred significant additional defense expenses, and the carrier’s request for the bankruptcy court’s leave to pay those additional amounts was pending when the jury returned the guilty verdict. Following the verdict, the carrier informed Farkas that, as a result of the verdict and in reliance on the policy’s conduct exclusions, it would no longer fund Farkas’s defense costs, and it reserved its right to seek recoupment from Farkas of the amounts it had previously advanced.

 

Farkas filed an action in the Eastern District of Virginia seeking a judicial declaration that the jury verdict did not terminate the insurer’s defense obligation, and that in any event all of the fees he had incurred prior to the jury verdict must be paid. The D&O insurer filed a counterclaim seeking a judicial declaration that Farkas was not entitled to coverage under the policy and that Farkas was obligated to repay the amounts the insurer had previously advanced. The parties cross-moved for summary judgment. In her March 21, 2012 opinion, Eastern District of Virginia Judge Leonie Brinkema granted the insurer’s motion for summary judgment. Farkas appealed.

 

In arguing that as a result of the jury verdict coverage for Farkas’s criminal defense fees was precluded under the policy, the insurer relied on the policy exclusion specifying that “The Insurer shall not be liable to make any payment for Loss in connection with a Claim against an insured …arising out of, based upon or attributable to the committing in fact of any criminal, fraudulent or dishonest act, or any willful violation of any statute, rule or law.”

 

In seeking to have Farkas repay the amounts that it had advanced, the insurer relied on the language in the policy specifying that “advanced payments by the Insurer shall be repaid to the Insurer by the Insureds or the Company, severally according to their respective interests, in the event and to the extent that the Insureds or the Company shall not be entitled under the terms and conditions of this policy to payment of such Loss.”

 

The Fourth Circuit’s Opinion and the Ruling Below

On April 11, 2013, in a terse three-page per curium opinion, a three-judge panel of the Fourth Circuit affirmed the district court’s ruling. The appellate court said that “having carefully reviewed the briefs, record and appellate law, we affirm for the reasons stated by the district court in its thorough opinion.”

 

In her March 2012 opinion, Judge Brinkema had granted summary judgment for the D&O insurer, finding that the jury verdict in the criminal case represented an “in fact” finding that triggered the conduct exclusion; rejected Farkas’s argument that he was entitled to the payment of the defense costs incurred by not yet paid before the verdict was returned; ruled that the insurer was entitled to recoup from Farkas the defense cost amounts it has advanced prior to the verdict; and rejected Farkas’s argument that the district court should stay its ruling while Farkas’s criminal appeal was pending. (Farkas’s criminal conviction was in any event subsequently affirmed.)

 

In ruling that the jury verdict triggered the policy’s conduct exclusion, Judge Brinkema stated that “there can be no reasonable dispute that the jury verdict here is an objectively verified and pertinent factual finding.” She added that none of the courts that have held that an “in fact” wording in a policy exclusion requires a final adjudication had defined a final adjudication as an appeal. She concluded that “there is simply no support in the case law for plaintiff’s position that a jury verdict does not trigger the ‘in fact’ requirement in the exclusion.”

 

With respect to Farkas’s contention that the insurer should at least pay the defense costs he had incurred but that the insurer had not yet paid when the verdict was returned, Judge Brinkema said that Farkas’s argument “ignores the consequence of a particular claim being excluded.” Farkas’s conduct “was never actually covered under the Policy, and he was therefore never entitled to the monies advanced to him.” Pursuant to the policy language, the insurer, she found, “has the right to seek recoupment of any costs that it advanced before it determined that an exclusion applied.”

 

Discussion

The question of an insurer’s right to seek recoupment of advanced defense expenses is a recurring topic. As I have previously noted (here), although D&O insurers frequently assert their right to seek recoupment, it is still relatively rare for the insurers to actually do so. Among other reasons why the insurers rarely seek reimbursement is that it is relatively unusual for a D&O claim to proceed to the point that there has actually been a factual determination triggering an exclusion. Indeed, one of the many reasons why civil claims triggering D&O coverage frequently settle is that an insured defendant would risk a factual determination that might preclude policy coverage if the defendant were to press the case forward rather than settle.

 

This case’s criminal context obviously presents a different set of circumstances than does a civil case. A criminal defendant does not have the option of a pre-trial settlement that avoids a potentially coverage precluding outcome.

 

Just the same, the coverage outcome here is also due in part to an unusual feature of the policy at issue According to the court record, the D&O insurance policy at issue here was first issued to the Taylor Bean firm in 2008 and subsequently extended by endorsement. Even in 2008 it was standard for most D&O insurance policies to be issued with the “final adjudication” wording, rather than the “in fact” wording. With the final adjudication wording, the preclusive effect of the conduct exclusion does not apply under there has been a final judicial determination that the precluded conduct has occurred. The presence of the “in fact” exclusion language in the Taylor Bean policy is an anachronism that is unexpected and frankly a little bit surprising.

 

Because the policy had the “in fact” exclusionary language, Judge Brinkema had little trouble concluding that the jury verdict precluded coverage. Had the policy had the now-standard “final adjudication” language, the parties would then have had to argue about whether or not the criminal judgment against Farkas was “final” while his appeal was pending. I am well aware that there is extensive case law on the question whether or not a district court judgment if final and enforceable while an appeal is pending. But if the policy had contained the “final adjudication” language rather than the “in fact” language, Farkas might have had a better argument that the insurer was obligated to continue to advance his defense fees unless and until the conviction was affirmed.

 

It is worth noting that these circumstances demonstrate why the preferred exclusionary trigger is not just the “final adjudication” wording but rather the “final non-appealable adjudication” formulation. If the policy had the “non-appealable adjudication” wording, the insurer here would have been obligated not only to advance the amounts Farkas had incurred prior to the verdict but that the insurer had not yet paid, but also to continue to advance his defense expenses for his appeal. Farkas would have been able to continue to use his preferred counsel through his appeal (rather than, as Judge Brinkema noted, counsel appointed for him under the Criminal Justice Act). Farkas may well feel that the appeal might have turned out differently if he had been able to rely on his preferred counsel. I know for sure that if it were me, I would certainly want to be able to use my preferred counsel while appealing a criminal conviction.

 

The fact that Farkas had to rely on appointed counsel for his appeal suggests that he did not have resources of his own to rely on -- which begs the question of why the carrier went to the trouble to obtain an order requiring Farkas to repay the advanced amounts. I mentioned at the outset of this discussion that it is relatively rare for carriers to seek recoupment of advanced amounts, and among other reasons why it is rare is that often there is no point for the carrier to seek recoupment because usually by the time a serious D&O claim has concluded, the defendant is usually broke – which seems to be the case here, which in turn begs the question why the carrier even bothered to pursue a recoupment order.  It probably is worth noting in that regard that the D&O insurer did not initiate the coverage lawsuit here, Farkas did. The carrier only sought recoupment in its counterclaim, after Farkas had sued the insurer. Whether the carrier ultimately will recover anything under the recoupment order is a different question.

 

"Everything I Can See From Here": Two Men, a Dog, a Ball, and ....

 

Everything I Can See From Here from The Line on Vimeo.

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By now, many readers may have seen the 2012 Towers Watson D&O insurance survey, entitled “Directors and Officers Liability: 2012 Survey of Insurance Purchasing Trends,” which can be here. (I am only belatedly posting a link to the survey now owing to my travel schedule last week, when Towers Watson released the survey report).

 

As always, the survey report contains a number of interesting insights, including in particular the report’s conclusion that “the insurance marketplace for directors and officers liability is clearly firming, as evidenced by increased pricing experienced in many sectors.”

 

The report contains a number of other interesting insights about the current D&O insurance marketplace for both public and private/nonprofit entities, but readers will also want to note the precautionary comment in the report’s introduction, which state that “it is important that care is taken”  in drawing conclusions from the report owing to the fact that  "the majority of respondents were large organizations with total assets/revenues in excess of US$1 billion” and that “firms with assets/revenues under US$1 billion were not as well represented.”

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

 

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

 

Background

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

 

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

 

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

 

The March 1 Opinion

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Background

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

 

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

 

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

 

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

 

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

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

 

The February 26 Ruling

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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After entity coverage began to be added to the D&O insurance policy a couple of decades ago, a recurring problem in the bankruptcy context was whether or not the D&O policy proceeds were property of the estate under Bankruptcy Code Section 541(a) and subject to the automatic stay under Bankruptcy Code Section 362. The question arose because the directors and officers of the bankrupt company wanted access to the insurance proceeds to fund defense expense or settlements, but the bankruptcy trustee wanted the proceeds preserved so they are available to satisfy the trustee's own claims, and so the trustee sought to subject payment of the proceeds to the bankruptcy stay.

 

As most practitioners who regularly deal with these issues know, the practical solution to these issues that seems to have been worked out is for the insured directors and officers to approach the bankruptcy court in order to try to obtain an order lifting the stay to allow the carrier to advance their costs of defense, usually subject to certain terms and conditions. These orders are often referred to as “comfort orders,” since they allow the carrier to advance the defense costs without running afoul of the bankruptcy court.

 

Though these procedures may be well known to those who have to deal with them frequently, they may be less familiar to others in the industry who are not as frequently involved in claims presenting these issues. Recent developments in a high-profile case provide a window into these procedures. Although these case developments are not unprecedented, they still provide a useful and perhaps even interesting insight into the way these processes work, particularly for those who may be less familiar with the processes.

 

As was well-publicized at the time, in November 2012, the Rhode Island economic development agency sued former major league baseball star Curt Schilling and several executives at Schilling’s defunct video gaming company, 38 Studios, in a civil action in Rhode Island Superior Court, alleging that Schilling and the other executives, as well as certain officials from the economic development agency, committed fraud in connection with the state’s approval of a $75 million loan guarantee supposedly provided to induce the company to relocate to Rhode Island from Massachusetts.

 

At the time the lawsuit was filed, Schilling’s company and certain related entities were in Chapter 7 bankruptcy proceedings in the District of Delaware bankruptcy court. The trustee in the bankruptcy proceeding contended that the proceeds of the company’s D&O policy were subject to the automatic stay in bankruptcy. Schilling and three other executives from his company filed a motion in the bankruptcy court seeking to have the automatic stay lifted in order to permit the advancement under the D&O policy of their costs incurred in connection with the defense of the Rhode Island lawsuit. The bankruptcy trustee filed limited objections.

 

On February 7, 2013, Bankruptcy Court Judge Mary Walruth granted the executives’ motion and entered an order (a copy of which can be found here) authorizing the D&O insurer to advance the executives defense costs, subject to certain conditions. First, the carrier was directed to provide the trustee and the trustee’s counsel no more than 45 days after the close of each calendar quarter a report stating the total amount disbursed under the policy; the amount disbursed during the quarter; the amount of fee and costs requests pending for which the carrier had not yet made disbursement; and the total amount of coverage remaining under the policy. The order specified that the trustee retained the right to try to seek to have the stay reinstated. The order also specifically stated that the order did not modify the parties’ various rights and obligations under the policy.

 

With the benefit of the order, Schilling and the other officials will now be able to rely on the D&O policy proceeds to fund their defense against the claims in the Rhode Island lawsuit. While there may be nothing remarkable about this now, for many years this relatively straightforward process was highly controversial and extensively litigated, as a result of disputes over the extent to which the policy and the policy proceeds were assets of the estate of the bankrupt company. Fortunately, the processes followed here are now better established. This case provides a good illustration of the way these things now work for those that may not be entirely familiar with these practices.

 

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On February 5, 2013, in a detailed opinion exploring the nuances of a D&O policy’s extended reporting period provisions, Western District of North Carolina Judge Henry Herlong Jr.  determined that the directors of the failed Bank of Ashville of Asheville, North Carolina timely provided their D&O insurer notice of the FDIC’s lawsuit against them as the failed bank’s receiver. Practitioners in the D&O arena will want to read this opinion, a copy of which can be found here, for its examination of the interactions between the policy’s “basic” 60-day extended reporting period and its 12-month “supplemental” extended reporting period.

 

Background

The Bank of Asheville failed on January 21, 2011. As discussed here, on December 29, 2011, the FDIC as the failed bank’s receiver filed a lawsuit in the Western District of North Carolina against seven former directors of the bank. On December 29, 2011, the directors provided the bank’s holding company’s D&O insurer with notice of the FDIC’s lawsuit.

 

The D&O policy provided coverage for the period November 3, 2007 through November 3, 2010. However, the policy contains a 60-day “basic” extended reporting period, allowing for the notice of claims 60 days beyond the policy’s expiration. The policy also provided for a 12-month “supplemental” extended reporting period that, by endorsement and upon payment of an extra premium charge, allows an additional 12 month reporting period. The “supplemental” extended reporting provision in the policy provided that “the supplemental Period starts when the Basic Extended Reporting Period …ends.” 

 

Through a process that the court’s opinion reviewed in detail, the bank purchased the 12-month supplemental extended reporting period prior to the expiration of the policy period. The endorsement the D&O insurer issued specified that the supplemental extended reporting period is “11-01-2010 – 11-01-2011.”

 

After the directors submitted notice of the FDIC lawsuit to the insurer, the insurer took the position that the notice was untimely. The directors filed an action seeking a declaratory judgment that the insurer is required to pay defense costs and any settlements or judgments in the FDIC’s lawsuit. The directors also alleged a claim for reformation of the policy. The parties filed cross-motions for summary judgment.

 

The February 5 Opinion

In his February 5 opinion, Judge Herlong granted the directors’ motion for summary judgment, holding that the directors had timely provided notice of the FDIC lawsuit to the insurer prior to the expiration of the extended reporting period.

 

The dispute that the court considered came down to the question whether the 12-month supplemental extended reporting period ran from the end of the policy period of the policy or from the end of the policy’s 60-day basic extended reporting period.

 

After a detailed review of the communications between the various parties involved in the acquisition of the supplemental extended reporting period, the court concluded that

 

Although the Policy provided a 60-day basic Extended Reporting Period automatically, [the D&O insurer] charged the Bank the maximum permitted under the Policy, a 200 percent premium, for the 12-months of Supplemental Extended Reporting Period coverage. However [the D&O insurer] erroneously used the dates November 3, 2010 to November 3, 2011. Thus under [the D&O insurer’s] argument, the Bank paid for 12 months and received only 10 months of additional extended reporting coverage. Based on the foregoing, the court finds that the starting and ending dates of the Endorsement conflict with the terms of the Policy and is ambiguous because it is subject to different interpretations regarding the 60-day Basic Extended Reporting Period and the 12-month Supplemental Extended Reporting Period.

 

The D&O insurer argued that all of the documents and communications, including in particular the endorsement showing a supplemental extended reporting period from November 3, 2010 to November 3, 2011, “support a finding that the intent of the parties was to eliminate the 60-day Basic Extended Reporting Period.”

 

Judge Herlong said that this “is an amazing argument, “ asking the question “Why would the Bank forfeit the 60-day Basic Extended Reporting Period when the Policy specifically provides that if the Bank purchases an extended reporting period of 12 months, the 12-month period begins when the 60-day Basic Extended Reporting Period ‘ends’?”

 

Judge Herlong concluded that “the evidence is clear that the Plaintiffs did not know or intend to forfeit the 60-day Basic Extended Reporting Period. To the contrary, the only inference that can be drawn from the evidence is that the Plaintiffs paid for 14-months of extended reporting coverage, which includes the 60-day Basic Extended Reporting Period and the 12-month Supplemental Extended Reporting Period.” Judge Herlong granted the directors request to reform the schedule of the endorsement to allow for notice during the period January 3, 2011 to January 3, 2012, as a result of which the directors’ notice to the insurer of the FDIC’s lawsuit was timely.

 

Discussion

Although this decision is fact intensive and is a reflection of the specific policy language involved, it nevertheless represents a cautionary tale that is worth heeding. D&O policies are complex contracts with a variety of parts that interact in myriad subtle ways. My review of the sequence of events here as well as a familiarity with the way that the transaction of the kind involved here are processed suggests to me that the parties really were not fully conscious of the possible complications arising from the interaction between the basic extended reporting period and the supplemental extended reporting period.

 

Once the dispute arose, the parties tried to argue over what had been intended, when in reality there had really been no intent, as the persons involved in the transaction may not have been conscious of the potential issue in the first place; the carrier provided a quote with and issued the supplemental extended reporting period endorsement with dates that did not take the 60-day basic extended reporting period into account. The bank and its representatives accepted the quote and placed the order for the supplemental extended reporting period without objecting that the specific period that the carrier proposed to provide did not take the 60-day basic extended reporting period into account. Accordingly, faced with a fundamentally ambiguous situation (but taking into account the policy’s provision that the supplemental extended reporting period starts when the basic extended reporting period ends), the court construed the situation in the directors’ favor.

 

I think anyone who has been involved in these kinds of situations can see how this happened. The policy allowed for a 12 month reporting period extension, the bank said it wanted a 12 month extension, and the carrier issued an endorsement that extended the reporting period 12 months. Because I can see how what happened here could happen, I am reluctant to try to draw conclusions too broadly, other than to say that this case does provide a lesson for us all on the need when modifying a policy to consider all of the ways that the proposed modification will affect the policy.  On a much simpler level, the case does provide an important illustration of the ways that the policy’s various extended reporting provisions interact. I want to make clear that in stating these conclusions here, I do not mean to suggest that I am finding fault with anyone’s actions. As I said, I can see how this situation came about.

 

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The past year included dramatic and important developments involving elections, tragedies and natural disasters. While there was nothing in the world of Directors and Officers Liability to match this drama, it was nevertheless an eventful year, with many significant developments. In the latest issue of InSIghts, which can be found here, I take a look at Top Ten D&O Stories of 2012.

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As I have discussed in prior posts (refer here for example), one of the recurring D&O insurance coverage issues that has arisen in connection with the FDIC’s failed bank litigation is the question whether or not the FDIC’s claims as receiver for the failed bank against the bank’s former directors and officers trigger the D&O policy’s insured vs. insured exclusion. In a terse January 4, 2013 opinion (here), Northern District of Georgia Judge Robert L. Vining, Jr. held that, owing to the “multiple roles” in which the FDIC acts in pursuing claims against the former directors and officers of a failed bank, there is “ambiguity” on the question whether the FDIC’s lawsuit triggers the insured vs. insured exclusion.

 

Background

Omni National Bank of Atlanta Georgia failed on March 27, 2009 (refer here). The FDIC was appointed as receiver for the failed bank. On March 16, 2012, the FDIC initiated a lawsuit in the Northern District of Georgia against ten former directors and officers of the bank, asserting claims against the defendants for negligence and gross negligence in connection with the approval of certain loans on low-income residential properties.

 

The bank’s D&O insurer initiated a separate declaratory judgment action seeking a declaration that there is no coverage under the bank’s D&O policy for the FDIC’s claims against the bank’s former directors and officers.

 

The D&O insurer filed a motion for summary judgment the declaratory judgment action, on three grounds: first: the carrier argued that because the FDIC as receiver “steps into the shoes” of the failed bank, the FDIC’s claim represents a claim “by, on behalf of, or at the behest of, the Company,” and therefore is precluded from coverage under the policy’s insured vs. insured exclusion; second, that the losses the FDIC seeks to recover do not fall within the policy’s definition of “loss,” which includes the so-called “loan loss carve-out”; and third that the policy does not in any event provide coverage for wrongful acts alleged against the former directors and officers that took place after the policy’s expiration.

 

The January 4 Opinion

In his January 4, 2013 opinion, Judge Vining denied the carrier’s motion for summary judgment with on the first two grounds, but granted summary judgment with respect to the alleged wrongful acts that took place after the policy’s expiration.

 

In rejecting the insurer’s argument that coverage is precluded by the policy’s insured vs. insured exclusion, Judge Vining said that “it is unclear whether the FDIC-R’s claims are ‘by ‘or ‘on behalf of’ the failed bank.” He added that “it is unclear what exactly is encompassed by the phrase ‘steps into the shoes.” These “ambiguities” arise, Judge Vining found, “in part because the FDIC-R differs from other receivers or conservators that might step into the shoes of a failed or insolvent bank.”

 

Judge Vining then reviewed the FDIC’s authority under FIREEA to recover losses, and the fact that in recovering losses the FDIC has authority to act on behalf of the bank’s depositors, creditors and shareholders.  Judge Vining noted that “the FDIC-R has multiple roles.” Accordingly, he concluded that “the FDIC-R has show that some ambiguity exists in the insured versus insured exclusion,” and he denied the carrier’s motion for summary judgment in reliance on the exclusion.

 

Judge Vining also rejected the carrier’s motion for summary judgment based on the argument that the financial losses the FDIC sought to recover did not constitute covered loss under the policy. Judge Vining found that “ambiguity exists in the definition of ‘loss’” because the “loan loss carve-out” does not “clearly exempt tortious claims” which is “the basis” for the FDIC’s claims in the underlying D&O liability action.

 

Discussion

Although D&O insurers have raised the insured vs. insured exclusion as a defense to coverage in connection with a number of FDIC failed bank claims, Judge Vining’s ruling in the Omni National Bank is so far as I am aware only the second ruling in connection with the current failed bank wave in which a court has made a ruling regarding the applicability of the insured v. insured exclusion to an action brought by the FDIC in its capacity as a receiver for a failed bank.

 

As discussed here, in October 2012, District of Puerto Rico Judge Gustavo Gelpi denied the D&O insurer’s motion to dismiss the coverage action the FDIC had brought against the carrier under Puerto Rico’s direct action statute. The D&O carrier involved had sought to dismiss the suit on the grounds that the D&O policy’s insured vs. insured exclusion precluded coverage for the FDIC’s claims in its capacity of the failed Westernbank against the bank’s former directors and officers. Judge Gelpi declined to dismiss the action, noting that the FDIC has authority under FIRREA to act “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

In both cases, the respective judges held that the carriers were not entitled to a determination as a matter of law that the exclusion precluded coverage. Both Judge Gelpi in the prior case and Judge Vining here determined that the Insured vs. Insured did not preclude coverage as a matter of law because the FDIC has the authority under FIRREA to act on behalf of a variety of different constituencies. The FDIC as well as individual directors and officers seeking coverage under their bank’s D&O insurance policies undoubtedly will seek to rely on these rulings in order to try to fight other carrier’s attempts to assert the Insured vs. Insured exclusion as a defense to coverage.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action.

 

The carriers will further argue that the policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

Though these rulings unquestionably are helpful for the FDIC and the individual directors and officers, it seems likely that these issues will continue to be litigated in other cases.

 

Special thanks to a loyal reader for providing me with a copy of Judge Vining’s January 4 Order.

 

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Every fall, I assemble a list of the current hot topics in the world of Directors and Officers (D&O) Liability Insurance. While the past 12 months have not seen as many headline-grabbing D&O related events as in some past years, the issues that are currently unfolding have had a significant impact on the marketplace. In the latest issue of InSights (here), I take a look at what to watch now in the world of D&O. Readers of this blog will be particularly interested in the first entry of the article, discussing the question of whether the marketplace for D&O insurance is firming.

 

A prior version of the latest InSights article appeared in expanded form on this site, here.

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A significant side-effect from the current bank failure wave has been the FDIC’s assertion of claims against the former directors and officers of many of the failed banks. The FDIC’s claims have in turn raised significant questions of insurance coverage under many of the failed banks’ D&O insurance policies. As discussed in a prior post (here), one of the significant coverage issues that has come up is whether or not the claims of the FDIC, which it is asserting in its capacity as receiver for the failed banks, are precluded under the Insured vs. Insured exclusion found in most D&O insurance policies. (The Insured vs. Insured Exclusion is sometimes referred to as the I v I exclusion.)

 

In what is as far as I know the first decision on this issue as part of the coverage litigation arising out the current bank failure wave, the federal court in Puerto Rico has ruled that the I v I exclusion in the D&O insurance program of the failed Westernbank of Mayaguez, Puerto Rico does not preclude coverage for the FDIC’s claims against the failed bank’s former directors and officers. A copy of the court’s October 23, 2012 decision can be found here.

 

Regulators closed Westernbank on April 30, 2010, which according to the FDIC cost the insurance fund $4.25 billion. In October 2011, certain of the former Westernbank directors and officers had sued the bank's primary D&O insurer in state court in Puerto Rico (about which refer here). The FDIC as receiver for Westernbank moved to intervene in the state court action, and on December 30, 2011, removed the state court action to the District of Puerto Rico. On January 20, 2012, the FDIC filed its amended complaint in intervention, in which it named as defendants certain additional directors and officers,  and, in reliance on Puerto Rico’s direct action statute, the D&O insurers in the bank's D&O insurance program. A copy of the FDIC's amended complaint can be found here.

 

In its complaint, the FDIC, as Westernbank’s receiver, seeks recovery of over $176 million in damages from the former bank’s directors and officers as well as their conjugal partners, based on twenty-one alleged grossly negligent commercial real estate, construction and asset-based loans approved and administered from January 28, 2004 through November 19, 2009. In its complaint in intervention in the directors and officers coverage action against the bank’s D&O insurers, the FDIC seeks a judicial declaration that its claims against the directors and officers are covered under the policies. All of the defendants moved to dismiss the respective claims against them.

 

In his October 23 opinion and order, Judge Gustavo Gelpi denied all of the motions to dismiss. His rulings with respect to the D&O insurers’ motions to dismiss the coverage actions against them appear on pages 16 and following in the October 23 opinion.

 

The D&O insurers had moved to dismiss the coverage actions that had been filed against them in reliance on the I v I exclusion in the primary insurance policy. The exclusion provides that “The Insurer shall not be liable to make any payment for Loss in connection with any Claim made against an Insured …which is brought by, or on behalf of, an Organization or any Insured Person other than an Employee of an Organization, in any respect and whether or not collusive.” The insurers argued that as receiver for the failed Westernbank, the FDIC stood in the shoes of Westernbank, which is an insured under the policy, and therefore the FDIC’s claims against the failed bank’s directors and officers were precluded from coverage under the D&O insurance policies by operation of the I v I exclusion.

 

As Judge Gelpi noted in his opinion these same issues were raised and litigated in a number of cases during the S&L crisis two decades ago. And as Judge Gelpi also notes in his opinion, these prior courts had split on the question of whether or not a D&O insurance policy’s Insured vs. Insured Exclusion precludes coverage for claims brought by the FDIC in its capacity as receiver against a failed bank’s former directors and officers. In summarizing these cases, Judge Gelpi noted that the question of the applicability of the exclusion in this context “is ambiguous.”

 

Judge Gelpi then, “with these differences in mind,” turned to the “purposes of the exclusion, the complaint and the specific terms of the policy for guidance.” He noted that the “obvious purpose” of the exclusion is to protect against collusive law suits; however, he also noted that the exclusion itself on which the insurers sought to rely made the exclusion applicable to Insured vs. Insured claims “whether or not collusive.”

 

The question to which Judge Gelpi then turned is whether or not the FDIC’s claims against the former directors and officers of Westernbank were “brought by, on behalf of or in the right of, and Organization or any Insured Person.” Judge Gelpi noted that the policy defines the term “Organization” as the named entity, each subsidiary and debtors in bankruptcy proceedings. After citing these provisions, Judge Gelpi summarily concluded that “Accordingly, the court finds that the FDIC’s course of conduct does not run afoul of this provision.” In reliance on prior cases that had concluded that the I v I Exclusion “does not prelude the FDIC from seeking redress from the Insurers.” 

 

By way of further elaboration, Judge Gelpi noted that the FDIC is suing “on behalf of depositors, account holders, and a depleted insurance fund,” and therefore that “the FDIC’s role as a regulator sufficiently distinguishes it from those whom the parties intended to prevent from bringing claims under the Exclusion.”

 

Discussion

Judge Gelpi’s ruling in this case is a significant victory for the individual directors and officers who hoped to be able to rely on the D&O insurance policies in order to be able to defend themselves against the FDIC’s claims against them, as well as for the FDIC, which hopes to be able to recover the losses it claims from the D&O insurance policies.

 

As the first decision on this insurance coverage issue in connection with the current bank failure wave, Judge Gelpi’s ruling will also obviously be of great interest to other failed bank directors and officers who face FDIC claims and whose D&O insurance carriers have tried to deny coverage in reliance on their respective policies’ Insured vs. Insured Exclusions. But while Judge Gelpi’s decision unquestionably will be helpful to the directors and officers in the other cases, it is far from the final word on the subject.

 

For starters, the split of authority in the cases from S&L crisis era remains. As Judge Gelpi noted, the courts have gone both ways on these issues and the carriers undoubtedly will continue to attempt to rely on the cases holding that the Insured vs. Insured exclusion does preclude coverage for claims brought by the FDIC.

 

A further reason that Judge Gelpi’s decision is unlikely to provide the final word on the subject is that other courts may not find the logic on which Judge Gelpi relied as compelling as he did. Judge Gelpi does not, for example, appear to have even considered the question of whether or not an action by the FDIC in its capacity as receiver of a failed bank (and therefore in effect, “standing in the shoes of the failed bank”) is an action “in the right of” the Organization, within the language and meaning of the exclusion. Other courts may consider it important in considering the exclusion’s potential applicability to address this issue expressly, as Judge Gelpi’s opinion does not. These other courts, in more careful consideration of this issue, might also conclude that the FDIC asserting claims as a failed bank’s receiver is asserting claims “in the right of” the failed bank and therefore that the exclusion applies.

 

In support of his conclusion, Judge Gelpi also considered it important that the FDIC was not only suing in its capacity as receiver, but was also suing on behalf of “depositors, account holders, and a depleted insurance fund.” Indeed, many of the courts that had ruled during the S&L crisis era that the Insured vs. Insured exclusion did not preclude coverage for claims by the FDIC had made their decisions in reliance on the same or similar observations about the FDIC’s claims.

 

The insurers, however, will likely contend that even if the FDIC is acting on behalf of these other constituencies in bringing the suit, it is first and foremost bringing the suit in its capacity as receiver for the failed bank, as that is the basis upon which it has any right to bring the claims in the first place. The insurers will further argue that the sole basis on which the FDIC has any right to assert the claims is because, by operation of the receivership, it is acting “in the right of” the failed bank, and therefore the preclusive language of the exclusion applies, notwithstanding the fact that the FDIC may have other purposes and motivations in bringing the action. The policy’s exclusion does not require, in order for the exclusion to apply, that the action be brought “solely” or “only” “in the right of” the Organization. The insurers will argue that because the action was brought “in the right of” the Organization, the exclusion applies notwithstanding the fact that in bringing the claim the FDIC was also action on behalf of other constituencies.

 

All of which is a long way of saying that though the policyholders and the FDIC prevailed in this case, these issues are likely to continue to be litigated, and the split of cases we saw during the S&L crisis is likely to continue.

 

Very special thanks to the several readers who supplied me with copies of Judge Gulpi’s opinion.

 

Another Georgia Failed Bank Lawsuit: On October 23, 2012, the FDIC, as receiver for the failed United Security Bank of Sparta, Georgia filed its latest failed bank lawsuit. The complaint, which the FDIC filed in the Northern District of Georgia, can be found here.

 

United Security bank failed on November 6, 2009. The FDIC’s lawsuit as the bank’s receiver is filed against a single defendant, Pierce Neese, the bank’s former CEO and also a bank director. The FDIC’s complaint asserts claims of Negligence and Gross Negligence against Neese in connection with 16 loans made between November 10, 2005 and March 27, 2008, which the agency alleges caused damages to the bank of over $6.373 million.

 

An unusual feature of the FDIC’s complaint, and perhaps the explanation why there is only a singe defendant is the case, is the agency’s allegation that from 2002 until March 2006, Neese “was effectively the Bank’s senior credit officer and functioned as a ‘One-Man Bank.’” Even after the bank established itself as a three-person LLC at the direction of regulators, Neese “continued to function as the Bank’s ‘one-man’ LLC until the Bank failed. According to the complaint, the bank even had print advertisements stating, “Meet Our Loan Committee, Pierce Neese.” The FDIC alleges that by dominating and usurping the loan approval process, Neese rendered the usual lending controls ineffective.

 

The FDIC’s complaint against Neese is the latest that the FDIC has recently filed as banks that failed in 2009 approach the third year anniversary of their closure (about which refer here). The complaint is also is the 35^th lawsuit that the FDIC has filed as part of the current failed bank wave and the 17^th that the agency has filed so far in 2012. The FDIC’s lawsuit against Neese is also the tenth lawsuit the FDIC has filed in connection with a failed Georgia bank. Although Georgia has had more failed banks than any other state, the percentage of all failed bank lawsuit involving failed Georgia banks is even greater than the percentage of all bank failures involving Georgia banks. For now at least, it seems as if the regulators are focusing on Georgia more than other states.

 

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I am pleased to publish below a guest post written by Paul A. Ferrillo of the Weil Gotshal and Manges law firm. Paul’s guest post identifies the liability exposures that IPO companies and their directors and officers face, and describes the insurance considerations the companies should address in confronting those exposures. Paul’s article was first printed in Westlaw Journal Corporate Officers & Directors Liability, a Thomson Reuters publication.

 

I would like to thank Paul for his willingness to publish his article on this site. I welcome guest posts from responsible commentators on topics of interest to readers of this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Paul's guest post:

 

 

With a potentially improving economy and rebounding public markets, the idea of going public (a long-shelved consideration in the past few years) in an initial public offering (an “IPO”) has come back in vogue, both in the United States and abroad.  Going public, of course, can be a very good thing for a company, its directors, its initial investors (often venture capital firms or private equity firms), and its stockholders—if the stock does well. But sometimes the stock does not do well because the company misses earnings, or worse, finds some accounting problem that must be disclosed to investors. The price of “not doing well” is often more than just monetary—there could be mountains of lawsuits filed against the company and its directors and officers. These lawsuits can present unique problems for defendants, since the strict liability provisions of Section 11 of the 1933 Act (which govern liability with respect to the publication of alleged materially misleading statements in a company’s prospectus) are almost always implicated. That means, in sum, that any material misrepresentation, even negligently made (because scienter, or culpable knowledge, is not a requirement of a Section 11 claim), could form the basis of liability against a corporate director. Depending upon the severity of the problem and the resulting drop in the stock price, an IPO “failure” could also draw the attention of state and federal securities regulators and potentially the United States Attorneys office. Needless to say, securities class action litigations and investigations can cost millions or tens of millions to defend and settle.

 

 

The delicate balance between the “good” and the “bad” IPOs often ends up on the desk of a company’s risk manager.  Unfortunately, D&O insurance for IPOs is a very different product than other corporate insurance. Slips and falls, broken bones, workers compensation and fire losses are not the issue here. Instead, the personal assets of directors and the company’s most senior executives are at risk.  For this reason, leaving D&O insurance decisions for IPOs solely to risk managers is not advised.  Directors themselves need to understand the pitfalls and perils of poor decisions related to D&O insurance for IPOs. Directors need to understand the value that a sophisticated insurance broker brings to the D&O insurance purchasing decision.   This knowledge is especially important for directors in today’s environment where companies may be seeking to go public under the streamlined requirements for emerging growth companies as set forth in the Jumpstart Our Business Startups Act (“Jobs Act”) of 2012, which generally sets forth looser compliance and internal control requirements than under the Sarbanes Oxley Act of 2002. This article attempts to bring all of these issues together, in one place, for directors to understand what they need to know about D&O insurance (and related corporate insurances) when a company goes public.

 

 

How Much D&O Insurance to Buy?

 

Very often, after a director is recruited to sit on the board of a company going public, one of his first questions is “well, how much D&O insurance are you going to have?” Unfortunately, there is not one right answer to this question.  Some view it a “cost question.” Buying a lot of good D&O insurance costs money, and some companies don’t want to pay a lot for it, as they think it’s a “commodity.” Directors often take an opposite view.  They are on the firing line, and if there is not enough D&O insurance, they could be asked to write a personal check to the plaintiffs’ counsel to settle an action against them—a very unpalatable prospect. Finally, others view it as a question answered by reference to benchmarks—if the last company that did a $300 million IPO bought $20 million of D&O insurance, why shouldn’t we? 

 

 

All of these viewpoints have some ring of truth and make some sense. But the bottom line is that being uninsured is a very bad thing for everyone involved. So why not resolve to make a D&O IPO insurance purchase that makes better sense to all those potentially involved in the aftermath of a failed IPO? To do so, we recommend the following: First, ask your insurance broker for recommendations as to other similarly situated companies that went public in terms of what D&O limits they purchased. A sophisticated broker with experience in the public company D&O markets should have this information at his fingertips. Such benchmarking is a good start to get a ballpark figure of what limits to buy.  Second, an arguably better approach is a market capitalization analysis of potential stock drop scenarios, using generally-accepted settlement figures that are publicly-available. For instance, imagine that a company expects its market capitalization twelve months post-IPO to be $1 billion. And what if that company were to suffer a 40% stock drop as a result of the announcement of unexpected bad news? That would equate to a $400 market capitalization drop. Taking 10% of that number (10% being a “proxy” for the percent of shareholder losses that might be recoverable in a “medium” severity case) would equate to a potential settlement of $40 million (but note that in a Section 11 case with strict liability issues, the settlement percentage could arguably be higher!). Adding in attorney’s fees and the potential costs of an investigation might get you to a $50 million total per-claim loss. The $50 million number should be another data point to consider when evaluating a D&O limits purchase. Again, there is no “right” answer here. 

 

 

What Carriers to Use in “the Tower”

 

Years of experience defending securities class actions allow us to make some comments about the importance of good D&O insurance. D&O insurance is not a commodity. Not all D&O carriers are equal.  Not all D&O carriers have good reputations for handling and paying claims. Not all carriers will “step up to the plate” when its time to resolve the action. Directors should ask around (to other directors and other companies of boards they sit on) to understand which carriers are willing to pay claims and which are not. Good brokers will have this information too, if they are willing to share it with you. Lawyers who defend securities class action typically run into many carriers while mediating class actions, and may also have an opinion on which carriers are business-minded and stand behind their director clients. There is nothing worse that having a recalcitrant carrier at the settlement table that refuses to pay a claim. 

 

 

Portfolio Company IPO’s versus Spin-offs

 

Many times IPOs are a tool for private equity firms or hedge funds looking to exit or reduce an investment. Sometimes IPOs result from larger companies spinning off profitable subsidiaries into standalone public companies. Spin-offs present unique D&O challenges to consider in the D&O insurance purchasing decision: the potential for overlapping boards, the potential for not only a stock drop for the company going public, but for the parent as well under certain circumstances, counsel and privilege issues that might require multiple sets of defense counsel (which add to the cost of a litigation), and the selling shareholder liability of the ultimate parent who is selling its shares of the spin-off in the IPO.

 

 

Regardless of the challenges, one simple strategy for a director of the company going public is to insist that the company going public purchase enough D&O insurance to fully satisfy the company’s (and his) potential liability to shareholders.  Another question to ask is whether there will be any additional insureds on the policy (e.g. the private equity sponsor, or the ultimate parent who is spinning off the company going public) who may have other liability issues like potential selling shareholder liability.  If too many constituencies share from the same tower chances are that there may be not enough money left at the end of the day to effectuate a settlement of all outstanding litigations and investigations, especially in a Section 11 case.

 

 

Indemnifiable versus non-Indemnifiable Loss Coverage –Side A D&O Insurance

 

Part of any analysis of the purchase of D&O insurance is the purchase of Side A D&O coverage. “Side A” excess D&O coverage is for “non-indemnifiable loss,” i.e. loss incurred by a director for which a company cannot advance or indemnify, or is financially unable (because of an insolvency scenario) to advance or indemnify pursuant to its bylaws or certificate of incorporation. Side A coverage only exists for the benefit of the directors and officers—it would never cover the entity.

Though certainly a part of traditional D&O coverage, in the years after Enron and Worldcom, it has become standard to purchase separate Side A D&O coverage to cover the directors and officers with dedicated limits that are fully accessible in any insolvency situation. Though some would term this “bankruptcy-specific” D&O coverage, the need for Side A excess D&O insurance can come up in other ways. More specifically, under Delaware law, the settlement of a shareholder derivative action is “non-indemnifiable,” meaning the Company cannot fund such a settlement.  So having Side A coverage available for such a situation is a huge positive for a director. More specialized forms of Side A coverage also exist, like Side A “difference in conditions” coverage (which can, under certain circumstances, drop down and provide coverage in situations where an underlying carrier won’t pay), and “independent director” coverage (which expressly covers only independent directors) also exist. Directors and independent directors should insist on dedicated Side A limits as part of the overall IPO D&O structure.

 

 

Mandatory Advancement – Presumptive Indemnification Clauses

 

One of the new developments in the D&O marketplace over the last two years is mandatory advancement of defense costs under any circumstance. Previous to 2010 D&O carriers would generally advance defense costs from dollar one in insolvency settings, understanding that (1) in such a case a company “was unable to advance” defense costs within the retention, and (2) to not advance defense costs would potentially leave directors without adequate counsel, thus exposing them (and the carrier) to increased exposure. A soft market for D&O insurance, among other reasons, caused carriers to expand advancement of defense costs to situations where a company “simply refuses” to advance or pay a director’s defense costs, in addition to the insolvency scenario. That is a huge consideration when such defense costs could run into the hundreds of thousands of dollars. Further, presumptive indemnification language normally contained in D&O policies should be stricken or watered down so it does not conflict with the broad advancement of defense cost coverage now being offered in the D&O marketplace.

 

 

Definition of Loss Issues

 

A D&O policy is not particularly useful if it does not cover all claims-related payments and settlements concerning litigation commenced against directors and officers. A director should insist on the broadest definition of “loss” possible, which should include the payment of (1) all pre-claim investigation or inquiry costs, (2) all defense costs, judgments and settlements related to litigation and post-claim investigatory proceedings and litigation, (3) all expert costs, (4) any defense costs associated with bankruptcy-related investigations commenced by a trustee, receiver or creditors committee, and (5) all defense costs and settlements associated with claims against him under Sections 11, 12 and 15 of the 1933 Act. 

 

 

Bankruptcy Protections

 

Needless to say, the primary D&O policy should work in all settings, including bankruptcy settings. Directors should insist on broad “definition of claim” words to cover bankruptcy investigations, and a broad carve-out from the insured-versus-insured exclusion for derivative claims brought by creditors committee, bondholder committees or properly formed bankruptcy constituencies of the company. Finally, we recommend a simplified “order of payments” (or “priority of payments”) clause which does not leave any discretion to the company to withhold or direct payments under a D&O policy. 

 

 

Though our list of questions is long, it is certainly not exclusive of other D&O policy enhancements sophisticated brokers might also suggest for clients going public. A good broker can be an ally here, not a hindrance to the process. At the end of the day, however, it is up to the director himself to fully educate himself on the D&O coverage for any company for whom he or she is going to sit on the board. This is an area that is simply too important to overlook. Again, good D&O insurance often goes unnoticed. But poor D&O insurance often comes to light at the worst possible time for a director.

 

 

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Weil Gotshal & Manges Releases Latest Edition of "The 10b-5 Guide": In adddition to writing the above blog post, Paul Ferillo is also one of the co-authors, along with his colleagues Robert Carangelo, David Schwartz and Matthew Altemeier, all also of the Weil, Gotshal & Manges law firm, of the seventh edition of The 10b-5 Guide, which the firm released today. The  law firm's press release regarding the Guide can be found here and a link to the electronic version of the Guide can be found here. 

 

 

The Guide provides a comprehensive survhey of recent developments in the regarding 10b-5 actions, including in particular a complete overview of the decisions of the U.S. Supreme Court in the securities law arena during the 2010-11 term. The Guide is presented as a primer for corporate employees and securities ltigation practitioners and serves as a handbook to one of the SEC's most important rules.

 

 

The Guide is great resource and I highly recommend it for everyone. (Readers will note that I wrote the Foreward for this latest edition of the Guide.)

 

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In the August 2012 issue of Business Law Today, the ABA Business Law Section published an article entitled “Training for Tomorrow: Corporate Counsel Checklist for Supervising Creation/Renewal of D&O Protection Program” (here). The article describes the critical components of a comprehensive executive protection program. A detailed description of the article and an explanation of the process by which the ABA Business Section created and published the checklist can be found in a September 11, 2012 post by Kevin Brady on the Delaware Corporate and Commercial Litigation Blog

 

The ABA checklist and accompanying commentary emphasizes that there are multiple components of a comprehensive program to protect corporate directors and officers from potential financial and criminal liability. The first element, statutory exculpation, should be incorporated into the company’s certificate or articles of incorporation.

 

Three additional elements of the program described in the ABA article are:  the right to advancement of defense costs; relief from the duty to repay advances; and indemnity against settlement and judgments. All three of these elements should be address in the company’s corporate by-laws. As the article notes, the changing legal environment poses “significant hurdles” to “making sure that the entity’s by-laws actually provide the maximum rights to advancement and indemnity that the law permits. The article provides a short, useful checklist to be used in reviewing corporate by-laws in order to ensure that the provisions provide the recommended components of executive protection program. Readers of this blog will find this portion of the ABA article particularly useful.

 

The article also notes that D&O insurance is a critical component of a comprehensive executive protection program. The article also contains a D&O insurance checklist. The list contains many useful items. D&Oinsurance professionals will want to be familiar with the list, as it is possible that their clients, armed with checklist, might expect the insurance professionals to respond to each of the checklist items.

 

One item that should be added to the list is the critical importance of associating in the D&O insurance placement process an experienced and knowledgeable insurance professional that is qualified to negotiate policy terms and conditions and that is able to make informed recommendations about policy limits and structure. Corporate counsel that want to ensure that their company’s D&O insurance program is state of the marketplace will want to enlist the assistance of a D&O insurance professional that is out in the marketplace every day and that is fully informed about what is available in general and from each of the carriers.

 

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In an August 27, 2012 post (here), I discussed Central District of California Judge James Selna’s August 21, 2012 decision in Petersen v. Columbia Casualty, and in particular Judge Selna’s consideration of the insurer defendant’s duty to advance under its liability policy. Following my publication of the post, I was contacted by Jeffrey Kiburtz of the Shapiro, Rodarte & Forman law firm. Jeff had a differing perspective on Judge Selna’s opinion and he suggested the possibility of a guest post on the topic, to which I readily agreed. Jeff’s guest post discussing Judge Selna’s opinion is set forth below.

 

I would like to thank Jeff for his willingness to set out his views as a guest post on this site. I welcome guest posts from responsible commentators on topics of interest to this blog. Any readers who are interested in publishing a guest post on this site are encourage to contact me directly. Here is Jeff's guest post:

 

 

 

As a regular reader of Kevin’s blog, I always find it be well-written, informative and timely – it is truly a great resource and I am thankful to him for helping me stay up-to-date on a variety of management liability issues (as well as the opportunity to submit this guest blog). And while I also find myself in agreement with the majority of his substantive commentary, I felt compelled to provide a different perspective on the Petersen v. Columbia Casualty he discussed here. (For the record, I had no involvement in the Petersen case.)

 

 

As discussed in greater detail there, Petersen ostensibly addressed the standard for determining whether an insurer must advance defense costs under a non-duty to defend policy. For Kevin, “the court [in Petersen] correctly understood the insurer’s defense obligations and correctly declined to apply principles derived from duty to defend cases to the determination of the insurer’s obligations.” From my perspective, however, the court’s decision on the standard applicable to non-duty to defend policies did not expressly consider, and is in any event difficult to reconcile with, established Ninth Circuit precedent. (I’ll leave for others the issue of whether there is any actual conflict between our two stated perspectives.)

 

 

In refusing to apply duty to defend principles (most notably the principle that defense obligations are triggered by a “mere potential” for coverage) to the analysis of whether an insurer must advance defense costs, the court in Petersen appears to have relied nearly exclusively on Jeff Tracy, Inc. v. U.S. Specialty Ins. Co., 636 F. Supp. 2d 995 (C.D.Cal. 2009). Further, both Petersen and Jeff Tracy suggested that the only support for the insured’s “mere potential” argument was Gon v. First State Ins. Co. 871 F.2d 863 (9th Cir. 1989), which both courts distinguished as addressing the timing of when an insurer must begin to advance defense costs, not the method of determining whether such a duty exists in the first instance. Thus, in both Jeff Tracy and Petersen, the Central District concluded in one form or another that “the Ninth Circuit did not hold [in Gon] that the duty to defend or ‘potential for coverage’ standard still applied” to non-duty to defend policies. Jeff Tracy at 1003.

 

 

Now, admittedly, the specific reach of Gon (and a similar case, Okada v. MGIC Indem. Corp., 823 F.2d 276, 282 (9th Cir.1986)) is a little unclear, but the Ninth Circuit itself regards Gon and Okada as “circuit precedent requiring the advancement of defense costs for potentially covered claims.” Pan Pacific Retail Properties, Inc. v. Gulf Ins. Co., 471 F.3d 961, 970 (9th Cir. 2006). Moreover, although the court in Pan Pacific distinguished Gon and Okada on grounds that those cases are inapplicable when, as in Pan Pacific, the coverage action was brought after the conclusion of the underlying matter, the court made reasonably clear in a separate case that potentiality remains the test when contemporaneous advancement of defense costs is the issue. Unified Western Grocers, Inc. v. Twin City Fire Ins. Co., 457 F.3d 1106, 1112 (9th Cir. 2006).

 

 

Unified Western Grocers involved alleged fraudulent transfers in the context of a leveraged buyout. The insurer declined coverage on grounds that the underlying suit effectively constituted an action for restitution based on allegations of intentionally wrongful conduct. And, while the insured countered that the asserted breach of fiduciary duty was at least potentially covered, the insurer argued that the claim for breach of fiduciary duty and its related allegations were, in effect, inseparably intertwined with the non-covered, intentionally wrongful conduct and demand for restitution. Reversing the district court, the Ninth Circuit agreed with the insured, holding that the breach of fiduciary duty claim gave rise to a potential for coverage and the broad allegations of intentionally wrongful conduct did “not automatically subsume all allegations of a negligent character.” Id. at 1114.      

 

 

As most relevant to this discussion, the Ninth Circuit stated that “[i]n determining whether an unproven claim is covered by an applicable insurance policy, we are reluctant to frame coverage based on isolated allegations in an underlying complaint.” Id. at 1112 (citingGon and the seminal California duty to defend case Gray v. Zurich Ins. Co. (1966) 65 Cal.2d 263 for the proposition that “the third party complainant, who may overstate the claims against the insured, should not be the arbiter of the policy's coverage.”) Based on this, the court applied a potentiality test to the two coverage issues raised by the insurer (intentionally wrongful conduct and restitution), ultimately holding that there remained a possibility of covered liability based on the not-necessarily-intentional conduct alleged in connection with the breach of fiduciary claim and that the relief sought was not necessarily restricted to restitution.   

 

 

Further, lest one think that the Ninth Circuit missed that it was dealing with what appears to have been a pretty standard D&O policy that did not provide for a duty to defend, the court made clear that while “Gon and Gray involved interpretations of an insurer's duty to defend potentially covered claims” and are “not directly applicable to determining an insurer's duty to indemnify loss,” the determination that the district court’s decision below that there were “no covered claims as a matter of law . . . is closely analogous to the question of whether there is a potentially covered claim.” Id. at 1112 fn.8.  

 

 

Returning to Petersen, it is difficult to reconcile the court’s apparent rejection of any form of a potentiality test with the precedent discussed above, especially Unified Western Grocers. For example, like Unified Western Grocers and unlike Pan Pacific, coverage in Petersen was determined during the pendency of the underlying litigation. Further, while it appears that the court in Petersen implicitly distinguished Olympic Club v. Those Interested Underwriters at Lloyd's London, 991 F.2d 497 (9th Cir. 1993) (an earlier Ninth Circuit decision in which the court explicitly held that potentiality is the test for non-duty to defend policies) on grounds that the policy in Olympic Club did not expressly disclaim the insurer’s duty to defend, that would not be sufficient to distinguish Unified Western Grocers as the policy there plainly had no duty to defend. The Petersen court also appears to have distinguished Olympic Club on grounds that the policy in Petersen did not provide coverage for allegations of wrongful conduct, an assertion which does not appear factually accurate, as the definition of “Act” quoted in the Petersen decision encompassed allegations of wrongful conduct.  

 

 

The court in Petersen also appears to have been swayed by the presence of allocation provisions in the policy, which seems to suggest that the court viewed potentiality and allocation as mutually exclusive, i.e., that one cannot have a potentiality standard without also requiring the insurer to fund 100% of the defense of a mixed suit. Irrespective of the rationale, the policy’s allocation provisions would not in any event appear to be an adequate basis for distinguishing United Western Grocers, as the policy at issue there also contained an allocation provision. Lastly, while Unified Western Grocers did not mention the final policy attribute cited as militating against a potentiality standard in Petersen (i.e., that the policy required the insured to consult with the insurer before incurring defense costs), it is hard to imagine that factor being significant, especially since the “power of the purse” control that language provides the insurer makes the policy more akin to a duty to defend policy, arguably making it more appropriate to apply principles developed under duty to defend policies. 

 

 

It seems worth noting that the Petersen court’s decision on the standard applicable to determining whether an insurer must advance defense costs could be considered dicta, as it is not clear from the recited facts that application of a potentiality standard would have yielded a different result. Nevertheless, whether dealt with on that basis or otherwise, I would question the suggestion that Petersen (or Jeff Tracy for that matter) represents the law in California federal courts concerning the duty to advance defense costs. 

 

 

        

            

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

 

Background

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

 

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

 

The August 17 Holding

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In a June 29, 2012 opinion (here), the Seventh Circuit, applying Illinois law, held that when the defendants in a lawsuit include both persons who are insureds under the defendant company’s D&O policy and persons are not insureds, the policy’s Insured vs. Insured exclusion does not preclude coverage for the entire lawsuit, but only the portion attributable to the claims brought by the non-insured person defendants. The extent of coverage available when the defendants include both insured persons and non-insureds is to be determined by the policy’s allocation provisions.

 

Background

The underlying claim (referred to as the “Miller action”) involves a lawsuit brought by five individuals against Strategic Capital Bancorp, Inc. (SCBI) and two of its officers. In their suit, the plaintiffs asserted claims for fraud, civil conspiracy for alleged violations of the Illinois Consumer Fraud and Deceptive Business Practices Act. Three of the plaintiffs in the Miller action are former SCBI directors and therefore qualify as “Insureds” under the SCBI D&O policy. The other two Miller action plaintiffs are not Insureds under the policy.

 

The SCBI D&O policy includes an exclusion (of a type found in most D&O policies, and usually referred to as an “Insured vs. Insured” exclusion) precluding coverage for “Loss on account of any Claim made against any Insured: …brought or maintained by or on behalf of any Insured or Company in any capacity.” The Policy also contained an allocation provision, specifying that when loss from a Claim incudes both “covered and uncovered matters” the amount “shall be allocated” between covered Loss and uncovered loss based upon the relative legal exposures of the parties to the covered and uncovered matters.”

 

SCBI submitted the Miller action as a claim under its D&O policy. The carrier denied coverage for the claim in reliance on the Insured vs. Insured exclusion. Coverage litigation ensued. The District Court ruled in favor of the carrier, holding that the “plain language” of the exclusion precludes coverage for civil proceedings “brought or maintained by any Insured.” SCBI appealed.

 

The June 29 Opinion

In an opinion written by Judge David Hamilton for a three judge panel, the Seventh Circuit affirmed in part and reversed in part the holding of the district court. The appellate court affirmed the district court to the extent the lower court had held that coverage under the policy for the claims brought by the three former directors was precluded by the Insured vs. Insured exclusion, but reversed the district court to the extent that the lower court had held that the exclusion also precluded coverage for the claims brought by the plaintiffs who were not Insureds. The Seventh Circuit, In reliance on its 1999 decision in the Level 3 Communications, Inc. v. Federal Insurance Co.  case (here)– which the Court said was “practically indistinguishable“ from this case -- held that there was coverage under the policy for the claims brought by the non-insureds, and that defense costs and any indemnity amounts would have to be allocated between covered Loss and uncovered loss using the policy’s allocation provisions.

 

In the Level 3 case, the Seventh Circuit had also addressed the question of the application of an Insured vs. Insured exclusion in a D&O policy to a claim that ultimately included both insured and noninsured claimants. Initially, the claimants in the underlying case had only consisted of non-insureds. However, six months after the underlying lawsuit had been commenced, an insured person joined as a plaintiff. The Seventh Circuit held in the Level 3 case that in that situation “the insurance contract requires allocation of covered and noncovered losses rather than barring all recovery because of the presence of an insured on the plaintiff’s side of the case.”

 

The D&O insurer in this case attempted to distinguish the Level 3 case based on two factual differences: timing and “majority rule.”   The carrier first argued that in the Level 3 case, the insured plaintiff did not join the underlying suit until six months after it was filed. The Seventh Circuit said that its ruling in Level 3 had not depended on the timing, and so rejected this attempt to distinguish the earlier case.

 

Second, the carrier argued, in reliance on what the appellate court described as a “counting noses” approach that coverage in a mixed claimant case like this should be based o n the number of insured plaintiffs or proportion of damages claimed by insured plaintiffs. The court said that this “proposed additional requirement for a majority of non-insureds claimants or dollars has no basis in the …policy language.”

 

The appellate court also noted that the carrier attempted to rely on the Eleventh Circuit’s 2005 opinion in the Sphinx International v. National Union Fire Insurance Co. case (here), which also involved a claim brought both by insured persons and noninsureds. In that case, a former director initiated a securities suit and then published a nationwide notice soliciting other shareholders to join the suit. The former director then amended his complaint to add the additional plaintiffs.  The Eleventh Circuit held that coverage was precluded for the entire suit based upon the company’s D&O policy’s Insured vs. Insured exclusion., which precluded coverage for loss arising from a Claim brought “By or at the behest of … any DIRECTOR or OFFICER … unless such claim is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of any DIRECTOR OR OFFICER of the company.” The Eleventh Circuit had held that the director plaintiff had actively solicited the other plaintiffs, and therefore the exclusion precluded coverage for the entire claim.

 

The Seventh Circuit found the Sphinx decision to be distinguishable by its fact, including in particular with regard to the policy language involved in that case. The Seventh Circuit also noted that Sphinx itself had distinguished the Level 3 case because the policy language in the earlier case was “too dissimilar” to the language at issue in Sphinx “to be decisive.”

 

Discussion

One of the reasons carriers include Insured vs. Insured exclusions in their policies is that, in addition to avoiding collusive suits, the carriers don’t want to pick up coverage for corporate infighting. Internecine battles can be vexatious and often are not susceptible to resolution on a rational business basis. Given this justification for the inclusion of an Insured vs. Insured exclusion in the policy, I can see how the carriers would take the position that if any one of the plaintiffs is an insured person, the entire claim should be excluded. The argument would be the involvement of even one insured presents too great a risk that the carrier might be dragged into corporate infighting or persona score settling.

 

There may be something to this argument; the carrier did succeed in convincing the district court that the involvement of even one insured as a plaintiff – or more specifically, the involvement here of three insured persons among the five claimants  – is sufficient to preclude coverage for the whole claim.

 

The problem with this argument – that one insured person plaintiff “taints the entire suit,” as the appellate court put it-- is that it can lead to some hard questions. As the appellate court noted, the carrier here took this “proposed rule” to “its logical limit,” arguing that it should apply and control even if there were 99 plaintiffs who were not insureds and only one insured person plaintiff. The appellate court also noted that the carrier had argued that the rule should apply even if separate complaints by an insured person plaintiff and non-insured were consolidated, even if only for pretrial proceedings. These examples from the logical limits of the insurer’s argument proved to be more than the court could accept, leading the appellate court to follow a solution based on allocation of between covered Loss and uncovered loss.

 

For carriers that nonetheless believe that Insured vs. Insured exclusion should apply even if only one of many plaintiffs is an insured person will want to consider the Seventh Circuit’s analysis of the Sphinx International opinion. The more encompassing exclusionary language at issue in that case seems likelier to preclude coverage when claimants include both insured person plaintiffs and non-insureds, particularly where the insured person plaintiff is actively involved in t he litigation.

 

For all D&O insurance practitioners the potentially different claims outcome based on the differences between the exclusionary language at issue in the Sphinx International case and the language involved here underscores the critical importance of these differences in policy wordings. In particular, those of us who are involved in representing policyholders in the insurance purchasing process will want to play close attention to the language used in the Insured vs. Insured exclusion in prospective policies, in order to determine whether it more closely resembles the language at issue in the Sphinx International case or the language involved here.

 

It is probably worth noting one particular challenge the carrier faced on appeal in the Seventh Circuit. The three judge panel that heard this case included Judge Richard Posner. Judge Posner wrote the opinion in the Level 3 case. Given that fact, it was always going to be the case that the Level 3 decision was toing to loom large here.

 

For general background regarding the Insured vs. Insured exclusion, please refer here and, here (in the bankruptcy context) and here (in failed bank litigation).

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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On May 30, 2012, Representative Barney Frank introduced a bill entitled the “Executive Compensation Clawback Full Enforcement Act” (here) that by its own terms is designed to “prohibit individuals from insurance against possible losses from having to repay illegally-received compensation or from having to repay civil penalties.” The proposed Act’s appears primarily addressed to the compensation clawback sections in the FDIC’s “orderly liquidation authority” in the Dodd-Frank Act. However, the proposed Act’s separate prohibition of insurance for “civil money penalties” appears to address the long-standing question of insurance for civil money penalties imposed on bank officials by the FDIC.

 

Title II of The Dodd-Frank Wall Street Reform and Consumer Protection Act provides for “orderly liquidation authority” for the FDIC to act as a receiver of failed “systemically important” financial institutions. Section 210(s) of the Act permits the FDIC to recover compensation from any senior executive or officer deemed to be “substantially responsible” for the failure of the financial institution. The FDIC may clawback all compensation the executive or director received during the tw0-year period preceding the FDIC’s appointment as receiver.

 

In response to these provisions, at least one industry participant introduced a new insurance product designed to provide protection against these new compensation clawback measures. The new insurance product was not only intended to provide protection for the costs of defending against a clawback action, but also “indemnification for damages sought by the FDIC “for “ earned salaries, wages, commissions, benefits, or other compensation obligations repudiated and recouped by the FDIC.

 

In public statements about this new product, a spokesman for the company that introduced it conceded that product could “possibly” provide indemnification for these clawbacks “if they're insurable under the law," adding that "the basic premise, of course, (is that) you're not going to be able to insure something that the law says is not insurable,"

 

As least as interpreted in news coverage of Rep. Frank’s introduction of the bill, the proposed Act appears to be expressly addressed to this compensation clawback insurance product. Frank himself is quoted as saying “"the creation of insurance policies to insulate financial executives from claw-backs is one more effort by some in the industry to perpetuate a lack of accountability.”

 

However, the proposed Act’s provisions reach more broadly than just the Dodd-Frank orderly liquidation authority clawback provisions. The proposed Act’s provisions also seem expressly designed to address the question of insurance for the FDIC’s imposition of “civil money penalties” against senior officials at depositary institutions.

 

The proposed Act provides in Section 2 that an officer, director, employee or “institution-affiliated party” of “a depository institution, depository holding company or nonbank financial company” who is required by law “to repay previously earned compensation or pay a civil money penalty” shall be “personally liable for the amounts so owed” and “may not , directly or indirectly insure or hedge against, or otherwise transfer the risks associated with, personal liability for the amounts so owed.”

 

The proposed Act provide further that the Section 2 is not intended to preclude a person from “being provided funds necessary to defend against a previously earned compensation recovery,” either from the company itself or “under an insurance policy.” The proposed Act also specifies that the Act is not intended to preclude a person from obtaining insurance against being held personally liable for “penalties, judgments or other amounts assessed against a depositary institution, depositary institution holding company, or nonbank financial company.” The Act is also not intended to prohibit insurance for personal liability against “unintentional outcomes associated with the ordinary exercise of trade or business judgment”

 

The question of insurability of civil money penalties is a long-standing one. As discussed in a prior guest post on this site, the FDIC has taken the position on an individual institution level basis that insurance protecting individual bank directors and officer from civil money penalties was prohibited. But while there was some discussion of and concern about these issues, the question of insurability of civil money penalties remained an uncertain issue (at least for the banks themselves, if not for the FDIC). However, if Rep. Frank’s bill becomes law, or at least of its provisions prohibiting insurance of civil money penalties becomes law, the question would obviously be resolved.

 

With respect to the Act’s provisions relating to compensation clawbacks, it is worth noting that the provisions prohibit insurance only with respect to the returned compensation. The proposed Act expressly allows insurance for defense costs. The insurance industry’s working presumptions about the FDIC’s clawback authority generally has been that the company’s traditional D&O insurance would, all else equal, provide defense cost protection, but that the traditional policy would not cover the returned compensation amounts. In other words, Rep. Frank’s proposed bill would not appear to change the insurance coverage arrangements that would likely apply in most situations. The bill seems only to change things with respect to the recently introduced new insurance products that promised provide insurance protection for the returned compensation.

 

Finally, it is probably worth noting that the proposed Act by its own terms applies only to corporate officials as depositary institutions, depositary institution holding companies and nonbank financial companies. Accordingly, the proposed bill would not seem to have any impact on the vast run of companies, one way or the other.

 

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A company’s D&O insurance policy provides liability protection for the company’s individual directors and officers, but only for their actions undertaken in their capacities as directors and officers. It does not protect them when they are acting in a personal capacity. So, when a company’s CEO signs a loan guaranty for the company, is he acting in an official or personal capacity, and will the D&O insurance policy provide protection for liability under the guaranty? Those were the questions addressed in a May 14, 2012 decision of a three-judge panel of the Court of Appeals of the State of Washington. A copy of the opinion can be found here.

 

Background

In March 2008, S-J Management LLC (SJM) obtained a $3.5 million line of credit from Commerce Bank. Michael Sauter, SJM’s CEO and manager, signed the loan agreement and promissory note in his official capacity on behalf of SJM. In addition Sauter provided Commerce Bank a guaranty, which he signed as “Michael J. Sauter” and which was secured by seven deeds of trust on real property owned by Sauter and his wife.

 

In May 2009, SJM’s line of credit matured and SJM failed to pay its indebtedness. Commerce Bank demanded that Sauter pay in full under his “personal guaranty of indebtedness” SJM’s $2.8 million obligation. Sauter in turn demanded that SJM indemnify him for the amount he was obligated to pay, to which SJM’s members (of which Sauter was one) agreed. However, SJM was financially unable to indemnify Sauter. After Commerce Bank threatened that Sauter’s failure to cure the default could result in the sale of the six real properties securing the guaranty, SJM’s counsel tendered the bank’s demand to SJM’s D&O insurer.

 

SJM’s insurer denied coverage with respect to Sauter’s obligation, and Sauter filed an action against the insurer seeking damages and a judicial declaration of coverage. The parties filed cross motions for summary judgment. The trial court denied Sauter’s motion but granted the insurer’s motion, holding that there was no coverage because no act by Sauter constituted a “Wrongful Act” under the policy and Sauter suffered no “Loss” as defined by the Policy. Sauter appealed.

 

The Appellate Court’s May 14, 2012 Opinion

In an opinion written for the three-judge panel by Judge Stephen J.  Dwyer and applying Washington law, the intermediate appellate court affirmed the trial court’s ruling. The court noted that the policy provides that an act by an “Insured Person” constitutes a “Wrongful Act” only when that person commits the act “while acting in [his or her] capacity as…such on behalf of the Insured Organization.” An “Insured Person” acts “in his capacity as ...such on behalf of the Insured Organization” when that person commits the act in his or her official capacity as a “director, officer, general partner, manager or equivalent executive” of the insured company.

 

In recognition of this language, the court said that because the policy “explicitly provides coverage for the personal liability of the corporate officer incurred for acts performed in his or her capacity as such,” the policy “does not insure against losses incurred where the officer acts in his or her personal capacity.”

 

The court said that “the fact that Sauter is an officer of SJM is not dispositive of the question presented,” which is -- in what capacity did Sauter sign the guaranty, his capacity as an officer or his personal capacity? The Court noted that “a guaranty executed by a corporate officer that secures the indebtedness of the corporation is not executed in the officers’ official capacity.” Indeed, the execution of the guaranty in an official capacity “would result in the corporation itself guaranteeing its own indebtedness, thus negating the very purpose of the guaranty.”

 

Because Sauter was acting in his personal capacity when he signed the guaranty, Sauter committed no “Wrongful Act” as defined in SJM’s D&O insurance policy, and thus the court concluded that the policy does not provide coverage for Sauter’s financial obligation to Commerce Bank.

 

The Court went on to note in addition that any purported “Loss” suffered by Sauter did not result from a “Claim” made against Sauter for a “Wrongful Act.” Rather, the court noted, “Sauter incurred the obligation to pay SJM’s indebtedness by executing the guaranty – not by failing to satisfy his obligation pursuant thereto.” In other words, the court said, “his obligation to Commerce Bank was not the result of Commerce Bank’s demand on the guaranty; instead his obligation was the result of the guaranty itself.” Accordingly, because his obligation to pay was the result of his voluntary undertaking, “it is not a ‘Loss resulting from any Claim … for a Wrongful Act.”

 

Discussion

D&O insurance policies protect individual directors and officers. But that protection does not extend to everything those individuals might do. Rather, the protection only extends to their actions undertaken in their capacities as directors and officers, not to actions undertaking in the personal capacities.

 

There principles are easy to state, but the lines of demarcation between actions undertaken in an official capacity and actions undertaken in a personal capacity may not always be clear. This case illustrates how the lines can sometimes be difficult to discern. Here, it was SJM that wanted to borrow the money, and Sauter was clearly motivated by a desire to facilitate SJM’s borrowing. What matters though is not his motivations but his actions. When he signed the loan agreement and the promissory note, he was clearly acting in his official capacity. But he separately signed a guaranty. Sauter’s guaranty was designed to obligate Sauter not the corporation, and his undertaking was clearly a separate, personal undertaken, as evidence by the fact that the guaranty was secured by deeds of trust on property owned by Sauter and his wife.

 

There is a further reason why Sauter’s guaranty should not be the responsibility of the insurance company. One cannot undertake an obligation to pay, default on that obligation, and send the bill to the insurance company. For that reason, many courts have held that as a matter of public policy repayment of a contractual obligation does not represent a Loss under a D&O insurance policy. As discussed here, many D&O policies incorporate express contractual liability exclusions.

 

Coverage disputes arising from the questions of whether or not an individual was or was not actin g in an insured capacity are occur frequently, particularly in connection with smaller or closely held corporations, when an individual’s roles may overlap or run together. It may sometimes be very difficult, for instance, in the context of a closely held company to distinguish when an individual is acting as an investor or shareholder and when the individual is acting as a director or officer.

 

Indeed, in many instances, individuals may have been acting in dual capacities or multiple capacities, which can make questions concerning coverage for related claims particularly challenging. One critical coverage issue that is sometimes overlooked in the dual capacity context is that to trigger coverage under most policies, an individual need only have been acting in an insured capacity – most policies do not require that the individual have been acting “solely” in an insured capacity. The problem then of course, if the individual is insured only to the extent he or she was acting in an insured capacity, is figuring out the extent of coverage. The fact that these kinds of disputes tend to be very fact-specific does not make them any easier to resolve.

 

Similar questions can also arise when a director or officer is also acting a director or officer of more than one entity or organization -- for example, where an individual is serving at the request of a private equity or venture capital firm on the board of a portfolio company. These concerns are among the many issues that may arise as a result of the interplay between the investment firm’s insurance and the portfolio company’s insurance, as discussed here.  

 

Many thanks to Aidan McCormick of DLA Piper for sending me a copy of the decision. DLA Piper represented the D&O insurer in this case.

 

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The negotiated resolution of securities class action lawsuits – and absent dismissal, there is rarely any other types of securities suit resolution – is always complicated and occasionally messy, and often involves inefficiencies and sometimes produces distortions and even excesses. Anyone who has ever been through a securities suit settlement negotiation likely will have had the thought that there has to be a better way for resolving the cases.

 

In an April 12, 2012 paper entitled “How Collective Settlements Camouflage the Costs of Shareholder Lawsuits” (here), Fordham Law School Professor Richard Squire catalogues the many shortcomings in the current securities class action settlement process and sets out his proposal to improve the process and to eliminate process inefficiencies and excesses. UPDATE: Please note that Professor Squire also completed a separate response to this blog post in a seprate guest post of his own. His guest post can be found here.

 

According to Squire, securities class action settlements suffer from a “collective action problem,” owing to the fact that current practices and law require a single case resolution that collectively binds the defendant and all of its D&O insurers – even though the D&O insurance itself is “segmented” in a tower of insurance with the insurers in the different layers having different settlement positions and differing perspectives and interests regarding the settlement.

 

Among other things, Squire notes that insurers in the primary layers and lower level excess layers are often compelled to contribute toward settlement when the settlement demand (or more accurately, the settlement opportunity) exceeds their layer. This compulsion, Squire notes, is often effectively given legal force through a rarely identified but nonetheless very real “duty to contribute.” These forces lead to a number of ills, including “plaintiff overcompensation at insurer expense”; overpriced liability insurance; and lawsuits of doubtful merit.

 

Identifying the requirement for collective settlements as the source of the problem, Squire proposes allowing “segmented settlements” – that is, allowing each defense-side party (and in particular each of the carriers in the D&O insurance tower) to “settle with the plaintiffs separately for its respective slice of the damages ranges.” Under this approach, trial would occur unless all slices settled and the plaintiff would collect at trial only those awarded damages (if any) that fell within the unsettled slice.

 

Squire postulates that this approach would eliminate the conflict of interest between the defense-side parties, “removing the cramdown dynamic that can lead to plaintiff overcompensation.” The elimination of this dynamic will, Squire contends, ultimately lead to more shareholder lawsuit settlements being paid by corporations rather than by insurers, an outcome Squire that further contends would “benefit shareholders, as it would improve the accuracy of a firm’s reported earnings as a measure of the contribution of that firm’s managers to overall shareholder wealth.”

 

I have set out below my thoughts about Squire’s proposal. I note at the outset that I approach commenting on academic papers with trepidation. Even though D&O insurance and D&O claims resolution are areas to which I have devoted my entire professional life, the world of academic analysis, even with respect to a topic within my area of expertise, seems unbound by constraints that operate in the world to which I am accustomed. My usual trepidation is even greater where, as here, I am already committed to commenting in person on the academic analysis in a public forum. Specifically, on May 8, 2012, I will be attending a conference at Fordham Law School at which I will be participating in panel in with my friends Tom Baker of U.Penn. Law School and Sean Fitzpatrick of Endurance Risk Solutions. The purpose of the panel is to discuss Professor Squire’s paper.

 

As a threshold matter, I will say that an important aspect of Squire’s analysis for which I give him high marks is his understanding of the central importance of D&O insurance in the securities class action settlement process. All too often, commentators under-appreciate the significance of the role that D&O insurance plays in the process. A particularly important insight Squire has with respect to the role of D&O insurance is that the different D&O insurers’ interests and positions in the settlement process differ based on where they are in the insurance tower.

 

Squire’s understanding of the role of D&O insurance is particularly accurate when he describes the “cramdown” effect – that is, the pressure that the insured company and the upper level excess carriers can bring to bear on the primary and lower level excess insurers to force the lower level insurers to throw in their limits. Squire perceptively describes what is too often unconsidered, which is the presumed “duty to contribute” that compels lower level insurers to tender their limits where there is pressure to settle a case at a number beyond their limit of liability.

 

Squire is also on target with his identification of the undesirable consequences this dynamic can produce. It can, as he notes, produce plaintiff overcompensation (which he also correctly notes, inures disproportionately to the benefit of the plaintiffs’ lawyers) and it can result in higher priced liability insurance. And the opportunity for further occasions of overcompensation undoubtedly attracts additional lawsuits.

 

Having identified these problems with the current system, the question is whether Squire’s proposed solution would in fact solve the problems in an appropriate and acceptable way, a question to which I turn below. However, having noted above the respects in which I agree with Squire’s understanding of the process and the dynamic, I must also as a preliminary matter identify the respects in which my understanding differs from Squire’s. These considerations may or may not alter the ultimate merits or demerits of Squire’s proposed solution to securities suit settlement; but to the extent these considerations might (and they well might, given that much of Squire’s analysis depends on these understandings and assumptions), it is worth my setting out here my differing understandings.

 

First and foremost, D&O insurance provides a contractual way for companies to manage their indemnification obligations, and to ensure that these indemnification obligations can be honored even if the company itself is unable to do so when the need arises. Because D&O insurance derives from the indemnification obligation, and because the company’s indemnification obligation includes both the obligation to provide for defense expense and for indemnity amounts, the D&O insurance policy has always provided coverage for both defense expense and for settlements and judgments.

 

Second, companies buy D&O insurance in a marketplace that has been “soft” for almost all of the last 25 years. During that time, dozens of new insurers have entered the marketplace, while at the same time there are many fewer public companies than there were even a short time ago. With an abundance of insurance capacity chasing a dwindling number of insurance buyers, the marketplace is heavily tilted in the favor of the buyers. Buyers expect and get very broad coverage for prices that remain advantageous for the buyer. Owing to the constraints of competition, insurers have a limited ability to impose defensive measures or to constrain coverage. The insurers’ options are two-fold: either to play ball or to sit out the game. Most decide to continue to play.

 

Third, as a result of the number of persons insured under D&O policies and the number of insurers that are involved in the typical D&O insurance tower, there are in connection with any securities class action settlement many participants, each with their own counsel. Often there are other parties (auditors, underwriters) who are named as defendants but who are strangers to the D&O policy. Not only are the insurers’ interests not aligned but often the insured persons’ interests are not aligned, and the insured persons’ interests often differ from the other named defendants. The carriers’ interests differ not only according to their attachment point in the insurance tower, but also based on situation specific factors such as how much defense expense has been expended and what the anticipated defense expense burn rate will be. The various carriers’ approach to settlement may also depend upon whether they believe they may have coverage defenses that potentially affect their payment obligations.

 

Not only are there a host of negotiating parties, there often are a host of proceedings involved, other than just the securities class action lawsuit. If a securities suit is serious enough to implicate the excess insurance, there will almost always be multiple other actions ongoing at the same time – usually a parallel derivative suit, often a pending SEC investigation or enforcement action, sometimes even a DoJ investigation or prosecution. The existence of these other proceedings can complicate the settlement dynamic in myriad ways. Serious securities class action settlement negotiations usually do not take place in a vacuum.

 

A final point about securities suits that should be emphasized is that securities class action lawsuits go to trial so rarely that the possibility of trial can safely be disregarded for most practical purposes. Everyone involved in the case knows it will never go to trial. There are very good reasons that these cases very rarely go to trial. The most important is that the theoretical damages almost always exceed the available insurance and in many cases outstrip the defendant company’s financial resources as well. A less dramatic constraint is that trials are costly, burdensome, and unpredictable and would constitute a huge distraction on senior company management. By the same token, the company could ill-afford a judicial determination that conduct that would preclude coverage has taken place. The plaintiffs have their own concerns; the expense of a complex jury trial could be enormous yet at the same time involves the risk of a defense verdict.

 

Together with these preliminary observations about D&O insurance and about the settlement process, I should also add the following observations on Professor Squire’s understandings and assumptions about D&O insurance.

 

First, Professor Squire assumes that corporate buyers consciously and deliberately structure their D&O insurance in multi-layered tiers because that creates “conflicts of interest among insurers that serve the interests of corporate managers,” as, he postulates, the conflicts “actually make insurance-covered settlements more likely.” There may be some buyers out there who are so canny that they manage their insurance buying decisions with these calculations in mind.

 

My own experience is that most insurance buyers would prefer to buy fewer, larger layers of insurance, because that would afford claims administrative simplicity, eliminate the headaches that always arise in the claims context when the insured company has to fight its way through multiple layers, and would simplify the insurance acquisition process.

 

The reason that D&O insurance programs are layered is because of the carriers’ preferences, not the buyers’ preferences. No D&O insurer could sustain the concentration of risk that would be involved with exposing outsized amounts of capital to any single large corporate exposure. Professor Squire assumes away this concern by saying that insurers could issue a single policy and simply “protect themselves from this risk through reinsurance.” However, there are a finite number reinsurers and they require a spread of risk every bit as much as the insurers do. The layering of D&O insurance is an inevitable by-product of an insurance marketplace where any given company’s insurance needs exceed the ability of any one insurer (or even one insurer and its reinsurers) to absorb all of the concentrated exposure associated with one risk.

 

Professor Squire also sees something amiss with the fact that D&O insurance policies cover both defense expenses and indemnity amounts. From my perspective, this arrangement is a natural reflection of the outgrowth of D&O insurance as a way for companies to contractually manage their indemnification obligations. In any event, the typical insurance buyer would consider it a strange notion indeed that their D&O liability insurance would not provide defense expense protection or at least that they would have to buy a defense cost policy separate from their liability policy.

 

With respect to Professor Squire’s analyses of the settlement dynamic, I note that in all of Professor Squires hypothetical settlement examples (and all of his examples are in fact hypothetical), he refers to the “expected trial liability” or “the actuarially fair settlement amount.” These are abstractions. There is no such thing in the securities context as “expected trial liability,” simply because there is effectively no data to describe such a thing. (For the same reason, talk of a party’s “bias to toward trial” or “aversion to trial” is equally inapposite.) By the same token, the idea that there is an objectively knowable amount equivalent to an “actuarially fair settlement amount’ is equally unwarranted.

 

What we actually have is a much rougher, much more approximate concept that usually is described as “what cases like this settle for.” Basically every single person in the settlement room will have their own version of this number, as well as their own concept of what features of the case make the comparables relevant. These points of reference are subjective, not objective; rarely the subject of agreement between the parties, at least at the outset; dependent on a host of assumptions; and allow for a range of possible outcomes that might constitute reasonable case resolutions depending on the myriad of factors.

 

In addition, the procedural posture of the case matters; the existence of related pending actions matter; the level of defense expenditure and the anticipated defense expense burn rate matters; the extent to which the defendants’ interests are aligned matters; whether some insurers believe they have unique coverage defenses matters; these and many other features matter and will influence the settlement dynamic and possibly affect the outcome of negotiations.

 

My point is that the settlement dynamic is complex and multifaceted. The very idea that settlement negotiations can be reduced to a mathematical formula with a few variables that explain outcomes in all cases – or even one case – is an interesting theory, as is the idea that settlement outcomes might be measured against a single, knowable measure that represents the “fair” outcome.  The idea that settlement of the class action could be taken in isolation from the myriad other factors – for example, the existence of other related pending proceedings – is an interesting hypothesis.

 

Turning to the specifics of Professor Squire’s proposal that settlements should be segmented rather than collective, I have the following observations. It is possible that the alternative settlement arrangement Professor Squire has proposed could work to produce settlements that are fairer to all participants and that could eliminate the many ills that Professor Squire has identified. I suspect his proposal would be particularly attractive to the carriers that are most routinely in the primary and first level excess layers. It would less attractive to the insurers that are most often in the upper excess layers. And it would be extremely unattractive to policyholders.

 

First, with respect to the upper level excess participants, if all defense side participants have to negotiate their own settlements, there could be an unfortunate dynamic that forces the excess to the settlement table and forces them to pony up money that they otherwise shouldn’t have to pay and wouldn’t pay now. This effect, the direct result of reducing the protection to the excess carrier from the underlying layers, would increase the loss costs of the excess insurers. This would likely make excess insurance more expensive and partially or entirely offset any savings that might be available if primary and lower level excess carrier loss costs were reduced. In other words, to eliminate the cramdown effect, the segmented settlement process would substitute a “cram-around” effect, or maybe a “cram-up” effect.

 

Second, the possibility of a settlement holdout will not be eliminated. But the process when there is a holdout will change. Let’s consider the possibilities. Assume that all of the other participants have settled except one middle layer insurer. Sure, there would be a lot of pressure on the holdout. But there would be enormous pressure on the policyholder, too. Every additional dollar of defense expense incurred will reduce the sole remaining layer, forcing the policyholder toward a possible trial with ever-dwindling amounts of defense costs protection and little or no insurance remaining for any judgments that might result. For all the reasons outlined above, the policyholder could never run this trial risk, and so could be forced to contribute to settlement to avoid the range of unpalatable outcomes. Indeed, crafty insurance players aware of this possible dynamic might become strategic obstructionists, in order to compel the policyholder to absorb settlement costs and possibly allow the obstructing insurer to negotiate a discount settlement deal.

 

My concern is that one almost inevitable outcome of the segmented settlement process that Professor Squire has proposed is that policyholders would be compelled to contribute more frequently and in much greater quantities toward settlement. To the extent I read Professor Squire’s proposal correctly, he fully anticipates this process effect. For example, he says “If the settlements were segmented, more of them would be paid for by corporations rather than by their insurers.” Indeed, as I understand his analysis, he reckons this as one of the positive factors supporting his proposal, because it would force more companies to recognize in their securities litigation loss costs in their financial statements.

 

However, if I am right about the way that this settlement dynamic would work out, the introduction of a segmented settlement process would simply substitute a different cramdown dynamic for the existing one. The new dynamic would be particularly pernicious as it would threaten to put the insurers in the position where they were jockeying to force loss costs elsewhere, including in particular onto their own insured. I am at a loss to see how this could ever be viewed as an appropriate or desirable arrangement of affairs between an insurer and a policyholder. No insurer interested in maintaining its reputation as a good corporate citizen would ever propose such a thing. No well-informed policyholder would ever propose such a thing, either.

 

Another practical concern is that requiring segmented settlements would prolong cases. Process participants jockeying for position would have every incentive to try to game the system, hoping that the eroding limits and the ongoing litigation burden will compel other participants, particularly the policyholder, to pony up to get rid of the case. Company management would be burdened and distracted by a complex multistage process that never seems to end and distracts them from the things they need to do to make their businesses successful. Litigation is bad enough as it is, but one settlement deal ends it. If multiple deals were required, it could go on and on and on… And all of these problems would be magnified enormously if there are other related procedural matters pending. 

 

My most important objection to Professor Squire’s proposal is that it is commercially impractical. He simply asserts that “segmented settlements could easily be achieved contractually.” This statement lacks a connection to the insurance marketplace. The theoretical possibility that in the long run segmented settlements might lower insurance costs or reduce the number of lawsuits will have no meaning to an insurance buyer, when compared to the very real possibility that the segmented settlement arrangement would cause the buyer to have to absorb loss costs that would otherwise be covered. No company would ever agree to do it -- nor should any company ever agree to it.

 

All of that said, there unquestionably are serious ills with the current securities suit settlement process, many of which ills Professor Squire identifies in his paper. I am not sure I know how to remedy these ills. One possibility that Professor Squire considers and rejects is the possibility of a quota share arrangement, where the various carrier participants’ interests are arranged vertically, rather than horizontally. Under this arrangement, each carrier would share ratably in each dollar of loss costs, so the carriers’ interests in trying to save loss costs would be aligned in a way that would eliminate the conflict of interest problems Professor Squire identifies.

 

The shortcoming of the quota share approach is that it would be very difficult for all of the participating insurers to cede control to a single decision maker. In the absence of a single point of control, the claims process could be reduced to chaos. But on the plus side, there are multiple places in the insurance world now where quota share arrangements already are in place and functioning successfully. There is a lot to be said for an insurance arrangement that already actually exists as a possible solution for an insurance-related problem.

 

I would like to thank Professor Squire for allowing me the opportunity to read his interesting and thought-provoking paper and for allowing me to comment about his paper here. I enjoyed reading his paper and writing this comment – it kept from going crazy on a very long plane flight. I hope that readers of this blog will review the Professor’s paper on their own and will post their thoughts and comments about his paper here using this site’s comment feature.

 

And in Other News: With a long plane flight on Saturday, I not only had the leisure to type out this long blog post, but I also had the opportunity to read the Financial Times weekend edition at length and in full. With a more thorough reading than I am usually able to enjoy, I gleaned a couple of very interesting observations from articles in the paper.

 

First, in a April 14, 2012 article entitled “Unorthodox Behavior Rattles Russian Church” (here), the article’s author notes the following about Kirill I, the patriarch of the Russian Orthodox Church: “Last week bloggers discovered that a photograph of the patriarch on the Church’s website had been altered to remove a $30,000 Bruguet watch from the churchman’s wrist. While someone had used Photoshop to erase the offending object, they had forgotten to erase the watch’s reflection on a nearby mahogany table.”

 

And in an April 14, 2012 article entitled “Who Needs the Shard When You Have Shakespeare?” (here), commenting on the latest addition to the London Skyline (now under construction), the article’s author notes that

 

The skylines of European cities have traditionally told us something about what they believe in, and they still do. Until Harold Macmillan eased restrictions on buildings exceeding the height of St. Paul’s, London’s skyline consisted of two 100m-high buildings: St. Paul’s and the Big Ben clock tower. It was easy to see what London stood for: the Church and parliamentary sovereignty and not necessarily in that order. The skyline of modern London, with its dozen or so buildings more than 100m-tall, also sends a message. It is best summed up by the London Eye, which proclaims the city less a workplace than a tourist attraction. The rest of the buildings are about money.

 

On the Road Again: This upcoming week I will be a panelist at a session in Beijing co-sponsored by the American Bar Association Torts and Insurance Practice Section and by the China Council for the Promotion of International Trade. Information about the conference, which is entitled “Doing Business in the United States: What you Need to Know about Investing, Product Liability and Dispute Resolution,” can be found here. I will be on a panel entitled “Directors and Officers Liability, Securities Issues and Class Action Exposure” with my good friend Perry Granof, as well as Patrick Zeng of Zurich China, whom I am looking forward to meeting for the first time on this trip.

 

From Beijing, I will be going on to Professional Liability Underwriting Society (PLUS) Chapter events in Hong Kong and Singapore. Perry Granof will also be joining me educational sessions at these PLUS Chapter Events, as will my old friend Joe Monteleone. To those readers who may be attending the PLUS Chapter events, I am looking forward to seeing you. If we have not met before, I hope you will please take the opportunity to introduce yourself.

 

With the distances, time differences and commitments involved, I am not sure what sort of publication schedule will be possible over the next few days. The D&O Diary’s normal publication schedule should resume the week of April 30, 2012. 

 

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The process of restructuring financially distressed companies is complicated and fraught with challenges. Among the many potentially complicating challenges that can arise is the possibility of claims against the company’s management. Because of the risks involved with these kinds of claims, it is critically important that steps are taken to insure that directors and officers are protected appropriately throughout and after the reorganization process.

 

The “best practices” for ensuring that directors and officers are protected before, during and after a reorganization are reviewed in an interesting March 14, 2012 memorandum from Shaunna Jones and Jeffrey Clancy of the Willkie Farr law firm entitled “Reorganization and D&O: Not Always Business as Usual” (here).

 

The memo contains key observations and practical advice regarding D&O insurance for companies involved in a financial reorganization. I review the memo’s key points below. However, it is important to note at the outset that the specific requirements of any particular company will be a reflection of the company’s financial circumstances; the specific reorganization process in which the company engages and how that process unfolds; and the particulars of the D&O insurance program that the company has in place at the time of its reorganization.

 

Because of these variables, there is no one single set of insurance-related steps that will apply to every financial reorganization. In order to determine the appropriate D&O insurance-related steps that any particular financially distressed company should take, the company should consult closely with its financial, legal and insurance advisors. That said, however, there are certain considerations that should be taken into account when these circumstances arise.

 

First, a company should determine whether the reorganization process has triggered the “change in control” provisions of the company’s existing D&O insurance program, and if the process has or will trigger those provisions, when the chance in control took place or will take place. This question is relevant, because the existing D&O insurance program will not provide coverage for any acts, errors or omissions that occur after the change in control.

 

The typical D&O insurance policy will provide that a change in control occurs when another person or entity acquires 50 percent or more of the voting control or power to select a majority of the board of directors of the insured company. Many policies also provide that that a change in control is triggered upon the appointment of a receiver, liquidator or trustee (although other policies do not have these trustee provisions, or the provisions are deleted by endorsement).

 

Whether and when the provisions are triggered will depend on the specific reorganization process in which the company has engaged. A Section 11 bankruptcy filing may not trigger a change in control, particularly where (as is often the case) no trustee has been appointed. The change in control in a Chapter 11 bankruptcy may not take place until the reorganization plan is implemented, on the plan’s “effective date.” The routine appointment of a trustee in a Chapter 7 bankruptcy, by contrast, potentially could trigger the change in control, depending on the applicable policy wording.

 

Regardless of the form of the reorganization and the timing of the change in control, if there is to be a “going forward” business following the reorganization, steps must be taken to protect the officers and directors of the new entity, and to ensure that the “going forward” protection dovetails with the insurance protection that is in place for the directors and officers of the former entity or operation. To make sure that all of these things are in place when and as they should be, without gaps in coverage, several steps should be taken at the before and during the reorganization process.

 

 The two critical insurance-related structures that need to be addressed are the implementation of an appropriate “run-off” for the directors and officers of the former entity and that “going forward” coverage is available for the directors and officers of the new entity (if there is to be one following the reorganization). The run-off coverage extends the period within which claims arising in connection with pre-reorganization conduct may be noticed. The “going forward” coverage is necessary to address claims involving post-reorganization conduct.

 

One question that often arises is why directors and offices need run-off coverage if the plan of reorganization involves a release of claims that could be asserted by creditors. The fact is that post-organization claims can and often do arise and they can be costly to defend, even if the directors and officers have a defense based on the release. There is also always the risk that the particular claim that arises may not be precluded by the release.

 

A practical complication that often arises is that the financial distress and/or the commencement of the restructuring process “may complicate a company’s ability to expend funds on D&O insurance.” Also, a potentially complicating factor that often arises is that the existing program may expire before the date of the change in control, which could require the company to go through a renewal transaction before the run off coverage is put in place.

 

Many companies facing a renewal date during the reorganization process will extend their existing program rather than acquiring a renewal program. This approach may be less time-consuming and may actually be more attractive to the insurer(s), who may not want to expose “fresh limits” to a financially distressed company. There may be drawbacks to an extension, particularly if the current program’s limits are “impaired” by an existing claim. The key is to ensure that the insurance protection remains in place throughout the reorganization process.

 

It may be that the payment of the premiums for the extension or renewal will require bankruptcy court approval. In some situations, it may be possible to include within a restructuring support agreement or plan support agreement a provision allowing for both the purchase of both necessary extensions or renewals of the D&O insurance and for the purchase of run-off coverage. Similarly, if the company is purchasing debtor-in-possession financing, the company should take steps to ensure that the costs associated with extensions and run-off purchases are including within the financing.

 

Provisions may be made for the post-reorganization entity to indemnify the directors and officers of the former entity. This indemnification may be structured in a variety of ways. The authors suggest that the “best practice” is to confirm the indemnity arrangements with the insurers, including adding the new entity as an insured under the run-off policy to ensure coverage for the new entity’s indemnification. The authors suggest that it should be confirmed that notwithstanding the indemnification that no retention would apply under the run-off policy and that the insured vs. insured endorsement should be modified to insure coverage for claims by the new entity against the directors and officers of the former entity. The authors acknowledge that while all of these options may be available, they should be considered and pursued.

 

Discussion

The authors’ memo is interesting and contains much sound advice. Notwithstanding the authors’ practical approach, the memo does underscore how complicated the insurance issues can be for companies going through financial reorganizations. The complications underscore how important it is for companies planning a financial reorganization to coordinate with the insurance advisors – as well as how important it is to have knowledgeable, experienced financial advice before and during a financial reorganization.

 

One particular issue the authors do not address is the way in which the “run-off” and “going forward” programs should be organized in order to allow for the possibility of a claim that “straddles” the past-acts/future acts dates of the two programs. It is important in protecting against this possibility that the “other insurance” provisions of the policies are coordinated.

 

Although the memo contains many useful observations, perhaps the most important is the authors’ emphasis on the need for these issues to be monitored and addressed before, during and after the reorganization process. Advance planning can reduce the likelihood that problems will arise, for example, in connection with payment for extensions and run-off purchases. Reassessment may be required throughout the reorganization process, particularly if the process unfolds differently than was expected at the outset (if for example, the plan changes from a reorganization to a liquidation).

 

I know that there is a lot more than can be said on these topics and that there are additional issues involved beyond those discussed above. I encourage readers to add their thoughts and comments on this topic, using this blog’s comment feature.

 

The Latest FDIC Failed Bank Lawsuit: On March 16, 2012, the FDIC filed its latest failed bank lawsuit. In its complaint (here), filed in the Northern District of Georgia in its capacity as receiver of the failed Omni Bank of Atlanta, the agency has sued ten of the bank’s former officers, seeking to recover over $24.5 million the bank allegedly sustained on over two hundred loans on loans involving low income residential properties and $12.6 million in wasteful expenditures on low income other real estate owned properties. The complaint, which can be found here, asserts claims against the defendants for negligence and for gross negligence.

 

As Scott Trubey reported in his March 16, 2012 Atlanta Journal Constitution article about the suit (here), since its failure, the bank has been the center of several criminal investigations involving both banker and borrower misconduct. Jeffrey Levine, a former bank executive vice president who was also named as a defendant in the FDIC’s lawsuit, is among those who have been hit with criminal charges.

 

The FDIC’s latest lawsuit is the seventh that the agency has filed so far involving a failed Georgia bank, the most of any state. (Georgia has also had more bank failures than any other state). The latest suit is the 27^th that the agency has filed as part of the current wave of bank failures and the ninth so far in 2012. It is interesting to note that the agency filed this suit just short of the third anniversary of the bank’s March 27, 2009 closure. As the current year progresses, the agency will be facing similar anniversaries of bank closures, which coincides with the FDIC’s three year statute of limitations for bringing suit. Since the bank closure rate hit its high water mark in 2009, we are likely to see increasing numbers of suits this year. It already seems that the pace of lawsuit filing has picked up, as I noted in a recent post. 

 

Counsel Selected for Second Circuit Appeal of Issues Surrounding the Settlement of the SEC’s Enforcement Action Against Citigroup: As I noted in a recent post, the Second Circuit has stayed the SEC’s enforcement action against Citigroup, so that the appellate court can consider whether or not Southern District of New York Judge Jed Rakoff erred in rejecting the parties settlement of the case. One of the anomalous features of the case is that in connection with the motions to stay and for interlocutory appeal, since both the SEC and Citigroup had moved for the stay and for the appeal, the adversarial position had not been represented. In its ruling staying the case and granted the motion for appeal, the Second Circuit directed the Clerk of the district court to appoint counsel so that the adverse position (that is, that Judge Rakoff had not erred in rejecting the settlement) would be represented before the merits panel.

 

The counsel to represent the adverse position has now been selected – it will be John “Rusty” Wing, of the Lankler, Siffert and Wohl law firm. As Susan Beck notes in her March 16, 2012 Am Law Litigation Daily article about the appointment (here), there are a variety of unusual aspects of this appointment. The first is that it has been well over a decade since Wing argued before the Second Circuit. The second is that Wing apparently was selected by Rakoff himsef, almost as if Wing were to be representing  Rakoff in person, rather than merely arguing in support of his ruling rejecting the settlement. Wing is in fact a former colleague of Rakoff’s when the two served in the U.S. Attorney’s office together. The selection of Wing, and more particularly the process by which he was selected, raise a number of interesting questions about who he is representing and what his role will be. For example, should Wing be consulting with Rakoff in preparing his appellate brief?

 

The selection of Wing represents just one more unexpected and unusual twist in a case that has already had more than its fair share of unexpected twists and turns. In any event, Wing will face an uphill battle given the finding of the three-judge Second Circuit that granted the stay that the SEC and Citigroup have demonstrated a “substantial likelihood” of success on the merits.

 

Alison Frankel has an interesting March 16, 2012 post about Wing’s selection on Thomson Reuters News & Insight (here).

 

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A fundamental tenet of corporate law is that a business corporation is organized and carried on for the benefit of its stockholders.  In recent times, an increasing number of for-profit organizations have formed in order to pursue social and environmental goals. There is a growing investor movement toward the financial support of organizations that have social benefit purposes at the center of their existence. However, it may be difficult for directors and officers of these organizations to pursue these social purposes without running afoul of traditional fiduciary duties requiring corporate managers to maximize shareholder value.

 

In order to address these concerns, a group of lawyers and academics have proposed a new form of enterprise, the benefit corporation. The idea behind this organizational form is to create an enterprise that can utilize the tools of business financing and management to address social and environmental issues. In order to deal with the legal issues involved with organizing a business enterprise for broader goals, the proponents of this idea have crafted Model Benefit Corporation Legislation.

 

Since 2010, the model legislation has been adopted in whole or in part in seven states, including California, New Jersey and Virginia, and is under consideration in a number of others. New York’s version  became law  on February 10, 2012. Although the model legislation’s provisions address a number of issues, the “heart” of the model benefit corporation legislation is its provisions addressing concerns related to potential director and officer liability.

 

In this post, I examine the circumstances that have led to the proposal for the development of the benefit corporation concept; the specifics of the organizational form described in the Model Benefit Corporation Legislation; and the aspects of director and officer liability addressed in the legislation. I conclude with my thoughts about the proposed organizational form, including the implications from both a liability and insurance standpoint.

 

My analysis of these issues relies heavily on the November 16, 2011 paper entitled “The Need and Rationale for the Benefit Corporation” (here).  A number of contributors participated in the creation of this document, but the paper’s principal authors are William H. Clark, Jr. of the Drinker Biddle law firm, and Larry Vranka of Canonchet Group LLC. I also refer below to the Model Benefit Corporation Legislation, which can be found here. Information about benefit corporations generally can be found at the Benefit Corporation Information Center. The January 7, 2012 article in The Economist magazine the first piqued my interest in benefit corporations can be found here.

 

Background

Two recent trends have come together to create the need for a new form of business enterprise. On the one hand, there is a growing class of investors joining the socially responsible investing movement. These investors hope to create a direct social impact through targeted equity and debt investments. (A November 2010 J.P. Morgan study on impact investing can be found here.) On the other hand, for-profit social entrepreneurs, who are interested in pursuing mission-driven businesses, are increasingly common.

 

An earlier initial response to these developments was the 2007 formation of the B Lab, a non-profit organization whose purpose was to devise and implement a certification system for companies interested in distinguishing themselves in order to try to attract the socially focused investors. B Lab promulgated a number of certification standards for these companies. The difficulty is that these standards were to be adopted within the existing legal framework.

 

A critical component of the existing legal framework is the basic principal that business corporations exist to maximize shareholder value. This principal constrains the ability of businesses, at least within the existing framework, to consider the interests of constituencies other than shareholders. To be sure, a number of states, in response to takeover battles in the 80’s, did implement so-called “constituency” statues that enable boards and senior company officials to take in account community interests when considering a takeover bid.  Unfortunately, among the states that have not adopted constituency statues is Delaware, the place of incorporation for many companies. In addition, even in the states that have adopted constituency statutes, there is a dearth of case law interpreting the statutes, and so there is very little guidance on what other interests a board may consider and to what extent. In addition, constituency statutes are often merely permissive, not mandatory.

 

Owing to the absence of clear legal standards in these areas, directors may be hesitant to consider social goals or the interests of other constituencies for fear of breaching their fiduciary duties to shareholders. The legal uncertainties and need for greater clarity have led to the proposal of a new form of business enterprise to address the needs of for-profit mission-driven businesses.

 

The Benefit Corporation

In order to address the legal concerns, reformers have proposed the benefit corporation. The three distinct aspects of the benefit corporation are that it has 1) a corporate purpose to create a material positive impact on society and the environment; 2) expanded fiduciary duties of directors that require consideration of nonfinancial interests; and 3) an obligation to report on its overall social and environmental performance as assessed against third-party standards.

 

These attributes are embodied in the Model Benefit Corporation Legislation, which has provided the basis for the benefit corporation statues that have been enacted in the seven states. (The seven states are Maryland, Hawaii, Vermont, Virginia, California, New Jersey and New York. Four other states are currently considering similar legislation.) 

 

               

Under the model legislation, the benefit corporation is required to have a purpose of “general public benefit” and allowed to identify one or more “specific public benefit” purposes. The model legislation lists seven non-exhaustive possibilities for specific public benefit goals, which include: providing products or services to low income individuals; providing economic opportunities for individuals or communities; preserving the environment; improving human health; promoting the arts or sciences; increasing the flow of capital to public benefit enterprises; or the accomplishment of any other particular benefit to society or the environment.

 

The model legislation further provides that in considering the best interests of the corporation, the directors of the corporation “shall consider the effects of any action or inaction” on the shareholders; the employees of the corporation; the customers; community or societal factors; the local and global environment; the short-term and long-term interests of the benefit corporation; and the ability of the benefit corporation to accomplish its general and specific benefit purposes.

 

In addition to providing this broad array of factors directors must consider, the model legislation provides certain protections for the benefit corporation directors (and officers). First, the model legislation provides that consideration of the interests of all stakeholders shall not constitute a violation of the general fiduciary duty standards for directors. Second, the model legislation expressly exonerate the directors and officers from monetary damages for any action taken in compliance with the preexisting standards for director duties; and for the failure of the benefit corporation to pursue or create its stated general or specific public benefit. These provisions are intended to eliminate directors’ concerns that they could face damages liability for the enterprise’s failure to fulfill its purposes or for considering the interest of constituencies other than shareholders.

 

The model legislation does provide for a form of injunctive relief action, to require the benefit corporation to live up to its commitments. Under these provisions, shareholders have the right to bring a legal action in the form of a “benefit enforcement proceeding” on the grounds that a director or officer has failed to pursue the stated general or specific purpose or failed to consider the interest of the various stakeholders identified in the statute. However, only shareholders or directors can bring a benefits enforcement proceeding; beneficiaries of the corporation’s public purpose have no right of action. The exclusion of any right of action by third parties protects the benefit corporation from unknown, expanded liability that might create disincentives to becoming a benefit corporation

 

Discussion

The purpose of the benefit corporation is to provide an appropriate enterprise vehicle for for-profit mission-driven businesses. Among the objectives in structuring the benefit corporation form is the need to address critical issues regarding the duties and potential liabilities of directors and officers. The key objectives of the model legislation are to ensure that directors and officers of the benefit corporation do not incur liability for considering the interests of constituencies other than shareholders and to ensure that the directors and officers do not incur monetary liability for allegedly failing to fulfill the organization’s general or specific benefit purposes.

 

It is important to note that although the model legislation provides that the directors and officers cannot be held liable for damages under the benefit corporation provisions, the benefit corporation provisions do not exempt the directors and officers from liability for violating general standards of fiduciary care. The exemption from monetary damages in the model legislation provide only that directors is “not personally liable for monetary damages for (1) any action taken as a director if the directors performed the duties of office in compliance [existing statutory provisions specifying the duties of directors generally]; or (2) failure of the benefit corporation to pursue or create general public benefit or specific public benefit.” Parallel provisions provide similar protections for officers. 

 

The point is that the exemption from monetary damages under the benefit corporation provisions does not exempt the directors and offices from claims for damages for violation of their general fiduciary duties. By the same token, however, the model legislation specifies that the directors and officers of the benefit corporation cannot be held liable for considering the interests of constituencies other than shareholders.

 

The model legislation does provide for a “benefits enforcement action,” for shareholders to pursue injunctive relief if the organization is not pursuing its benefits objectives or providing required reporting. Even though this action does not allow for damages, it does create a context within which defense costs could be incurred.

 

In other words, not withstanding the liability protections in the model legislation, directors and officers of a benefit corporation continue to face the possible liability exposures and defense expense exposures.

 

As a for-profit venture organized to pursue a public good, a benefit corporation does not really fit within the usual D&O insurance framework, which divides the world between non-profit and commercial enterprises. In addition, the benefit corporation regime has unique aspects that could have insurance implications, such as the possibility of a benefit enforcement action.

 

In just over two years, seven states have enacted legislative provisions allowing for benefit corporations. Implementing legislation is under consideration in several more states. It seems likely that adoption of benefit corporation legislation will become more generalized in the months and years ahead. It also seems likely that as the benefit corporation form become more widespread that insurers will be called upon to address the insurance needs of this new type of enterprise. The unique features of these organizations raises the possibility that new insurance solutions, targeted to the unique needs of these kinds of companies, will be required.

 

In any event, benefit corporations represent an interesting innovation on the corporate enterprise landscape. If, as seems likely, more states adopt benefit corporation enabling legislation, the issues involved in addressing these companies’ insurance requirements will become an increasingly common concern.

 

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On March 7, 2012, Towers Watson released the report of its 2011 Directors and Officers Liability Survey. This report, which summarizes the results of the firm’s annual survey, reflects the survey respondents’ D&O insurance arrangements and purchasing patterns. The annual Towers Watson report is much-anticipated for its insights into the practices of corporate insurance buyers, and this year’s report does not disappoint. The 2011 report can be found here.

 

The Survey Pool

As with the results of any survey, it is very important in connection with this survey report to understand the characteristics of the survey participants. In particular, it is very important to understand that the pool of respondents to the 2011 survey is heavily weighted toward very large companies. Excluding nonprofits and charities, the average annual revenues of the survey participants was $4.254 billion. The average asset size (excluding nonprofits and charities) was over $5 billion. The average market capitalization of the public company participants was $5.3 billion. Only 19 of the public company participants had market caps under $1 billion. Even the private company respondents were very large; about half of the private company respondents had assets over $1 billion.

 

The respondents were also concentrated in certain industries. Over half of the respondents were concentrated in just four industries: financial service/insurance; manufacturing; energy and utilities; and financial services excluding insurance. The pool of respondents including only small percentages of respondents from other industries, including communications; natural resources; transportation; and healthcare/pharmaceuticals.

 

The Survey Results

Over half of the survey respondents reported that the premium charged for their primary D&O insurance policy had declined at the last renewal. However, this result diverged between the public company and private company respondents. Among public companies, 62% reported a decline in the premium for their primary D&O insurance policy, but only 35% of private company respondents reported a decline. In addition, a slightly higher percentage of private company respondents saw a premium increase (18%) compared to public companies (14%). The report states that these data can be interpreted to suggest “a potential hardening in the private/nonprofit segment with insurers looking to drive rates.”

 

The survey’s information regarding limits purchasing patterns is very highly reflective of the respondent pool’s composition of very large companies. Thus, excluding charities and nonprofits, the average total limits purchased among all survey respondents is $98 million. Even among private company respondents, the average total limits purchased was $36.3 million. The average total limit for public company respondents was $126.8 million. However, among public companies with market caps under $250 million, the average total limits purchased was $25.7 million and the median was $15 million. Among private companies with assets under $250 million, the average limits purchased was $8.3 million and the median was $5.5 million. A quarter of public companies reported that they had increased their limits at the most recent renewal, compared to 14% of private and nonprofit organizations.  

 

Over three quarters (77%) of respondents reported that, in addition to primary D&O insurance, they purchased excess insurance from at least one additional insurer. 57% of all respondents purchased excess Side A or Side/DIC insurance. However, 78% of public company respondents reported that they purchased Side A or Side A/DIC insurance. Consistent with the heavy representation in the respondent pool of very large companies, the average Side A and Side A/DIC limits purchased among public company respondents was $54.6 million, and the median was $30 million. These average and median figures were much lower for smaller public companies; for example, for public companies with market caps under $250 million, the average was $13 million and the median was $10 million.

 

Though the majority of respondents said that the most important consideration in purchasing D&O insurance was the scope of coverage for the directors, only a very small percentage of respondents reported that the purchased independent director liability insurance. For example, only 7% of public company respondents reported that they purchased IDL insurance.

 

Excluding charities and nonprofits, 56% of respondents, and 68% of public company respondents, reported that they have international operations. Of the public companies with international operations, 39% reported that they purchased local D&O insurance policies in foreign jurisdictions, while 17% of private companies reported that they have international units that purchase local policies. These figures undoubtedly reflect the predominance in the respondent pool of larger organizations, as the survey itself showed that the larger the company, the more likely it was to purchase local policies. The report itself notes with respect to the local policy purchasing patterns that the “results continue to demonstrate the strides organizations have made in understanding the complexities and exposures when conduction business outside the United States.”

 

66% of the survey respondents reported having had a D&O claim in the past then years. The larger companies were more susceptible to claim activity, with the largest companies reporting the highest levels of claim activity. About two-thirds of respondents who had claims reported that they were satisfied with their insurers’ handling of the claim, but nearly 20% of the respondents reported that they were dissatisfied with how the insurers handled the claims. (This 20% figure is consistent with same level of dissatisfaction reported in the 2010 survey.)

 

Discussion

The Towers Watson survey report is a very valuable resource for the D&O insurance industry and for D&O insurance buyers. The survey report provides valuable insight into limits purchasing patterns, program structure and program design. All of us in the industry should be grateful that Towers Watson has undertaken the survey and made its report publicly available.

 

Anyone using or relying on the survey data, however, should take into account the fact that the pool of survey respondents was weighted toward very large companies, even among the private company respondents. Because a number of the survey results directly reflect that presence of a significant number of larger companies among the respondents, some results may be less relevant for smaller companies. In addition, as noted above, the survey pool was heavily weighted towards companies in certain industries. This should be taken into account in connection with companies from industries that were not as well represented in the respondent pool.

 

The survey’s results with respect to Side A purchasing patterns and with respect to the inclusion of local policies among companies with international operations are interesting. These results show the extent to which these program structures are becoming pervasive, at least among larger public companies. 

 

The survey’s results regarding the survey respondents’ claim experience represents something of a mixed review for the industry. On the one hand, about two thirds of respondents were generally satisfied with the way their insurers handled their claims. On the other hand, fully one out of five of respondents was dissatisfied, and this level of reported dissatisfaction was consistent in both the 2010 and the 2011 survey reports. This level of reported dissatisfaction suggests that there may be significant opportunities for the D&O insurance industry to deliver claims services in more customer focused way.

 

One final note about the survey. Everyone in the industry benefits from this survey and the survey report is a resource that is available to everyone. I hope that the industry will keep this in mind in future years and in particular make sure that the survey itself is distributed as broadly as possible so that the survey results are as fully representative as possible. Everyone can do their part to make the survey results even more meaningful in the future.

 

Very special thank to the survey report’s principal author, Larry Racioppo of Towers Watson, for providing me with a copy of the report.

 

The Latest FDIC Failed Bank Lawsuit: On March 2, 2012, the FDIC filed its latest failed bank lawsuit, against certain former directors and officers of the failed Freedom Bank of Georgia, of Commerce Georgia. The FDIC’s complaint, which was filed in the Northern District of Georgia, can be found here. In its lawsuit, the FDIC seeks to recover over $11 million dollars it alleges was caused by the twelve individual defendants’ negligence and gross negligence.

 

With this lawsuit, the FDIC has now filed 24 lawsuits in connection with the current wave of bank failures, including six so far in 2012. Of the 24 lawsuits overall, six have involved failed Georgia banks. Like many of these cases, this latest suit was filed just short of the expiration of the three-year statute of limitations. (The March 2 filing date came shorty before the third anniversary of the bank’s March 6, 2009 closure.) Because so many banks failed during 2009, it may be expected as the current year progresses we will be seeing an increasing number of lawsuits involving the class of 2009.

 

Scott Trubey’s March 6, 2012 Atlanta Journal Constitution article about the Freedom Bank case can be found here.

 

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One of the perennial D&O insurance issues is the question of coverage for investigative costs. Several recent cases have taken a close look at these recurring issues.  In the following guest post, my good friend Kara Altenbaumer-Price (pictured) examines recent developments in this area and the important factors that can affect the analysis. Kara is the Director of Complex Claims & Consulting for insurance broker USI.  

 

Many thanks to Kara 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.

 

 

The potentially high cost of internal investigations has increased demand for insurance coverage. This article explores how investigation costs may, at least in part, not be covered by traditional directors and officers (D&O) policies, and options that may provide greater protection.

 

 

Traditional D&O insurance policies afford some level of investigations coverage.  As with any insurance arrangement, however, the parties must carefully assess whether the risk being covered is the same risk that they seek to have covered.  Thus, while companies may believe they have purchased so-called “investigations coverage,” these policies are often seriously lacking in comparison to the number, size, complexity, and cost of modern investigations.  These limitations can be so consequential that the insured’s expectations for the policy will not be substantially met.  This article addresses a number of the gaps between common expectations and commonly available policies and suggests how companies and individuals can more accurately locate the extent of coverage that they desire.

 

 

Before discussing some of the pertinent aspects of investigation insurance products, we turn to a   2010 U.S. federal court ruling that illustrates some of the issues and potentially costly gaps in investigations coverage that can arise for any company, public or private. The case addressed a not atypical sequence of investigation-related events that gave rise to significant costs for a public company. Office Depot found itself the subject of an inquiry by the U.S. Securities and Exchange Commission (SEC) related to potential violations of Regulation FD (Fair Disclosure). This regulation requires that public companies release the same information — at the same time — to the public as they do to investors and securities professionals. Office Depot chose to cooperate with the SEC by voluntarily providing requested documents and making its officers and employees available for sworn testimony without the issuance of subpoenas. About the same time, an internal whistleblower raised issues related to Office Depot’s accounting. The Company self-reported the allegations to the SEC, which expanded its investigation. Office Depot’s audit committee also began an internal investigation, which led to a financial restatement

 

 

The SEC later issued a Formal Order of Investigation against the Company, which included “allegations of wrongful conduct generally attributable to [Office Depot’s] officers and directors” but did not identify any individuals by name. The Formal Order led to subpoenas issued to the Company and a group of its current and former officers and directors, some of whom had previously voluntarily testified in the informal investigation. Two years later, the SEC reached a settlement with the Company and issued Wells Notices informing several Company officers of charges the SEC planned to bring against them.

 

 

Over the course of the SEC and internal investigations, Office Depot incurred costs of over U.S. $20 million and turned to its D&O carriers for reimbursement. The primary carrier acknowledged coverage for approximately U.S. $1 million in costs incurred by officers and directors in responding to SEC subpoenas and Wells notices and costs incurred in several related shareholder securities lawsuits, but denied coverage for the Company’s voluntary response to the SEC or the internal investigation. The company then sued its primary insurance carrier; the excess carrier intervened into the suit. The issue in the litigation was whether the costs of voluntarily responding to the SEC and conducting an internal investigation related to the same issues were covered by the policy. The court held that “the disputed investigatory costs do not fall within the … policy’s definition of loss ‘arising from’ a covered ‘Securities Claim’ made against [Office Depot], or a covered ‘Claim’ made against one of its officers, directors or employees.

 

 

First, the court held that the informal SEC investigation and the company’s internal investigation did not meet the policy’s definition of “securities claim.” Specifically, the policy language exempted an “administrative or regulatory proceeding against or investigation of” the Company unless “such proceeding is also commenced and continuously maintained against an Insured Person.” The court determined that the use of the term “proceeding” and the absence of the term “investigation” in the carve-back language for proceedings involving both the Company and insured individuals meant that coverage did not include investigations, whether formal or informal. Second, the court held that while the policy did provide coverage for investigations of insured individuals, it did not provide such coverage unless the individuals were “‘identified in writing’ by the investigating authority as a person against whom a civil, criminal, administrative or regulatory proceeding ‘may be commenced’ or in case of an investigation by the SEC … after service of a subpoena upon such Insured Person.” The court agreed with the carriers’ assertion that “[b]ecause the SEC informal and formal investigations began well before either one of these discrete signal points, …the investigations do not fall within the Policy’s definition of a ‘Claim.’” It did not matter that three individuals ultimately received Wells Notices. Third, the Company had argued that “relation back” language in the policy served to pull pre-claim costs into coverage. The language at issue was a common provision in the policy providing that when an insured notifies the carrier of facts that could later give rise to a claim and a claim does indeed later arise, the claim relates back to time of the original “notice of circumstances.” The court held that the relation back language in the notice of circumstances portion of the policy related only to determining when the claim was made for determining the applicable policy period for a “claims made” policy. Office Depot had a substantial retention — or deductible — on its primary D&O policy, effectively resulting in no loss transfer in this case.

 

 

The implications for D&O insurance coverage related to investigations are significant. In order to ensure the maximum coverage possible for costs associated with investigations, several portions of a policy must be addressed. In considering these changes, it is also important to remember that D&O insurance policies are not off-the-shelf products. Instead, they differ widely from carrier to carrier and insured to insured and can — and should — be tailored to meet a given company’s needs.

 

 

Definition of claim

 

Generally, a D&O policy does not provide coverage until a “Claim” has been made against a company. More importantly, costs incurred before a formal “Claim” has occurred under the policy do not apply toward a company’s self-insured retention, nor do they get retroactively picked up later by the policy. What constitutes a claim is a defined term under each D&O policy and almost universally includes lawsuits, written demands for monetary relief, and administrative proceedings in court or before an administrative body. Policies differ widely, however, in how they cover — or not — government investigations. Many provide coverage upon the receipt of a subpoena, a Wells Notice, or a target letter. As was discussed above, however, these triggers imply a formal investigation and can occur very far into an investigation.

 

 

Indeed, significant legal costs can be spent in trying to prevent an informal investigation from becoming formal, and policy language varies widely in how it covers — or doesn’t cover — these costs. This can be avoided by ensuring that the definition of “Claim” in your policy incorporates government investigations and, if possible, informal investigations. In 2010, at least one major insurance company released a new D&O policy form that provided for coverage of informal investigations of insured individuals by updating its public company D&O form to include coverage for certain “preclaim” inquiries. The policy defines “pre-claim inquiry” as a “verifiable request for an Insured Person … to appear at a meeting or interview or produce documents that, in either case, concerns the business of that Organization or that Insured Person’s insured capacities.” The request must come from a government enforcement body, or the entity or its board must request that individual to appear in relation to an inquiry into or investigation of the entity by an enforcement body. Interestingly, the policy goes on to define “pre-claim inquiry costs” independently of “defense costs” so as to exclude the costs of responding to document requests if the documents are in the control of the company, meaning that coverage for document production is only provided if those documents are in the control of an individual insured, which very few documents will be. By specifically including coverage for the costs associated with attending a request for an interview by an enforcement body, the policy seems to be focused only on the costs of lawyers’ preparation time. The policy, in its unendorsed form, excludes coverage for all   investigations — formal or informal — of the company unless those investigations are also maintained against insured persons.

 

 

A number of other carriers responded to this insurer’s new policy. For example, one released an endorsement that provides coverage for individuals incurred in responding to “a request by an Enforcement Unit for an Insured Person to appear for an interview or meeting with respect to the Insured Capacity of such Insured Person or an Organization’s business activities.” Like the policy discussed earlier, this insurer’s endorsement also includes scenarios in which the company requests that an insured individual appear for an interview or meeting in relation to a government inquiry. The endorsement specifically excludes coverage for costs associated with a “document production demand or discovery request.” This exclusion is notable since the cost of producing potentially millions of pages of documents in a large investigation can be substantial.

 

 

Co-defendant language

 

A number of D&O policies that provide investigations coverage either restrict coverage to insured individuals or require individuals to be co-defendants before a company’s costs in defending itself could be covered. The trigger in these policies is usually when an insured individual is named in a Wells Notice or target letter or, in some cases, when an insured individual receives a subpoena. In addition to the late coverage trigger discussed above, this language presents an additional problem in that it does not match up with the reality of how investigations are pursued. It is rare for a government investigation to name an individual up front. Instead, if anyone is named in the early stages, it is the entity itself. Even when it is clear to the entity’s lawyers and forensic accountants that one or more individuals are the targets of an investigation, the D&O policy is not triggered unless the individuals are named.

 

 

Because individuals do not have the same incentive to cooperate that entities do, individuals are often named only as an investigation is nearing its end. As a result, if such language is included, as is demonstrated by the Office Depot case above, little to no coverage may be afforded even if “investigations coverage” was purchased.

 

 

Definition of loss

 

Presuming that a policy does provide investigations coverage, a policy will still only cover those costs that are defined as “loss” under the policy. Loss will almost universally be defined to include costs associated with defending any Claim under the policy. While “defense costs” is often undefined, some policies do explicitly define it. In order to ensure broad investigations coverage, it is important to consider all the costs of defending an investigation, not just legal fees. Significant fees can be spent on forensic accountants, document production vendors, and other specialists in responding to the often very in-depth investigations of a government regulator. It is important to consider all of these costs when defining “loss” and “defense costs” under a D&O policy and, where possible, explicitly define the costs to include non-lawyer defense costs.

 

 

Conduct exclusions and adjudication language

 

D&O policies typically contain certain conduct exclusions that prohibit coverage in cases of certain intentional conduct, such as fraud, criminal conduct, or intentional violations of the law. Mere allegations of such conduct, however, do not prevent coverage. Instead, each policy should contain language that defines when these conduct exclusions are triggered. For example, policies may state that a guilty plea triggers the conduct exclusion, while others may state that a determination by a court that the conduct occurred triggers the exclusion.

 

 

In the context of investigations coverage, the broadest trigger is “final adjudication in the underlying action,” meaning that the conduct exclusion will not be triggered until a court

involved in the enforcement action at issue makes a final adjudication of wrongdoing. This prevents a carrier from bringing a declaratory coverage action in another court in order to cut off defense costs. Also, because the vast majority of government investigations are settled without court involvement or are filed in a court simultaneously with an agreed settlement, in many cases the conduct exclusions will never be triggered. Two changes in SEC enforcement methods may have particular impact on these conduct exclusions.

 

 

First, the SEC is considering releasing more detailed findings of its investigations. Currently, when an investigation is settled, often only a brief release is issued stating the statutory violations and a bare bones recitation of the factual allegations. Releasing more detailed factual findings could lead to coverage issues as additional facts are laid out that could implicate conduct exclusions. Second, changes made in 2010 to the SEC’s Enforcement Manual designed to spur cooperation provide leniency — or in some cases, immunity — to individuals who provide valuable evidence to the SEC. It is likely that more individuals will “confess” to the SEC in order to obtain these benefits. This could create coverage issues in policies containing certain conduct exclusions. Additionally, 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 legal representation rises, also causing an increase in defense costs.

 

 

Civil fines and penalties coverage

 

Historically, the insurance market has considered civil fines and penalties to be uninsurable for public policy reasons. Recently, however, the demand for investigations coverage and increased competition among D&O carriers has led some carriers to offer civil fines and penalties coverage. While it is still unclear when and how much these policies will pay out in the event of claims, it is important to understand that such coverage is now available.

 

 

When evaluating such coverage, however, companies should read the policy terms very closely to understand exactly what is being offered for the price. Endorsements may appear to be broad, but may be limited by the statutes under which coverage is provided. For example, a number of carriers are now offering coverage for a certain amount of civil fines and penalties assessed under the U.S. Foreign Corrupt Practices Act (FCPA).

 

 

However, the language of a given endorsement, when read closely, may reveal that it provides coverage only to insured individuals and only for civil penalties assessed by the U.S. Department of Justice (DOJ). Another important consideration in fines and penalties  coverage is the actual language of the FCPA and similar statutes, as well as the reality of settlements and whether such insurance could be tapped at all under the terms of a government settlement. The statute states that whenever a civil fine or penalty “is imposed … upon any officer, director, employee, agent, or stockholder of an issuer, such fine may not be paid, directly or indirectly, by such issuer.” Also, it is now standard language in SEC settlement documents that individuals stipulate that their companies will not pay their fines, including any payments from insurance proceeds. Arguably, this issue may be solved by assigning a portion of the D&O premium to the fines and penalties coverage and requiring that premium amount to be paid by individual officers and directors.

 

 

Separate investigations policies

 

In addition to updating its public company D&O form, a major insurer has also released a new stand-alone policy designed to cover investigation costs. The policy addresses one of the primary issues present in expanding investigations coverage — the eroding of insurance limits for use by officers and directors when the company’s investigations costs are transferred to insurance. The policy provides up to $25 million in coverage for investigations by the SEC, DOJ, and similar authorities into violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 or any of the acts’ associated rules and regulations. It covers both formal and informal government investigations and can be endorsed to provide up to $5 million coverage for investigations related to violations of the FCPA. In addition to investigation costs, the policy also covers insurable settlements other than disgorgement, fines, penalties, or remediation costs. A separate policy gives companies the option to look only to an investigations policy for coverage and choose not to seek coverage under their D&O policies, even if some coverage is provided.

 

 

A major insurance broker also announced the creation of a policy that covers legal, accounting, auditing and consulting costs associated with FCPA investigations. Although the insurance carrier underwriting the FCPA Corporate Response form was not publicly named, the form is designed to cover both FCPA and UK Bribery Act investigation costs incurred by both insured individuals and the company. Although it is not clear from the literature released on the policy, it appears to cover informal investigation costs, at least to some degree. Similar policy releases from other insurance carriers are likely as corporate demand increases.

 

 

When considering the options for transferring a portion of the risk associated with investigations to insurance, companies must consider the broader implications of this decision as well. When an insurance policy is expanded to cover investigation costs, that may, in practice, offer better protection for the company than to individual officers and directors. This can arise if most or all of the policy’s coverage is consumed by the company. This can leave little or no money for insured individuals to defend themselves in the investigation or in any follow-on civil litigation from shareholders. When assessing whether to purchase investigations coverage, companies may also consider whether overall limits should be increased, or whether additional limits should be set aside for insured individuals only under the “Side A” portion of the D&O policy reserved for losses incurred by individuals that the company cannot indemnify due to insolvency or law, to ensure adequate limits remain available.

 

 

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

 

Background

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

 

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

 

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

 

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

 

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

 

The February 15 Ruling

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

 

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

 

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

 

Discussion

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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Of all the questions surrounding liability insurance, the one issue that seemingly ought to be most obvious is the amount of insurance potentially available to respond to claims. Indeed, the question of the amount of insurance potentially available for a single claim usually is relatively straightforward and usually is answered by reference to the limit of liability identified on the face of the policy. When multiple claims arise, however, things become more complicated, particularly if multiple claims arise during separate policy periods.

 

In our litigious society, it is not uncommon for a given set of circumstances to trigger multiple complaints. A liability insurance policy will typically provide that if claims are related, they are treated as a single claim and that the claims made date for the claim is the date on which the first complaint was filed. Fair enough, you may say. The hard question is -- what is it that makes claims “related”? The question of whether or not two claims are related can matter deeply, because if two claims made in two different policy periods are unrelated, then two limits of liability (or two separate towers of insurance) are triggered; but if they are related, then only a single limit (or tower of insurance) applies.

 

“Relatedness” is not self-defining. It is, in fact, a concept that recedes away from you the harder you try to think about it. At a certain level of generalization, everything in the universe is related, all joined together in the all-powerful and all- knowing mind of almighty God. Yet from another perspective, nothing is related, as all of creation consists of nothing more than chaotic, swirling bits of matter randomly spinning away within the cosmic void.

 

And even if we are more practical and less theoretical, what is the type of relationship that determines relatedness – is it temporal or spatial relationship? Is it causal or logical relationship? Must events involve the same actors acting with the same purpose and intent and using the same methodology for the events to be related – and if the actors, purposes and methodology don’t have to be identical, how much may they vary without eliminating the link of relationship between different events?

 

D&O insurance policies attempt to retrieve these issues from the outer realms of philosophy. Typically the policy will define the term “Related Claims” as “all Claims for Wrongful Acts based upon, arising from, or in consequence of the same or related facts, circumstances, situations, transactions or events or the same or related series of facts, circumstances, situations, transactions or events.” Unfortunately, these words do not eliminate the fundamental definitional predicament, because the meaning of the defined phrase –“related”-- depends on a determination of what makes given facts or circumstances “the same or related.” (This is what I meant when I said that the more you try to think about these issues, the more they recede away from you.)

 

The problems these kinds of questions present are playing a prominent role in some very high-profile cases arising out of the global financial crisis. To pick just two examples about which I have previously written on this blog, the collapse of both Lehman brothers and Indy Mac bank not only triggered a wave of claims, but also have generated a fierce debate whether the onslaught of claims, filed as they were over a period of months, has in each case triggered only one tower of insurance or two. As discussed here, in the case of Lehman Brothers, the question is whether the claims trigger only a single $250 million tower of insurance, or two. In the case of IndyMac, as discussed here, the question is whether the claims trigger only a single $80 million tower of insurance, or two. (The possibility that IndyMac’s second tower of insurance might be drawn into the claims was discussed in open court at a recent discovery proceeding in one of the IndyMac cases, as I noted here.) Obviously in these cases as in many others, the outcome of “relatedness” question will make an enormous difference for everyone involved.

 

One of the many vexing aspects of these relatedness issues is that the various parties are not always interested in the same kind of analytic outcome in every situation. Although the insured persons (and claimants, to be sure) in the Lehman Brothers and IndyMac cases clearly are interested in a finding that the various claims are unrelated, a finding of unrelatedness is not always in the policyholders’ interests. For example, policyholders may want to find that claims are related if the question is not how many limits of insurance apply, but rather is how many policy retentions apply.

 

Most D&O policies will typically provide with respect to the retentions something along the lines of “a single Retention amount shall apply to Loss arising from all Claims alleging the same Wrongful Act or related Wrongful Acts.” Under this language, a finding that multiple smaller claims are unrelated could leave the policyholder responsible for multiple policy retentions and render much of the loss deriving from the various claims as uninsured.

 

As should be apparent, these issues arise frequently, and over t he years, many courts addressed the “relatedness” question. However, anyone expecting to find clarity from the various cases will be disappointed. Taken collectively, the cases illustrate nothing so much as how elusive these issues can be.

 

The courts addressing the “relatedness” question typically will frame the inquiry as one designed to determine whether or not there is a sufficient “nexus” between events or transactions to treat them as a single claim. The parties in the case interested in a determination that the events or transactions represent a single claim will typically argue that the events or transactions involve “ a single course of conduct” or a “continuing series of events” The parties arguing in favor of a finding that the events or transactions represent multiple claims will argue that the events or transactions involve “discrete acts” or “disparate actors” and the presence of events separated by time, geography, methodology, purpose and outcome.

 

Many of the published case decisions in this area arose out of the insurance coverage litigation that followed in the wake of the S&L crisis. In those cases, policyholders (or more typically, the FDIC) argued that each of the various allegedly negligently made loans represented a separate act of negligence and therefore a separate claim. The insurers argued that because all of the loans were made by the same group of loan officers applying the same aggressive lending approach, the loans were interrelated and the allegations of negligence therefore constituted only a single claim. The FDIC had some success making these arguments in at least some cases. Yet in other cases, seemingly no different, these arguments were unsuccessful, particularly where the question was whether multiple loans made across multiple policy periods triggered multiple limits of liability.

 

As a result of these and many other judicial decisions, there are a multitude of cases for either side to cite in any relatedness dispute today. Indeed, in their 2009 article entitled “Interrelated Acts, Unrelated Case Law” (here), Robert Chesler and Syrion Anthony Jack of the Lowenstein Sandler law firm comment that “unfortunately for both insurers and policyholders, the case law regarding these issues is hopelessly irreconcilable.” The unpredictability of the issue “stems in part from the fact-intensive analysis that most courts apply in attempting to resolve such disputes.”

 

I do not mean to suggest there are never times when the obvious outcome is clear. For example, if there are two complaints, one a securities class action suit and the other a shareholders derivative suit, and each based on the same, say, options backdating allegations, those two complaints are related. If however, one complaint alleges options backdating and the other alleges, say, the failure of a development stage product to clear a regulatory threshold, then those two complaints probably are unrelated. It is the realm between these two points of relative clarity where the problems emerge.

 

My perception is that courts generally approach the analysis of these issues with an unconscious bias in favor of whatever outcome will maximize the amount of insurance available. Insurers can overcome these biases, and it clearly matters to them that they do, since limits and retentions are instrumental in determining premiums and ultimately in determining profitability. In the end, the outcome of any particular “relatedness” dispute is going to depend on the facts presented, the policy language involved, the case law applicable in any given jurisdiction – and the predilections of the decision maker.

 

With all of these variables in play, outcomes can be unpredictable. Yet the outcomes can and often do make an enormous difference in the amount of insurance available to respond to the claims presented.

 

I suspect that many readers will have reactions to my views here, perhaps even strong reactions. I hope that readers with views on this topic will take the time to share their views with others by posting their thoughts on this site using the Comment feature.

 

More About M&A Litigation: Regular readers know that I have written extensively of late about the rising tide of litigation related to mergers and acquisitions. All too often this litigation fails to produce anything except fees for the lawyers involved. The expensive pointlessness of so much of this litigation is well detailed in a February 16, 2012 Bloomberg article entitled “Merger Lawsuits Often Mean No Cash for Investors” (here). The problems associated with this kind of litigation are increasingly a matter of increased awareness and heightened scrutiny.

 

More About the Developments in the Netherlands: In a recent post (here), I wrote about the recent decision of a Dutch court authorizing the use of the Dutch collective-settlement statute to settle disputes on a classwide, opt-out basis. The significance of this development is discussed in a good, brief February 18, 2012 post on the Harvard Law School Forum on Corporate Governance and Financial Regulation (here). The article concludes that:

 

The Court’s decision illustrates that the Dutch Act provides a viable class action settlement mechanism for complex multi-jurisdictional securities class actions. In particular, if the claims asserted face significant obstacles under U.S. law, the Dutch Act should be considered as a potential strategic alternative to resolve the dispute globally in conjunction with a United States settlement. Further, where a U.S. court will not hear investor claims because the shares of the company allegedly involved in wrongdoing were listed and purchased on a European-based stock exchange, the company should be aware that it (with European and American investors) can seek to resolve those claims on a classwide basis in a European forum.

 

A Bad Karma Reverse Hat Trick: In Sunday's 5th Round FA Cup fixture between Liverpool and Brighton at Anfield (Liverpool's home pitch), Brighton scored four goals and Liverpool scored only three, yet Liverpool won, 6-1 -- because Brighton scored three "own goals," the first time that has happened in FA cup competition. Two of the three own goals were put in the net by Brighton's unfortunate defender, Liam Bridcutt. And you thought you were having a tough day at the office.

 

 

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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 p